Module 2-Supply, Demand & Equilibrium

To be done- DEMAND ANALYSIS

✔ Assumptions of the competitive market model: all agents are price
takers, homogeneous products.
✔ Demand & supply: determinants of demand & supply, demand &
supply curves, consumer and producer surplus, divisibility, the
“laws” of demand and supply, movements along versus shifts of
demand and supply curves.
✔ Normal & inferior goods, complements & substitutes, individual
demand and supply vs market demand and supply
✔ Equilibrium prices and quantities, price as a mechanism for equilibration.
✔ Determination of equilibrium price and quantity.
Basics of demand
▪ By definition, demand is the ability and willingness of a consumer to buy or purchase a particular
product.
▪ To an economist, the term ‘demand’ refers to a specific relationship of various quantities (of a
particular product) per unit of time (say a day, a week, a month or a year) to such variable as the price
of the product under consideration, income of the buyer(s), prices of substitutes, prices of comple­
ments, expected future conditions, seasonal factors, availability of consumer credit and various other
factors.
▪ The Demand curve is the relationship between the Price and Quantity Demanded.
▪ The demand curve indicates the quantity of a good that people are willing to buy as the price per unit
changes.
▪ Mathematically, this relationship can be written in the form of an equation as :

▪ The equation explains that the demand is a function of the price of the product.
case study- Demand for Big Macs
Demand function
LAW OF DEMAND
▪ Law of Demand-The consumer buys more unit of the good when
the price is low and fewer units when the price increases. In other
words, demand is a negative function of the price. Graphically,
demand is a downward sloping curve labeled as “D”
Assumptions of the law of demand :
▪ The law is valid only when the following assumptions hold:
▪ (a) The price of the related goods remains the same.
▪ (b) The income of the consumers remains unchanged.
▪ (c) Tastes and preferences of the consumers remain the same. (d) All
the units of the goods are homogeneous.
▪ (e) Commodity should be a normal good..
Exceptions to the Law of Demand

• 1. Speculative Demand:
• 2. Veblen goods- luxury or status goods
• 3. Using Price as an Index of Quality:
• 4. Highly Essential Goods:
• 5. Giffen goods(low-priced, non-luxury product,
generally with no close subsititutes, for which
demand increases as the price increases and vice
versa)
Demand Schedule
It is a tabular presentation showing the different quantities
of a good that buyers of the good are willing to buy at
different prices during a given period of time.

Y=A - BX SLOPE= -B= CHG IN Y/CHG IN X

Q=A-BP SLOPE= -1/B = CHGIN P/CHG IN Q
P= A/B - Q/B, SLOPE =-1/B=-1/2
Q INTERCEPT= 40
P INTERCEPT=20, P= 20-0.5Q
Demand curve
▪ The graphical representation of the demand function is called a demand curve. The demand
curve also represents the average revenue function for the product. It is because aver­age
revenue is the same as the price of a product.
▪ The demand curve usually slopes downward from left to the right.
▪ The independent variable (price) is measured along the y-axis and dependent variable
(quantity) is measured along the x-axis. T
▪ If the income of the buyer increases, the consumer will buy more of the same commodity
even at the same price.
▪ A change in the price of a related good or a change in the tastes and preferences of buyers
is likely to have the same effect.
▪ Factors other than price are conceived as demand curve shifters — forces that move the
price-quantity relation­ship, left or right. Changes in demand imply such shifts of demand
curves.
Reasons behind Downward Slope of the Demand
Curve
• a)Law of Diminishing Marginal Utility.
• b)Substitution Effect.
• Substitution effect means with fall in the price of a good,
consumer feels a rise in relative price of other goods,
which in turn leads to more demand for the good.
• (c) Income Effect.
• (d) New Consumers Creating Demand.
Individual and market demand curve

The individual demand curve for good X is the quantities of good X demanded by one
participant in the market for good X.

The market demand curve for good X includes the quantities of good X demanded by all
participants in the market for good X. The market demand curve is found by taking the
horizontal summation of all individual demand curves.
Sum
• A market for a commodity consists of 3 individulas A, B, C
whose demand functins are:
• Qa= 40-2P
• Qb=25.5-0.75P
• Qc=36.5-1.25P
• Find the market demand function.
• Qm=Qa+Qb+Qc
• Qm=102-4P
• Suppose : P=36-0.5Qa, P=50-0.25Qb, P=40-2Qc, Find the
market demand function
Change in Quantity Demanded (Movement) vs. Change in Demand (Shift) of Demand Curve

• Movement: Change in Quantity Demanded

• A movement along the demand curve is caused by a change in the
price of the good, other things remaining constant. Movement along
a demand curve can bring about: (a) Expansion of demand, or (b)
Contraction of demand
• Shift: Change in Demand
• A shift of the demand curve is caused by changes in factors other
than price of the good. A shift of the demand curve can bring about:
(a) Increase in demand, or (b) Decrease in demand.
 A shift of demand curve versus movement along the demand curve

⮚ The shift in the demand curve is caused by factors other than price. This is referred as the
change in demand.
⮚ In contrast, change in quantity demanded, is shown by a movement along the curve
due to price changes (keeping other factors constant).
 Demand equation
• Qd = a – b(P)
• Q = quantity demand (the dependent variable)
• a = all factors affecting demand other than price (e.g. income, fashion)
• 1/b = slope of the demand curve.
• P = Price of the good. (an independent variable) P

Q P
40 0 Q-ve `Q
38 1
36 2
34 3
32 4
30 5
28 6
26 7
0 20
 Supply ANALYSIS

• Supply and demand analysis can:

▪ Help us understand and predict how real world economic
conditions affect market price and production
▪ Analyze the impact of government price controls, minimum
wages, price supports, and production incentives on the economy
▪ Determine how taxes, subsidies, tariffs and import quotas affect
consumers and producers.
• The Supply Curve
The relationship between the quantity of a good that producers are
willing to sell and the price of the good.
It Measures quantity on the x-axis and price on the y-axis. Mathem
atically:
• Qs= -c+dP
 Supply equation
• Qs=-c+dP
• c is the Q intercept and d is price coefficient of
supply. P Qs

• d is the inverse of the slope. 2 20

• d is change in Q/ change in P 3 50
4 80
• Higher the d, more responsive producers 5are to 110
price, flatter the curve. 6 140
7 170
• Find the supply equation by the following supply
schedule
The Supply Curve
 Factors Affecting Supply Curve

Just like demand which is effected by internal and external Factors. So is the Supply.

1.Costs of Production
2.Technology

•Cost of Production
• Labor
• Capital
• Raw Materials
Lower costs of production allow a firm to produce more at each price and vice versa i.e the supply curve shifts.
3. Subsidies/ Taxes
4. Price of other goods
5. Expectation about prices
6. Size of the market

Change in Supply and Change in Quantity Supplied

▪ Movement along the curve caused by a change in price. In other words, thee is only a change in Quantity Supplied
when prices changes. Or Factors within the Graph (Price).
• Change in Supply
• Shift of the curve caused by a change in something other than the price of the good would result in a change in Supply.
Just like we described Technology and cost of Production that effect Supply Curve other than Price.
Supply equation

• Example of linear supply curve

• P = 30+ 0.5(Qs) or Q=-60+2P
• Shift in slope of supply curve
• P = 30+ 1.2(Qs)
Qs P
0 30
10 35
20 40
30 45
40 50
50 55
60 70
Law of supply

• There is a positive relation between price and quantity

supplied.
• ASSUMPTIONS
• Competitive market
• Increase in marginal cost due to diminishing returns
• Aim at maximum profits or sales revenue
• Technology remains constant
• Input prices are constant
Shift in the supply curve

P = 0 + 1.2 (Qs) shifts the supply curve

downwards so it starts at the 0,0
Effect of specific tax on supply equation
• If supply equation is Qs= -c+dP, P= (c+Qs)/d.
• If specific tax T is imposed, new equation is P= T+(c+Qs)/d
• Example: P = 0 +2Q. Suppose specific tax is 5 Rs. per unit.
⮚ A specific tax will shift supply curve upwards by 5. After tax. The supply curve
will be
• P = 5+2Q
⮚ An Indirect tax will shift supply curve upwards by a certain percentage. e.g.
VAT = 20%
• P = 0+2Q. After VAT will be P = 0+(2Q * 1.2)
Effect of Subsidy on supply equation

❑Suppose we have supply curve

• P = 30+0.5Q
❑After subsidy of 10
• P = 20+0.5Q
Market Equilibrium
▪ When the demand for good X equals the supply of good X, the market for good X
is said to be in equilibrium.
▪ The determination of equilibrium quantity and price, known as equilibrium
analysis
▪ Equilibrium quantity of good X.
▪ The equilibrium price for good X- clearing price
▪ At the higher price P1, a surplus develops, so price falls. (Role of price as an
invisible hand).
▪ At the lower price P2, there is a shortage, so price is bid up.
Can the supply remain constant at each price? what does that signify?
Q. Industry demand and supply curve are; QD=1000 – 2P and Qs = 3P a. What is the
equilibrium price and quantity? b. Plot the demand and supply curve and show the
equilibrium point. c. At a price of Rs. 100, will there be a shortage or a surplus, how large
will it be? d. At a price of Rs. 300, will there be a shortage or a surplus, how large will it be?
Show in the diagram.
Shifts in demand and supply curves

How to determine the effect of any event:

1. Does the event affect the demand or supply

side in the market
2. What is happening to the demand or supply
curves in the market
3. How does the change impact the market
equilibrium.
Determination of equilibrium price and quantity

• Let us suppose we have two simple supply and demand equations

• Qd = 20 – 2P Suppose a subsidy of Rs.2.
• Qs = -10 + 2P P=0.5Qs+5, P= 0.5Qs+3, P=0.5(20-2P)+3, P=6.5 ,
Q=7
• To find where QS = Qd we put the two equations together
• 20-2P = -10 + 2P
• 20+10= 4P
• 30/4=P
• P = 7.5
• To find Q, we just put this value of P into one of the equations
• Q = 20 – (2×7.5)
• Q= 5
 Qd = 20 – 2P Qs = -10
+ 2P

P Qd QS
0 20 -10
1 18 -8
2 16 -6
3 14 -4
4 12 -2
5 10 0
6 8 2
7 6 4
7.5 5 5
8 4 6
9 2 8
10 0 10
11 -2 12
12 -4 14
case study
• LINES AT THE GAS PUMP
As we discussed in Chapter 5, in 1973 the Organization of Petro_x0002_leum Exporting
Countries (OPEC) reduced production of crude oil, thereby increasing its price in world oil markets.
Because crude oil is the major input used to make gasoline, the higher oil prices reduced the supply
of gasoline. Long lines at gas stations became commonplace, and motorists often had to wait for
hours to buy only a few gallons of gas. What was responsible for the long gas lines? Most people
blame OPEC. Surely, if OPEC had not reduced production of crude oil, the shortage of gasoline would
not have occurred. Yet economists blame the U.S. government regulations that limited the price oil
companies could charge for gasoline.

• Figure 2 reveals what happened. As panel (a) shows, before OPEC raised the price of crude
oil, the equilibrium price of gasoline, P1, was below the price ceiling. The price regulation,
therefore, had no effect.
• When the price of crude oil rose, however, the situation changed. The increase in the price of
crude oil raised the cost of producing gasoline, and this reduced the supply of gasoline. As
panel (b) shows, the supply curve shifted to the left from S1 to S2. In an unregulated market,
this shift in supply would have raised the equilibrium price of gasoline from P1 to P2,
• and no shortage would have resulted. Instead, the price ceiling prevented the price from rising
to the equilibrium level. At the price ceiling, producers were willing to sell QS, but consumers
were willing to buy QD. Thus, the shift in supply caused a severe shortage at the regulated
price.
• Eventually, the laws regulating the price of gasoline were repealed. Lawmakers came to
understand that they were partly responsible for the many hours Americans lost waiting in line
to buy gasoline. Today, when the price of crude oil changes, the price of gasoline can adjust to
bring supply and demand into equilibrium. ●
Price floor- case of minimum wages
PRICE CEILING & PRICE FLOOR

A price ceiling keeps a price from rising above a certain level (the “ceiling”), while
a price floor keeps a price from falling below a certain level (the “floor”).
• Show on a diagram- equilibrium price of ice cream rises from $3.00 to $3.30, and the equilibrium quantity falls from
100 to 90 cones. Because sellers sell less and buyers buy less in the new equilibrium, the tax reduces the size of
the ice-cream market.
• How Taxes on Buyers Affect Market outcomes?
CONSUMER SURPLUS
▪ Individual consumer surplus is the
difference between the maximum
amount that a consumer is willing to pay
for a good and the amount that the
consumer actually pays.
▪ It is the benefit from the consumption of
a product less the total cost of
purchasing it. s
1
▪ It is measured by the area below an
individual's demand curve and above
the market price of the product.
Producer surplus

▪ A producer surplus is a difference between

how much of a good the producer is willing
to supply versus how much he receives in
the trade.
▪ It is measured as the area above a
producer’s supply curve and below the
market price. S
▪ It is also defined as the difference between
E
the firm’s revenue and its total variable
cost.
A
Economic welfare

In market analysis economic welfare at

equilibrium can be calculated by adding
consumer and producer surplus.

Consumer surplus and producer surplus are the

basic tools that economists use to study the
welfare of buyers and sellers in a market.
P Total surplus in a market is the total value to
1 buyers of the goods, as measured by
their willingness to pay, minus the total cost to
sellers of providing those goods.

Welfare analysis considers whether economic

decisions by individuals, organisations, and the
government increase or decrease economic
welfare.
Evaluating the Market Equilibrium
• Those buyers who value the good more than the price choose to buy the
good; buyers who value it less than the price do not.
• Those sellers whose costs are less than the price choose to produce and sell
the good; sellers whose costs are greater than the price . THUS:

• 1. Free markets allocate the supply of goods to the buyers who value them
most highly, as measured by their willingness to pay.
• 2. Free markets allocate the demand for goods to the sellers who can
produce them at the lowest cost.
• 3. Free markets produce the quantity of goods that maximizes the sum of
consumer and producer surplus.(demand curve reflects the value to buyers and
the supply curve reflects the cost to sellers.)
Consumers gain an area of A and lose an area
of B.
Producers lose areas C and A NET GAIN IN CONSUMER SURPLUS= A-B
NET LOSS IN PRODUCER SURPLUS= A+C
NET LOSS IN TOTAL MARKET SURPLUS=
A+C- (A-B)
=B+C= DWL
Consumers lose an area of A and lose an area
of C.
Producers increase an area of A and lose B NET LOSS IN CONSUMER SURPLUS= A+C
B and C is dead weight loss NET GAIN IN PRODUCER SURPLUS= A-B
NET LOSS IN TOTAL SURPLUS= A+C- (A-B)
=B+C= DWL
Dead weight loss
• The loss in producer and consumer surplus due to an inefficient level of production
perhaps resulting from market failure or government failure.
 Government levies a $3 gas tax on producers
Effect of taxes Supply curve will shift up by $3.
Producers do not receive $5, they now only receive $2, as $3 has to be sent t
government.
Consumers responds by decreasing the quantity demanded for the higher pri
good.
• Before
• The market surplus before the tax has not been shown, as the process should be
routine. Ensure you understand how to get the following values:
• Consumer Surplus = $4 million
• Producer Surplus = $8 million
• Market Surplus = $12 million

• After
• The market surplus after the policy can be calculated in reference to Figure 4.7d
• Consumer Surplus (Blue Area) = $1 million
• Producer Surplus (Red Area)= $2 million
• Government Revenue (Green Area) = $6 million
• Market Surplus = $9 million
practice questions
Consider the supply and demand diagram below. Assume no
externalities.

If a price floor of $20 is introduced, then which area will represent the deadweight loss?
a) e.
b) e + d.
c) e + b + d.
d) The deadweight loss will be zero.
PRACTICE QUESTIONS
• Draw the demand and supply curves. What is unusual about the supply curve? Why might this be
true?
• What are the equilibrium price and quantity of tickets?
• Annual demand and supply for the Electronics company is given by:
• Qd=5000+0.5I+0.2A-100P and Qs=-5000+100P, where Q is the quantity per year, P is the
price, I is the income per household, and A is the advertising expenditure.
• A. If A=$10,000 and I=$25,000, what is the demand curve?
• B. Given the demand curve in part a, what is the equilibrium price and quantity?
• C. If consumer incomes increase to $30,000, what will be the impact on equilibrium price
and quantity?
• 1. Industry demand and supply curve are; QD=1000 – 2P and Qs = 3P
– What is the equilibrium price and quantity?
– Plot the demand and supply curve and show the equilibrium point.
– At a price of Rs. 100, will there be a shortage or a surplus, how large will it be?
– At a price of Rs. 300, will there be a shortage or a surplus, how large will it be? Show in the
diagram.

• 2. The market demand function for a product is given by Q d=300-2P. How much consumer surplus do
they receive when
• P=45?
• P=30?
• 3. Suppose the market demand and supply functions are given by Qd=60-P and Qs=P-20. Determine
the consumer and producer surplus if a price ceiling of 32 is imposed in this market. What is the
amount of dead weight loss?