Market Demand, Supply And Equilibrium - Part A - Copy PDF

MARKET DEMAND, SUPPLY AND EQUILIBRIUM Adjunct Faculty: Fot-Chyi Wong  Lesson Outline PART A PART B  Introduction  Supply Analysis Basic Decision-Making Units in An Factors...

MARKET DEMAND, SUPPLY AND EQUILIBRIUM Adjunct Faculty: Fot-Chyi Wong  Lesson Outline PART A PART B  Introduction  Supply Analysis Basic Decision-Making Units in An Factors that change quantity supplied Economy and supply Circular Flow of Economic Activity The supply function Competitive Market Assumptions ✓ Direct Supply Function  Demand Analysis ✓ Inverse Supply Function Factors that change demand and ✓ Market Supply quantity demanded The demand function Producer Surplus ✓ Direct Demand Function  Market Equilibrium ✓ Inverse Demand Function Price As A Regulator and Price ✓ Market Demand Adjustments Consumer Surplus Changes in Market Equilibrium Efficiency in Competitive Markets  Lesson Outline PART A  Introduction Basic Decision-Making Units in An Economy Circular Flow of Economic Activity Competitive Market Assumptions  Demand Analysis Factors that change demand and quantity demanded The demand function ✓ Direct Demand Function ✓ Inverse Demand Function ✓ Market Demand Consumer Surplus Introduction  Introduction  In a broad sense, economics is the study of production, distribution and consumption.  It answers the 3 basic questions: What gets produced? How is it produced? Who gets what is produced?  Economics can be divided into 2 major areas: Macroeconomics: studies the economic behaviour of aggregates, viz. income, employment, output, etc. on a national scale. Microeconomics: studies the functioning of individual industries and the behaviour of individual decision-making units, viz. firms and households.  Introduction  Supply and demand are the two words economists use most often. They are the forces that: make market economies work determine the quantity of each good produced and the price at which it is sold.  This lesson introduces the theory of supply and demand in the product or output market: how buyers and sellers behave and how they interact with one another how supply and demand determine prices in a market economy and how prices, in turn, allocate the economy’s scarce resources.  Introduction  Basic Decision-Making Units in a Simple Market Economy: ✓ Firms: Firms are the primary producing units in a market economy that transform resources (inputs) into products (outputs). ✓ Households: The consuming units in an economy, as well as the suppliers of resources (inputs) to the production process.  Introduction  Input and Output Markets in a Simple Market Economy: Markets in which goods and services are exchanged. Markets in which the resources used to produce goods and services are exchanged.  Introduction  Circular Flow of Economic Activity in A Simple Market Economy  Introduction  The terms supply and demand refer to the behaviour of people as they interact with one another in competitive markets.  A market is a group of buyers and sellers of a particular product.  A competitive market is one with many buyers and sellers, each has a negligible effect on price.  In a perfectly competitive market: The output of all producers is the same Buyers & sellers so numerous that no one can affect market price—each is a “price taker”  In this lesson, we assume markets are perfectly competitive. Demand Analysis  General Demand Function  A household’s decision about what quantity Qd of a particular output, or product, to demand depends on a number of variables, including: 1. Price of good or service (P) 2. Incomes of the households or consumers (M) 3. Accumulated wealth of the households (W) 4. Prices of related goods & services (PR) 5. Preferences or taste patterns of consumers (T) 6. Expected future price of product (PE)  General demand function Qd = f(P, M, W, PR, T, PE)  General Demand Function Qd = f(P, M, W, PR, T, PE) Change in Current and Expected Future Prices of Product  Current Price (P) Consumers are willing and able to buy more of a good the lower the price of the good and will buy less of a good the higher the price of the good. Price and quantity demanded are negatively (inversely) related Price P is the most important determinant of Qd.  Expected Future Price (PE) Consumers’ expectations about the future price of a product can change their current purchasing decisions. If consumers expect the price to be higher in a future period, demand will probably rise in the current period, and vice versa.  General Demand Function Qd = f(P, M, W, PR, T, PE) Change in Consumer’s Income (M) or Wealth (W)  Income (M): The sum of a household’s wages, salaries, profits, interest income, rental income, and other forms of earnings in a given period of time. It is a flow measure.  Wealth (W) or Net Worth: Flow Stock The total value of what a household owns minus what it owes at a point in time. It is a stock measure.  General Demand Function Qd = f(P, M, W, PR, T, PE) Change in Consumer’s Income (M) or Wealth (W)  Normal good A good or service for which an increase (decrease) in income or wealth causes consumers to demand more (less) of the good, holding all other variables in the general demand function constant  Inferior good A good or service for which an increase (decrease) in income or wealth causes consumers to demand less (more) of the good, all other variables held constant  General Demand Function Qd = f(P, M, W, PR, T, PE) Change in Prices of Related Goods (PR)  Substitutes Two goods are substitutes if an increase (decrease) in the price of one good causes consumers to demand more (less) of the other good, holding all other variables constant  Complements Two goods are complements if an increase (decrease) in the price of one good causes consumers to demand less (more) of the other good, all other things held constant  General Demand Function Qd = f(P, M, W, PR, T, PE) Change in Tastes (T) and Preferences  Changes in preferences can and do manifest themselves in market behaviour.  Within the constraints of prices and incomes, preference shapes the demand curve, but it is difficult to generalize about tastes and preferences.  General Demand Function Qd = f(P, M, W, PR, T, PE)  One simple, but useful, representation of a demand function is the linear demand function: Qd = a + bP + cM + dW + ePR + fT + gPE  b, c, d, e, f and g are slope parameters Measure effect on Qd of changing one of the determinants of demand while holding the others constant  Sign of parameter shows how a determinant is related to Qd Positive sign indicates direct relationship Negative sign indicates inverse relationship General Demand Function Qd = a + bP + cM + dW + ePR + fT + gPE Variable Relation to Qd Sign of Slope Parameter P Inverse b = Qd /P is negative Direct for normal goods c = Qd /M is positive M Inverse for inferior goods c = Qd /M is negative Direct for normal goods d = Qd /W is positive W Inverse for inferior goods d = Qd /W is negative Direct for substitutes e = Qd /PR is positive PR Inverse for complements e = Qd /PR is negative T Direct f = Qd /T is positive PE Direct g = Qd /PE is positive Direct Demand Function  The direct demand function, or simply demand, shows how quantity demanded, Qd , is related to product price, P, when all other variables are held constant: ഥ W, 𝑷 𝑸𝒅 = 𝒇(𝑷, 𝑴, ഥ 𝑷 ഥ 𝑹 , T, ഥ 𝑬) 𝑸𝒅 = 𝒇(𝑷)  Direct Demand Function 𝑸𝒅 = 𝒇(𝑷)  Distinction between “quantity demanded” and “change in demand”.  The Law of Demand Qd increases when P falls, all else constant Qd decreases when P rises, all else constant Qd /P must be negative  The negative relationship between price and quantity demanded: Ceteris paribus, as price rises, quantity demanded decreases; as price falls, quantity demanded increases during a given period of time, all other things remaining constant.  Direct Demand Function  For example, consider the following 3-variable general demand function, Qd = f(P, M, PR): 𝑸𝒅 = 𝟑𝟐𝟎𝟎 − 𝟏𝟎𝑷 + 𝟎. 𝟎𝟓𝑴 − 𝟐𝟒𝑷𝑹  To derive a direct demand function, Qd = f(P), the variables M and PR must be assigned specific (fixed) values.  Suppose consumer income is $60,000 and the price of a related good is $200. To find the direct demand function, the fixed values of M and PR are substituted into the general demand function: 𝑸𝒅 = 𝟑𝟐𝟎𝟎 − 𝟏𝟎𝑷 + 𝟎. 𝟎𝟓(𝟔𝟎𝟎𝟎𝟎) − 𝟐𝟒(𝟐𝟎𝟎) 𝑸𝒅 = 𝟑𝟐𝟎𝟎 − 𝟏𝟎𝑷 + 𝟑𝟎𝟎𝟎 − 𝟒𝟖𝟎𝟎 𝑸𝒅 = 𝟏𝟒𝟎𝟎 − 𝟏𝟎𝑷  Inverse Demand Function  Traditionally, price (P) is plotted on the vertical axis & quantity demanded (Qd) is plotted on the horizontal axis The equation plotted is the inverse demand function, P = f(Qd) [NOTE: Strictly, if Qd = f(P), then P = f -1(Qd) = g(Qd), where g is the inverse function of f. We use f to denote generically all functions.] E.g. using our earlier illustration, the inverse demand function ban be derived as: 𝑸𝒅 = 𝟏𝟒𝟎𝟎 − 𝟏𝟎𝑷 𝑷 = 𝟏𝟒𝟎 − 𝟎. 𝟏𝑸𝒅  Graphing Demand Curves  Demand schedule: Shows how much of a given product a household would be willing to buy at different prices for a given time period.  Demand curve: A graph illustrating how much of a given product a household would be willing to buy at different prices.  Graphing Demand Curves  A point on a demand curve P ($/unit) shows either: Maximum amount of a good that will be purchased for a given price Q (units/period)  Graphing Demand Curves  A point on a demand curve P ($/unit) shows either: Maximum amount of a good that will be purchased for a given price Maximum price consumers will pay for a specific amount of the good (demand price) ✓ demand price can thus be interpreted as the economic value of any specific unit of Q (units/period) a product.  Graphing Demand Curves ❑ Table shows Alex’s demand schedule and Figure shows Alex’s demand curve for energy bars. (bars per week) (bars per week)  Graphing Demand Curves ❑ Figure shows an increase in Alex’s demand. ❑ Because an energy bar is a normal good, an increase in Alex’s income increases his demand for energy bars. (bars per (bars per week) week) (bars per week) Change in Quantity Demanded vs Change in Demand A Movement along the Demand Curve  When the price of the good changes and other things remain the same, the quantity demanded changes and there is a movement along the demand curve. Change in Quantity Demanded vs Change in Demand A Shift of the Demand Curve  If the price remains the same but one of the other influences on buyers’ plans changes, demand changes and the demand curve shifts. Change in Quantity Demanded vs Change in Demand  Change in quantity demanded Occurs when price changes Movement along demand curve  Change in demand Occurs when one of the other variables, or determinants of demand, changes Shifts in the demand curve rightward or leftward Market Demand  Market demand curve Illustrates the relationship between the total quantity and price per unit of a good ALL consumers are willing and able to purchase, ceteris paribus or holding other variables constant.  The sum of all the quantities of a good or service demanded per period by ALL the households buying in the market for that good or service. Horizontal sum of the demand curves of individual buyers Size of market demand increases with the number of consumers in market (N)  Market Demand  For example, if Alex and Naomi are the only consumers in the market for a product, the market demand curve is the horizontal sum of the individual demand curves of Alex and Naomi: Alex’s Demand Naomi’s Demand Market Demand Price Price Price $17 $17 $17 20 $12 $12 $12 60 50 $5 $5 $5 0 60 0 20 0 20 110 Quantity 50 Quantity Quantity (a) (b) (c) Consumer Surplus  Marketing strategies – like value pricing and price discrimination – rely on understanding consumer value for products. Total consumer value is the sum of the maximum amount a consumer is willing to pay at different quantities. Total expenditure is the per-unit market price times the number of units consumed. Consumer surplus is the extra value that consumers derive from a good but do not pay extra for.  Consumer surplus = difference between the amount consumers are willing to pay and the amount they have to pay for a good.  Market Demand and Consumer Surplus Consumer surplus  For illustration, assume that there are 6 consumers willing to pay the following amounts for an electric car: Consumer A: $65,000; Consumer B: $60,000; Consumer C: $55,000; Consumer D: $50,000; Consumer E: $45,000; and Consumer F: $40,000  With this information, we can construct a market demand schedule for electric cars as shown: Price of Electric Car Quantity Demanded Which Consumers? $70,000 0 none $65,000 1 A $60,000 2 A, B $55,000 3 A, B, C $50,000 4 A, B, C, D $45,000 5 A, B, C, D, E $40,000 6 A, B, C, D, E, F  Market Demand and Consumer Surplus Consumer surplus  We can also construct the market demand curve for electric cars as shown in the diagram  Due to the discrete nature of the good, since we cannot Price ($10K) have fractions of a car, the market demand curve is step- wise. $7 $6 $5 $4 $3 Market Demand $2 $1 0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity  Market Demand and Consumer Surplus Consumer surplus  We can also construct the market demand curve for electric cars as shown in the diagram  Due to the discrete nature of the good, since we cannot Price ($10K) have fractions of a car, the market demand curve is step- Consumer wise. $7 A  For each consumer, the consumer value is depicted by the B $6 C shaded area under the demand curve if the consumer gets D to buy and enjoy the good. $5 E $4 F $3 Market Demand $2 $1 0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity  Market Demand and Consumer Surplus Consumer surplus  As illustrated, some consumers (Consumer A) value the electric car more highly and are willing to pay as much as $65K each unit … Price ($10K)  … while others (such as Consumer D) value it less and are Consumer willing to pay something less, at $50K. $7 A B  If the market price of electric cars is $40K per unit, the $6 C consumers purchase a total of 6 units. [Note: We will discuss D $5 E how the market price is established later.] F Market Price $4 $3 Market Demand $2 $1 0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity  Market Demand and Consumer Surplus Consumer surplus  For many goods, we can approximate the step-wise demand curve with a continuous linear demand curve as shown. Price ($10K)  Total consumer value is then the area under the market $7 demand curve up to the quantity demanded or purchased.  It is equal to the area of the shaded trapezium and is $6 calculated as $330K. $5 Market Price $4 Total Consumer Value: $3 0.5($70K – $40K)x6+($40K – $0)x6 $2 = $330K $1 Market Demand 0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity  Market Demand and Consumer Surplus Consumer surplus  Total consumer expenditure for 6 units of the good purchased at the market price of $40K is given by Price ($10K) the area of the shaded rectangle...  … , which is calculated as $240K. $7 $6 $5 Market Price $4 $3 Total Consumer Expenditure: $40K x 6 = $240K $2 $1 Market Demand 0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity  Market Demand and Consumer Surplus Consumer surplus  Consumer surplus, which is the difference between total consumer value and total consumer Price ($10K) expenditure, is thus given by the area of the shaded triangle... $7  … , which is equal to $90K. $6 Consumer Surplus: 0.5 x ($70K - $40K) x 6 = $330K – $240K = $90K $5 Market Price $4 $3 $2 $1 Market Demand 0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity  Connecting-the-Dots Article in RED: For Discussion in Class  Change in Taste: WSJ - The Biggest Music Comeback of 2014 - Vinyl Records, 11 Dec 2014  Change in Income: WSJ - Imports Are Surging in Developing Nations, 08 July 1996  Change in Price of Related Products: Zero Hedge - Deflation Is Coming To The Auto Industry As Used Car Prices Drop, Off-Lease Deluge Looms, 08 Mar 2016  Change in Expected Future Price of Product: ST - Rumours spark panic buying of cooking oil, 05 Jan 2011 In A Nutshell  General demand function: 𝑄𝑑 = 𝑓(P, M, W, PR, T, PE, N)  Direct demand function: 𝑄𝑑 = 𝑓(P)  Inverse demand function: 𝑃 = 𝑓(𝑄𝑑 )  Change in demand vs change in quantity demanded Shift in demand curve vs movement along demand curve  Consumer surplus = consumer value – consumer expenditure