Topic 2

Price: The Role of Demand and

Supply

Law of Demand
The quantity purchased of a good or

service is inversely related to the

price, all other things being equal
(ceteris paribus)

The Law of Demand

Price changes lead to
qty demanded
changing.......
Represented by
movements along
demand curve.
Inverse relationship
between price and
quantity demanded
gives rise to a
downward- sloping
demand curve.

Price

negative slope

DD
5

15

Quantity/wk

Quantity Demanded versus

Demand
Quantity demanded
The quantities of a good or service that
people will purchase at a specific price
over a given period of time
Demand
A schedule of the total quantities of a

good or service that purchasers will buy

at different prices at a given time
4

Demand
Individual demand
The quantity of a good or service that an

individual or firm stands ready to buy at

various prices at a given time
Market demand
The sum of the individual demands in

the marketplace
5

Demand Schedule and Demand

Curve
Demand schedule
A table showing the various quantities
of a good or service that will be
demanded at various prices
Demand curve
A curve that indicates the number of
units of a good or service that
consumers will buy at various prices at
a given time
6

Demand Curve for Internet Time

$1.55
1.50

Table 4-1 provides the detail for

the demand curve presented here

Price per Hour

1.45
1.40
1.35
1.30
1.25
1.20
1.15

1.10
1.05
0
7

10 11 12 13

Quantity (millions of hours)

Changes in Quantity Demanded and in

Demand
Change in quantity demanded
Movement along the demand curve
that occurs because the price of the
product has changed
Change in demand
A change in the amounts of the product
that would be purchased at the same
given prices; a shift of the entire
demand curve
8

Demand Curves for Internet Time

$1.55

A shift from D to D1 is an increase in

demand more will be purchased at
each price

1.50

Price per Hour

1.45
1.40

A shift from D to D2 is a
decrease in demand less
will be purchased at each
price

1.35
1.30
1.25
1.20
1.15
1.10

D
D2

1.05
0
9

D1

10 11 12 13

Quantity (millions of hours)

Determinants of Demand
Changes in income
Higher incomes increase in demand
Lower incomes decrease in demand

Changes in tastes and preferences

Change in consumer expectations

10

Determinants of Demand
Changes in the prices of other goods
Substitutes Increase in the price

of substitutes increase in
demand
Complements Increase in the
price of complements decrease
in demand
11

Supply
Supply
The total quantities of a good or service that sellers

stand ready to sell at different prices at a given time

Individual supply
Quantities offered for sale at various prices at a given

time by an individual seller

Market supply
Sum of the individual supply schedules in the

marketplace

12

Supply
Supply schedule
A table showing the various quantities
of a good or service that sellers will
offer at various prices at a given time
Supply curve
A line showing the number of units of a
good or service that will be offered for
sale at different prices at a given time
13

Law of Supply
The quantity offered by sellers of a good or service is directly related to price,
all things being equal
Why?
Producers are more willing to sell greater amounts of a good at a higher

price , because this good has become relatively more profitable to produce,
compared to other gds

14

Changes in Quantity Supplied and

in Supply
Change in the quantity supplied
Movement along the supply curve that occurs

because the price of the product has changed

Change in supply
A change in the amount of the product that would be

offered for sale at the same given price; a shift of the

entire supply curve

15

Supply Curves for Internet Time

$1.55
1.50

Price per Hour

1.45
1.40
1.35

A shift from S to S2
S2
is a decrease in
demand a smaller
amount offered for
sale at each price

S1
A shift from S to S1 is
an increase in demand
a larger amount
offered for sale at each
price

1.30
1.25
1.20
1.15
1.10
1.05
0

16

10 11 12 13

Quantity (millions of hours)

Determinants of Supply
Changes in the cost of resources
Increase in the cost of resources decrease in

supply
Technology
Improvements increase in supply

Expectations of future prices(Shift to the right)

Prices of related products

17

Expectations of Future Prices

If sellers expect

price of the good to

fall in the future,

they will sell more now before the
price actually falls!!
Supply increases today...
..rightward shift
18

Price of related goods

Related goods
(Supply side of the market)

19

Substitutes in production
Require the same resources
to produce

Complements in production
Jointly produced with
the same pool of resources

Example
Rubber bands
Rubber erasers

Example
Beef
Leather

Price of related goods

(substitutes in production)
Assume that the price of Rubber Erasers (RE) has increased .
What impact does this have on the supply of Rubber Bands

(RB) ?

Price

Price

SS
SS

SS

Supply of RE
20

Quantity
Supply of RB

Quantity

Price of related goods

(complements in production)
Assume that the price of beef has increased.
What impact does this have on the supply of leather ?

Price

Price

SS
SS

SS

Supply of Beef

21

Quantity
Supply of Leather

Quantity

Equilibrium Price
The price at which the quantity
demanded equals the quantity supplied
Market Equilibrium
A state whereby the forces of market
demand and market supply exactly
balance each other and there is no
tendency for change
22

Demand, Supply, and Market Price

for Internet Time
$1.55

Demand

Supply

1.50
1.45

Price per Hour

1.40
1.35

At a price of $1.21, 6 million

hours of Internet time will be
offered for sale and an equal
amount purchased

1.30

1.25
1.20
1.15
1.10
1.05
0

23

10 11 12 13

Quantity (millions of hours)

24

Surplus of Internet Time

$1.55

Demand

1.50

Price per Hour

1.45
1.40

Surplus

1.35
1.30
1.25

1.20
1.15
1.10
1.05
0 1

25

3 4

7 8

At a price of $1.30, 7.8

Supply
million hours will be
offered for sale but
consumers are only
willing to purchase 4.2
million hours Qs > Qd
surplus of Internet
hours
Rather than hold on to these
hours, sellers will offer to sell at
lower prices with the result that
more consumers enter the
market price moves toward
$1.20
9

10

11 12 13

Quantity (millions of hours)

Shortage of Internet Time

$1.55

Demand

Supply

1.50
1.45

Price per Hour

1.40
1.35
1.30

1.25
1.20
1.15
1.10
1.05

Shortage
0 1

26

At a price of $1.10, buyers

want to buy 8.5 million hours
but sellers are willing to offer
only 3.6 million hours Qd
> Q shortage

7 8

Some buyers will be willing to

pay more with the result that
the price will increase and
sellers will increase the
amount they offer for sale
move toward $1.20
9 10

11 12 13

Quantity (millions of hours)

Changes in Equilibrium
Price & Quantity
Once equilibrium is attained, there is no

tendency for change, unless demand, supply

or both market forces change.
Demand & supply change when there is a
change in determinants of demand and/or
supply.

27

Increase in Demand
Price
SS
P
P

Increase in
Pe & Qe

E
E
DD

DD

Quantity
Q
28

Decrease in Demand
Price
SS
E
P
P

Decrease in
Pe & Qe

DD

DD

Quantity
Q Q
29

Increase in Supply
SS

Price

SS
E

Decrease in Pe,
Increase in Qe

P
E

DD
Q
30

Quantity

Decrease in Supply
SS

Price

SS
E

Increase in Pe,
Decrease in Qe

P
E

DD

Quantity
Q
31

Change In Both Demand & Supply

At The Same Time
the effect on only either P or Q can be

determined straight away

the impact on the other variable cannot be
determined ,
unless given more information
on the size of the relative shifts

32

What happens when:

Demand and supply increase simultaneously?
The equilibrium qty will definitely increase,
but whether the equilibrium price
will increase or decrease depends on
how much demand shifts relative to supply
33

Three Possible Situations:

Demand increases more than supply does
Price

SS

DD

DD

SS

P
P

E
E

Q
34

Increase in Pe,
Increase in Qe

Quantity

Three Possible Situations:

Supply increases more than demand does
Price

SS

DD

DD

SS

P
P

Q
35

Decrease in Pe,
Increase in Qe

Quantity

Three Possible Situations:

Demand increases by the same amount
as supply
Price

DD

SS

DD
P

SS
E

Q
36

No change in Pe,
Increase in Qe

Quantity

General Guidelines
An increase in demand relative to

supply higher price

A decrease in demand relative to
supply lower price
An increase in supply relative to
demand lower price
A decrease in supply relative to
demand higher price
37

Disequilibrium Due To
Government Intervention
The government may

step in to restrict the free

operation of the market
and create disequilibrium
prices by imposing a
PRICE CEILING or
PRICE FLOOR

38

Price Ceiling
A government-mandated maximum

price that can be charged for a good or a

service below the market equilibrium
Producers cannot sell at a price higher
than the ceiling price

39

Why Imposed Price Ceiling ?

Prevent consumers from being

overcharged !!!! E.g. rent control

Price control on necessities eg rice, sugar, oil,
etc..
40

The Effects of a Price Ceiling on

Rental Housing
Monthly Price ($)

S
The effect of the
price ceiling on
rental housing is to
cause a shortage and
reduce housing
opportunities to
those families they
are intended to
accommodate

700

500

Shortage
0
41

18,000

30,000

40,000

Quantity (housing units)

How Are Consumers Affected By A

Price Ceiling?
Since there is little incentive to maintain the quality of
rent-controlled housing, consumers may have to put up
with the deteriorating quality of such housing .
The amount bought and sold with a price ceiling
imposed is less than that at market equilibrium.
The shortage caused by the price ceiling forces
consumers to spend more time searching for an
alternative.
Some people are willing to pay more to get some of the
good. These people may end up relying on political
connections and paying coffee money.

42

Why Imposed Price Floor???

To ensure producers a higher and
more stable income eg. Price floors on
agricultural products, or min wage to
ensure workers a min standard of
living

43

The Effects of a Price Floor on Wheat

S
Surplus

Price per Bushel ($)

PF

3.00
2.00

The impact of the price

floor is to cause a
surplus the
government must then
buy and store the
surplus that is created
by the price floor
D

0
44

75,000 100,000 115,000

Quantity (bushels)

Effects of Price Floors

Price floors create surpluses... govt intervention is needed

to prevent downward pressure on price

Govt often steps in to buy up the surplus, as part of its
support program towards producers

45

What Does The Government

Do With The Surplus?
Surplus may be distributed to the poor
But govt has to ensure that its actions

does not lead to falling demand

Alternatively, surplus may simply
be stored up .... wasteful if quality
deteriorates over time

46

How Are Consumers Affected By A

Price Floor?
Consumers pay a higher price than at market

equilibrium (PF higher than Pe).

Consumers pay taxes to cover government
support for producers.
The amount bought and sold with a price floor
imposed is less than that at market
equilibrium.

47

Price Elasticity of Demand

A measure of the sensitivity or

responsiveness of quantity demanded

to a change in price
Formula method
Total revenue method

48

Formula Method
Price elasticity

percentage change in quantity demanded

percentage change in price

Q2 Q1
(Q1 Q2 )/2

P2 P1
( P1 P2 )/2
49

Demand Curve Showing Different

Elasticities
$13
12
11

D1

D2
D

Price

10

Elastic demand

9
8
7
6
5

Unit elastic

D1

Inelastic demand

2
1
0
50

1,600

2,000

2,400

Quantity/Time

Unit Elastic Demand

Demand that exists when a percentage

change in price causes an equal

percentage change in quantity
demanded
Has an elasticity coefficient equal to
1.0
Demand curve D in Figure 4-9
51

Elastic Demand
Demand that exists when a

percentage change in price causes a

greater percentage change in quantity
demanded
Has an elasticity coefficient greater
than 1.0
Demand curve D1 in Figure 4-9
52

Inelastic Demand
Demand that exists when a percentage

change in price causes a smaller

percentage change in quantity
demanded
Has an elasticity coefficient less than
1.0
Demand curve D2 in Figure 4-9
53

Total Revenue Method

If price changes but total revenue remains constant,

unit price elasticity of demand exists

If price changes but total revenue moves in the
opposite direction, demand is elastic
If price changes and total revenue moves in the same
direction, demand is inelastic

54

Characteristics Affecting Price

Elasticity of Demand
Trend Toward
Elastic Demand
Luxuries
Large expenditures
Durable goods
Substitute goods
Multiple uses

55

Trend Toward
Inelastic Demand
Necessities
Small expenditures
Perishable goods
Complementary goods
Limited uses

Three Demand Curves Showing

Different Elasticities
(a)

(b)

P
Perfectly
Elastic

(c)

D2
Perfectly
Inelastic

D1

Perfectly
Unit
Elastic
D3

Q/t

56

Q/t

Q/t

Demand Curve Showing Different

Elasticities

Price

8
7
6

Elasticity changes along the

demand curve from elastic at
the top to inelastic at the
bottom

Ine
De las
ma tic
nd

El
as
tic

10

Un
it

11

Ela
De stic
ma
nd

$12

5
4
3
2
1
0 10

57

20 30 40 50 60

70

80 90 100 110 120

Quantity/Time

Other Types of Elasticity

Cross elasticity of demand
Income elasticity of demand
Elasticity of supply

58

Cross Elasticity of Demand

A measure of the responsiveness of the
quantity demanded of one product as a
result of a change in the price of another
product
Cross elasticity of demand

percentage change in the quantity demanded of product B

percentage change in the price of product A

59

Cross Elasticity of Demand

Substitute goods
Functionally equivalent goods
Complementary goods
Goods that are used together
A change in the price of one product,

if it is substitute or complementary
product, can affect the quantity
demanded of the other

60

Cross Elasticity of Demand

The coefficient of cross elasticity can

be positive or negative

Positive in the case of substitutes

Negative in the case of complements

The larger the coefficient, the greater

the cross elasticity

61

Income Elasticity of Demand

A measure of the responsiveness of
quantity demanded to a change in
income
Income elasticity of demand

62

percentage change in quantity

percentage change in income

Income Elasticity of Demand

Normal goods
Positive coefficient
Demand varies in the same direction
as income
Inferior goods
Negative coefficient
Demand varies inversely with changes
in income
63

Elasticity of Supply
A measure of responsiveness of quantity
supplied to a change in price
Price elasticity of supply

64

percentage change in quantity supplied

percentage change in price

Time and Elasticity of Supply

Immediate
P

Demand increases from D to

D1 and because the sellers
cannot adjust the quantity
supplied on such short notice,
the only impact is an increase
in price

P1

D1
D
Q

65

Q/t

Time and Elasticity of Supply

Short Run
P

In the short run, the

seller has sufficient
time to vary some
productive resources
supply becomes
more elastic and the
quantity supplied
increases, causing the
price to fall

P2
P
D1
D
Q
66

Q2

Q/t

Time and Elasticity of Supply

Long Run
P

Over the long run,

the supply curve
becomes still more
elastic because
producers can
S vary all productive
resources and
make use of new
technology

P3
P

D1

D
Q
67

Q3

Q/t

Effects of a Tax on Cigarettes

Price per Pack
($)

5.25

Price per Pack

S + $1
($)
S

5.75

S + $1
S

e
R

5.00

5.00
D
40 50

Quantity (millions of packs)

68

D
48 50

Quantity (millions of packs)

Note that the same $1 tax has a much larger impact on quantity when
demand is more elastic than when it is inelastic