Demand and Supply

Udayan Roy
 Theories and Predictions
We need to be able to predict the
consequences of
alternative policies, and
events that may be outside our control
The mental tool we use to make such
predictions is called a theory
A theory is of no use if its predictions
are inaccurate

SUPPLY AND DEMAND 2

 We need a theory of prices
The theory of demand and supply is a
simple example of an economic theory
It can be used to make predictions
about the price and quantity of some
commodity
In a free-market economy, most
economic decisions are guided by prices
Therefore, without a reliable theory of
prices, you will get nowhere in
economic analysis
SUPPLY AND DEMAND 3
Assume perfect competition
The theory of supply and demand
assumes that commodities are traded in
perfectly competitive markets
A perfectly competitive market is a
market in which
there are many buyers
many sellers
and all sellers sell the exact same product
As a result, each buyer and seller has a
negligible impact on the market price
SUPPLY AND DEMAND 4
DEMAND

SUPPLY AND DEMAND 5

 Demand
Quantity demanded is the amount
of a good that buyers are willing and
able to purchase
Demand is a full description of how
the quantity demanded changes as
the price of the good changes.

SUPPLY AND DEMAND 6

Catherines Demand Schedule
and Demand Curve
Price of
Ice-Cream Cone
$3.00

2.50

1. A decrease
2.00
in price...

1.50

1.00

0.50

0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of
Ice-Cream Cones
2. ... increases quantity
of cones demanded.
SUPPLY AND DEMAND 7
Copyright 2004 South-Western
Market Demand is the Sum of
Individual Demands

SUPPLY AND DEMAND 8

 Law of Demand
The law of demand states that
the quantity demanded of a good
falls when the price of the good
rises, and vice versa, provided all other
factors that affect buyers decisions are
unchanged

SUPPLY AND DEMAND 9

 provided all other factors
are unchanged
Thats an important phrase in the wording of the
Law of Demand
The quantity demanded of a consumer good such
as ice cream depends on
The price of ice cream
The prices of related goods
Consumers incomes
Consumers tastes
Consumers expectations about future prices and
incomes
Number of buyers, etc
The Law of Demand says that the quantity
demanded of a good is inversely related to its
price, provided all other factors are unchanged
SUPPLY AND DEMAND 10
 Why Might Demand
Increase?
Quantity Demanded How can we explain
Price Situation A Situation B the difference in
0.00 12 20 Catherines
behavior in
0.50 10 16
situations A and B?
1.00 8 12 Why does she
1.50 6 8 consume more in
2.00 4 6 situation B at every
2.50 2 4 possible price?
Pric
e
3.00 0 2
SUPPLY AND DEMAND 11
Quantity
Shifts in the Market Demand
Curve
are caused by changes in:
Consumer income
Prices of related goods
Tastes
Expectations, say, about future
prices and prospects
Number of buyers

SUPPLY AND DEMAND 12

 Shifts in the Demand Curve
Price of
Ice-Cream
Cone

Increase
in demand

Decrease
in demand
Demand
curve,D2
Demand
curve,D1
Demand curve,
D3
0 Quantity of
SUPPLY AND DEMAND Ice-Cream Cones
13
Shifts in the Demand Curve
Consumer Income
As income increases the demand for a
normal good will increase
As income increases the demand for an
inferior good will decrease
Prices of Related Goods
When a fall in the price of one good reduces
the demand for another good, the two
goods are called substitutes
When a fall in the price of one good
increases the demand for another good, the
two goods are called complements
SUPPLY AND DEMAND 14
 The Law of Demand
Explanations
There are two ways to explain the
Law of Demand
Substitution effect
Income effect

SUPPLY AND DEMAND 15

 Substitution Effect
When the price of a good decreases,
consumers substitute that good
instead of other competing
(substitute) goods

1. When the price of 2. Consumption 3. Consumption

Coke decreases of Pepsi of Coke
decreases increases

Clothe Coke Book Movies Pepsi

s s
SUPPLY AND DEMAND 16
 Income Effect
A decrease in the price of a
commodity is essentially equivalent
to an increase in consumers income

SUPPLY AND DEMAND 17

 Lower Prices = Higher
Income
Situation A
If income rises, Situation
Price of an Apple $1.00 A becomes Situation B.
Price of an Orange $2.00
Situation B
Income $10.00
Price of an Apple $1.00
If prices fall, Situation A Price of an Orange $2.00
becomes Situation C. Income $20.00

Situation C
Price of an Apple $0.50 Q: Which change is
better?
Price of an Orange $1.00
A: They are both equally
Income $10.00 desirable. A fall in
prices is equivalent to
an increase in income.
SUPPLY AND DEMAND 18
 Income Effect
Consumers respond to a decrease in the
price of a commodity as they would to an
increase in income
They increase their consumption of a wide
range of goods, including the good that
had a price decrease
1. When the price of 2. 3. Consumption of
Coke decreases Consumers Coke and other goods
feel richer increases

Clothe Coke Book Movies Pepsi

s s
SUPPLY AND DEMAND 19
SUPPLY

SUPPLY AND DEMAND 20

 SUPPLY
Quantity supplied is the amount of a
good that sellers are willing and able
to sell
Supply is a full description of how the
quantity supplied of a commodity
responds to changes in its price

SUPPLY AND DEMAND 21

 Bens supply schedule and supply
curve
Price of
Ice-Cream
Cones Supply curve
$3.00
Price of Quantity of 2.50 1. An increase
Ice-cream Cones in price . . .
cone supplied 2.00
$0.00 0 cones 1.50
0.50 0 2. . . . increases quantity
1.00 1 1.00 of cones supplied.
1.50 2
2.00 3 0.50
2.50 4
3.00 5 0 1 2 3 4 5 6 7 8 9 1011 12
Quantity of Ice-Cream Cones

22
Market supply and individual
supplies

Price of ice-cream Ben Jerry Marke

cone t
$0.00 0 + 0 = 0
0.50 0 0 0
1.00 1 0 1
1.50 2 2 4
2.00 3 4 7
2.50 4 6 10
3.00 5 8 13

23
 Market supply and individual
supplies
Bens
+ Jerrys
= Market
supply supply supply
Price of Price of Price of
Ice Ice Ice
Cream Cream Cream
Cones SBen Cones Cones
$3.00 $3.00 $3.00 SMarket
SJerry
2.50 2.50 2.50

2.00 2.00 2.00

1.50 1.50 1.50

1.00 1.00 1.00

0.50 0.50 0.50

0 1 2 3 4 5 6 7 8 9 101112 0 1 2 3 4 5 6 7 0 2 4 6 8 1012141618
Quantity of Ice-Cream Cones Quantity of Quantity of Ice-Cream Cone
Ice-Cream Cones
24
 Law of Supply
The law of supply states that, the
quantity supplied of a good rises
when the price of the good rises,
as long as all other factors that affect
suppliers decisions are unchanged

SUPPLY AND DEMAND 25

Law of SupplyExplanation
How can we make
sense of the numbers in
Bens supply schedule?
The best guess is that
his costs must be
something like the cost
schedule below.
A specific ice- Its cost ($)
cream cone
1st 0.75
2nd 1.35 In this way, the Law of
Supply follows from the
3rd 1.75 assumption of Increasing
4th 2.30 Costs (or, Diminishing
Returns)
5th 2.85
6th 3.10 SUPPLY AND DEMAND 26
 Shifts in the Supply Curve: What
causes them?
Price of
Ice-Cream Supply curve,
S3
Supply
Cone
curve,S1
Supply
Decrease curve,S2
in supply

Increase
in supply

0 Quantity of
SUPPLY AND DEMAND Ice-Cream Cones
27
 Supply Shift
How could Bens Bens Supply Schedule

supply have increased? Price ($) Quantity Supplied

Before After
0.00 0 0
0.50 0 1
Ice-cream Its cost ($)
cone 1.00 1 2

Before After 1.50 2 3

1st 0.75 0.45 2.00 3 4

2nd 1.35 0.85 2.50 4 5

3rd 1.75 1.45 3.00 5 6

4th 2.30 1.95

Anything that
5th 2.85 2.45
reduces
6th 3.10 2.90 production costs,
SUPPLY ANDshifts
DEMAND supply to 28
the right.
Shifts in the Supply Curve
are caused by changes in
Input prices
Technology
Number of sellers (short run)
The market supply will shift right if
Raw materials or labor becomes cheaper
The technology becomes more efficient
Number of sellers increases

SUPPLY AND DEMAND 29

EQUILIBRIUM

SUPPLY AND DEMAND 30

 Interaction of demand and
supply
We have seen what demand and
supply are
We have seen why demand and supply
may shift
Now it is time to say something about
how buyers and sellers collectively
determine the market outcome
To do this, we assume equilibrium

SUPPLY AND DEMAND 31

 Equilibrium
We assume that the price will
automatically reach a level at which
the quantity demanded equals the
quantity supplied

SUPPLY AND DEMAND 32

 SUPPLY AND DEMAND
TOGETHER
Demand Supply
Schedule Schedule

At $2.00, the quantity

demanded is equal to the
quantity supplied!
SUPPLY AND DEMAND 33
 Equilibrium of supply and
Price of
Ice-Cream demand
Cones Supply
$3.00

2.50 Equilibrium
price Equilibrium
2.00

1.50

1.00
Equilibrium Demand
0.50 quantity

0 1 2 3 4 5 6 7 8 9 1011 12
Quantity of Ice-Cream Cones

34
 Equilibrium
Can we justify the assumption of
equilibrium?

35
 Markets Not in Equilibrium

(a) Excess Supply

Price of
Ice-Cream Supply
Cone Surplus
$2.50

2.00

Demand

0 4 7 10 Quantity of
Quantity Quantity Ice-Cream
demanded supplied Cones
SUPPLY AND DEMAND 36
 Markets Not in Equilibrium

Surplus
When price exceeds equilibrium price,
then quantity supplied is greater than
quantity demanded
There is excess supply or a surplus
Suppliers will lower the price to increase
sales, thereby moving toward equilibrium

SUPPLY AND DEMAND 37

 Markets Not in Equilibrium

(b) Excess Demand

Price of
Ice-Cream Supply
Cone

$2.00

1.50
Shortage

Demand

0 4 7 10 Quantity of
Quantity Quantity Ice-Cream
supplied demanded Cones
SUPPLY AND DEMAND 38
 Markets Not in Equilibrium

Shortage
When price is less than equilibrium
price, then quantity demanded exceeds
the quantity supplied
There is excess demand or a shortage
Suppliers will raise the price due to too
many buyers chasing too few goods, thereby
moving toward equilibrium

SUPPLY AND DEMAND 39

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

SUPPLY AND DEMAND 40

 Equilibrium: skepticism
required
Although the Law of Supply and
Demand is a good place to start the
discussion of prices, it should not be
taken to be the gospel truth.
In some cases the price might get
stuck at some other level and
quantity supplied and quantity
demanded may not be equal.
Example: unemployment

SUPPLY AND DEMAND 41

 Unemployment: a failure of equilibrium
when the wage is too high and stuck
Wage

Labor
Labor surplus Supply
(unemployment)
Too-high
wage

Labor
demand
0 Quantity Quantity Quantity of
demanded supplied Labor
SUPPLY AND DEMAND 42
Lets make some predictions
We can use our understanding of the
factors that shift the demand and
supply curves to predict the
consequences of
Alternative policy proposals, and
Events outside our control

SUPPLY AND DEMAND 43

 How an Increase in Demand Affects the
Equilibrium
Price of
Ice-Cream 1. Hot weather increases
Cone the demand for ice cream . . .

Supply

$2.50 New equilibrium

2.00
2. . . . resulting Initial
in a higher equilibrium
price . . .
D

0 7 10 Quantity of
3. . . . and a higher Ice-Cream Cones
quantity sold.SUPPLY AND DEMAND 44
 How a Decrease in Supply Affects the
Equilibrium
Price of
Ice-Cream 1. An increase in the
Cone price of sugar reduces
the supply of ice cream. . .
S2
S1

New
$2.50 equilibrium

2.00 Initial equilibrium

2. . . . resulting
in a higher
price of ice
cream . . . Demand

0 4 7 Quantity of
3. . . .and a lower Ice-Cream Cones
quantity
SUPPLY AND DEMANDsold. 45
 A Shift in Both Supply and
Demand
Event Effect on Price Effect on Quantity
Demand increases Up Up
Supply decreases Up Down
Both Up Ambiguous

SUPPLY AND DEMAND 46

A Shift in Both Supply and
Demand

SUPPLY AND DEMAND 47

 Prediction exercises
Effect of a rise in the price of oil on
the market for
Hybrid cars
Real estate
Staple foods (corn, wheat, rice)
Effect of the development of cheaper
and better batteries for electric cars
on the market for
traditional cars
gas
SUPPLY AND DEMAND 48
 Other kinds of markets
Factor/resource markets
Assets markets
Prediction markets
Iowa electronic markets:
http://www.biz.uiowa.edu/iem/
Intrade prediction markets:
http://www.intrade.com/

SUPPLY AND DEMAND 49