© 2007 Thomson South-Western Demand, Supply and Market Equilibrium

Allocation Mechanisms How does society allocate the goods and services produced among those who want them? How does society allocate the goods and services produced among those who want them? –First come first serve. –Divide them equally. –Allocate them to a certain group. –Give only to the poorest individuals –To the highest bidder.

Each allocation mechanism creates incentives for people to behave in a certain way. Each allocation mechanism creates incentives for people to behave in a certain way. For example, the First come first serve mechanism creates incentives for people to be the first in line. For example, the First come first serve mechanism creates incentives for people to be the first in line. Allocation Mechanisms What incentives does the market mechanism create?

A market is a group of buyers and sellers of a particular good or service. A market is a group of buyers and sellers of a particular good or service. The terms supply and demand refer to the behavior of people... as they interact with one another in markets. The terms supply and demand refer to the behavior of people... as they interact with one another in markets. What is a Market?

Buyers determine demand. Buyers determine demand. Sellers determine supply. Sellers determine supply. What is a Market?

What Is Competition? A competitive market is a market in which A competitive market is a market in which  The product is homogenous  Numerous buyers and sellers so that each has no influence over price  Buyers and Sellers are price takers there are many buyers and sellers so that each has a negligible impact on the market price.  Free entry and exit

DEMAND Quantity demanded is the amount of a good that buyers are willing and able to purchase at a given price. Quantity demanded is the amount of a good that buyers are willing and able to purchase at a given price. Law of Demand Law of Demand –The law of demand states that the quantity demanded of a good falls when the price of the good rises, ceteris paribus.

The Demand Curve: The Relationship between Price and Quantity Demanded Demand Curve Demand Curve –The demand curve is a graph of the relationship between the price of a good and the quantity demanded.

Price of Ice-Cream Cone Quantity of Ice-Cream Cones $ A decrease in price increases quantity of cones demanded.

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

Price of Ice- Cream Cone Quantity of Ice-Cream Cones Catherine’s Demand Nicholas’s Demand Market Demand + = When the price is $2.00, Catherine will demand 4 ice-cream cones. When the price is $2.00, Nicholas will demand 3 ice-cream cones. The market demand at $2.00 will be 7 ice-cream cones. When the price is $1.00, Catherine will demand 8 ice-cream cones. When the price is $1.00, Nicholas will demand 5 ice-cream cones. The market demand at $1.00, will be 13 ice- cream cones. The market demand curve is the horizontal sum of the individual demand curves!

Change in Quantity Demanded Change in Quantity Demanded Change in Quantity Demanded –This refers to a change in the quantity that a consumer wants to buy as a result of a change in its price –Graphically represented by a movement along the demand curve.

0 D Price of Ice- Cream Cones Quantity of Ice-Cream Cones A rise in the price of ice-cream cones results in a movement along the demand curve. A B $ Changes in Quantity Demanded

This happens as the buying behavior changes, which can be due to change in This happens as the buying behavior changes, which can be due to change in –income –Prices of related goods –Tastes –Expectations –Number of buyers Shifts in the Demand Curve

$ Price of Ice- Cream Cone Quantity of Ice-Cream Cones 0 Increase in demand An increase in income... D1D1 D2D2 Consumer Income Normal Good

$ Price of Ice- Cream Cone Quantity of Ice-Cream Cones 0 Decrease in demand An increase in income... D1D1 D2D2 Consumer Income Inferior Good

Related Goods Prices of Related Goods Prices of Related Goods –When two goods are substitutes, a fall in the price of one good reduces the demand for the other good. –When two goods are complements, a fall in the price of one good increases the demand for the other good.

Variables that Influence Buyers

SUPPLY Quantity supplied is the amount of a good that sellers are willing and able to sell. Quantity supplied is the amount of a good that sellers are willing and able to sell. Law of Supply 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.

The Supply Curve: The Relationship between Price and Quantity Supplied Supply Curve Supply Curve –The supply curve is the graph of the relationship between the price of a good and the quantity supplied.

Price of Ice-Cream Cone Quantity of Ice-Cream Cones $ An increase in price increases quantity of cones supplied.

Changes in Quantity Supplied Movement along the supply curve. Movement along the supply curve. Caused by a change in the price. Caused by a change in the price.

1 5 Price of Ice- Cream Cone Quantity of Ice-Cream Cones 0 S 1.00 A C $3.00 A rise in the price of ice cream cones results in a movement along the supply curve. Change in Quantity Supplied

Input prices Input prices Technology Technology Expectations Expectations Number of sellers Number of sellers Shifts in the Supply Curve

Price of Ice-Cream Cone Quantity of Ice-Cream Cones 0 Increase in supply due to improved technology Decrease in supply due to a rise in input prices Supply curve,S 3 curve, Supply S 1 curve,S 2

Variables That Influence Sellers

The Equilibrium concept. Equilibrium in general refers to a situation where each agent is satisfied with the decision he made given everyone else’s choices. Equilibrium in general refers to a situation where each agent is satisfied with the decision he made given everyone else’s choices. Thus, equilibrium refers to a state where there is no tendency for change. Thus, equilibrium refers to a state where there is no tendency for change.

Market equilibrium refers to a situation in which the price has reached the level where quantity supplied equals quantity demanded. Market equilibrium refers to a situation in which the price has reached the level where quantity supplied equals quantity demanded. SUPPLY AND DEMAND TOGETHER

Equilibrium Price 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. Equilibrium Quantity 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.

At $2.00, the quantity demanded is equal to the quantity supplied! SUPPLY AND DEMAND TOGETHER Demand ScheduleSupply Schedule

The Equilibrium of Supply and Demand Price of Ice-Cream Cone Quantity of Ice-Cream Cones 13 Equilibrium quantity Equilibrium price Equilibrium Supply Demand P* 2.00

Why not a Price Higher Than P*? Price of Ice-Cream Cone 0 Supply Demand (a) Excess Supply Quantity demanded Quantity supplied Surplus Quantity of Ice-Cream Cones 4 $ For all prices higher than P*: the quantity supplied > quantity demanded. there is excess supply or a Surplus. Suppliers will lower the price to increase sales.

Why not a Price Lower Than P*? Price of Ice-Cream Cone 0 Quantity of Ice-Cream Cones Supply Demand (b) Excess Demand Quantity supplied Quantity demanded $ Shortage For all prices lower than P*: the quantity demanded > the quantity supplied. There is excess demand or a shortage. Suppliers will raise the price due to too many buyers chasing too few goods.

Three Steps for Analyzing Changes in Equilibrium

How an Increase in Demand Affects the Equilibrium Price of Ice-Cream Cone 0 Quantity of Ice-Cream Cones Supply Initial equilibrium D D 3....and a higher quantity sold resulting in a higher price Hot weather increases the demand for ice cream New equilibrium $

How a Decrease in Supply Affects the Equilibrium Price of Ice-Cream Cone 0 Quantity of Ice-Cream Cones Demand New equilibrium Initial equilibrium S1S1 S2S resulting in a higher price of ice cream An increase in the price of sugar reduces the supply of ice cream and a lower quantity sold $2.50 4

What Happens to Price and Quantity When Supply or Demand Shifts?