Supply and Demand: Theory (Part II) Ch. 3, Economics, R.A. Arnold

Market An arrangement where buyers and sellers meet to trade. Here we focus on the sellers or businesses or prodicers (the supply side of the market) What is the incentive to produce? Profit is the incentive to produce or supply

DEMAND AND SUPPLY (The two sides of a market) The willingness and ability of buyers to purchase different quantities of goods At different prices During a specific period of time The willingness and ability of sellers to produce and offer to sell different quantities of goods At different prices During a specific period of time

LAW OF DEMAND AND SUPPLY (In both cases there are four ways to represent the law) LAW OF SUPPLY 1. As the price(𝑃) of a good rises, the quantity demanded ( 𝑄 𝑑 ) of the good falls, and as the price of a good falls, quantity demanded of the good rises, ceteris paribus. 2. In symbols: i𝑓, 𝑃↑𝑡ℎ𝑒𝑛 𝑄 𝑑 ↓ 𝑎𝑛𝑑 𝑖𝑓, 𝑃↓𝑡ℎ𝑒𝑛 𝑄 𝑑 ↑, ceteris paribus 1. As price (P) of a good rises, the quantity supplied ( 𝑄 𝑠 ) of the good rises, and as the price of the good falls, quantity supplied ( 𝑄 𝑠 ) of the good falls, ceteris paribus. 2. In symbols: i𝑓, 𝑃↑𝑡ℎ𝑒𝑛 𝑄 𝑠 ↑𝑎𝑛𝑑 𝑖𝑓, 𝑃↓𝑡ℎ𝑒𝑛 𝑄 𝑑 ↓, ceteris paribus

LAW OF DEMAND AND SUPPLY Law of SUPPLY 3. Demand schedule: The numerical tabulation of the quantity demanded of a good at different prices (numerical representation of the law of DD) 4. Demand curve: The graphical representation of the law of demand. (A downward sloping line or curve; inverse relationship). Drawn using the demand schedule. 3. Supply schedule: numerical tabulation of quantity supplied of a good at different prices 4. An upward sloping line or curve (indicating a direct relationship). Drawn using the supply schedule.

Explaining The Upward Sloping Supply Curve Theory 1: Assuming ceteris paribus, higher prices implies higher profits which acts as an incentive for the producers/sellers/firms to produce more Theory 2: Due to the law of increasing opportunity costs, costs rise when more units of a good are produced. So a larger quantity of goods is supplied only at a higher price. Since, suppliers will only supply if, price > cost of production

CHANGE IN ‘QUANTITY SUPPLIED’ (QS) Implies movement along the supply curve Factor causing this movement: change in price From the next slide. ‘S’ represents ‘Supply’ And Qs represents quantity supplied. They are DIFFERENT concepts.

CHANGE IN SUPPLY Changes in supply (S) or shift of the supply curve occurs due to a factor other than price. These factors are connected to profit which is the main incentive for supply. Profit = Revenue - Cost Factors that cause this shift 1) Prices of relevant resources (R) P(R) ↑, Profit ↓, S ↓ P(R) ↓, Profit ↑ , S ↑ ceteris paribus 2) Technology Technological improvement → more output using same resources → cost of production ↓ → profit ↑ and hence, S ↑ 3) Prices of other goods Sellers/producers shift to goods with higher prices (more profit), hence S of the good being produced now ↓

if, # of sellers ↑ then, supply (S) ↑ 4) Number of sellers if, # of sellers ↑ then, supply (S) ↑ 5) Expectations (E) of future prices E (future prices) ↑, current S ↓, future S ↑ (Since sellers will be able to make more profit in the future) 6) Taxes and subsidies Taxes cause cost ↑, profit ↓, hence S ↓ Subsidies cause cost ↓, profit ↑, hence S ↑ 7) Government restrictions Generally restricts/reduces supply (barriers to entry, compliance with certain criteria, import quota) The diagram next slide summarizes the concepts of last few slides

The Market: D and S Together Here we look at the entire market i.e. Demand and Supply together. So we combine the demand and supply curves in the same graph (next slide). In the graph the equilibrium point (E), where the demand and supply curves meet (i.e. Qd = Qs), gives us the equilibrium price and quantity in a market. Equilibrium Price (PE), $10 (next slide) Equilibrium Quantity, 100 units (next slide) Surplus: Qs > Qd occurs when P > PE Disequilibrium Shortage: Qd > Qs occurs when P < PE

Moving (from Disequilibrium) to Equilibrium So a market may be in any one of the three states (equilibrium, shortage or surplus). If a market is not in equilibrium it will move towards it (by itself) in the following manner: If, a market is experiencing surplus i.e. Qs > Qd then suppliers will reduce the price to sell the excess goods. Price falls until the equilibrium price, where the market clears i.e. Qs = Qd If, a market is experiencing shortage* i.e. Q(D) > Q(S), then buyers bid the price ‘up’ (they compete with each other for the limited goods). Price rises until the equilibrium price is reached where the market clears i.e. Qd = QS. *Wants > Number of goods => scarcity => competition between buyers => price goes up

From One Equilibrium to Another Last slide we saw that how a market moves towards equilibrium. And a market should remain in equilibrium unless the demand or supply curve shifts. If the demand or supply curve shifts then the market will move to a new equilibrium. This is illustrated in the next slide and will be discussed in class in detail. In diagram (a) the demand has increased (shifted right) and the market moves to a new equilibrium point (2) which gives us the new equilibrium price (P2), which is greater than the previous equilibrium price (P1). So if the demand increases the market price is likely to increase. We can similarly analyse the other diagrams. Home work.

Equilibrium and Predictions: An Application of the Theory of Supply and Demand Examples… Housing market: Empty flats in Uttara is an indication of surplus in the housing market. In the future we might expect house rents to decline. Education market: Current situation indicates a shortage in this market. Many students can’t get admitted due to limited seats. In the future tuition fees of private universities may increase. **Remember: a good theory should be able to predict what happens in the real world (Ch. 1)**