Demand, Supply and Price Theory

Week 2

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

Recap

Economics is a Science Economists devise theories, collect

data and analyze it Scientific economists make positive

statements

The Scientific Method

Identify the problem

Develop a model based on simplified assumptions

Collect data and

test models

The Circular Flow Diagram The production possibilities frontier Market equilibrium

Three Economic Mode

“A visual model of the economy that shows

how money flows through markets amongst households and firms”

The Circular flow diagram

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

Production Possibilities Frontier

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 and Competition

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.

What is a Market?

Quantity Demanded – the amount of a good that buyers

are willing and are able to pay.

Market Demand – the sum of all individual demand for a particular good or service

Demand

Law of DemandThe claim that other things equal the

quantity Demanded of a good falls when the price of

The good increases.

Price Quantity

Demanded

0 6

50 5

100 4

150 3

200 2

250 1

300 0

Demand

Shifts in the demand curveDemand curves can shift• To the RIGHT (A)• To the LEFT (B)

Shifts to the right means demand hasincreasedShift to the left means demand has decreased

Income Prices of Related goods Tastes Expectations Number of Buyers

Variables that cause Demand Curves to

shift

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.

Income

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.

Price of Related Goods

Quantity Supplied

The amount of a good that sellers are willing and able to sell.

Supply

Law of SupplyThe claim that other things equal the

quantity Supplied of a good increase when the price

of The good increases.

Price of cone

Quantity Supplied

0 0

50 0

100 1

150 2

200 3

250 4

300 5

Supply

Shifts in the Supply Curve

• Shifts to the right increase supply• Shifts to the left decrease supply

Input Prices

Costs of inputs. If they increase production decreases, if they decrease production will increase

Technology Machinery increases productivity

Expectation Number of Sellers

Variables that cause the supply curve to

shift

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

Market Equilibrium

Law of Supply and DemandThe claim that the price of any good adjusts to bring the Qd and the Qs for the good into

balance.

Surplus – A situation where Qs is greater than

Qd Shortage – A situation where Qd is greater

than Qs

Surplus and Shortage

No change in Supply

An increase in supply

Decrease in supply

No change in demand

P.Q No change

P downQ up

P upQ down

Increase in Demand

P up Q down

P ambiguousQ up

P is upQ ambiguous

Decrease in demand

P downQ up

P downQ ambiguous

P ambiguousQ down

We use absolute numbers even though Qd is negatively related to its price.

|Ped|= △Q/△P = 20/10 = 2

Elasticity of Supply and Demand

Price Elasticity

of Demand

Perfectly Inelastic Demand Inelastic Demand Unitary Elastic Demand Elastic Demand Perfectly Elastic Demand

Different Types of Demand

Sustainability Nature of the Product Proportion of Income Definition of Market The Possibility of new purchases Time Horizons Addiction Complementary goods Price expectations

Determinants of Price Elasticity

A measure of how much the quantity

demanded for a good responds to a change in consumers income.

Income Elasticity of Demand

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

(Ey)

The measure of how much the quantity

demanded of one good responds to a change in the price of another good.

The Cross Price Elasticity of Demand

Es = △Q/Q = △Q x P △P/P △P Q

Price Elasticity of Supply

Time Excess Supply or Unsold Stock Factor Mobility Natural Constraints Risk Taking

Determinants of Elasticity of Supply