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PART TWO: SUPPLY AND
DEMAND I:
HOW MARKETS WORK
THE MARKET FORCES OF
SUPPLY AND DEMAND
Chapter 4
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What we learn in Part Two?
• Part Two introduces the model of supply and
demand in a market economy
• Supply and demand is the basic tool of economic
analysis
• In Principle Five and Chapter 3 we learned that
specialisation and trade makes everybody better off
• Principle Five tells us that markets are a good way
to organise economic activity
• Now we must see how markets work to achieve this
result
• Markets work through supply and demand
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Plan of Part Two
• There are three chapters in Part Two
• Chapter 4: Market forces of supply and demand
• It introduces the concept of supply and demand
along with other basic concepts such as competition,
market type, etc.
• Chapter 5: Elasticity and its applications
• It is about the relation between changes in prices
and changes in quantities
• Chapter 6: Supply, demand and government policies
• The tools of supply and demand are used to evaluate
different government policies towards markets
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Plan of this chapter
• We start by defining market types such as
competition, monopoly, oligopoly, etc.
• Then examine the factors that determine the demand
for a good or service in a competitive market
• Next we look at the determinants of the supply of a
good or service again in a competitive market
• Supply and demand come together to set the price of
the good or service and the quantity sold
• We establish how changes in demand or in supply
conditions affect the price and quantity
• And look at the key role of prices in allocation
scarce resources of society
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Market forces of
supply and demand
• Supply and demand are certainly the two words that
economists use most often
• Supply and demand are the forces that make market
economies work efficiently
• Supply and demand determine the quantity of each
good produced and the price at which it is sold
• Any event or policy that affects the economy will
work through its impact on supply and demand of
some goods
• Modern microeconomics is about supply, demand,
and the market equilibrium that results from their
interaction
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Markets
• The terms supply and demand refer to the behavior
of people as they interact with one another in
markets
• A market is a group of buyers and sellers of a
particular good or service
– Buyers determine demand
– Sellers determine supply
• Some markets are formally organised with a
building, etc. such as the Stock Market, Commodities
Market, etc.
• Most markets are not formally organised but they
exist because buyers and sellers know them
• People know where to go to buy a car, bread, etc.
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A Competitive Market
• A competitive market is a market
– with many buyers and sellers
– that is not controlled by any one person
– in which a narrow range of prices are
established that buyers and sellers act upon
• The number of buyers and sellers are an important
part of the definition of competition
• The second element is that a buyer or seller cannot
influence prices by his own actions alone
• When these two characteristics exist the market is
called competitive
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Types of markets
• Economic theory distinguishes among four different
types of markets
• Perfect Competition
– Competitive market where products are the same
• Monopoly
– One seller, and seller controls price
• Oligopoly
– Few sellers
– Not always aggressive competition
• Monopolistic Competition
– Many sellers
– Differentiated products
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The Concept of Demand
• We begin our analysis of demand by examining the
behaviour of buyers in the market for a good or
service
• Quantity demanded is the amount of a good that
buyers are willing and able to purchase
• Quantitiy demanded will vary with the price of the
good in question
• The demand schedule is a table that shows the
relationship between the price of the good and the
quantity demanded
• The demand curve is the downward-sloping line
relating price to quantity demanded
• Market demand is the sum of individual demands
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Demand for Ice Cream
Price of
Ice-Cream
Cone
Price Quantity $3.00
$0.00 12 2.50
0.50 10
2.00
1.00 8
1.50 6 1.50
2.00 4 1.00
2.50 2 0.50
3.00 0
0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of
Ice-Cream Cones
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Law of Demand
Price of
Ice-Cream
Cone
$3.00
• The law of
demand states that 2.50
there is an inverse 2.00
relationship
between price and 1.50
quantity 1.00
demanded.
0.50
0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of
Ice-Cream Cones
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Determinants of Demand
• What are the factors that determine how much of a
product is bought in the market for that product?
• In the previous slides we looked at the demand for ice
cream
• What determines how much ice cream will be
bought?
– Market price of ice cream
– Consumer income
– Prices of related goods
– Tastes
– Expectations
– Number of consumers
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Demand function
• We can present the determinants of demand by the
symbols of a function
Q = F ( P , Y , Pn , Pe ,
• It is called the demand function
– P = price of the good or service
– Y = income
– Pn = prices of other goods and services
– Pe = expectations about the change in price
– fashion and tastes of consumers
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Demand function
• What is the meaning of the demand function
Q = F ( P , Y , Pn , Pe ,
• We we look at the relation between price and
quantity demanded while we keep other factors as
constant
• In other words, P is the only independent variable,
the others are kept constant
• Changes in income, other prices, price expectations
and tastes will cause a shift in the demand curve
• Whereas changes in price only affect quantities
• Change in prices changes the quantity demanded by
not the demand function
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Changes in income: normal and
inferior goods
• Changes in income cause a shift in the demand
curve
• Usually the direction of the shift is upward
• In other words, higher income means more demand
for most goods at all prices
• These are called normal goods
• However, for some goods, an increase in income
may actually result in less demand or a downward
shift in the demand curve
• These are called inferior goods
• They are consumed by the very poor
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Effect of an increase in income:
normal good
Price of
• As income Ice-Cream
Cones
increases the Increase
in demand
demand for a
normal good
will increase.
Demand
Demand
curve, D 2
curve, D 1
0 Quantity of
Ice-Cream Cones
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Effect of an increase in income
inferior good
Price of
• As income Ice-Cream
Cones
increases the
demand for
an inferior
good will Decrease
in demand
decrease. Demand
curve, D 1
Demand curve, D 3
0 Quantity of
Ice-Cream Cones
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Prices of Related Goods
• The effects of changes in the prices of related goods
depend on the characteristics of the goods
• Two goods are called substitutes if they represent
similar goods for the consumer: beans or chick peas
are close substitutes
• A fall in the price of a substitute will reduce demand
for a good (demand curve shifts down)
• Two goods are called complements when consuming
one entails consuming the other: a car and tyres
• A fall in the price of a complement will increase
demand for a good (demand curve shifts up)
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Ceteris Paribus
• Attention to one aspect of the analysis so far
• We change one constant at a time while we keep the
others constant
• For example, when we look at the effect of a change
in income we keep the prices of related products
plus tastes plus price expectations unchanged
• Economic theory uses a short-cut to express this
method
• Ceteris paribus is a Latin phrase that means that all
variables other than the ones being studied are
assumed to be constant
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Change in Quantity Demanded
versus Change in Demand
• The distinction between change in demand and
change in quantity demanded is vital to understand
the analysis of demand
• Change in Quantity Demanded
– Movement along the demand curve.
– Caused by a change in the price of the product
• Change in Demand
– A shift in the demand curve, either to the left or
right
– Caused by a change in a determinant other than
the price (income, tastes, etc)
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Change in Quantity Demanded
versus Change in Demand
Variables that
Affect Quantity Demanded A Change in This Variable . . .
Price Represents a movement along
the demand curve
Income Shifts the demand curve
Prices of related goods Shifts the demand curve
Tastes Shifts the demand curve
Expectations Shifts the demand curve
Number of buyers Shifts the demand curve
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Changes in Quantity Demanded
Price of
Cigarettes,
per Pack A tax that raises the price of
cigarettes results in a movement
along the demand curve.
$4.00
2.00
D1
0 12 20 Number of Cigarettes
Smoked per Day
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Changes in Quantity Demanded
Price of
Cigarettes,
per Pack A tax that raises the price of
cigarettes results in a movement
C along the demand curve.
$4.00
A
2.00
D1
0 12 20 Number of Cigarettes
Smoked per Day
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Change in Demand
Price of
Cigarettes,
per Pack
A policy to discourage
smoking shifts the
demand curve to the left.
B A
$2.00
D2 D1
0 10 20 Number of Cigarettes
Smoked per Day
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The Concept of Supply
• Goods and services are supplied to the market by
producers who are also sellers
• Supply looks at the behaviour of the producers
• Quantity supplied is the amount of a good or
service that sellers are willing and able to sell
• What determines the quantitiy supplied?
– Market price of the good or service
– Input prices (of those used in its production)
– Technology (with which it was produced)
– Expectations about the future level of prices
– Number of producers of the good or service
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Law of Supply
• The law of supply states that there is a direct
(positive) relationship between price and the
quantity supplied
• At higher prices there will be higher quantities of
the good or service supplied
• The supply schedule is a table that shows the
relationship between the price of the good or service
and the quantity supplied
• The supply curve is the upward-sloping line relating
price to quantity supplied
• Market supply curve is the sum of the supply curves
of the individual producers
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Supply Curve
Price of
Ice-Cream
Cone
Price Quantity $3.00
$0.00 0 2.50
0.50 0
1.00 1 2.00
1.50 2 1.50
2.00 3 1.00
2.50 4
3.00 5 0.50
0 1 2 3 4 5 6 Quantity of
Ice-Cream Cones
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Change in Quantity Supplied
versus Change in Supply
• As in the demand, attention must be paid to the
difference between changes in the supply and
changes in the quantity supplied
• Change in Quantity Supplied
– Movement along the supply curve
– Caused by a change in the market price of the
product
• Change in Supply
– A shift in the supply curve, either to the left or
right
– Caused by a change in a determinant other than
price (input prices, technology, expectations, etc)
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Change in Quantity Supplied
versus Change in Supply
Variables that
Affect Quantity Supplied A Change in This Variable . . .
Price Represents a movement along
the supply curve
Input prices Shifts the supply curve
Technology Shifts the supply curve
Expectations Shifts the supply curve
Number of sellers Shifts the supply curve
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Increase in Supply
Price of
Ice-Cream
Cone Supply
curve, S1
Supply
curve, S2
Increase
in supply
0 Quantity of
Ice-Cream Cones
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Decrease in Supply
Price of
Ice-Cream Supply curve, S3
Cone Supply
curve, S1
Decrease
in supply
0 Quantity of
Ice-Cream Cones
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Supply and demand together
• Market works by the interaction of supply and
demand
• Now we can see how the two come together
• Market equilibrium corresponds to a price where
quantitiy demanded and supplied is equal
• Equilibrium Price
– The price that balances supply and demand. On a
graph, it is the price at which the supply and
demand curves intersect
• Equilibrium Quantity
– The quantity that balances supply and demand. On
a graph it is the quantity at which the supply and
demand curves intersect
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Equilibrium of Supply and
Demand
Price of
Ice-Cream
Cone
Supply
$2.00
Demand
0 1 2 3 4 5 6 7 8 9 10 11 12 13 Quantity of
Ice-Cream Cones
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Equilibrium of Supply and
Price of
Demand
Ice-Cream
Cone
Supply
Equilibrium price Equilibrium
$2.00
Demand
Equilibrium
quantity
0 1 2 3 4 5 6 7 8 9 10 11 12 13 Quantity of
Ice-Cream Cones
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Markets Not in Equilibrium
• To understand the meaning of market equilibrium
we can look at a market not in equilibrium
• Outside of equilibrium there will be either unsold
products or unsatisfied customer demand
• Excess Supply
– Price is above equilibrium price
– Producers are unable to sell all they want at the
going price
• Excess Demand
– Price is below equilibrium price
– Consumers are unable to buy all they want at the
going price
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Excess Supply
Price of
Ice-Cream
Cone
Excess
supply Supply
$2.50
2.00
Demand
0 4 7 10 Quantity of
Quantity Quantity Ice-Cream Cones
demanded supplied
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Excess Demand
Price of
Ice-Cream
Cone
Supply
$2.00
1.50
Excess
demand Demand
0 4 7 10 Quantity of
Quantity Quantity Ice-Cream Cones
supplied demanded
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Changes in Equilibrium
• For market equilibrium to change one or more of the
determinants of demand or supply must have changes
• When faced with an event or policy that affects the
market
• First, we must try to understand whether the event
shifts the supply or demand curve (or both)
• Then we search for the direction of the shift(s) in the
curve(s): upward or downward
• Only then can we determine the impact of the event
or policy on the equilibrium price and quantities
• And also the direction of the change
How an increase in demand
affects market equilibrium
(a) Price Rises, Quantity Rises
Price of
Ice-Cream 1. Hot weather increases
Cone the demand for ice cream...
Supply
$2.50 New equilibrium
2.00
2. ...resulting
in a higher Initial
price... equilibrium
D2
D1
0 7 10 Quantity of
3. ...and a higher Ice-Cream Cones
quantity sold.
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How a Decrease in Supply
Affects the Equilibrium
(b) Price Rises, Quantity Falls
Price of
1. An earthquake reduces
Ice-Cream
the supply of ice cream...
Cone S2
S1
New
$2.50 equilibrium
2.00 Initial equilibrium
2. ...resulting
in a higher
price...
Demand
0 1 2 3 4 7 8 9 10 11 12 13 Quantity of
3. ...and a lower Ice-Cream Cones
quantity sold.
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Conclusion
• Trade happens in markets of different types, some
competitive other not
• Market economies harness the forces of supply and
demand
• Demand comes from the consumers
• Quantity demanded of a good depends on its price,
on income, on the prices of related goods, on
expectation, on tastes and fashion
• When we analyse demand, only the price is allowed
to change while the other factors are kept constant
(ceteris paribus)
• Quantity demanded is a decreasing function of price
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Conclusion
• Changes in the other factors cause upward or
downward shifts in the demand curve
• Supply comes from producers or sellers
• Quantity supplied is a function of the price, of input
prices, of technology, etc.
• Higher prices increase quantity supplied
• Supply and demand together determine the prices of
the economy’s goods and services as well as the
quantities produced
• Market equilibrium changes when supply or demand
(or both) shifts
• Prices are the signals that guide the allocation of
resources in the market economy
