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MANAGERIAL ECONOMICS (ECO501)MNU BUSINESS
SCHOOLAhmed Inaz / 2019

• LECTURE 3 Demand, Supply and Market Equilibrium

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Topics and main sub topics

• Demand and Supply schedule, curve and functions
• Inverse demand and supply function
• Movements vs shifts of demand and supply curves
• Market equilibrium and changes to market
  equilibrium including effect of taxes and
  subsidies

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Learning Objectives

• Explain the laws of demand and supply, and
  identify factors that cause demand and supply to
  shift
• Explain price determination in a competitive
  market
• Show how equilibrium changes in response to
  changes in determinants of demand and supply

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(I) MARKET DEMAND

• The demand for a good or service is defined as
• Quantities of a good or service that people are
  ready (willing and able) to buy at various prices
  within some given time period, other factors
  besides price held constant.

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Demand in Output Markets

• A demand schedule is a table showing how much of
  a given product a household would be willing to
  buy at different prices.
• Demand curves are usually derived from demand
  schedules.

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The Demand Curve

• The demand curve is a graph illustrating how much
  of a given product a household would be willing
  to buy at different prices.

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Market Demand

• Market demand is the sum of all the individual
  demands.

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Market Demand is the Sum of Individual Demands

• Assuming there are only two households in the
  market, market demand is derived as follows

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The Law of Demand

• The law of demand states that there is inverse
  relationship between price and the quantity of a
  good demanded.
• This is why the demand curves slopes downward.

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The Law of DemandExplanations

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

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Two Reasons for the Inverse Relationship
P
Q

• Substitution effect
• When price of a good decreases, the consumer
  substitutes the lower priced good for the more
  expensive ones.
• Income effect
• When price decreases, the consumers real income
  (or purchasing power) increases, so he tends to
  buy more.

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Two Reasons for the Inverse Relationship
P
Q

• Substitution effect
• When price of a good increases, the consumer
  tends to substitute it with the lower priced
  goods.
• Income effect
• When price increases, the consumers purchasing
  power (or real income) decreases, so he tends to
  buy less.

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Shift of Demand Versus Movement Along a Demand
Curve

• Changes in price result in changes in the
  quantity demanded.
• This is shown as movement along the demand curve.
• Changes in non price determinants result in
  changes in demand.
• This is shown as a shift in the demand curve.

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Shift of Demand Versus Movement Along a
Demand Curve
Shift

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

• 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.

Movement!
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Change in quantity demanded
Price

• A decrease in price from p1 to p2 brings about an
  increase in quantity demanded from q1 to q2
• It is shown as a movement along the same demand
  curve

p1
p2
D
Quantity
q1
q2
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Change in demand
Price

• An increase in demand means that at the same
  price such as p1 more will be brought, due to
  other factors such as increased incomes, increase
  in number of consumers, etc.
• It is shown as a shift in the entire demand curve

p1
This is a decrease in demand
D1
D0
D2
Quantity
q1
q2
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Non-price determinants of demand

1. Consumer incomes
2. Prices of related commodities (substitutes and
   complements)
3. Tastes and preferences
4. Number of consumers
5. Price expectations

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Non-price determinants of demand

• Income As income changes, demand for a
  commodity usually changes
• Normal goods are goods whose demand respond
  positively to changes in income.
• Most goods are normal goods. As income increases,
  more of shoes, TVs, clothes, are bought.
• Inferior goods are goods whose demand respond
  negatively to change in income
• Few but existent. Examples are firewood,
  bicycles, etc.

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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

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Other factors affecting demand

• Prices of related commodities in consumption
• Substitutes are goods that are substitutable
  with each other (not necessarily perfect).
• Examples are coffee and tea, Coke and Pepsi.
• When the price of a substitute increases,
  quantity bought of a good increases. --- Py Qx
  (direct relationship)
• Complements are goods that are used or consumed
  together.
• Examples are coffee and sugar, bread and butter,
  tennis rackets and tennis balls.
• When the price of a complement increases,
  quantity bought of a good decreases. --- Py Qx
  (inverse relationship)

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The Impact of a Change in the Price of Related
Goods

• Demand for complement good (ketchup) shifts left

• Demand for substitute good (chicken) shifts right

• Price of hamburger rises

• Quantity of hamburger demanded falls

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Other factors affecting demand

• Consumer tastes and preferences
• When consumer tastes shift towards a particular
  good, greater amounts of a good are demanded at
  each price.
• Example consumers preference for drinking
  mineral water increases so its demand curve will
  shift rightward.
• If consumer preferences change away from a good,
  its demand will decrease at every possible
  price, less of the good is demanded than before.
• Example the demand for VCDs and VHS tapes
  decreases due to preference for DVDs.

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Other factors affecting demand

• Consumer expectations Expectations about future
  prices and income affect our current demand for
  many goods and services.
• If we expect prices of dried fish to increase
  with coming of the rainy season, we might stock
  up on the good to avoid the expected price
  increase. Thus, current demand for dried fish
  might increase
• those who expect to lose their jobs due to bad
  economic conditions, will reduce their demand for
  a variety of goods in the current period.

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Other factors affecting demand

• Number of Consumers affects the total demand
  for a good.
• Total demand is also known as market demand. It
  is the summation of the individual demand of all
  consumers
• An increase in the number of consumers shifts the
  market demand curve to the right
• Example demand for housing and transportation
  increases with an increase in population.
• On the other hand, less consumers will cause the
  market demand to decrease, resulting in a shift
  to the left of the entire demand curve.

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General Demand Function

• Variables that influence Qd
• Price of good or service (P)
• Incomes of consumers (M)
• Prices of related goods services (PR)

• Expected future price of product (Pe)
• Number of consumers in market (N)

• General demand function

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Demand Function

• Quantity demanded (Q) is expressed as a
  mathematical function of price (P). The demand
  function may thus be written as Qd a - bP
• where
• a is the horizontal intercept of the equation or
  the quantity demanded when price is zero
• (-b) is the slope of the function.
• Example Qd 8 - 0.02P

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Demand Function

• The processed fish demand function is
• Q D(p, pb, pc, Y)
• where Q is the quantity of fish demanded
• p is the price of fish (dollars per kg)
• pb is the price of beef (dollars per kg)
• pc is the price of chicken (dollars per kg)
• Y is the income of consumers (thousand dollars)

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Demand Function to the Demand Curve

• Estimated demand function for fish
• Q 171-20p 20pb 3pc 2Y
• Using the values pb 4, pc 3.33 and Y 12.5,
  we have
• Q 286-20p
• which is the linear demand function for fish.

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Demand Function to the Demand Curve
Q 286-20p

• If p 0, then
• Q 286

If p 3.30 then, Q 220
14.30
, per kg
p
1
Demand cu
r
v
e
f
or fish
D
In general, DQ -20Dp slope Dp
4.30
3.30
2.30
200
220
240
286
0
Q
, Million kg of fish
r
per
y
ear
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Solved Problem

• Express the price that consumers are willing to
  pay as a function of quantity.
• Q 286-20p
• 20p 286 - Q
• p 14.30 - 0.05Q

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Solved Problem (workout)

• Use the inverse demand curve to determine how
  much the price must change for consumers to buy 1
  million more kg of fish per year.
• ?p p2 - p1
• (14.30 - 0.05Q2) - (14.30 -
  0.05Q1)
• 0.05(Q2 - Q1)
• 0.05?Q.
• The change in quantity is ?Q Q2 - Q1 (Q1
  1)-Q1 1, so the change in price is ?p 0.05.

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Market supply
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(II) MARKET SUPPLY

• The supply of a good or service is defined as
• Quantities of a good or service that people are
  ready to sell at various prices within some given
  time period, other factors besides price held
  constant.

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The Supply Curve and the Supply Schedule

• A supply curve is a graph illustrating how much
  of a product a firm will supply at different
  prices.

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Market Supply

• As with market demand, market supply is the
  horizontal summation of individual firms supply
  curves.

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The Law of Supply

• The law of supply states that there is a positive
  relationship between price and quantity of a good
  supplied.
• This means that supply curves typically have a
  positive slope.

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Shift vs. movement of market supply

• Changes in price result in changes in the
  quantity supplied.
• This is shown as movement along the supply curve.
• Changes in non-price determinants result in
  changes in supply.
• This is shown as a shift in the supply curve.

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Change in quantity supplied
S
Price

• An increase in price from p1 to p2 results in an
  increase in quantity supplied from q1 to q2
• It is shown as a movement along the same supply
  curve

p2
p1
Quantity
q1
q2
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Change in supply
S0
S2
S1
Price

• An increase in supply means that at the same
  price such as p1 more will be sold, due to other
  factors such as improvement in technology,
  increase in number of producers, etc.
• It is shown as a shift in the entire supply curve

p1
This is a decrease in supply
Quantity
q1
q2
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A Change in Supply Versusa Change in Quantity
Supplied
To summarize
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Non-price determinants of supply

• Non-price determinants of supply
• resource prices
• prices of related goods in production
• technology
• expectations
• number of sellers.

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Other factors affecting supply

• Resource prices
• When prices of inputs to production increase, the
  supply of the firm's product decreases.
• Decreases in resource prices, however, translate
  to an increase in supply. The entire supply curve
  shifts to the right.

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Other factors affecting supply

• Prices of related goods in production
• Resources can be employed to produce several
  alternative goods and services.
• Examples from agriculture
• a piece of farmland can be use to grow rice,
  corn, or sugarcane. An increase in price of
  sugarcane may result in decreased supply of rice
  and corn.
• farmers can use their land and labor to produce
  ornamental flowers instead of vegetables. If
  vegetable prices decrease, the supply of
  ornamental flowers may increase.

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Other factors affecting supply

• Technology
• A change in production techniques can lower or
  raise production costs and affect supply.
• Improvements in technology shift the supply curve
  to the right.
• A cost-saving invention will enable firms to
  produce and sell more goods than before at any
  given price.
• New high yielding crop varieties will increase
  production on the same amount of land.

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Other factors affecting supply

• Producer expectations
• When producers expect the price of their product
  to increase in the future, they may hoard their
  output for later sale, thus reducing supply in
  the present period. Thus the supply curve shifts
  to the left.
• If firms expect that the price of their product
  will fall in the near future, supply may increase
  in the current period as firms try to increase
  production as well as to dispose of their
  inventory.

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Other factors affecting supply

• Number of sellers
• As the number of sellers increases, so will total
  supply.
• The market supply is the horizontal summation of
  the supply schedules of individual producers.
• As more firms enter the market, more will offered
  for sale at each possible price, thus shifting
  the supply curve to the right.
• Similarly, the supply curve shifts to the left
  when firms exit the market.

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Market Supply

• Variables that influence Qs
• Price of good or service (P)
• Input prices (PI )
• Prices of goods related in production (Pr)
• Technological advances (T)
• Expected future price of product (Pe)
• Number of firms producing product (F)
• General supply function

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General Supply Function

• k, l, m, n, r, s are slope parameters
• Measure effect on Qs of changing one of the
  variables while holding the others constant
• Sign of parameter shows how variable is related
  to Qs
• Positive sign indicates direct relationship
• Negative sign indicates inverse relationship

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Supply Function

• Quantity supplied (Qs) is expressed as a
  mathematical function of price (P). The supply
  function may thus be written as Qs c dP
• where
• c is the horizontal intercept of the equation or
  the quantity demanded when price is zero
• d is the slope of the function.
• Example Qs 0 0.02P

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Market Equilibrium
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(III) MARKET EQUILIBRIUM

• Market equilibrium is that state in which the
  quantity that firms want to supply equals the
  quantity that consumers want to buy.
• The price that clears the market is called the
  equilibrium price and the quantity (sold and
  bought) is called the equilibrium quantity.
• The market is said to be "at rest" since the
  equilibrium price and equilibrium quantity will
  stay at those levels until either demand or
  supply changes.

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Market Equilibrium

• Equilibrium price The price that equates the
  quantity demanded with the quantity supplied.
• Equilibrium quantity The amount that people are
  willing to buy and sellers are willing to offer
  at the equilibrium price level.

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Market Equilibrium
TABLE 3.3. Market for Denim Pants TABLE 3.3. Market for Denim Pants TABLE 3.3. Market for Denim Pants
Price of Denim Pants (in pesos) Quantity Demanded per month (No. of pairs) Quantity Supplied per month (No. of pairs)
0 8 0
50 7 1
100 6 2
150 5 3
200 4 4
250 3 5
300 2 6
350 1 7
400 0 8
Equilibrium Price200
Equilibrium Quantity4
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Market Equilbrium

• At prices above the equilibrium price, quantity
  supplied is greater than quantity demanded,
  resulting in a temporary surplus.
• In a surplus situation, producers will try to
  reduce price to entice consumers to buy more
  denim pants. Actions by both producers and the
  public will wipe out the temporary surplus
• At prices below the equilibrium price, consumers
  desire to buy more denim pants than are
  available, creating a temporary shortage.
• Consumers will try to outbid each other, thus
  pushing up the price. As price rises, firms
  increase their production while some consumers
  reduce their purchases.

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Market Disequilibria

• Excess demand, or shortage, is the condition that
  exists when quantity demanded exceeds quantity
  supplied at the current price.

• When quantity demanded exceeds quantity supplied,
  price tends to rise until equilibrium is restored.

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Market Disequilibria

• Excess supply, or surplus, is the condition that
  exists when quantity supplied exceeds quantity
  demanded at the current price.

• When quantity supplied exceeds quantity demanded,
  price tends to fall until equilibrium is restored.

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Market Equilibrium
P
S
400
Surplus
Price (in pesos)
300
200
100
Shortage
Q
0
2
4
6
8
Quantity
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Using Math to Determine the Equilibrium
Example 1

• Algebraic solution equate the demand and supply
  equations (QdQs).
• Qd 8 - 0.02P
• Qs 0 0.02 P
• Step by step solution
• 8 - 0.02P 0 0.02 P
• 0.04P 8
• P 8/0.04 200
• Qd 8 0.02(200) 8 4 4
• P 200 per unit, Q 4 per month

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Using Math to Determine the
Equilibrium
Example 2

• Demand Qd 286 - 20p
• Supply Qs 88 40p
• Equilibrium
• Qd Qs
• 286 - 20p 88 40p
• 60p 198
• P 3.30
• Q 286 20(3.3) 220

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Using Math to Determine the Equilibrium
Example 3 (Do it yourself)
Demand QD 50 P (i) Supply QS
10 2P (ii)

• Set QD QS find market equilibrium P and Q
• 50 P 10 2P
• 3P 60
• P 20
• Knowing P, find Q
• Q 50 P
• 50 20 30
• Check the solution
• i) 30 50 20 and (ii) 30 10 40
  
• In both equations if P20 then Q30

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Market Equilibrium Excise Tax

• Impose a tax t on suppliers per unit sold
• Shifts the supply curve to the left
• QD a bP
• QS d eP with no tax
• QS d e(P t) with tax t on suppliers
• OR P Qs/e t
• IF QD a bP with tax ? QD b(Pt)
• OR P QD/ e - t
• So from example 1.
• QD 50 P,
• QS 10 2P becomes
• QS 10 2(P-t) 10 2P 2t cont..

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Tax Problem.
QD 132 8P QS 6 4P

• Find the equilibrium P and Q.
• How does a per unit tax t affect outcomes?
• What is the equilibrium P and Q if unit tax t
  4.5?

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Solution..

• (i) Market Equilibrium values of P and Q
• Set QD QS
• 132 8P 6 4P
• 12P 138
• P 11.5
• Knowing P, find Q
• Q 6 4P
• 6 4(11.5) 40
• Equilibrium values P 11.5 and Q 40

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Solution..
QD 132 8P QS 6 4(P t) 6
4P 4t
Set QD QS 132 8P 6 4P 4t 12P 138
4t P 11.5 1/3 t 13 if t
4.5 Imposing t gt ? consumer P by 1/3t, supplier
pays 2/3t Knowing P, find Q Q 132 8(13)
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(iii) If per unit t 4.5
Tax 0 Consumer Price 11.5 Supplier
Price 11.5 Tax 4.5 Consumer Price
13 Supplier Price 8.5 Tax Revenue PQ
4.528 126
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Increases in Demand and Supply

• Higher demand leads to higher equilibrium price
  and higher equilibrium quantity.

• Higher supply leads to lower equilibrium price
  and higher equilibrium quantity.

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Decreases in Demand and Supply

• Lower demand leads to lower price and lower
  quantity exchanged.

• Lower supply leads to higher price and lower
  quantity exchanged.

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Relative Magnitudes of Change

• The relative magnitudes of change in supply and
  demand determine the outcome of market
  equilibrium.

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Relative Magnitudes of Change

• When supply and demand both increase, quantity
  will increase, but price may go up or down.

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The Effects Of Simultaneous Shifts In Supply And
Demand
The Market for Corn Tortilla Chips
Price (/bag)
Millions of bags per month
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Questions?