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SUPPLY AND DEMAND I: HOW MARKETS WORK
The Market Forces of
Supply and Demand
Copyright © 2011 Cengage Learning
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Brief Outline of Today’s Lecture
• What is a market?
• Types of markets
• From perfectly competitive to monopoly
• Perfectly competitive markets
• Definition, demand, supply, equilibrium, changes in
equilibrium
• Prices as signals guiding economic decisions.
• Smith’s invisible hand.
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Supply and Demand
• Supply and demand are the two words that
economists use most often.
• Supply and demand are the forces that make
market economies work.
• Modern microeconomics is about supply,
demand, and market equilibrium.
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MARKETS AND COMPETITION
• A market is a group of buyers and sellers of a
particular good or service.
• The terms supply and demand refer to the
behaviour of people . . . as they interact with
one another in markets.
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MARKETS AND COMPETITION
• Buyers determine demand.
• Sellers determine supply.
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Competition: Perfect and Otherwise
• Perfect Competition
• Products are the same
• Numerous buyers and sellers so that each has no
influence over price
• Buyers and Sellers are price takers
• A competitive market is a market in which there
are many buyers and sellers so that each has a
negligible impact on the market price.
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Competition: Perfect and Otherwise
• Monopoly
• One seller, and seller controls price
• Oligopoly
• Few sellers
• Not always aggressive competition
• Monopolistic Competition
• Many sellers
• Slightly differentiated products
• Each seller may set price for its own product
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DEMAND
• Quantity demanded is the amount of a good that
buyers are willing and able to purchase.
• Law of Demand
• The law of demand is the claim that, other things
equal, the quantity demanded of a good falls when
the price of the good rises.
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The Demand Curve: The Relationship
between Price and Quantity Demanded
• Demand Schedule
• The demand schedule is a table that shows the
relationship between the price of the good and the
quantity demanded.
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Sabine’s Demand Schedule
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The Demand Curve: The Relationship
between Price and Quantity Demanded
• Demand Curve
• The demand curve is a graph of the relationship
between the price of a good and the quantity
demanded.
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Figure 1 Sabine’s Demand Schedule and Demand Curve
Copyright©2011 South-Western
Market Demand versus Individual Demand
• Market demand refers to the sum of all
individual demands for a particular good or
service.
• Individual demand: how?
• Preferences → utility functions → optimal choice
• Graphically, individual demand curves are
summed horizontally to obtain the market
demand curve.
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Figure 2 Market Demand as the Sum of Individual
Demands
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Cengage
Cengage
Learning
Learning
Change in Quantity Demanded
• Movement along the demand curve.
• Caused by a change in the price of the product.
• For instance through the introduction of a tax.
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Changes in Quantity Demanded
Price of IceCream
Cones
B
€2.00
A tax that raises the
price of ice-cream
cones results in a
movement along the
demand curve.
A
€1.00
D
0
4
8
Quantity of Ice-Cream Cones
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Shifts in the Demand Curve
• A shift in the demand curve, either to the left or
right.
• Caused by any change (other than price) that
alters the quantity demanded at every price.
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Figure 3 Shifts in the Demand Curve
Price of
Ice-Cream
Cones
Increase
in demand
Decrease
in demand
Demand
curve, D2
Demand
curve, D1
Demand curve, D3
0
Quantity of
Ice-Cream Cones
Copyright©2011 South-Western
Shifts in the Demand Curve …
… are caused by changes in:
•
•
•
•
•
Consumer income
Prices of related goods
Tastes
Expectations (e.g., future income, future prices)
Number of buyers
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Shifts in the Demand Curve …
• … through a change in consumer income
• As income increases (other things equal) the
demand for a normal good will increase.
• Examples: clothing, food, etc.
• As income increases (other things equal) the
demand for an inferior good will decrease.
• Examples: bus rides, second-hand TV sets, etc.
• Don’t confuse “inferior goods” with “bads” (things
you would not pay for).
• Examples: garbage, pollution, etc.
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Consumer Income
Normal Good
Price of IceCream Cones
€ 3.00
An increase
in income...
2.50
Increase
in demand
2.00
1.50
1.00
0.50
D1
0 1
2 3 4 5 6 7 8 9 10 11 12
D2
Quantity of
Ice-Cream
Cones
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Consumer Income
Inferior Good
Price of IceCream Cones
€ 3.00
2.50
A decrease in
income...
2.00
Decrease
in demand
1.50
1.00
0.50
D2
0 1
D1
2 3 4 5 6 7 8 9 10 11 12
Quantity of
Ice-Cream
Cones
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Shifts in the Demand Curve …
• … through a change in 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.
• Examples: apples and oranges, margarine and butter, tea
and coffee, etc.
• When a fall in the price of one good increases the
demand for another good, the two goods are called
complements.
• Examples: coffee and sugar, printers and ink cartridges,
DVD players and DVDs, etc.
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Table 1 Variables That Influence Buyers
Copyright©2010 South-Western
SUPPLY
• Quantity supplied is the amount of a good that
sellers are willing and able to sell.
• Law of Supply
• The law of supply is the claim that, other things
equal, the quantity supplied of a good rises when
the price of the good rises.
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The Supply Curve: The Relationship between
Price and Quantity Supplied
• Supply Schedule
• The supply schedule is a table that shows the
relationship between the price of the good and the
quantity supplied.
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Häagen’s Supply Schedule
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The Supply Curve: The Relationship between
Price and Quantity Supplied
• Supply Curve
• The supply curve is the graph of the relationship
between the price of a good and the quantity
supplied.
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Figure 5 Häagen’s Supply Schedule and Supply Curve
Copyright©2010 South-Western
Market Supply versus Individual Supply
• Market supply refers to the sum of all
individual supplies for all sellers of a particular
good or service.
• Individual supply: how?
• technology → profit functions → optimal choice
• Graphically, individual supply curves are
summed horizontally to obtain the market
supply curve.
Copyright © 2011 Cengage Learning
Figure 6 Market Supply as the Sum of Individual Supplies
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© 2011
© 2011
Cengage
Cengage
Cengage
Learning
Learning
Change in Quantity Supplied
• Movement along the supply curve.
• Caused by a change in the price of the product.
Copyright © 2011 Cengage Learning
Change in Quantity Supplied
Price of IceCream
Cones
S
C
€3.00
€1.00
0
A rise in the price
of ice cream
cones results in a
movement along
the supply curve.
A
1
5
Quantity of
Ice-Cream
Cones
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Shifts in the Supply Curve
• A shift in the supply curve, either to the left or
right.
• Caused by a change in a determinant other than
price.
Copyright © 2011 Cengage Learning
Figure 7 Shifts in the Supply Curve
Price of
Ice-Cream
Cones
Supply curve, S3
Decrease
in supply
Supply
curve, S1
Supply
curve, S2
Increase
in supply
0
Quantity of
Ice-Cream Cones
Copyright©2011 South-Western
Shifts in the Supply Curve
…
… are caused by changes in:
•
•
•
•
Input prices
Technology
Expectations
Number of sellers
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Table 2 Variables That Influence Sellers
Copyright©2011 South-Western
SUPPLY AND DEMAND
TOGETHER
• Equilibrium refers to a situation in which the
price has reached the level where quantity
supplied equals quantity demanded
• such that there is no downward or upward pressure
on price.
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SUPPLY AND DEMAND
TOGETHER
• Equilibrium Price
• The price that balances quantity supplied and
quantity demanded.
• On a graph, it is the price at which the supply and
demand curves intersect.
• Equilibrium Quantity
• The quantity supplied and the quantity demanded at
the equilibrium price.
• On a graph it is the quantity at which the supply and
demand curves intersect.
Copyright © 2011 Cengage Learning
Figure 8 The Equilibrium of Supply and Demand
Price of
Ice-Cream
Cones
Supply
€ 2.00
Equilibrium
Equilibrium price
Equilibrium
quantity
0
1
2
3
4
5
6
7
8
Demand
9 10 11 12 13
Quantity of Ice-Cream Cones
Copyright©2011 South-Western
Figure 9 Markets Not in Equilibrium
(a) Excess Supply
Price of
Ice-Cream
Cones
Supply
Surplus
€ 2.50
2.00
Demand
0
4
Quantity
demanded
7
10
Quantity
supplied
Quantity of
Ice-Cream
Cones
Copyright©2011 South-Western
Equilibrium
• Surplus
• When price > equilibrium price, then quantity
supplied > quantity demanded.
• There is excess supply or a surplus.
• Suppliers will lower the price to increase sales, thereby
moving toward equilibrium.
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Figure 9 Markets Not in Equilibrium
(b) Excess Demand
Price of
Ice-Cream
Cones
Supply
€ 2.00
1.50
Shortage
Demand
0
4
Quantity
supplied
7
10
Quantity of
Quantity
Ice-Cream
demanded
Cones
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Equilibrium
• Shortage
• When price < equilibrium price, then quantity
demanded > 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.
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Equilibrium
• Law of supply and demand
• The claim that the price of any good adjusts to bring
the quantity supplied and the quantity demanded for
that good into balance.
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Changes in Equilibrium
• How do markets respond to changes in supply
and demand?
→ Change in the market equilibrium
• Assume market is initially in equilibrium (P1*, Q1*).
• Then, some event shifts the demand or supply curve
(or both).
• Market will changes to a new equilibrium (P2*, Q2*).
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Three Steps to Analyzing Changes in
Equilibrium
1. Decide whether the event shifts the supply or
demand curve (or both).
2. Decide whether the curve(s) shift(s) to the left
or to the right.
3. Use the supply and demand diagram to see
how the shift affects equilibrium price and
quantity.
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Figure 10 How an Increase in Demand Affects the
Equilibrium
Price of
Ice-Cream
Cones
1. Hot weather increases
the demand for ice cream . . .
Supply
€ 2.50
New equilibrium
2.00
2. . . . resulting
in a higher
price . . .
Initial
equilibrium
D
D
0
7
3. . . . and a higher
quantity sold.
10
Quantity of
Ice-Cream Cones
Copyright©2011 South-Western
Figure 11 How a Decrease in Supply Affects the
Equilibrium
Price of
Ice-Cream
Cones
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
quantity sold.
Quantity of
Ice-Cream Cones
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Figure 12 A Shift in Both Supply and Demand (i) (1)
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Figure 12 A Shift in Both Supply and Demand (i) (2)
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Figure 13 A Shift in Both Supply and Demand (ii) (1)
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Figure 13 A Shift in Both Supply and Demand (ii) (2)
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Figure 13 A Shift in Both Supply and Demand (ii) (3)
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Table 4 What Happens to Price and Quantity When Supply
or Demand Shifts?
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Some maths (1)
The demand equation:
QD = a - bP
(1)
where QD denotes the quantity demanded, P the price while a and
b are two positive constants.
The supply equation:
QS = c + dP
(2)
where QS s the quantity supplied, while c and d are two constants.
We assume that the constant d is positive.
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Some maths (2)
Market equilibrium is where quantity demanded equals quantity
supplied:
QD = QS
a  bP  c  dP  bP  dP  a  c  P(b  d )  a  c  P* 
 Q *  Q D ( P * )  QS ( P * ) 
ac
bd
ad  bc
bd
P* is the equilibrium price that equates quantity demanded and
quantity supplied.
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What, how and for whom?
• The market:
• decides how much of a good should be produced
• by finding the price at which the quantity demanded
equals the quantity supplied
• tells us for whom the goods are produced
• those consumers willing to pay the equilibrium price
• determines what goods are being produced
• there may be goods for which no consumer is prepared
to pay a price at which firms would be willing to
supply
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The Invisible Hand
Invisible hand:
• the tendency of market prices to direct
individuals pursuing their own self interests
into productive activities that also promote the
economic well-being of society.
• This direction, provided by markets, is a key to
economic progress.
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The Invisible Hand
“Every individual is continually exerting himself to find
out the most advantageous employment for whatever
capital [income] he can command. It is his own
advantage, indeed, and not that of the society which he
has in view. But the study of his own advantage
naturally, or rather necessarily, leads him to prefer that
employment which is most advantageous to society.
. . . He intends only his own gain, and he is in this, as in
many other cases, led by an invisible hand to promote an
end which was not part of his intention.”
– Adam Smith, The Wealth of Nations (1776)
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Prices
Prices: Coordinating Actions of Market Participants
• Price changes coordinate the choices
of buyers and sellers and bring them into harmony.
• Price changes create profits and losses which change
production levels for products.
• Example:
• Suppose, consumers develop an increased taste for rice and rice
products.
• This increases demand, pushing the price up.
• Increased price provides incentives to producers to produce more
rice.
• Thus it is the price of rice that signals our wants and desires.
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Markets
Markets: Motivating Economic Participants
• Suppliers have an incentive to produce efficiently (at a low
cost).
• Entrepreneurs have an incentive to both innovate and
produce goods that are highly valued relative to cost.
• Resource owners have an incentive both to develop and
supply resources that producers value highly.
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Summary
• Economists use the model of supply and
demand to analyze competitive markets.
• In a competitive market, there are many buyers
and sellers, each of whom has little or no
influence on the market price.
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Summary
• The demand curve shows how the quantity of a
good depends upon the price.
• According to the law of demand, as the price of a
good falls, the quantity demanded rises. Therefore,
the demand curve slopes downward.
• In addition to price, other determinants of how
much consumers want to buy include income, the
prices of complements and substitutes, tastes,
expectations, and the number of buyers.
• If one of these factors changes, the demand curve
shifts.
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Summary
• The supply curve shows how the quantity of a
good supplied depends upon the price.
• According to the law of supply, as the price of a
good rises, the quantity supplied rises. Therefore,
the supply curve slopes upward.
• In addition to price, other determinants of how
much producers want to sell include input prices,
technology, expectations, and the number of sellers.
• If one of these factors changes, the supply curve
shifts.
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Summary
• Market equilibrium is determined by the
intersection of the supply and demand curves.
• At the equilibrium price, the quantity demanded
equals the quantity supplied.
• The behaviour of buyers and sellers naturally
drives markets toward their equilibrium.
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Summary
• To analyze how any event influences a market,
we use the supply and demand diagram to
examine how the even affects the equilibrium
price and quantity.
• In market economies, prices are the signals that
guide economic decisions and thereby allocate
resources.
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