Demand and Supply: How Markets Work Lecture 1 – academic year 2015/16 Introduction to Economics Dimitri Paolini

Today’s Plan: The market: what is it? Demand: what changes the quantities demanded? Supply: what changes the quantities supplied? How do we explain changes in prices as a result of shifts in demand and supply? 2

Market Definition: “A market consists of a group of buyers and sellers of a given good or service” – Buyers determine the demand. – Sellers determine the supply. 3 During the first part of the course we will focus mainly on markets for goods. However, the same reasoning hold also for factors of production (e.g. labour, capital).

Typologies of Markets Perfect competition Many sellers and many buyers, each of them with no influence on market prices Goods are perfect substitute 4 Fruits market in Panajii - India

Typologies of Markets Monopoly Only one seller that fix the price 5

Typologies of Markets Oligopoly Few sellers, not always in competition with each other (cartels) 6

Typologies of Markets Monopolistic competition Many sellers, tough competition, and product differentiation 7 …

The Demand The quantity demanded is the quantity that buyers want and can buy 8

Demand Table and Curve The demand table contains information on the relationship between the price of a good and the quantity demanded. The demand curve is a graph that shows the relationship between the price of a good and the quantity demanded. 9

Example: Demand of Ice-cream 10 Price of ice-cream Quantity of ice-cream

Example: Demand of Ice-cream 11 Price of ice-cream Quantity of ice-cream

12 Example: Demand of Ice-cream Price of ice-cream Quantity of ice-cream

Law of the Demand There exist an inverse relationship between price and quantity demanded 13 Price of ice-cream Quantity of ice-cream

The Determinants of Demand What determines the quantity of ice-cream that is demanded ? Market price. Consumer’s income. Price of other goods. Consumer’s preferences. Consumer’s expectations. 14

The quantity demanded can vary for two reasons Movements along the demand curve: caused by a Δ in market prices; Shifts of the demand curve: caused by a Δ of the other determinants of demand (income, price of other goods, preferences, expectations). 15 Why does the quantity demanded vary?

16 Why does the quantity demanded vary?

Changes of the quantity demanded 17

18 Price of cigarettes (a packet in euro) Number of cigarettes smoked in a day D1D Changes of the quantity demanded

19 D1D Price of cigarettes (a packet in euro) Number of cigarettes smoked in a day A tax on the production of tobacco increases the price of cigarettes. Therefore, it induces a movement along the demand curve. Changes of the quantity demanded

20 D1D C A Price of cigarettes (a packet in euro) Number of cigarettes smoked in a day A tax on the production of tobacco increases the price of cigarettes. Therefore, it induces a movement along the demand curve. Changes of the quantity demanded

21 D1D C A Price of cigarettes (a packet in euro) Number of cigarettes smoked in a day A tax on the production of tobacco increases the price of cigarettes. Therefore, it induces a movement along the demand curve. Changes of the quantity demanded

Shift of the Demand Curve 22

23 D1D Price of cigarettes (a packet in euro) Number of cigarettes smoked in a day 4.00 Shift of the Demand Curve

24 D1D Price of cigarettes (a packet in euro) Number of cigarettes smoked in a day A public provision aimed at discouraging smoking induces a leftward shift in the demand curve Shift of the Demand Curve

25 D1D Price of cigarettes (a packet in euro) Number of cigarettes smoked in a day D 2D 2D 2D A public provision aimed at discouraging smoking induces a leftward shift in the demand curve. Shift of the Demand Curve

26 D1D Price of cigarettes (a packet in euro) Number of cigarettes smoked in a day D 2D 2D 2D 2 B A A public provision aimed at discouraging smoking induces a leftward shift in the demand curve. Shift of the Demand Curve

27 D1D What about a change in income? Price of cigarettes (a packet in euro) Number of cigarettes smoked in a day

28 D1D Price of cigarettes (a packet in euro) 4.00 D 2 30 What about a change in income? Number of cigarettes smoked in a day

29 D1D Price of cigarettes (a packet in euro) What about a change in income? Number of cigarettes smoked in a day D 2

30 D1D Price of Ice-ream (a cone in euro) What about a change in income? Number of cigarettes smoked in a day D 2

31 D1D Price of Ice-ream (a cone in euro) For a normal good, an increase in income increases the quantity demanded What about a change in income? Number of cigarettes smoked in a day D 2

Price of other goods When a decrease in the price of one good causes a decrease in the quantity demanded of another good, the two goods are called substitute (e.g. tea and coffee). 32

Price of other goods When a decrease in the price of one good causes an increase in the quantity demanded of another good, the two goods are called complementary (e.g. PCs and High-speed Internet access). 33

Example: what shifts the demand of a Toshiba PC? How does the demand of a Toshiba personal computer (PC) shift if: Consumers’ income decrease; The price of a Compaq PC decreases; The price of high-speed Internet connection reduces; The use of Internet across households increases; 34

35 Caterina’s demand Price of ice-cream Nicola’s Demand Quantity of Ice-cream From Individual Demand… Price of ice-cream Quantity of Ice-cream

36 (=4+3) …. To Market Demand Price of ice-cream Quantity of Ice-cream

Supply 37 The quantity supplied is the quantity that sellers want and can sell

The Determinants of Supply Market prices Cost of factors of production Technology Expectations 38

Law of the Supply Law of the Supply : the quantity supplied of a given good increases with the price. Why? Because, for given costs of production and commercialization, an increase in price generates greater revenues (all costs being equal) and thus it induces sellers to increase production. 39

Supply Table and Curve The supply table is a table that contains information on the relationship between the price of a good and the quantity supplied The supply curve is a graph that shows the relationship between the price of a good and the quantity supplied 40

Supply Curve Quantity of ice-cream Price of ice-cream

Supply Curve Quantity of ice-cream Price of ice-cream

Supply Curve Quantity of ice-cream Price of ice-cream

Why does the quantity supplied vary? The quantity supplied can vary for two reasons: Movements along the supply curve, caused by a Δ in market prices; Shifts of the supply curve, caused by a Δ of the other determinants of supply (technology, cost of factors of production, expectations) 44

45 Why does the quantity supplied vary?

Increase of Supply 46

47 0 S1S1 Quantity of ice-cream Price of ice-cream Increase of Supply

48 0 S1S1 Quantity of ice-cream Price of ice-cream Increase of supply S2S2 Increase of Supply

49 0 S1S1 Quantity of ice-cream Price of ice-cream Increase of Supply

50 0 S1S1 Quantity of ice-cream Price of ice-cream Decrease of supply S3S3 Increase of Supply

Example: what shifts the supply of a Toshiba PC How does the supply of a Toshiba personal computer (PC) shift if: The price of semi-conductors increases; Toshiba re-organize her production lines to improve efficiency; Toshiba’s managers expects a decrease in the price of semi-conductors in the future; 51

Summary Until Now Every market has two sides: demand and supply The main determinants of demand are the price of the good, consumer’s income, the price of other goods, consumer’s preferences and expectations The main determinants of supply are the price of the good, costs of production, technology and expectations 52

Equilibrium Price Is the price for which demand equals supply. Graphically, it is the price for which the demand curve and the supply curve intersect. 53 Equilibrium of Demand and Supply

Equilibrium Quantity Is the quantity for which demand equals supply. Graphically, it is the quantity for which the demand curve and the supply curve intersect. 54 Equilibrium of Demand and Supply

Supply Demand Equilibrium of Demand and Supply Price of ice-cream Quantity of Ice-cream

Supply Demand Equilibrium of Demand and Supply Price of ice-cream Quantity of Ice-cream Equilibrium

Supply Demand Equilibrium of Demand and Supply Price of ice-cream Quantity of Ice-cream Equilibrium Equilibrium quantity Equilibrium price

Market out of equilibrium Excess supply Price is greater then its equilibrium level Sellers cannot sell the quantity they want at that price 58 Excess demand Price is lower then its equilibrium level Buyers cannot buy the quantity they want at that price

Supply Demand Quantity demanded Quantity supplied Excess Supply Price of ice-cream Quantity of Ice-cream Excess Supply

Supply Demand Quantity supplied Quantity demanded Price of ice-cream Quantity of Ice-cream Excess Demand Excess Supply

What happens if… External events alter the market equilibrium. How do we study the determination of the new equilibrium? We have three things to do: To understand if the external event causes shifts in the demand curve and/or the supply curve To understand in which direction the demand shift. To understand if the shift affects the equilibrium prices and quantities, and how the new equilibrium is achieved. 61

Initial Equilibrium D1D1 Equilibrium effects of an increase in demand Price of ice-cream Quantity of Ice-cream S1S1

Initial Equilibrium D1D1 Equilibrium effects of an increase in demand Price of ice-cream Quantity of Ice-cream S1S1 1. Nice weather causes an increase in the demand of ice-cream

Initial Equilibrium D1D1 Price of ice-cream Quantity of Ice-cream S1S1 D2D2 New Equilibrium Nice weather causes an increase in the demand of ice-cream Equilibrium effects of an increase in demand

Initial Equilibrium D1D1 Price of ice-cream Quantity of Ice-cream S1S1 D2D2 New Equilibrium Nice weather causes an increase in the demand of ice-cream Equilibrium effects of an increase in demand 2….that causes an increase in prices… 3….and an increase in the quantity that is sold…

How do we move from the old to the new equilibrium? We saw that nice weather causes a shift in the equilibrium. We haven’t yet explained how this happens. To do so, we use the concept of excess demand. If the demand increases, the quantity demanded is greater than the quantity supplied at the initial price. Market prices will tend to increase. 66

How do we move from the old to the new equilibrium? When the price increases, two things happen: The quantity supplied increases (Law of the Supply) The quantity demanded reduces (Law of Demand) Results: the initial excess demand reduces gradually, until in the new equilibrium it is equal zero. 67

Conclusion The combination of demand and supply determines the price of the goods (and services) available in the market. Prices are the signals (information) that address the allocation of (scarce) resources and ensure the achievement of the market equilibrium. 68

Next week We will start to look at some properties of demand and supply…. In particular, elasticity … 69