1. Sotiris Georganas City University London
EC 1008 Introduction to Microeconomics Lecture 2: Analyzing markets: supply and demand

2. Learning outcomes To understand the demand and supply function
To outline the laws of demand and supply
To analyse what causes movements and shifts
To understand the concepts of equilibrium and comparative statics

3. Background
Understanding how markets work is a key part of a course in economics
In particular you need to understand the key role played by prices

4. Markets Differ in a number of important ways
Number of buyers and sellers
Level of information
Knowledge about the product and different prices
How easy it is to set up in business
Barriers to entry
Can service/product be easily copied?

5. Perfect competition One type of market structure
A market is perfectly competitive if no participant has market power
Market power: the power to set the price of the good
Key Assumptions
Numerous (many!) buyers and sellers
Perfect information
Free entry and exit

6. Demand, supply and (goods) markets
Consumer demand
Supply by firms

7. Demand
Demand: the amount of a good or service that consumers are willing and able to purchase at each price
Can be different from the amount purchased
Reflects the degree of value/pleasure/utility consumers place on the good/service
Different people will value the same good/service differently

8. Determinants of demand by consumers for goods and services
What?

9. Determinants of demand by consumers for goods and services
Income
Preferences
Good’s price
Other goods’ prices

10. Demand Market demand function:
relationship between quantity demanded of a particular product and all factors that influence demand
Qdx= f(Px, Py, I,....)
Quantity demanded is the ‘dependent’
(endogenous) variable
Price, income etc are the independent variables

11. Demand curves Isolate the impact of price Qdx = f(Px) ceteris paribus
(demand depends on price, holding all else equal)
Complication – demand curves are drawn with price (independent variable) on the vertical axis
Why ?
Walras (1834 – 1910) developed the theory, with quantity the dependent variable
Marshall (1842 – 1924) developed graphical representation (probably following Cournot’s work 30 years earlier), with price as the dependent variable
Today we use Walrasian theory, but the Marshallian representation

12. Since price is the vertical axis we use the inverse demand for graphs
Inverse demand : Px = g(Qdx)
“Price as a function of quantity”
Direct demand : Qdx = f(Px)
Where g=f-1

13. Example: demand for potatoes

14. Monthly market demand for potatoes

15. Law of demand Isolate the impact of price
↑ Px ⇒ ↓ Qdx (Ceteris paribus)
↓ Px ⇒ ↑ Qdx (Ceteris paribus)
Why?
Substitution effect - as price rises consumers have an incentive to switch to cheaper alternatives
Income effect - a rise in price reduces consumers’ `real’ income so they purchase less of a `normal’ good

16. Movements along and shifts in the demand curve
We can use this model of demand to analyse the effect on demand of changes in price and other variables, such as income.
We distinguish between these by use of special terms:
– Movement along the demand curve, for price changes
– Shift in the demand curve, for changes in other variables

17. Movement along the demand curve

18. An increase in demand

19. Types of goods
Substitutes: If price of X increases and demand for Y goes up, X and Y are substitutes.
Complements: If price of X increases and demand for Y goes down, X and Y are complements.
Normal Goods: If increase in income leads to increase in demand
Inferior goods: If increase in income leads to decrease in demand.
Examples?

20. Examples
substitutes
“inferior”
“normal”

21. Supply
Supply – the amount of a good or service producers are willing to offer for sale at each and every price
Market supply function – relationship between quantity supplied and all the factors that influence that supply
Supply curve isolates the impact of price
Qsx = f(Px) ceteris paribus
Inverse supply curve: Px=g(Qsx)
As before, g=f-1

22. Determinants of supply
Technology
Good’s price
Other goods’ prices

23. Supply simple supply functions Qs =a+bP
more complex supply functions Qs =a+bP+dPi –ePj
a simple demand function Qd =a-bP

24. Example: supply of potatoes

25. Monthly market supply of potatoes

26. Law of supply ↑ Px ⇒ ↑ Qsx (ceteris paribus) Why?
Higher price, ceteris paribus, the more profitable the good. Acts as an incentive
In the short run, existing suppliers switch more resources into producing good X
The existing producers increase supply because it is profitable to produce more – has to do with the cost function.

27. Shifts in the supply curve

28. Market equilibrium

29. Market equilibrium: undersupply

30. Market equilibrium: oversupply

31. Market equilibrium: all clear

32. Effect of a shift in the demand curve on equilibrium

33. Effect of a shift in the supply curve on equilibrium

34. Example Demand and supply curves are: Qd= a-bP (1) Qs= c+dP (2)
We need to solve for equilibrium price and quantity (P* , Q*)
Set quantity demanded and supplied equal, and solve for P .
(1)=(2) =>
a-bP*=c+dP* => a-c= bP*+dP* => a-c= (b+d)P* =>
P*=(a-c)/(b+d) (3)
Insert result (3) into (1) =>
Q*=a-b( (a-c)/(b+d) )
So if, for example, a=30, b=1, c=0, d=2,we have
P*=30/3 = 10 and Q*= 30-(10)=20 units

35. Learning outcomes To understand the demand and supply function
To outline the laws of demand and supply
To analyse what causes movements and shifts
To understand the concepts of equilibrium and comparative statics