Demand, Supply, and Equilibrium

How does a market work?

Markets are dynamic (like weather) They are constantly evolving

A careful study of markets reveal certain forces

underlying the movements in a market

Need a model - demand & supply model to forecast

the prices and outputs in individual markets

In a competitive market SS and DD determine the

quantity of each good produced and the price at which it is sold

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DEMAND

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Demand Schedule
Quantity demanded of any good/service by an

individual is the amount of the good/service that the individual is willing and able to purchase at alternative prices during a given period of time, and other things held constant
A demand schedule or demand curve shows the

relationship between the market price of a good/service and the quantity demanded of that good/service, other things held constant
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Demand Schedule
It shows how demand varies with price, ceteris paribus

Price per unit 10 12 14 16 18

Quantity per week 200 170 140 110 80

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Demand Curve
20 18 16

Price per unit

14 12 10 8 6 4 2 0 80 110 140 170 200 Qty de m ande d

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Demand Schedule
The demand curve slopes downward (a negatively

sloped demand curve)

Indicates an inverse relationship between price and

quantity demanded

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Law of Demand
A decrease in the price of a good, all other things

held constant (ceteris paribus), will cause an increase in the quantity demanded of the good.
An increase in the price of a good, all other things

held constant (ceteris paribus), will cause a decrease in the quantity demanded of the good.

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Change in Quantity Demanded

Price

P1

An increase in price causes a decrease in quantity demanded.

P0

Q1

Q0

Quantity

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Change in Quantity Demanded

Price

A decrease in price causes an increase in quantity demanded. P0

P1

Q0

Q1

Quantity

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Market Demand
A market demand schedule specifies the units of

good or service all individuals in the market are willing and able to purchase at alternative prices
Qd = f(P)
In other words, market demand is the sum of all the

individual demands for a particular good or service

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Why an inverse relationship?

Quantity demanded tends to fall as price rises for

two reasons: (1) Substitution effect: When price of a commodity falls an individual buy more of it to substitute for other similar goods whose price has not changed (2) Income effect: When price falls, the purchasing power of an individual with a given income increases, allowing him to buy more of it

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Factors Behind the Demand Curve

The market demand for a commodity is influenced

not only by the commoditys price

A whole array of factors influences how much will be

demanded at a given price:

Average disposable income of the consumers Prices of other related commodities Wealth of the consumers Tastes and preferences Size of the market (population) Special Influences (govt. policies, seasons, etc.) Expectations

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Classification of Goods
Inferior Good:
An inferior good is a good that decreases in demand

when consumer income rises

Inferiority, in this sense, relate to affordability rather

than about the quality of the good

Example: People moving from public transport to taxies

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Classification of Goods
Giffen Good:
A Giffen Good is a good that experiences increased

demand for when the price rises and decreased demand for when the price falls
Absence of any close substitutes

Mainly a theoretical concept

A rise in the price of bread makes so large a drain on the resources of the poorer labouring families, that they are forced to cut their consumption of meat and the more expensive foods: and, bread being still the cheapest food which they can get and will take, they consume more, and not less of it.
- Sir Robert Giffen
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Prices of Related Goods

Substitutes
A substitute good is a good that can

be used in place of some other good.

Assume Pepsi and Coca cola are

substitutes
We want to study market demand

for Pepsi
Assume price of Pepsi and Coca Cola

is Rs.10
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Complementary goods
Any relation between demand

for CDs and CD Players?

If a good is jointly consumed

with another good, then it is called complementary good

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Change in Demand
Price An increase in demand refers to a rightward shift in the market demand curve.

P0

Q0

Q1

Quantity

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Change in Demand
Price

A decrease in demand refers to a leftward shift in the market demand curve.

P0

Q1
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Quantity

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IMPORTANT !
Demand Vs. Quantity Demanded
Movement along curves versus shifts of curves

i.e., change in quantity demanded and change in demand are different

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SUPPLY

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Supply Schedule
Supply schedule (or supply curve) for a commodity

shows the relationship between its market price and the quantity of that commodity that producers are willing to produce and sell, other things held constant Qs = f(P)

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Supply Schedule
Price per unit 10 12 14 16 18 Quantity supplied per week 50 70 90 110 130

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Law of Supply
A decrease in the price of a good, all other things

held constant (ceteris paribus), will cause a decrease in the quantity supplied of the good.
An increase in the price of a good, all other things

held constant (ceteris paribus), will cause an increase in the quantity supplied of the good.

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Change in Quantity Supplied

Price A decrease in price causes a decrease in quantity supplied.

P0

P1

Q1

Q0

Quantity

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Change in Quantity Supplied

Price

P1 P0

An increase in price causes an increase in quantity supplied.

Q0
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Shifts in Supply Curve

Change in Production Technology Change in Input (factors & materials) Prices Change in the Number of Sellers/Producers Change in Government policies Change in Prices of Related Goods Expectations Special Influences (seasons, natural impacts, etc.)
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Change in Supply
Price An increase in supply refers to a rightward shift in the market supply curve.

P0

Q0
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Quantity

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Change in Supply
Price A decrease in supply refers to a leftward shift in the market supply curve.

P0

Q1
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MARKET EQUILIBRIUM

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Market Equilibrium
Market equilibrium is determined at the intersection

of the market demand curve and the market supply curve.

The equilibrium price causes quantity demanded to

be equal to quantity supplied.

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Market Equilibrium
Equilibrium is a position of balance No incentive for anyone to change their behaviour Market equilibrium exists when demand equals

supply
The equilibrium price clears the market

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Market Equilibrium
Price per unit Quantity demanded per week Quantity supplied per week

10 12 14
Equilibrium

200 170 140 110 80

50 70 90 110 130

16 18

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Market Equilibrium
Price

P=16

Q=110

Quantity

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Market Equilibrium
Price D0 P1 P0 D1 An increase in demand will cause the market equilibrium price and quantity to increase S0

Q 0 Q1
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Quantity

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Market Equilibrium
Price D1 P0 P1 D0 A decrease in demand will cause the market equilibrium price and quantity to decrease S0

Q1 Q0
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Market Equilibrium
Price

D0

S0

S1

An increase in supply will cause the market equilibrium price to decrease and quantity to increase.

P0
P1

Q0 Q1

Quantity

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Market Equilibrium
Price

D0

S1

S0

A decrease in supply will cause the market equilibrium price to increase and quantity to decrease.

P1
P0

Q1 Q0

Quantity

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A Rise in Input Prices

An increase in wages, for example, will increase

firms costs
The supply curve will therefore shift upwards to the

left, as firms now require a higher price for their output

The equilibrium price will rise and the quantity will

fall

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Application of Supply and Demand Analysis

To analyse the impact of a tax on transactions
Suppose there is a fixed excise tax, say Rs.T per unit,

on the sellers for a particular good sold What happens to the supply curve?
S0 shifts leftwards S1 and the vertical distance

between the two curve is Rs.T

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Application of Supply and Demand Analysis

Price D0 S1 S0

P1
P0 P
T

The outcome in terms of price and quantity would be identical whether a tax on transaction is levied on the buyer or the seller

Q
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Application of Supply and Demand Analysis

Interpretation
Before tax, at price P0, the suppliers were willing to sell Q0

quantity (shown by S0 curve)

And at price P, the suppliers were willing to supply Q

quantity (in the same S0 curve)

Now, after the tax, the suppliers have to sell the same

quantity Q at P1=(P+T) price

The new equilibrium price P1 is higher than the pre-tax

price P0
And the net of tax price P is lower than this pre-tax price

P0
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Application of Supply and Demand Analysis

That is, now; The sellers are getting a much lower price And the buyers are paying a much higher price The burden of the tax is borne by both the sellers and the buyers
Note: The outcome in terms of price and quantity would be identical whether a tax on transaction is levied on the buyer or the seller

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The Economics of Price Controls

Price Ceilings
Price ceiling is a legally established maximum price that sellers may charge.

Example: rent control

The direct effect of a price ceiling below the

equilibrium price is a shortage: quantity demanded exceeds quantity supplied.

The Impact of a Price Control

Price

Consider the rental housing market where the price (rent) P0 would bring the quantity of rental units demanded into balance with the quantity supplied. A price ceiling like P1 imposes a price below market equilibrium causing quantity demanded QD to exceed quantity supplied QS resulting in a shortage. Because prices are not allowed to direct the market to equilibrium, non-price elements will become more important in determining where the scarce goods go.
P0

(rent)

S Rental housing market

P1
Shortage

Price ceiling

D
QS QD
Quantity of housing units

Effects of Rent Control

Shortages and black markets will develop. Inefficient use of housing will result. The future supply of housing will decline. The quality of housing will deteriorate. Non-price methods of rationing will increase in

importance (first come, first serve)

Long-term renters will benefit at the expense of

newcomers.

Price Floor
Price floor is a legally established minimum price that buyers must pay.

Example: minimum wage, agricultural price support

The direct effect of a price floor above the equilibrium

price is a surplus: quantity supplied exceeds quantity demanded.

The Impact of a Price Floor

Price

A price floor like P1 imposes a price above market equilibrium causing quantity supplied QS to exceed quantity demanded QD resulting in a surplus. Because prices are not allowed to direct the market to equilibrium, non-price elements of exchange will become more important in determining where scarce goods go

Surplus

S
Price floor

P1

P0

D
QD QS Quantity

Minimum Wage Effects

Direct effect:
Reduces

employment of low-skilled labor.

Indirect effects:
Reduction Less

in non-wage component of compensation.

on-the-job training.

A higher minimum wage does little to help the poor.

Employment and the Minimum Wage

Consider the market for labor where a price (wage) of $4.00 could bring the quantity of labor demanded into balance with the quantity supplied. A minimum wage (price floor) of $5.15 would increase the earnings of those who were able to maintain employment (E1), but would reduce the employment of others. Those who lose their job (E0 to E1) would be pushed into either the unemployment rolls or some other less preferred form of employment.
E1 E0
Price (wage) $ 5.15 Excess supply

S
Minimum wage level

$ 4.00

D
Quantity
(employment)

Questions for Thought:

1. Which of the following can be expected to result from a price ceiling that keeps the price of a product below market equilibrium level?
a. A surplus of the product will result. b. A shortage of the product will result. c. Changes in non-price factors that will be favorable to

buyers and unfavorable to sellers will occur.

d. Changes in non-price factors that will be favorable to

sellers and unfavorable to buyers will occur.

Exercise 1
Explain how would an increase in the minimum wage from the current level to $10 per hour affect:
(a) Employment in skill categories previously earning less than $10 per hour. (b) The unemployment rate of teenagers

(c) The availability of on-the-job training for low-skill workers.

(d) The demand for high-skill workers who provide good substitutes for the labor offered by low-skill workers, who are paid higher wage rates due to the increase in the minimum wage.

Exercise 2
Illustrate each of the following events using a demand and supply diagram for apples.
a) There is a report that imported apples are infected with a deadly virus b) There is a drop in the consumers income

c) The prices of apples goes up

d) The prices of oranges falls due to very good harvest e) Consumers expect that the pries of apples to decrease in the near future f) The government has increased the excise duty of apples from 5% to 15%

References
1. Chapter 2 in Dominic Salvatore (2009), Principles of Microeconomics, 5th edition, Oxford publications. 2. Chapters 3 in William Boyes and Michael Melvin (2009), Textbook of Economics, 6th edition, Biztantra publications.