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DEMAND, SUPPLY AND

MARKET EQUILIBRIUM

Contents

of chapter
Introducing demand, supply and
markets
Learning

Outcome
At the end of the lesson, learners
should be able to explain the meaning
of demand, supply and market
situations

Market Defined
An

institution or mechanism
that brings together buyers
(demanders) and sellers
(suppliers) of goods & services
markets
Local, national & international
Highly personal or face-to-face
Impersonal or remote

Product

exchange

market - goods & services

(Output)
Resource market - factors of production
(Input)

Circular Flow

Both Flows Are Equal


Resource
Market

Businesses

Households

Product
Market

Basic Assumptions in Demand and Supply


Analysis
Ceteris paribus
The

word ceteris paribus is Latin for


other things being held constant. or.
all other things being held equal
Economists often use this ceteris
paribus assumption to draw their
diagrams as well as isolate the effects of
specific changes in a market.
Rationality
The

assumption stated that individuals


do not intentionally make decisions that
would leave them worse off.

Demand And Supply Analysis


Demand
The

demand schedule shows the


various amounts of a product
consumers are willing and able to
buy at each specific price in a series
of possible prices during a specific
time period
Table 1 shows demand schedule for
wheat

Demand Analysis
Price ($ per ton
of wheat in
2005)

Quantity Demanded (tonnes of


wheat)

$5
$4
$3
$2
$1

9
10
12
15
20
Table 1

Demand Analysis
The

schedule shows how much


buyers are willing and able to buy at
five possible prices
The market price depends on demand
and supply

Demand Analysis
The

Law of Demand
Fundamental characteristic of demand
behavior
Other things being constant, as price of a
product increases, the corresponding
quantity demanded falls & vice versa
Inverse relationship between P & Q
demanded
Its called the Law of Demand.

Price of wheat (dollars per ton)

Demand Curve

5
10
15
Quantity of wheat (tons of wheat in the year 2005)

20

Demand Analysis
Downward sloping Demand curve
The inverse relationship between the
price & quantity causes movement
along the demand curve

Price

P1

P2

D0

Q1

Q2

Qty

Law of Demand
Law

of diminishing marginal utility


consumption of additional units of a
good or service gives less extra
satisfaction than the first
Income effect
Lower price increases the purchasing
power of money
Substitution effect
Consumer moves from higher priced
goods to lower priced substitute goods

0
1
2
3
4
5
6
7

Marginal
utility
(2)

0
10

Copyright McGraw-Hill, Inc. 1999

Marginal Utility (utils)

Hamburgers Total
consumed Utility
per meal

Total Utility (utils)

Total and Marginal Utility


TU

30
20
10

Units consumed per meal

10
8
6
4
2
0
-2
1

2
3
4
5
6
Units consumed per meal

MU
7

0
10

Copyright McGraw-Hill, Inc. 1999

10

TU

30
Total Utility (utils)

0
1
2
3
4
5
6
7

Marginal
utility
(2)

20
10

0
Marginal Utility (utils)

Hamburgers Total
consumed Utility
per meal

Units consumed per meal

10
8
6
4
2
0
-2
1

2
3
4
5
6
Units consumed per meal

MU

0
10
18

Copyright McGraw-Hill, Inc. 1999

10
8

TU

30
Total Utility (utils)

0
1
2
3
4
5
6
7

Marginal
utility
(2)

20
10

0
Marginal Utility (utils)

Hamburgers Total
consumed Utility
per meal

Units consumed per meal

10
8
6
4
2
0
-2
1

2
3
4
5
6
Units consumed per meal

MU

0
10
18
24

10
8
6

TU

30
Total Utility (utils)

0
1
2
3
4
5
6
7

Marginal
utility
(2)

20
10

0
Marginal Utility (utils)

Hamburgers Total
consumed Utility
per meal

Units consumed per meal

10
8
6
4
2
0
-2
1

2
3
4
5
6
Units consumed per meal

MU

0
10
18
24
28

10
8
6
4

TU

30
Total Utility (utils)

0
1
2
3
4
5
6
7

Marginal
utility
(2)

20
10

0
Marginal Utility (utils)

Hamburgers Total
consumed Utility
per meal

Units consumed per meal

10
8
6
4
2
0
-2
1

2
3
4
5
6
Units consumed per meal

MU

0
10
18
24
28
30

10
8
6
4
2

TU

30
Total Utility (utils)

0
1
2
3
4
5
6
7

Marginal
utility
(2)

20
10

0
Marginal Utility (utils)

Hamburgers Total
consumed Utility
per meal

Units consumed per meal

10
8
6
4
2
0
-2
1

2
3
4
5
6
Units consumed per meal

MU

0
10
18
24
28
30
30

10
8
6
4
2
0

TU

30
Total Utility (utils)

0
1
2
3
4
5
6
7

Marginal
utility
(2)

20
10

0
Marginal Utility (utils)

Hamburgers Total
consumed Utility
per meal

Units consumed per meal

10
8
6
4
2
0
-2
1

2
3
4
5
6
Units consumed per meal

MU

0
10
18
24
28
30
30
28

10
8
6
4
2
0
-2

TU

30
Total Utility (utils)

0
1
2
3
4
5
6
7

Marginal
utility
(2)

20
10

0
Marginal Utility (utils)

Hamburgers Total
consumed Utility
per meal

Units consumed per meal

10
8
6
4
2
0
-2
1

2
3
4
5
6
Units consumed per meal

MU

Total and Marginal Utility

0
10
18
24
28
30
30
28

10
8
6
4
2
0
-2

TU

30
Total Utility (utils)

0
1
2
3
4
5
6
7

Marginal
utility
(2)

20
10

0
Marginal Utility (utils)

Hamburgers Total
consumed Utility
per meal

Observe
Diminishing
Marginal
Utility

Units consumed per meal

10
8
6
4
2
0
-2
1

2
3
4
5
6
Units consumed per meal

MU

Demand Analysis
Other

things being constant


refers to
Consumers

income

tastes
Number of buyers
Prices of related goods &
Other things beside price

Determinants of demand (Shift of the


demand curve)
To

draw the demand curve in price and


quantity space, we have to hold the other
things constant like income, taste and the
prices of other products.
These other factors are called "shift
factors" because if one of these factors
changes, the demand curve will shift
inwards or outwards.

Determinants of demand
Tastes

favourable change shifts the


demand curve up
Number of buyers more buyers lead to shift
the demand curve upward
Income I D for normal goods but for
inferior goods (used furniture) I D
Prices of related goods Substitute goods PEPSI & COCA-COLA
are substitute goods.
If price of PEPSI Demand for COCACOLA (+)

Determinants of demand
Complementary goods
Film and Camera are

complementary

goods.
If the price of camera , the demand
for camera and thus the demand
for film also (-)
Expectations about the
future prices, product availability &
income shift the demand curve.

Determinants of demand

Price

D2

D1

D0

Qty

Figure 6: Shifts of the Demand Curve

Supply Analysis
Supply
Shows

the amount of a product a


producer is willing & able to produce &
sell at each specific price in a series of
possible prices during a specified time
period
The schedule shows quantities that will
be offered at various prices

Supply Analysis
Price
($ per tonne in 2005)

Quantity Supplied
(tonnes of wheat)

20

35

50

60
Table 2

Supply Analysis
Law

of supply
It shows direct or positive relationship
between price and quantity supplied
Higher price increases production & sale
direct relationship between price and
quantity supplied
Given production costs, a higher price
means greater profit, thus an incentive to
increase the quantity supplied.
As shown in Figure 6

Supply Analysis
P

P
S2
S0

D
P2

S0
S1

P1

Q1

Q2

Qty

Figure 6: The Supply Curve, and


Movements Along it

Qty
Figure 7: Shifts of the Supply
Curve

Supply Analysis
The

supply curve
The supply curve is an upward sloping
curve implying that the lower the price,
other things constant, the less units firms
will produce and vice versa.

Determinants of supply
Unlike

demand curve, there are shift


factors or determinants that influence the
supply curve (Fig. 7)
shift factors of supply are those factors
that cause shifts in the entire supply
curve to the left or right
Resource prices - resource prices
supply curve vice versa
Technology technological improvement ;
supply curve

Determinants of supply
Taxes

and subsidies

business tax is treated as a cost, so decreases


supply
A subsidy lowers cost of production, so increases
supply

Prices

of related goods - price of substitute

goods , production of higher priced goods


rises & supply of the original good decreases
Expectations - future price of a product current
supply to increase or decrease
Number of sellers large number of seller
greater supply

Equilibrium Analysis
S0

PE

D0

QE
Figure 8: Demand and
Supply Equilibrium

Equilibrium Analysis
Price ($ per
tonne)

Quantity
Demanded

Quantity
Supplied

2000

12000

4000

10000

7000

7000

11000

4000

16000

1000

Table 3: The Demand and Supply Schedule


Combined

Equilibrium Analysis
The

forces of supply and demand lead to a


so-called market equilibrium and thereby set
the market price
At equilibrium (Fig. 8),
quantity supplied = quantity demanded.
there is no excess supply or excess
demand.
prices have no tendency to change.
Market clearing or market price is another
name of equilibrium price
This is the price at which the invisible
hands drives the market

Equilibrium Analysis
Table 3 shows combined data of the demand
and supply schedule
Disequilibrium:
Prices above equilibrium excess supply
Prices below equilibrium excess demand
Changes in supply and demand, and equilibrium
Changing demand with supply held constant

equilibrium Q P ; D equilibrium Q P

Changing supply with demand held constant


o

S equilibrium P Q ; S equilibrium P Q

Equilibrium Analysis
When both supply and demand curves
shift
If S D P , but new equilibrium qty
depends on relative sizes of shifts in
demand and supply
If S D P , but new equilibrium qty
depends again on relative sizes of shifts
in demand and supply

Disequilibrium
The

Dynamic Laws of Supply and


Demand

If quantity demanded is greater than


quantity supplied (excess demand),
prices tend to rise.
If quantity supplied is greater than
quantity demanded (excess supply),
prices tend to fall.

Disequilibrium
The

Dynamic Laws of Supply and


Demand
The larger the difference between
quantity demanded and quantity
supplied, the greater the pressure
for prices to rise (if there is excess
demand) or fall (if there is excess
supply).

A Surplus
D

S
Surplus

B
Supply more
than Demand

4
3
C
2
1
0

S
5

10

13

15

18

20

A Shortage
D

5
4

Demand is greater
than supply

3
2

Shortage
1
0

S
5

10

15

20

Changes in Supply and Demand


A

shift in demand that moves the


demand curve to the right causes
upward pressure on price.

Eventually, a new equilibrium is reached


at a higher price.

What If Both Curves Shift?


In such cases, supply and demand
analysis can be especially helpful in
figuring out the net effect of such changes
on price and thereby help dictate your
business plans.

Simultaneous Changes in
Both Demand and Supply
1. Increase in Demand and Supply
2. Increase in Demand and Decreased in
Supply
3. Decreased in Demand and Increased in
Supply
4. Decreased in Demand and Supply

1. Increase in Demand and Supply


At

the new equilibrium point, quantity always


increases. Lets look at these 3 different
situations
Price

decreased if increase in demand <


increase in supply
Price remains the same if increase in
demand = increase in supply
Price increased if increase in demand >
increase in supply

Situation 1 : Increase in demand is


less than increase in supply
P
Price
decreases

D1

S1

P1
P2

Quantity
Increases

D1
S1

Q1

D
Q2

Situation 2 :
Increase in demand = increase in supply
P
Price
Unchanged

D1

S1

Quantity
Increases

P1

D1
S1

Q1

D
Q2

Situation 3 :
Increase in demand is greater
than increase in supply
P
Price
Increases

D1

S1

P2
P1

Quantity
Increases

D1
S1

Q1

D
Q2

2. Increase in Demand and Decrease


in Supply
At the new equilibrium point, price always
increase, lets look at the 3 different
conditions

Quantity decreased if increase in demand


< decrease in supply
Quantity remain the same if increase in
demand = decrease in supply
Quantity increased if increase in demand
> decrease in supply

3. Decrease in Demand and Increase


in Supply
At the new equilibrium point, price always
decreased, lets look at the 3 different
conditions

Quantity decreased if decreased in


demand > increased in supply
Quantity remains the same if decreased
in demand = increased in supply
Quantity increased if decreased in
demand < increased in supply

4. Decrease in Demand and Supply


At the new equilibrium point, quantity
always decreased, lets look at the 3
different conditions

Price decreased if decreased in demand


> decreased in supply
Price remain the same if decreased in
demand = decreased in supply
Price increased if decreased in demand <
decreased in supply

Summary
Demand

and supply works differently.


Movements along the curve and a shift
in the curve means different things
one refers to a change in price while
the other refers to changes in other
factors than price.