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Theory of Demand and Supply - -Subhalakshmi Paul Ghosh Chandidas Mahavidyalaya, - Dept. of Economics - B.A. 1st year (Pass)) Topic Discuss Under Demand • • • • • • What is Demand? Function of Demand Law of Demand Causes of negatively sloped demand curve Exceptions of law of demand Difference between individual & market demand curve • Difference between change in demand & change in quantity demanded. What is Demand? • Quantity demanded is the amount of a good that buyers are willing and able to purchase • Demand is a full description of how the quantity demanded changes as the price of the good changes. • Definition: “A schedule of the quantities of a good that buyers are willing and able to purchase at each possible price during a period of time, ceteris paribus. [all other things held constant]” • Demand can also be perceived as a schedule of the maximum prices buyers are willing and able to pay for each unit of a good. Functions of Demand Is the functional relationship between the price of the good and the quantity of that good purchased in a given time period [UT], income, other prices and preferences being held constant. • A change in the price of the good under consideration will change the “quantity demanded.” Q = f (P, M, Py, preferences ) where: M = income , Py = prices of related goods • DP causes a change in X [DQ], this is a “change in quantity demanded”. Law of Demand “provided all other factors … are unchanged” • That’s an important phrase in the wording of the Law of Demand • The quantity demanded of a consumer good such as ice cream depends on – – – – – – The price of ice cream The prices of related goods Consumers’ incomes Consumers’ tastes Consumers’ expectations about future prices and incomes Number of buyers, etc • The Law of Demand says that the quantity demanded of a good is inversely related to its price, provided all other factors are unchanged Demand Schedule and Demand Curve Price of Ice-Cream Cone $3.00 2.50 1. A decrease in price ... 2.00 1.50 1.00 0.50 6 7 8 9 10 11 12 Quantity of Ice-Cream Cones 2. ... increases quantity of cones demanded. 0 1 2 3 4 5 SUPPLY AND DEMAND 6 Copyright © 2004 South-Western Causes of Negatively sloped Demand Curve The Law of Demand—Explanations • There are two ways to explain the Law of Demand – Substitution effect – Income effect – Marginal Rates of Diminishing Return SUPPLY AND DEMAND 7 Substitution Effect • When the price of a good decreases, consumers substitute that good instead of other competing (substitute) goods 1. When the price of Coke decreases… Clothes Coke 2. Consumption of Pepsi decreases… Books Movies SUPPLY AND DEMAND 3. Consumption of Coke increases Pepsi 8 Income Effect • A decrease in the price of a commodity is essentially equivalent to an increase in consumers’ income SUPPLY AND DEMAND 9 Lower Prices = Higher Income Situation A Price of an Apple $1.00 Price of an Orange $2.00 Income $10.00 If prices fall, Situation A becomes Situation C. If income rises, Situation A becomes Situation B. Situation B Price of an Apple $1.00 Price of an Orange $2.00 Income $20.00 Situation C Price of an Apple $0.50 Price of an Orange $1.00 Income $10.00 SUPPLY AND DEMAND Q: Which change is better? A: They are both equally desirable. A fall in prices is equivalent to an increase in income. 10 Income Effect • Consumers respond to a decrease in the price of a commodity as they would to an increase in income • They increase their consumption of a wide range of goods, including the good that had a price decrease 1. When the price of Coke decreases… Clothes Coke 2. Consumers feel richer… Books Movies SUPPLY AND DEMAND 3. Consumption of Coke and other goods increases Pepsi 11 Exception of Law of Demand • • • • • Giffen Goods Veblem Effects Price Expectation Snob Effects Bandwagon Effects For all of the above cases demand curve is positively sloped rather than the negative.. Market Demand is the Sum of Individual Demands SUPPLY AND DEMAND 13 Shifts Versus Movements Along the Demand Curve • Any change that varies the quantity that buyers wish to buy at a given price shifts the demand curve • Changes in price that varies the quantity that buyers wish to buy is represented as a movement along the demand curve • To summarize: Demand curve shows what happens to the quantity demanded of a good when its price varies, holding constant all other determinants of quantity demanded. When one of these determinants changes, the demand curve shifts. Why Might Demand Increase? Quantity Demanded Price Situation A 0.00 0.50 1.00 1.50 2.00 2.50 3.00 12 10 8 6 4 2 0 Situation B 20 16 12 8 6 4 2 • How can we explain the difference in Catherine’s behavior in situations A and B? • Why does she consume more in situation B at every possible price? SUPPLY AND DEMAND Price 15 Quantity Demanded Shifts in the Market Demand Curve • … are caused by changes in: – Consumer income – Prices of related goods – Tastes – Expectations, say, about future prices and prospects – Number of buyers SUPPLY AND DEMAND 16 Shifts in the Demand Curve Price of Ice-Cream Cone Increase in demand Decrease in demand Demand curve, D 3 0 SUPPLY AND DEMAND Demand curve, D 1 Demand curve, D 2 Quantity of Ice-Cream Cones 17 Shifts in the Demand Curve • Consumer Income – As income increases the demand for a normal good will increase – As income increases the demand for an inferior good will decrease • Prices of Related Goods – When a fall in the price of one good reduces the demand for another good, the two goods are called substitutes – When a fall in the price of one good increases the demand for another good, the two goods are called complements SUPPLY AND DEMAND 18 Topic Discuss Under Demand • • • • What is Supply? Function of Supply Law of Supply Difference between individual & market demand curve • Shifts of the Supply Curve SUPPLY • Quantity supplied is the amount of a good that sellers are willing and able to sell • Supply is a full description of how the quantity supplied of a commodity responds to changes in its price SUPPLY AND DEMAND 20 Law of Supply • The law of supply states that, the quantity supplied of a good rises when the price of the good rises, as long as all other factors that affect suppliers’ decisions are unchanged SUPPLY AND DEMAND 21 supply schedule and supply curve Price of Ice-Cream Cones $3.00 Price of Ice-cream cone Quantity of Cones supplied 2.50 $0.00 0.50 1.00 1.50 2.00 2.50 3.00 0 cones 0 1 2 3 4 5 2.00 1.50 1.00 Supply curve 1. An increase in price . . . 2. . . . increases quantity of cones supplied. 0.50 0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of Ice-Cream Cones 22 Market supply and individual supplies Price of ice-cream cone Ben $0.00 0.50 1.00 1.50 2.00 2.50 3.00 0 0 1 2 3 4 5 Jerry + 0 0 0 2 4 6 8 Market = 0 0 1 4 7 10 13 23 Market supply and individual supplies Price of Ice Cream Cones $3.00 Ben’s supply + SBen Price of Ice Cream Cones $3.00 Jerry’s supply = Price of Ice Cream Cones SJerry $3.00 2.50 2.50 2.50 2.00 2.00 2.00 1.50 1.50 1.50 1.00 1.00 1.00 0.50 0.50 0.50 0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of Ice-Cream Cones 0 1 2 3 4 5 6 7 Quantity of Ice-Cream Cones 0 Market supply SMarket 2 4 6 8 10 12 14 16 18 Quantity of Ice-Cream Cones 24 Shifts in the Supply Curve: What causes them? Price of Ice-Cream Cone Supply curve, S 3 Decrease in supply Supply curve, S 1 Supply curve, S 2 Increase in supply 0 SUPPLY AND DEMAND Quantity of Ice-Cream Cones 25 EQUILIBRIUM Interaction of demand and supply • We have seen what demand and supply are • We have seen why demand and supply may shift • Now it is time to say something about how buyers and sellers collectively determine the market outcome • To do this, we assume equilibrium SUPPLY AND DEMAND 27 Equilibrium • We assume that the price will automatically reach a level at which the quantity demanded equals the quantity supplied SUPPLY AND DEMAND 28 Supply and demand together Demand Schedule Supply Schedule At $2.00, the quantity demanded is equal to the quantity supplied! SUPPLY AND DEMAND 29 Equilibrium of supply and demand Price of Ice-Cream Cones $3.00 2.50 2.00 Supply Equilibrium price Equilibrium 1.50 1.00 0.50 0 Equilibrium quantity Demand 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of Ice-Cream Cones 30 Equilibrium • Can we justify the assumption of equilibrium? 31 Markets Not in Equilibrium (a) Excess Supply Price of Ice-Cream Cone Supply Surplus $2.50 2.00 Demand 0 4 Quantity demanded 7 10 Quantity supplied SUPPLY AND DEMAND Quantity of Ice-Cream Cones 32 Markets Not in Equilibrium • Surplus – When price exceeds equilibrium price, then quantity supplied is greater than quantity demanded • There is excess supply or a surplus • Suppliers will lower the price to increase sales, thereby moving toward equilibrium SUPPLY AND DEMAND 33 Markets Not in Equilibrium (b) Excess Demand Price of Ice-Cream Cone Supply $2.00 1.50 Shortage Demand 0 4 Quantity supplied 7 10 Quantity demanded SUPPLY AND DEMAND Quantity of Ice-Cream Cones 34 Markets Not in Equilibrium • Shortage – When price is less than equilibrium price, then quantity demanded exceeds the quantity supplied • There is excess demand or a shortage • Suppliers will raise the price due to too many buyers chasing too few goods, thereby moving toward equilibrium SUPPLY AND DEMAND 35 Equilibrium • Law of supply and demand – The price of any good adjusts to bring the quantity supplied and the quantity demanded for that good into balance SUPPLY AND DEMAND 36 Unemployment: a failure of equilibrium when the wage is too high and stuck Wage Labor surplus (unemployment) Labor Supply Too-high wage Labor demand 0 Quantity demanded Quantity supplied SUPPLY AND DEMAND Quantity of Labor 37 Let’s make some predictions • We can use our understanding of the factors that shift the demand and supply curves to predict the consequences of – Alternative policy proposals, and – Events outside our control SUPPLY AND DEMAND 38 Analyzing Changes in Equilibrium: Application 1. Change in demand- shifts in the demand curve 2. Change in supply- shifts in the supply curve 3. Changes in both supply and demandChange in equilibrium quantity and price A simple application How an Increase in Demand Affects the Equilibrium Price of Ice-Cream Cone 1. Hot weather increases the demand for ice cream . . . Supply New equilibrium $2.50 2.00 2. . . . resulting in a higher price . . . Initial equilibrium D D 0 7 10 3. . . . and a higher SUPPLY AND DEMAND quantity sold. Quantity of Ice-Cream Cones 40 How a Decrease in Supply Affects the Equilibrium Price of Ice-Cream Cone S2 1. An increase in the price of sugar reduces the supply of ice cream. . . S1 New equilibrium $2.50 Initial equilibrium 2.00 2. . . . resulting in a higher price of ice cream . . . Demand 0 4 7 3. . . . and a lower SUPPLY AND DEMAND quantity sold. Quantity of Ice-Cream Cones 41 A Shift in Both Supply and Demand Event Effect on Price Effect on Quantity Demand increases Up Up Supply decreases Up Down SUPPLY AND DEMAND 42 A Shift in Both Supply and Demand SUPPLY AND DEMAND 43 Analyzing Changes in Equilibrium: Summary DEMAND/ SUPPLY No change in demand No change in Supply Increase in supply Decrease in supply Increase in demand P same Q same P up Q up P up Q down P up Q ambiguous Decrease in demand P down Q down P down Q up P ambiguous Q up P down Q ambiguous P ambiguous Q down