Topic 2 (a) Demand & Supply Module 2 Topic 1

Demand & Supply 1. Demand 2. Supply 3. Market Equilibrium 4. Consumer & Producer Surplus

1.1 What is demand? No. of units of a good or service that consumers are willing and able to purchase during a period, under a given set of conditions

1.2 Why is the study of demand important for firms? Determines a firm’s profitability Affect long run planning and strategic decisions Affects short run decisions

$ = 1 $ $ $ $ Price Fred Mary Total Demanded Market Demand Schedule for Compact Discs per year

$20 $15 $10 $ P Q Fred’s Demand Curve D1D1

$20 $15 $10 $ P Q Mary’s Demand Curve D2D2

$20 $15 $10 $ P Q Market Demand Curve D3D3 12

1.3 The Law of demand: Law of Demand: There is an inverse relationship b/w the price of a good and the quantity buyers are willing to purchase in a defined time period, other things being the same (ceteris paribus). When the price of a good rises the quantity demanded will fall and vice versa.

1.3 Law of demand Reasons for inverse relationship: Income effect: ↑P=> ↓ Real income => ↓ Purchasing power => ↓ Qd Substitution effect: ↑P => the good becomes relatively more expensive => consumers switch to other products => ↓ Qd

1.4 Demand curve The demand curve illustrates the relationship b/w the quantity demanded and the price of a good (assuming all other influences on the demand are held constant).

IMPORTANT - KNOW THE DIFFERENCE BETWEEN A CHANGE IN THE QUANTITY DEMANDED AND A CHANGE IN DEMAND

When price changes, what happens? The curve does not shift - there is a change in the quantity demanded

Change in Price Change in Quantity Demanded

$20 $15 $10 $ A B A change in price causes a change in the quantity demanded D P Q 50

Price increases Upward movement along the demand curve Decrease in quantity demanded

Price decreases Downward movement along the demand curve Increase in quantity demanded

When something changes other than price, what happens? The whole curve shifts,there is a change in demand

$20 $15 $10 $ D1D1 D2 P 50 A When the ceteris paribus assumption is relaxed, the whole curve can shift Q B

Change in nonprice determinant Change in demand

What can cause a demand curve to shift? A change in: Number and price of substitute goods Number and price of complementary goods Number of consumers in the market Expected price changes Incomes Tastes, preferences, fashions, trends Advertising

Shift in Demand Curve P Price 0 Q0Q0 Q1Q1 D0D0 D1D1 QuantityQ2Q2 Decrease Increase A change in demand results from a change in one or more of determinants of demand, other than the price of the goods. A change in demand can be represented by a shift in the position of the demand curve.

Some definitions… Substitute goods are good that can be used in place of another good (eg. Coke & Pepsi) Complementary goods are goods that are used in conjunction with each other (eg. Bread and butter) Normal goods are goods whose demand varies directly with income (also known as superior goods) Inferior goods are goods whose demand varies inversely with income

1.4 Psychological (or non- functional) factors affecting demand: Bandwagon effect Everyone is doing it, so will I Snob effect Not everyone can do it, so I will Conspicuous consumption Let everyone see how much money I have

Bandwagon effect A situation where the more of goods are sold in the market, the greater the strength of demand for that goods. “Jumping on the bandwagon” Because some consumers possess the goods, it causes other consumers to desire it. This is often the case with new consumer goods introduced onto the market eg, plasma TV, iPod

Snob effect Demand for the good strengthens as the availability of that good is reduced. The scarcity of the good leads consumers to psychologically re-appraise the qualities of the goods. Eg, Limited Edition Books or Prints; Exclusive Designer Wear

Conspicuous consumption Where the consumers valuation of the good is influenced by the price of goods in the market. Satisfaction is gained not only from the good itself, but also from being seen to be able to afford it. This may be the case with such prestige items such as paintings, or expensive clothes and cars.

2. What is Supply ? No. of units of a good or service firms are willing and able to produce during a period, under a given set of conditions

2.2 Law of Supply There is a direct relationship between the price of a good and the quantity sellers are willing to offer for sale in a defined time period, ceteris paribus

2.1 Supply curve Supply curve: The supply curve shows the relationship between quantity supplied & price, other things being the same (citeris paribus)

A $20 40 B C 6 20 Point Price Quantity An Individual Seller’s Supply for Compact Discs

$20 $15 $10 $ A B C Supply Curve A company’s Supply Curve for Compact Discs P Q

Why do supply curves have a positive slope? A higher price means more profitable to suppliers/sellers. Therefore, they will supply more of the good or service.

$ = 60 $ $ $ $ Price Super Sound High Vibes Total Market Supply Schedule for Compact Discs per year

$25 $20 $15 $10 10 P Q 1520 Super Sound Supply Curve S1S1 25

$25 $20 $15 $10 20 P Q 2530 High Vibes Supply Curve S2S2 35

$25 $20 $15 $10 40 P Q 4555 Market Supply Curve 60 S total

IMPORTANT - KNOW THE DIFFERENCE BETWEEN A CHANGE IN THE QUANTITY SUPPLIED AND A CHANGE IN SUPPLY

When price changes, what happens? The curve does not shift - there is a change in the quantity supplied

$20 $15 $10 $ A B C Supply Curve A change in price causes a change in the quantity supplied P Q

Change in Price Change in Quantity Supplied

When something changes other than price, what happens? The whole curve shifts - there is a change in supply

$20 $15 $10 $ S1S1 S2S2 When the ceteris paribus assumption is relaxed, the whole curve can shift P Q

Change in nonprice determinant Change in supply

What can cause a supply curve to shift? A Change in : price of substitutable goods (on the supply side) cost of production (eg. Price of raw materials, labour, capital) taxes & subsidies technology profit expectations number of suppliers

Shift in Supply Curve Price 0 S0S0 S1S1 Quantity Increase Decrease S2S2 A change in supply results from a change in one or more of determinants of supply, other than the price of the goods. A change in supply can be represented by a shift in the position of the supply curve.

3. Market equilibrium The point where quantity demanded equals quantity supplied Market forces keep the price at equilibrium (how?)

Equilibrium price and output : The Market Demand and Supply of Potatoes (Monthly) Copyright 2001 Pearson Education Australia

fig The determination of market equilibrium (potatoes: monthly) Quantity (tonnes: 000s) Price ($ per kg) E D C B A a b c d e Supply Demand Copyright 2001 Pearson Education Australia

Markets not in equilibrium Shortage When market price 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.

fig Quantity (tonnes: 000s) Price ($ per kg) E D C B A a b d e Supply Demand SHORTAGE ( ) The determination of market equilibrium (potatoes: monthly) Copyright 2001 Pearson Education Australia c

Markets not in equilibrium Surplus When market 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.

fig Quantity (tonnes: 000s) Price ($ per kg) E D C B A a b c d e SURPLUS ( ) Supply Demand The determination of market equilibrium (potatoes: monthly) Copyright 2001 Pearson Education Australia

4. 1 Consumer SurplusConsumer Surplus the difference between what the consumers are willing to pay (shown on the demand curve) and what they actually pay (the market price) In other words, Consumer surplus is the area between the Demand curve and the Price line

fig Consumer surplus D P1P1 Q1Q1 P Q O Copyright 2001 Pearson Education Australia

fig Consumer surplus D Totalconsumerexpenditure P1P1 Q1Q1 P Q O Copyright 2001 Pearson Education Australia

fig Consumer surplus D Totalconsumerexpenditure TotalconsumersurplusTotalconsumersurplus P1P1 Q1Q1 P Q O Copyright 2001 Pearson Education Australia

Consumer Surplus CS is the area between the demand curve and the market price line. It measures how much the consumer gains from buying goods in the market

4.2 Producer surplus the amount producers receive (market price) above the minimum price required to make them supply the good (shown on the supply curve) Producer surplus is the area between the Price line and the Supply curve

fig Producer surplus P1P1 Q1Q1 P Q O Copyright 2001 Pearson Education Australia S Producer Surplus Total Producer surplus Market price

4.3 CS and PS – Economic efficiency CS and PS are an important tool for measuring the performance of an economic system or for assessing the impact of alternative government policies in that system.

fig CS and PS – Economic efficiency PmPm QmQm P Q O Copyright 2001 Pearson Education Australia S Producer Surplus PS CS D

fig CS and PS – Economic efficiency PmPm Too little P Q O Copyright 2001 Pearson Education Australia S Producer Surplus PS D A B Deadweight loss: area A + B CS

fig CS and PS – Economic efficiency PmPm Too much P Q O Copyright 2001 Pearson Education Australia S Producer Surplus PS D CS C D Negative PS & Negative CS: area C + D

fig CS and PS – Economic efficiency PmPm Efficient P Q O Copyright 2001 Pearson Education Australia S Producer Surplus PS CS D