basic concepts in economics: theory of demand and supply

Basic Concepts in Economics: Theory of Demand and Supply

Discussant :Md. Alamgir

Assistant Professor, BIBM

Definition of economics Economics, the Science of Scarcity The science of how individuals and

societies deal with the fact that wants are greater than the limited resources available to satisfy those wants.

The study of how individuals and societies use limited resources to satisfy unlimited wants.

Fundamental economic problem

Scarcity. The condition in which our wants

are greater than the limited resources available to satisfy those wants.

Individuals and societies must choose among available alternatives.

Opportunity Costs The most highly valued opportunity or

alternative forfeited when a choice is made.

Economists believe that a change in opportunity cost can change a person’s behavior.

The higher the opportunity cost of doing something, the less likely it will be done.

Marginal Benefits

Is additional benefits. The benefits connected to consuming

an additional unit of a good or undertaking one more unit of an activity.

Marginal Costs Is additional costs. The costs connected to consuming

an additional unit of a good or undertaking one more unit of an activity.

Building A Definition of Economics~ Goods and Bads ~

Good - Anything from which individuals receive utility or satisfaction.

Utility - The satisfaction one receives from a good.

Bad - Anything from which individuals receive disutility or dissatisfaction.

Disutility - The dissatisfaction one receives from a bad.

Economic goods, free goods, and economic bads economic good (scarce good) - the

quantity demanded exceeds the quantity supplied at a zero price.

free good - the quantity supplied exceeds the quantity demanded at a zero price.

economic bad - people are willing to pay to avoid the item

Positive vs. Normative Economics Positive - The study of “what is” in

economic matters. Cause Effect

Normative - The study of “what should be” in economic matters

Judgment and Opinion

Examples?

Microeconomics

Microeconomics deals with human behavior and choices as they relate to relatively small units—an individual, a business firm, an industry, a single market.

Macroeconomics

Macroeconomics deals with human behavior and choices as they relate to highly aggregate markets (e.g., the goods and services market) or the entire economy.

Barter vs. monetary economy Barter – goods are traded directly

for other goods Problems:

requires double coincidence of wants high information costs

Monetary economy has lower transaction and information costs

Relative and nominal prices Relative price = price of a good in

terms of another good Nominal price = price expressed in

terms of the monetary unit Relative price is a more direct

measure of opportunity cost

Markets In a market economy, the price of

a good is determined by the interaction of demand and supply

DemandThe willingness and ability of buyers to purchase different quantities

of a good at different prices during a specific time period.

A relationship between price and quantity demanded in a given time period, ceteris paribus.

Demand Schedule:The numerical tabulation of the quantity demanded of a good at different prices.

A demand schedule is the numerical representation of the law of demand.

Downward Slopping Demand Curve

The graphical representation of the demand schedule and law of demand.

Demand schedule

Demand - Schedule and Graph

Law of demand An inverse relationship exists

between the price of a good and the quantity demanded in a given time period, ceteris paribus.

Law of Demand

As the price of a good rises, the quantity demanded of the good falls, and as the price of a good falls, the quantity demanded of the good rises,

ceteris paribus.

Price

Quantity

Ceteris Paribus A Latin term meaning “all other thingsconstant” or “nothing else changes.”

Ceteris paribus is an assumption used to

examine the effect of one influence on an outcome while holding all other influences constant.

Change in quantity demanded vs. change in demand

Change in quantity demanded Change in demand

Market demand curve Market demand is the horizontal summation of

individual consumer demand curves

Determinants of demand tastes and preferences prices of related goods and

services income number of consumers expectations of future prices and

income

Tastes and preferences Effect of fads:

Prices of related goods substitute goods – an increase in

the price of one results in an increase in the demand for the other.

complementary goods – an increase in the price of one results in a decrease in the demand for the other.

Change in the price of a substitute good Price of coffee rises:

Change in the price of a complementary good Price of DVDs rises:

Income and demand: normal goods A good is a normal good if an increase in income

results in an increase in the demand for the good.

Income and demand: inferior goods A good is an inferior good if an increase in income

results in a reduction in the demand for the good.

Demand and the # of buyers An increase in the number of buyers

results in an increase in demand.

Expectations A higher expected future price will

increase current demand. A lower expected future price will

decrease current demand. A higher expected future income will

increase the demand for all normal goods. A lower expected future income will

reduce the demand for all normal goods.

International effects exchange rate – the rate at which

one currency is exchanged for another.

currency appreciation – an increase in the value of a currency relative to other currencies.

currency depreciation – a decrease in the value of a currency relative to other currencies.

International effects (continued) Domestic currency appreciation causes

domestically produced goods and services to become more expensive in foreign countries.

An increase in the exchange value of the U.S. dollar results in a reduction in the demand for U.S. goods and services.

The demand for U.S. goods and services will rise if the U.S. dollar depreciates.

Factors Causing a Shift in the Demand Curve

Income Preferences Prices of substitute goods Prices of complementary goods Number of buyers Expectations of future prices

Supply The relationship that exists between the

price of a good and the quantity supplied in a given time period, ceteris paribus.

The willingness and ability of sellers to produce and offer to sell different quantities of a good at different prices during a specific time period.

Law of Supply As the price of a good rises, the quantity

supplied of the good rises, and as the price of a good falls, the quantity supplied of the good falls, ceteris paribus.

Price

Quantity

Supply Curve The graphical representation of the law

of supply, which states that price and

quantitysupplied are directly related, ceteris

paribus.

Supply Schedule The numerical tabulation of the quantity

supplied of a good at different prices.

A supply schedule is the numerical representation of the law of supply.

Supply schedule

Change in Quantity Supplied A change in quantity supplied

refers to a movement along a supply curve.

The only factor that can directly cause a change in the quantity supplied of a good is a change in the price of the good, or own price.

Law of supply A direct relationship exists

between the price of a good and the quantity supplied in a given time period, ceteris paribus.

Reason for law of supply The law of supply is the

result of the law of increasing cost. As the quantity of a good

produced rises, the marginal opportunity cost rises.

Sellers will only produce and sell an additional unit of a good if the price rises above the marginal opportunity cost of producing the additional unit.

Change in supply vs. change in quantity supplied

Change in supply Change in quantity supplied

Individual firm and market supply curves The market supply curve is the

horizontal summation of the supply curves of individual firms. (This is equivalent to the relationship between individual and market demand curves.)

Determinants of supply the price of resources, technology and productivity, the expectations of producers, the number of producers, and the prices of related goods and

services note that this involves a relationship in

production, not in consumption

Price of resources As the price of a resource rises, profitability declines,

leading to a reduction in the quantity supplied at any price.

Technological improvements Technological improvements (and any changes that raise the

productivity of labor) lower production costs and increase profitability.

Expectations and supply An increase in the expected future

price of a good or service results in a reduction in current supply.

Increase in # of sellers

Prices of other goods Firms produce and sell more than one

commodity. Firms respond to the relative profitability

of the different items that they sell. The supply decision for a particular good

is affected not only by the good’s own price but also by the prices of other goods and services the firm may produce.

International effects Firms import raw materials (and often the final

product) from foreign countries. The cost of these imports varies with the exchange rate.

When the exchange value of a dollar rises, the domestic price of imported inputs will fall and the domestic supply of the final commodity will increase.

A decline in the exchange value of the dollar raises the price of imported inputs and reduce the supply of domestic products that rely on these inputs.

Factors that Cause the Supply Curve to Shift

Prices of relevant resources Technology Number of sellers Expectation of future prices Taxes and subsidies Government restrictions

Market equilibrium

Surplus and Shortage Surplus (Excess Supply) - A condition in

which quantity supplied is greater than quantity demanded.

Surpluses occur only at prices above equilibrium price.

Shortage (Excess Demand) - A condition in which quantity demanded is greater than quantity supplied.

Shortages occur only at prices below equilibrium price.

Move to Market Equilibrium

Moving to Market Equilibrium

Equilibrium

Demand and Supply as Equations

Let’s now look at demand and supply as equations. Here is a demand equation: Qd = 1,500 − 32P

To see what this equation says, we let price (P ) in the equation equal $10 and then solve for quantity demanded Qd. We get Qd = 1,180.

Qd = 1,500 - 32(10) = 1,180 So this equation says that if price is $10, it follows

that quantity demanded is 1,180 units. We could find other quantities demanded by

plugging in different dollar amounts for price (P).

Now here is a supply equation: QS = 1,200 + 43P

To find what quantity supplied (QS) equals at a particular price, we let $5 equal price (P ) and solve for quantity supplied. We get 1,415.

QS = 1,200 + 43(5) = 1,415

Now suppose we want to find equilibrium price and quantity given our demand and supply equations. How would we do it?

Demand and Supply as Equations (Cont.)

First, we know that in equilibrium the quantity demanded (Qd ) of a good is equal to the quantity supplied (Qs ), so let’s set the two equations equal to each other this way:

1,500 -32P = 1,200 + 43P

Now we can solve for P. We add 32P to both sides of the equal sign and subtract 1,200 from both sides. We are left with: 75P = 300 ; It follows then that P = 300/75 or $4.00.

Demand and Supply as Equations (Cont.)

Once we know equilibrium price is $4.00, we can place this value in either the demand or supply equation to find the equilibrium quantity. Let’s place it in the demand equation: Qd = 1,500 - 32(4.00) = 1,372

Just to make sure that 1,372 is also the quantity supplied, we put the equilibrium price of $4.00 into the supply equation: QS = 1,200 43(4.00) = 1,372

Demand and Supply as Equations (Cont.)

In summary, given our demand and supply equations, equilibrium price is $4.00 and

equilibrium quantity is 1,372.

In summary, given our demand and supply equations, equilibrium price is $4.00 and

equilibrium quantity is 1,372.

Consumer Surplus

CS = Maximum buying price - Price paid

CS = the difference between the maximum price a buyer is willing and able to pay for a good or service and the price actually paid.

Producer Surplus

PS = Price received - Minimum Selling Price

PS = the difference between the price sellers receive for a good and the minimum or lowest price for which they would have sold the good.

Consumer and Producer Surplus

Total Surplus (TS)

TS = CS + PS

Total Surplus (TS) is the sum of consumers’ surplus and producers’ surplus.

Total Surplus

Equilibrium

Utility Utility = level of happiness or

satisfaction associated with alternative choices

utility maximization

Total and marginal utility total utility - the level of happiness

derived from consuming the good marginal utility - the additional

utility that is received when an additional unit of a good is consumed

Marginal utility

0 0

1 70

2 110

3 130

4 140

5 145

6 140

-

70

40

20

10

5

-5

# of slices of pizza total utility marginal utility

Law of diminishing MU law of diminishing marginal utility -

marginal utility declines as more of a particular good is consumed in a given time period, ceteris paribus

even though marginal utility declines, total utility still increases as long as marginal utility is positive. Total utility will decline only if marginal utility is negative

Demand rises

Demand falls

Supply rises

Supply falls