Module 2 Demand, Supply, and Market Equilibrium

Market Forces : Demand & Supply

Demand and supply are the two words that economists use most often. Demand and supply are the forces that make market economies work. Demand and supply refer to the behavior of people as they interact with one another in competitive markets. Markets characterized by many buyers and sellers and markets in which a homogeneous or relatively nondifferentiated good or service is sold. Price-takers because prices are determined by the forces of the marketplace- namely demand and supply.
2

What is a Market?
A market is a group of buyers and sellers of a particular good or service. More specifically, a market is any arrangement through which buyers and sellers exchange/ transact final goods or services, resources used for production, or, in general, anything of value. We view the concept of a market quite broadly, taking into account of the advances in technology. Buyers demand goods and services. Sellers supply goods and services.
3

Markets & transaction costs

Markets facilitate exchange between buyers and sellers Markets reduce transaction costs for both parties Transaction costs are the costs of making transaction happen, which are additional costs of doing business over and above the price paid.
4

Markets & Transaction Costs : An Example

You have a car to sell. You can choose to sell your car in two ways. One way is to find a buyer by canvassing your neighborhood (by keep knocking on the doors of your neighbors!). Eventually, you may find one who is willing to pay a price you are willing to accept. But it requires a lot of your time. Probably you may end up buying a new pair of shoes! Second way is to run an advertisement in any web platform namely, http://www.carsalesindia.com/, describing your car and stating the price you are willing to accept for it. Here, the market is the web platform used to run the car ad. It saves time and of course reduces transaction cost.
5

DEMAND
Demand refers to the various amounts of good or service a buyer is willing and able to buy at various possible prices during a given period of time, say a week or a month. Quantity demanded is the amount of a good or service that buyers are willing and able to purchase at any given price during a given period of time, say a week or a month. Quantity demanded is a desired quantity, not necessarily how much they actually succeed in purchasing. It is a flow.

Various Concepts
Consumer Goods Vs Producer Goods Perishable Vs Durable Derived Vs Autonomous Demand (Sugar and Tea, Auto Battery & car) Company demand and Industry demand
    

Perfect competition Monopoly Monopolistic competition Oligoploy Homogeneous Oligopoly Differentated

Demand By market Vs Market Segments (Sedan Vs Hatchback)



Esp when they differ by Price, Margins, Seasonalities, Cyclical sensitivities etc

Factors affecting quantity demanded

A multitude of factors To simplify analysis & make it manageable, economists use 6 important factors
1. 2. 3.

4. 5.

Price of the good or service (ind) Incomes of consumers (Ind) The prices of related goods and services (Ind) Tastes of consumers (ind) Expected price of the product in future periods
(Durables typically)

6.

No. of consumers in the market (mkt Dem not ind)

8

Generalized Demand Functions (GDF)

Is the functional relationship between quantity demanded and the six factors. Qd = f (P, M, Pr , T, Pexp , N) Where f means is a function of , and Qd = Quantity demanded of the good P = price of the good M = consumers income Pr = price of related goods T= Taste patterns of consumers Pexp = expected price of the good N= number of consumers in the market
9

Summary of the GDF

Sl. no 1 2 M Direct for normal goods, Inverse for inferior goods (shoe repair services, bus rides, used cars) Direct for substitute goods (movie tickets and video rentals, 7-up and Sprite), Inverse for complement goods (computers and software, Petrol and Car, tennis rackets and balls) Direct Direct Direct
10

Variable P

Relation to quantity demanded Inverse

Pr

4 5 6

T Pexp N

These relations are in the context of other things being equal.

11

Ordinary Demand Function (ODF)

Shows the relation between quantity demanded and the price of the product when all other variables affecting demand are held constant at specific values. Derived from GDF Traditionally, ODF is referred to as demand functions or demand.
12

Demand Function
The functional relation between price and quantity demanded per period of time, when all other factors that affect consumer demand are held constant, is called a demand function or simply demand. It gives, for various prices of a good, the corresponding quantities that consumers are willing and able to purchase at each of those prices, all other things held constant.
13

A demand function is obtained by holding all the variables in the GDF constant except price. You can express this relation as an equation, a schedule or table, or a graph: Qd = f (P)
 

Marginal consumers : leave if Price rises and enter when P falls. So Q = F(-P) Intra Marginal consumers - Dont leave mkt fully. Then , 2 effects as below When P falls, Commodity becomes cheaper and substitution effect is + When P falls, real income increases. Hence for superior goods Income effect is + But for Inferior goods, the income effect is negative Price effect = Inc + subs Effect = negative for Superior Price effect = Inc + sub effect = can be (-) or (+) for inferior goods : Giffens superior goods : Stock mkt behavior and Prod Obsolescence
14

There are 2 effects in operation : Income and substitution effect

    

Exceptions to Law of Demand

Demand Schedule


The demand schedule is a table that shows the relationship between the price of the good and the quantity demanded. It shows a list of several prices and the quantity demanded per period of time at each of the prices, again holding all variables other than price constant.
15

Catherines Demand Schedule

16

Demand Curve
The demand curve is a graph of the relationship between the price of a good and the quantity demanded.

17

Figure 1 Catherines Demand Schedule and Demand Curve

Price of Ice-Cream Cone $3.00 2.50 1. A decrease 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 demanded.
Copyright 2004 South-Western

18

Market Demand versus Individual Demand

Market demand refers to the sum of all individual demands for a particular good or service. Graphically, individual demand curves are summed horizontally to obtain the market demand curve.

19

20

Law of Demand


 

The law of demand states that, other things equal, the quantity demanded of a good falls when the price of the good rises and the quantity demanded of a good rises when the price of the good falls. Not simply a characteristic of the specific demand function. The inverse relation is so pervasive that economists refer to it as law of demand
21

Change in Quantity Demanded

 

Movement along the demand curve. Caused by a change in the price of the product. The other five variables that influence demand in the GDF are fixed in value for any particular demand equation.
22

Changes in Quantity Demanded

Price of Ice-Cream Cones

$2.00

A tax that raises the price of ice-cream cones results in a movement along the demand curve.
A

1.00

D
0

23 Quantity of Ice-Cream Cones

Shifts (Changes) in Demand

1.

When any one of the five variables held constant when deriving a demand function from the GDF changes value, a new demand function results, causing the entire demand curve to shift to a new location.

2.

3. 4. 5.

Consumer income Prices of related goods Tastes Expectations Number of buyers

24

 

A shift in the demand curve, can be either leftward or rightward. Caused by any change that alters the quantity demanded at each and every price.

25

Increase in demand: A change in the demand function that causes an increase in quantity demanded at every price and is reflected by a rightward shift in the demand curve.

Decrease in demand A change in the demand function that causes a decrease in quantity demanded at every price and is reflected by a leftward shift in the demand curve.
26

Figure 3 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 27 Ice-Cream Cones
Copyright2003 Southwestern/Thomson Learning

RECAPITULATION

28
Copyright2004 South-Western

RECAPITULATION
Sl. No 1 Determinants of demand Income Normal good Inferior good 2 Price of related goods Substitute Complement 3 4 5 Consumer Tastes Expected price Number of consumers Price rises Price falls Taste rises Expectation of price rise Number rises Price falls Price rises Taste falls Expectation of price falls Number falls
29

Demand increases

Demand decreases

Income rises Income falls

Income falls Income rises

SUPPLY
Supply refers to the various amounts of good or service a producer / seller is willing and able to sell at various possible prices during a given period of time, say a week or a month. Quantity supplied is the amount of a good or service that a seller is willing and able to sell at any given price during a given period of time, say a week or a month. Supply is a flow variable.

30

Factors affecting quantity supplied

Economists concentrate on certain important variables that have the greatest effect on quantity supplied. Economists assume that the quantity of a good or service supplied depends on 6 major variables. Price of the good Price of the inputs used to produce the good Prices of goods related in production, substitutes in production and complements in production level of available technology Expectations of the producers concerning the future price of the good Number of firms or the amount of productive capacity in the industry. 31

Generalized Supply Function (GSF)

This function shows how all six of these variables determine the quantity supplied.
Qs = g (P, Pi, Pr, T, Pe, F)

P = price of the good or service Pi = price of the inputs Pr = prices of the goods that are related in production. T = level of available technology Pe = expectations of producers concerning the future price of the good. F = Number of firms or the amount of productive capacity in the industry. 32

Summary of GSF
Sl. no 1 2 Pi 3 Pr T Pe F Inverse Inverse for substitute goods (Corn and Wheat). Direct for complement goods (Cars and Petrol) Direct Inverse Direct
33

Variable P

Relation to quantity supplied Direct

4 5 6

Supply Function
Derived from GSF Shows how quantity supplied is related to product price, holding the determinants of supply (five other variables that influence supply) Qs = g (P, Pi, Pr, T, Pe, F) = g (p) Thus a supply function expresses quantity supplied as a function of product price only i.e., Qs = g(p)
34

Supply Schedule


Supply Schedule is a table that shows the relationship between the price of the good and the quantity supplied. It shows a list of possible product prices and the corresponding quantities supplied, holding all variables other than price constant.

35

Bens Supply Schedule

Price of Ice-Cream Cone $0.00 0.5 1 1.5 2 2.5 3 Quantity of Cones Supplied 0 0 1 2 3 4 5
36

Supply Curve
Supply curve is a graph showing the relation between quantity supplied and price, when all other variables influencing quantity supplied are held constant.

37

Figure 5 Bens Supply Schedule and Supply Curve

Price of Ice-Cream Cone $3.00 1. An increase in price ... 2.50 2.00 1.50 1.00 0.50

1 2

9 10 11 12 Quantity of Ice-Cream Cones

38
Copyright2003 Southwestern/Thomson Learning

2. ... increases quantity of cones supplied.

Individual Supply to Market Supply

Market supply refers to the sum of the supplies of all sellers of a particular good or service. Graphically, individual supply curves are summed horizontally to obtain the market supply curve.
39

Individual Supply to Market Supply

40

Law of Supply


The law of supply states that, other things equal, the quantity supplied of a good rises when the price of the good rises and the quantity supplied of a good falls when the price of the good falls.

41

Change in Quantity Supplied



Can be caused only by a change in the price Ceteris paribus (all else constant) Movement along the supply curve

42

Change in Quantity Supplied

Price of IceCream Cone

S
C A rise in the price of ice cream cones results in a movement along the supply curve.

$3.00

1.00

Quantity of Ice-Cream 43 Cones

Shifts (Changes) in Supply

A shift in supply occurs only when one of the five determinants of supply (Pi, Pr, T, Pe, F) changes value. A shift in the supply curve can be either rightward or leftward. Caused by any change that alters the quantity supplied at each and every price.
44

Increase in supply A change in the supply function that causes an increase in quantity supplied at every price, and is reflected by a rightward shift in the supply curve.

Decrease in supply A change in the supply function that causes a decrease in quantity supplied at every price, and is reflected by a leftward shift in the supply curve.
45

Figure 7 Shifts in the Supply Curve

Price of Ice-Cream Cone Supply curve, S3

Supply curve, S1

Decrease in supply

Supply curve, S2

Increase in supply

Quantity of 46 Ice-Cream Cones

Copyright2003 Southwestern/Thomson Learning

RECAPITULATION

47
Copyright2004 South-Western

RECAPITULATION
Sl. No 1 Determinants of supply Input prices Supply increases Price falls Supply decreases Price rises

Price of related goods in production Substitute Price falls Price rises

Complement

Price rises

Price falls

3 4 5

Technology Expected price Number of sellers

Technology rises Expectation of price fall Number rises

Technology falls Expectation of price rise Number falls

48

MARKET EQUILIBRIUM
The interaction of buyers and sellers in the marketplace leads to market equilibrium. Market Equilibrium refers to a situation in which the price has reached the level where quantity supplied equals quantity demanded. In other words, market equilibrium is a situation in which, at the prevailing price, consumers can buy all of a good they wish and producers can sell all of the good they wish.
49

MARKET EQUILIBRIUM
Equilibrium Price  The price that balances quantity supplied and quantity demanded.  On a graph, it is the price at which the supply and demand curves intersect.  Price at which Qd = Qs Equilibrium Quantity  The quantity supplied and the quantity demanded at the equilibrium price.  On a graph it is the quantity at which the supply and demand curves intersect.

50

MARKET EQUILIBRIUM
Demand Schedule Supply Schedule

At $2.00, the quantity demanded is equal to the quantity supplied!

51

Demand Function Domain for P <= $ 3 Range = 19 - 6 P Domain For 'P" < $ 1

Supply Function Rang Zero

for P > $3

= 0

For " P > = $ 1

1 + 6(P-1)

Equilibrium

19 - 6P 19 -6P 19 + 5 24 P

= = = = = 2

1 + 6(P-1) 1 + 6P -6 12P 12P

52

Figure 8 The Equilibrium of Supply and Demand

Price of Ice-Cream Cone

Supply

Equilibrium price $2.00

Equilibrium

Equilibrium quantity 0 1 2 3 4 5 6 7 8

Demand

9 10 11 12 13 Quantity of Ice-Cream Cones53

Copyright2003 Southwestern/Thomson Learning

$2 is the equilibrium price $2 is also called as market clearing price Market clearing price is the price of a good at which buyers can purchase all they want and sellers can sell all they want at that price. Market clearing price is another name for the equilibrium price.
54

Surplus (Excess Supply)



When price > equilibrium price, then quantity supplied > quantity demanded. i.e., quantity supplied exceeds quantity demanded Suppliers will lower the price to increase sales, thereby moving toward equilibrium.
55

Figure 9 Markets Not in Equilibrium

(a) Excess Supply Price of Ice-Cream Cone $2.50 2.00 Supply Surplus

Demand

4 Quantity demanded

10 Quantity supplied

Quantity of Ice-Cream Cones

56

Copyright2003 Southwestern/Thomson Learning

Shortage ( Excess Demand)

Shortage ( Excess Demand)



When price < equilibrium price, then quantity demanded > the quantity supplied. i.e., quantity demanded exceeds quantity supplied Suppliers will raise the price due to too many buyers chasing too few goods, thereby moving toward equilibrium.
57

Figure 9 Markets Not in Equilibrium

(b) Excess Demand Price of Ice-Cream Cone Supply

$2.00 1.50 Shortage Demand

4 Quantity supplied

10 Quantity of Quantity Ice-Cream demanded Cones

58

Copyright2003 Southwestern/Thomson Learning

A final point about Market Equilibrium

In the analysis of demand and supply there will never be either a permanent shortage or a permanent surplus as long as price is allowed to adjust freely to the equilibrium level. We assume that market price adjusts quickly to the equilibrium level. In the absence of impediments to the adjustment of prices (price ceilings or floors), the market is always assumed to clear.
59

Changes in Market Equilibrium

Qualitative forecast


Predicts only the direction in which an economic variable will move Predicts both the direction and the magnitude of the change in an economic variable
60

Quantitative forecast


Supply, Demand Equilibrium

Pd = Ps = What is the equilibrium price 100 - 0.5Q = 100 - 10 Q = P = 100 - 0.5Q = 55 If a Price ceiling of Rs 40 is introduced , impact ? P Qs = 2Ps - 20 Q = = = 40 120 60 60only. Shortage 70
61

100 - 0.5 Qd 10 + 0.5Qs 10 + 0.5 Q Q

200 - 2Pd = Qd 2 Ps - 20 = Qs

90

Qd = 200 - 2 Pd =

Black market impact If Q = 60, price = Pd = 100 - .5Q = Buy @ 40, sell at 70 and make 30 / unit profit.

200 - 2P P 0 10 25 40 55 58 70 85 Qd 200 180 150 120 90 84 60 30

2P - 20 Qs

With tax Ps Ps 0 0 30 60 90 96 120 150 16 31 46 61 52 76 91

62

Chart Title
250 200 150 100 50 25, 30 0 0 10, 0 20 40 60 80 40, 60 0, 200 10, 180 25, 150 40, 120 55, 90 70, 60 85, 30 70, 120 85, 150

Qd Qs

100
63

Taxes
Pd Ps = 100 0.5 Qd = 10 + 0.5 Qs 100 0.5 Qd = 16 + 0.5 Qs 100 16 = Q

100 - .5 Q = 10 + 0.5 Q Solving , we get Q = 90 : P = 55

Q = 84 : Pd = 58 : Ps-6 = 52

P d+ 6 Now, tax @ Rs 6 /unit As Consumer pays = Eq Pric Supplier receives = EP -6 Pd = 100 0.5 Qd 10 + 0.5 Qs Ps

= 100 0.5 q = 10 + 0.5 Q

94 0.5 Q = 10 + 0.5 Q Q = 84 : Ps = 52 : Pd + 6 = 58

Ps -6 =

64

Taxes
Pd Ps = Cd - Nd Q = Cs + Ns Q 100 : 0.5 10 : 0.5

Cd - Nd Q Cd Cs

= Cs + Ns Q = Ns Q + Nd Q 100 10 / (0.5 + 0.5) = 90

(Cd Cs)/ (Ns+Nd) = Q

P = Cd Nd Q = Cd Nd {(Cd-Cs)/(Ns+Nd)} = Ns Cd + NdCs (0.5 * 100 ) + (0.5* 10) = 55

65

Assignment 1
Function for a Holiday Package Qd Qs = 81 0.05 P = - 24 + 0.025 P

Calculate equilibrium Price and Quantity, algebraically and Graphically Graph the Supply and Demand function, showing equilibrium Now the Govt. imposes a Cap on the Price at Rs 1200. Show the impact both algebraically and graphically Now, Govt imposes a Tax of Rs 120. Write down the equation for the supply function adjusted for Tax. Show the impact Graphically

66

Substitutes

Qdx Qsx 82 3 Px + Py -Py + 18 Px 18 Py Px + 17 Py + 17 Py Py + Px 19Px + 19 Py Px + Py

= 82 3Px + Py = - 5 + 15 Px = - 5 + 15Px = = 87 49

Qd y Qsy 92 + 2Px 4 Py 36 Py - 2 Px 18 Py - Px Solving

= 92 + 2Px 4Py = - 6 +32 Py = - 6 + 32Py = 98 = 49

87 + Py - 18 Px = 0

98 36 Py + 2 Px = 0

= 136 = 8 = 38 = 2 Px = 5 : Py = 3 Qx = 70 : Qy = 90

67

Changes in Demand (Supply Constant)

68

Changes in Supply (Demand Constant)

69

Simultaneous Shifts
When demand & supply shift simultaneously
Can predict either the direction in which price changes or the direction in which quantity changes, but not both  The change in equilibrium price or quantity is said to be indeterminate when the direction of change depends on the relative magnitudes by which demand & supply shift

70

Simultaneous Shifts: (oD, oS)

P S S S B

P P P

C
D D Q

Price may rise or fall; Quantity rises

71

Simultaneous Shifts: (qD, oS)

P S S S A

P B

P P

C
D Q Q Q

Price falls; Quantity may rise or fall

72

Simultaneous Shifts: (oD, qS)

P S S P P A S C B

D D Q Q Q Q

Price rises; Quantity may rise or fall

73

Simultaneous Shifts: (qD, qS)

P S S S

P P P

C
B

D D Q Q Q Q

Price may rise or fall; Quantity falls

74

Ceiling & Floor Prices

Ceiling price
Maximum price government permits sellers to charge for a good  When ceiling price is below equilibrium, a shortage occurs


Floor price
Minimum price government permits sellers to charge for a good  When floor price is above equilibrium, a surplus occurs

75

Ceiling & Floor Prices

Px Px

Price (dollars)

Price (dollars)

Sx

Sx 3 2

2 1

Dx 22 50 62 Qx 32 50 84

Dx Qx

Quantity

Quantity

Panel A Ceiling price

Panel B Floor price

76

To Sum up
Market equilibrium analysis provides a core tool for understanding and analyzing economic decisions of managers Two groups of independent players in most market situations--buyers and sellers Demand represents behavior of buyers, supply represents the behavior of sellers Common link between buyers and sellers in markets is price
77

So, future managers listen!

You need to understand economics because you are required to make successful business decisions by analyzing changing economic conditions and by learning how these conditions would affect the market. This is precisely what economic analysis is designed to do.
78

Reading List
Managerial Economics by Thomas and Maurice Chapter 2 (Page number 34 to 73). Read Illustration 2.1, 2.2, and 2.3. Principles of Economics by Gregory Mankiw Chapter 4 ( Page number 63 to 84) Managerial Economics by Truett & Truett Chapter 1 (Page number 20 to 30)
79