Lecture-1: Demand, Supply and Market

Equilibrium

Abdul Quadir
XLRI

August 27, 2020

Textbook and Evaluation

Textbook: Microeconomics by David Besanko and Ronald

Braeutigam

Evaluation
I Assignment 5 points
I Quiz 15 points
I Class Quizes 5 points
Readings

Chapter 2 of the Textbook

Introduction

I The exchange of goods and services happen in a complex way

through market system
I Market system is ubiquitous almost everywhere
I The complexity of market system arises because people have
heterogeneous preferences and wants
I The producers align their production along with the
preferences of people
I What are the basic forces that derive the market system?
I We would like to understand how the individuals and firms
make their decision of purchase and production in absence of
any central planner or director.
The Basic Decision Making Units: Firms and Households

I Firm: An organization that transforms resources (inputs) into

products (outputs)
I Firms are the primary producing units in a market economy
I When does a firm come into existence?
I A firm exists when a person or a group of people decides to
produce a product or products by transforming inputs
I Entrepreneur A person who organizes, manages, and
assumes the risks of a firm, taking a new idea or a new
product and turning it into a successful business
I In most cases, the objective of the firm is to make profits
I Households: The consuming units in an economy
Inputs and Output Markets

I The firms and households interact in both the input and

output market markets
I Product or output markets: The markets in which goods
and services are exchanged
I Input or factor markets: The markets in which the resources
used to produce products are exchanged
I Input and output markets are connected through the behavior
of both firms and households
I Analysis of demand and supply will lead up to a theory of how
market prices are determined
Circular Flow Graph
Demand

I A household’s decision about what quantity of a particular

output, or product, to demand depends on a number of
factors including:
1. The price of the product in question
2. The income available to the household
3. The household’s amount of accumulated wealth
4. The prices of other products available to the household
5. The household’s tastes and preferences
6. The household’s expectations about future income, wealth,
and prices
I Quantity demanded The amount (number of units) of a
product that a household would buy in a given period if it
could buy all it wanted at the current market price
Demand

I A household’s decision about what quantity of a particular

output, or product, to demand depends on a number of
factors including:
1. The price of the product in question
2. The income available to the household
3. The household’s amount of accumulated wealth
4. The prices of other products available to the household
5. The household’s tastes and preferences
6. The household’s expectations about future income, wealth,
and prices
I Quantity demanded The amount (number of units) of a
product that a household would buy in a given period if it
could buy all it wanted at the current market price
Change in Quantity Demanded and Demand

I We use often ceteris paribus, or “all else equal” except price

from the determinants of the demand
I We write that quantity demand is a function of price q(p)
I If prices changes, then the quantity demanded changes
I If income level of households change, then demand of goods
changes
Law of Demand

I Suppose there is a person named Karim who earns 50k per

month
I He lives alone in a flat
I He prefers eating outside than cooking his dinner
I Given his income level and prices, he can eat only 15 days
outside
I Suppose only the price of food in restaurant has increased, all
else are same
Karim’s Demand Schedule

I His number of times of eating outside in a month at different

prices are given by
Price (per meal) Quantity demanded (no. of eating outside)
0 30
100 25
150 23
200 15
250 12
300 5
350 0
Demand Curve

350

300

250

100
5 12 25 30 q
Law of Demand

I Law of demand: All else equal , there is a negative

relationship between price and quantity demanded
I As price rises, quantity demanded decreases. As price falls,
quantity demanded increases
I Mathematically, we can write demand function as q(p) where
dq
dp < 0
I Demand has a downward slope
I Demand curve helps to understand what could be behaviour
of the household under different levels of prices
I Why do we have downward slope for demand curve?
I Economists explain it by the concept of utility
I Why does the quantity demanded of some luxury item
increase even if prices increase?
Properties of Demand Curves

I They have a negative slope

I An increase in price is likely to lead to a decrease in quantity
demanded, and a decrease in price is likely to lead to an
increase in quantity demanded
I They intersect the quantity X -axis
I a result of time limitations and diminishing marginal utility
I They intersect the price Y -axis
I a result of limited incomes and wealth
Other Determinants of Demand: Income or Wealth

I Income: The sum of all household’s wages, salaries, profits,

interest payments, rents, and other forms of earnings in a
given period of time
I It is a flow measure
I Wealth or net worth: The total value of what a household
owns minus what it owes
I It is a stock measure
I In general, we would expect higher demand at higher levels of
income/wealth and lower demand at lower levels of
income/wealth
I Let us call m income or wealth level of a household.
I Mathematically, we can write quantity demanded as a
function of own price and wealth of a consumer, q(p, m)
Normal and Inferior Goods

Commodities could be classified as

I Normal goods: Goods for which demand goes up when
income is higher and for which demand goes down when
income is lower
I Inferior goods: Goods for which demand tends to fall when
income rises
∂q
I Mathematically if ∂m ≥ 0, then it is normal goods and if
∂q
∂m < 0, it is an inferior good.
Other Determinants of Demand: Prices of Other Goods

I No consumer decides in isolation about the amount of any

one commodity to buy
I We can write the demand function as function of own price
and price of related goods, q(p, p r )
I Substitutes Goods: These goods can serve as replacements
for one another: when the price of one increases, demand for
the other goes up
I Perfect substitutes: Identical products
I Complements, complementary goods: Goods that “go
together”: a decrease in the price of one results in an increase
in demand for the other, and vice versa
I Kindle and prices of e-books, Ipods and prices of songs etc
Other Determinants of Demand: Tastes and Expectation

I Tastes and preferences

I Two persons might have same amount of income right now
but they might have different expectation of future income
I For instance, a daily wage worker and a student
Shift in Demand Curve

I Note the demand is the function of price only, all else remain
constant
I ‘All else’ includes prices of other goods, tastes, income and
expectation
I If price of own product changes, quantity demanded changes
along that demand curve
I This is known as a movement along a demand curve
I What about the changes in other determinants of demands?
I Change in income, preferences, or prices of other goods or
services leads to Change in demand (shift of the demand
curve)
Shift in Demand Curve

I His number of times of eating outside in a month at different

prices are given by
Price (per meal) q at income level 50k q at income level 75k
0 30 30
100 25 27
150 23 25
200 15 17
250 12 13
300 5 6
350 0 0
Shift in the Demand Curve

350

300

250

100
5 12 25 30 q
Shift in The Demand Curve

q
General Form of demand Function
I We can write a general form of demand function for a
commodity as
qxd = f (px , py , m, h)
I The demand function can take different functional forms
I Linear is the most common form

qxd = α0 + αx px + αy py + αm m + αh h

I αi s are the fixed numbers that firm’s research department or

economic consultant typically provides
I What are the signs of αi s?
I αx < 0. αy could be negative or positive depending good y is
complement or substitute
I αm could be negative or positive depending good x is inferior
or normal
General Form of demand Function
I We can write a general form of demand function for a
commodity as
qxd = f (px , py , m, h)
I The demand function can take different functional forms
I Linear is the most common form

qxd = α0 + αx px + αy py + αm m + αh h

I αi s are the fixed numbers that firm’s research department or

economic consultant typically provides
I What are the signs of αi s?
I αx < 0. αy could be negative or positive depending good y is
complement or substitute
I αm could be negative or positive depending good x is inferior
or normal
Example: Demand Function

I Suppose an economic consultant provides the following

estimate of demand function to the marketing manager of
Corp. X

qxd = 12, 000 − 3px + 4py − 1m + 2Ax

I Ax is the advertisement expenditure

I Suppose px = 200, py = 15, m = 10, 000 and Ax = 200,
answer the following questions:
I How much of good x do consumers purchase?
I Are goods x and y substitutes or complements?
I Is good x a normal or inferior good?
Example: Plotting of Demand Function

I Note that a demand curve is a relation between price and

quantity
I Note also that a representative demand curve holds everything
constant except price
I To recover the formula for demand curve, we have to insert
the values of demand shifters, leaving only px in the equation
I For example, do this in the previous example

qxd = 12, 000 − 3px + 4 × 15 − 1 × 10, 000 + 2 × 2000

= 6060 − 3px
Example: Plotting Demand Curve
I Generally, we plot the demand function considering prices on
y −axis and quantity on x−axis
I We can write the above equation as
1
px = 2020 − qxd
3
I This is known as inverse demand curve
px

2020

6060 qx
Market Demand

I Market demand: The sum of all the quantities of a good or

service demanded per period by all the households buying in
the market for that good or service
I Mathematically, Qdi = ni=1 qix (p)
P
Market Demand
Market Demand

Suppose individual 1 and 2’s demand functions are given by

q1 (p) = 20 − p
q2 (p) = 10 − 2p

What is the market demand?

(
30 − 3p for p ≤ 5
Q d (p) =
20 − p for p > 5
Market Demand

Suppose individual 1 and 2’s demand functions are given by

q1 (p) = 20 − p
q2 (p) = 10 − 2p

What is the market demand?

(
30 − 3p for p ≤ 5
Q d (p) =
20 − p for p > 5
Supply

I Successful firms make profits because they are able to sell

their products for more than it costs to produce them
I Profit: The difference between revenues and costs.
I Supply schedule: A table showing how much of a product
firms will sell at different prices
Price (per Burger ) quantity supplied
0 0
100 10,000
150 20,000
200 30,000
250 45,000
300 45,000
Law of Supply

I Law of supply: The positive relationship between price and

quantity of a good supplied
I An increase in market price will lead to an increase in quantity
supplied
I A decrease in market price will lead to a decrease in quantity
supplied
Supply Curve

q
Other Determinant of Supply

Assuming that its objective is to maximize profits, a firm’s decision

about what quantity of output, or product, to supply depends on
1. The price of the good or service
2. The cost of producing the product, which in turn depends on
I The price of required inputs (labor, capital, and land)
I The technologies that can be used to produce the product
3. The prices of related products
Movement along or Shift of the Supply Curve

I Movement along a supply curve: The change in quantity

supplied brought about by a change in price
I Shift of a supply curve: The change that takes place in a
supply curve corresponding to a new relationship between
quantity supplied of a good and the price of that good
I The shift is brought about by a change in the original
conditions
I Example: Suppose the cost of producing burger has decreased
I More Burgers will be supplied at the same price
Shift in Supply

I Supply schedule: A table showing how much of a product

firms will sell at different prices
Price (per Burger ) quantity supplied quantity supplied
at new input cost
0 0 0
100 10,000 13,000
150 20,000 25,000
200 30,000 32,000
250 45,000 48,000
300 45,000 48,000
Shift in Supply Curve

S0

S1

q
Factors That Causes Shift in Supply Curve

I Change in price of a good or service leads to Change in

quantity supplied (movement along a supply curve).
I Change in income, preferences, or prices of other goods or
services leads to Change in supply (shift of a supply curve).
Supply Function

I Mathematically, we can write the supply function given by

qxs = f (px , pr , w , h)

I w is the price of the input h is the value of some other variable

that affects supply such technology, taxes, no. of firms etc.
I It could take different functional forms but linear form is more
in use
I Linear form is given by

qxs = β0 + βx px + βr pr + βw w + βh h
Example: Supply Function

I Suppose a TV manufacturer estimates that the supply

function of its television is given by

qxs = 2, 000 + 3px − 4pr − pw

I px is the price of the television, pr is the price of a computer

monitor, pw is the price of an input made for making
television.
I Suppose px = 20, 000, pr = 10, 000 and pw = 8000.
I How many units of television will be sold?
Market Supply
Equilibrium

I Equilibrium: The condition that exists when quantity

supplied and quantity demanded are equal
I At equilibrium, there is no tendency for price to change
I Mathematically, we equat Qxd = Qxs for finding the equilibrum
quanity and price
I Excess demand or shortage: The condition that exists when
quantity demanded exceeds quantity supplied at the current
price
I For unregulated market, if there is excess demand, then there
is a tendency that price increases
I For instance, take the example of auctions
Excess Demand

3 shortage

200 300 400 q

Excess Supply or Surplus
I Excess supply or surplus: The condition that exists when
quantity supplied exceeds quantity demanded at the current
price
p

3 surplus

200 300 400 q

Example: Market Equilibrium

I Consider the demand and supply estimated for a product is

given by
Q d = 10 − 2p Q s = 2 + 2p
I What is the equilibrium price and quantity?
I p ∗ = 2 and Q ∗ = 6
Example: Market Equilibrium

I Consider the demand and supply estimated for a product is

given by
Q d = 10 − 2p Q s = 2 + 2p
I What is the equilibrium price and quantity?
I p ∗ = 2 and Q ∗ = 6
Example: Comparative Statics
Suppose that the demand and supply (when p ≥ 8) for aluminum
are given by the equations

Qd = 500 − 50p + 10m, Qs = −400 + 50p

where p is the price of aluminum expressed in rupees per kilogram

and m is the average income per person (in thousands of rupees
per year) and quantity is measured in millions of kilograms of
aluminum per year.
1. What is the market equilibrium price of aluminum when
m = 10 (i.e., 10,000 rupees per year)?
2. What happens to the demand curve if average income per
person is only 5,000 rupees per year. Calculate the impact of
this demand shift on the market equilibrium price and quantity
and then sketch the supply curve and the demand curves
(when m = 10 and when m = 5) to illustrate this impact.
Example: Comparative Statics

10
9.5

D1 , m = 10
D2 , m = 5

75 100 q