Introduction

The capitalist and mixed economy systems

today require decentralised mechanisms for
coordinating the activities of millions of
participants
Markets are the most important means for
achieving this coordination
This course will deal with:
- How markets function, when do they deliver
the best results
- Reasons for market failures and solutions to
cases of market failure
 Demand and Supply

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.
 Demand-supply Analysis
A market consists of the buyers and
sellers of a good or service: abstraction
from any concept of specific time and
location of a market.
We need to summarise the factors that
motivate the buyers and sellers.
We will do this separately.

Next, we bring together the two sets of

players to explain what will be the
market outcome
 Demand and supply
The buyers’ behavior is summarized by
means of the demand schedule and
the demand curve

The market demand schedule shows the

amounts of the commodity that
buyers are prepared to buy at different
prices.
Demand Schedule
The Demand Curve: The Relationship
between Price and Quantity
Demanded
Demand Curve
The demand curve is a graph of the
relationship between the price of a good and
the quantity demanded.
Demand Schedule and Demand Curve

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
 Market Demand versus Individual Demand
 The quantity demanded in the market is the sum of the
quantities demanded by all buyers at each price.
 Suppose Neha and Rohit are the only two buyers in
the ice cream cones market.(Qd = quantity demanded)
Price Neha’s Qd Rohit’s Qd Market Qd
$0.00 16 + 8 = 24
1.00 14 + 7 = 21
2.00 12 + 6 = 18
3.00 10 + 5 = 15
4.00 8 + 4 = 12
5.00 6 + 3 = 9
6.00 4 + 2 = 6
 Law of Demand

The downward sloping demand curve

obeys the law of demand: quantity
demanded decreases as price increases.
The slope is negative (but may not be
constant) at all points of the demand
curve.
It is obvious from even casual
observation or introspection that demand
depends on many things.
 Ceteris paribus

When we draw the demand curve, we

are focusing only on the relationship
between price and quantity demanded.
We can do this by assuming that
“everything else” is being kept fixed at
certain levels.
 Demand drivers
In general, the quantity demanded is
expected to depend, in addition to the
own price, on
incomes
tastes and preferences
prices of “related” commodities
change in number of buyers
expectations, etc.
A change in any of these other factors thus leads to
a shift in the entire curve.
 A numerical example
Suppose that the demand function is
Qd = 1800 – 20P +0.6M – 50PR
Also suppose M = 20,000 and PR = 250
Then Qd = 1800 – 20P +0.6(20,000) – 50(250)
= 1800 – 20P + 12,000 – 12,500
Qd = 1300 – 20P
Any change in M or PR affects the demand
curve through the intercept term – shifts the
demand curve
(ii) The sign of the coefficient of PR is negative –
hence this is a complement
 Terms for Shift vs. Movement Along Curve

 Change in the quantity demanded:

a movement along a fixed D curve
occurs when P changes

 Change in demand: a shift in the D curve

occurs when a non-price determinant of demand
changes (like income or # of buyers)
 Changes in Quantity
Demanded
Price of Ice-
Cream A tax that raises the price of ice-
Cones cream cones results in a movement
along the demand curve.
B
$2.00

1.00 A

D
0 4 8 Quantity of Ice-Cream Cones
 Shifts in the Demand Curve

Price of
Ice-Cream
Cone

Increase
in demand

Decrease
in demand
Demand
curve, D2
Demand
curve, D1
Demand curve, D3
0 Quantity of
Ice-Cream Cones
Copyright©2003 Southwestern/Thomson Learning
Change in factors other than price

How do we expect the “other things”

to influence demand?
Income:
If I (income) increases, we expect
more to be demanded at every price –
the demand curve will shift to the
right.
 Consumer Income
Normal Good
Price of Ice-Cream
Cone
$3.00 An increase in
income...
2.50 Increase
in demand
2.00

1.50

1.00

0.50
D2
D1 Quantity of
Ice-Cream
0 1 2 3 4 5 6 7 8 9 10 11 12 Cones
However, there may be some ‘inferior’
goods whose demand falls as income
increases.

For example, an increase in the incomes

of poor farmers might lead them to buy
more of rice and wheat and less of coarse
cereals like ragi, jowar, and bajra.
 Consumer Income
Price of Ice-
Inferior Good
Cream Cone
$3.00

2.50 An increase in
income...
2.00
Decrease
1.50 in demand
1.00

0.50

D2 D1 Quantity of
Ice-Cream
0 1 2 3 4 5 6 7 8 9 10 11 12 Cones
 Tastes and preferences
If T (tastes and preferences) change such that
buyers like a commodity more, again the same
thing will happen

Tastes and preferences can change for many reasons:

 Demographic changes
If population comes to consist of larger proportion of
older people, this will affect pattern of demand.
 New Information
Dissemination of the information on harmful side-effects
of drugs can lead to a fall in demand for these drugs.
 Prices of related goods
If the price of a substitute rises, we
expect the demand to rise, too (as
price of coffee rises, the demand
curve for tea shifts upward and to the
right).

If the price of a complement rises, we

expect the demand to fall (as price of
sugar rises, the demand curve for tea
shifts downward and to the left).
 D1 D2 D D1
P1 D2
P
P2 P

Complement
QD1 QD2 Substitute
[Direct]
[Inverse]
Cereal Pop Tarts
Milk
 Prices of related goods contd.:
Complements

The dramatic fall in the price of

computers over the past twenty years
has significantly increased the demand
for printers, monitors and internet
access.
air travel and hotel rooms
movies and popcorn
bathing suits and sun tan lotion
candy and dentistry
Prices of related goods contd.: Substitutes

movies (in theaters) and sporting events

restaurants and dining at home
holiday in Goa versus holiday in
Mussourie
economics courses and political science
courses
 Expectations

An expectation that prices will rise

in the future shifts the demand
curve to the right.
If there is expected to be a major
shortage of some commodity, then
consumers will stock up now or risk
not getting any.
 D1 D2

QD1 QD2
The simple thing to remember is:

a change in commodity’s own price by itself

can only represent a movement along the
demand curve and not a shift in the curve;

however, a change in any of the “other

things” will lead to a shift of the demand
curve.
The market supply schedule shows the
amounts of the commodity that sellers
are prepared to sell at different prices.
Supply Schedule
 Market Supply versus Individual Supply
 The quantity supplied in the market is the sum of
the quantities supplied by all sellers at each price.
 Suppose Vadilal and Kwality are the only two sellers
in this market. (Qs = quantity supplied)
Price Vadilal Kwality Market Qs
$0.00 0 + 0 = 0
1.00 3 + 2 = 5
2.00 6 + 4 = 10
3.00 9 + 6 = 15
4.00 12 + 8 = 20
5.00 15 + 10 = 25
6.00 18 + 12 = 30
The Supply Curve: The Relationship
between Price and Quantity Supplied

Supply Curve
The supply curve is the graph of the
relationship between the price of a good and
the quantity supplied.
 Supply Schedule and Supply Curve

Price of
Ice-Cream
Cone
$3.00

2.50
1. An
increase
in price ... 2.00

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.
Copyright©2003 Southwestern/Thomson Learning
The upward sloping supply curve that has
been drawn exemplifies the law of supply:
quantity supplied increases as price
increases.

Like demand, supply also depends on

many things.

 To draw the supply curve, we need the

ceteris paribus assumption
In general, the quantity supplied is
expected to depend on

 own price

 technological knowledge

 input prices,
 alternative output price changes,

 expectations, etc.
 Terms for Shift vs. Movement Along Curve

 Change in the quantity supplied:

a movement along a fixed S curve
occurs when P changes

 Change in supply: a shift in the S curve

occurs when a non-price determinant of supply
changes (like input prices or # of sellers)
 Change in Quantity Supplied
Price of Ice-
Cream S
Cone
C
$3.00
A rise in the price
of ice cream
cones results in a
movement along
A the supply curve.
1.00

Quantity of
Ice-Cream
0 1 5 Cones
Shifts in the Supply Curve

Change in Supply
A shift in the supply curve, either to the left
or right.
Caused by a change in a determinant other
than price.
 Shifts in the Supply Curve

Price of
Ice-Cream Supply curve, S3
Supply
Cone
curve, S1
Supply
Decrease curve, S2
in supply

Increase
in supply

0 Quantity of
Ice-Cream Cones
Copyright©2003 Southwestern/Thomson Learning
 A numerical example

Suppose that the supply function is

Qs = 50 + 10P – 8PI + 5T
If PI = 50 and T = 90, then
Qs = 50 + 10P – 8(50) + 5(90)
= 50 + 10P – 400 + 450
Qs = 100 + 10P
How do we expect the “other things” to
influence supply?

A change in technology that allows the

commodity to be produced more
cheaply should shift the supply curve
downwards and to the right.

If input prices increase, exactly the

opposite should happen.
I only have “Substitutes in production”
200 acres Broccoli Corn S2 S1
S
P2
P
P1

QS1 QS2
Producers want to produce more of the good where price is increasing,
Broccoli Corn S1
S
P1 S2
P
P2

QS2 QS1
or at least, where the price is not going down.
 [“INVERSE”]

S2 S1 S2

Oil Prices Oil Prices

P
expected expected
to decrease to increase

If oil producers expect future oil prices to

decline, they will (increase/decrease)
current production.

If oil producers expect future oil prices to

increase, they will (increase/decrease)
current production.
 Equilibrium
 The demand and supply curves intersect
to determine the market equilibrium
 Equilibrium: a price-quantity pair
 Find a price P* such that Qd = Qs = Q* at
that price
 Then (P*, Q*) constitutes an equilibrium
 SUPPLY AND DEMAND
TOGETHER
Demand Schedule Supply Schedule

At $2.00, the quantity demanded

is equal to the quantity supplied!
 The Equilibrium of Supply and Demand

Price of
Ice-Cream
Cone Supply

Equilibrium price Equilibrium

$2.00

Equilibrium Demand
quantity

0 1 2 3 4 5 6 7 8 9 10 11 12 13
Quantity of Ice-Cream Cones
Copyright©2003 Southwestern/Thomson Learning
 A numerical example

Equation of demand curve:

Qd = 1300 – 20P
Equation of supply curve:
Qs = 100 + 10P
At equilibrium Qd = Qs
1300 – 20P = 100 + 10P
Solving, P = 40
Qd = Qs = 500
 Equilibrium

 Why call it equilibrium?

1. If the market is at (P*, Q*), there are
no forces to move it away from (P*,
Q*)
2. If the market is not at equilibrium, it
tends to come back to equilibrium
Equilibrium

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.
 P
S
D
Excess supply/Surplus

P’

P*

S D

0 Q* Q
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.
 P
S
D

P*

P’’

Excess demand/Sortage

S D

0 Q* Q
 Shifts in equilibrium

More interesting is the case where there

are shifts in supply and/or demand
curves
As a result, the equilibrium shifts
Sometimes, it is useful to predict the
direction of shift
Three Steps to Analyzing Changes in
Equilibrium
Decide whether the event shifts the
supply or demand curve (or both).
Decide whether the curve(s) shift(s) to
the left or to the right.
Use the supply-and-demand diagram to
see how the shift affects equilibrium
price and quantity.
 EXAMPLE 1: A Shift in Demand for Electric Cars
EVENT TO BE ANALYZED:
Increase in price of petrol. P
S1
STEP 1: P2
D curve shifts
because
STEP 2: price of gas P1
affects demand for
D shifts right
hybrids.
because
STEP 3: high gas
S curve
price doeshybrids
makes not D1 D2
The shift
shift, causes
because an
price
more attractive Q
increase
of gas in price
does not cars. Q1 Q2
relative to other
and quantity
affect cost of of
electric cars.
producing hybrids.
EXAMPLE 1: A Shift in Demand

Notice: P
When P rises,
S1
producers supply
a larger quantity P2
of electric cars,
even though the S P1
curve has not
shifted.
D1 D2
Always be careful
to distinguish b/w Q
Q1 Q2
a shift in a curve
and a movement
along the curve.
EXAMPLE 2: A Shift in Supply
EVENT: New technology
reduces cost of P
producing electric cars. S1 S2
STEP 1:
S curve shifts
because
STEP 2: event affects P1
cost of production.
S shifts right P2
D curve does
because event not
STEPbecause
shift, 3:
reduces cost, D1
The shift causes
production technology
makes production Q
price
is not to
onefallof the Q1 Q2
more profitable at
and quantity
factors that to rise.
affect
any given price.
demand.
EXAMPLE 3: A Shift in Both Supply
EVENTS:
and Demand
Price of petrol rises AND P
new technology reduces S1 S2
production costs
STEP 1: P2
Both curves shift.
P1
STEP 2:
Both shift to the right.
STEP 3: D1 D2
Q rises, but effect Q
on P is ambiguous: Q1 Q2
If demand increases more
than supply, P rises.
EXAMPLE 3: A Shift in Both Supply
EVENTS:
and Demand
price of petrol rises AND P
new technology reduces S1 S2
production costs

STEP 3, cont.
P1
But if supply
increases more P2
than demand,
D1 D2
P falls.
Q
Q1 Q2
 Government interventions

Sometimes Governments try to correct

the the existing pattern of income
distribution.
They often try to achieve the results
indirectly, by interfering with the market
processes.
Examples are rent control laws and
minimum wage legislation.
 Rent Control Laws

Governments sometimes try to set a

ceiling on rents in the belief that rents in
free market equilibrium would be too
high for most people to afford renting
flats/apartments.
Thus in the market for housing, the
maximum rent allowed is r’ which is less
than the equilibrium level r*
 r

S
D

r*

r’
Excess demand

S
D

0 H
 Rent Control Laws

At r’, there will be excess demand for

housing.
Who gains from this arrangement?
The people who are able to get housing
at the low rents.
 Rent Control Laws
But the unsatisfied demand shows up in
various ways.
- First, landlords charge high deposits and
“pugrees”.
- Secondly, illegal transactions take place
in the form of charging high rents
without issuing corresponding receipts.
- Landlords also might use their discretion
to screen applicants, e.g., some
landlords might rent out flats only to
vegetarians.
 Rent Control Laws
More importantly, in the long run, the
smaller value from housing as an asset
might discourage landlords from
providing adequate maintenance
services.
Over time, funds are switched to other
types of investment and less funds are
deployed in the housing industry, thus
shifting the supply curve to the left,
(from SS to S'S') and aggravating the
initial condition of excess demand.
 r S’
S
D

r*

r’

S’
S
D

0 H
 Minimum Wage Legislation

Minimum wage legislation is undertaken

to ensure that wages paid to workers do
not fall below a certain minimum.
Hence, in the labor market, a floor is set
on wages, i.e., wages are not allowed to
fall below a certain level.
 w

S
D

Excess supply
w’

w*

S
D

0 L
 Minimum Wage Legislation
At wage rate w*, there is excess supply
of labor.
- Since some workers would have been
willing to work for lower wages, a
“contract” system of wages tends to
develop.
- Workers are employed for smaller periods
or in smaller numbers, so that the
minimum wage provision does not apply,
or they are not paid other benefits like
medical benefits, PF, gratuity, etc.
 Minimum Wage Legislation

- In the longer run, employers might

switch to more machine-intensive
processes to economize on labor costs.
- This shifts the demand curve for labor to
the left and aggravates the initial
condition of excess supply.
 Conclusion
Are interventions in the forms of price
ceilings or price floors always
undesirable?
There is some gain from each of these
actions and there are some losses, and
these must be balanced by society
against each other.
But when markets are not allowed to
operate freely, forces build up that tend
to bypass regulations, with unintended
and undesirable outcomes.