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Chapter 3 Demand, supply and the market David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 9th Edition, McGraw-Hill, 2005 PowerPoint presentation by Alex Tackie and Damian Ward ©The McGraw-Hill Companies, 2008 Some key terms • Market – a set of arrangements by which buyers and sellers are in contact to exchange goods or services • Demand – the quantity of a good buyers wish to purchase at each conceivable price • Supply – the quantity of a good sellers wish to sell at each conceivable price • Equilibrium price – price at which quantity supplied = quantity demanded ©The McGraw-Hill Companies, 2008 Some key terms (2) • Some goods are related to each other. • Substitutes: If the two goods fulfill similar needs they are called substitutes. E.g. Tea and Coffee. • Complements: If the two goods complete each other when consumed, they are called complements. E.g. Tea and sugar. ©The McGraw-Hill Companies, 2008 Some Key Terms (3) • 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. ©The McGraw-Hill Companies, 2008 Some Key Terms (4) • Consumer Income – As income increases the demand for a normal good will increase. E.g. Cars – As income increases the demand for an inferior good will decrease. E.g Bread ©The McGraw-Hill Companies, 2008 Price The Demand curve shows the relation between price and quantity demanded holding other things constant D Quantity • “Other things” include: – the price of related goods – consumer incomes – consumer preferences • Changes in these other things affect the position of the demand curve Law of Demand: The quantity demanded of a good decreases as its prices increases, all other things equal. ©The McGraw-Hill Companies, 2008 Price The Supply curve shows the relation between price and quantity supplied holding other things constant S Quantity • “Other things” include: – technology – input costs – government regulations • Changes in these other things affect the position of the demand curve Law of Supply: The quantity supplied of a good increases as its prices increases, all other things equal. ©The McGraw-Hill Companies, 2008 Market equilibrium (1) S D0 P0 E0 • Market equilibrium is at E0 where quantity demanded equals quantity supplied – with price P0 and quantity Q0 D0 S Q0 Quantity ©The McGraw-Hill Companies, 2008 Market equilibrium and disequilibrium D P1 S excess supply E P0 P2 S excess demand D Q0 Quantity • If price were below P0 there would be excess demand – consumers wish to purchase more than producers wish to supply • If price were above P0 there would be excess supply – producers wish to supply more than consumers wish to purchase ©The McGraw-Hill Companies, 2008 A shift in demand D1 D0 If the price of a substitute good decreases ... S P0 less will be demanded at each price. E0 P1 The demand curve shifts from D0D0 to D1D1. E1 S D1 Q1 Q0 D0 Quantity If price stayed at P0 there would be excess supply. So the market moves to a new equilibrium at E1. ©The McGraw-Hill Companies, 2008 Shift in demand (2) • Consumer income: • Normal goods: Demand shifts right if the income increases • Inferior goods: Demand shifts left if the income increases. • Preferences: If the change in preference is in favor of the good, the demand will shift to the right. E.g: Ice cream in summer. ©The McGraw-Hill Companies, 2008 Shift in demand (3) • Population increase shifts the market demand curve to the right. • Subsititutes: If a substitute good price increases, the other good’s demand will shift to the right. • Complements: If a complement good’s price increases, the other good’s demand will shift to the left. ©The McGraw-Hill Companies, 2008 A shift in supply S1 S0 D E2 P1 P0 The supply curve shifts to S1S1 E0 If price stayed at P0 there would be excess demand S1 D S0 Q1 Q0 Suppose safety regulations are tightened, increasing producers’ costs So the market moves to a new equilibrium at E2 Quantity ©The McGraw-Hill Companies, 2008 Shift in supply (2) • Increase in input’s price shift the supply curve to the left. • Taxes shifts the supply curve to the left. • Expectation about future consumers shifts the supply curve to the right. • External conditions also shift the supply curve. E.g Weather conditions for agricultural products. ©The McGraw-Hill Companies, 2008 Two ways in which demand may increase (1) • (1) A movement along the demand curve from A to B • represents consumer reaction to a price change • could follow a supply shift A P0 P1 B D Q0 Q1 Quantity ©The McGraw-Hill Companies, 2008 Two ways in which demand may increase (2) P0 P1 C A B F D0 D1 Q0 Q1 Q2 Q3 • (2) A movement of the demand curve from D0 to D1 • leads to an increase in demand at each price • e.g. at P0 quantity demanded increases from Q0 to Q2: at P1 quantity demanded increases from Q1 to Q3 Quantity ©The McGraw-Hill Companies, 2008 A market in disequilibrium S D P2 E P0 P1 A B excess demand D RATIONING is needed to cope S QS Q0 • Suppose a disastrous harvest moves the supply curve to SS • government may try to protect the poor, setting a price ceiling at P1 • which is below P0, the equilibrium price level • The result is excess demand QD Quantity with the resulting excess demand ©The McGraw-Hill Companies, 2008 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 ©The McGraw-Hill Companies, 2008