Download a. supply and demand

A. SUPPLY AND DEMAND
This chapter outlines the basic concept of supply and demand model. Also, analyses how
equilibrium prices and quantity are influenced by the variety of forces that affects
market: namely, consumer tastes, input prices substitute goods, innovations etc.
Market and Key assumptions of Supply and Demand
The specific product being bought and sold at a particular location and a particular point
in time is defined as market.
Key assumptions
• Single market is focused;
• All goods in the market are identical;
• All the goods sold in the market sell for the same price, everyone has same
information;
• Many producers and consumers in the market.
Demand
Combined amount of a good that all consumers are willing to buy is known as demand.
Factors influencing demand
• Price: less price, more demand and vice-versa;
• Number of consumer: all else equal, more consumers result in more demand
for a good;
• Consumer income: more income will lead to buying of more goods. However,
luxury goods are bought less even if there is more income;
• Consumer taste: favorable taste will attract consumers to buy more goods;
• Price of other goods: when price of substitute good (goods that can be used in
place of other) falls, consumer buys more of it and less of initial good. When price
of compliment good (good that is purchased and used in combination with another
good) falls, consumers will buy more of it and also the initial good.
Demand curve
Relationship between the quantity of a good that consumers demand and goods price,
holding all the other factors constant. Price of a good and its quantity is inversely
proportional, i.e. higher price will lead to lower quantity.
Shift in demand curves
When a good’s non-price factors change, there is a change in demand. This leads to shift
in the demand curve entirely. Nonetheless, when the good’s price changes holding other
factors constant, there is a change in quantity demanded. This results in movement
along the demand curve.
Supply
Combined amount of a good that all producers in a market are willing to sell is called
Supply.
Factors influencing supply
• Price: higher price means more supply of a good;
• Cost of production: lower cost implies more supply;
• Number of sellers: more suppliers will have more goods to supply;
• Seller’s outside option: substitute and compliment goods can be used for
changing the quantity of supply.
Supply curve
The relationship between the quantities supplied of a good and the good’s price, holding
all the other factors constant. Supply curve is an upward sloping and the price is directly
proportional to the quantity supplied.
Shifts in supply curve
When a good’s non-price factors change, it leads to shift in the supply curve called
change in supply. However, a change in the price of a good supplied, there is a
movement along the curve, also known as change in quantity supplied.
Market Equilibrium
It means a point at which the quantity demanded exactly equals the quantity supplied by
producers.
Qs=Qd
Market towards Equilibrium
Excess supply: amount by which quantity supplied exceeds quantity demanded when
market price is higher than equilibrium, it’s called Surplus. Higher price, more quantity.
Excess Demand: amount by which quantity demanded exceeds quantity supplied when
market price is lower than equilibrium price, also known as shortage. Lower price, less
quantity.
Figure 1 shows these two, in the left graph the price is too high, however, in the right
graph, the price is too low.
Figure 1: Excess supply and excess demand.
Table 1: Effects of Supply and Demand shifts.
Curve that
shifts
Direction of shift
Out (increase in demand)
Demand curve
Supply curve
In (decrease in demand)
Out (increase in supply)
In (decrease in supply)
price
quantity
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Size of the price and quantity changes depend on whether the demand and supply curves
are flatter or steeper:
• Demand curve shift with a flatter supply curve: a shift in the demand curve
to right will result in a small increase in the equilibrium price and a large increase
in the equilibrium quantity;
• Demand curve shift with a steeper supply curve: a shift in the demand curve
to the right will result in a large increase in the equilibrium price and a small
increase in the equilibrium quantity;
• Supply curve shift with a flatter demand curve: a shift in the supply curve to
the right will lead to a small decrease in the equilibrium price and a large increase
in equilibrium quantity;
• Supply curve shift with a steeper demand curve: a shift in the supply curve
to the right implies a large decrease in the equilibrium price and a small increase
in the equilibrium quantity.
When both the curves shift at the same time, we will know with certainty about the
direction change of either the equilibrium price or quantity, but never both.
Elasticity
Ratio of the percentage change in one value to the percentage change in another refers
to as elasticity. Slope and elasticity are certainly related but not the same. Using slopes
of the curve to measure the price responsiveness is incorrect.
𝑃𝑟𝑖𝑐𝑒𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦𝑜𝑓𝑑𝑒𝑚𝑎𝑛𝑑 =
𝑃𝑟𝑖𝑐𝑒𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦𝑜𝑓𝑠𝑢𝑝𝑝𝑙𝑦 =
%𝑐ℎ𝑎𝑛𝑔𝑒𝑖𝑛𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
%𝑐ℎ𝑎𝑛𝑔𝑒𝑖𝑛𝑝𝑟𝑖𝑐𝑒
%𝑐ℎ𝑎𝑛𝑔𝑒𝑖𝑛𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑
%𝑐ℎ𝑎𝑛𝑔𝑒𝑖𝑛𝑝𝑟𝑖𝑐𝑒
When demand curve is price sensitive, small change in price will have a large change in
quantity demanded. Change in demand in negatively related to price, i.e. positive change
in price will result in negative change in demand. When it is easy for consumers to switch
between products, they will be more price sensitive. Thus, it means, price elasticity of
demand will be relatively large.
• Elastic: price elasticity with an absolute value > 1;
• Inelastic: price elasticity with an absolute value < 1;
• Unit Elastic: price elasticity with an absolute value = 1;
• Perfectly Inelastic: price elasticity =0. This means, changes in price have no
effects on quantity demanded or supplied;
• Perfectly elastic: price elasticity = infinity. This means that, a small change in
price could lead to infinite change in quantity demanded or supplied.
Unlike the demand curve, a supply curve will never intersect the horizontal axis. There is
a relationship between the expenditures of a consumer and the price elasticity of
demand.
Total expenditure = total revenue = P x Q
Expenditure rises with increase in price if the demand is inelastic and decline with prices
if the demand is elastic. Besides, price elasticity, there is also an income elasticity of
demand. This is the ratio between percentage change in quantity demanded and 1%
change in consumer income.