EC 1008 Introduction to Microeconomics Lecture 2: Analyzing markets: supply and demand

1. Sotiris Georganas City University London EC 1008Introduction to MicroeconomicsLecture 2: Analyzing markets: supply and demand

2. Learning outcomes • To understand the demand and supply function • To outline the laws of demand and supply • To analyse what causes movements and shifts • To understand the concepts of equilibrium and comparative statics

3. Background • Understanding how markets work is a key part of a course in economics • In particular you need to understand the key role played by prices

4. Markets • Differ in a number of important ways • Number of buyers and sellers • Level of information • Knowledge about the product and different prices • How easy it is to set up in business • Barriers to entry • Can service/product be easily copied?

5. Perfect competition • One type of market structure • A market is perfectly competitive if no participant has market power • Market power: the power to set the price of the good • Key Assumptions • Numerous (many!) buyers and sellers • Perfect information • Free entry and exit

6. Demand, supply and (goods) markets

7. Demand • Demand: the amount of a good or service that consumers are willing and able to purchase at each price • Can be different from the amount purchased • Reflects the degree of value/pleasure/utility consumers place on the good/service • Different people will value the same good/service differently

8. Determinants of demand by consumers for goods and services What?

9. Determinants of demand by consumers for goods and services

10. Demand • Market demand function: relationship between quantity demanded of a particular product and all factors that influence demand Qdx= f(Px, Py, I,....) • Quantity demanded is the ‘dependent’ (endogenous) variable • Price, income etc are the independent variables

11. Demand curves • Isolate the impact of price • Qdx = f(Px) ceteris paribus • (demand depends on price, holding all else equal) • Complication – demand curves are drawn with price (independent variable) on the vertical axis • Why ? • Walras(1834 – 1910) developed the theory, with quantity the dependent variable • Marshall (1842 – 1924) developed graphical representation (probably following Cournot’s work 30 years earlier), with price as the dependent variable • Today we use Walrasian theory, but the Marshallian representation

12. Since price is the vertical axis we use the inverse demand for graphs • Inverse demand : Px= g(Qdx) • “Price as a function of quantity” • Direct demand : Qdx = f(Px) • Where g=f-1

13. Example: demand for potatoes

14. Monthly market demand for potatoes

15. Law of demand • Isolate the impact of price • ↑ Px ⇒ ↓ Qdx (Ceteris paribus) • ↓ Px ⇒ ↑ Qdx (Ceteris paribus) • Why? • Substitution effect - as price rises consumers have an incentive to switch to cheaper alternatives • Income effect - a rise in price reduces consumers’ `real’ income so they purchase less of a `normal’ good

16. Movements along and shifts in the demand curve • We can use this model of demand to analyse the effect on demand of changes in price and other variables, such as income. • We distinguish between these by use of special terms: • – Movement along the demand curve, for price changes • – Shift in the demand curve, for changes in other variables

17. Movement along the demand curve

18. An increase in demand

19. Types of goods • Substitutes: If price of X increases and demand for Y goes up, X and Y are substitutes. • Complements: If price of X increases and demand for Y goes down, X and Y are complements. • Normal Goods: If increase in income leads to increase in demand • Inferior goods: If increase in income leads to decrease in demand. • Examples?

20. Examples substitutes “inferior” “normal”

21. Supply • Supply – the amount of a good or service producers are willing to offer for sale at each and every price • Market supply function – relationship between quantity supplied and all the factors that influence that supply • Supply curve isolates the impact of price • Qsx = f(Px) ceteris paribus • Inverse supply curve: Px=g(Qsx) • As before, g=f-1

22. Determinants of supply

23. Supply • simple supply functionsQs=a+bP • more complex supply functionsQs=a+bP+dPi–ePj • asimple demand function Qd=a-bP

24. Example: supply of potatoes

25. Monthly market supply of potatoes

26. Law of supply • ↑ Px ⇒ ↑ Qsx (ceteris paribus) • Why? • Higher price, ceteris paribus, the more profitable the good. Acts as an incentive • In the short run, existing suppliers switch more resources into producing good X • The existing producers increase supply because it is profitable to produce more – has to do with the cost function.

27. Shifts in the supply curve

28. Market equilibrium

29. Market equilibrium: undersupply

30. Market equilibrium: oversupply

31. Market equilibrium: all clear

32. Effect of a shift in the demand curve on equilibrium

33. Effect of a shift in the supply curve on equilibrium

34. Example • Demand and supply curves are: Qd= a-bP (1) Qs= c+dP (2) • We need to solve for equilibrium price and quantity (P* , Q*) • Set quantity demanded and supplied equal, and solve for P . (1)=(2) => a-bP*=c+dP* => a-c= bP*+dP* => a-c= (b+d)P* => P*=(a-c)/(b+d) (3) Insert result (3) into (1) => Q*=a-b((a-c)/(b+d)) • So if, for example, a=30, b=1, c=0, d=2,we have P*=30/3 = 10 and Q*= 30-(10)=20 units

35. Learning outcomes • To understand the demand and supply function • To outline the laws of demand and supply • To analyse what causes movements and shifts • To understand the concepts of equilibrium and comparative statics