Demand SIDE

Examining a Market The market for any good or service consists of all buyers and sellers of that good. As economists, typically represent a basic market in the form of supply and demand.

Types of markets Market is a group of buyers and sellers of a particular good or service. Buyers determine the demand for a product and sellers determine the supply of the product. Competitive market is a market in which there are many buyers and many sellers in the market so that each has a negligible impact on the market price We assume perfectly competitive markets when we study the theory of demand and supply.

Types of Markets Perfectly competitive markets have the following two characteristics: Goods being sold are all the same Both Buyers and sellers are price takers Monopoly is characterized by: One seller and many buyers Seller sets the price or Sellers set output Oligopoly is characterized by Few sellers without rigorous competition The sellers get together to set a price Monopolistic competition is characterized by Many sellers, each selling a differentiated product Sellers have some ability to set the price for their own product

Assumptions. The model of Demand and Supply assumes that we are analyzing a perfectly competitive market. Perfectly Competitive Market. A market that meets the conditions of Many buyers and sellers All firms sell identical products and No barriers to new firms entering the market.

The Basic Decision-Making Units A firm is an organization that transforms resources (inputs) into products (outputs). Firms are the primary producing units in a market economy. An entrepreneur is a person who organizes, manages, and assumes the risks of a firm, taking a new idea or a new product and turning it into a successful business. Households are the consuming units in an economy.

Demand Demand Schedule — a table showing the total quantity of a good(or service) that buyers wish to buy at each price Demand curve—a graph showing the total quantity of a good (or service) that buyers wish to buy at each price.

Demand Quantity demanded — The amount of a good or service that a consumer is willing and able to purchase at a given price. Market demand — The demand by all the consumers of a given good or service

Market Versus Individual Demand Market demand is the horizontal sum of all individual demands for a particular good or service. Market demand is derived from individual demands and thus depends on all those factors that determine individual demand (income, expectations, etc) In our case, market demand curve shows the variations in the quantity demanded of a good as price changes.

From Household Demand to Market Demand Assuming there are only two households in the market, market demand is derived as follows:

The ceteris paribus Condition Ceteris paribus (“all else equal”) condition. Ceteris paribus is the Latin word for all else equal. It is the requirement that when analyzing the relationship between two variables- such as price and qty demanded – other variables be held constant.

The Law of Demand. States that “all else equal” (ceteris paribus), when the price of a product falls, the quantity demanded of the product will increase, and when the price of a product rises, the quantity demanded of the product will decrease.

The Law of Demand The law of demand states that there is a negative, or inverse, relationship between price and the quantity of a good demanded and its price. This means that demand curves slope downward.

Demand Schedule & Curve for Movies Why is the demand curve downward sloping Price Quantity Demanded 5 50 4 40 3 30 2 20 1 10

Price/Quantity Relationship A demand curve is downward sloping from left to right because of the inverse relationship b/w price and quantity demanded. The demand curve has a negative slope, consistent with the law of demand. This is why consumers consume more of a commodity at lower price. Other reasons include the income and Substitution effects.

Determinants of Demand Own Price Income (normal, inferior) Prices of related goods (substitutes, complements) Tastes & Preferences Expectations Number of buyers (Market demand curve) Population Size

A Change in Demand Vs a Change in Quantity Demanded. A change in quantity demanded is a movement along the demand curve that occurs in response to a change in the price of the product in question ONLY. A change in demand is a shift of the entire demand curve.

A shift occurs if there is a change in one of the shifter variables, other than the price of the product, that affects the willingness of consumers to buy the product. Any change that varies the quantity that buyers wish to buy at a given price shifts the demand curve Changes in price that varies the quantity that buyers wish to buy is represented as a movement along the demand curve To summarize: Demand curve shows what happens to the quantity demanded of a good when its price varies, holding constant all other determinants of quantity demanded. When one of these determinants changes, the demand curve shifts.

Shift of Demand Versus Movement Along a Demand Curve A change in demand is not the same as a change in quantity demanded. In this example, a higher price causes lower quantity demanded. Changes in determinants of demand, other than price, cause a change in demand, or a shift of the entire demand curve, from DA to DB.

A Change in Demand Versus a Change in Quantity Demanded When demand shifts to the right, demand increases. This causes quantity demanded to be greater than it was prior to the shift, for each and every price level.

A Change in Demand Versus a Change in Quantity Demanded To summarize: Change in price of a good or service leads to Change in quantity demanded (Movement along the curve). Change in income, preferences, or prices of other goods or services leads to Change in demand (Shift of curve).

Shifts in Demand Curves: 1. Change in the price of a complement. 2. Change in the price of a substitute. 3. Change in consumer income. 4. Change in preferences of demanders of the good. 5. Change in the population of potential buyers. 6. An expectation of future prices.

1. Change in the Price of a Complement Complements—Goods and services that are used together. Eg. Cars and gas, coffee and sugar, shoe and socks. Two goods are complements in consumption if an increase in the price of one causes a leftward (inward) shift in the demand curve for the other.

2. Change in the Price of a Substitute Substitutes— Goods and services that can be used for the same purpose. Eg. Coke and Pepsi,.. two goods are substitutes in consumption if an increase in the price of one causes a rightward (outward) shift in the demand curve for the other.

The Impact of a Change in the Price of Related Goods Demand for complement good (ketchup) shifts left Demand for substitute good (chicken) shifts right Price of hamburger rises Quantity of hamburger demanded falls

3. Change in Consumer Income Normal good—a normal good is a good for which the demand increases as income rises and decreases as income falls. For a normal good, the demand curve shifts rightward (outward) when the incomes’ of buyers increase. Wealth, or net worth, is the total value of what a household owns minus what it owes. It is a stock measure.

The Impact of a Change in Income Higher income decreases the demand for an inferior good Higher income increases the demand for a normal good

Shift in Supply of Bread What happened here? P0 Q1 Q0 Q

Shift in the Demand for Sugar P P1 What happened here? P0 D1 D0 S Q0 Q1 Q

Inferior good—an inferior good is a good for which the demand increases as income falls and decreases as income rises. For an inferior good, the demand curve shifts leftward (inward) when the incomes’ of buyers increase.

4. Changes in the Preferences of Demanders for the Good If preferences shift away from a good, the demand curve for the good will shift downward.

5. Change in the Population of Potential Buyers. Increases in population generally shift outward the demand curves for most goods.

6. An Expectation of Higher Future Prices. Higher expected prices will shift outward the demand curve for a good.

Supply side

Supply Supply curve—a graph showing the total quantity of a good (or service) that sellers wish to sell at each price. Why is the supply curve upward sloping?

Supply Schedule & Curve Price Quantity Supplied 5 50 4 40 3 30 2 20 1

This shape of the supply curve reflects the reality that the number of firms willing to supply that commodity increases as the market price increases.

The only thing we allow to change along a given supply curve is the price of the good itself. If anything else changes, the entire supply curve shifts.

The law of Supply It states that, holding all else constant, increases in price cause increases in the quantity supplied, and decreases in price cause decreases in the quantity supplied. Why do producers produce more output when prices rise? They seek higher profits They can cover higher marginal costs of production

Quantity Supplied Quantity Supplied: The amount of a good or service that a firm is willing and able to supply at a given price. A change in quantity supplied is a movement along the supply curve that occurs in response to a change in price.

A Change in Supply Versus a Change in Quantity Supplied A change in supply is not the same as a change in quantity supplied. In this example, a higher price causes higher quantity supplied, and a move along the demand curve. In this example, changes in determinants of supply, other than price, cause an increase in supply, or a shift of the entire supply curve, from SA to SB.

A Change in Supply Versus a Change in Quantity Supplied When supply shifts to the right, supply increases. This causes quantity supplied to be greater than it was prior to the shift, for each and every price level.

A Change in Supply Versus a Change in Quantity Supplied To summarize: Change in price of a good or service leads to Change in quantity supplied (Movement along the curve). Change in costs, input prices, technology, or prices of related goods and services leads to Change in supply (Shift of curve).

Market Versus Individual Supply Market supply is derived by horizontally summing the individual supply curves Market supply curve shows how the quantity supplied varies as the price of the good varies Any change that varies the quantity supplied at a given price shifts the supply curve Changes in price that varies the quantity supplied in the market is represented as a movement along the supply curve

From Individual Supply to Market Supply The supply of a good or service can be defined for an individual firm, or for a group of firms that make up a market or an industry. Market supply is the sum of all the quantities of a good or service supplied per period by all the firms selling in the market for that good or service.

Market Supply As with market demand, market supply is the horizontal summation of individual firms’ supply curves.

SUPPLY Quantity supplied of any good is the amount that sellers are willing to sell in the market Determinants of supply: Price Input prices Technology Expectations Number of sellers (Market supply curve) Taxes and Subsidies

A change in supply is a shift of the entire supply curve. A change in supply has taken place if, at the same price, a different quantity is supplied.

Shifts in Supply Curves: 1) Changes in the cost of materials, labor, or other inputs used in the production of the good or service. 2) An improvement in technology that reduces the cost of production of the good or service. 3) A change in the weather (especially for agricultural products). 4) A change in the number of producers (suppliers). 5) An expectation of lower future prices.

1. Changes in Input Costs Changes in the cost of materials, labor, or other inputs used in the production of the good or service.

2. Technology An improvement in technology that reduces the cost of production of the good or service.

3. Weather A change in the weather (especially for agricultural products).

4. Change in the Number of Producers As the number of firms within a given market changes, the available supply of the goods or services produced by those firms will also fluctuate.

5. Change in Future Expectations An expectation of future prices will influence the firm’s behavior today regarding available supply of goods

demand and supply Equilibrium Markets

SUPPLY AND DEMAND How do supply and demand combined together determine the quantity and price of a good sold in the market? Supply and demand curves intersect. At this equilibrium price quantity supplied equals quantity demanded Equilibrium is a situation in which supply equals demand Equilibrium price is also called as the market clearing price as quantity supplied equals quantity demanded

Supply = Demand Market equilibrium occurs when all buyers and sellers are satisfied with their respective quantities at the market price. At equilibrium, QD=QS.

Increases in Demand and Supply Higher demand leads to higher equilibrium price and higher equilibrium quantity. Higher supply leads to lower equilibrium price and higher equilibrium quantity.

Decreases in Demand and Supply Lower demand leads to lower price and lower quantity exchanged. Lower supply leads to higher price and lower quantity exchanged.

Relative Magnitudes of Change The relative magnitudes of change in supply and demand determine the outcome of market equilibrium.

Relative Magnitudes of Change When supply and demand both increase, quantity will increase, but price may go up or down.

Market Disequilibria What happens when market price is not equal to the equilibrium price? Excess supply- surplus in the market Excess demand- shortage in the market Free markets reach equilibrium through the interaction of buyers and sellers and price is the tool through which the market is cleared. In economics, an equilibrium is a situation in which: there is no inherent tendency to change, quantity demanded equals quantity supplied, and the market just clears.

Shortages and Surpluses A shortage occurs when quantity demanded exceeds quantity supplied. A shortage implies the market price is too low. A surplus occurs when quantity supplied exceeds quantity demanded. A surplus implies the market price is too high.

Excess Demand A situation where QD > QS. Shortage: A situation in which the quantity demanded is greater than the quantity supplied. Therefore, price tends to rise until equilibrium is restored.

Excess Supply A situation where QS > QD. Surplus: A situation in which the quantity supplied is greater than the quantity demanded. Therefore, price tends to fall until equilibrium is restored.

The effect of shift in Demand and Supply over time. Whenever only demand or only supply shifts, we can easily predict the effect on equilibrium price and quantity. But what happens if both shift ? Eg. In many markets demand curve shifts to the right over time as population increases. The supply curve also often shifts to the right as new firms enter the market.

Whether the equilibrium price in a market rises or falls over time depends on whether demand shifts to the right more than does supply.

Summary No Change in S An Increase in S A Decrease in S No Change in D P same, Q same P down, Q up P up, Q down An Increase in D P up, Q up P ambiguous, Q up P up, Q ambiguous A Decrease in D P down, Q down P down, Q ambiguous P ambiguous, Q down

Price Controls The free market does not always lead to the best outcomes for all producers, consumers or the society in general, and so governments intervene in the market to correct the situation. Two forms of government intervention in markets are: Price ceiling or Maximum (low) Price floor or Minimum (high)

Price Ceiling A price ceiling is a legal maximum imposed by the government to help reduce the price of necessities and/or merit goods. The price is not allowed to exceed the price ceiling. The price ceiling is imposed below the equilibrium price.

Example Rent Controls Staples Bread Governments may attempt to impose maximum prices on rented accommodation to ensure affordable accommodation for those on low incomes Staples Governments may set maximum prices in agricultural and food markets to ensure low-cost food for the poor. Bread

Price ceiling P S At Pmax, there is a shortage. The quantity demanded by buyers, Qd exceeds the quantity supplied, Qs. PE Pmax Qs Qd D Q Shortage

Price Ceiling A price ceiling is set at K2 resulting in a shortage of 20 units.

Problems Long lines (Queues) Black market, where products are sold at higher prices. Favoritism

Government’s attempts to reduce the shortage The government can solve these problems either through: A. Shifting the demand curve to the left (which defies the purpose) OR B. Shifting the supply curve to the right Subsidies Direct provision Releasing previously stored stock A rationing scheme could be used e.g. ration coupons Opportunity Cost If the government spends money supporting such industries, it may have to reduce spending on other areas, like bridges and railways.

Government’s attempts to reduce the shortage If the government subsidized the products, produced it or released stored stocks, the supply will shift to the right and a new equilibrium will be created at Pmax. P S2 S1 PE Pmax Qs Qd D Q2 Q1 Q Shortage

Effects of Price Control D S P International Market Price Controlled Maximum Price S D QS QD Quantity of Oil

Price Ceilings & Floors A price ceiling is a legal maximum that can be charged for a good. Results in a shortage of a product Common examples include apartment rentals and credit cards interest rates. A price floor is a legal minimum that can be charged for a good. Results in a surplus of a product Common examples include soybeans, milk, minimum wage

Price Floors & Ceilings Price Floors and Price Ceilings are Price Controls, examples of government intervention in the free market which changes the market equilibrium. They each have reasons for using them, but there are large efficiency losses with both of them.

Why Ceiling are always below the Equilibrium Price ceilings are regulations designed to protect low income individuals from not being able to afford important resources. However, many economists question their effectiveness for several reasons. For example, price ceilings will have no effect if the equilibrium price of the good is below the ceiling.

Price Floor A price floor is set at K4 resulting in a surplus of 20 units.

Government Intervention To eliminate the surplus, the government attempts to: Buy the surplus In the case where the surplus is bought there is a number of options available to deal with the stocks It can be stored ; however, some items (fresh ones) cannot be stored for long periods of time and can therefore be immediately ruled out. Even the ones that can be stored will result in high storage costs. It can be destroyed, but this is considered to be wasteful. It can be sold to other countries; however, selling the stock abroad could be regarded as dumping and therefore not welcomed by other countries. It can be given as overseas assistance, but this encourages the overdependence of LDCs on MDCs and discourage them from pursuing their own growth strategies. Limit producers by quotas Advertise to create more demand

How Prices allocate Resources Prices act as signals that guide the allocation of scarce resources in a market economy. Prices in turn are determined by forces of supply and demand.

Market Friction 1: Price Floor Price floor—A price floor specifics a minimum legal price below which goods cannot be sold.

Minimum Wage

The minimum wage D S L W (by workers) Wmin The minimum wage results in excess supply of labor, i.e. unemployment Qs W* (by firms) Qd Surplus

Problems The minimum wage results in unemployment Price floors imposed on commodities Taxpayers will bear the burden of this policy as the government will need to buy the surplus Higher prices paid by consumers.

Market Friction 2: Price Ceiling Price ceiling—A price ceiling specifies the highest price that firms may legally charge.

Rent Control

Market Example 1: Energy Prices Due to relatively high unemployment over the last few years, the demand curve for energy has shifted inward.

Market Example 2: Market for Bank Loans Supply of bank loans: Banks Demand for bank loans: Households and business firms Price of bank loans = interest rate on bank loans

Market for Bank Loans

Credit Crunch In a credit crunch banks greatly reduce their lending. As a result, the supply curve for bank loans shifts inward.

Credit Crunch Market for bank loans.

Credit Crunch Fewer loans are granted at a higher interest rate.

Practice Question Suppose the supply of a good is given by the equation P = 200 + Q and the demand for the good is given by the equation P = 500 - Q/2, where quantity is measured in millions of units and P is measured in dollars per unit.   What is the equilibrium quantity in this market? What is the equilibrium price in this market? Graph?

How do the demand curve and supply curve look like (draw)? Practice Questions The market for cheese is characterized by the following demand and supply curve: Demand: Qd= 9 – P Supply: Qs= 3P – 3 Where P represent the price (in Euro per Kg.) and Q represent the quantity (in Kg.). How do the demand curve and supply curve look like (draw)? Which is the value of the equilibrium prices and quantities?