demand supply

1
Chapter 2
Demand, Supply, &
Market Equilibrium
• Demand is the quantity of a good
or service that consumers are
willing and able to purchase during
a specified period under a given
set of economic conditions. The
time frame may be an hour, a day,
a month or a year.
Basis for Demand
• Direct Demand
• Demand is the quantity customers are willing
to buy under current market conditions.
• Direct demand is demand for consumption.
• Derived Demand
• Derived demand is input demand.
• Firms demand inputs that can be profitably
employed.
Market Demand Function
• Determinants of Demand
• Demand is determined by price, prices
of other goods, income, and so on.
• Industry Demand Versus Firm
Demand
• Industry demand is subject to general
economic conditions.
• Firm demand is determined by
economic conditions and competition.
Demand
• Quantity demanded (Qd)
• Amount of a good or service
consumers are willing & able to
purchase during a given period of time
General Demand Function
• Six variables that influence Qd
• Price of good or service (P)
• Incomes of consumers (M)
• Prices of related goods & services (PR)
• Expected future price of product (Pe)
• Number of consumers in market (N)
• General demand function
• Taste patterns of consumers ( Á)
• ( , , , , , ) d R e Q = f P,M, P Á P N) P M N
2
General Demand Function
• b, c, d, e, f, & g are slope parameters
• Measure effect on Qd of changing one of the
variables while holding the others constant
• Sign of parameter shows how variable
is related to Qd
• Positive sign indicates direct relationship
• Negative sign indicates inverse relationship
Qd = a + bP +cM +dPR + eÁ + fPe + gN
General Demand Function
Variable Relation to Qd Sign of Slope Parameter
P
Pe
N
M
PR
Inverse
Direct
Direct
Direct
Direct for normal goods
Inverse for inferior goods
Direct for substitutes
b = DQd/DP is negative
c = DQd/DM is positive
c = DQd/DM is negative
d = DQd/DPR is positive
d = DQd/DPR is negative
f = DQd/DPe is positive
g = DQd/DN is positive
Inverse for complements
Á e = DQd/D Á 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
• Qd = f(P)
• Law of Demand
• Qd increases when P falls & Qd decreases when
P rises, all else constant
• DQd/DP must be negative
Determinants of demand
• Qx = f (Price of X, Price of related goods,
consumer income, Tastes and preferences,
advertising expenditures and so on...)
• For managerial decisions, the demand functions must be
expressed explicitly. Such as a linear demand function for
automobile industry may be given by:
Q = a1P + a2PI + a3I + a4Pop + a5i + a6A
P: Av. Price domestic cars
PI: Av price of imported cars
I : Disposable income per household
Pop: Population ( in millions)
i : Av. Interest on car loans ( in Percent)
A: Advertising expenditure (in $ millions)
– The terms : a1 , a2 , .......a6 are called the parameters of the
demand function
Suppose the parameters of the
demand functions have been
estimated and the demand function
is given as
Q = -0.002P + 0.001P I + 0.0008I + 0.22Pop - 800i + 0.002A
– (Interpret what is the meaning of these
parameters)
Industry demand vs firm demand
• Note that firm demand function may contain
competitors price and their advertising
expenditures also.
• In other words firms demand function may be
different (in shape and variables) from the industry
demand function.
• (If firm has the 100% market share then the
firm demand and industry demand will be
identical)
3
Demand function and demand curve
• The demand function specifies the relation
between the quantity demanded and all variables
that determine demand.
• The demand curve is the part of the demand
function that expresses the relation between the
price charged for a product and the quantity
demanded, holding constant the effects of all
other variables.
• Frequently a demand curve is shown in a graph,
and all variables in the demand function except
price and quantity of the product are held fixed
at specified levels.
Estimating industry Demand for domestic
automobile industry
Independent variable Parameter Estimated value of Variable Estimated Demand
(1) (2) (3) (4) = (2)*(3)
Av. Price domestic cars (P) - 0.002 20,000 -40
Av price of imported cars (PI) 0.001 22,000 22
Income per household (I) 0.0008 40,000 32
Population ( in millions) (Pop) 0.22 250 55
Av. Interest on car loans (%) (i) -800 8 -64
Advertising expenditure (A) 0.002 5,500 11
Total (Million Cars) 16
• At the given level of the independent variables, the DEMAND CURV E can be
expressed as:
Q= -0.002P + 0.001(22000) + 0.0008(40000) + 0.22(250) -800(8) + 0.002(5500)
Q = 56 - 0.002P
Alternatively:
P = 28000 - 500Q
The equation is:
Q= -0.002P + 0.001(22000) + 0.0008(40000) + 0.22(250) - 800(8) + 0.002(5500)
Q = 56 - 0.002P
Alternatively: P = 28000 - 500Q
56
28
Price in Thousand
Cars in Mn
What happens to the changes
in those other variables that
we have assumed constant?
The demand curve shifts.
Right OR Left?
Depends on the sign of the
coefficients. SHOW these
changes.
Relation Between the Demand
Curve and Demand Function
• Move along demand curve when
price changes.
• Shift to another demand curve
when non-price variables change.
Graphing Demand Curves
• 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
• Demand curve shifts rightward or
leftward
4
Market supply function
• Market supply function for a product is
a statement of relation between the
quantity supplied and all factors
affecting that quantity.
§ Qx= f(Price of X, Price of related goods, Current
state of technology, Input prices, weather
and so on...)
• As is true with the demand function, for
managerial decisions, the supply
functions also must be expressed
Basis For Supply
• How Output Prices Affect Supply
• Firms offer supply to make profits.
§ Higher prices boost the quantity supplied.
§ Lower prices cut the quantity supplied.
• Other Factors That Influence
Supply
• Everything that affects marginal
production costs affects supply.
§ If MC falls, supply rises.
§ If MC rises, supply falls.
Market Supply Function
• Determinants of Supply
• Supply is determined by price, prices
of other goods, technology, and so on.
• Industry Supply Versus Firm
Supply
• Firm supply is determined by economic
conditions and competition.
• Industry supply is the horizontal sum
of firm supply.
A linear supply function for automobile
industry may be given by:
Q = b1P + b 2PT + b 3W + b4S + b 5E + b 6i
P: Av. Price domestic cars
PT: Av price of New domestic trucks
W : Hourly wage of labor
S : Av. Cost of Steel
E: Av. Cost of energy
i : Av. Interest rate (Price of capital in %)
The terms : b1 , b2 , .......b6 are called the parameters of the
supply function
• Suppose the parameters of the
supply functions have been
estimated and the supply function
is given as
Q = 0.004P -0.001PT - 0.12W -0.04S - 0.8E -
400i
(Interpret what is the meaning of these parameters)
5
Industry supply vs firm supply
• Note that firm supply function may be
different (in shape and variables) from
the industry supply function.
• Various firms may use differing
technology, production methods and have
different factors affecting differently.
Supply function and supply curve
• The supply function specifies the relation
between the quantity supplied and all
variables that determine supply.
• The supply curve is the part of the supply
function that expresses the relation between
the price charged for a product and the
quantity supplied, holding constant the
effects of all other variables.
• Frequently a supply curve is shown in a
graph, and all variables in the supply function
except price and quantity of the product are
Estimating industry supply for domestic
automobile industry
• Independent variable Parameter Estimated value of Variable Estimated Supply
(1) (2) (3) (4) = (2)*(3)
Av. Price domestic cars (P) 0.004 20,000 80
Av price of Domestic Trucks(PT) -0.001 16,000 -16
Hourly Wage (W) -0.12 50 - 6
Av. Cost of Steel -0.04 200 - 8
Av. Cost of energy (E) -0.8 2.5 -2
Av. Interest on car loans (%) (i) -400 8% -32
Total (Million Cars) 16
• At the given level of the independent variables, the SUPPLY CURV E can be expressed
as:
Q = 0.004P - 0.001(16000) - 0.12(50) -0.04(200) - 0.8(2.5) - 400(8)
Q = -64 + 0.004P
Alternatively:
P = 16000 + 250Q
The equation is:
Q = 0.004P - 0.001(16000) - 0.12(50) -0.04(200) - 0.8(2.5) - 400(8)
Q = -64 + 0.004P
Alternatively: P = 16000 + 250Q
40
40
Price in Thousand
Cars in Mn
16
Supply Curve
This equation is shown in
the graph:
What happens to the changes
in those other variables that
we have assumed constant?
The supply curve shifts.
Right OR Left?
Depends on the sign of the
coefficients. SHOW these
changes.
Market equilibrium
• It will be at
price
$20,000
and 16
million total
cars will be
sold
• Shortages &
Surpluses
• At Various
prices.....
40
40
Price in Thousand
Cars in Mn
16
Supply Curve
Demand Curve
20
16
Comparative statics: Changing demand
• With no change in supply what happens
to equilibrium price and quantity if
interest rate decreases to, say, 6.5%
level.
Solve: Demand shifts up,
Qd = 68 - 0.002P
Qs = -64 + 0.004P
P = $22,000, and Q = 24 units
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Comparative statics : Changing supply
With no change in demand what
happens to equilibrium price and
quantity if interest rate decreases to,
say, 6.5% level.
Solve:Supply shifts down (Right)
§ Qd = 56 - 0.002P
§ Qs = -58 + 0.004P
§ P = $19,000, and Q = 18 units
Comparative statics : Changing demand and
supply
• What happens to equilibrium price and quantity if interest rate
decreases to, say, 6.5% level if both demand & supply change
• Solve: Supply shifts down (Right) and Demand shifts up
Qd = 68 - 0.002P
Qs = -58 + 0.004P
P = $21,000, and Q = 26 units
• The comparative statics can be carried out for other changes in
interest rates.
• This analysis can also be extended for the change in other
variables.
Market Equilibrium
• Surplus and Shortage
• Surplus is excess supply.
• Shortage is excess demand.
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Comparative Statics:
Changing Demand
• Equilibrium changes with demand
shifts.
• Comparative Statics: Changing
Supply
§ Equilibrium changes with supply
shifts.
• Comparative Statics: Changing
Graphing Supply Curves
• A point on a direct supply curve
shows either:
• Maximum amount of a good that will be
offered for sale at a given price
• Minimum price necessary to induce
producers to voluntarily offer a
particular quantity for sale
Graphing Supply Curves
• Change in quantity supplied
• Occurs when price changes
• Movement along supply curve
• Change in supply
• Occurs when one of the other
variables, or determinants of supply,
changes
• Supply curve shifts rightward or
leftward
Shifts in Supply (Figure 2.4)
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)
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Graphing Demand Curves
• A point on a direct demand curve
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
Inverse Supply Function
• Traditionally, price (P) is plotted on
the vertical axis & quantity
supplied (Qs) is plotted on the
horizontal axis
• The equation plotted is the inverse
supply function, P = f(Qs)
Value of Market Exchange
• Typically, consumers value the
goods they purchase by an amount
that exceeds the purchase price of
the goods
• Economic value
• Maximum amount any buyer in the market
is willing to pay for the unit, which is
measured by the demand price for the
unit of the good
Measuring the Value of Market
Exchange
• Consumer surplus
• Difference between the economic value of a
good (its demand price) & the market price
the consumer must pay
• Producer surplus
• For each unit supplied, difference between
market price & the minimum price producers
would accept to supply the unit (its supply
price)
• Social surplus
• Sum of consumer & producer surplus
• Area below demand & above supply over the
relevant range of output
Measuring the Value of Market
Exchange (Figure 2.6)
Changes in Market Equilibrium
• Qualitative forecast
• Predicts only the direction in which an
economic variable will move
• Quantitative forecast
• Predicts both the direction and the
magnitude of the change in an
economic variable
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Demand Shifts (Supply Constant)
(Figure 2.7)
Supply Shifts (Demand Constant)
(Figure 2.8)
Simultaneous Shifts
• When demand & supply shift
simultaneously
• Can predict either the direction in
which price changes or the direction in
which quantity changes, but not both
• The change in equilibrium price or
quantity is said to be indeterminate
when the direction of change depends
on the relative magnitudes by which
demand & supply shift
S
D’
S’’
S’
D
Simultaneous Shifts: (­D, ­S)
Q
Price may rise or fall; Quantity rises
P
•A
Q
P
B•
P’
Q’ Q’ ’
P’’ • C
D
Simultaneous Shifts: (¯D, ­S)
S
D’
S’’
S’
Q
Price falls; Quantity may rise or fall
P
•A
Q
P
B•
P’
Q’ Q’ ’
P’’ • C
S’’
Simultaneous Shifts: (­D, ¯S)
D
S
D’
S’
Q
Price rises; Quantity may rise or fall
P
•A
Q
P
B•
P’
Q’ ’ Q’
P’’ • C
10
Simultaneous Shifts: (¯D, ¯S)
S’’
D
S
D’
S’
Q
Price may rise or fall; Quantity falls
P
•A
Q
P
P’ • B
Q’ ’ Q’
P’’ • C
Ceiling & Floor Prices
• Ceiling price
• Maximum price government permits
sellers to charge for a good
• When ceiling price is below
equilibrium, a shortage occurs
• Floor price
• Minimum price government permits
sellers to charge for a good
• When floor price is above equilibrium,
a surplus occurs
Ceiling & Floor Prices (Figure 2.12)
Qx
Quantity
Price (dollars)
Qx
Px Px
Quantity
Price (dollars)
Sx
Dx
2
50
1
22 62
3
32 84
Panel A – Ceiling price
Sx
Dx
2
50

1. Panel B – Floor price