Demand, Supply
and Price Theory
WEEK 2
Recap
What is opportunity Cost?
Why are incentives important to policy makers?
Why isn’t trade amongst countries a game with winners and losers?
Why is productivity important?
What is the relationship between Marginal Benefit and Marginal Cost
The Scientific Method
Economics is a Science
Economists devise theories, collect data and analyze it
Scientific economists make positive statements
Identify the
problem
Develop a model
based on
simplified
assumptions
“In questions of science, the authority
of a thousand is not worth the humble
reasoning of a single individual.”
― Galileo Galilei
Collect data
and test
models
“Everything must be taken into account. If
the fact will not fit the theory---let the
theory go.”
― Agatha Christie
Three Economic Models
The Circular Flow Diagram
The production possibilities frontier
Market equilibrium
The Circular flow diagram
“A visual model of the economy that shows how money flows through
markets amongst households and firms”
Production Possibilities Frontier
A graph that shows the combinations of output that the economy can
possibly produce given the available factors of production and the
available production technology.
Example
◦
◦
◦
◦
Economy can produce 300 shirts or 100 cakes
Producing at the PPF causes the market to be “efficient”
It is easy to see trade offs and opportunity costs
Opportunity Cost = the slope of the PPF Line
Slope = Change in Y/ Change in X
◦ 300-0/100/0 = 3
Markets and Competition
What happens
◦ To the price of petrol when war breaks out in Iran
◦ To the price of mangoes when farmers have an abundant year
◦ To the number of tourists when the tsunami hit Sri-Lanka
All of the above show the workings of Supply and Demand
Supply and Demand are the forces that make market economies work.
◦ They determine the following
◦ Quantity of Goods produced
◦ Price of which goods are sold
Markets do very weird things because it reacts to how
people behave, and sometimes people are a little screwy.
Alan Greenspan
What is a Market?
A group of buyers and sellers of a particular good or service.
Characteristics of markets
◦ Organized markets
◦ Less Organized markets.
A competitive market is a market which has many buyers and sellers so
that each has a negligible impact on price.
For today’s class we will assume that markets are perfectly competitive.
◦ The goods offered for sale are exactly the same so that no single buyer or
seller has influence over price.
Demand
Quantity Demanded – the amount of a good that buyers are willing and are
able to pay.
Law of Demand
The claim that other things equal the quantity
Demanded of a good falls when the price of
The good increases.
Market Demand – the sum of all individual demand for a particular good or
service
Teach a parrot the terms 'supply and demand' and
you've got an economist.
Thomas Carlyle
Demand
Price
Quantity
Demanded
0
6
50
5
100
4
150
3
200
2
250
1
300
0
Shifts in the demand curve
Demand curves can shift
• To the RIGHT (A)
• To the LEFT (B)
Shifts to the right means demand has
increased
Shift to the left means demand has
decreased
Variables that cause Demand
Curves to shift
Income
Prices of Related goods
Tastes
Expectations
Number of Buyers
Income
Normal goods
◦ A good for which other things equal an increase in income leads to an
increase in demand
Inferior Good
◦ A good for which other things equal an increase in income leads to a
decrease in demand.
Price of Related Goods
Substitutes
◦ Two goods for which an increase in price of one leads to an increase in
demand for the price of the other
Complements
◦ Two goods for which an increase in the price of one leads to a decrease in
demand for the other.
Supply
Quantity Supplied
◦ The amount of a good that sellers are willing and able to sell.
Law of Supply
The claim that other things equal the quantity
Supplied of a good increase when the price of
The good increases.
Supply
Price of
cone
Quantity
Supplied
0
0
50
0
100
1
150
2
200
3
250
4
300
5
Shifts in the Supply Curve
• Shifts to the right increase supply
• Shifts to the left decrease supply
Variables that cause the supply
curve to shift
Input Prices
◦ Costs of inputs. If they increase production decreases, if they decrease
production will increase
Technology
◦ Machinery increases productivity
Expectation
Number of Sellers
Market Equilibrium
Equilibrium – A situation which the market price has reached the level at
which quantity supplied equals the quantity demanded.
◦ Equilibrium price – the price that balances Qd and Qs
◦ Equilibrium quantity – the quantity that balances Pd and Ps
Law of Supply and Demand
The claim that the price of any good adjusts to bring
the Qd and the Qs for the good into balance.
Surplus and Shortage
Surplus – A situation where Qs is greater than Qd
Shortage – A situation where Qd is greater than Qs
No change in
Supply
An increase in
supply
Decrease in
supply
No change in
demand
P.Q No change
P down
Q up
P up
Q down
Increase in
Demand
P up
Q up
P ambiguous
Q up
P is up
Q ambiguous
Decrease in
demand
P down
Q down
P down
Q ambiguous
P ambiguous
Q down
Elasticity of Supply and Demand
Price
Elasticity of
Demand
We use absolute numbers even though Qd is negatively related to its
price.
|Ped|= △Q/△P
= 20/10 = 2
Different Types of Demand
Perfectly Inelastic Demand
Inelastic Demand
Unitary Elastic Demand
Elastic Demand
Perfectly Elastic Demand
Determinants of Price Elasticity
Sustainability
Nature of the Product
Proportion of Income
Definition of Market
The Possibility of new purchases
Time Horizons
Addiction
Complementary goods
Price expectations
Income Elasticity of Demand
A measure of how much the quantity demanded for a good responds to a
change in consumers income.
(Ey)
Negative elasticity
◦ Ey>0 – D decreases as I increases
Zero Income Elasticity
◦ Ey=0 – D does not change as I rises of falls
Income Inelastic Demand
◦ 0<Ey<1 – D rises at a smaller proportion than I
Unit Income Elasticity
◦ Ey=1 – D rises exactly the same proportion as I
Income elastic demand
◦ 1<Ey<∞ - D rises at a greater proportion than income
The Cross Price Elasticity of Demand
The measure of how much the quantity demanded of one good responds
to a change in the price of another good.
Price Elasticity of Supply
Es = △Q/Q = △Q x P
△P/P
△P
Q
Determinants of Elasticity of Supply
Time
Excess Supply or Unsold Stock
Factor Mobility
Natural Constraints
Risk Taking