Demand, Supply, and Market Equilibrium

In a market mechanism, the demand and supply curves interact to determine

the price and quantity of a good or services.
•The analysis of demand and supply is essential to understand price and output
movement in a market.
•Demand is the behavior of potential buyers in a market.
•Demand is defined as the entire relationship between price and quantity.
•Quantity demanded of a commodity is defined as the quantity of that
commodity demanded at a certain price during any particular period of time.

Demand and Supply Analysis

Why Should Managers Study Supply and Demand?
Managers need to understand supply and demand to develop their own
competitive strategies and to respond to the actions of their competitors.
Managers need to understand how the structure of the market that their firm
operates in impacts supply and demand.
Managers need to understand how public policy will impact supply and
demand.

Demand
•Demand
•Demand schedule or demand curve
•Amount consumers are willing and able to purchase at a given price
•Other things equal
•Individual demand
•Market demand

Individual demand
•The demand of an individual consumer
•Market demand
•Sum of individual demands of all consumers in the market

Features of Demand
oIt depends on the utility of the commodity;
oIt always means effective demand. Always backed by purchasing power and
willingness or ability to spend it;
oIt is a flow concept;
oIt refers to demand for final consumer goods;
oIt is always related to certain price;
oIt is a desired quantity. It shows consumers wish or need to buy the
commodity;
oIt does not refer to quantity actually bought.

Factors Affecting/ Determining Demand

Main factors:
Own price;
Prices of other goods;
Consumers’ income;
Weather conditions
Consumers’ tastes and
preferences
Other factors:
Income distribution;
Past levels of demand and
income;
Population growth;
Government policy;
Wealth of the consumers.

DEMAND DEFINED
The amount of a good or service a consumer wants to buy, and is able to buy per unit time.

THE “STANDARD” MODEL OF DEMAND

•The DEPENDENT variable is the amount demanded.
•The INDEPENDENT variables are:
•the good’s own price
•the consumer’s money income
•the prices of other goods
•preferences (tastes)

THE DEMAND FUNCTION

Functional relationship between demand for a commodity and its determinants
is known as demand function.

Dx= f(Px, Py, Y, T);

•Where

Dx = Demand for commodity x;

Px = Price of commodity x;
Py = Price of other commodity y;
Y = Consumers’ incomes
T = Consumers’ tastes and preference.

Demand Functional Relationship

•A relation between the price of a good and the quantity that consumersare
willing and ableto buy during a given period, other things constant.
•Willing: you want to buy the product
•Able: you can afford the buy the product

Law of demand
•Other things equal, as price falls, the quantity demanded rises, and as price
rises, the quantity demanded falls
•Explanations
•Price acts as an obstacle to buyers
•Law of diminishing marginal utility
•Income effect and substitution effect

In other words, higher the price, lower the demand and lower the price, higher
the demand, if other things remain same. That is, the quantity demanded is
negatively related to the price of the good.

Law of Demand
Dx = f (Px)
Dx = a –bPx
Where,
Dx = Demand of commodity, x
Px = Price of commodity, x
f = functional relationship
a = Vertical Intercept of the demand curve; and
b = slope of the demand curve.

Price increases Quantity Demanded decreases

•Price decreases Quantity demanded increases
•Creates a downward sloping demand curve

Reasons behind downward slope of demand curve

Or, why demand curve slopes downwards to the right?
oLaw of diminishing marginal utility
oSubstitution effect
oIncome effect
oNew consumers

Exceptions to the law of demand:

oGiffen goods;
oVeblen good;
oException of a price rise in future;
oBandwagon effect;
oEmergency;
oGood with uncertain product quality;
oSnob appeal;
oBrand loyalty.
Substitution Effect
•Unlimited wants/scarce resources
•When the price of a good falls, consumers substitute that good for other goods,
which become relatively more expensive.
•Reverse also holds true

Income Effect
•Money income: is simply the number of peso received per period
•Real income: your income measured in terms of what it can buy.
•A fall in the price of a good increases consumers’ real income making
consumers more able to purchase goods; for a normal good, the quantity
demanded increases.
•Demand curve:
–a curve showing the relation between the price of a good and quantity demanded during a given
period, other things constant.
–Suppose we are making pandesal.
Price of Good Quantity Demanded
Php3 200
Php4 150
Php5 100
Php6 75
Php7 50

The demand curve for any good shows the quantity demanded at each price,
holding constant all other determinants of demand.
•The DEPENDENT variable is the quantity demanded.
•The INDEPENDENT variable is the good’s own price.
Movement Along the Demand Curve
•Caused by a change in price
•Only a change in price
•Move from one point to another on the same graph
•Called a
•Change in quantity demanded.

Determinants of demand
•Change in consumer tastes and preferences
•Change in the number of buyers
•Change in income
•Normal goods

•Inferior goods

Change in prices of related goods

•Complementary good
•Substitute good
•Change in consumer expectations
•Future prices
•Future income
Complementary goods
•Two goods are said to be complements if an increase in the price of one good
leads to a fall in the quantity demanded of other.

Example: Car and Petrol

Substitute goods
•Two goods are said to be substitute if an increase in the price of one lead to an
increase in the quantity demanded of the other.

Example: Tea and Coffee

Changes in determinants
•Results in changes to the RELATIONSHIP BETWEEN PRICE AND QUANTITY
DEMANDED.
•At each and every price a DIFFERENT quantity is demanded.
•Results in a shift in the demand curve
•New curve must be drawn
Increase in consumer income
•Causes consumers to buy more of the product at each and every price.
•Normal goods
•Inferior goods
Normal goods
•A good for which demand increases as consumer income rise

•Inferior goods
•A good which demand increases as consumer income falls

Changes in Price of Related Goods

•Substitutes
•Goods that are not consumed jointly
•Goods that are related in such a way that an increase in the price of one shifts
the demand curve for the other rightward.
•Increase in price of Coke leads to increase in demand for Pepsi

Complements
•Goods that are related in a such a way that an increase in the price of one
shifts the demand of the other leftward
•Two goods that are consumed jointly.
•An decrease in the price of one will increase demand for the other
Such as expectations in
•Prices and income
•Affect how consumers spend their money and their demand
•If product cheaper today than tomorrow, then increase in demand

Changes in consumer tastes

•Consumer preferences likes and dislikes in consumption assumed to be
constant along a given demand curve assumed constant along a given demand
curve
•Changes in taste will cause a shift in the demand curve as different quantities
are demanded at each and every price.

Change in the number and composition of consumers

•The market demand curve is the sum of the individual demand curves.
•If the number of consumers falls then the sum will be smaller thus shifting the
demand curve

Change in Quantity Demanded (Movement: Expansion or Contraction):

oA movement along the demand curve is caused by a change in the price of the
good only, other things remaining the same.
oIt is also called change in quantity demanded of the commodity.
Change in Demand (Shift: Increase or Decrease in Demand Curve)
oA shift of the demand curve is caused by changes in factors other than price of
the good. These other factors are:
Consumer’s income;
Price of other goods;
Consumers’ tastes and preferences, etc.
oA change in any of these factors causes shift of the demand curve. It is also
called change in demand curve.
oShift in demand curve means a new demand curve is drawn.
oA shift of the demand curve (or change in demand curve) can be of two types:
Increase in demand; and
oDecrease in demand.

oIncrease in demand refers to more demand at a given price or same demand at

a higher price. This is due to-
Increase in the income of the consumers;
Increase in the price of substitute goods;
Fall in the price of complementary goods;
Consumers taste becoming stronger in favor of the good.
Review of Demand
•A change in quantity demanded is not a change in demand
•Change in quantity demanded is caused by a change in price
•Change in quantity demanded is a movement along the demand curve
•Change in demand is caused by a change in the determinants
•Change in demand shifts the demand curve
•Supply
•Supply schedule or a supply curve
•Amount producers are willing and able to sell at a given price
•Individual supply
•Market supply

Supply and stock are different from each other.

•Stock of a commodity refers to the quantity of commodity available with the seller
at a point of time.
•Supply is that part of the stock which is offered for sale corresponding to different
possible prices of the commodity.

Supply Function
•It shows the relationship between quantity supplied and its determinants. That
is,

Sx = f (Px, Py, T, C, Gp)

•Where:
oSx = Supply of commodity x;
oF = function of
oPx = Price of commodity x;
oPy = Price of commodity y;
oT = Technological changes
oC = Cost of production or price of inputs;
oGp = Government policy or excise tax rate.
Factors Determining Supply
oPrice of the Commodity: Price is the prime determinant of supply. As stated
earlier, higher the price, higher the quantity supplied and lower the price, lower
the quantity supplied.
oPrice of Related Goods: Supply of a commodity is also affected by price of
related goods. An increase in the price of a related good induces a firm to adjust
its supplies. Example: If price of cars rises, supply of 2-wheeler is expected to be
restricted. Implying that the firms will now sell 2-wheelers only at a higher price.
oNumber of Firms: Larger the number of firms, greater the quantity supplied and
vice versa. Thus, under conditions of perfect competition, supply of a commodity
is generally higher than under monopoly.
oGoal of the Firm: Supply of a good also depends upon goal of the firm.
Generally, a sales maximizing firm offers a higher quantity of the good for sale
than a profit-maximizing firm.
oPrice of Factor Inputs: The price of inputs (such as labor, raw material)
determines the cost of production. If input price rises, cost of production increases
and profits are reduced. This will cause supply to fall at the given price.
oTechnology: Technological improvement reduces cost of production. It induces
the producers to produce more and increase the supply of a commodity. More is
offered for sale at a given price.

oGovernment Policy: Changes in taxation and subsidy policy of the government

also affects the market supply of a commodity. Higher tax burden on the firms
restricts the supply, while subsidies are an inducement to increase the supply of a
commodity.
oProducers’ Expectations: Generally, supply is restricted if the producers expect
that price of a commodity to rise in the near future, and vice versa.

Law of supply
•Other things equal, as the price rises, the quantity supplied rises and as the price
falls, the quantity supplied falls
•Explanation
•Price acts as an incentive to producers
•At some point, costs will rise
The quantity of a good supplied during a given period is usually directlyrelated to
the price of the good
•Increase in price leads to increase in quantity supplied
•Decrease in price leads to decrease in quantity supplied.
•Creates upward sloping supply curve

Determinants of Supply
•A change in technology
•A change in the number of sellers
•A change in taxes and subsidies
•A change in prices of other goods
•A change in producer expectations

Individual supply
•It refers to supply of a commodity by an individual firm in the market.
•The supply of an individual producer
•Market supply
•The sum of individual supplies of all producers in the market
•Individual Supply Curve
•Supply curve is a graphic presentation of supply schedule showing positive
relationship between price of a commodity and its quantity supplied.

Reasons behind Upward Sloping Supply Curve

•Law of diminishing marginal productivity
•Goals of profit maximization.

Change in quantity supplied (movement-expansion or contraction)

oA movement along the supply curve is caused by changes in the price of the
good, other things remaining constant.
oIt is also called change in quantity supplied of the commodity. In a movement,
no new supply curve is drawn.
oMovement along the supply curve can be of two types:
a)Expansion or extension of supply; and

b)Contraction of supply.
oExpansion or extension of supply refers to rise in supply due to rise in price of
the good. Contraction of
supply refers to fall in supply
due to fall in the price of
good.
Causes of increase in Supply
•Improvements in Technology
•Changes in relevant resources
•Decrease in the price of resources
•Lowers costs
•Changes in price of alternative goods
•If price of alternative good increases, supply of the good increases
•Changes in producers expectations
Changes in technology
•Technology is the economy’s stock of knowledge about how to combine resources
efficiently

Improvements in technology
•Causes an increase in supply
•More of the product is available at all prices
Changes in prices of Alternative Goods
•Alternative goods
•Other goods that use some or all of the same resources as the good in question
•Beef and leather.
•If the price of beef increases, producers will supply more beef thus increasing the
supply of leather.
Changes in Producers Expectations
•Expectation of future prices of resources or their own product can cause
producers to change what they offer at each individual price
Changes in the Number of Producers
•As the number of producers change so does the supply of the product
•A decrease in the number of producers will lead to a decrease in supply

Causes of Decrease in Supply

•Backward movement in Technology
•Changes in relevant resources
•Increase in the price of resources
•Raises costs
•Changes in price of alternative goods
•If price of alternative good decreases, supply of the good decreases
•Changes in producers expectations

Changes in Relevant Resources

•Are those employed in the production of the good in question
•Increase in price of resources
•Results in decrease in supply
•Less of the good is available at all prices

Producer’s Expectation
•Nationalization

•Expropriation

Supply Review
•Change in Quantity Supplied
•Caused by a change in the price of the product
•Movement along the supply curve
•Change in Supply
•Caused by change in the determinants
•Results in a shift in the supply curve
Market Mechanism: Interaction between Demand and SupplyMarket
Equilibrium

Market
•Includes all the arrangements used to buy and sell
•Reduce transaction costs
•The place where buyers and sellers meet to determine price and quantity
The two curves intersect at the equilibrium point (EP) or market-clearing price and
quantity.
•At this price (EP), the quantity demanded and the quantity supplied are just
equal (EQ) as can be seen in the following figure.

Equilibrium occurs where the demand curve and supply curve intersect
•Equilibrium price and equilibrium quantity
•Surplus and shortage
•Rationing function of prices
•Efficient allocation

oExample:
The supply curve for sugar is given as
Supply: Qs = 1800 + 240P and demand for sugar is given as
Demand: Ds = 3550 –266P; where P is price in SR per kg.

The equilibrium price of sugar and equilibrium quantity of sugar in the free
market will be there where quantity demanded is equal to quantity supplied in the
market. That is,
Supply: Qs = Demand: Ds
1800 + 240P = 3550 –266P
240P + 266P = 3550-1800
506P = 1750
P = 1750/506
P = 3.46

So, the price of sugar will be SR 3.46 per kg.

To find out the market-clearing quantity (equilibrium quantity), substitute this

price of SR 3.46 into either the supply curve equation or the demand curve
equation. Substituting into the supply curve equation, we get;
Supply: Qs = 1800 + 240P
Qs = 1800 + 240*3.46 = 2630 Kg.
So, equilibrium price is SR 3.46 per kg and equilibrium quantity of supply is
2630 kg.

Efficient Allocation
•Productive efficiency
•Producing goods in the least costly way
•Using the best technology
•Using the right mix of resources
•Allocative efficiency
•Producing the right mix of goods
•The combination of goods most highly valued by society
Equilibrium
•At specific price where:

Quantity demanded = Quantity supplied

•Equilibrium price –
•market clearing price
•Equilibrium quantity –
•D = S

If market price is ABOVE equilibrium

•Qs > QD
•Economy is at a SURPLUS
•Market price will fall

If the market price is BELOWthe equilibrium price

•QD > Qs
•Shortage exists
•Market price rises to equilibrium

Shifts in Demand
•Demand increases
•Equilibrium price increases
•Equilibrium quantity increases

Decrease in demand
•decrease in price
•decrease in equilibrium

Increase in supply
•Decrease in equilibrium price
•Increase in quantity
Government Set Prices
•Price ceiling
•Set below equilibrium price
•Rationing problem
•Black markets
•Example is rent control

Price floor
•Prices are set above the market price
•Chronic surpluses
•Example is the minimum wage law

Price Floors
•A minimum legal price below which a good or service cannot be sold
•If above equilibrium causes surplus

Price Ceilings
•A maximum legal price above which a good or service cannot be sold
•Below equilibrium price
•Shortage occurs

The Elasticity of Demand

•Elasticity
•Measure of the responsiveness of quantity demanded or quantity supplied
•To one of its determinants

Price elasticity of demand

•Measure of how much quantity demanded of a good responds
•To a change in the price of that good
•Percentage change in quantity demanded
•Divided by the percentage change in price
•Measures how willing consumers are to buy less of the good as its price rises

Elastic demand
•Quantity demanded responds substantially to changes in the price
•Inelastic demand
•Quantity demanded responds only slightly to changes in the price

Determinants of price elasticity of demand

•Availability of close substitutes
•Goods with close substitutes
•More elastic demand
•Necessities vs. luxuries
•Necessities –inelastic demand
•Luxuries –elastic demand
•Definition of the market

•Narrowly defined markets –more elastic demand

•Time horizon
•More elastic over longer time horizons
Determinants of Price Elasticity of Demand
•Substitutability
•More substitutes, demand is more elastic
•Proportion of income
•Higher proportion of income, demand is more elastic

Luxuries versus necessities

•Luxury goods, demand is more elastic
•Time
•More time available, demand is more elastic
Cross Elasticity of Demand
•Measures responsiveness of purchases of one good to change in the price of
another good
•Substitute goods if elasticity is positive
•Complement goods if elasticity is negative
•Independent goods if elasticity is 0
L
Income Elasticity of Demand
•Income elasticity of demand
•Measure of how much the quantity demanded of a good responds
•To a change in consumers’ income
•Percentage change in quantity demanded
•Divided by the percentage change in income
•Normal goods: positive income elasticity
•Necessities: smaller income elasticities
•Luxuries: large income elasticities
•Inferior goods: negative income elasticities
High income elasticities
•Most affected by a recession
•Low or negative income elasticity
•Not affected that much by a recession

The Elasticity of Supply

•Price elasticity of supply
•Measure of how much the quantity supplied of a good responds
•To a change in the price of that good
•Percentage change in quantity supplied
•Divided by the percentage change in price
•Depends on the flexibility of sellers to change the amount of the good they
produce

Price elasticity of supply

•Elastic supply
•Quantity supplied responds substantially to changes in the price
•Inelastic supply
•Quantity supplied responds only slightly to changes in the price
•Determinant of price elasticity of supply
•Time period
•Supply is more elastic in long run
The Elasticity of Supply
Computing price elasticity of supply
•Percentage change in quantity supplied
•Divided by percentage change in price
•Variety of supply curves
•Supply is perfectly inelastic
•Elasticity =0
•Supply curve –vertical
•Supply is perfectly elastic
•Elasticity = infinity
•Supply curve –horizontal

The Elasticity of Supply

Variety of supply curves
•Unit elastic supply
•Elasticity =1
•Elastic supply
•Elasticity >1
•Inelastic supply
•Elasticity < 1

Price Elasticity of Supply

•Measures sellers’ responsiveness to price changes
•Elastic supply, producers are responsive to price changes
•Inelastic supply, producers are not as responsive to price changes

Time is primary determinant of elasticity of supply

•Time periods considered
•Immediate market period
•Short run

•Long run