2.

Introducing
Markets
By Prof. Angel Hernando-Veciana
How do markets work?
Topics
• Markets and its analysis:
• Demand
• Supply
∂
• Equilibrium
• Terminology: movements and shifts
• Comparative static
Markets
What is a market?
• The set of:
• Buyers, sellers and rules used to trade (freely) a
good.
• For instance: ∂
• Second hand car market.
Elements in the analysis of
markets
• Exogenous:
• Demand:
• (The buyers) the number of units buyers want and
∂
can buy under any possible circumstances.
• Supply:
• (The sellers) the number of units sellers want and
can buy under any possible circumstances.
• Endogenous (equilibrium):
• Prediction of the outcome in the market.
The demand and demand curve
• The demand refers to the buyers.

• The demand curve: ∂

• Is a function (or a graph) that shows the quantity
demanded as a function of the price assuming
everything else constant (ceteris paribus).
• It is downward sloping.
Example of a demand function
Price Quantity

10£ 1
9£ 1
∂
8£ 1
7£ 2
6£ 3
5£ 3
4£ 3
… …
Usual representation: the linear demand function

∂
10

5
The inverse demand function

∂
10

5
The supply and supply curve
• The supply refers to the sellers.

• The supply curve: ∂

• Is a function (or a graph) that shows the quantity
supplied as a function of the price assuming
everything else constant (ceteris paribus).
• It is upward sloping.
Example of a demand function
Price Quantity

1£ 2

2£ ∂2
3£ 2

4£ 3

5£ 4

6£ 6

7£ 8
Usual representation: the linear supply function

∂
10

0 20
The inverse supply function

∂
10

0 20
The Definition of Equilibrium
Supply and Demand together

• Equilibrium Price
• The price that equates the supply and the demand.

∂
• Equilibrium Quantity
• The quantity supplied and demanded at the
equilibrium price.
Supply and demand together
Demand schedule Supply schedule

Price Quantity Price Quantity

10£ 1 10£ 13
9£ 2 9£ 13
8£ 2 ∂ 8£ 12
7£ 3 7£ 10
6£ 4 6£ 8
5£ 6 5£ 6
At 5£, quantity demanded is
4£ 8 4£ 5
equal to the quantity
3£ 10 supplied! 3£ 3
The Equilibrium Price and Quantity
Price (£)

Supply

∂
Equilibrium
5

Demand

0 10
Quantity
The Equilibrium Price and Quantity
Price (£)

Supply
10
∂
Equilibrium
5

Demand

0 10
Quantity
The relevance of the equilibrium
Is the equilibrium a reasonable prediction?
Price (£)

Surplus
Supply
9 ∂

Demand

0 2 10
Quantity
Is the equilibrium a reasonable prediction?
Price (£)

Supply

5
Shortage

1 Demand

0 2 10
Quantity
Is the equilibrium a reasonable prediction?
Price (£)

Supply

Demand

0 10
Quantity
Movements and shifts:
the demand
Factors that affect demand
• Market price
• Consumer’s income
• Prices of other goods ∂
•…
Quantity demanded and movements
• There is a change in the quantity demanded or
movement along the demand if:

∂
the price of the good changes, ceteris paribus.
Movement
Price

B
£4

£2 A

D1
0
12 20 Quantity
Shifts in demand
• Some other factor that affects the demand other
than the price of the good changes:

∂
There is a shift in the demand or a change in the
demand
Shifts in demand
Price

Increase in
demand

Decrease in
demand
D2
D1
D3
0 Quantity
Movements and shifts:
the supply
Quantity supplied and movements

• There is a change in the quantity supplied or

movement along the supply if:
∂

The price of the good changes, ceteris paribus.

Movement
Price S
B
£3

∂
A
£1

Quantity
0 1 5
Determinants of supply (beyond the price)
• Input Prices

• Technology
∂

• Number of producers

• Expectations
Shifts in supply
• Some other factor that affects the supply other
than the price of the good changes:

∂
There is a shift in the supply or a change in the
supply.
Supply shifts
S3
Price S1
S2
Supply
reduction
∂
Supply
increase

Quantity
0
Comparative statics
Comparative Statics

• Use a model to make predictions about the

endogenous variables when there is a change in
the exogenous variables.
• Recall: ∂
• Endogenous: equilibrium price and quantity.
• Exogenous: factors that determine demand and supply
(but the price).
Comparative Statics

• A 3-step recipe:

1. What did it change: demand, supply or both?

∂
2. In which direction?
3. How did it affect the equilibrium?
Comparative statics
Price
• The market
for umbrellas.

Supply

∂ Initial
£25 equilibrium

D1
0 5000 Quantity
Comparative statics
Price
• The market
for umbrellas. 2. A decrease in the demand

Supply

∂ Initial
£25
equilibrium
£20 New equilibrium
3a. ...a 1.The demand changes
lower
price...
D1
3b. ...and a lower 0 3500 5000 D2 Quantity
quantity sold.
Exercises of comparative static
• Determine the effect on the market of:
• Software of an increase in the wage of programmers.
• Train tickets of an increase in the price of cars.
• Air tickets of an increase in the price of oil.
∂
Exercises of comparative static
• Determine the effect on the market of:
• Software of an increase in the wage of programmers.
• Train tickets of an increase in the price of cars.
• Air tickets of an increase in the price of oil.
∂
Exercises of comparative static
• Determine the effect on the market of:
• Software of an increase in the wage of programmers.
• Train tickets of an increase in the price of cars.
• Air tickets of an increase in the price of oil.
∂
Exercises of comparative static
• Determine the effect on the market of:
• Software of an increase in the wage of programmers.
• Train tickets of an increase in the price of cars.
• Air tickets of an increase in the price of oil.
∂
Exercises of comparative static
• Determine the effect on the market of:
• Software of an increase in the wage of programmers.
• Train tickets of an increase in the price of cars.
• Air tickets of an increase in the price of oil.
∂
Summary of Comparative Static Cases
• What happens to price and quantity if the supply and
demand shift?
Supply does Supply Supply
not change Increases Decreases

Demand does P equal

∂ P decreases P increases
not change Q equal Q increases Q decreases
Demand P increases P indeterm. P increases
Increases Q increases Q increases Q indeterm.
Demand P decreases P decreases P indeterm.
Decreases Q decreases Q indeterm. Q decreases
Slopes matter
• The size of the change in prices and quantities depend on slopes
(as well of the absolute change).

∂
Slopes and units of measure

Price
Demand

5
∂
4

75 100 Quantity in liters

Slopes and units of measure

Price
Demand

5
∂
4

150 200 Quantity in pints

Solution:

Elasticities, our
∂ next topic
Topics
• Markets and its analysis:
• Demand
• Supply
∂
• Equilibrium
• Terminology: movements and shifts
• Comparative static