Understanding Market Demand and Supply

Introduction

• Markets work based on consumer demand and producer supply.
• Prices in markets adjust naturally to address disequilibrium.
• Measuring the extent of change in markets utilizes the concept of elasticity.

Chapter Objectives

• Understand demand and its influencing factors
• Explain supply and its determinants in a market
• Analyze shifts in demand (D) and supply (S) curves.
• Differentiate between shifts and movements along demand/supply curves
• Understand market equilibrium and factors causing its change
• Explain the elasticity of demand and supply

Theory of Demand

• Demand is the quantity of goods or services consumers are willing and able to purchase at a given market price within a specific period, assuming all other factors remain constant (ceteris paribus).
• The theory of demand describes the relationship between consumer desire for goods/services and their market prices.
• The law of demand states the price of a commodity and its demanded quantity are inversely related.
• All else being equal, a product's higher price leads to less demand, while a lower price increases demand.

The 'Ceteris Paribus' Assumption

• Ceteris paribus is a Latin term, meaning 'other things remain equal' or unchanged.
• Economists use ceteris paribus to simplify analyses to changes of single circumstances.
• Economists model the effects of one change at a time by assuming everything else is unchanged.

Demand schedule

• Demand Schedule lists various quantities an individual consumer purchases at different market price levels.

Demand Curve

• The demand curve is a graph that shows relationship between the quantities of a commodity that are demanded at different prices per time period.

Demand Function

• Demand Function is a mathematical equation showing the relation between price and quantity demanded, with all other variables held constant..
• Qd = f(P), where Qd = quantity demanded, P = commodity price.

Market Demand

• Market Demand for a commodity is derived by horizontally summing the quantities demanded by all buyers at each price.

Market Demand Function

• With an individual demand function of Q = 20 - 2P and 100 identical buyers, the market demand function is Qm = 100 (20 – 2P) = 2000-200P.

Note on Demand

• Demand refers to the whole demand schedule
• Quantity demanded refers to a specific point on the demand curve at a certain price.
• Demand shift is caused by demand shifters like preferences, related good prices, income, demographic attributes, and buyer expectations.
• Change in price, there is movement along the demand curve

Determinants of Demand

• Determinants of demand are:
  • Qx,t - Quantity demand of good x at period t
  • Px,t - Price of good x at period t
  • Yt, - Income of the consumers
  • Pr,t - Price of related goods (substitutes or complements)
  • Px,t+i - Expected price of good x in some future period
  • Yt+i - Consumer's expectation of income in future period
  • N - Number of buyers in the market
  • T - Taste or preference of consumers

Change in Demand

• A change in any determinant of demand, excluding the good’s price, results in a shift of the demand curve.

Change in Demand: Price of Related Goods

• Two goods are related when a price change in one affects the demand of the other.
• Substitute Goods: goods which satisfy the same desire of the consumer - If substitute, price of one and demand for the other are directly related
• Complimentary Goods: those goods which are jointly consumed - If complementary, price of one and demand for the other are inversely related

Change in Demand: Income of the consumer

• Normal goods demand increases when consumer income increases.
• Inferior goods demand is inversely related to consumer income.

Change in Demand: Consumer expectation of income and price

• Price Expectation: Higher price expectation will increase current while a lower future price expectation will decrease the demand for the good
• Income Expectation: Higher expectation of future income increase current demand while lower expectation of future income decrease demand.

Change in Demand: Number of buyer in the market

• Since market demand is the horizontal sum of individual demand, an increase in the number of buyers will increase demand while a decrease in the number of buyers will decrease demand.

Change in Demand: Taste or preference of the consumer

• When the taste of a consumer changes in favor of a good, her/his demand will increase and vise versa.

Possible causes for shifts in the demand curve (Right)

• An increase in income
• An increase in the price of substitutes
• A decrease in the price of complements
• A favourable change in fashion, taste and attitudes.

Possible causes for shifts in the demand curve (Left)

• A decrease in income
• A decrease in the price of substitutes
• An increase in the price of complements
• An unfavourable change in fashion, taste and attitudes.

Elasticity of Demand

• Elasticity of Demand measures responsiveness of quantity demanded to changes in price, income, or related goods' prices
• Types of demand elasticity:
  • Price elasticity
  • Income elasticity
  • Cross-price elasticity

Price Elasticity of Demand

• Price Elasticity indicates how much demand changes in response to a price change.
• Measures degree of responsiveness of demand to change in price.
• Computed as the percentage change in quantity demanded, divided by the percentage change in price.
  • If |ε| > 1, demand is elastic
  • If 0 ≤ |ε| < 1, demand is inelastic
  • If |ε| = 1, demand is unitary elastic
  • If |ε| = 0, demand is perfectly inelastic
  • If |ε| = ∞, demand is perfectly elastic.

Point elasticity of demand

• Point elasticity of demand: is calculated to find elasticity at a given point.
• See formulas in document

Arc elasticity of demand

• Arc elasticity of demand: calculates elasticity by taking midpoints of the old and the new values of both price and quantity demanded.
• See formulas in document

Relating Elasticity to Changes in Total Revenue (Price Elastic)

• An increase in price reduces total revenue.
• A reduction in price increases total revenue.
• Total revenue moves in the direction of the quantity change.

Relating Elasticity to Changes in Total Revenue (Price Inelastic)

• An increase in price increases total revenue.
• A reduction in price reduces total revenue.
• Total revenue moves in the direction of the price change.

Relating Elasticity to Changes in Total Revenue (Unit price Elastic)

• An increase in price does not change total revenue.
• A reduction in price does not change total revenue.
• Total revenue does not change as price changes.

Determinants of Price Elasticity of Demand

• Availability of Substitutes: Products with numerous substitutes have more elastic demand
• Time: Price elasticity tends to be more elastic longrun
• Proportion of Income: Goods that consume smaller income portions have less elastic demand
• Commodity's Importance: Luxury items usually have elastic demand. Necessities tend to have inelastic demand.

Income Elasticity of Demand

• Income Elasticity: Measures demand change relative to income change
• See formulas in document
  • If ε > 1, the good is luxury
  • If ε <1(and positive), the good is necessity
  • If ε < 0, (negative), the good is inferior

Cross price Elasticity of Demand

• Cross-Price Elasticity measures how the quantity demanded of one good responds to a change in the price of another good.
• See formulas in document
  • Substitute goods have a positive cross-price elasticity
  • Complementary goods have a negative cross-price elasticity
  • Unrelated goods have a zero cross-price elasticity

Theory of Supply

• Supply: quantities of a product that sellers will provide at a given market price, within a time-period.
• Describes relationship between producers' supply of goods/services and market prices.
• Law of Supply: Direct relationship between price and quantity supplied. Ceteris paribus.

Supply Schedule

• Supply schedule is a list of quantities a producer offers for sale at different market price levels.

Supply curve

• Supply curve is a graph that shows the relationship between the quantities of a commodity that are supplied at different prices per time period.

Supply function

• Supply Function shows the relation between price and quantity supplied. All other things constant.
• Qs = f(P), where Qs = quantity supplied and P = commodity price.

Market Supply

• Market Supply is derived by horizontally summing the quantity supplied by all sellers at each price.

Determinants of Supply

• Determinants of Supply include:
  • Qxs,t - Quantity supply of good x at period t
  • Px,t - Price of good x at period t
  • Pin,t - Price of inputs at time t (cost of inputs)
  • Pr,t - Prices of related goods at time t
  • Px,t+i - Sellers' expectation of price of the product
  • T&S - Taxes & subsidies
  • N - Number of sellers in the market
  • W - Weather
  • Tec- Technology

Determinants of Supply - Input Prices

• Increase in Input Price: causes a decrease in the supply of the product which is represented by a leftward shift of the supply curve.
• Decrease in Input Price: causes an increase in supply.

Determinants of Supply - Price of related goods

• Substitute good price rises; thereby leading the firm to increase supply of more profitable products.
• Complementary good price rises; causing increased supply of the complementary product.

Determinants of Supply - Supplier Expectations

• Higher expected prices in the future will reduce current supply
• Lower expected prices in the future will increase current supply

Determinants of Supply - Taxes and Subsidies

• Increased taxes reduce supply
• Increased subsidies increase supply.

Determinants of Supply - Weather

• Bad weather decreases the supply of agricultural products
• Good weather increases it

Determinants of Supply - Technology

• Technological advancements cause in a firm to produce and supply more in a market
• Shifts the supply curve

Possible causes for right shifts in the supply curve.

• A decrease in costs of production
• Growth in the size of the industry
• A decrease in the price of competitor's goods
• Decrease in an indirect tax or increase in subsidy.

Possible causes for left shifts in the supply curve

• An increase in costs of production
• Decline in the size of the industry
• An increase in the price of competitor's goods
• Increase in an indirect tax or fall in subsidy.

Elasticity of Supply

• Measures degree of supply responsiveness to price
• See formulas in document
• Supply can be elastic, inelastic, unitary elastic, perfectly elastic, or perfectly inelastic.

Determinants of Elasticity of Supply

• Elasticity of Supply determinants:
  • Complexity: Less complex goods have more elastic supply.
  • Factor Availability: Ready availability of production factors enables more elastic PES.
  • Response Time: the longer time a producer has to respond to price changes will cause supply to be more elastic.
  • Inventories: High stock levels enable more elastic supply.
  • Marginal Cost: Skyrocketing marginal costs lead to inelastic supply.
  • Capacity: Excess production capacity enables more elastic supply.
  • Infrastructure: Developed infrastructure leads to more elastic supply.
  • Market Entry: Free market entry leads to more elastic supply.

Market Equilibrium

• Market equilibrium is where Qd (quantity demanded) = Qs (quantity supplied).
• At equilibrium point, market demand equals market supply.
• Market Equilibrium Price: where market clearing occurs
• Market Equilibrium Quantity: market clearing quantity

Market Equilibrium - Surplus

• Surplus occurs when quantity supplied exceeds quantity demanded.
• Called "excess supply."

Market Equilibrium - Shortage

• Shortage happens when quantity demanded exceeds quantity supplied.
• Called "excess demand."

Market Equilibrium - Numerical Example

• Given Qd= 100-2P and P =( Qs /2) + 10, at equilibrium:
  • P=30 and Q=40
  • At P=25, there exists a shortage of 20 units
  • At P=35, there exists a surplus of 20 units

Effects of Shift in Demand and Supply on Equilibrium Price and Quantity (Demand Changes and Supply Remains Constant)

• Equilibrium price and quantity change

Effects of Shift in Demand and Supply on Equilibrium Price and Quantity (Supply Changes and Demand Remains Constant)

• Equilibrium price and quantity change

Effects of Shift in Demand and Supply on Equilibrium Price and Quantity (Combined Changes in Demand and Supply)

• When both demand and supply increase, the quantity increases
• It is not certain whether the price will rise or fall
  • If demand increase is more than the supply's, then the price goes up.
  • If demand supply increase is more than the demand's, the price falls.
  • If demand increase is same as the supply's one, the price remains the same.
• Decreases in both demand and supply follow same principle.

Price and Quantity Changes when Demand/Supply Shifts

• No change: Market equilibrium tables summarize possible cases

Combined Change Example 1: An Increase in Demand and an Increase in Supply

• When ↑ in demand is more than ↑ in supply, both Q and P goes up
• When ↑ in demand is less than ↑ in supply, the Q goes up and P goes down
• When ↑ in demand and supply is the same, the P remains the same, Q goes up

Combined Change Example 2: An Increase in Demand and a Decrease in Supply

• When ↑ in demand is more than ↓ in supply, both Q and P go up
• When ↑ in demand is less than ↓ in supply, the Q goes down and P goes up
• When ↑ in demand and ↓ in supply is the same, the Q remains the same, P goes up