Demand, Supply and Market Equilibrium

Session 2

Dr. Sumudu Perera

 What do we learn in this lesson?
• What a competitive market is and how it is described by the
supply and demand model?
• Estimation of Demand/ Supply Curves
• Determination of Market Equilibrium
• Changes in the Market Equilibrium
• Government Intervention in the Market

2
 Supply and Demand
• A competitive market:
• Many buyers and sellers
• Similar good or service
• The supply and demand model is a model of how a competitive
market works.
• Key elements of a competitive market:
• Demand curve
• Supply curve
• Demand and supply curve shifts
• Market equilibrium
• Changes in the market equilibrium
 Demand
• Quantity demanded (Qd)
• Amount of a good or service consumers are willing & able to purchase
during a given period of time
• Demand function
• Quantity demand as a function of the independent variables that
influence the quantity demanded
• Direct demand
• The direct relationship between the quantity demanded and price (other
independent variables held constant)
• Inverse demand
• The direct relationship between price and quantity demanded
• Demand curve
• A graphical presentation of inverse demand
 Demand Function

Variables that influence Qd

 Price of good or service (P)
 Incomes of consumers (M)
 Prices of related goods & services (PR)
 Taste and preferences of consumers (T)
 Expected future price of product (Pe)
 Number of consumers in market (N)

Demand function
Qd = f(P, M, PR, T, Pe , N)
 Demand Function

Qd = a + bP + cM + dPR + eT + fPe + gN
b, c, d, e, f, & g are slope parameters
Measure effect on Qd of changing one of the
variables while holding the others constant
Sign of parameter shows how variable is related
to Qd
Positive sign indicates direct relationship
Negative sign indicates inverse relationship
Parameters/variables in the demand function

Variable Relation to Qd Sign of Slope Parameter

P Inverse b = Qd/P is negative

Direct for normal goods c= Qd/M is positive
M Qd/M
Inverse for inferior goods c = is negative

PR Direct for substitutes d = Qd/PR is positive

Inverse for complements d = Qd/PR is negative

T Direct e = Qd/T is positive

Pe Direct f = Qd/Pe is positive

N Direct g = Qd/N is positive

 Demand Function
The direct demand function, or simply demand,
shows how quantity demanded, Qd , is related to
product price, P, when all other variables are held
constant
Qd = f(P)
Law of Demand
Qd increases when P falls, all else constant
Qd decreases when P rises, all else constant
Qd/P must be negative
 Direct Demand Function
Demand for Bananas
Qd  f ( p, pb, pc, Y )
Qd  171  20 p  20 pb  3 pc  2 y
Qd / pb  20, q / pc  3, q / y  2
pb  4, pc  3, y  13
Qd  286  20 p
 Inverse Demand Function
Traditionally, price (P) is plotted on the vertical axis &
quantity demanded (Qd) is plotted on the horizontal axis
The equation plotted is the inverse demand function,
P = f(Qd)

How much consumers are willing to pay as a function of quantity

Q  286  20 p
p  14.30  0.05Q
p / Q  .05
 Graphing Demand Curves
Price of an
Apple)

A demand curve is the graphical

representation of the demand schedule; it
$2.00 shows how much of a good or service
1.75 consumers want to buy at any given price.

1.50

1.25

1.00

0.75 As price rises, the Demand

quantity curve, D
0.50 demanded falls

0 7 9 11 13 15 17
Quantity of Apples in
millions
Movement Along the Demand
Curve
Price of an A movement along the demand
Apple)
curve is a change in the quantity
A shift of the
demand curve…
demanded of a good that is the
$2.00
result of a change in that good’s
price.
1.75
A C … is not the same
1.50 thing as a movement
along the demand
1.25 curve
B
1.00

0.75

0.50 D D
1 2

0 7 8.1 9.7 10 13 15 17
Quantity of Apples in
millions)
 Shifts of the Demand Curve
A “decrease in demand”,
Price means a leftward shift of
the demand curve: at any
given price, consumers
Increase in demand a smaller quantity
demand
than before. (D1D3)

Decrease in
demand

D D D
3 1 2

Quantity
 Individual Demand Curve and the Market Demand Curve

The market demand curve is the horizontal sum of the individual demand
curves of all consumers in that market.
(a) (b) (c)
Mala’s Individual Rani’s Individual Market Demand Curve
Demand Curve Demand Curve
Price of an Price of an Price of an
Apple Apple Apple

$2 $2 $2

DMarket
1 1 1
DMala DRani

0 20 30 0 10 20 0 30 40 50
Quantity of Apples in Quantity of Apples in Quantity of Apples in
millions) millions millions
 Demand Estimation
Multiple Regression Analysis

Quantity Price Income Price of Kithul Develop a model for

50 1.5 12 1.8 estimating demand for
80 1.35 14.2 1.55 cured in the month of
95 1.25 15 1.45 January, 2017 based on the
105 1.2 16 1.35 average price, income and
70 1.4 13.8 1.6 price of Kithul
85 1.3 14.3 1.5
55 1.5 13.3 1.7
60 1.45 13.3 1.7 Degrees of
  Freedom (df)
75 1.35 13.7 1.6
Regression 3
90 1.25 14.5 1.5
Residual 8
100 1.2 15.2 1.35 Total 11
65 1.45 13.6 1.65
 The output table

Coefficient Standard Lower Upper Lower Upper

  s Error t Stat P-value 95% 95% 95.0% 95.0%
Intercept 176.27 45.29 3.89 0.00 71.83 280.71 71.83 280.71
Cured P -106.69 15.52 -6.87 0.00 -142.49 -70.89 -142.49 -70.89
Income M 4.57 1.81 2.53 0.04 0.40 8.73 0.40 8.73
Kithul PH -12.16 20.97 -0.58 0.58 -60.52 36.21 -60.52 36.21

Qd=176.27-106.69P+4.57M-12.16PH

For each rupee increase in For each rupee increase in price of

price of cured, the estimated
average amount demand used
is decreased by 106.69 liters,
holding price of Kithul
constant.
Kithul , the estimated average
demand for cured is decreased by
12.16 liters , holding price of cured
constant.
 Interpretation of the Results

Regression Statistics  
Multiple R 0.998
R Square 0.996
Adjusted R Square 0.994
Standard Error 1.342
Observations 12.000

R Square - 99.6% of the total variation in demand for cured can be

explained by price of cured, Income and price of Kithul
Adjusted R Square -99.4% of the total fluctuation in demand for cured
can be explained by price of cured, Income and price of
Kithul after adjusting for the number of explanatory variables
and sample size.
 Test for Overall Significance:
Example Solution
H0: 1 = 2 = … = k = 0 Test Statistic:

H1: At least one j  0

F  658.54
 = .05
df = 3 and 8
Decision:
(k-1) (n-k)
Reject at  = 0.05.
Critical Value: 4.07

Conclusion:
 = 0.05
There is evidence that at
least one independent
variable affects Y. 18
0 4.07
 t Test Statistic : Excel Output:
Example
Coefficient Standard
s Error
  (bi) (sbi) t Stat P-value
Intercept 176.27 45.29 3.89 0.00
Cured P -106.69 15.52 -6.87 0.00
Income M 4.57 1.81 2.53 0.04
Kithul H -12.16 20.97 -0.58 0.58

bi Critical t value at 95%

t Two tailed test = 2.306
Sbi
19
 Supply

Quantity supplied (Qs)

Amount of a good or service offered for sale during a given period
of time.
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
Qs = f(P, PI, Pr, T, Pe, F)
 Supply Function

Qs = h + kP + lPI + mPr + nT + rPe + sF

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
 Supply Function

Variable Relation to Qs Sign of Slope Parameter

k = Qs/P is positive
P Direct
PI Inverse l = Qs/PI is negative

Inverse for substitutes m = Qs/Pr is negative

Pr m = Qs/Pr is positive
Direct for complements

T Direct n = Qs/T is positive

Pe Inverse r = Qs/Pe is negative

F Direct s = Qs/F is positive

 Direct Supply Function
The direct supply function, or simply supply, shows how quantity
supplied, Qs , is related to product price, P, when all other
variables are held constant
Qs = f(P)
Supply of Apples
Q  S ( p, ph )

Q  178  40 p  60 ph

ph  $1.50

Q  88  40 p
 Inverse Supply Function

Traditionally, price (P) is plotted on the vertical axis & quantity

supplied (Qs) is plotted on the horizontal axis
The equation plotted is the inverse supply function,
P = f(Qs)

Qs  88  40 p
p  2.2  .025Qs
 Supply Curves

A point on a direct supply curve shows either:

Maximum amount of a good that will be offered for sale at a
given price
Minimum price necessary to induce producers to voluntarily
offer a particular quantity for sale

Qs  S ( P , PI , F )
Qs  100  20 P  10 PI  20 F
PI  100, F  25
Qs  400  20 P
Inverse Supply
P  20  1 / 20Qs
 Change in Supply

 Change in quantity supplied

Occurs when price changes
Movement along supply curve
 Change in supply
Occurs when one of the other variables, or determinants of
supply, changes
Supply curve shifts rightward or leftward
 Market supply and individual supplies
Ben’s Jerry’s Market
supply + supply = supply
Price of Price of Price of
Ice Ice Ice
Cream Cream Cream
Cones SBen Cones Cones
$3.00 $3.00 $3.00 SMarket
SJerry
2.50 2.50 2.50

2.00 2.00 2.00

1.50 1.50 1.50

1.00 1.00 1.00

0.50 0.50 0.50

0 1 2 3 4 5 6 7 8 9 10 11 12 0 1 2 3 4 5 6 7 0 2 4 6 8 10 12 14 16 18
Quantity of Ice-Cream Cones Quantity of Quantity of Ice-Cream Cones
Ice-Cream Cones
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 Market Equilibrium

Equilibrium price & quantity are determined by the intersection

of demand & supply curves
At the point of intersection, Qd = Qs
Consumers can purchase all they want & producers can sell
all they want at the “market-clearing” or “equilibrium” price
Qd  1,400  10 P
Qs  400  20 P
Qd  Qs
1,400  10 P  400  20 P
Pe  $60
Qe  800
 Market Equilibrium

Excess demand (shortage)

Exists when quantity demanded exceeds quantity
supplied
Excess supply (surplus)
Exists when quantity supplied exceeds quantity
demanded
 Changes in market equilibrium

• 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

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 How an Increase in Demand Affects the Equilibrium
Price of
Ice-Cream 1. Hot weather increases
Cone the demand for ice cream . . .

Supply

$2.50 New equilibrium

2.00
2. . . . resulting
Initial
in a higher
equilibrium
price . . .
D

0 7 10 Quantity
31 of
3. . . . and a higher Ice-Cream Cones
quantity sold.
 How a Decrease in Supply Affects the Equilibrium
Price of
Ice-Cream 1. An increase in the
Cone price of sugar reduces
the supply of ice cream. . .
S2
S1

New
$2.50 equilibrium

2.00 Initial equilibrium

2. . . . resulting
in a higher
price of ice
cream . . . Demand

0 4 7 Quantity32of
3. . . . and a lower Ice-Cream Cones
quantity sold.
 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

33
 A Shift in Both Supply and
Demand

Can predict either the direction in which price changes or the direction in which
quantity changes, but not both The change in equilibrium price or quantity is said
to be indeterminate when the direction of change depends on the relative
magnitudes by which demand & supply shift
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 Exercises

Example 1: Suppose that the price of Chinese food rises. What

happens to the market for pizza?

Example 2: Suppose instead that the Chinese food business is incredibly

popular and profitable. What happens to the market for pizza?

Example 3: Now lets combine examples 1 and 2 so that what happens to

the market for pizza?

35
Government Intervention in the
market
 Ceiling & Floor Prices

Ceiling price
Maximum price government permits sellers to charge for a good
When ceiling price is below equilibrium, a shortage occurs
Floor price
Minimum price government permits sellers to charge for a good
PWhen
x
floor price is above equilibrium, a surplus occurs
Px
Sx Sx

Price (dollars)
Price (dollars)

3
2 2
1

Dx
Qx Qx
22 50 62 32 50 84
Quantity
Ceiling price
Floor price
 Price Ceiling -Example

Qd  1,400  10 P If government
Qd  1,400  10(50) impose a price ceiling
of $50
Qd  900
Qs  400  20 P
Qs  400  20(50)
A price ceiling is only
effective when it is set
Qs  600
below the equilibrium
Excess demand  Qd  Qs  300 price
 Price Floor
Qd  1,400  10 P If government
Qd  1,400  10(80) impose a price floor
Qd  600 of $ 80
Qs  400  20 P
Qs  400  20(80)
Qs  1,200 A price floor is only
Excess supply  Qs  Qd  600 effective when it is set
above the equilibrium
price
 Value of Market Exchange

Typically, consumers value the goods they purchase by an amount

that exceeds the purchase price of the goods
Economic value
Maximum amount any buyer in the market is willing to pay for
the unit, which is measured by the demand price for the unit
of the good
 Measuring the Value of Market Exchange

Consumer surplus
Difference between the economic value of a good (its
demand price i.e the price that consumer is willing to
pay) & the market price the consumer must pay
Producer surplus
For each unit supplied, difference between market
price & the minimum price producers would accept
to supply the unit (its supply price)
Economic/Social surplus
Sum of consumer & producer surplus
Area below demand & above supply over the
relevant range of output
 Consumer and Producer Surplus

Price

Consumer S
Surplus

Po Producer Surplus

Qo
Quantity
 Loss in Efficiency
Too High of Price (Price Floor)

Price Deadweight Loss

Lost
New Consumer
Consumer S
Surplus
Surplus
Price Floor
PH

Po Lost Producer Surplus

New Producer
Surplus
D

QL Qo
Quantity
Loss in Efficiency -Too Low of Price (Price
Ceiling)

Price Deadweight Loss

Lost
Consumer S
Surplus
New Consumer
Surplus

Po Lost Producer Surplus

PL
New Producer Price ceiling
Surplus
D

QL Qo
Quantity
 Taxation and Government

 For government to provide goods and services such as national

defense, social security, public health services, free education
etc. it must have money.

 The Government raises money several ways including direct

taxes and indirect taxes.

 Taxes may be paid by everyone or only those that use a good or

service: who pays depends on the type of tax.
 The Costs of Taxation
• The costs of taxation include:
• The direct cost of the revenue paid to
government
• The loss of consumer and producer surplus
caused by the tax
• The cost of administering the tax codes.
 The Costs of Taxation
Consumer Surplus Before Tax: A + B + C
Consumer Surplus After Tax: A
Producer Surplus Before Tax: D + E + F
Producer Surplus After Tax: F
Deadweight Loss: C + E

Price Consumer S1
surplus
S0
A
P1 tax
B C Deadweight
P0 loss
D E
P1–t
F

Producer Demand
surplus
Q1 Q0 Quantity
 Who Bears the Burden of a
Tax?
• The supply and demand framework gives the answer
to this question when the elasticities of the supply and
demand curves are considered.
• The person who physically pays the tax is not
necessarily the person who bears the burden of the
tax.
• The burden of the tax is rarely shared equally since
the elasticities are rarely equal.
 Who Bears the Burden of a
Tax?
$70,000 S0
Price of milk powder

60,000 Consumer pays

50,000 Supplier pays

tax
40,000 D0
30,000 D1
20,000
10,000 510

200 400 600 Quantity of milk powder

Burden Depends on Relative Elasticity
• Elasticity is a measure of how easy it is for the supplier
and consumer to change their behavior and substitute
other goods.
• Consequently, the more one group (consumers or
suppliers) is able or willing to change its behavior
relative to the other group the more likely it is to avoid
the tax burden.
• The relative burden of the tax dictates that the more
relatively inelastic the behavior of one’s group (supply
or demand), the larger the tax burden one will bear.
• If demand is more inelastic than supply, consumers will
pay the higher share. If supply is more inelastic than
demand, suppliers will pay the higher share.