Lecture3 Posting-1

Lecture 3:
Demand, market equilibrium

and welfare
Reading: NW Ch. 6, 9
The story so far…
Costs Firm
objectives
Supply
2
The story so far…
Consumer preferences
Costs Firm
and wealth
objectives
Demand Supply
3
The story so far…
Consumer preferences
Costs Firm
and wealth
objectives
Demand Supply
Market outcome:
price, quantity, welfare
4
Outline
• Consumer behaviour – DEMAND
– Consumers aim to maximize their well-being
– Relate marginal benefit of consuming a good to demand
• Functioning of MARKETS:
– Demand + Supply => equilibrium
– Market equilibrium: price, quantity traded
– Welfare analysis: surplus for consumers and firms
BUSS1040 - Lecture 3 5
Demand
NW Ch. 6
Background
• Consumer behaviour  demand for goods & services
• In economics we examine consumer behaviour assuming

each consumer tries to maximize their well-being, or the
benefit he or she gets from consuming goods and
services, subject to their budget constraint (trade-offs)
• First, we consider competitive markets

– That’s where the choices of individual consumers do not affect
the price in the market – consumers are price takers.
Benefit and willingness to pay
• A consumer derives some benefit from consuming a
particular good or service.
• The benefit a consumer gets is also their willingness

to pay (WTP).
– The maximum price a consumer will pay for a good is
equal to the benefit they anticipate getting from the item
(in money terms).
Total benefit and marginal benefit
• When a consumer buys multiple units of a good,
important to distinguish between total and marginal
benefit.
• Example: Candice's willingness to pay for coffee is $4

for the first cup, $3 for the second and $2 for the third.
– Her total benefit for the three cups is $9.
– Her marginal benefit (MB) measures how much extra
benefit she derives from consuming an additional cup.
o Her marginal benefit is $4 for the first cup, $3 for the
second cup and $2 for the third cup of coffee.
Marginal benefit
• Generally, we expect marginal benefit to decline with
each additional unit consumed (declining or
diminishing MB).
o The extra benefit a consumer gets from a good gets
smaller the more of that good the consumer has already
enjoyed.
• When the consumer buys many units of a good,
typical to have a continuous (smooth) MB curve.
A typical marginal benefit curve
$
Individual demand
• We can use a consumer's marginal benefit curve to derive his
individual demand curve.
• An individual’s demand is the quantity of a good or

service that a consumer is willing and able to buy at a
certain (market) price.
o Hence, the individual demand curve traces out all
combinations of (a) market price and (b) individual
demand at that price, holding everything else constant
(ceteris paribus).
o Q: what are some of the other determinants of “buying plans”, that

we hold constant when considering an individual’s demand curve?
Individual demand and MB
• The maximum price a consumer will pay for a good is
equal to the benefit they anticipate getting from the
item (in money terms).
• A consumer will purchase units of the good up until
the point where P = MB. Why?
Individual demand and MB
• The maximum price a consumer will pay for a good is
equal to the benefit they anticipate getting from the
item (in money terms).
• A consumer will purchase units of the good up until
the point where P = MB. Why?
o If P<MB for a unit of a good the consumer should buy
that unit because her willingness to pay for that unit
exceeds the price.
o If P> MB for a unit of the good, the consumer should
not buy that unit.
o Given diminishing MB, consumer should buy the good
until P = MB.
Individual demand
• A consumer purchases units of a good up to P=MB
• Consequently, a consumer's individual demand

curve is her MB curve.
o Due to diminishing MB, individual demand is
downward sloping.
• A demand curve represents how much a consumer is

willing and able to buy at different market prices.
Individual demand
An individual consumer's demand curve is

given by his or her marginal benefit curve.
Law of demand
• The downward slope of the demand curve means
that a consumer consumes fewer units when the
price is higher.
• This negative relationship between price and
quantity demanded is known as the law of demand.
Movement along a demand curve
• The demand curve is derived by assuming that only
price and quantity can change.
• If there is a change in the price/quantity, there will
be a movement along the demand curve.
o If there is a movement downwards along the demand
curve, this is called an ‘increase in the quantity demanded’.
o If there is a movement up along the demand curve, this is
called a ‘decrease in the quantity demanded’.
Movement along a demand curve
𝑃
A movement along the demand curve is known

as a ‘change in the quantity demanded’.
𝑝1
𝑝2
𝐷
𝑞
𝑞1 𝑞2
Change in demand
• A demand curve is drawn assuming all other relevant
factors (other than the price of the good itself and the
resulting quantity demanded) are held constant (ceteris
paribus).
o These factors include the income, tastes, price
expectations and the prices of other related goods.
• If any of these factors change, the demand curve itself will

shift in or out.
• A shift of the demand curve is called a change in demand.
o If demand shifts right this is called an ‘increase in demand’;
o A shift to the left, this is called a ‘decrease in demand’.
Change in demand
A movement of the demand curve
itself is called a ‘change in
demand‘; a shift from D1 to D2 is an
increase in demand. A shift from D2
to D1 is a decrease in demand.
Market demand
• An individual consumer's demand curve is given by
his MB curve.
o We can use this to derive the market demand curve.
• The MARKET demand curve traces out combinations

of (a) market price and (b) quantities that all
consumers in a market are together willing and able
to buy at that price.
Market demand
• We often are interested in demand at the market
level (rather than just for one individual).
• The market demand curve can be derived by adding
together the quantity demanded by each individual
consumer at each price.
o Example: suppose the market price of apples is $4, and
that there are just two consumers in the market.
o At this price, Sonia is willing to buy six apples and Elizabeth
is willing to buy three apples.
o This means that, at $4, the total quantity demanded in the
market is nine apples.
Market demand
• Also need to check how much Sonia and Elizabeth
would together be willing to buy when the price of
apples is $2, $3, $5, $6 etc.
• This means that, graphically, the market demand

curve is the horizontal summation of the individual
demand curves (the individual MB curves) along the
q-axis.
Market Demand
Price Adam Eve Market
(DfA) (DfE) (DfA+E)
$11 5 1 6
$9 7 3 10
$7 9 5 14
$5 11 7 18
$3 13 9 22
$1 15 11 26
12$
11
10
3 DfA+E
2
1 DfE DfA
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Quantity
21 22 23of 24
Pizza
25 26
Market demand – horizontal
summation of individual MB curves
Market demand
• Note, the law of demand also holds for the market
demand curve.
o If the law of demand holds for all individual demand
curves, it will hold for market demand, which is their
horizontal summation.
• We can also use the term change in the quantity
demanded to refer to movements along the market
demand curve, and the term change in demand to
refer to a shift of the demand curve itself.
Concluding comments - Demand
• We have now derived the individual and market
demand curves.
• A demand curve answers the question ‘if the

consumer faces a certain price, what quantity would
they buy?’, for a range of possible prices.
• Note, it is only possible to answer this question if the

consumer is a price taker – that is the individual
consumer’s choices have no impact on price.
Market equilibrium and welfare
analysis
NW Ch. 9
Introduction
• Together, demand and supply determine the price
and quantity traded of a good or service in a market.
• These market outcomes are the focus of this part of

the lecture.
Market equilibrium
• A market is in equilibrium if, at the market price, the
quantity demanded by consumers equals the
quantity supplied by firms in the market.
• The price at which this occurs is called the market-

clearing price (or ‘equilibrium price’).
• If a market is not in equilibrium, there will be

pressure on price and quantity to move towards the
equilibrium price and equilibrium quantity.
Market equilibrium
𝑃
A market in equilibrium.
The equilibrium price is
𝑃∗ 𝐴 P* and the equilibrium
quantity traded is Q*
𝐷
𝑄
𝑄∗
Market equilibrium
• A market is in equilibrium if, at the market price, the
quantity demanded by consumers equals the
quantity supplied by firms in the market.
• The price at which this occurs is called the market-

clearing price (or ‘equilibrium price’).
• If a market is NOT in equilibrium, there will be

pressure on price and quantity to move towards the
equilibrium price and equilibrium quantity.
Excess supply – price above market
clearing price
𝑃
𝑆
excess supply
𝑃1
𝐷
𝑄
𝑄1𝑑 𝑄1𝑠
Excess supply
• If the market price is above the equilibrium price, the
quantity supplied exceeds the quantity demanded.
o This difference is called excess supply.
o Sellers cannot find buyers for all units supplied to the
market.
o There will be downward pressure on prices
• sellers try to bring more consumers into the market by lowering
prices; at the same time, the quantity supplied will fall and
quantity demanded will rise in response to the decrease in prices.
o This downward pressure on prices will continue until the
excess of supply is eliminated, moving the market towards
equilibrium.
Excess demand
𝑃
When market price is

below the equilibrium
price, there is an
excess of demand in
the market.
𝑃2
excess demand
𝐷
𝑄
𝑄2𝑠 𝑄2𝑑
Excess demand
• If the market price is below the equilibrium price, there is
excess demand.
o The quantity demanded exceeds the quantity supplied
o Sellers do not supply enough units to meet consumer demand.
o There will be upward pressure on prices
• buyers compete for limited units in the market; this increase in prices
will increase the quantity supplied and also decrease quantity
demanded.
o This upward pressure on prices will continue until the excess of
demand is eliminated, moving the market towards equilibrium.
Comparative static analysis
• Markets are affected by a change or event beyond
the direct control of buyers or sellers in that market.
• In such cases, we may want to analyse how that

change or event affects the choices of firms and/or
consumers in the market, and how those choices
affect market outcomes.
Comparative static analysis
• How do we deal with it?
1. Assume that the market in question is initially in
equilibrium.
2. Ascertain whether the change or event will affect the
demand curve or the supply curve of the market (or
both).
o That is, which curve will shift, and which way will it move.
3. Use the demand and supply diagram to compare prices

and quantities traded in the market before and after the
change.
Example: car market
Consider the market for cars when the price of steel increases.
Example: car market
Consider the market for cars when the price of steel increases.
1. The market is initially in equilibrium at (Q*,P*).
2. Assuming that steel is an input in the production of cars,

the MC of making each car will increase, causing the
supply curve to shift up to S2 (decrease in supply).
3. This will cause a decrease in the quantity demanded, as

we move along the demand curve D1 to the new
equilibrium. At the new equilibrium (Q2,P2).
o Price of cars is higher but quantity traded is lower than before
the change in the price of steel.
Example: car market with an increase
in the steel price
𝑃
𝑆2
𝑆1
𝑃2∗
𝑃1∗
𝐷1
𝑄
𝑄2∗ 𝑄1∗
Question
• Consider the market for cars. Following a

technological innovation in steel production overseas,
car producers can import steel at a lower price than
before. What happens in the car market?
A. Increase in supply
B. Market price for cars drops
C. Quantity of cars sold rises
D. All of the above
E. I have no idea
Answer
• Consider the market for cars. Following a

technological innovation in steel production overseas,
car producers can import steel at a lower price than
before. What happens in the car market?
A. Increase in supply
B. Market price for cars drops
C. Quantity of cars sold rises
D. All of the above
E. I have no idea
Welfare – the benefit to market
participants
• Markets are one of the main ways that goods and
services are produced and distributed.
• Consumers and firms will only participate in markets if

it is beneficial to them
– they are at least as well off from trading than if they do not
• We can measure and observe changes in the benefits

to these participants using welfare analysis.
Consumer surplus
• Consumer surplus (CS) is the welfare consumers
receive from buying units of a good or service in the
market.
• We can measure consumer surplus by evaluating the
net value (net benefit) of a good or service to the
consumer, as he or she perceives it.
• That is, consumer surplus is given by the consumer's
willingness to pay, minus the price actually paid, for
each unit bought.
Consumer surplus – intuition
• Hamish buys a chocolate bar. His willingness to pay (or
marginal benefit) for the chocolate bar is $5.50, but the
price is $2.
• He receives $5.50 benefits, minus the price actually

paid of $2.
• Therefore, his surplus (or net benefit) from buying the

chocolate bar is $3.50.
• Repeating this process for every unit purchased
calculates the CS Hamish receives from all the
chocolate bars he buys.
Consumer surplus and the demand
curve
• Recall the individual demand curve traces out a
consumer's marginal benefit or willingness to pay
• An individual's CS is by calculating the area between

the individual demand curve and the price line.
• Similarly, we can find the CS of all consumers in the

market by calculating the area between the market
demand curve and the price line.
Consumer surplus
𝑃
The area of consumer
𝑆
surplus in this market
is denoted by the
grey-shaded area –
CS the area under the
𝑃∗ demand curve above
the price line.
𝐷
𝑄
𝑄∗
Change in CS with a decrease in price
If price falls from P1 to P2 , CS
increases due to 2 reasons:
𝑃 (1) on all the units previously
consumed, the difference
between MB and price is now
larger, increasing the net
benefit from consuming each
A of these units (area B); and
(2) the lower price now means
𝑃1 that more units are
B purchased, generating an
C
𝑃2
additional net benefit to
consumers (area C).
𝐷
𝑄
𝑄1 𝑄2
Producer surplus
• Producer surplus (PS) is the welfare producers
(firms) receive from selling units of a good or service
in the market.
• Producer surplus can be measured by considering

the net benefit of selling a good or service.
• That is, producer surplus is given by the price the

producer receives, minus the cost of production, for
each unit of the good or service bought.
Producer surplus – intuition
• Adam sells chocolate bars. The price of chocolate bars
is $2. The marginal cost to Adam of producing the
chocolate bar is $0.50.
• If Adam sells the chocolate bar, his net benefit is the $2

received, minus $0.50 in extra production costs.
• Therefore, his PS from selling the chocolate bar is

$1.50.
• If Adam sells multiple units, add up the surplus from

each chocolate bar to get his PS from selling chocolate
bars.
Producer surplus and the supply curve
• A firm's supply curve is given by its MC curve.
• A firm's PS can be found by calculating the area

between the price line and the firm's supply curve.
• Similarly, we can find the PS of all producers in the

market by calculating the area between the price
line and the market supply curve.
Producer surplus
𝑃
𝑆
The area of producer
surplus in this market is
denoted by the grey-shaded
area.
𝑃∗
PS
𝐷
𝑄
𝑄∗
Producer surplus with an increase in
price
𝑃
𝑆
When the market price increases
from P1 to P2, PS increases from A to
𝑃2 A+B+C. The area B represents the
B C
increase in PS from an increase in the
𝑃1 net benefit of selling units that would
have been sold previously. The area C
A
is the increase in PS from the sale of
additional units.
𝑄
𝑄1 𝑄2
Total surplus
• We can also measure the total welfare of all participants
in the market.
o Here, there are only two types of participants: consumers and
producers.
o In later chapters, we will allow for other participants in the
market (namely, the government).
• With only consumers and producers in the market, total

surplus (TS) is the sum of consumer surplus and
producer surplus in the market equilibrium:
TS = CS + PS
→ total gains from trade
Total surplus – sum of CS and PS
𝑆 In this market, TS is the

area between the
demand and supply
curves, up to the market
equilibrium quantity q*.
TS TS in this market is
denoted by the grey-
shaded area
𝐷
𝑄
Pareto efficiency
• To analyse welfare in a market further, we introduce the
concept of Pareto efficiency.
• Pareto efficient if it is not possible to make someone better

off without making someone else worse off.
– Conversely, an outcome is not Pareto efficient if it is possible to
reallocate resources (or do things differently in the market) and make
someone better off without making someone else worse off.
• Another way of thinking about Pareto efficiency in this

context is that the Pareto efficient outcome maximizes total
surplus.
Competitive market outcome and
efficiency
𝑃
𝑆 The competitive market maximizes

the total gains from trade, hence it
is Pareto efficient. It is not possible
to change the level of output (up
or down) and make at least one
TS person better off without making
anyone worse off.
𝐷
𝑄
efficiency
The outcome in a competitive market is Pareto
efficient:
• For all the trades up to the competitive market equilibrium
(Q*), MB ≥ MC.
• Hence, the consumer is willing to pay more than the extra
cost required to make the item.
• Trading all units up until Q* increases total surplus (as it
increases CS, PS or both).
efficiency
• If fewer than Q* units are traded, this outcome is not Pareto
efficient, because it is possible to increase the number of
units traded in order to make the consumer and/or the
producer better off, without making any one worse off.
• If more than Q* units are traded we know that MC > MB. All
units traded beyond Q* make someone worse off: either the
buyer paid more than his MB, the seller received a price less
than her MC, or both. Therefore, this outcome is not Pareto
efficient, because total surplus would rise if output were
reduced (back to Q*).
efficiency
efficiency
• In the competitive-market equilibrium, all the potential
gains from trade are exhausted.
o There are no consumers left in the market with a willingness to
pay higher than any seller’s MC to provide an additional unit.
o Importantly, the price mechanism ensures that the people with

the highest value for the product (those that are willing to pay
more than the price) end up with the goods, and that those
firms with the lowest cost are the ones who make the goods
(the firms who have a MC less than the market price).
o While these actions are completely decentralized, in the sense

that there is no one person coordinating the actions of the
many parties in the market, a competitive market manages to
maximize total surplus (that is, reach a Pareto efficient
outcome).
Caveat regarding Pareto efficiency
• Pareto efficiency has a very strict and specialized
definition.
• It does not imply either uniqueness or
fairness/equity.
o It is possible that there is more than one market outcome
in an economy that is Pareto efficient.
 Unclear which one is best
o Further, an outcome that is Pareto efficient is not
automatically the most fair or equitable, or even the most
desirable.
Concluding comments – market
equilibrium
• We defined consumer surplus, producer surplus and
total surplus.
• A competitive market has the following characteristics:
o (i) via the price mechanism, it allocates goods to
consumers who value them most highly; and
o (ii) via the price mechanism, it allocates demand for goods
to sellers who can produce at the least cost.
o (iii) a competitive market maximizes total surplus and,
hence, is Pareto efficient. It follows that a person who can
dictate the price and quantity of a good traded in the
market (a ‘social planner') cannot achieve an outcome that
is more efficient than the free (competitive) market.
Next week
• ELASTICITY: responsiveness of one variable to a change
in another variable
– Examples: how does the equilibrium quantity traded respond to a
change in the market price? How does demand respond to changes in
consumer income? How does supply respond to a change in input prices?
• Market structure
– Perfectly competitive markets
• Characteristics
• Short run vs. long run
• Supply: firm and market
• Short vs. long run market equilibrium

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Lecture 3:

Demand, market equilibrium

• In economics we examine consumer behaviour assuming

• First, we consider competitive markets

• The benefit a consumer gets is also their willingness

• Example: Candice's willingness to pay for coffee is $4

• An individual’s demand is the quantity of a good or

o Q: what are some of the other determinants of “buying plans”, that

• Consequently, a consumer's individual demand

• A demand curve represents how much a consumer is

An individual consumer's demand curve is

A movement along the demand curve is known

• If any of these factors change, the demand curve itself will

• The MARKET demand curve traces out combinations

• This means that, graphically, the market demand

• A demand curve answers the question ‘if the

• Note, it is only possible to answer this question if the

• These market outcomes are the focus of this part of

• The price at which this occurs is called the market-

• If a market is not in equilibrium, there will be

• The price at which this occurs is called the market-

• If a market is NOT in equilibrium, there will be

When market price is

• In such cases, we may want to analyse how that

3. Use the demand and supply diagram to compare prices

1. The market is initially in equilibrium at (Q*,P*).

2. Assuming that steel is an input in the production of cars,

3. This will cause a decrease in the quantity demanded, as

• Consider the market for cars. Following a

• Consider the market for cars. Following a

• Consumers and firms will only participate in markets if

• We can measure and observe changes in the benefits

• He receives $5.50 benefits, minus the price actually

• Therefore, his surplus (or net benefit) from buying the

• An individual's CS is by calculating the area between

• Similarly, we can find the CS of all consumers in the

• Producer surplus can be measured by considering

• That is, producer surplus is given by the price the

• If Adam sells the chocolate bar, his net benefit is the $2

• Therefore, his PS from selling the chocolate bar is

• If Adam sells multiple units, add up the surplus from

• A firm's PS can be found by calculating the area

• Similarly, we can find the PS of all producers in the

• With only consumers and producers in the market, total

𝑆 In this market, TS is the

• Pareto efficient if it is not possible to make someone better

• Another way of thinking about Pareto efficiency in this

𝑆 The competitive market maximizes

o Importantly, the price mechanism ensures that the people with

o While these actions are completely decentralized, in the sense

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1. The market is initially in equilibrium at (Q,P).