Supply and Demand

The Market Demand Curve

Demand Schedule amounts of the
commodity consumers are willing to buy at
different prices
Demand function algebraic expression
of demand schedule
Demand Curve graphical representation,
using the inverse demand curve
A Demand Schedule
Corresponding Demand Function
Price of
Ice-Cream Cone
$3.00

2.50

1. A decrease
2.00
in price ...

1.50

1.00

0.50

0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of
Ice-Cream Cones
2. ... increases quantity
of cones demanded.
Copyright 2004 South-Western
Alternately
Demand Function: Qd = 10 P

Demand Schedule?

Demand Curve?

Individual demand curve and market demand

curve HORIZONTAL summation

Some Conventions., P and Q axis, shift vs.

movement along, change in demand vs. change
in quantity demanded
Demand contd
Law of Demand: Quantity demanded decreases as price
increases
Negative (not necessarily constant) slope
This is market demand curve = aggregated individual demand
curve

Qd = f (I, T, Pr, E, P)
Ceteris paribus : Qd = f (P; I = i, T = t, Pr = pr, E = e)

Variables and parameters

Change in quantity demanded vs. shift in demand
Examples
/Parameter /Parameter
Market Supply Curve
Supply Schedule
Supply Function
Individual Supply Curve > market supply curve
example
Backward bending supply curve
Law of supply: ceteris paribus as price rises quantity
supplied rises
Factors influencing Supply

Qs = f (Te, PI, Es, P)

Ceteris paribus: Qs = f (P, Te = te, PI = pi, Es = es)

Movements (variables) and shifts (parameters) of supply

curve
 Price ($) Quantity (units)
Price of
Ice-Cream 1 1
Cone
$3.00 1.5 2

2.50 2 3
1. An
increase 2.5 4
in price ... 2.00
3 5
1.50

1.00

0.50

0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of
Ice-Cream Cones
2. ... increases quantity of cones supplied.
Market Equilibrium
Equilibrium refers to a situation in which the price has
reached the level where quantity supplied equals
quantity demanded.
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.

From earlier examples: Qd = 10-P, Qs = P, setting Qd =

Qs = Q*, we get 10-P = P, or P* = 5, Q* = 5
Equilibrium from demand and supply
schedule
Demand Supply
Schedule Schedule

At $2.00, the quantity demanded

is equal to the quantity supplied!
 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 9 Markets Not in Equilibrium

Price of
Ice-Cream Supply
Cone

P*= $2.00

1.50
Shortage

Demand

0 4 Q*=7 10 Quantity of
Quantity Quantity Ice-Cream
supplied demanded Cones

Copyright2003 Southwestern/Thomson Learning

 Shifts in Curves versus Movements along Curves
A shift in the supply curve is called a change in supply.
A movement along a fixed supply curve is called a change
in quantity supplied.
A shift in the demand curve is called a change in demand.
A movement along a fixed demand curve is called a
change in quantity demanded.
Introducing Costs
 The Supply Curve: The Production Decision
To take production decisions, we need to understand
1. Production technology
2. Choice of inputs
3. Cost constraints
1 and 2 comprise the production function, the relationship between
inputs and the maximum amount that can be produced within a given
period of time with a given level of technology

q F ( K , L)
Where
q = quantity produced (flow)
K = kapital (flow) factors of production
L = labour (flow) factors of production, and all other variable inputs
like raw material
F is defined by technology
16
 Production with one variable input (short run)
average product = Output per unit
of a particular input, = q/L
marginal product = Additional .D
output produced as an input is
increased by one unit. = q/ L

To the left of point E in (b),

MP> AP, AP is increasing;
to the right of E, MP< AP,
AP is decreasing.
E represents the point at
which AP=MP, when AP is
maximum. .E
At D, when total output is
maximized, the slope of
total product curve is 0, as
is the MP.
17
Production with one variable input (short run)

.D
To the left of point E in (b),
MP> AP, AP is increasing;
to the right of E, MP< AP,
AP is decreasing.
E represents the point at
which AP=MP, when AP is
maximum.
At D, when total output is
maximized, the slope of
total product curve is 0, as
is the MP.
.E

18
Production with two variable inputs
TABLE 6.4 Production with Two Variable Inputs
Isoquant: Curve showing
LABOR INPUT
all possible combinations
Capital Input
of inputs that yield the 1 2 3 4 5
1 20 40 55 65 75
same output
2 40 60 75 85 90
3 55 75 90 100 105
4 65 85 100 110 115
5 75 90 105 115 120

isoquant map:
Graph combining a
number of isoquants,
used to describe a
production function

19
 Fixed Costs and Variable Costs
Total cost (TC or C) = Total economic cost of production,
consisting of fixed and variable costs. = FC+VC
Fixed cost (FC) Variable cost (VC)
Cost that does not vary with the
level of output and that can be Cost that varies as output varies.
eliminated only by shutting Over a very short time horizon
down. say, a few monthsmost costs
does not change as the firms level are fixed - the firm is usually
obligated to pay for contracted
of output changes
shipments of materials.
Shutting down: By reducing the
output to zero, the company could Over a very long time horizon
eliminate cost of raw materials and say, ten yearsnearly all costs
labor. The only way to eliminate are variable. Workers can be
fixed costs would be to close the laid off, machinery can be sold
doors, turn off the electricity, and off or scrapped.
perhaps sell off or scrap
machinery.
 Costs
marginal cost (MC) Increase in
cost resulting from the production of
one extra unit of output

average total cost (ATC) Firms

total cost divided by its level of
output = AFC+AVC
average fixed cost (AFC) Fixed
cost divided by the level of output. =
FC/Q
average variable cost (AVC)
Variable cost divided by the level of
output. = VC/Q
As output increases:
Marginal cost first falls and then
rises
Average cost follows the same
pattern
 A Firms Short RunCosts
Rate of Fixed Variable Total Marginal Average Average Average
Output Cost Cost Cost Cost Fixed CostVariable Cost Total Cost
(Units (Rs (Rs (Rs (Rs (Rs (Rs (Rs
per Year)per Year) per Year) per Year) per Unit) per Unit) per Unit) per Unit)

(FC) (VC) (TC) (MC) (AFC) (AVC) (ATC)

(1) (2) (3) (4) (5) (6) (7)

0 50 0 50 -- -- -- --
1 50 50 100 50 50 50 100
2 50 78 128 28 25 39 64
3 50 98 148 20 16.7 32.7 49.3
4 50 112 162 14 12.5 28 40.5
5 50 130 180 18 10 26 36
6 50 150 200 20 8.3 25 33.3
7 50 175 225 25 7.1 25 32.1
8 50 204 254 29 6.3 25.5 31.8
9 50 242 292 38 5.6 26.9 32.4
10 50 300 350 58 5 30 35
11 50 385 435 85 4.5 35 39.5
 AC and MC Curves
AC, AVC, and MC Curves
AC, AVC, and AFC
Curves
 Costs in the Long Run
No FC, all inputs variable, work with 2 variable inputs (L,K)
w= cost of labour, L
r= user cost of capital, K = annual cost of owning and using a capital
asset = depreciation rate + interest rate(financial return forgone)
r=rentalrate for capital (cost of renting a unit of capital)

ISOCOST line
Total Cost, C = wL+rK, also called an
Or, K=C/r-wL/r
slope = (w/r), the negative of the ratio of input prices

Problem: How to select inputs to produce a given output at

minimum cost.
 Producing a given Q at minimum Cost
Isocost curve C1 is tangent to
isoquant q1 at A => q1
produced at minimum cost
with (L1,K1).
No-Overlap Other input combinations(L2,
Rule: The
area below the K2 ), (L3, K3) yield q1 at higher
isocost line cost, C2.
that runs What if
through the
firms least- wage rate, w increases?
cost input rental rate, r increases?
combination
does not
overlap with
the area
above the Q-
unit isoquant
 Onto the Firms Cost Function

Need to know the least

cost input combination
for every output level
So, first obtain the
firms output
expansion path the
curve passing through
points of tangency
between a firms
isocost lines and its
isoquants.
Then graph the output-
cost combination the
firms total cost curve
The Inflexibility of Short-Run
Production
The Relationship Between Short-Run
and Long-Run Cost

With economies and diseconomies of scale, the minimum points of the

short-run average cost curves do not lie on the long-run average cost
curve.