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 marketsMarket 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 productCompetitive 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 priceWe assume perfectly competitive markets when we study the theory of demand and supply

Types of MarketsPerfectly competitive markets have the following two characteristics:Goods being sold are all the sameBoth Buyers and sellers are price takersMonopoly is characterized by: One seller and many buyersSeller sets the priceOligopoly is characterized by Few sellers without rigorous competitionThe sellers get together to set a priceMonopolistic competition is characterized by Many sellers, each selling a differentiated productSellers have some ability to set the price for their own product

Law of DemandOther things equal, the quantity demanded of a good falls when the price of the good rises. Price and quantity demanded are negatively relatedQuantity demanded is the amount of the good that buyers are willing to purchase

Determinants of DemandDeterminants of quantity demanded: Income (normal, inferior)Prices of related goods (substitutes, complements)TastesExpectations Number of buyers (Market demand curve)Demand schedule and Demand curveDemand schedule is a table that shows the relationship between the price of a good and the quantity demandedDemand curve graphs the demand schedule. The demand curve slopes downward

Market Versus Individual DemandMarket demand is the horizontal sum of all individual demands for a particular good or serviceMarket 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 CurveAny 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 curveTo 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 smokingPolicy impact on substitutesPolicy impact on complements

SUPPLYQuantity supplied of any good is the amount that sellers are willing to sell in the marketDeterminants of supply: PriceInput pricesTechnologyExpectationsNumber of sellers (Market supply curve)

Law of SupplyOther 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 goodSupply schedule is a table that shows the relationship between the price of a good and the quantity suppliedSupply curve graphs the supply schedule. It is upward sloping

Market Versus Individual SupplyMarket supply is derived by horizontally summing the individual supply curvesMarket supply curve shows how the quantity supplied varies as the price of the good variesAny 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 DEMANDHow 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 demandedEquilibrium 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 DEMANDWhat 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 DEMANDOther things remaining same, the price of any good adjusts to bring the supply and demand for that good into balance. Shifts versus movements along curvesChange 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: ApplicationChange in demand- shifts in the demand curve Change in supply- shifts in the supply curveChanges in both supply and demand- Change in equilibrium quantity and priceA simple application

Analyzing Changes in Equilibrium: Summary

How Prices allocate ResourcesPrices act as signals that guide the allocation of scarce resources in a market economyPrices in turn are determined by forces of supply and demand