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Chapter 3

Topic 3

Supply and

DEMAND AND SUPPLY

Demand

ANALYSIS

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Ahmed Munawar

(I) MARKET DEMAND

The demand for a good or service is

defined as:

Quantities of a good or service that

people are ready (willing and able) to

buy at various prices within some given

time period, other factors besides price

held constant.

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Demand in Output Markets

ANNA'S DEMAND

SCHEDULE FOR

TELEPHONE CALLS

QUANTITY
PRICE
DEMANDED
(PER
(CALLS PER
CALL)
MONTH)
\$
0
30
0.50
25
3.50
7
7.00
3
10.00
1
15.00
0

A demand schedule is a table showing how

much of a given product

a household would be willing to buy at

different prices.

Demand curves are usually derived from

demand schedules.

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The Demand Curve

ANNA'S DEMAND
SCHEDULE FOR
TELEPHONE CALLS
QUANTITY
PRICE
DEMANDED
(PER
(CALLS PER
CALL)
MONTH)
\$
0
30
0.50
25
3.50
7
7.00
3
10.00
1
15.00
0

The demand curve

is a graph

illustrating how

much of a given

product a

household would be willing to buy

at different prices.

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Market Demand

Market demand is the sum of all the individual demands.

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Market Demand is the Sum of

Individual Demands

Assuming there are only two households in the market, market demand is derived as follows:

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The Law of Demand

The law of demand states
that there is a negative, or
inverse, relationship
between price and the
quantity of a good
demanded and its price.
This means that demand
curves slope downward.

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The Law of DemandExplanations

There are two ways to explain the Law

of Demand

Substitution effect

Income effect

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Two Reasons for the Inverse

Relationship

Substitution effect

P

Q

When price of a good decreases, the

consumer substitutes the lower priced good for the more expensive ones.

Income effect

When price decreases, the consumer’s

increases, so he tends to buy more.

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1.

Two Reasons for the Inverse

Relationship

Substitution effect

P

Q

When price of a good increases, the

consumer tends to substitute it with the

lower priced goods.

2.

Income effect

When price increases, the consumer’s

decreases, so he tends to buy less.

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Shift of Demand Versus Movement Along a Demand Curve

Changes in price result in changes in the quantity demanded.

This is shown as movement along the demand curve.

Changes in nonprice determinants

result in changes in demand.

This is shown as a shift in the demand

curve.

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Shift of Demand Versus Movement Along a Demand Curve

• A change in demand is
not the same as a change
in quantity demanded.
• In this example, a higher
price causes lower
quantity demanded.
• Changes in determinants
of demand, other than
price, cause a change in
demand, or a shift of the
entire demand curve, from
D A to D B .

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Change in quantity demanded

Price
p
1
•A decrease in price from p 1
to p 2 brings about an
increase in quantity
demanded from q 1 to q 2
•It is shown as a movement
along the same demand
p
2
curve
D
Quantity
q 1
q 2

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Change in demand

•An increase in demand
Price
means that at the same
price such as p1 more will
be brought, due to other
factors such as increased
p
incomes, increase in number
1
of consumers, etc.
•It is shown as a shift in the
entire demand curve
This is a
decrease in
demand
D
1
D
0
D
2
Quantity
q
q
1
2

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Change in Demand

P

D

D’

Q

Increase in Demand

P

D’

D

Q

Decrease in Demand

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Nonprice determinants of demand

 1 Consumer incomes 2 Prices of related commodities (substitutes and complements) 3 Tastes and preferences 4 Number of consumers 5 Price expectations

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Nonprice determinants of demand

1. Income:

As income changes, demand a commodity

usually changes

Normal goods are goods whose demand respond

positively to changes in income.

Most goods are normal goods. As income increases, more of shoes, TVs, clothes, are bought.

Inferior goods are goods whose demand respond

negatively to change in income

Few but existent. Examples are firewood, “tuyo”, “adidas or

chicken feet”, bicycles, etc.

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The Impact of a Change in Income

Higher income decreases the demand

for an inferior good

Higher income increases the demand

for a normal good

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Other factors affecting demand

2. Prices of related commodities in consumption:

Substitutes are goods that are substitutable with each other (not necessarily perfect).

Examples are coffee and tea, Coke and Pepsi

When the price of a substitute increases, quantity bought of a good increases. --- P y Q x (direct relationship)

Complements are goods that are used or consumed together.

Examples are coffee and sugar, bread and butter, tennis rackets and tennis balls.

When the price of a complement increases, quantity bought of a good decreases. --- P y Q x (inverse relationship)

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The Impact of a Change in the Price of Related Goods

Demand for complement good (ketchup) shifts left

Demand for substitute good (chicken) shifts right

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Price of hamburger rises

Quantity of hamburger demanded falls

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Other factors affecting demand

3. Consumer tastes and preferences:

When consumer tastes shift towards a particular good,

greater amounts of a good are demanded at each price.

Example: consumers preference for drinking mineral water increases so its demand curve will shift rightward.

If consumer preferences change away from a good, its demand will decrease; at every possible price, less of the good is demanded than before.

Example: the demand for VCDs and VHS tapes

decreases due to preference for DVDs.

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Other factors affecting demand

4. Consumer expectations: Expectations about future prices and income affect our current

demand for many goods and services.

If we expect prices of dried fish to increase with coming of the rainy season, we might stock up on the

good to avoid the expected price increase. Thus, current

demand for dried fish might increase

those who expect to lose their jobs due to bad economic conditions, will reduce their demand for a variety of

goods in the current period.

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Other factors affecting demand

5. Number of Consumers: affects the total demand for a good.

Total demand is also known as market demand. It is the

summation of the individual demand of all consumers

An increase in the number of consumers shifts the market demand curve to the right

Example: demand for housing and transportation

increases with an increase in population.

On the other hand, less consumers will cause the

market demand to decrease, resulting in a shift to

the left of the entire demand curve.

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General Demand Function

Variables that influence Q d

Price of good or service (P)

Incomes of consumers (M)

Prices of related goods & services (P R )

•• TasteTaste patternspatterns ofof consumersconsumers (( ))

Expected future price of product (P e )

Number of consumers in market (N)

General demand function

Q

Q

d

d

f (P,M, P ,, P , N)

)

f (

P M

,

,

P

R

R

P

,

e

e

N

,

,

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Demand Function

Quantity demanded (Q) is expressed as a mathematical function of price (P). The demand

function may thus be written as:

Qd = a - bP

where

a is the horizontal intercept of the equation or the quantity demanded when price is zero

(-b) is the slope of the function.

Example:

Qd = 8 - 0.02P

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Demand Function

The processed fish demand function is:

Q = D(p, p b , p c , Y)

where Q is the quantity of fish demanded

p is the price of fish (dollars per kg)

p b is the price of beef (dollars per kg)

p c is the price of chicken (dollars per kg)

Y is the income of consumers (thousand dollars)

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Demand Function to the Demand Curve

Estimated demand function for fish:

Q = 171−20p + 20p b + 3p c + 2Y

Using the values p b = 4, p c = 3.33 and Y = 12.5, we have

Q = 286−20p

which is the linear demand function for fish.

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Demand Function to the Demand Curve

Q = 286−20p

14.30
If p = 0, then
Q = 286
If p = \$3.30 then,
Q = 220
Demand curve for fish
D 1
In general,
DQ = -20Dp
= slope Dp
4.30
3.30
2.30
0
200 220 240
286
p, \$ per kg

Q, Million kg of fishr per year

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Solved Problem

1. Express the price that consumers are willing to pay as a function of quantity.

Q = 286−20p

20p = 286 - Q

p = 14.30 − 0.05Q

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Solved Problem

2. Use the inverse demand curve to determine how much the price must change for consumers to buy 1 million more kg of pork per year.

Δp = p2 − p1

= (14.30 − 0.05Q2) − (14.30 − 0.05Q1)

= –0.05(Q2 − Q1)

= –0.05ΔQ.

The change in quantity is ΔQ = Q2 − Q1 = (Q1 +

1)−Q1 = 1, so the change in price is Δp = 0.05.

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(II) MARKET SUPPLY

The supply of a good or service is

defined as:

Quantities of a good or service that people

are ready to sell at various prices within

some given time period, other factors besides price held constant.

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The Supply Curve and

the Supply Schedule

• A supply curve is a graph illustrating how much
of a product a firm will supply at different prices.

CLARENCE BROWN'S

SUPPLY SCHEDULE

FOR SOYBEANS

QUANTITY
SUPPLIED
PRICE
(THOUSANDS
(PER
OF BUSHELS
BUSHEL)
PER YEAR)
\$
2
0
1.75
10
2.25
20
3.00
30
4.00
45
5.00
45
6
5
4
3
2
1
0
0
10
20
30
40
50
Price of soybeans per bushel (\$)

Thousands of bushels of soybeans

produced per year

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Market Supply

As with market demand, market supply is the horizontal summation of individual firms’ supply curves.

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The Law of Supply

6
5
4
3
2
1
0
Price of soybeans per bushel (\$)

0

10

20

30

40

50

Thousands of bushels of soybeans

produced per year

The law of supply states that there is a positive relationship between price and quantity of a good supplied.

This means that supply curves

typically have a positive slope.

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Shift vs. movement of market supply

Changes in price result in changes in the quantity supplied.

This is shown as movement along the supply

curve.

Changes in nonprice determinants result in

changes in supply.

This is shown as a shift in the supply curve.

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Change in quantity supplied

S
Price
•An increase in price from p 1
to p 2 results in an increase in
quantity supplied from q 1 to
p
2
q
2
•It is shown as a movement
along the same supply curve
p
1
Quantity
q 1
q 2

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Change in supply

S
S
0
2
S
1
Price
•An increase in supply
means that at the same
p
1
price such as p1 more will
be sold, due to other factors
such as improvement in
technology, increase in
number of producers, etc.
This is a
decrease in
supply
•It is shown as a shift in the
entire supply curve
Quantity
q
q
1
2

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Change in Supply

P

S
S’

Q

Increase in Supply

P

S’

S

Q

Decrease in Supply

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A Change in Supply Versus a Change in Quantity Supplied

To summarize :

Change in price of a good or service leads to

Change in quantity supplied (Movement along the curve).

Change in costs, input prices, technology, or prices of related goods and services leads to

Change in supply

(Shift of curve).

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Non-price determinants of supply

Non-price determinants of supply

 1 resource prices 2 prices of related goods in production

3. technology

4. expectations

5. number of sellers.

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Other factors affecting supply

1. Resource prices:

When prices of inputs to production increase, the supply of the firm's product decreases.

Decreases in resource prices, however,

translate to an increase in supply. The entire supply curve shifts to the right.

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Other factors affecting supply

2. Prices of related goods in production:

Resources can be employed to produce several alternative goods and services.

Examples from agriculture:

a piece of farmland can be use to grow rice, corn, or

sugarcane. An increase in price of sugarcane may

result in decreased supply of rice and corn.

farmers can use their land and labor to produce ornamental flowers instead of vegetables. If vegetable

prices decrease, the supply of ornamental flowers may

increase.

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3.

Other factors affecting supply

Technology:

A change in production techniques can lower or

raise production costs and affect supply.

Improvements in technology shift the supply curve to the right.

A cost-saving invention will enable firms to produce

and sell more goods than before at any given price.

New high yielding crop varieties will increase production on the same amount of land.

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Other factors affecting supply

4. Producer expectations:

When producers expect the price of their product to

increase in the future, they may hoard their output for

later sale, thus reducing supply in the present period. Thus the supply curve shifts to the left.

If firms expect that the price of their product will fall

in the near future, supply may increase in the current period as firms try to increase production as well as to dispose of their inventory.

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Other factors affecting supply

5. Number of sellers:

As the number of sellers increases, so will total

supply.

The market supply is the horizontal summation of the supply schedules of individual producers.

As more firms enter the market, more will offered for

sale at each possible price, thus shifting the supply curve to the right.

Similarly, the supply curve shifts to the left when

firms exit the market.

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Market Supply

Variables that influence Q s

Price of good or service (P)

Input prices (P I )

Prices of goods related in production (P r )

Expected future price of product (P e )

Number of firms producing product (F)

General supply function

Q

f

(

P P

P , T

P

F )

,
,
,
,
s
I
r
e
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Q

s

General Supply Function

h kP lP mP

I

r

nT rP sF

e

k, l, m, n, r, & s are slope parameters

Measure effect on Q s of changing one of the variables while holding the others constant

Sign of parameter shows how variable is related to Q s

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Supply Function

Quantity supplied (Qs) is expressed as a mathematical function of price (P). The supply

function may thus be written as:

Qs = c + dP

where

c is the horizontal intercept of the equation or the quantity demanded when price is zero

d is the slope of the function.

Example:

Qs = 0 + 0.02P

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(III) MARKET EQUILIBRIUM

Market equilibrium is that state in which the quantity that firms want to supply equals the

quantity that consumers want to buy.

The price that clears the market is called the equilibrium price and the quantity (sold and

bought) is called the equilibrium quantity.

The market is said to be "at rest" since the equilibrium price and equilibrium quantity will stay at those levels until either demand or supply changes.

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Market Equilibrium

Equilibrium price: The price that

equates the quantity demanded with

the quantity supplied.

Equilibrium quantity: The amount

that people are willing to buy and sellers are willing to offer at the

equilibrium price level.

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Market Equilibrium

TABLE 3.3.
Market for Denim Pants
Quantity Demanded
Quantity Supplied
Price of Denim Pants
(in pesos)
per month
(No. of pairs)
per month
(No. of pairs)
0
8
0
Equilibrium
50
7
1
Price=200
100
6
2
150
5
3
200
4
4
250
3
5
300
2
6
350
1
7
400
0
8
Equilibrium
Quantity=4

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Market Equilbrium

At prices above the equilibrium price, quantity supplied is greater than quantity demanded, resulting in a temporary surplus.

In a surplus situation, producers will try to reduce price to

entice consumers to buy more denim pants. Actions by both producers and the public will wipe out the temporary surplus

At prices below the equilibrium price, consumers desire

to buy more denim pants than are available, creating a temporary shortage.

Consumers will try to outbid each other, thus pushing up the

price. As price rises, firms increase their production while some consumers reduce their purchases.

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Market Disequilibria

Excess demand, or

shortage, is the condition

that exists when quantity

demanded exceeds quantity supplied at the current price.

• When quantity demanded
exceeds quantity supplied,
price tends to rise until
equilibrium is restored.

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Market Disequilibria

Excess supply, or surplus, is the condition that exists when quantity supplied

exceeds quantity demanded

at the current price.

• When quantity supplied
exceeds quantity demanded,
price tends to fall until
equilibrium is restored.

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Market Equilibrium

P

S
400
Surplus
300
200
100
Shortage
0
2
4
6
8
Price (in pesos)

Quantity

Q

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Example 1

Using Math to Determine the Equilibrium

Algebraic solution: equate the demand and supply equations (Qd=Qs).

Qd = 8 - 0.02P

Qs = 0 + 0.02 P

Step by step solution:

8 - 0.02P = 0 + 0.02 P

0.04P = 8

P* = 8/0.04 = 200

Qd = 8 0.02(200) = 8 4 = 4

P* =200 per unit, Q* = 4 per month

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Example 2

Using Math to Determine the Equilibrium

Demand: Q d = 286 − 20p

Supply: Q s = 88 + 40p

Equilibrium:

Q d = Q s 286 − 20p = 88 + 40p

60p = 198 P = \$3.30 Q = 286 20(3.3) = 220

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Example 3

Using Math to Determine the Equilibrium

 Demand Q D = 50 – P (i) Supply Q S = – 10 + 2P (ii)

Set Q D = Q S find market equilibrium P and

Q

50 P = 10 + 2P

3P = 60

P = 20

Knowing P, find Q

Q = 50 P

= 50 20 = 30

Check the solution

i) 30 = 50 20

and (ii) 30 = 10 + 40

In both equations if P=20 then Q=30

P
50
S
20
5
D
-10
0
30
50

Q

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Increases in Demand and Supply

equilibrium price and higher equilibrium quantity.

equilibrium price and higher equilibrium quantity.

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Decreases in Demand and Supply

price and lower quantity exchanged.

price and lower quantity exchanged.

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Relative Magnitudes of Change

• The relative magnitudes of change in supply and demand
determine the outcome of market equilibrium.

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Relative Magnitudes of Change

• When supply and demand both increase, quantity will
increase, but price may go up or down.

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The Effects Of Simultaneous Shifts In

Supply And Demand

Price

The Market for Corn Tortilla Chips

(\$/bag)
S
S’
S’ after reduction in price of
corn harvesting equipment
P
D’ after discovery that oils are
harmful to people’s health
P’
D
D’
Millions of bags per
month
Q’
Q