Individual MarketsDemand and Supply

Lecture 5 & 6Dominika Milczarek-

Andrzejewska

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Outline of Lecture 5 & 6

• Definition of Market• Demand• Supply• Market Equilibrium• Changes in Supply and Demand, and

Equilibrium • Applications

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Market Market is an institution or mechanism that

brings together buyers (demanders) and sellers (suppliers) of particular goods and services

– Local, national, or international markets– Highly personal, face-to-face exchanges or

impersonal and remote markets

• A product market involves goods and services

• A resource market involves factors of production

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Demand

Demand schedule shows the various amounts of a product that consumers are willing and able to buy– at each specific price in a series of

possible prices – during a specified time period

$54321

1020355580

Various AmountsVarious Amounts

A Series of Possible PricesA Series of Possible Prices

…a specified time period…other things being equal

P QD

Demand Schedule

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Law of DemandLaw of demand is a fundamental

characteristic of demand behavior

• Other things being equal, as price increases, the corresponding quantity demanded falls

• Restated, there is an inverse relationship between price and quantity demanded

“Other-things-equal” assumption refers to:– consumer income and tastes, – prices of related goods, – and other things besides the price of the product being

discussed

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Explanation of the Law of Demand:

• Diminishing marginal utility– The decrease in added satisfaction with

consumption of additional units of a good or service,

– i.e., the second “Big Mac” yields less extra satisfaction (or utility) than the first

• Income effect– A lower price increases the purchasing power of

money income, enabling the consumer to buy more at a lower price

• Substitution effect– A lower price gives an incentive to substitute the

lower-priced good for now relatively higher-priced goods

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Demand Curve:

• Illustrates the inverse relationship between price and quantity

• The downward slope indicates – lower quantity (horizontal axis) at higher

price (vertical axis) and – higher quantity at lower price,

• reflecting the Law of Demand

P

Qo

$5

4

3

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P QD

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Price of Corn

Quantity of Corn

CORN

10 20 30 40 50 60 70 80

Graphing Demand

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Individual Versus Market Demand

• Transition from an individual to a market demand - summing individual quantities at various price levels

• Market curve is horizontal sum of individual curves

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Individual Versus Market Demand

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Individual Versus Market Demand

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Change in Demand

• An increase in demand involves a rightward shift, and

• A decrease in demand involves a leftward shift

P

Qo

$5

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P QD

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D

Price of Corn

Quantity of Corn

CORN

10 20 30 40 50 60 70 80

D’

Increasein

Demand

Increasein QuantityDemanded

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30406080 +

Increase in Demand

P

Qo

$5

4

3

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P QD

$54321

1020355580

D

Price of Corn

Quantity of Corn

CORN

10 20 30 40 50 60 70 80

-- 10204060

D’

Decreasein

Demand

Decreasein QuantityDemanded

Decrease in Demand

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Determinants of the Change in Demand

1. Tastes• favorable change leads to an increase in

demand• unfavorable change - a decrease in demand

2. Number of buyers• more buyers lead to an increase in demand • fewer buyers lead to a decrease

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3. Income• more leads to an increase in demand • less leads to a decrease in demand for

normal goods • The rare case of goods whose demand

varies inversely with income is called inferior goods

4. Expectations• consumer views about future prices, product

availability, and income can shift demand

Determinants of the Change in Demand

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Determinants of the Change in Demand

5. Prices of related goodsa. Substitute goods - can be used in place

of each other• The price of the substitute good and

demand for the other good are directly related

• If the price of Coke rises, demand for Pepsi should increase

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Determinants of the Change in Demand

5. Prices of related goodsb. Complementary goods - are used

together like tennis balls and rackets• there is an inverse relationship between

the price of one and the demand for the other

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Increase in Demand1. Favorable change in consumer tastes2. Increase in the number of buyers3. Rising income if product is a normal good4. Falling incomes if product is an inferior

good5. Increase in the price of a substitute good6. Decrease in the price of a complementary

good7. Consumer expectation of higher prices or

incomes in the future

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Decrease in Demand

1. Unfavorable change in consumer tastes2. Decrease in number of buyers3. Falling income if product is a normal good4. Rising income if product is an inferior good5. Decrease in price of a substitute good6. Increase in price of a complementary good7. Consumers expectation of lower prices or

incomes in the future

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Important Distinction Between:

• a change in quantity demanded caused by price change and

• a change in demand caused by change in determinants.

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Supply

• Supply - a schedule that shows amounts of a product a producer is willing and able to produce and sell at each specific price– in a series of possible prices – during a specified time period

• What quantities will be offered at various prices or

• What price will be required to induce various quantities to be offered?

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P QS

CORN

Various AmountsVarious Amounts

A Series of Possible PricesA Series of Possible Prices

…a specified time period…other things being equal

520355060

Supply Schedule

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Law of Supply• Producers will produce and sell more of their

product at a high price than at a low price

• There is a direct relationship between price and quantity supplied

• Explanation: – Given product costs, a higher price means greater

profits and thus an incentive to increase the quantity supplied

– Beyond some production quantity producers usually encounter increasing costs per added unit of output

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Supply Curve

• shows a direct relationship in an upward sloping curve.

SP

Qo

$5

4

3

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1

10 20 30 40 50 60 70 80

$54321

60503520 5

P QS

Price of Corn

Quantity of Corn

CORN

Graphing Supply

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Change in Supply

• An increase in supply involves a rightward shift

• and a decrease in supply involves a leftward shift

SP

Qo

$5

4

3

2

1

10 20 30 40 50 60 70 80

Price of Corn

Quantity of Corn

$54321

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P QS

CORN

8070604530

S’Increasein

Supply

Increasein QuantitySupplied

Increase in Supply

SP

Qo

$5

4

3

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1

10 20 30 40 50 60 70 80

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60503520 5

P QS

Price of Corn

Quantity of Corn

CORN

S’

453020 0 --

Decreasein

Supply

Decreasein QuantitySupplied

Decrease in Supply

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Determinants of the Change in Supply

Six basic determinants of supply:

1. Resource prices• a rise in resource prices causes a decrease

in supply• a decrease in resource prices causes an

increase in supply

2. Technology• a technological improvement means more

efficient production and lower costs, so an increase in supply results

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Determinants of the Change in Supply

3. Taxes and subsidies• a business tax is treated as a cost, so

decreases supply• a subsidy lowers cost of production, so

increases supply

4. Prices of related goods• if the price of substitute production good

rises, producers might shift production toward the higher-priced good, causing a decrease in supply of the original good

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Determinants of the Change in Supply

5. Expectations• about the future price of a product

6. Number of sellers• generally, the larger the number of sellers

the greater the supply

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Important Distinction Between:

• a change in quantity supplied due to price changes and

• a change or shift in supply due to change in determinants of supply

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Market Equilibrium

• Where quantity supplied equals the quantity demanded

• The equilibrium price and quantity. – Market clearing or market price is another

name for equilibrium price

– The rationing function of prices is the ability of competitive forces of supply and demand to establish a price where buying and selling decisions are coordinated

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Market Equilibrium

• An excess quantity or surplus – at prices above the equilibrium

• An excess quantity demanded or shortage – at prices below the equilibrium

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P QD

BUSHELSOF CORN MARKE

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DEMAND

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P QS

BUSHELSOF CORN MARKE

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SUPPLY

EQUILIBRIUM

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Market Demand and Supply

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Market Equilibrium

• Graphically, the equilibrium price and quantity are where the supply and demand curves intersect

• It is NOT correct to say supply equals demand!

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SP

Qo

$5

4

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1

2 4 6 8 10 12 14 16

P QD

$54321

2,0004,0007,000

11,00016,000

12,00010,000

7,0004,0001,000

D

P QS

Price of Corn

Quantity of Corn

CORNMARKET

CORNMARKET

Market Clearing Equilibrium

Market Equilibrium

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SP

Qo

$5

4

3

2

1

2 4 6 8 10 12 14 16

P QD

$54321

2,0004,0007,000

11,00016,000

$54321

12,00010,000

7,0004,0001,000

D

P QS

Price of Corn

Quantity of Corn

CORNMARKET

CORNMARKETSurplus

At a $4 pricemore is beingsupplied than

demanded

Surplus

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SP

Qo

$5

4

3

2

1

2 4 6 8 10 12 14 16

P QD

$54321

2,0004,0007,000

11,00016,000

$54321

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7,0004,0001,000

D

P QS

Price of Corn

Quantity of Corn

CORNMARKET

CORNMARKET

At a $2 pricemore is being

demanded thansupplied

Shortage

Shortage

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The Analogy of Scissors

Economist Alfred Marshall (1842-1924) used the analogy of scissors to illustrate the relative importance of supply and demand:

• Equilibrium price and quantity is determined by both supply and demand, just as both blades of a pair of scissors cut the paper

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Key Terms• MARKET• DEMAND• LAW OF DEMAND• DEMINISHING MARGINAL

UTILITY• INCOME EFFECT• SUBSTITUTION EFFECT• DEMAND CURVE• DETERMINANTS OF

DEMAND• NORMAL GOODS• INFERIOR GOODS• SUBSTITUTE GOODS• COMPLEMENTARY GOODS• CHANGE IN DEMAND

• CHANGE IN QUANTITY DEMANDED

• SUPPLY• LAW OF SUPPLY• SUPPLY CURVE• DETERMINANTS OF SUPPLY• CHANGE IN SUPPLY• CHANGE IN QUANTITY

SUPPLIED• SURPLUS• SHORTAGE• EQUILIBRIUM PRICE• EQUILIBRIUM QUANTITY• RATIONING FUNCTION OF

PRICES