Lecture 2

Excess Supply If price is higher than equilibrium price then quantity supplied will be greater than quantity demanded. So in this case there will an excess supply in the market that is producers can’t sell their products. Competition among producers to increase sales leads to a downward pressure on price and so they need to lower the price to sell out their product. If the price decreases then the quantity demanded increases and quantity supplied decreases. So the excess supply decreases ( the gap between supply and demand curve decreases). This process will continue until equilibrium price is reached where quantity demanded is equal to quantity supplied.

Excess Demand If price is lower than equilibrium price then quantity demanded will be greater than quantity supplied. So in this case there will an excess demand in the market. To meet the excess demand, producer will increase the supply but they will do this if they get a higher price. So there is an upward pressure on price. When the price increases the quantity demanded decreases and quantity supplied increases. So the excess demand decreases. This process will continue until equilibrium price is reached where quantity demanded is equal to quantity supplied.

Equation of Demand and Supply Curve Assume that demand and supply curves are linear that is straight lines. Equation of linear demand is P= a- b*Qd Intercept= a and slope=-b Equation of linear supply is P= c+ d *Qs Intercept= c and slope=d Why do we have a positive value of c?

Value of Equilibrium Price and Quantity To find the equilibrium price and quantity, we have to the following: We know, Demand curve equation is P= a- b*Qd Supply curve equation is P= c+ d*Qs As the equilibrium price is unique, so we can equate right hand side of demand and supply equation that is a -bQ d = c + dQ s (1) As in the equilibrium, quantity supplied=quantity demanded=equilibrium quantity or Qs=Qd=Qe, so from (1) we get a -bQ e = c + dQ e Qe(b+d)= a-c Q e = (a-c)/( b+d) If we insert this value for the equilibrium quantity into either the demand or supply equation, we can determine that the equilibrium price. Now suppose we plug this value in demand equation and get Pe=a – b(a-c)/(b+d) By simplifying we get P e = (ad+bc)/(b+d)

Example Suppose the equation for demand curve is P = Q D The equation for supply curve is P = Q S Find the equilibrium price and quantity?

Change in equilibrium due to shift in demand If there is a rightward shift in demand ( say for an increase in income) then a new equilibrium will restore at a higher price and higher quantity.

Change in equilibrium due to shift in Supply If there is a rightward shift in Supply ( say for an increase in production due to good weather) then a new equilibrium will restore at a lower price and higher quantity.

Change in equilibrium due to shift in both demand and supply Suppose there is a shift in demand which leads to a new equilibrium at E2. This leads to a higher price P2 and a higher quantity Q2. To stabilize the price we can increase the supply which will change the equilibrium to E3 where the price has got back to its initial value of P1 and quantity is increased further to Q3. Example: Price increase during Ramadan due to increase in demand. Govt. tries to stabilize price by increasing the supply.