1. Lecture 2 Supply and demand
Microeconomics 1000
Lecture 2 Supply and demand

2. Key points You will learn today: what a competitive market is
how supply and demand together set the price of a good and the quantity sold.
the key role of prices in allocating scarce resources in market economies. 2

3. Background
As we have seen in Lecture 1, quantity demanded is the amount of a good that buyers are willing and able to purchase.
Law of Demand
The law of demand states that, other things equal, the quantity demanded of a good falls when the price of the good rises.
The reason is that when the price rises, less consumers purchase the good and/or each consumer purchases less units of the good 8

4. Figure 1 Demand Schedule and Demand Curve
Price of
Ice-Cream Cone
$3.00
2.50
1. A decrease
in price
...
2.00
1.50
1.00
0.50 1 2 3 4 5 6 7 8 9 10 11 12
Quantity of 2.
...
increases quantity
of cones demanded.
Ice-Cream Cones
Copyright © South-Western

5. Equilibrium price We now ask, what determines the price of a good?
This is one of the most fundamental issues in economics

6. Fixed supply
We start from the case that there is a fixed quantity of the good, which can be used only for consumption (no alternative uses, including any possible future use)

7. Figure 2 The Equilibrium with fixed Supply
Price
Supply
Demand
Equilibrium
Equilibrium price
quantity
Quantity
Copyright©2003 Southwestern/Thomson Learning

8. Equilibrium What is special about the intersection point?
It is the only level of the price for which the plans of the different buyers are consistent; that is, all agents can realize their desired trade

9. Models of the adjustment process
The auctioneer model (Leon Walras)
The market is highly organised, with a broker that quotes the price
The broker’s objective is to guarantee that the market functions smoothly, so he changes the price until all agents can realize their desired trades
The “competitive” model
Sellers and buyers who cannot trade even if they wish to, or who realise that market conditions are favourable, propose price changes

10. In other words, not only buyers but also sellers are price taker
Competitive Markets
A competitive market is a market in which there are many buyers and sellers so that each has a negligible impact on the market price.
In other words, not only buyers but also sellers are price taker 5

11. Figure 3 Markets Not in Equilibrium
(a) Excess Supply
Price
Supply
Surplus
Demand 10 4
Quantity
Quantity
demanded
Quantity
supplied
Copyright©2003 Southwestern/Thomson Learning

12. Equilibrium
Surplus
When price > equilibrium price, then quantity supplied > quantity demanded.
There is excess supply or a surplus.
In the auctioneer model
The auctioneer reduces the price , thereby moving toward equilibrium.
In the “competitive” model
Suppliers will lower the price to increase sales, thereby moving toward equilibrium.

13. Figure 4 Markets Not in Equilibrium
(b) Excess Demand
Price
Supply
Demand 10 4
Shortage
Quantity
Quantity
supplied
Quantity
demanded
Copyright©2003 Southwestern/Thomson Learning

14. Equilibrium
Shortage
When price < equilibrium price, then quantity demanded > the quantity supplied.
There is excess demand or a shortage.
In the auctioneer model
The auctioneer increases the price , thereby moving toward equilibrium.
In the “competitive” model
Suppliers will raise the price due to too many buyers chasing too few goods, thereby moving toward equilibrium.

15. Who obtains the good?
Remember that along the demand schedule consumers are ranked according their willingness to pay for the good (or their marginal willingness to pay is case they consume more than one unit)
Hence, it is clear that the consumers who obtain the good are those that value it most
Consider again the example we used in the first lecture

16. price vA 20 vB 12 vC 8 vD 3 O
quantity 1 2 3 4

17. Who obtains the good?
If one unit of the good is available, it will be obtained by consumer A
It the supply is fixed at two units, they will be obtained by consumers A and B
Etc.
This solution is efficient as it maximizes the total gain from trade
However, it is not necessarily fair when income distribution is unequal

18. Constant unit cost
Now consider another special case, where the good can be reproduced as many times as needed, at a constant unit cost
For example, consider a software program, or drug pills
(In both cases, there is a large fixed cost to develop the product, but once the product has been designed, the unit cost is approximately constant)

19. Figure 5 The Equilibrium with constant unit cost
Price
Demand
Equilibrium
Equilibrium price
Supply
unit cost
quantity
Quantity
Copyright©2003 Southwestern/Thomson Learning

20. Comparison
Note the duality between the case of fixed supply and constant unit cost
With fixed supply, quantity is fully determined by supply and demand determines the price only
With constant unit cost, price is fully determined by cost and demand determines the quantity traded only 17

21. The classical economists
In the case of constant unit cost, we have a simple “theory of prices”: prices are fully determined by production costs
This theory was endorsed by classical economists, such as Adam Smith and David Ricardo
They recognized that “cost” should include the normal profit; indeed, one of their main concerns was what determines the normal rate of profit

22. General case
In general, we may guess that supply is not necessarily fixed, but that it is not always possible to produce as many units as needed at a constant cost either
In these cases, it seems reasonable to assume that producers are willing to supply a larger quantity if the price increases
Later, we shall study the behaviour of producers in greater detail to confirm this guess (Lecture 10)

23. The Supply Curve: The Relationship between Price and Quantity Supplied
Supply Schedule
The supply schedule is a table that shows the relationship between the price of the good and the quantity supplied.
Supply Curve
The supply curve is the graph of the relationship between the price of a good and the quantity supplied. 29

24. Figure 6 Supply Curve Price $3.00 2.50 1. An increase in price ...
2.00
1.50
1.00
0.50 1 2 3 4 5 6 7 8 9 10 11 12
Quantity 2.
...
increases quantity supplied.
Copyright©2003 Southwestern/Thomson Learning

25. SUPPLY AND DEMAND TOGETHER
Equilibrium refers to a situation in which the price has reached the level where quantity supplied equals quantity demanded. 36

26. SUPPLY AND DEMAND TOGETHER
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
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. 36

27. SUPPLY AND DEMAND TOGETHER
Demand Schedule
Supply Schedule
At $2.00, the quantity demanded is equal to the quantity supplied! 36

28. Figure 7 The Equilibrium of Supply and Demand
Price of
Ice-Cream
Cone
Supply
Demand
Equilibrium
Equilibrium price
$2.00
Equilibrium
quantity 1 2 3 4 5 6 7 8 9 10 11 12 13
Quantity of Ice-Cream Cones
Copyright©2003 Southwestern/Thomson Learning

29. Law of supply and demand
Equilibrium
Law of supply and demand
The claim that the price of any good adjusts to bring the quantity supplied and the quantity demanded for that good into balance.

30. Summary
Economists use the model of supply and demand to analyze competitive markets.
In a competitive market, there are many buyers and sellers, each of whom has little or no influence on the market price.

31. Summary
The demand curve shows how the quantity of a good depends upon the price.
According to the law of demand, as the price of a good falls, the quantity demanded rises. Therefore, the demand curve slopes downward.

32. Summary
The supply curve shows how the quantity of a good supplied depends upon the price.
According to the law of supply, as the price of a good rises, the quantity supplied rises. Therefore, the supply curve slopes upward.

33. Summary
Market equilibrium is determined by the intersection of the supply and demand curves.
At the equilibrium price, the quantity demanded equals the quantity supplied.
The behavior of buyers and sellers naturally drives markets toward their equilibrium.