THE MARKET FORCES OF SUPPLY AND DEMAND

POINTS
Market

and Competition Demand Supply Equilibrium Elasticity

MARKETS AND COMPETITION

The terms supply and demand refer to the behaviour of people A market is a group of buyers and sellers Buyers determine demand... Sellers determine supply

COMPETITION: PERFECT OR OTHERWISE

Perfectly Competitive: Buyers and Sellers are Price Takers

Monopoly: One Seller, controls price

DEMAND DEFINED
A schedule or a curve that shows the various amounts of a product that consumers are willing and able to purchase at each of a series of possible prices.

LAW OF DEMAND
An inverse relationship exists between price and quantity demanded
As

Price Falls Quantity Demanded Rises As Price Rises Quantity Demanded Falls

TABLE 1 : CATHERINES DEMAND SCHEDULE Price of Ice-cream Cone ($)

0.00 0.50 1.00 1.50 2.00 2.50 3.00

Quantity of cones Demanded

12 10 8 6 4 2 0

FIGURE 1: CATHERINES DEMAND CURVE

Price of IceCream Cone

$3.00 2.50

2.00 1.50 1.00 0.50

10

12

Quantity of IceCream Cones

TABLE 2: MARKET DEMAND AS THE SUM OF INDIVIDUAL DEMANDS

Price of Ice-cream Cone ($)
0.00 0.50 1.00 1.50 2.00 2.50 3.00 Catherine 12 10 8 6 4 2 0 + Nicholas 7 6 5 4 3 2 1 = Market 19 16 13 10 7 4 1

FIGURE 2: SHIFTS IN THE DEMAND CURVE

Price of IceCream Cone

Increase in demand

Decrease in demand

D2
D1 D3
Quantity of IceCream Cones

DETERMINANTS OF DEMAND
Income

Normal (Superior) & Inferior Goods

Prices of Related Goods

Substitutes & Complements

Tastes

Expectations Number

of Buyers

SHIFT VERSUS MOVEMENT ALONG DEMAND CURVE FIGURE 3-A): A SHIFTS IN THE DEMAND CURVE
Price of Cigarettes, per Pack.

A policy to discourage smoking shifts the demand curve to the left.

B
$2.00

D1 D2
0 10 20

Number of Cigarettes Smoked per Day

FIGURE 3-B): A MOVEMENT ALONG THE DEMAND CURVE

Price of Cigarettes, per Pack.

C
$4.00

A tax that raises the price of cigarettes results in a movements along the demand curve.

A
$2.00

D1

12

20

Number of Cigarettes Smoked per Day

TABLE 3: THE DETERMINANTS OF QUANTITY DEMANDED

SUPPLY DEFINED
Supply is a schedule or a curve showing the amounts of a product that producers are willing and able to make available for sale at each of a series of possible prices.

LAW OF SUPPLY
A direct relationship exists between price and quantity supplied
As

Price Rises Price Falls

Quantity Supplied Rises

As

Quantity Supplied Falls

TABLE 4: BENS SUPPLY SCHEDULE

Price of Ice-cream Cone ($)
0.00 0.50 1.00 1.50 2.00 2.50 3.00

Quantity of cones Supplied

0 0 1 2 3 4 5

FIGURE 4: BENS SUPPLY CURVE

Price of IceCream Cone

$3.00 2.50

2.00 1.50 1.00 0.50

10

12

Quantity of IceCream Cones

TABLE 5: MARKET SUPPLY AS THE SUM OF INDIVIDUAL SUPPLIES

Price of Ice-cream Cone ($)
0.00 0.50 1.00 1.50 2.00 2.50 3.00 Ben 0 0 1 2 3 4 5 + Nicholas 0 0 0 2 4 6 8 = Market 0 0 1 4 7 10 13

FIGURE 5: SHIFTS IN THE SUPPLY CURVE

Price of IceCream Cone

S3 S1 S2

Decrease in supply

Increase in supply

Quantity of IceCream Cones

DETERMINANTS OF SUPPLY

Input Prices Technology Expectations Number of Sellers

TABLE 6: THE DETERMINANTS OF QUANTITY SUPPLIED

SUPPLY AND DEMAND TOGETHER

Equilibrium refers to a situation in which the price has reached the level where quantity supplied equals quantity demanded.

EQUILIBRIUM

Equilibrium Price The price that balances quantity supplied and quantity demanded. On a graph, it is the price at which the supply and demand curves intersect. Equilibrium Quantity The quantity supplied and the quantity demanded at the equilibrium price. On a graph it is the quantity at which the supply and demand curves intersect.

EQUILIBRIUM
Demand Schedule Supply Schedule

At $2.00, the quantity demanded is equal to the quantity supplied!

FIGURE 6: THE EQUILIBRIUM OF SUPPLY AND DEMAND

Price of IceCream Cone

Supply

$2.00

Equilibrium price

Equilibrium

Demand
Equilibrium quantity

10

11

Quantity of IceCream Cones

NOT IN EQUILIBRIUM

Surplus When price > equilibrium price, then quantity supplied > quantity demanded. There is excess supply or a surplus. Suppliers will lower the price to increase sales, thereby moving toward equilibrium. Shortage When price < equilibrium price, then quantity demanded > the quantity supplied. There is excess demand or a shortage. Suppliers will raise the price due to too many buyers chasing too few goods, thereby moving toward equilibrium.

FIGURE 7-A): EXCESS SUPPLY

Price of IceCream Cone

Surplus Supply
$2.50

$2.00

Demand

4
Quantity Demanded

10
Quantity Supplied

11

Quantity of IceCream Cones

FIGURE 7-B): EXCESS DEMAND

Price of IceCream Cone

Supply

$2.00

$1.50

Shortage

Demand

4
Quantity Supplied

10
Quantity Demanded

11

Quantity of IceCream Cone

THREE STEPS TO ANALYZING CHANGES IN EQUILIBRIUM

Decide whether the event shifts the supply or demand curve (or both). Decide whether the curve(s) shift(s) to the left or to the right. Use the supply-and-demand diagram to see how the shift affects
equilibrium price and quantity.

Example: A Heat Wave

FIGURE 8: HOW AN INCREASE DEMAND AFFECTS THE EQUILIBRIUM

Price of IceCream Cone
1. Hot weather increases the demand for ice cream

Supply
$2.50
New equilibrium

$2.00
2. resulting in a higher price

Initial equilibrium

D2

D1

10

11

Quantity of IceCream Cone

3. and a higher quantity sold.

FIGURE 9: HOW A DECREASE SUPPLY AFFECTS THE EQUILIBRIUM

Price of IceCream Cone

S2
1. An earthquake reduces the supply of ice cream

S1

$2.50

New equilibrium

$2.00
2. resulting in a higher price

Initial equilibrium

Demand

10

11

Quantity of IceCream Cones

3. and a lower quantity sold.

FIGURE 10-A): A SHIFT IN BOTH SUPPLY AND DEMAND

Price of IceCream Cone
Large increase in demand

New equilibrium

S2 S1
Small decrease in supply

P2

P1

Initial equilibrium

D2

D1 0 Q1
Q2
Quantity of IceCream Cone

FIGURE 10-B): A SHIFT IN BOTH SUPPLY AND DEMAND

Price of IceCream Cone
Small increase in demand

New equilibrium

S2
S1

P2
Large decrease in supply

P1

Initial equilibrium

D2

D1 0 Q2 Q1
Quantity of IceCream Cone

The Concept of Elasticity

Elasticity is a measure of how much buyers and sellers respond to changes in market conditions. Elasticity allows us to analyze supply and demand with greater precision.

ELASTICITY OF DEMAND AND SUPPLY

Price Elasticity of Demand (Ep) Calculating Percentage Change Significance of Price Elasticity of Demand (Ep) Determinants of Price Elasticity of Demand (Ep)

THE PRICE ELASTICITY OF DEMAND

It measures how much the quantity demanded responds to a change a price. Demand for a good is elastic if the quantity demanded responds substantially to changes in the price. Demand is said to be inelastic if the quantity demanded responds only slightly to changes in the price.

COMPUTING THE PRICE ELASTICITY OF DEMAND The price elasticity of demand is the change in quantity demanded divided by the percentage change in price.

Percentage change in quantity demanded ED Percentage change in price

MIDPOINT METHOD

Midpoint method is a better way to calculate percentage changes and elasticities.

Q2 Q1 1 Q1 Q2 E 2 P P 2 1 1 P P 1 2 2

PERFECTLY INELASTIC DEMAND

We say that demand is perfectly inelastic when a 1% change in the price would result in no change in quantity demanded.

Price

Perfectly Inelastic Demand (elasticity = 0)

Quantity

PERFECTLY ELASTIC DEMAND

We say that demand is perfectly elastic when a 1% change in the price would result in an infinite change in quantity demanded.

Price
Perfectly Elastic Demand (elasticity = )

Quantity

PRICE ELASTICITY OF DEMAND

From Formula Ep = % Change in Qd % Change in Price If Price Elasticity of Demand > 1, demand is elastic If Price Elasticity of Demand = 1, demand is unit elastic If Price Elasticity of Demand < 1, demand is inelastic

SLOPE OF THE DEMAND CURVE

DP is the change in price. (DP<0) DX is the change in quantity. slope = DP/ DX 1/slope = DX/ DP

Price

Demand

P slope X

P P+ DP DP DX

X + DX

Quantity

CROSS ELASTICITY OF DEMAND

A measure of the extent to which the demand for a good changes when the price of a substitute or complement changes, ceteris paribus

% Change in Quantity Demanded % Change in Price of one of its substitutes or complements

INCOME ELASTICITY OF DEMAND

A measure of the extent to which the demand for a good changes when income changes, ceteris paribus

% Change in Quantity Demanded % Change in Income

SIGNIFICANCE OF PRICE ELASTICITY OF DEMAND

Profit maximization requires that business set a price that will maximize the firms profit Elasticity tells the firm how much control it has over using price to raise profit If Ep > 1, then the % Change in Qd > % Change is Price and demand is said to be elastic

An increase in price will reduce total revenue A decrease in price will increase total revenue

SIGNIFICANCE OF PRICE ELASTICITY OF DEMAND

If Ep < 1, then the % change in Qd < % change in price, and demand is said to be inelastic

An increase in price will increase total revenue A decrease in price will decrease total revenue

If Ep = 1, then the % change in Qd = % change in Price, and

demand is said to be unit elastic

An increase in price will have no impact on total revenue A decrease in price will have no impact on total revenue

PRICE ELASTICITY OF SUPPLY

It measures how much the quantity supplied responds to changes in the price. Supply of a good is said to be elastic if the quantity supplied responds substantially to changes in the price. Supply is said to be inelastic if the quantity supplied responds only slightly to changes in the price.

COMPUTING THE PRICE ELASTICITY OF SUPPLY

The price elasticity of supply is the proportional change in quantity demanded relative to the proportional change in price.

Percentage change in quantity supplied ES Percentage change in price

PERFECTLY INELASTIC SUPPLY

We say that supply is perfectly inelastic when a 1% change in the price would result in no change in quantity supplied.

Price

Perfectly Inelastic Supply (elasticity = 0)

Quantity

PERFECTLY ELASTIC SUPPLY

We say that supply is perfectly elastic when a 1% change in the price would result in an infinite change in quantity supplied.

Price

Perfectly Elastic Supply (elasticity = )

Quantity

COMPUTING PRICE ELASTICITY OF SUPPLY

Percentage change in quantity supplied Percentage change in price
If Price Elasticity of Supply > 1, Supply is elastic If Price Elasticity of Supply = 1, Supply is unit elastic If price elasticity of supply< 1, Supply is inelastic

INFLUENCES ON PRICE ELASTICITY OF SUPPLY

Production Possibilities -- Opportunity Costs constant or gently rising opportunity costs = elastic price elasticity -- Fixed Production = inelastic price elasticity -- Time Elapse longer time > price elasticity

INFLUENCES OF PRICE ELASTICITY OF SUPPLY

Storage Possibilities
The better the storability, the more elastic is the price elasticity of supply

DETERMINANTS OF ELASTICITY

Time period The longer the time under consideration the more elastic a good is likely to be Number & closeness of substitutes The greater the number of substitutes, the more elastic. The proportion of income taken up by the product The smaller the proportion the more inelastic. Luxury or Necessity For example, addictive drugs.

IMPORTANCE OF ELASTICITY

Relationship between changes in price and total revenue Importance in determining what goods to tax (tax revenue) Importance in analysing time lags in production Influences the behaviour of a firm

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