Lecture 02: Lecture on Market: Demand & Supply

Prof. Syed Hasanuzzaman

Market

Definition of Market: A market is an institution or mechanism that brings together buyers

(demanders) and sellers (suppliers) of particular goods and services.
1. A market may be local, national, or international in scope.
2. Some markets are highly personal, face-to-face exchanges; others are impersonal and
remote.
3. This chapter concerns purely competitive markets with a large number of independent
buyers and sellers.
4. A product market involves goods and services.
5. A resource market involves factors of production.

Demand

Demand
Demand is an economic term that refers to the amount of products or services that consumers
wish to purchase at any given price level. The mere desire of a consumer for a product is not
demand. Demand includes the purchasing power of the consumer to acquire a given product at a
given period. In other words, it’s the amount of products or services that consumers are willing
and able to purchase.

Demand schedule
Demand schedule shows the various amounts of a product that consumers are willing and able to
buy at each specific price in a series of possible prices during a specified time period.
1. Example of a demand schedule for ice-cream Cate is:

2. The schedule shows how much Cate is willing and able to purchase at possible prices.
3. The market price depends on demand and supply.
4. To be meaningful, the demand schedule must have a period of time associated with it.
Law of demand
Law of demand is a fundamental characteristic of demand behavior.
1. Other things being equal, as price (Px) of a good x increases, the corresponding quantity
demanded (Qd) falls.
2. Restated, there is an inverse relationship between price and quantity demanded.
3. Note the “other-things-equal” assumption refers to consumer income and tastes, prices of
related goods, and other things besides the price of the product being discussed.

The demand curve:

1. Illustrates the inverse relationship between price and quantity.
2. The downward slope indicates lower quantity (horizontal axis) at higher price (vertical
axis) and higher quantity at lower price, reflecting the Law of Demand.

Nonprice determinants of demand:

The nonprice determinants of demand are:
a. Income (I)—more leads to an increase in demand; less leads to a decrease in demand for
normal goods.
b. Tastes (T)—favorable change leads to an increase in demand; unfavorable change to a
decrease.
c. Prices of related goods (Py) also affect demand.
i. Substitute goods (those that can be used in place of each other): The price of the
substitute good and demand for the other good are directly related. If the price of Coke
rises, demand for Pepsi should increase.
ii. Complementary goods (those that are used together like tennis balls and rackets): When
goods are complements, there is an inverse relationship between the price of one and the
demand for the other.
So a demand function for good x can be described as:
Qdx = f(Px, I, T, Py)
With the assumption of ‘other things remaining constant’/ ‘everything else remains the same’/
‘ceteris paribus’, that is, if I, T, Py remains constant and hence, Qdx = f(Px) we ended up
with the demand curve.

Individual versus market demand

1. Transition from an individual to a market demand schedule is accomplished by summing
individual quantities at various price levels.
2. Market curve is horizontal sum of individual curves (see Figure below).

Changes in demand versus in quantity demanded:

Changes in demand: It is occurred by any change in nonprice determinant of quantity demanded.
An increase in demand is shown in the first panel, notice that at each price there is a greater
quantity demanded along D2 (the dotted line) than was demanded with D1 (the solid line). The
second panel shows a decrease in demand, notice that there is a lower quantity demanded at each
price along D2 (the dotted line) than was demanded with D1 (the solid line).
A summary of what can cause an increase in demand.
Favorable change in consumer tastes.
Increase in the number of buyers.
Rising income if product is a normal good.
Increase in the price of a substitute good.
Decrease in the price of a complementary good.

A summary of what can cause a decrease in demand.

Unfavorable change in consumer tastes.
Decrease in number of buyers.
Falling income if product is a normal good.
 Decrease in price of a substitute good.
Increase in price of a complementary good.

Changes in quantity demanded: A change in quantity demanded due to the change in the own
price of a good. Movement along a demand curve is called a change in the quantity demanded.
Changes in quantities demanded are caused by changes in price. When price decreases from P1
to P2, the quantity demanded increases from Q1 to Q2; when price increases from P2 to P1 the
quantity demanded decreases from Q2 to Q1.
Supply

Law of Supply
1. The law of supply is that producers will supply more the higher the price of the
commodity, provided that all other things remain constant.
2. Restated: There is a direct relationship between price and quantity supplied.
3. Explanation: Given product costs, a higher price means greater profits and thus an
incentive to increase the quantity supplied.

a. Supply schedule - are the quantities supplied at each and every price.

Supply curve - is nothing more than a schedule of the quantities at each and every price (holding
other things constant).
a. There is a positive relation between price and quantity on a supply curve.
b. Changes in one or more of the nonprice determinants of supply cause the supply curve to
shift. A shift to the left of the supply curve is called a decrease in supply; a shift to the
right is called an increase in supply.
Market equilibrium
Market equilibrium occurs where supply equals demand (supply curve intersects demand curve).

An equilibrium implies that there is no force that will cause further changes in price, hence
quantity exchanged in the market. This is analogous to a cherry rolling down the side of a glass;
the cherry falls due to gravity and rolls past the bottom because of momentum, and continues
rolling back and forth past the bottom until all of its' energy is expended and it comes to rest at
the bottom - this is equilibrium [a rotten cherry in the bottom of a glass].

The following graphical analysis portrays a market in equilibrium. Where the supply and demand
curves intersect, equilibrium price is determined (Pe) and equilibrium quantity is determined
(Qe)
Changes in supply and demand
Changes in supply and demand in a market result in new equilibria. The following graphs
demonstrate what happens in a market when there are changes in nonprice determinants of
supply and demand.
D1 to D2: Movement of the demand curve from D1 (solid line) to D2 (dashed line) is a decrease
in demand. Such decreases are caused by a change in a nonprice determinant of demand (for
example, the price of a substitute declined). With a decrease in demand there is a shift of the
demand curve to the left along the supply curve, therefore both equilibrium price and quantity
decline.
D2 to D1: If we move from D2 to D1 that is called an increase in demand, possibly due to an
increase in the price of a substitute good or an increase in the number of consumers in the
market. When demand increases both equilibrium price and quantity increase as a result.

S1 to S2: Movement of the supply curve from S1 to S2 is an increase in supply. Such increases
are caused by a change in a nonprice determinant (for example, the number of suppliers in the
market increased or the cost of capital decreased). With an increase in supply there is a shift of
the supply curve to the right along the demand curve, therefore equilibrium price and quantity
move in opposite directions (price decreases, quantity increases).
S2 to S1: If we move from S2 to S1 that is called an decrease in supply, possibly due to an
increase in the price of a productive resource (capital) or the number of suppliers decreased.
When supply decreases, equilibrium price increases and the quantity decreases as a result. That is
the result of the supply curve moving up along the negatively sloped demand curve (which
remains unchanged).
Both the demand curve and supply curve change at the same time

In the first case where demand increases, but supply decreases the equilibrium price increases. In
the second panel where demand decreases and supply increases, the equilibrium price decreases.
The quantity remains the same in both graphs.

In the event that demand and supply both increase then price remains the same and quantity
increases, and if both decrease then price remains the same and quantity decreases.
Government intervention: Price ceiling / Price flooring

Shortages and surpluses occur because of effective government intervention in the market.

Price ceiling: Shortage is caused by an effective price ceiling (the maximum price you can
charge for the product). Consider the following diagram that demonstrates the effect of a price
ceiling in an otherwise purely competitive industry.

For a price ceiling to be effective it must be imposed below the competitive equilibrium price.
Note that the Qs is below the Qd, which means that there is an excess demand for this
commodity that is not being satisfied by suppliers at this artificially low price. The distance
between Qs and Qd is called a shortage.

Price flooring: Surplus is caused by an effective price floor (i.e., the minimum you can charge):
For a price floor to be effective, it must be above the competitive equilibrium price. Notice that
at the floor price Qd is less than Qs, the distance between Qd and Qs is the amount of the
surplus. Minimum wages are the best-known examples of price floors.
In briefs:
Price ceilings –
1. The maximum legal price a seller may charge, typically placed below
equilibrium.
2. Shortages result as quantity demanded exceeds quantity supplied.
3. Examples: Rent controls and gasoline price controls (1970s)
Price floors –
1. The minimum legal price a seller may charge, typically placed below equilibrium.
2. Surpluses result as quantity supplied exceeds quantity demanded.
3. Examples: Minimum wage, farm price supports