Department of Business Administration

FALL 2014-15

Demand, Supply, and Equilibrium

By

Dr Loizos Christou

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Demand and Supply

Economics begins and ends with the “Law” of supply and demand. The laws of supply and demand are an important beginning in the attempt to answer vital questions about the working of a market system.

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Demand

Demand for a good or service is defined as quantities of a good or service that people are ready (willing and able) to buy at various prices within some given time period, other factors besides price held constant.

4

Supply

The supply of a good or service is defined as quantities of a good or service that people are ready to sell at various prices within some given time period, other factors besides price held constant.

5

Demand Side

Every market has a demand side and a supply side.

The demand side can be represented by a market demand curve which shows the amount of commodity buyers would like to purchase at different prices.

Demand curves are drawn on the assumption that buyers’ tastes, income, the number of consumers in the market and the price of related commodities are unchanged.

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Law of Demand

The inverse relationship between the price of the commodity and the quantity demanded per period is referred to as the law of demand.

A decrease in the price of a good, all other things held constant (ceteris paribus), will cause an increase in the quantity demanded of the good.

An increase in the price of a good, all other things held constant, will cause a decrease in the quantity demanded of the good.

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Change in Quantity Demanded

Quantity

Price

P0

Q0

P1

Q1

An increase in price causes a decrease in quantity demanded.

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Change in Quantity Demanded

Quantity

Price

P0

Q0

P1

Q1

A decrease in price causes an increase in quantity demanded.

9

Changes in Demand

Changes in price result in changes in the quantity demanded. This is shown as movement along the

demand curve. Changes in nonprice determinants

result in changes in demand. This is shown as a shift in the demand

curve.

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Changes in Demand

Nonprice determinants of demand Tastes and preferences Income Prices of related products Future expectations Number of buyers

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Changes in Demand

Change in Buyers’ Tastes-Today’ consumer purchases leaner meats compared to old generations-due to the level of blood cholesterol and body weight

Change in Buyers’ Incomes Normal Goodsi.e., shoes, steaks, travel, automobiles, education Inferior Goods i.e., potatoes, hotdogs, hamburger

Change in the Number of Buyers Change in the Price of Related Goods

Substitute Goods i.e., Carrots can be replaced by cabbage

Complementary Goods i.e., cars and gasoline or electric stove and electricity.

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Change in Demand

Quantity

Price

P0

Q0 Q1

An increase in demand refers to a rightward shift in the market demand curve.

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Change in Demand

Quantity

Price

P0

Q1 Q0

A decrease in demand refers to a leftward shift in the market demand curve.

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Demand, Supply and Equilibrium

Every market has a demand side and a supply side. The Supply side can be represented by a market supply curve which shows the amount of commodity sellers would offer a sale at various prices.

Supply curves are drawn on the assumption of technology and input or resources (as such labor, capital and land) and prices.

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Law of Supply

The direct relationship between the price of the commodity and the quantity supplied per period is referred to as the law of supply.

A decrease in the price of a good, all other things held constant (ceteris paribus), will cause a decrease in the quantity supplied of the good.

An increase in the price of a good, all other things held constant, will cause an increase in the quantity supplied of the good.

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Change in Quantity Supplied

Quantity

Price

P1

Q1

P0

Q0

A decrease in price causes a decrease in quantity supplied.

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Change in Quantity Supplied

Quantity

Price

P0

Q0

P1

Q1

An increase in price causes an increase in quantity supplied.

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Changes in Supply

Nonprice determinants of supply Costs and technology Prices of other goods or services

offered by the seller Future expectations Number of sellers Weather conditions

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Changes in Supply Change in Production Technology

- An improvement in the technology and a reduction in input prices would make it possible to produce a commodity at a lower cost. This indicates that sellers would be willing to sell more the goods at each price

Change in Input Prices-↓ in agriculture product, ↓ price of lamb meat, ↑ quantity supplied so rightward shift in the market supply curve

Change in the Number of Sellers- ↑ in no of sellers, the market supply curve shifts to right or ↓ in no of sellers, the market supply curve shifts to left

Prices of other goods or services offered by the seller- i.e., BMW, Mercedes, Woswagen (Subs. Goods)- i.e., lamp meat and lamp leather (comp. Goods)

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Change in Supply

Quantity

Price

P0

Q1Q0

An increase in supply refers to a rightward shift in the market supply curve.

21

Change in Supply

Quantity

Price

P0

Q1 Q0

A decrease in supply refers to a leftward shift in the market supply curve.

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Market Equilibrium

Market equilibrium is determined at the intersection of the market demand curve and the market supply curve.

Equilibrium price: The price that equates the quantity demanded with the quantity supplied.

Equilibrium quantity: The amount that people are willing to buy and sellers are willing to offer at the equilibrium price level.

The equilibrium price causes quantity demanded to be equal to quantity supplied.

An increase or decrease in the demand or supply curve, it defines a new equilibrium point.

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Market Equilibrium

Quantity

Price

P

Q

D S

If the quantity supplied of a commodity exceeds the quantity demanded, this is called excess supply or surplus between D and S over point p.

If the quantity demanded of a commodity exceeds the quantity supplied, this is called excess demand or shortage between D and S below point p.

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Market Equilibrium

Shortage: A market situation in which the quantity demanded exceeds the quantity supplied. A shortage occurs at a price below the

equilibrium level. Surplus: A market situation in which

the quantity supplied exceeds the quantity demanded. A surplus occurs at a price above the

equilibrium level.

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Market Equilibrium

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Market Equilibrium

Quantity

Price

P0

Q0

D0 S0

Q1

P1

D1

An increase in demand will cause the market equilibrium price and quantity to increase.

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Market Equilibrium

Quantity

Price

P1

Q1

S0

Q0

P0

D0D1

A decrease in demand will cause the market equilibrium price and quantity to decrease.

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Market Equilibrium

Quantity

Price

P0

Q0

D0 S0

Q1

P1

An increase in supply will cause the market equilibrium price to decrease and quantity to increase.

S1

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Market Equilibrium

Quantity

Price

P1

Q1

D0

Q0

P0

A decrease in supply will cause the market equilibrium price to increase and quantity to decrease.

S1 S0

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The Demand Schedule and the demand curve-Example

How can the relationship between quantity demanded and price be portrayed?

Demand schedule

Demand curve

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Table 1: A demand schedule for carrots

Av income:$ 20000

60Z 120

62.5Y 100

67.5X 80

77.5W 60

90V 40

110U $ 20

Thousands ton per months

D (quantity demanded)

P (price per ton)

Table 1 is a hypothetical demand schedule for carrots. It shows the quantity of carrots that would be demanded at various prices on the assumption that average household income is fixed at $ 20000 and all other price do not change. (i.e. if the price of carrots were $60 per ton, consumers would desire to purchase $77,500 tons of carrots per month.

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A demand curve for carrots A second method of showing the relation between

quantity demanded and price is to draw a graph. It is a downward slope which indicates quantity demanded increases as price falls.

0

20

40

60

80

100

120

140

1109077.567.562.560

Quantity

Pri

ce

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Shifts in the demand curve-Example

A demand curve or line is drawn on the assumption that everything except the commodity’s own price is held constant. A change in any of variables previously held constant will shift the demand curve or line to a new position. (i.e. A rise in household income has shifted the demand curve or line to the right.

A demand curve can shift in mainly two ways: If more bought at each price, the demand curve shift right so that each price corresponds to a higher quantity than before. If less is bought at each price, the demand curve shifts left so that each price represents to a lower quantity than before.

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Table 2: Two Alternative Demand Schedule for carrots

7860120

81.362.5100

87.567.580

100.877.560

1169040

140110$ 20

Q1 (D1)Q (D)P

An increase in average income will rise the quantity demanded at each price. When AV income rises from $20000 to $ 24000 per year, quantity demanded at price of $60 per ton increases from 77500 tons per month to 100800 tons per month. Similar rise occurs at every other price.Av in: $ 20000 $ 24000

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Table 2: Two Alternative Demand Schedule for carrots

Put differently, A rise in av household income shifts the demand curve for most commodities to right so this indicates that more will be demanded at each possible price. Ultimately, the demand schedule relating columns P and D is replaced by one relating columns P and D1 in the previous table. The graphical presentation of the two functions are seen in the following graph.

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Shifts in the demand curve-Example

020406080

100120140160

60 80 90 100 120 140

Quantity

pri

ce

Q D

Q1D1

7860120

81.362.5100

87.567.580

100.877.560

1169040

140110$ 20

Q1(D1)Q (D)P

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Other Prices

Earlier, we saw that the downward slope of a commodity’s demand curve occurs because the lower its price, the cheaper the commodity is relative to other commodities that can satisfy the same needs or desires. Those other commodities are called substitutes (i.e. Carrots can be made cheap relative to cabbage either by lowering the price of carrots or raising the price of cabbage).

A rise in the price of a substitute for a commodity shifts the demand curve for the commodity to the right.

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Other Prices

Another class of commodities is called complements. These are the commodities that tend to be used jointly each other. Such as cars and gasoline or electric stove and electricity.

A fall in the price of a complementary commodity will shift a commodity’s demand curve to the right.

For example, a fall in the price of airplane trips to Paris will lead to a rise in the demand for Disney Land tickets at paris even though their price is unchanged.

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Tastes

Tastes have a large effect on people’s desired purchased. A change in tastes may be long-lasting such as the shift from fontain pens to ball-point pens. In this case, a change in tastes in favor of a commodity shifts the demand curve to the right.

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Distribution of Income

A change in the distribution of income will shift to the right the demand curves for commodities bought most by those gaining income. On the other hand, it will shift to the left the demand curves for commodities bought most by those losing income.

If, for example, the government increases the deductions for children on the income tax and compensates by raising basic taxes, income will be transferred from childness persons to the large familes. So commodity more heavily bought by families with no child decline in demand.

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Population

Population growth does not by itself create new demand. The additional people must have purchasing power before demand is changed.

Extra people of working age, however, usually means extra output and if they produce, they will earn income.

When this happens, the demand for all the commodities purchased by the new income earners will rise. Thus a rise in population will shift the demand curves to the right.

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Individual Demand function

The demand for a commodity arises from the consumers’ willingness and ability to purchase the commodity. Consumer demand theory postulates that the quantity demanded of a commodity is a function of / or depends on the price of the commodity, the consumers’ income, the price of related commodities, and the tastes of the consumer.

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Functional form

Qdx= (Px, I, Py, T)

An inverse relationship is expected between the quantity demanded of a commodity and its price (law of demand). That is, when the price rises, the quantity purchased declines, and when the price falls, the quantity sold increases.

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Functional form

Qdx= (Px, I, Py, N,T)

QdX/PX < 0

QdX/I > 0 if a good is normal

QdX/I < 0 if a good is inferior

QdX/PY > 0 if X and Y are substitutes

QdX/PY < 0 if X and Y are complements

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Recall: Consumer Demand Theory

Consumer demand theory postulates that the quantity demanded of a commodity per time period increases with a reduction in its price, with an increase in the consumer’s income, with an increase in the price of substitute commodities and a reduction in the price of complementary commodities, and with an increased taste for the commodity. On the other hand, the quantity demanded of a commodity declines with the opposite changes.

Consumer demand theory postulates that the quantity demanded of a commodity is a function of / or depends on the price of the commodity, the consumers’ income, the price of related commodities, the number of consumers in the market, and the tastes of the consumer.

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Relating Concepts

The increase in Qx when Px falls occurs because in consumption, the individual consumer substitutes commodity x for other commodities which are now relatively expensive. This is called the substitution effect.

In addition, when Px falls, a consumer can purchase more of x with a given amount of money (i.e., the consumer’s real income increases). This is called the income effect.

The movement along a given demand curve resulting from a change in the commodity price is referred to as a change in the quantity demanded, while a shift in the demand curve resulting from a change in any of the factors that affect demand, other than the commodity price, is referred to as a change in demand.

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Individual and Market Demand Curve Example Horizontal Summation: From Individual to Market Demand

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Individual and Market Demand Curve Example

Given the following data: Pdx=$4 and Qdx=4 and Qddx=400, while at Px=$3, Qdx=6 and Qdd=600, construct the relevant individuals and market curves

Market

0

2

4

6

8

0 200 400 600 800 1000 1200

Qdx

Px

Individuals

0

2

4

6

8

0 2 4 6 8 10 12

Qdx

Px

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Price Elasticity of Demand

The price elasticity of demand (Ep) is measured by the percentage change in the quantity demanded of the commodity divided by the percentage change in commodity’s price, holding constant all other variables in the demand function.

/

/P

Q Q Q PE

P P P Q

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Price Elasticity of Demand

/

/P

Q Q Q PE

P P P Q

Point DefinitionOr Elasticity at given point

Linear Function1P

PE a

Q

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Price Elasticity of Demand

2 1 2 1

2 1 2 1P

Q Q P PE

P P Q Q

Arc Definition

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Marginal Revenue and Price Elasticity of Demand

11

P

MR PE

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Price Elasticity of Demand- Example

Market

AB

CD

EF G

0

2

4

6

8

0 200 400 600 800 1000 1200

Qdx

Px

Find Ep at point A, B, C and G

Ep=(ΔQ/ ΔP) (P/Q) At point A, Ep=(0-

200/ 6-5) (6/0) Ep=-200 (6/0)= -

indefinite At point B, Ep=

(200-400/5-4) (5/200)=-5

At point C, Ep=(400-600/4-3) (4/400)=-2

At point G, Ep=(-200)(0/1200)=0

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Price Elasticity of Demand- Example

Find Ep at point A, B, C and G Ep=(ΔQ/ ΔP) (P/Q) At point A, Ep=(-200/ 6-5) (6/0) Ep=-200 (6/0)= - indefinite At point B, Ep= (200-400/5-4) (5/200)=-

5 At point C, Ep=(400-600/4-3) (4/400)=-

2 At point G, Ep=(-200) (0/1200)=0

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Arc Elasticity of Demand- Example

Find arc Ep between points B and C Ep=(Q2-Q1)/(P2-P1) (P2+P1)(Q2+Q1) Ep= (400-200)/(4-5) (4+5)/(400+200) Ep=-3 Absolute value of Ep Greater than 1- elastic Equals 1- unit elastic Less than 1- inelastic

Market

AB

CD

EF G

0

2

4

6

8

0 200 400 600 800 1000 1200

Qdx

Px

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MR and TR based on Elasticity- Example

-31,000-1/51,0001

-5001,2000

-11,600-1/28002

11,800-16003

31,600-24004

51,000-52005

-$ 0-indefinite0$ 6

(5)(4)(3)(2)(1)

MR=DTR/DQ

TR=P.QEpQP

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MR and TR based on Elasticity- Example

Find MR by using P and Ep at Px =$4 and $3 MR= P{1+(1/Ep)} At Px =$4 MR=4{1+(1/-2)=$2 At Px =$3 MR=3{1+(1/-1)=0 Based on the previous table: P decreases TR increases when Ep is elastic TR max or unchanged when Ep is unitary

elastic TR decreases when Ep is inelastic

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Graphically Showing Elasticities and MR-TR

MR>01PE 1PE

MR<0TR

1PE MR=0QX

600 12000

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Graphically Showing Elasticities and MR-TR

MRX

PX

1PE 1PE

1PE

QX600 12000

6

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Income Elasticity of Demand

/

/I

Q Q Q IE

I I I Q

Point Definition

Linear Function

3I

IE a

Q

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Income Elasticity of Demand

2 1 2 1

2 1 2 1I

Q Q I IE

I I Q Q

Arc Definition

Normal Good Inferior Good

0IE

Luxuries GoodNecessities Good

0IE

1IE 1I0 < E <

62

Cross-Price Elasticity of Demand

/

/X X X Y

XYY Y Y X

Q Q Q PE

P P P Q

Point Definition

Linear Function 4Y

XYX

PE a

Q

63

Cross-Price Elasticity of Demand

2 1 2 1

2 1 2 1

X X Y YXY

Y Y X X

Q Q P PE

P P Q Q

0XYE

Arc Definition

Substitutes Complements

0XYE

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Income, Cross and Arc Elasticises- Example

Find arc EI between two levels of income i.e I=$10000 and I=$ 11000 when the demand for commodity X is 400.

Ep=(Q2-Q1)/(I2-I1) (I2+I1)(Q2+Q1) Ep= (600-400)/(11-10) (11+10)/(600+400) EI= 4.2 Thus commodity x is normal and luxury. Find arc Exy between two levels of price y i.e Py=$ 1 and

Py =$ 2 when the demand for commodity X is 400.

Ep=(Q2-Q1)/(P2-P1) (P2+P1)(Q2+Q1) Ep= (600-400)/(2-1) (2+1)/(600+400) EI= 0.6 Thus commodity y is substitute compared to

commodity X

Market

AB

CD

EF G

0

2

4

6

8

0 200 400 600 800 1000 1200

Qdx

Px

0XYE Substitutes

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Using Elasticises In Managerial Decision Making-Example

A firm selling coffee brand X and estimated relevant demand regression as follows:

Qx=1.5-3.0 Px+0.8 I+2.0 Py-0.6 Ps+1.2 A Qx is sales of coffee brand X, I is disposable

income, Py is price of competitive coffee brand, Ps is price of sugar and A is advertising expenditures for coffee brand X.

Suppose: Px=$2, I=$2.5, Py=$1.80, Ps=$0.50 and A=$1

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Using Elasticities In Managerial Decision Making Example

Calculate Qx and the elasticities of sales with respect to each variable in the relevant demand function

Qx=1.5-3.0(2)…1.2(1)=2 mn pounds coffee Calculate the elasticities of the demand for coffee brand X Ep=-3(2/2)=-3,Ei=0.8(2.5/2)=1, Exy=2(1.8/2) Exs=-0.6(0.5/2)=-0.15, Ea=1.2(1/2)=0.6 RECALL the Formulae

3I

IE a

Q

1P

PE a

Q 4

YXY

X

PE a

Q

67

Using Elasticises In Managerial Decision Making-Example

Next year, the firm would like to increase Px by 5%, A by 12%, I by 4%, and Py 7% whereas Ps fall by 8%.

Determine sales of coffee brand X in the next year.

Qxx=Qx+Qx(DPx/Px)Ep……+Qx(DA/A)Ea Qxx=2+2(5%)(-3)…..+2(5%)(0.6) Qxx=2.2 or 2,200,000 pounds

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The important steps by using Elasticities

The analysis of the forces or variables that affect on demand and reliable estimates of their quantitative effect on sales (elasticities) are essential in order for firm to make best operating decisions in shor-run and to plan for its growth in the long-run.

The firms can use the elasticities of demand of the variables under their controls to find out best policies as well as to maximize their profits.

If the demand for the firm’s product is price inelastic, the firm will want to increase the product price since that would increase its total revenue and reduce its total cost.

If the elasticity of the firm’s sales wrt the variable beyod its control or If the cross-price elasticity of demand for the firm’s product is very high, the firm will need to respond quickly to a competitor’s price reduction otherwise losing a great deal of its sales.

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The important steps by using Elasticities

The size of the price elasticity of demand is larger, the closer and the greater is the number of available substitutes for the commodity. For example, sugar is more price elastic than table salt (e.g. honey)

In general, the greater is its price elasticity of demand, the greater will be the number of substitutes

For a given price change, the quantity response is likely to be much larger in the long run than short run so the price elasticity odf demand is likely to be much greater in the long run than short run .

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The End

Thanks