Theory of Demand and

Supply: Equilibrium
Why do we need to know the demand and
supply of a commodity/service?
What determines demand and supply?
Is there a market for all goods and
services?
Can you relate this to the case?
Problem
• More parents wish to enroll their children in morning kindergarden
than there are available slots.
• Many parents who prefer morning kindergarden lose out
• Is there a more efficient way to allocate the scarce supply of morning
slots?
Public provision of a private good
• Provided the nature of the public school system, each child is entitled
to attend the public school
• Funded by taxpayers. Amount of taxes is not related to number of
children.
• Marginal cost of providing education is positive but the additional
price paid of sending an additional child is zero.
• Morning and afternoon slots are not interchangeable for parents
• Existing system: First cum first served basis
Conventional Price System
• 100 kindergarden children/slots (50 morning and 50 afternoon)
• More than 50 parents want their children in the morning session
(demand>supply)
• “Want” is defined to mean willingness to pay some positive price. Is it
correct for all commodity?
• Price is the surcharge imposed for morning as opposed to afternoon
kindergarden
Case 1: Q=1-50 are assigned to morning
kindergarden

• If parents with the 50 strongest

preferences phone are allotted under P=0,
consumer surplus is area ACEG
• Now let parents be charged an
equilibrium price of GH
• Consumer surplus=area ACH
• Net loss in consumer surplus of HCEG
• Thus implementation of traditional price
system results in a net decrease in
consumer surplus.
• 1-50 parents are worse off
Case: Parents 26-75 are assigned to
Morning Kindergarden
• Consumer Surplus is area BDF
• Under conventional price system,
equilibrium price=GH
• Area CDE represents the loss to parents
51-75
• Area ICEF represents the loss to parents
26 to 50 as they have to pay a price GH
• Losses equals gains
• Consumer surplus under the current
system is exactly equal to consumer
surplus under the price system
Voluntary Exchange
Case 3: A Modified Market System
• Are there gains from trade when
morning kindergarden is initially
allocated under the current system, and
then parents are permitted to exchange
slots among themselves?
• Figure shows the parents’ supply and
demand for slots that have already
been assigned by the township that are
available for trade among parents.
• Pareto superior: 1-25 are better off, 26-
50 are no worse off, 51-75 are better
off
Case 4: Perfect price discrimination under
a modified market system
• Parents 1-25 pays the highest price he is willing to pay
• Parents 51-75 receives his reservation price
• Parents 26-50 do not participate
• No consumer surplus for 1-25: not worse off than not having
• Parents 51-75 lose consumer surplus equal to area CED, but gain
equal to area ABFG, net gain ABIG
• Parents 26-50 no worse off
• Pareto superior
Is it correct to assume ‘rational’ economic
person?

Survey found
no market
among parents
for morning
kindergarden
Basic Definitions
• Market: A market is a group of buyers and sellers of a particular good
or service. The buyers as a group determine the demand for the
product, and the sellers as a group determine the supply of the
product.
• Competition in the market: a market in which there are many buyers
and many sellers so that each has a negligible impact on the market
price
What will determine my demand?
Demand
• Quantity demanded
• The amount of a good or service consumers are willing and able to
purchase during a given period.
• Three types of demand relations:
• General demand functions- which show how quantity demanded is
related to product price and five other factors that affect demand.
• Example- Income, Price of related goods etc.
• Direct demand functions- which show the relation between quantity
demanded and the price of the product
• Other factors are held constant.
• Inverse demand functions- maximum prices buyers are willing to pay
to obtain various amounts of product
General DEMAND Function
• How quantity demanded is related to six principal factors.
• The six principal variables that influence the quantity demanded of a good
are:
• The price of the good or service
• The incomes of consumers
• The prices of related goods and services
• The tastes or preference patterns of consumers
• The expected price of the product in future periods
• The number of consumers in the market
•
• Isolating the individual effect of a single variable requires that all other
variables that affect be held constant
General DEMAND Function
• Normal Good: If an increase in income causes consumers to demand
more of a good.
• Inferior Good: Increase in income would reduce consumer demand, other
variables held constant. Examples-shoe repair services and used cars
• Substitutes
• If an increase(decrease) in the price of one of the goods causes
consumers to demand more (less) of the other good, holding all other
factors constant. Examples- Tea and Coffee, Coke and Pepsi.
• Complements
• If an increase (decrease) in the price of one of the goods causes
consumers to demand less (more) of the other good, all other things
held constant. Example- Car & Petrol.
Relationship of factors with Quantity
demanded
Direct Demand Function
• Relationship between price and quantity demanded per period of time,
when all other factors are held constant.

• Demand curve
• A graph showing the relation between quantity demanded and price
when all other variables are constant.
Does this follow the law of demand?
Market Demand versus Individual
Demand
Shifts in the Demand Curve
Two Ways to Reduce the Quantity of
Smoking Demanded
Inverse demand function
• The demand function when price is expressed as a function of quantity
demanded.
• P
• Suppose the demand function is given as
• Inverse demand function for this function is P=140-(1/10
• Managers wish to know the highest price that can be charged for any given
amount of the product.
• Every point on a demand curve can be interpreted in either of two ways:
• Maximum amount of a good that will be purchased if a given price is charged
• Maximum price that consumers will pay for a specific amount of a good
• Every price along a demand curve is called the demand price for the
corresponding quantity on the horizontal axis
What determines supply?
SUPPLY
• The amount of a good or service offered for sale during a given period of time.
• Economists assume that the quantity of a good offered for sale depends on 6
major variables:
• The price of the good itself
• The prices of the inputs used to produce the good.
• The prices of goods related in production.
• The level of available technology.
• The expectations of the producers concerning the future price of the good.
• The number of firms or the amount of productive capacity in the industry
The General Supply Function
• T-Better technology-->Lower cost of production-->greater profits--
>increased supply of goods to the market.
Does this satisfy the law of supply?
Market Supply versus Individual Supply
What causes supply curve to shift?
Market Equilibrium

• A market equilibrium is a price such that, at this price,

the quantities demanded and supplied are the same
• Demand and supply curves intersect at equilibrium
• Excess supply or a surplus exists when the quantity
supplied exceeds the quantity demanded
• When quantity demanded exceeds quantity supplied it
is called excess demand or a shortage.
Equilibrium
Excess Supply and Excess Demand
What will happen in equilibrium price and
quantity of ice-cream in hot summers?
Now suppose that the price of sugar
increase?
Now suppose both the effects take place. What
will happen to equilibrium price and quantity?
CONSUMER SURPLUS
• Economic value-->maximum amount some buyer is willing to pay for
the unit.
• Consumers almost never have to pay the maximum amount they are
willing to pay.
• They instead must pay the market price, which is lower than the
maximum amount consumers are willing to pay.
• The difference between the economic value of a good and the price of
the good is the net gain to the consumer, and is called consumer
surplus.
How Price Affects Consumer Surplus
How a Higher Price Raises Producer
Surplus
Consumer surplus
• Consumer surplus: Difference between what a consumer is willing to pay for a good and the amount
actually paid.

• For e.g. a person is willing to pay Rs. 200 for a rock concert but its cost is Rs. 80, so how much is the
consumer surplus? 200

180 Demand curve

• Willingness to buy another ticket decreases and so 160

Price (rupees per ticket)

does the consumer surplus. 140

120 Consumer
surplus
• Actual expenditure: Calculate at equilibrium. 100 Market
price
• 80 X 6500 = Rs. 5,20,000 80

• Consumer surplus: Calculate the area of the triangle. 60

Actual Expenditure

• ½ (200-80) X 6500 = Rs. 3,90,000 0

1 2 3 4 5 6 7
Rock concert tickets
(thousands)
Consumer and Producer Surplus in the
Market equilibrium
The efficiency of the equilibrium Quantity
What do we learn from the case?
Impact of Price Cap on equilibrium
demand and supply of private schools
Stakeholders
• Schools
• Teachers
• Student
• Parents
Summary
• The issues raised by parents regarding annual fee hikes by private
schools were a serious concern.
• However, controlling the school fee as per FRA guidelines could also
have severe repercussions on the long-term health of the education
sector in Gujarat.
Case: Questions to think over
• What would be the long-term impact of FRA on the education sector
in Gujarat?
• Which stakeholders would be impacted the most?
• What should the private schools and government do to maximise
social welfare?
Case: Questions to think over
• Should the Gujarat government revise the FRA to make it more robust
(if it is not so already) or wait to gauge the impact of the current FRA?
• What steps could the government take to address the concerns of the
parents and the schools while preventing the private schools from
exploiting loopholes in the current system?
• What solution could the private school(s) propose to the government
to resolve their concerns, while ensuring a positive impact on all
stakeholders?
• Instead of a fee cap, what would happen if the government reduced
the barriers to entry for private schools?
Areas for improvement
• Subjective guidelines: Act was not clearly defined, executed
differently across the four zones
• Quantification of parameters: measurement error (teacher quality)
and verification error
• No parents representation
• Schools finding loopholes (de-bundling offers and modifying
documents for higher fee approval)
• Low fee school increases their fee
• Intended target school segment is small
Ceiling and Floor Prices

• Ceiling price
• The maximum price the government permits sellers to charge for a good.
• When this price is below equilibrium, a shortage occurs.
• Floor price
• The minimum price the government permits sellers to charge for a good.
• When this price is above equilibrium, a surplus occurs.
Example
Binding and Non-binding price ceiling
The Market for Gasoline with a Price
Ceiling
• In 1973 the Organization of Petroleum Exporting Countries (OPEC) raised the
price of crude oil in world oil markets.
• Because crude oil is the major input used to make gasoline, the higher oil prices
reduced the supply of gasoline.
• Long lines at gas stations became commonplace, and motorists often had to wait
for hours to buy only a few gallons of gas.
• What was responsible for the long gas lines?
• Most people blame OPEC. Surely, if OPEC had not raised the price of crude oil,
the shortage of gasoline would not have occurred.
• Yet economists blame U.S. government regulations that limited the price oil
companies could charge for gasoline
The Market for Gasoline with a Price
Ceiling
Rent Control in the Short Run and in the
Long Run
A Market with a Price Floor
How the Minimum Wage Affects the Labor
Market
Questions

• 1. Egg Industry: Majority of the poultry farms in India were non- mechanized till
the recent past. In 2012, with the invention of new technology we observed an
increase in the process of egg production. On the other hand, the society has
become more health conscious and their consumption of eggs have gone down.
Assuming eggs to be normal product, what would happen to the equilibrium
price and quantity of eggs produced. Explain the causes.
• 2. Education Industry: After implementation of AICTE regulations, the higher
educational institutes in India implemented the norms for maintaining good
standard of education. This means capital expenditure on the classrooms,
laboratories and libraries. With implementation of 7th Pay Commission, the
salaries of faculty also needed to be increased. At the same time, due to
increased awareness about education, more students enrolled in colleges.
Assuming college education as an inelastic good, determine what would happen
to the equilibrium prices and quantity of college education.
QUESTION Equilibrium
• and
• a. What are the equilibrium price and quantity?
• b. What is the market outcome if price is $2.75? What do you expect to happen? Why?
• c. What is the market outcome if price is $4.25? What do you expect to happen? Why?
• d. What happens to equilibrium price and quantity if the demand function becomes
• e. What happens to equilibrium price and quantity if the supply function becomes (demand is )?
• Solution: a) At equilibrium P= $3.75 and Q=20
• b) At P= $2.75, and , so shortage=18- Consumers will bid up price until it reaches 3.75
• c) At P= $4.25, and , so surplus=9, producers will lower price until it reaches equilibrium
• d) P= $4.25 and Q=25
• e) P= $5 and Q=10
Network externalities
• Situation in which each individual’s demand depends on the purchase of other
individuals

• Bandwagon effect: Positive network externality in which

a consumer wishes to possess a good because others D40
do.
D80

Price (rupees per unit)

• Increase in number of customers depend on decrease in
price. 300

• Market demand with bandwagon effect is relatively elastic. 200

Demand
curve
Pure price effect
• Bandwagon effect increases the quantity demanded in the 0
20 40 60 80 100
market with decrease in price. Quantity Bandwagon
(thousands per
effect
month)
Snob Effect
• Negative network externality in which a consumer wishes to own an exclusive or
unique good.
• Increase in number of customers reduces demand and hence Price (rupees
per unit)
the price decreases.
300,000

• Market demand curve is relatively inelastic. Demand

curve

• Snob effect decreases the quantity demanded in the market Pure price effect
with decrease in price. 150,000
D2
• Less elastic demand makes it possible for firms to raise
prices.
D6
0
2 4 6 8 10 12 14
Quantity (thousands per
Snob effect
month)
Question
Where is quantity demanded of good A each month, is price of good A, s average household income, the
price of related good B, is a consumer taste index ranging in value from 0 to 10 (the highest rating), is
price consumers expect to pay next month for good A, and N is number of buyers in the market for good
A.
a. Interpret the intercept parameter in the general demand function.
b. What is the value of the slope parameter for the price of good A? Does it have the correct algebraic
sign? Why?
c. Interpret the slope parameter for income. Is good A normal or inferior? Explain.
d. Are goods A and B substitutes or complements? Explain. Interpret the slope parameter for the price of
good B.
e. Are the algebraic signs on the slope parameters for and N correct? Explain.
f. Calculate the quantity demanded of good A when is $5, M is $25,000, =40, = 6.5, =$5.25, and
N=2,000.
Solution
a. 600 units of good A can be sold each month if , M, , , and N are all simultaneously
equal to zero.
b. -4. The slope parameter for a good’s own price must be negative because the law of
demand stipulates that quantity demanded and price of a good are inversely related.
c. The slope parameter on M (-0.03) indicates that a $1 increase in average household
income, all else constant, will decrease sales of good A by 0.03 unit per month. (Or a
$1,000 increase in M will decrease by 30 units per month.) Good A is an inferior good
because the slope coefficient on M is negative.
d. Complements. The slope parameter on is negative. A $1 increase in the price of
good B, all other factors constant, will cause the quantity demanded of good A to
decrease by 12 units per month.
e. These three slope parameters should all be positive, since each of the variables varies
directly (rather than inversely) with quantity demanded. For tastes, note that the slope
parameter (=15) is not restricted to the range 1 to 10 as is the value of the taste index .
f. =2,479.0 units of good A per month
QUESTION- CEILING PRICE and floor
price

Use the following graph to answer these questions.

a. What are the equilibrium price and quantity?
b. What is the effect of a ceiling price of $40?
c. What is the effect of a floor price of $70?
SOLUTION
• a. P=$60 and Q=400 units.
• b. A shortage of 400 (600-200) units occurs.
• c. A floor price of $70 results in a surplus of 200 (500-300) units.
Thank you