Theory of Supply and Demand
 How supply and demand determine the
price of a good and the quantity sold in
the market?
 Role of prices in allocating resources in
the market economy
Types of markets
 Market is a group of buyers and sellers of a
particular good or service
 Buyers determine the demand for a product and
sellers determine the supply of the product
 Competitive market is a market in which there
are many buyers and many sellers in the market
so that each has a negligible impact on the
market price
 We assume perfectly competitive markets when
we study the theory of demand and supply
Types of Markets
 Perfectly competitive markets have the following two
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characteristics:
 Goods being sold are all the same
 Both Buyers and sellers are price takers
Monopoly is characterized by:
One seller and many buyers
 Seller sets the price
Oligopoly is characterized by
 Few sellers without rigorous competition
 The sellers get together to set a price
Monopolistic competition is characterized by
 Many sellers, each selling a differentiated product
 Sellers have some ability to set the price for their own
product
Law of Demand
 Other things equal, the quantity
demanded of a good falls when the
price of the good rises.
 Price and quantity demanded are
negatively related
 Quantity demanded is the amount of
the good that buyers are willing to
purchase
Determinants of Demand
 Determinants of quantity demanded:
 Income (normal, inferior)
 Prices of related goods (substitutes,
complements)
 Tastes
 Expectations
 Number of buyers (Market demand curve)
 Demand schedule and Demand curve
 Demand schedule is a table that shows the
relationship between the price of a good and
the quantity demanded
 Demand curve graphs the demand schedule.
The demand curve slopes downward
Market Versus Individual Demand
 Market demand is the horizontal sum of
all individual demands for a particular
good or service
 Market demand is derived from
individual demands and thus depends on
all those factors that determine individual
demand (income, expectations, etc)
 In our case, market demand curve shows
the variations in the quantity demanded
of a good as price changes
Shifts Versus Movements Along the
Demand Curve
 Any change that varies the quantity that buyers
wish to buy at a given price shifts the demand
curve
 Changes in price that varies the quantity that
buyers wish to buy is represented as a
movement along the demand curve
 To summarize: Demand curve shows what
happens to the quantity demanded of a good
when its price varies, holding constant all other
determinants of quantity demanded. When one
of these determinants changes, the demand
curve shifts.
Application of law of Demand:
Policy to Reduce Smoking
 Option #1: Raise prices of cigarettes by
levying a tax
 Option #2: Introduce a public
awareness program regarding ill
effects of smoking
 Policy impact on substitutes
 Policy impact on complements
SUPPLY
 Quantity supplied of any good is the
amount that sellers are willing to
sell in the market
 Determinants of supply:
 Price
 Input prices
 Technology
 Expectations
 Number of sellers (Market supply
curve)
Law of Supply
 Other things equal, the quantity
supplied of a good rises when the price
of the good rises.
 Quantity supplied is positively related
to the price of the good
 Supply schedule is a table that shows
the relationship between the price of a
good and the quantity supplied
 Supply curve graphs the supply
schedule. It is upward sloping
Market Versus Individual Supply
 Market supply is derived by horizontally
summing the individual supply curves
 Market supply curve shows how the quantity
supplied varies as the price of the good
varies
 Any change that varies the quantity supplied
at a given price shifts the supply curve
 Changes in price that varies the quantity
supplied in the market is represented as a
movement along the supply curve
SUPPLY AND DEMAND
 How do supply and demand combined
together determine the quantity and price
of a good sold in the market?
 Supply and demand curves intersect. At this
equilibrium price quantity supplied equals
quantity demanded
 Equilibrium is a situation in which supply
equals demand
 Equilibrium price is also called as the
market clearing price as quantity supplied
equals quantity demanded
SUPPLY AND DEMAND
 What happens when market price is
not equal to the equilibrium price?
 Excess supply- surplus in the market
 Excess demand- shortage in the market
 Free markets reach equilibrium through
the interaction of buyers and sellers and
price is the tool through which the
market is cleared
LAW OF SUPPLY AND DEMAND
 Other things remaining same, the price of
any good adjusts to bring the supply and
demand for that good into balance.
 Shifts versus movements along curves
 Change in quantity supplied and change in
quantity demanded is represented as a
movement along the fixed supply and demand
curves respectively
 Change in supply and change in demand is
represented as shifts in supply and demand
curves respectively
Analyzing Changes in
Equilibrium: Application
1. Change in demand- shifts in the
demand curve
2. Change in supply- shifts in the supply
curve
3. Changes in both supply and demandChange in equilibrium quantity and
price
A simple application
Analyzing Changes in
Equilibrium: Summary
DEMAND/
SUPPLY
No change in
demand
No change in Increase in
Supply
supply
Decrease in
supply
Increase in
demand
P same
Q same
P up
Q up
P up
Q down
P up
Q ambiguous
Decrease in
demand
P down
Q down
P down
Q up
P
ambiguous
Q up
P down
Q
ambiguous
P ambiguous
Q down
How Prices allocate Resources
 Prices act as signals that guide the
allocation of scarce resources in a
market economy
 Prices in turn are determined by forces
of supply and demand