supply demand theory

Price: The Role of Demand and Supply

Topic 2

Law of Demand

2

The quantity purchased of a good or service is inversely related to the price, all other things being equal (ceteris paribus)

The Law of Demand

Price changes lead to qty demanded changing.......

Represented by movements along demand curve.

Inverse relationship between price and quantity demanded gives rise to a downward- sloping demand curve.

3

DD

Price

Quantity/wk

A

B3

2

5 15

negative slope

Quantity Demanded versus Demand

4

Quantity demanded The quantities of a good or service that

people will purchase at a specific price over a given period of time

Demand A schedule of the total quantities of a

good or service that purchasers will buy at different prices at a given time

Demand

5

Individual demand The quantity of a good or service that an

individual or firm stands ready to buy at various prices at a given time

Market demand The sum of the individual demands in

the marketplace

Demand Schedule and Demand Curve

6

Demand schedule A table showing the various quantities

of a good or service that will be demanded at various prices

Demand curve A curve that indicates the number of

units of a good or service that consumers will buy at various prices at a given time

Demand Curve for Internet Time

7

$1.55

1.50

1.45

1.40

1.35

1.30

1.25

1.20

1.15

1.10

1.05

0 1 2 3 4 5 6 7 8 9 10 11 12 13

Quantity (millions of hours)

Pri

ce p

er H

our

D

Table 4-1 provides the detail for the demand curve presented here

Changes in Quantity Demanded and in Demand

8

Change in quantity demanded Movement along the demand curve

that occurs because the price of the product has changed

Change in demand A change in the amounts of the product

that would be purchased at the same given prices; a shift of the entire demand curve

Demand Curves for Internet Time

9 Quantity (millions of hours)

$1.55

1.50

1.45

1.40

1.35

1.30

1.25

1.20

1.15

1.10

1.05

0 1 2 3 4 5 6 7 8 9 10 11 12 13

Pri

ce p

er H

our

DD2

D1

A shift from D to D1 is an increase in demand more will be purchased at

each price

A shift from D to D2 is a decrease in demand less will be purchased at each

price

Determinants of Demand

10

Changes in income Higher incomes increase in demand Lower incomes decrease in demand

Changes in tastes and preferences Change in consumer expectations

Determinants of Demand

11

Changes in the prices of other goods Substitutes Increase in the price

of substitutes increase in demand

Complements Increase in the price of complements decrease in demand

Supply

12

Supply The total quantities of a good or service that sellers

stand ready to sell at different prices at a given time Individual supply

Quantities offered for sale at various prices at a given time by an individual seller

Market supply Sum of the individual supply schedules in the

marketplace

Supply

13

Supply schedule A table showing the various quantities

of a good or service that sellers will offer at various prices at a given time

Supply curve A line showing the number of units of

a good or service that will be offered for sale at different prices at a given time

Law of Supply

14

The quantity offered by sellers of a good or service is directly related to price, all things being equalWhy?

Producers are more willing to sell greater amounts of a good at a higher price , because this good has become relatively more profitable to produce, compared to other gds

Changes in Quantity Supplied and in Supply

15

Change in the quantity supplied Movement along the supply curve that occurs

because the price of the product has changed Change in supply

A change in the amount of the product that would be offered for sale at the same given price; a shift of the entire supply curve

Supply Curves for Internet Time

16 Quantity (millions of hours)

$1.55

1.50

1.45

1.40

1.35

1.30

1.25

1.20

1.15

1.10

1.05

0 1 2 3 4 5 6 7 8 9 10 11 12 13

Pri

ce p

er H

our

SS2 S1

A shift from S to S2 is a decrease in

demand a smaller amount offered for sale at each price A shift from S to S1 is

an increase in demand a larger amount

offered for sale at each price

Determinants of Supply

17

Changes in the cost of resources Increase in the cost of resources decrease in

supply

Technology Improvements increase in supply

Expectations of future prices(Shift to the right)

Prices of related products

Expectations of Future Prices

18

If sellers expect price of the good to fall in the future,

they will sell more now before the price actually falls!!Supply increases today...

..rightward shift

Price of related goods

19

Related goods(Supply side of the market)

Substitutes in productionRequire the same resources

to produce

Complements in productionJointly produced with

the same pool of resources

ExampleRubber bands

Rubber erasers

ExampleBeef

Leather

Price of related goods (substitutes in production)

20

Assume that the price of Rubber Erasers (RE) has increased.

What impact does this have on the supply of Rubber Bands (RB) ?

Price

Quantity

SS

Supply of RE

Price

QuantitySupply of RB

SS’

SS

Price of related goods (complements in production)

21

Assume that the price of beef has increased. What impact does this have on the supply of leather ?

Price

QuantitySupply of Leather

SS

SS’

Supply of Beef

Price

Quantity

SS

Equilibrium Price

22

The price at which the quantity demanded equals the quantity supplied

Market EquilibriumA state whereby the forces of market demand and market supply exactly balance each other and there is no

tendency for change

Demand, Supply, and Market Price for Internet Time

23 Quantity (millions of hours)

$1.55

1.50

1.45

1.40

1.35

1.30

1.25

1.20

1.15

1.10

1.05

Pri

ce p

er H

our

SupplyDemand

EE

At a price of $1.21, 6 million hours of Internet time will be offered for sale and an equal

amount purchased

0 1 2 3 4 5 6 7 8 9 10 11 12 13

24

Surplus of Internet Time

25 Quantity (millions of hours)

$1.55

1.50

1.45

1.40

1.35

1.30

1.25

1.20

1.15

1.10

1.05

0 1 2 3 4 5 6 7 8 9 10 11 12 13

Pri

ce p

er H

our

SupplyDemand

E

Surplus

At a price of $1.30, 7.8 million hours will be offered for sale but consumers are only

willing to purchase 4.2 million hours Qs > Qd

surplus of Internet hours

Rather than hold on to these hours, sellers will offer to sell at lower prices with the result that

more consumers enter the market price moves toward

$1.20

26

Shortage of Internet Time

Quantity (millions of hours)

$1.55

1.50

1.45

1.40

1.35

1.30

1.25

1.20

1.15

1.10

1.05

0 1 2 3 4 5 6 7 8 9 10 11 12 13

Pri

ce p

er H

our

SupplyDemand

E

Shortage

At a price of $1.10, buyers want to buy 8.5 million hours

but sellers are willing to offer only 3.6 million hours

Qd > Q shortage

Some buyers will be willing to pay more with the result that the price will increase and

sellers will increase the amount they offer for sale

move toward $1.20

Changes in EquilibriumPrice & Quantity

27

Once equilibrium is attained, there is no tendency for change, unless demand, supply or both market forces change.

Demand & supply change when there is a change in determinants of demand and/or supply.

Increase in Demand

28

Price

Quantity

SS

DD DD’

E’

EP’

P

Q Q’

Increase in Pe & Qe

Decrease in Demand

29

Price

Quantity

SS

DD’ DD

P

P’

QQ’

E

E’Decrease in

Pe & Qe

Increase in Supply

30

Price

Quantity

SS

DD

SS’

P

P’

Q Q’

E

E’

Decrease in Pe, Increase in Qe

Decrease in Supply

31

Price

Quantity

SS’

DD

SS

P’

P

Q’ Q

E

E’ Increase in Pe, Decrease in Qe

Change In Both Demand & Supply At The Same Time

32

the effect on only either P or Q can be determined straight away

the impact on the other variable cannot be determined ,

unless given more information on the size of the relative shifts

What happens when:

33

Demand and supply increase simultaneously? The equilibrium qty will definitely increase, but whether the equilibrium price will increase or decrease depends on how much demand shifts relative to supply

Three Possible Situations:Three Possible Situations:

34

Price

Quantity

DD

DD’ SS

SS’

P’

P

Q Q’

Demand increases more than supply does

E

E’

Increase in Pe, Increase in Qe

Three Possible Situations:Three Possible Situations:

35

Price

Quantity

DDDD’ SS

SS’

P’P

Q Q’

Supply increases more than demand does

EE’

Decrease in Pe, Increase in Qe

Three Possible Situations:Three Possible Situations:

36

Price

Quantity

DD

DD’ SS

SS’

P

Q Q’

Demand increases by the same amount as supply

E E’No change in Pe, Increase in Qe

General Guidelines

37

An increase in demand relative to supply higher price

A decrease in demand relative to supply lower price

An increase in supply relative to demand lower price

A decrease in supply relative to demand higher price

Disequilibrium Due To Government Intervention

The government may step in to restrict the free operation of the market and create disequilibrium prices by imposing a PRICE CEILING or PRICE FLOOR

38

Price Ceiling

39

A government-mandated maximum price that can be charged for a good or a service below the market equilibriumProducers cannot sell at a price higher than the ceiling price

Why Imposed Price Ceiling ?Why Imposed Price Ceiling ?

Prevent consumers from being overcharged !!!! E.g. rent control

Price control on necessities eg rice, sugar, oil, etc..

40

The Effects of a Price Ceiling on Rental Housing

41

700

500

0 18,000 30,000 40,000

ShortageD

S

E

Mon

thly

Pri

ce (

$)

Quantity (housing units)

The effect of the price ceiling on

rental housing is to cause a shortage and

reduce housing opportunities to

those families they are intended to accommodate

How Are Consumers Affected By A How Are Consumers Affected By A Price Ceiling?Price Ceiling?

42

Since there is little incentive to maintain the quality of rent-controlled housing, consumers may have to put up with the deteriorating quality of such housing .

The amount bought and sold with a price ceiling imposed is less than that at market equilibrium.

The shortage caused by the price ceiling forces consumers to spend more time searching for an alternative.

Some people are willing to pay more to get some of the good. These people may end up relying on political connections and paying “coffee money”.

Why Imposed Price Floor???Why Imposed Price Floor???

43

To ensure producers a higher and more stable income eg. Price floors on agricultural products, or min wage to ensure workers a min standard of living

The Effects of a Price Floor on Wheat

44

3.00

2.00

0 75,000 100,000 115,000

Surplus

D

SP

rice

per

Bus

hel (

$)

Quantity (bushels)

The impact of the price floor is to cause a

surplus the government must then

buy and store the surplus that is created

by the price floor

PF

Effects of Price FloorsEffects of Price Floors

45

Price floors create surpluses... govt intervention is needed to prevent downward pressure on price

Govt often steps in to buy up the surplus, as part of its support program towards producers

What Does The GovernmentDo With The Surplus?

46

Surplus may be distributed to the poorBut govt has to ensure that its actions

does not lead to falling demandAlternatively, surplus may simply

be stored up .... wasteful if quality

deteriorates over time

How Are Consumers Affected By A Price Floor?

47

Consumers pay a higher price than at market equilibrium (PF higher than Pe).

Consumers pay taxes to cover government support for producers.

The amount bought and sold with a price floor imposed is less than that at market equilibrium.

Price Elasticity of Demand

48

A measure of the sensitivity or responsiveness of quantity demanded to a change in price Formula method Total revenue method

Formula Method

49

pricein change percentage

demandedquantity in change percentageelasticity Price

)/2(

)/2(

21

12

21

12

PPPP

QQQQ

Demand Curve Showing Different Elasticities

50

D2

D2

Quantity/Time

$13

12

11

10

9

8

7

6

5

4

3

2

1

0 1,600 2,000 2,400

Pri

ce

D

DD1

D1

Unit elastic

Elastic demand

Inelastic demand

Unit Elastic Demand

51

Demand that exists when a percentage change in price causes an equal percentage change in quantity demanded

Has an elasticity coefficient equal to 1.0 Demand curve D in Figure 4-9

Elastic Demand

52

Demand that exists when a percentage change in price causes a greater percentage change in quantity demanded

Has an elasticity coefficient greater than 1.0 Demand curve D1 in Figure 4-9

Inelastic Demand

53

Demand that exists when a percentage change in price causes a smaller percentage change in quantity demanded

Has an elasticity coefficient less than 1.0 Demand curve D2 in Figure 4-9

Total Revenue Method

54

If price changes but total revenue remains constant, unit price elasticity of demand exists

If price changes but total revenue moves in the opposite direction, demand is elastic

If price changes and total revenue moves in the same direction, demand is inelastic

Characteristics Affecting Price Elasticity of Demand

55

Trend Toward

Elastic Demand

Luxuries

Large expenditures

Durable goods

Substitute goods

Multiple uses

Trend Toward

Inelastic Demand

Necessities

Small expenditures

Perishable goods

Complementary goods

Limited uses

Three Demand Curves Showing Different Elasticities

56

D1

P P P

Q/t Q/t Q/t

D2

D3

(a) (b) (c)

Perfectly Elastic

Perfectly Inelastic

Perfectly Unit

Elastic

Demand Curve Showing Different Elasticities

57 Quantity/Time

$12

11

10

9

8

7

6

5

4

3

2

1

Pri

ce

Elas

tic

Dem

and

0 10 20 30 40 50 60 70 80 90 100 110 120

Uni

t Ela

stic

Inel

astic

D

eman

d

Elasticity changes along the demand curve from elastic at

the top to inelastic at the bottom

Other Types of Elasticity

58

Cross elasticity of demand Income elasticity of demand Elasticity of supply

Cross Elasticity of Demand

59

A measure of the responsiveness of the quantity demanded of one product as a

result of a change in the price of another product

Aproduct of price in the change percentage

Bproduct of demandedquantity in the change percentage demand of elasticity Cross

Cross Elasticity of Demand

60

Substitute goods Functionally equivalent goods

Complementary goods Goods that are used together

A change in the price of one product, if it is substitute or complementary product, can affect the quantity demanded of the other

Cross Elasticity of Demand

61

The coefficient of cross elasticity can be positive or negative Positive in the case of substitutes Negative in the case of complements

The larger the coefficient, the greater the cross elasticity

Income Elasticity of Demand

62

A measure of the responsiveness of quantity demanded to a change in

income

incomein change percentage

quantity in change percentage demand of elasticity Income

Income Elasticity of Demand

63

Normal goods Positive coefficient Demand varies in the same direction

as income Inferior goods

Negative coefficient Demand varies inversely with changes

in income

Elasticity of Supply

64

A measure of responsiveness of quantity supplied to a change in price

pricein change percentage

suppliedquantity in change percentage supply of elasticity Price

Time and Elasticity of Supply – Immediate

65

P

Q Q/t

D1

S

D

PDemand increases from D to

D1 and because the sellers cannot adjust the quantity

supplied on such short notice, the only impact is an increase

in priceP1

Time and Elasticity of Supply – Short Run

66

P2

P

Q Q2 Q/t

D1

S

D

P In the short run, the seller has sufficient time to vary some

productive resources supply becomes more elastic and the

quantity supplied increases, causing the

price to fall

Time and Elasticity of Supply – Long Run

67

P3

P

Q Q3 Q/t

D1

S

D

P Over the long run, the supply curve

becomes still more elastic because producers can

vary all productive resources and

make use of new technology

Effects of a Tax on Cigarettes

68

D

S

Price per Pack ($)

40 50

D

S

Quantity (millions of packs)

5.25

5.00

Quantity (millions of packs)

S + $1

5.75

5.00

48 50

S + $1

ee

R R

Price per Pack ($)

Note that the same $1 tax has a much larger impact on quantity when demand is more elastic than when it is inelastic