Introduction to Economics Eco-101 Lecture # 02 THE PRICE MECHANISM Demand and Supply Analysis Instructor: Farhat Rashid

Demand Demand indicates how much amount of a product consumers are both willing and able to buy at each possible price during a given time period. Emphasis on individual being both willing and able to buy is called demand.

3 Demand, Wants, and Needs C onsumer demand and wants are not the same thing – Wants ignore the importance of ability to buy as expressed by a person’s budget Nor is demand the same as need – Need focuses on the willingness and again ignores the ability to purchase

Law of Demand A fundamental characteristic of demand is this : All else equal, as price falls, the quantity demanded rises, and as price rises the quantity demanded falls. In short there is negative or inverse relationship between price and quantity demanded. Economists call this relationship the law of demand.

Individual Demand Quantity Demanded (bushels per week) Price (per bushel) PQdQd $ Individual Demand P Q D

6 Shifts of the Demand Curve Demand curve focuses on the relationship between the price of a good and the quantity demanded when other factors that could affect demand remain unchanged – Money income of consumers – Prices of related goods – Consumer expectations – Number and composition of consumers in the market – Consumer tastes

7 Changes in Consumer Income Goods can be classified into two broad categories depending on how the demand for the good responds to changes in money income – Normal goods: the demand increases when income increases and decreases when income decreases – Inferior goods: the demand decreases when income increases and increases when income decreases NOTE:As income increases, consumers tend to switch from consuming these goods to consuming normal goods

8 Changes in the Prices of Related Goods The prices of other goods are another of the factors assumed constant along a given demand curve Two general relationships – Two goods are substitutes if an increase in the price of one shifts the demand for the other rightward and, conversely, if a decrease in the price of one shifts the demand for the other good leftward – Two goods are complements if an increase in the price of one shifts the demand for the other leftward and a decrease in the price of one shifts the demand for the other rightward

9 Changes in Consumer Expectations A change in consumer expectations with respect to future prices and future incomes is another of the factors which shifts demand Changes in income expectations – If individuals expect income to increase in the future, current demand increases and vice versa – If individuals expect prices to increase in the future, current demand increases and decreases if future prices are expected to decrease

10 Changes in Consumer Tastes Tastes are nothing more than a person’s likes and dislikes as a consumer Difficult to say what determines tastes but clearly they are important And whatever factors change taste will clearly change demand

Quantity Demanded Price PQdQd $ Individual Demand P Q D1D Demand Can Increase or Decrease Decrease in Demand D2D2 D3D3 An Increase in Demand Means a Movement of the Line A Movement Between Any Two Points on a Demand Curve is Called a Change in Quantity Demanded

12 Reminder Remember the distinction between a movement along a demand curve and a shift of a demand curve A change in price, other things constant, causes a movement along a demand curve, changing the quantity demanded contraction/expansion) A change in one of the determinants of demand other than the price causes a shift of the demand curve  changing demand (rise/fall)

13 Individual Demand Market Demand Individual demand :refers to the demand of an individual consumer Market demand :is the sum of the individual demands of all consumers in the market

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

15 Supply Supply indicates how much of a good producers are willing and able to offer for sale per period at each possible price, other things constant Law of supply states that the quantity supplied is usually directly related to its price, other things constant – The lower the price, the smaller the quantity supplied – The higher the price, the greater the quantity supplied

16 Law of Supply Two reasons producers tend to offer more for sale when the price rises First, as the price increases, other things constant, a producer becomes more willing to supply the good – Prices act as signals to existing and potential suppliers about the rewards for producing various goods  higher prices attract resources from lower-valued uses

Determinants of supply Resource prices Technology Taxes and subsidies Number of sellers Producers expectations

18 Individual Supply and Market Supply Individual supply refers to the supply of an individual producer Market supply is the sum of individual supplies of all producers in the market

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

20 Reminder Remember the distinction between a movement along a supply curve and a shift of a supply curve A change in price, other things constant, causes a movement along a supply curve, changing the quantity supplied A change in one of the determinants of supply other than the price causes a shift of the supply curve  changing supply

21 Equilibrium When the quantity that consumers are willing and able to pay equals the quantity that producers are willing and able to sell, the market reaches equilibrium  the independent plans of both buyers and sellers exactly match  market forces exert no pressure to change price or quantity

22 Disequilibrium Prices Markets do not always reach equilibrium quickly and during the time required for adjustment, the market is in disequilibrium Disequilibrium is usually temporary as the market gropes for equilibrium Sometimes, as a result of government intervention in markets, disequilibrium can last a long time

Market Disequilibria Excess demand, or shortage, is the condition that exists when quantity demanded exceeds quantity supplied at the current price. When quantity demanded exceeds quantity supplied, price tends to rise until equilibrium is restored.When quantity demanded exceeds quantity supplied, price tends to rise until equilibrium is restored.

Market Disequilibria Excess supply, or surplus, is the condition that exists when quantity supplied exceeds quantity demanded at the current price. When quantity supplied exceeds quantity demanded, price tends to fall until equilibrium is restored.When quantity supplied exceeds quantity demanded, price tends to fall until equilibrium is restored.

Change in Market Equilibrium Changes in Demand Changes in Supply Changes in Equilibrium

26 Changes in Equilibrium Once a market reaches equilibrium, that price and quantity will prevail until one of the determinants of demand or supply changes A change in any one of these determinants will usually change equilibrium price and quantity in a predictable way

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.

28 Shifts of the Supply Curve An increase in supply  a rightward shift of the supply curve reduces the equilibrium price but increases equilibrium quantity On the other hand, a decrease in supply  a leftward shift of the supply curve increases equilibrium price but decreases 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.

30 Summary If demand and supply shift in opposite directions, we can say what will happen to equilibrium price – It will increase if demand increases and supply decreases – It will decrease if demand decreases and supply increases Without reference to the size of the shifts, we cannot say what will happen to equilibrium quantity

ASSIGNMENT # 1: SHOW THESE SIMULTANEOUS SHIFTS IN DEMAND AND SUPPLY WITH THE HELP OF GRAPHS. 31 in D > in S in D < in S in D > in S in D = in S in D < I in S