Demand and Supply

Ms. Amanpreet Kaur

The Basic Decision-Making Units

• A firm is an organization that transforms resources (inputs) into products (outputs). Firms are the primary producing units in a market economy.

• An entrepreneur is a person who organizes, manages, and assumes the risks of a firm, taking a new idea or a new product and turning it into a successful business.

• Households are the consuming units in an economy.

Theories and Predictions

• We need to be able to predict the consequences of – alternative policies, and– events that may be outside our control

• The mental tool we use to make such predictions is called a theory

• A theory is of no use if its predictions are inaccurate

SUPPLY AND DEMAND 3

We need a theory of prices

• The theory of demand and supply is a simple example of an economic theory

• It can be used to make predictions about the price and quantity of some commodity

• In a free-market economy, most economic decisions are guided by prices

• Therefore, without a reliable theory of prices, you will get nowhere in economic analysis

SUPPLY AND DEMAND 4

Assume perfect competition

• The theory of supply and demand assumes that commodities are traded in perfectly competitive markets

• A perfectly competitive market is a market in which– there are many buyers– many sellers– and all sellers sell the exact same product

• As a result, each buyer and seller has a negligible impact on the market price

SUPPLY AND DEMAND 5

DEMAND

SUPPLY AND DEMAND 6

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.

SUPPLY AND DEMAND 7

Catherine’s Demand Schedule and Demand Curve

SUPPLY AND DEMAND 8

Copyright © 2004 South-Western

Price ofIce-Cream Cone

0

2.50

2.00

1.50

1.00

0.50

1 2 3 4 5 6 7 8 9 10 11 Quantity ofIce-Cream Cones

$3.00

12

1. A decrease in price ...

2. ... increases quantity of cones demanded.

Market Demand is the Sum of Individual Demands

SUPPLY AND DEMAND 9

Law of Demand

• The law of demand states that – the quantity demanded of a good falls when the price of

the good rises, and vice versa, provided all other factors that affect buyers’ decisions are unchanged

SUPPLY AND DEMAND 10

“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

SUPPLY AND DEMAND 11

Shift of Demand Versus Movement Along a Demand Curve

• A change in demand is not the same as a change in quantity demanded.

• Changes in Price, i.e., In this example, a higher price causes lower quantity demanded.

• Changes in determinants of demand, other than price, cause a change in demand, or a shift of the entire demand curve, from DA to DB.

A Change in Demand Versus a Change in Quantity Demanded

To summarize:

Change in price of a good or service leads to

Change in quantity demanded(Movement along the curve).

Change in income, preferences, orprices of other goods or services

leads to

Change in demand(Shift of curve).

Why Might Demand Increase?

• 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 14

Quantity DemandedPrice Situation A Situation B

0.00 12 200.50 10 161.00 8 121.50 6 82.00 4 62.50 2 43.00 0 2

Price

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 15

Shifts in the Demand Curve

SUPPLY AND DEMAND 16

Price ofIce-Cream

Cone

Quantity ofIce-Cream Cones

Increasein demand

Decreasein demand

Demand curve, D3

Demandcurve, D1

Demandcurve, D2

0

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 17

The Impact of a Change in Income

• Higher income decreases the demand for an inferior good

• Higher income increases the demand for a normal good

The Impact of a Change in the Price of Related Goods

• Price of hamburger rises

• Demand for complement good (ketchup) shifts left

• Demand for substitute good (chicken) shifts right

• Quantity of hamburger demanded falls

The Law of Demand—Explanations

• There are two ways to explain the Law of Demand– Substitution effect– Income effect

SUPPLY AND DEMAND 20

Substitution Effect

• When the price of a good decreases, consumers substitute that good instead of other competing (substitute) goods

SUPPLY AND DEMAND 21

Coke Books MoviesClothes

1. When the price of Coke decreases…

Pepsi

2. Consumption of Pepsi decreases…

3. Consumption of Coke increases

Income Effect

A decrease in the price of a commodity is essentially equivalent to an increase in consumers’ income

SUPPLY AND DEMAND 22

Lower Prices = Higher IncomeSituation A

Price of an Apple $1.00

Price of an Orange $2.00

Income $10.00 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 23

If prices fall, Situation A becomes Situation C.

If income rises, Situation A becomes Situation B.

Q: Which change is better?

A: They are both equally desirable. A fall in prices is equivalent to an increase in income.

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

SUPPLY AND DEMAND 24

Coke Books MoviesClothes

1. When the price of Coke decreases…

2. Consumers feel richer…

3. Consumption of Coke and other goods increases

Pepsi

SUPPLY

SUPPLY AND DEMAND 25

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 26

Ben’s supply schedule and supply curve

27

Supply curve

Price ofIce-cream cone

Quantity ofCones supplied

$0.000.501.001.502.002.503.00

0 cones012345

0 1210 1191 2 3 4 5 6 7 8Quantity of Ice-Cream Cones

$3.00

2.50

2.00

1.50

1.00

0.50

Price of Ice-Cream

Cones

1. An increasein price . . .

2. . . . increases quantityof cones supplied.

Market supply and individual supplies

28

Price of ice-cream cone Ben Jerry Market

$0.000.501.001.502.002.503.00

0012345

+ 0002468

= 00147

1013

Market supply and individual supplies

29

SBen

0 1210 1191 2 3 4 5 6 7 8

Quantity of Ice-Cream Cones

$3.00

2.50

2.00

1.50

1.00

0.50

Price of Ice

CreamCones

Ben’ssupply

SJerry

0 1 2 3 4 5 6 7

Quantity of Ice-Cream Cones

$3.00

2.50

2.00

1.50

1.00

0.50

Price of Ice

CreamCones

Jerry’ssupply+ =

SMarket

0 182 4 6 8 10 12 14 16

Quantity of Ice-Cream Cones

$3.00

2.50

2.00

1.50

1.00

0.50

Price of Ice

CreamCones

Marketsupply

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 30

Law of Supply—Explanation • How can we make sense of

the numbers in Ben’s supply schedule?

• The best guess is that his costs must be something like the cost schedule below.

A specific ice-cream cone

It’s cost ($)

1st 0.75

2nd 1.35

3rd 1.75

4th 2.30

5th 2.85

6th 3.10SUPPLY AND DEMAND 31

In this way, the Law of Supply follows from the assumption of Increasing Costs (or, Diminishing Returns)

Shifts in the Supply Curve: What causes them?

SUPPLY AND DEMAND 32

Price ofIce-Cream

Cone

Quantity ofIce-Cream Cones

0

Increasein supply

Decreasein supply

Supply curve, S3

curve, Supply

S1Supply

curve, S2

Shifts in the Supply Curve…

• … are caused by changes in– Input prices– Technology– Number of sellers (short run)

• The market supply will shift right if– Raw materials or labor becomes cheaper– The technology becomes more efficient– Number of sellers increases

SUPPLY AND DEMAND 33

A Change in Supply Versus a Change in Quantity Supplied

• A change in supply is not the same as a change in quantity supplied.

• In this example, a higher price causes higher quantity supplied, and a move along the supply curve.

• In this example, changes in determinants of supply, other than price, cause an increase in supply, or a shift of the entire supply curve, from SA to SB.

A Change in Supply Versusa Change in Quantity Supplied

To summarize:

Change in price of a good or service leads to

Change in quantity supplied(Movement along the curve).

Change in costs, input prices, technology, or prices of related goods and services

leads to

Change in supply(Shift of curve).

EQUILIBRIUM

SUPPLY AND DEMAND 36

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 37

Equilibrium

• We assume that the price will automatically reach a level at which the quantity demanded equals the quantity supplied

SUPPLY AND DEMAND 38

39

Supply-Demand Equilibrium

qD = 1000 - 100p

qS = -125 + 125p

Equilibrium qD = qS

1000 - 100p = -125 + 125p225p = 1125

p* = 5q* = 500

At $2.00, the quantity demanded is equal to the quantity supplied!

SUPPLY AND DEMAND TOGETHER

SUPPLY AND DEMAND 40

Demand Schedule

Supply Schedule

Equilibrium of supply and demand

41

Supply

0 1210 1191 2 3 4 5 6 7 8Quantity of Ice-Cream Cones

$3.00

2.50

2.00

1.50

1.00

0.50

Price of Ice-Cream

Cones

Equilibrium

Demand

Equilibriumprice

Equilibriumquantity

Market Dis-equilibrium

42

Markets Not in Equilibrium

SUPPLY AND DEMAND 43

Price ofIce-Cream

Cone

0

Supply

Demand

(a) Excess Supply

Quantitydemanded

Quantitysupplied

Surplus

Quantity ofIce-Cream

Cones

4

$2.50

10

2.00

7

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 44

Markets Not in Equilibrium

SUPPLY AND DEMAND 45

Price ofIce-Cream

Cone

0 Quantity ofIce-Cream

Cones

Supply

Demand

(b) Excess Demand

Quantitysupplied

Quantitydemanded

1.50

10

$2.00

74

Shortage

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 46

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 47

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 48

How a Decrease in Supply Affects the Equilibrium

SUPPLY AND DEMAND 49

Price ofIce-Cream

Cone

0 Quantity of Ice-Cream Cones

Demand

Newequilibrium

Initial equilibrium

S1

S2

2. . . . resultingin a higherprice of icecream . . .

1. An increase in theprice of sugar reducesthe supply of ice cream. . .

3. . . . and a lowerquantity sold.

2.00

7

$2.50

4

A Shift in Both Supply and Demand

Event Effect on Price Effect on Quantity

Demand increases Up Up

Supply decreases Up Down

Both Up Ambiguous

SUPPLY AND DEMAND 50

A Shift in Both Supply and Demand

SUPPLY AND DEMAND 51

Queries…??

SUPPLY AND DEMAND 52