1

PART TWO: SUPPLY AND DEMAND

I:
HOW MARKETS WORK

THE MARKET FORCES OF

SUPPLY AND DEMAND
Chapter 4
 2

Markets
• The terms supply and demand refer to the behavior
of people as they interact with one another in
markets
• A market is a group of buyers and sellers of a
particular good or service
– Buyers determine demand
– Sellers determine supply
• Some markets are formally organised with a
building, etc. such as the Stock Market,
Commodities Market, etc.
• Most markets are not formally organised but they
exist because buyers and sellers know them
• People know where to go to buy a car, bread, etc.
 3

A Competitive Market
• A competitive market is a market
– with many buyers and sellers
– that is not controlled by any one person
– in which a narrow range of prices are
established that buyers and sellers act upon
• The number of buyers and sellers are an important
part of the definition of competition
• The second element is that a buyer or seller cannot
influence prices by his own actions alone
• When these two characteristics exist the market is
called competitive
 4

Types of markets
• Economic theory distinguishes among four different
types of markets
• Perfect Competition
– Competitive market where products are the same
• Monopoly
– One seller, and seller controls price
• Oligopoly
– Few sellers
– Not always aggressive competition
• Monopolistic Competition
– Many sellers
– Differentiated products
 5

The Concept of Demand

• We begin our analysis of demand by examining the
behaviour of buyers in the market for a good or
service
• Quantity demanded is the amount of a good that
buyers are willing and able to purchase
• Quantitiy demanded will vary with the price of the
good in question
• The demand schedule is a table that shows the
relationship between the price of the good and the
quantity demanded
• The demand curve is the downward-sloping line
relating price to quantity demanded
• Market demand is the sum of individual demands
 6

Demand for Ice Cream

Price of
Ice-Cream
Cone
Price Quantity $3.00

$0.00 12 2.50

0.50 10
2.00
1.00 8
1.50 6 1.50

2.00 4 1.00

2.50 2 0.50
3.00 0
0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of
Ice-Cream Cones
 7

Law of Demand
Price of
Ice-Cream
Cone
$3.00
• The law of
2.50
demand states that
there is an inverse 2.00
relationship
1.50
between price and
quantity 1.00
demanded.
0.50

0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of
Ice-Cream Cones
 8

Determinants of Demand
• What are the factors that determine how much of a
product is bought in the market for that product?
• In the previous slides we looked at the demand for
ice cream
• What determines how much ice cream will be
bought?
– Market price of ice cream
– Consumer income
– Prices of related goods
– Tastes
– Expectations
– Number of consumers
 9

Demand function
• We can present the determinants of demand by the
symbols of a function
Q = F ( P , Y , Pn , Pe , a )
• It is called the demand function
– P = price of the good or service
– Y = income
– Pn = prices of other goods and services
– Pe = expectations about the change in price
– a = fashion and tastes of consumers
 10

Demand function
• What is the meaning of the demand function
Q = F ( P , Y , Pn , Pe , a)
• We we look at the relation between price and
quantity demanded while we keep other factors as
constant
• In other words, P is the only independent variable,
the others are kept constant
• Changes in income, other prices, price expectations
and tastes will cause a shift in the demand curve
• Whereas changes in price only affect quantities
• Change in prices changes the quantity demanded by
not the demand function
 11

Changes in income: normal and

inferior goods
• Changes in income cause a shift in the demand
curve
• Usually the direction of the shift is upward
• In other words, higher income means more demand
for most goods at all prices
• These are called normal goods
• However, for some goods, an increase in income
may actually result in less demand or a downward
shift in the demand curve
• These are called inferior goods
• They are consumed by the very poor
 12

Effect of an increase in income:

normal good
Price of
Ice-Cream
• As income Cones
Increase
increases the in demand
demand for a
normal good
will increase.
Demand
Demand curve, D 2
curve, D 1

0 Quantity of
Ice-Cream Cones
 13

Effect of an increase in income

inferior good
Price of
Ice-Cream
• As income Cones

increases the
demand for
an inferior
Decrease
good will in demand
decrease. Demand
curve, D 1
Demand curve, D 3
0 Quantity of
Ice-Cream Cones
 14

Prices of Related Goods

• The effects of changes in the prices of related goods
depend on the characteristics of the goods
• Two goods are called substitutes if they represent
similar goods for the consumer: beans or chick peas
are close substitutes
• A fall in the price of a substitute will reduce demand
for a good (demand curve shifts down)
• Two goods are called complements when consuming
one entails consuming the other: a car and tyres
• A fall in the price of a complement will increase
demand for a good (demand curve shifts up)
 15

Ceteris Paribus
• Attention to one aspect of the analysis so far
• We change one constant at a time while we keep the
others constant
• For example, when we look at the effect of a change
in income we keep the prices of related products
plus tastes plus price expectations unchanged
• Economic theory uses a short-cut to express this
method
• Ceteris paribus is a Latin phrase that means that all
variables other than the ones being studied are
assumed to be constant
 16

Change in Quantity Demanded

versus Change in Demand
• The distinction between change in demand and
change in quantity demanded is vital to understand
the analysis of demand
• Change in Quantity Demanded
– Movement along the demand curve.
– Caused by a change in the price of the product
• Change in Demand
– A shift in the demand curve, either to the left or
right
– Caused by a change in a determinant other than
the price (income, tastes, etc)
 17

Change in Quantity Demanded

versus Change in Demand
Variables that
Affect Quantity Demanded A Change in This Variable . . .
Price Represents a movement along
the demand curve
Income Shifts the demand curve
Prices of related goods Shifts the demand curve
Tastes Shifts the demand curve
Expectations Shifts the demand curve
Number of buyers Shifts the demand curve
 18

Changes in Quantity Demanded

Price of
Cigarettes,
per Pack A tax that raises the price of
cigarettes results in a movement
along the demand curve.
$4.00

2.00

D1

0 12 20 Number of Cigarettes
Smoked per Day
 19

Changes in Quantity Demanded

Price of
Cigarettes,
per Pack A tax that raises the price of
cigarettes results in a movement
C along the demand curve.
$4.00

A
2.00

D1

0 12 20 Number of Cigarettes
Smoked per Day
 20

Change in Demand

Price of
Cigarettes,
per Pack
A policy to discourage
smoking shifts the
demand curve to the left.

B A
$2.00

D2 D1

0 10 20 Number of Cigarettes
Smoked per Day
 21

The Concept of Supply

• Goods and services are supplied to the market by
producers who are also sellers
• Supply looks at the behaviour of the producers
• Quantity supplied is the amount of a good or
service that sellers are willing and able to sell
• What determines the quantitiy supplied?
– Market price of the good or service
– Input prices (of those used in its production)
– Technology (with which it was produced)
– Expectations about the future level of prices
– Number of producers of the good or service
 22

Law of Supply
• The law of supply states that there is a direct
(positive) relationship between price and the
quantity supplied
• At higher prices there will be higher quantities of the
good or service supplied
• The supply schedule is a table that shows the
relationship between the price of the good or service
and the quantity supplied
• The supply curve is the upward-sloping line relating
price to quantity supplied
• Market supply curve is the sum of the supply curves
of the individual producers
 23

Supply Curve
Price of
Ice-Cream
Cone

Price Quantity $3.00

$0.00 0 2.50
0.50 0
1.00 1 2.00

1.50 2 1.50

2.00 3 1.00
2.50 4
3.00 5 0.50

0 1 2 3 4 5 6 Quantity of
Ice-Cream Cones
 24

Change in Quantity Supplied

versus Change in Supply
• As in the demand, attention must be paid to the
difference between changes in the supply and
changes in the quantity supplied
• Change in Quantity Supplied
– Movement along the supply curve
– Caused by a change in the market price of the
product
• Change in Supply
– A shift in the supply curve, either to the left or
right
– Caused by a change in a determinant other than
price (input prices, technology, expectations, etc)
 25

Change in Quantity Supplied

versus Change in Supply
Variables that
Affect Quantity Supplied A Change in This Variable . . .
Price Represents a movement along
the supply curve
Input prices Shifts the supply curve
Technology Shifts the supply curve
Expectations Shifts the supply curve
Number of sellers Shifts the supply curve
 26

Increase in Supply
Price of
Ice-Cream
Cone Supply
curve, S1
Supply
curve, S2

Increase
in supply

0 Quantity of
Ice-Cream Cones
 27

Decrease in Supply
Price of
Ice-Cream Supply curve, S3
Cone Supply
curve, S1

Decrease
in supply

0 Quantity of
Ice-Cream Cones
 28

Supply and demand together

• Market works by the interaction of supply and
demand
• Now we can see how the two come together
• Market equilibrium corresponds to a price where
quantitiy demanded and supplied is equal
• Equilibrium Price
– The price that balances supply and demand. On a
graph, it is the price at which the supply and
demand curves intersect
• Equilibrium Quantity
– The quantity that balances supply and demand.
On a graph it is the quantity at which the supply
and demand curves intersect
 29

Equilibrium of Supply and

Demand
Price of
Ice-Cream
Cone

Supply

$2.00

Demand

0 1 2 3 4 5 6 7 8 9 10 11 12 13 Quantity of
Ice-Cream Cones
 30

Equilibrium of Supply and

Price of
Demand
Ice-Cream
Cone

Supply

Equilibrium price Equilibrium

$2.00

Demand

Equilibrium
quantity

0 1 2 3 4 5 6 7 8 9 10 11 12 13 Quantity of
Ice-Cream Cones
 31

Markets Not in Equilibrium

• To understand the meaning of market equilibrium
we can look at a market not in equilibrium
• Outside of equilibrium there will be either unsold
products or unsatisfied customer demand
• Excess Supply
– Price is above equilibrium price
– Producers are unable to sell all they want at the
going price
• Excess Demand
– Price is below equilibrium price
– Consumers are unable to buy all they want at the
going price
 32

Excess Supply

Price of
Ice-Cream
Cone
Excess
supply Supply
$2.50
2.00

Demand

0 4 7 10 Quantity of
Quantity Quantity Ice-Cream Cones
demanded supplied
 33

Excess Demand

Price of
Ice-Cream
Cone

Supply

$2.00
1.50
Excess
demand Demand

0 4 7 10 Quantity of
Quantity Quantity Ice-Cream Cones
supplied demanded
 34

Changes in Equilibrium
• For market equilibrium to change one or more of the
determinants of demand or supply must have
changes
• When faced with an event or policy that affects the
market
• First, we must try to understand whether the event
shifts the supply or demand curve (or both)
• Then we search for the direction of the shift(s) in the
curve(s): upward or downward
• Only then can we determine the impact of the event
or policy on the equilibrium price and quantities
• And also the direction of the change
 How an increase in demand
affects market equilibrium
(a) Price Rises, Quantity Rises
Price of
Ice-Cream 1. Hot weather increases
Cone the demand for ice cream...

Supply

$2.50 New equilibrium

2.00
2. ...resulting
in a higher Initial
price... equilibrium
D2

D1

0 7 10 Quantity of
3. ...and a higher Ice-Cream Cones
quantity sold.
 36

How a Decrease in Supply

Affects the Equilibrium
(b) Price Rises, Quantity Falls
Price of
1. An earthquake reduces
Ice-Cream
the supply of ice cream...
Cone S2
S1

New
$2.50 equilibrium

2.00 Initial equilibrium

2. ...resulting
in a higher
price...
Demand

0 1 2 3 4 7 8 9 10 11 12 13 Quantity of
3. ...and a lower Ice-Cream Cones
quantity sold.
 37

Conclusion
• Trade happens in markets of different types, some
competitive other not
• Market economies harness the forces of supply and
demand
• Demand comes from the consumers
• Quantity demanded of a good depends on its price,
on income, on the prices of related goods, on
expectation, on tastes and fashion
• When we analyse demand, only the price is allowed
to change while the other factors are kept constant
(ceteris paribus)
• Quantity demanded is a decreasing function of price
 38

Conclusion
• Changes in the other factors cause upward or
downward shifts in the demand curve
• Supply comes from producers or sellers
• Quantity supplied is a function of the price, of input
prices, of technology, etc.
• Higher prices increase quantity supplied
• Supply and demand together determine the prices of
the economy’s goods and services as well as the
quantities produced
• Market equilibrium changes when supply or demand
(or both) shifts
• Prices are the signals that guide the allocation of
resources in the market economy