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Demand, Supply, and Equilibrium

T.J. Joseph

How does a market work?


Markets are dynamic (like weather) They are constantly evolving

A careful study of markets reveal certain forces

underlying the movements in a market


Need a model - demand & supply model to forecast

the prices and outputs in individual markets


In a competitive market SS and DD determine the

quantity of each good produced and the price at which it is sold


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DEMAND

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Demand Schedule
Quantity demanded of any good/service by an

individual is the amount of the good/service that the individual is willing and able to purchase at alternative prices during a given period of time, and other things held constant
A demand schedule or demand curve shows the

relationship between the market price of a good/service and the quantity demanded of that good/service, other things held constant
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Demand Schedule
It shows how demand varies with price, ceteris paribus

Price per unit 10 12 14 16 18

Quantity per week 200 170 140 110 80

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Demand Curve
20 18 16

Price per unit

14 12 10 8 6 4 2 0 80 110 140 170 200 Qty de m ande d

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Demand Schedule
The demand curve slopes downward (a negatively

sloped demand curve)


Indicates an inverse relationship between price and

quantity demanded

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Law of Demand
A decrease in the price of a good, all other things

held constant (ceteris paribus), will cause an increase in the quantity demanded of the good.
An increase in the price of a good, all other things

held constant (ceteris paribus), will cause a decrease in the quantity demanded of the good.

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Change in Quantity Demanded


Price

P1

An increase in price causes a decrease in quantity demanded.

P0

Q1

Q0

Quantity

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Change in Quantity Demanded


Price

A decrease in price causes an increase in quantity demanded. P0


P1

Q0

Q1

Quantity

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Market Demand
A market demand schedule specifies the units of

good or service all individuals in the market are willing and able to purchase at alternative prices, ceteris paribus. Qd = f(P)
In other words, market demand is the sum of all the

individual demands for a particular good or service

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Market Demand Schedule


Consider the market for cellular phone service. A market demand schedule lays out the quantity of cell phone service demanded in the market at various prices. We can graph these points (the different prices and respective quantities demanded) to make a demand curve for cell phone service.

Market Demand Schedule


Price (monthly bill) Cell phone service price
(monthly bill)

Cell phone subscribers


(millions)

120

$ 124 $ 92 $ 73 $ 58 $ 46 $ 41

3.5 7.6 16.0 33.7 55.3 69.2

100

80

60

Demand

40 0 10 20 30 40 50 60 70

Quantity (millions of subscribers)

Market Demand Schedule


Price (monthly bill) 120

Notice how the law of demand is reflected by the shape of the demand curve. As the price of a good rises consumers buy less.

100

80

60

Demand

40 0 10 20 30 40 50 60 70

Quantity (millions of subscribers)

Market Demand Schedule


Price (monthly bill)

The height of the demand 120 curve at any quantity shows the maximum price that consumers are 100 willing to pay for that additional unit. Here, for the 16th unit consumers are only willing to pay up to $73 for it. While they would be willing to pay up to $92 for the 7.6 (millionth) unit.
80

60

Demand

40

10

20

30 40

50

60

70

Quantity (millions of subscribers)

Why an inverse relationship?


Quantity demanded tends to fall as price rises for

two reasons: (1) Substitution effect: When price of a commodity falls an individual buy more of it to substitute for other similar goods whose price has not changed (2) Income effect: When price falls, the purchasing power of an individual with a given income increases, allowing him to buy more of it

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Factors Behind the Demand Curve


The market demand for a commodity is influenced

not only by the commoditys price


A whole array of factors influences how much will be

demanded at a given price:


Average disposable income of the consumers Prices of other related commodities Wealth of the consumers Tastes and preferences Size of the market (population) Special Influences (govt. policies, seasons, etc.) Expectations

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Classification of Goods
Inferior Good:
An inferior good is a good that decreases in demand

when consumer income rises


Inferiority, in this sense, relate to affordability rather

than about the quality of the good


Example: People moving from public transport to taxies

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Classification of Goods
Giffen Good:
A Giffen Good is a good that experiences increased

demand for when the price rises and decreased demand for when the price falls
Absence of any close substitutes

Mainly a theoretical concept


A rise in the price of bread makes so large a drain on the resources of the poorer labouring families, that they are forced to cut their consumption of meat and the more expensive foods: and, bread being still the cheapest food which they can get and will take, they consume more, and not less of it.
- Sir Robert Giffen
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Prices of Related Goods


Substitutes
A substitute good is a good that can

be used in place of some other good.


Assume Pepsi and Coca cola are

substitutes
We want to study market demand

for Pepsi
Assume price of Pepsi and Coca Cola

is Rs.10
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Complementary goods
Any relation between demand

for CDs and CD Players?


If a good is jointly consumed

with another good, then it is called complementary good

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Change in Demand
Price An increase in demand refers to a rightward shift in the market demand curve.

P0

Q0

Q1

Quantity

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Change in Demand
Price

A decrease in demand refers to a leftward shift in the market demand curve.


P0

Q1
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Q0

Quantity

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IMPORTANT !
Demand Vs. Quantity Demanded
Movement along curves versus shifts of curves

i.e., change in quantity demanded and change in demand are different

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SUPPLY

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Supply Schedule
Supply schedule (or supply curve) for a commodity

shows the relationship between its market price and the quantity of that commodity that producers are willing to produce and sell, other things held constant Qs = f(P)

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Supply Schedule
Price per unit 10 12 14 16 18 Quantity supplied per week 50 70 90 110 130

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Law of Supply
A decrease in the price of a good, all other things

held constant (ceteris paribus), will cause a decrease in the quantity supplied of the good.
An increase in the price of a good, all other things

held constant (ceteris paribus), will cause an increase in the quantity supplied of the good.

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Change in Quantity Supplied


Price A decrease in price causes a decrease in quantity supplied.

P0

P1

Q1

Q0

Quantity

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Change in Quantity Supplied


Price

P1 P0

An increase in price causes an increase in quantity supplied.

Q0
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Q1

Quantity

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Shifts in Supply Curve


Change in Production Technology

Change in Input (factors & materials) Prices


Change in the Number of Sellers/Producers

Change in Government policies


Expectations Special Influences (seasons, natural impacts, etc.)

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Change in Supply
Price An increase in supply refers to a rightward shift in the market supply curve.

P0

Q0
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Q1
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Quantity

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Change in Supply
Price A decrease in supply refers to a leftward shift in the market supply curve.

P0

Q1
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Q0
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Quantity

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MARKET EQUILIBRIUM

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Market Equilibrium
Market equilibrium is determined at the intersection

of the market demand curve and the market supply curve.


The equilibrium price causes quantity demanded to

be equal to quantity supplied.

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Market Equilibrium
Equilibrium is a position of balance No incentive for anyone to change their behaviour Market equilibrium exists when demand equals

supply
The equilibrium price clears the market

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Market Equilibrium
Price per unit Quantity demanded per week Quantity supplied per week

10 12 14
Equilibrium

200 170 140 110 80

50 70 90 110 130

16 18

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Market Equilibrium
Price

P=16

Q=110

Quantity

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Market Equilibrium
Price D0 P1 P0 D1 An increase in demand will cause the market equilibrium price and quantity to increase S0

Q 0 Q1
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Quantity

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Market Equilibrium
Price D1 P0 P1 D0 A decrease in demand will cause the market equilibrium price and quantity to decrease S0

Q1 Q0
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Quantity

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Market Equilibrium
Price

D0

S0

S1

An increase in supply will cause the market equilibrium price to decrease and quantity to increase.

P0
P1

Q0 Q1

Quantity

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Market Equilibrium
Price

D0

S1

S0

A decrease in supply will cause the market equilibrium price to increase and quantity to decrease.

P1
P0

Q1 Q0

Quantity

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A Rise in Input Prices


An increase in wages, for example, will increase

firms costs
The supply curve will therefore shift upwards to the

left, as firms now require a higher price for their output


The equilibrium price will rise and the quantity will

fall

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Exercise 1
Illustrate each of the following events using a demand and supply diagram for apples.
a) There is a report that imported apples are infected with a deadly virus b) There is a drop in the consumers income

c) The prices of apples goes up


d) The prices of oranges falls due to very good harvest e) Consumers expect that the pries of apples to decrease in the near future f) The government has increased the excise duty of apples from 5% to 15%

References
1. Chapter 2 in Dominic Salvatore (2009), Principles of Microeconomics, 5th edition, Oxford publications. 2. Chapters 3 in William Boyes and Michael Melvin (2009), Textbook of Economics, 6th edition, Biztantra publications.