Department of Business Administration

1. Department of Business Administration FALL 2007-08 Demand, Supply, and Equilibrium by Asst. Prof. Sami Fethi

2. Demand, Supply and Equilibrium • Economics begins and ends with the “Law” of supply and demand. The laws of supply and demand are an important beginning in the attempt to answer vital questions about theworking of a market system.

3. Demand, Supply and Equilibrium • Demand for a good or service is defined as quantities of a good or service that people are ready (willing and able) to buy at various prices within some given time period, other factors besides price held constant.

4. Demand, Supply and Equilibrium • The supply of a good or service is defined as quantities of a good or service that people are ready to sell at various prices within some given time period, other factors besides price held constant.

5. Demand, Supply and Equilibrium • Every market has a demand side and a supply side. The demand side can be represented by a market demand curve which shows the amount of commodity buyers would like to purchase at different prices. • Demand curves are drawn on the assumption that buyers’ tastes, income, the number of consumers in the market and the price of related commodities are unchanged.

6. Law of Demand • The inverse relationship between the price of the commodity and the quantity demanded per period is referred to as the law of demand. • A decrease in the price of a good, all other things held constant (ceteris paribus), will cause an increase in the quantity demanded of the good. • An increase in the price of a good, all other things held constant, will cause a decrease in the quantity demanded of the good.

7. Change in Quantity Demanded Price An increase in price causes a decrease in quantity demanded. P1 P0 Quantity Q1 Q0

8. Change in Quantity Demanded Price A decrease in price causes an increase in quantity demanded. P0 P1 Quantity Q0 Q1

9. Changes in Demand • Changes in price result in changes in the quantity demanded. • This is shown as movement along the demand curve. • Changes in nonprice determinants result in changes in demand. • This is shown as a shift in the demand curve.

10. Changes in Demand • Nonprice determinants of demand • Tastes and preferences • Income • Prices of related products • Future expectations • Number of buyers

11. Changes in Demand • Change in Buyers’ Tastes -Today’ consumer purchases leaner meats compared to old generations -due to the level of blood cholesterol and body weight • Change in Buyers’ Incomes • Normal Goods i.e., shoes, steaks, travel, automobiles, education • Inferior Goods • i.e., potatoes, hotdogs, hamburger • Change in the Number of Buyers • Change in the Price of Related Goods • Substitute Goods • i.e., Carrots can be replaced by cabbage • Complementary Goods • i.e., cars and gasoline or electric stove and electricity.

12. Change in Demand An increase in demand refers to a rightward shift in the market demand curve. Price P0 Quantity Q0 Q1

13. Change in Demand A decrease in demand refers to a leftward shift in the market demand curve. Price P0 Quantity Q1 Q0

14. Demand, Supply and Equilibrium • Every market has a demand side and a supply side. The Supply side can be represented by a market supply curve which shows the amount of commodity sellers would offer a sale at various prices. • Supply curves are drawn on the assumption of technology and input or resources (as such labor, capital and land) and prices.

15. Law of Supply • The direct relationship between the price of the commodity and the quantity supplied per period is referred to as the law of supply. • A decrease in the price of a good, all other things held constant (ceteris paribus), will cause a decrease in the quantity supplied of the good. • An increase in the price of a good, all other things held constant, will cause an increase in the quantity supplied of the good.

16. Change in Quantity Supplied A decrease in price causes a decrease in quantity supplied. Price P0 P1 Quantity Q1 Q0

17. Change in Quantity Supplied An increase in price causes an increase in quantity supplied. Price P1 P0 Quantity Q0 Q1

18. Changes in Supply • Nonprice determinants of supply • Costs and technology • Prices of other goods or services offered by the seller • Future expectations • Number of sellers • Weather conditions

19. Changes in Supply • Change in Production Technology - An improvement in the technology and a reduction in input prices would make it possible to produce a commodity at a lower cost. This indicates that sellers would be willing to sell more the goods at each price • Change in Input Prices -↓ in agriculture product, ↓ price of lamb meat, ↑ quantity supplied so rightward shift in the market supply curve • Change in the Number of Sellers - ↑ in no of sellers, the market supply curveshifts to right or ↓ in no of sellers, the market supply curveshifts to left • Prices of other goods or services offered by the seller - i.e., BMW, Mercedes, Woswagen (Subs. Goods) - i.e., lamp meat and lamp leather (comp. Goods)

20. Change in Supply An increase in supply refers to a rightward shift in the market supply curve. Price P0 Quantity Q0 Q1

21. Change in Supply A decrease in supply refers to a leftward shift in the market supply curve. Price P0 Quantity Q1 Q0

22. Market Equilibrium • Market equilibrium is determined at the intersection of the market demand curve and the market supply curve. • Equilibrium price: The price that equates the quantity demanded with the quantity supplied. • Equilibrium quantity: The amount that people are willing to buy and sellers are willing to offer at the equilibrium price level. • The equilibrium price causes quantity demanded to be equal to quantity supplied. • An increase or decrease in the demand or supply curve, it defines a new equilibrium point.

23. If the quantity supplied of a commodity exceeds the quantity demanded, this is called excess supply or surplus between D and S over point p. • If the quantity demanded of a commodity exceeds the quantity supplied, this is called excess demand or shortage between D and S below point p. Market Equilibrium Price D S P Quantity Q

24. Market Equilibrium • Shortage: A market situation in which the quantity demanded exceeds the quantity supplied. • A shortage occurs at a price below the equilibrium level. • Surplus: A market situation in which the quantity supplied exceeds the quantity demanded. • A surplus occurs at a price above the equilibrium level.

25. Market Equilibrium

26. D1 P1 Q1 Market Equilibrium Price D0 S0 An increase in demand will cause the market equilibrium price and quantity to increase. P0 Quantity Q0

27. D1 P0 P1 Q1 Q0 Market Equilibrium Price D0 S0 A decrease in demand will cause the market equilibrium price and quantity to decrease. Quantity

28. S0 S1 P1 Q1 Market Equilibrium Price An increase in supply will cause the market equilibrium price to decrease and quantity to increase. D0 P0 Quantity Q0

29. S1 S0 P1 P0 Q1 Q0 Market Equilibrium Price A decrease in supply will cause the market equilibrium price to increase and quantity to decrease. D0 Quantity

30. The Demand Schedule and the demand curveExample • How can the relationship between quantity demanded and price be portrayed? • Demand schedule • Demand curve

31. P (price per ton) D (quantity demanded) Thousands ton per months U $ 20 110 V 40 90 W 60 77.5 X 80 67.5 Y 100 62.5 Z 120 60 Av income:$ 20000 Table 1: A demand schedule for carrots • Table 1 is a hypothetical demand schedule for carrots. It shows the quantity of carrots that would be demanded at various prices on the assumption that average household income is fixed at $ 20000 and all other price do not change. (i.e. if the price of carrots were $60 per ton, consumers would desire to purchase $77,500 tons of carrots per month.

32. A demand curve for carrots • A second method of showing the relation between quantity demanded and price is to draw a graph. It is a downward slope which indicates quantity demanded increases as price falls.

33. Shifts in the demand curve-Example • A demand curve or line is drawn on the assumption that everything except the commodity’s own price is held constant. A change in any of variables previously held constant will shift the demand curve or line to a new position. (i.e. A rise in household income has shifted the demand curve or line to the right. • A demand curve can shift in mainly two ways:If more bought at each price, the demand curve shift right so that each price corresponds to a higher quantity than before. If less is bought at each price, the demand curve shifts left so that each price represents to a lower quantity than before.

34. P Q (D) Q1 (D1) $ 20 110 140 40 90 116 60 77.5 100.8 80 67.5 87.5 100 62.5 81.3 120 60 78 Table 2: Two Alternative Demand Schedule for carrots • An increase in average income will rise the quantity demanded at each price. When AV income rises from $20000 to $ 24000 per year, quantity demanded at price of $60 per ton increases from 77500 tons per month to 100800 tons per month. Similar rise occurs at every other price. Av in: $ 20000 $ 24000

35. Table 2: Two Alternative Demand Schedule for carrots • Put differently, A rise in av household income shifts the demand curve for most commodities to right so this indicates that more will be demanded at each possible price. Ultimately, the demand schedule relating columns P and D is replaced by one relating columns P and D1 in the previous table. The graphical presentation of the two functions are seen in the following graph.

36. P Q (D) Q1 (D1) $ 20 110 140 40 90 116 60 77.5 100.8 80 67.5 87.5 100 62.5 81.3 120 60 78 Shifts in the demand curve-Example 160 140 Q1D1 120 100 80 price 60 Q D 40 20 0 60 80 90 100 120 140 Quantity

37. Other Prices • Earlier, we saw that the downward slope of a commodity’s demand curve occurs because the lower its price, the cheaper the commodity is relative to other commodities that can satisfy the same needs or desires. Those other commodities are called substitutes (i.e. Carrots can be made cheap relative to cabbage either by lowering the price of carrots or raising the price of cabbage). • A rise in the price of a substitute for a commodity shifts the demand curve for the commodity to the right.

38. Other Prices • Another class of commodities is called complements. These are the commodities that tend to be used jointly each other. Such as cars and gasoline or electric stove and electricity. • A fall in the price of a complementary commodity will shift a commodity’s demand curve to the right. • For example, a fall in the price of airplane trips to Paris will lead to a rise in the demand for Disney Land tickets at paris even though their price is unchanged.

39. Tastes • Tastes have a large effect on people’s desired purchased. A change in tastes may be long-lasting such as the shift from fontain pens to ball-point pens. In this case, a change in tastes in favor of a commodity shifts the demand curve to the right.

40. Distribution of Income • A change in the distribution of income will shift to the right the demand curves for commodities bought most by those gaining income. On the other hand, it will shift to the left the demand curves for commodities bought most by those losing income. • If, for example, the government increases the deductions for children on the income tax and compensates by raising basic taxes, income will be transferred from childness persons to the large familes. So commodity more heavily bought by families with no child decline in demand.

41. Population • Population growth does not by itself create new demand. The additional people must have purchasing power before demand is changed. • Extra people of working age, however, usually means extra output and if they produce, they will earn income. • When this happens, the demand for all the commodities purchased by the new income earners will rise. Thus a rise in population will shift the demand curves to the right.

42. Individual Demand function • The demand for a commodity arises from the consumers’ willingness and ability to purchase the commodity. Consumer demand theory postulates that the quantity demanded of a commodity is a function of / or depends on the price of the commodity, the consumers’ income, the price of related commodities, and the tastes of the consumer.

43. Functional form • Qdx= (Px, I, Py, T) • An inverse relationship is expected between the quantity demanded of a commodity and its price (law of demand). That is, when the price rises, the quantity purchased declines, and when the price falls, the quantity sold increases.

44. Functional form Qdx= (Px, I, Py, N,T) QdX/PX< 0 QdX/I > 0 if a good is normal QdX/I < 0 if a good is inferior QdX/PY > 0 if X and Y are substitutes QdX/PY < 0 if X and Y are complements

45. Recall: Consumer Demand Theory • Consumer demand theory postulates that the quantity demanded of a commodity per time period increases with a reduction in its price, with an increase in the consumer’s income, with an increase in the price of substitute commodities and a reduction in the price of complementary commodities, and with an increased taste for the commodity. On the other hand, the quantity demanded of a commodity declines with the opposite changes. • Consumer demand theory postulates that the quantity demanded of a commodity is a function of / or depends on the price of the commodity, the consumers’ income, the price of related commodities, the number of consumers in the market, and the tastes of the consumer.

46. Relating Concepts • The increase in Qx when Px falls occurs because in consumption, the individual consumer substitutes commodity x for other commodities which are now relatively expensive. This is called the substitution effect. • In addition, when Px falls, a consumer can purchase more of x with a given amount of money (i.e., the consumer’s real income increases). This is called the income effect. • The movement along a given demand curve resulting from a change in the commodity price is referred to as a change in the quantity demanded, while a shift in the demand curve resulting from a change in any of the factors that affect demand, other than the commodity price, is referred to as a change in demand.

47. Individual and Market Demand Curve Example Horizontal Summation: From Individual to Market Demand

48. Individual and Market Demand Curve Example • Given the following data: Pdx=$4 and Qdx=4 and Qddx=400, while at Px=$3, Qdx=6 and Qdd=600, construct the relevant individuals and market curves

49. Price Elasticity of Demand • The price elasticity of demand (Ep) is measured by the percentage change in the quantity demanded of the commodity divided by the percentage change in commodity’s price, holding constant all other variables in the demand function.

50. Price Elasticity of Demand Point Definition Or Elasticity at given point Linear Function