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
 Product
  

Local, national & international Highly personal or face-to-face exchange Impersonal or remote

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) $5 $4 $3 $2 $1
Table 1

Quantity Demanded (tonnes of wheat) 9 10 12 15 20

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.

D
5 A

Demand Curve

4 Price of wheat (dollars per ton)

E D

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
0

A B
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

Total and Marginal Utility

Total Utility (utils)

Hamburgers consumed per meal

Total Utility

Marginal utility (2)

30

TU

0 1 2 3 4 5 6 7

0 10

20

10

0 Marginal Utility (utils)

Units consumed per meal

10 8 6 4 2 0 -2
1 2 3 4 5 6 7 Units consumed per meal

Copyright McGraw-Hill, Inc. 1999

MU

0 1 2 3 4 5 6 7

0 10

Total Utility (utils)

Hamburgers Total consumed Utility per meal

Marginal utility ((2)

30

TU

20

10

10

0 Marginal Utility (utils)

Units consumed per meal

10 8 6 4 2 0 -2
1 2 3 4 5 6 7 Units consumed per meal

MU

Copyright McGraw-Hill, Inc. 1999

0 1 2 3 4 5 6 7

0 10 18

Total Utility (utils)

Hamburgers Total consumed Utility per meal

Marginal utility ((2)

30

TU

20

10 8

10

0 Marginal Utility (utils)

Units consumed per meal

10 8 6 4 2 0 -2
1 2 3 4 5 6 7 Units consumed per meal

MU

Copyright McGraw-Hill, Inc. 1999

0 1 2 3 4 5 6 7

0 10 18 24

Total Utility (utils)

Hamburgers Total consumed Utility per meal

Marginal utility ((2)

30

TU

20

10 8 6

10

0 Marginal Utility (utils)

Units consumed per meal

10 8 6 4 2 0 -2
1 2 3 4 5 6 7 Units consumed per meal

MU

0 1 2 3 4 5 6 7

Marginal Utility (utils)

0 10 18 24 28

Total Utility (utils)

Hamburgers Total consumed Utility per meal

Marginal utility ((2)

30

TU

20

10 8 6 4

10

Units consumed per meal

10 8 6 4 2 0 -2
1 2 3 4 5 6 7 Units consumed per meal

MU

0 1 2 3 4 5 6 7

Marginal Utility (utils)

0 10 18 24 28 30

Total Utility (utils)

Hamburgers Total consumed Utility per meal

Marginal utility ((2)

30

TU

20

10 8 6 4 2

10

Units consumed per meal

10 8 6 4 2 0 -2
1 2 3 4 5 6 7 Units consumed per meal

MU

0 1 2 3 4 5 6 7

Marginal Utility (utils)

0 10 18 24 28 30 30

Total Utility (utils)

Hamburgers Total consumed Utility per meal

Marginal utility ((2)

30

TU

20

10 8 6 4 2 0

10

Units consumed per meal

10 8 6 4 2 0 -2
1 2 3 4 5 6 7 Units consumed per meal

MU

0 1 2 3 4 5 6 7

0 10 18 24 28 30 30 28

Total Utility (utils)

Hamburgers Total consumed Utility per meal

Marginal utility ((2)

30

TU

20

Marginal Utility (utils)

10 8 6 4 2 0 -2

10

Units consumed per meal

10 8 6 4 2 0 -2
1 2 3 4 5 6 7 Units consumed per meal

MU

Total and Marginal Utility

Total Utility (utils)

Hamburgers Total consumed Utility per meal

Marginal utility ((2)

30

TU

0 1 2 3 4 5 6 7

0 10 18 24 28 30 30 28

20

Marginal Utility (utils)

10 8 6 4 2 0 -2

10

Observe Diminishing Marginal Utility

0 1 2 3 4 5 6 7 Units consumed per meal

10 8 6 4 2 0 -2
1 2 3 4 5 6 7 Units consumed per meal

MU

Demand Analysis
 Other


things being constant 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

D1 D2 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) 1 2 3 4 5
Table 2

Quantity Supplied (tonnes of wheat) 5 20 35 50 60

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 S0 S1

D
P2 P1

Q1

Q2

Qty Figure 7: Shifts of the Supply Curve

Qty

Figure 6: The Supply Curve, and Movements Along it

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
P
S0

PE

D0 QE Figure 8: Demand and Supply Equilibrium

Equilibrium Analysis
Price ($ per tonne) 1 2 3 4 5 Quantity Demanded 2000 4000 7000 11000 16000 Quantity Supplied 12000 10000 7000 4000 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
D

equilibrium Q equilibrium P

P ; D equilibrium Q Q ;S

Changing supply with demand held constant

o

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 P
A 5 4 3 C 2 1

S Surplus
B
Supply more than Demand

S
0 5 9 10 13 15 18 20

A Shortage
D P
5 4 C 3
Demand is greater than supply

Shortage
1

S
0 5 7 10 15

D Q
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

the new equilibrium point, quantity always increases. Lets look at these 3 different situations 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
Price At

Situation 1 : Increase in demand is less than increase in supply

P Price decreases D D1 S S1

P1 P2

Quantity Increases

S S1 0 Q1 Q2 D

D1

Situation 2 : Increase in demand = increase in supply

P Price Unchanged D D1 S S1

P1

Quantity Increases

S S1 0 Q1 Q2 D

D1

Situation 3 : Increase in demand is greater than increase in supply

P Price Increases P2 P1 D D1 S S1

Quantity Increases

S S1 0 Q1 Q2 D

D1

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.