Chapter 2

Theory of Demand and Supply

Law of Demand
A decrease in the price of a good, all other things held constant, will cause an increase in the quantity demanded of the good. An increase in the price of a good, all other things held constant, will cause a decrease in the quantity demanded of the good.

Law of Demand
There is an inverse relationship between the price of a good and the quantity of the good demanded per time period. Substitution Effect Income Effect

Demand function
Individual Consumers Demand Dx = f(Px, Py, Pz, Y, T & )
Dx = Px = Py = Pz = Y= T= Quantity demanded of a commodity x by an individual per time period

Price per unit of Commodity x Prices of Substitute goods Prices of Complementary goods Consumers Income Tastes, Habits, Culture & Traditions & Fashions of the Consumer = Disturbing Factors

Dx = f(Px, Py, Pz, Y, T & )

(Dx/(Px < 0 (Dx /(Py > 0 if x and y are substitutes (Dx /(Pz < 0 if x and z are complementary goods (Dx/(Y > 0 if a good is normal (Dx/(Y < 0 if a good is inferior T, H, C&T, & F

Change in Quantity Demanded

Price An increase in price causes a decrease in quantity demanded.

P1 P0

Q1

Q0

Quantity

Change in Quantity Demanded

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

P0 P1 Q0 Q1 Quantity

Market Demand Curve: Horizontal summation of demand curves of individual consumers

Changes in Market Demand

Change in Buyers Tastes Change in Buyers Incomes
Normal Goods Inferior Goods

Change in the Number of Buyers Change in the Price of Related Goods

Substitute Goods Complementary Goods

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

P0

Q0

Q1

Quantity

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

P0

Q1

Q0

Quantity

Demand Faced by a Firm

Market Structure
Monopoly Oligopoly Monopolistic Competition Perfect Competition

Type of Good
Durable Goods Nondurable Goods Producers Goods - Derived Demand

Elasticity of Demand
 By Factors or Variables influencing Demand: Price Elasticity of Demand  Income Elasticity of Demand  Cross Elasticity of Demand

 By Degree or Extent of Change: Perfectly Elastic Demand  Relatively Elastic Demand  Unitary Elastic Demand  Relatively Inelastic Demand  Perfectly Inelastic Demand

Price Elasticity of Demand

Point Definition

( Q / Q (Q P EP ! ! (P / P (P Q
Q2  Q1 P2  P 1 EP ! P2  P Q2  Q1 1

Marginal Revenue and Price Elasticity of Demand

PX
EP " 1 EP ! 1 EP 1

QX

E "1 P

Law of Supply
A decrease in the price of a good, all other things held constant, will cause a decrease in the quantity supplied of the good. An increase in the price of a good, all other things held constant, will cause an increase in the quantity supplied of the good.

Change in Quantity Supplied

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

P0 P1

Q1

Q0

Quantity

Change in Quantity Supplied

Price An increase in price causes an increase in quantity supplied.

P1 P0

Q0

Q1

Quantity

Changes in Supply
Change in Production Technology Change in Input Prices Change in the Number of Sellers

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

P0

Q0

Q1

Quantity

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

P0

Q1

Q0

Quantity

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.

Market Equilibrium
Price D S

Quantity

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

Q0 Q1

Quantity

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

Q1 Q0

Quantity

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

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