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Chapter

Topic 3 3
Supply and
DEMAND AND SUPPLY
Demand
ANALYSIS
Managerial Economics: Economic
Tools for Today’s Decision Makers, 4/e
By Paul Keat and Philip Young
MICROECONOMICS (ECO101)
MNU Business School
The Maldives National University

Ahmed Munawar
(I) MARKET DEMAND

The 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.

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Demand in Output Markets

ANNA'S DEMAND
• A demand schedule is a
SCHEDULE FOR table showing how
TELEPHONE CALLS much of a given product
QUANTITY a household would be
PRICE DEMANDED
(PER (CALLS PER willing to buy at
CALL) MONTH) different prices.
$ 0 30
0.50 25 • Demand curves are
3.50 7
7.00 3
usually derived from
10.00 1 demand schedules.
15.00 0

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The Demand Curve
ANNA'S DEMAND
SCHEDULE FOR • The demand curve
TELEPHONE CALLS
QUANTITY
is a graph
PRICE
(PER
CALL)
DEMANDED
(CALLS PER
MONTH)
illustrating how
$ 0
0.50
30
25
much of a given
3.50
7.00
7
3 product a
10.00 1
15.00 0 household would
be willing to buy
at different prices.

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Market Demand
Market demand is the sum of all the
individual demands.

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Market Demand is the Sum of
Individual Demands

• Assuming there are only two households in the


market, market demand is derived as follows:

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The Law of Demand
• The law of demand states
that there is a negative, or
inverse, relationship
between price and the
quantity of a good
demanded and its price.

• This means that demand


curves slope downward.

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The Law of Demand—Explanations

• There are two ways to explain the Law


of Demand
• Substitution effect
• Income effect

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Two Reasons for the Inverse
Relationship

• Substitution effect P Q
• When price of a good decreases, the
consumer substitutes the lower priced
good for the more expensive ones.
• Income effect
• When price decreases, the consumer’s
real income (or purchasing power)
increases, so he tends to buy more.
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Two Reasons for the Inverse
Relationship

1. Substitution effect
P Q
• When price of a good increases, the
consumer tends to substitute it with the
lower priced goods.
2. Income effect
• When price increases, the consumer’s
purchasing power (or real income)
decreases, so he tends to buy less.
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Shift of Demand Versus Movement
Along a Demand Curve
• 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.
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Shift of Demand Versus Movement Along
a Demand Curve
• A change in demand is
not the same as a change
in quantity demanded.
• In this example, a higher
price causes lower
quantity demanded.

• Changes in determinants
of demand, other than
price, cause a change in
demand, or a shift of the
entire demand curve, from
DA to DB.
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Change in quantity demanded
Price
•A decrease in price from p1
to p2 brings about an
p1 increase in quantity
demanded from q1 to q2
•It is shown as a movement
along the same demand
p2 curve

Quantity
q1 q2

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Change in demand
•An increase in demand
Price means that at the same
price such as p1 more will
be brought, due to other
factors such as increased
p1 incomes, increase in number
of consumers, etc.
•It is shown as a shift in the
entire demand curve

This is a
decrease in
demand D1

D0
D2
Quantity
q1 q2

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Change in Demand

P P

D’ D
D’
D

Q Q

Increase in Demand Decrease in Demand

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Nonprice determinants of demand

1. Consumer incomes
2. Prices of related commodities
(substitutes and complements)
3. Tastes and preferences
4. Number of consumers
5. Price expectations

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Nonprice determinants of demand
1. Income: As income changes, demand a commodity
usually changes
• Normal goods – are goods whose demand respond
positively to changes in income.
• Most goods are normal goods. As income increases, more of
shoes, TVs, clothes, are bought.
• Inferior goods – are goods whose demand respond
negatively to change in income
• Few but existent. Examples are firewood, “tuyo”, “adidas or
chicken feet”, bicycles, etc.

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The Impact of a Change in Income
• Higher income • Higher income
decreases the demand increases the demand
for an inferior good for a normal good

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Other factors affecting demand
2. Prices of related commodities in consumption:
• Substitutes – are goods that are substitutable with each other
(not necessarily perfect).
• Examples are coffee and tea, Coke and Pepsi
• When the price of a substitute increases, quantity bought of a
good increases. --- Py Qx  (direct relationship)

Complements – are goods that are used or consumed together.


• Examples are coffee and sugar, bread and butter, tennis
rackets and tennis balls.
• When the price of a complement increases, quantity bought of
a good decreases. --- Py Qx (inverse relationship)

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The Impact of a Change in the Price of
Related Goods
• Demand for complement good (ketchup) shifts left

• Demand for substitute good (chicken) shifts right

• Price of hamburger rises


• Quantity of hamburger
demanded falls
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Other factors affecting demand

3. Consumer tastes and preferences:


• When consumer tastes shift towards a particular good,
greater amounts of a good are demanded at each price.
• Example: consumers preference for drinking mineral
water increases so its demand curve will shift
rightward.
• If consumer preferences change away from a good, its
demand will decrease; at every possible price, less of the
good is demanded than before.
• Example: the demand for VCDs and VHS tapes
decreases due to preference for DVDs.

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Other factors affecting demand

4. Consumer expectations: Expectations about


future prices and income affect our current
demand for many goods and services.
• If we expect prices of dried fish to increase with
coming of the rainy season, we might stock up on the
good to avoid the expected price increase. Thus, current
demand for dried fish might increase
• those who expect to lose their jobs due to bad economic
conditions, will reduce their demand for a variety of
goods in the current period.

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Other factors affecting demand
5. Number of Consumers: affects the total
demand for a good.
• Total demand is also known as market demand. It is the
summation of the individual demand of all consumers
• An increase in the number of consumers shifts the
market demand curve to the right
• Example: demand for housing and transportation
increases with an increase in population.
• On the other hand, less consumers will cause the
market demand to decrease, resulting in a shift to
the left of the entire demand curve.

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General Demand Function
• Variables that influence Qd
• Price of good or service (P)
• Incomes of consumers (M)
• Prices of related goods & services (PR)
• Taste patterns of consumers (  )
• Expected future price of product (Pe)
• Number of consumers in market (N)
• General demand function
• Qd  f ( P, M , PR , , Pe , N )
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Demand Function

• Quantity demanded (Q) is expressed as a


mathematical function of price (P). The demand
function may thus be written as:

Qd = a - bP
where
• a is the horizontal intercept of the equation or the
quantity demanded when price is zero
• (-b) is the slope of the function.
• Example: Qd = 8 - 0.02P
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Demand Function
• The processed fish demand function is:
Q = D(p, pb, pc, Y)

• where Q is the quantity of fish demanded


• p is the price of fish (dollars per kg)
• pb is the price of beef (dollars per kg)
• pc is the price of chicken (dollars per kg)
• Y is the income of consumers (thousand dollars)

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Demand Function to the Demand Curve
• Estimated demand function for fish:

Q = 171−20p + 20pb + 3pc + 2Y

• Using the values pb = 4, pc = 3.33 and Y = 12.5,


we have
Q = 286−20p

• which is the linear demand function for fish.

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Demand Function to the Demand Curve
Q = 286−20p
If p = $3.30 then,
p, $ per kg

14.30 If p = 0, then
Q = 220
Q = 286
Demand curve for fish D1
In general,
DQ = -20Dp
= slope Dp

4.30
3.30
2.30

0 200 220 240 286


Q, Million kg of fish
r per year

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Solved Problem

1. Express the price that consumers are


willing to pay as a function of quantity.
Q = 286−20p

20p = 286 - Q

p = 14.30 − 0.05Q

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Solved Problem
2. Use the inverse demand curve to determine how
much the price must change for consumers to
buy 1 million more kg of pork per year.

Δp = p2 − p1
= (14.30 − 0.05Q2) − (14.30 − 0.05Q1)
= –0.05(Q2 − Q1)
= –0.05ΔQ.
• The change in quantity is ΔQ = Q2 − Q1 = (Q1 +
1)−Q1 = 1, so the change in price is Δp = –0.05.

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(II) MARKET SUPPLY

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.

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The Supply Curve and
the Supply Schedule

• A supply curve is a graph illustrating how much


of a product a firm will supply at different prices.

Price of soybeans per bushel ($)


CLARENCE BROWN'S 6
SUPPLY SCHEDULE 5
FOR SOYBEANS
QUANTITY 4
SUPPLIED
PRICE (THOUSANDS 3
(PER OF BUSHELS
BUSHEL) PER YEAR)
2
$ 2 0
1
1.75 10
2.25 20 0
3.00 30
4.00 45 0 10 20 30 40 50
5.00 45 Thousands of bushels of soybeans
produced per year

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Market Supply

• As with market demand, market supply is the


horizontal summation of individual firms’ supply
curves.

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The Law of Supply
• The law of supply
Price of soybeans per bushel ($)

6
states that there is a
5
positive relationship
4
3
between price and
2 quantity of a good
1 supplied.
0 • This means that
0 10 20 30 40 50
Thousands of bushels of soybeans supply curves
produced per year
typically have a
positive slope.
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Shift vs. movement of market supply

• Changes in price result in changes in the


quantity supplied.
• This is shown as movement along the supply
curve.
• Changes in nonprice determinants result in
changes in supply.
• This is shown as a shift in the supply curve.

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Change in quantity supplied
S
Price
•An increase in price from p1
to p2 results in an increase in
quantity supplied from q1 to
p2
q2
•It is shown as a movement
along the same supply curve
p1

Quantity
q1 q2

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Change in supply
S2 S0
S1
Price

•An increase in supply


p1 means that at the same
price such as p1 more will
be sold, due to other factors
such as improvement in
technology, increase in
number of producers, etc.
This is a
decrease in •It is shown as a shift in the
supply entire supply curve

Quantity
q1 q2
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Change in Supply
S’
P S P
S
S’

Q Q

Increase in Supply Decrease in Supply

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A Change in Supply Versus
a Change in Quantity Supplied
To summarize:
Change in price of a good or service
leads to

Change in quantity supplied


(Movement along the curve).

Change in costs, input prices, technology,


or prices of related goods and services
leads to
Change in supply
(Shift of curve).

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Non-price determinants of supply

Non-price determinants of supply


1. resource prices
2. prices of related goods in production
3. technology
4. expectations
5. number of sellers.

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Other factors affecting supply

1. Resource prices:
• When prices of inputs to production
increase, the supply of the firm's
product decreases.
• Decreases in resource prices, however,
translate to an increase in supply. The
entire supply curve shifts to the right.

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Other factors affecting supply
2. Prices of related goods in production:
• Resources can be employed to produce several
alternative goods and services.
• Examples from agriculture:
• a piece of farmland can be use to grow rice, corn, or
sugarcane. An increase in price of sugarcane may
result in decreased supply of rice and corn.
• farmers can use their land and labor to produce
ornamental flowers instead of vegetables. If vegetable
prices decrease, the supply of ornamental flowers may
increase.
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Other factors affecting supply

3. Technology:
• A change in production techniques can lower or
raise production costs and affect supply.
• Improvements in technology shift the supply
curve to the right.
• A cost-saving invention will enable firms to produce
and sell more goods than before at any given price.
• New high yielding crop varieties will increase
production on the same amount of land.

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Other factors affecting supply

4. Producer expectations:
• When producers expect the price of their product to
increase in the future, they may hoard their output for
later sale, thus reducing supply in the present period.
Thus the supply curve shifts to the left.
• If firms expect that the price of their product will fall
in the near future, supply may increase in the current
period as firms try to increase production as well as to
dispose of their inventory.

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Other factors affecting supply

5. Number of sellers:
• As the number of sellers increases, so will total
supply.
• The market supply is the horizontal summation of the
supply schedules of individual producers.
• As more firms enter the market, more will offered for
sale at each possible price, thus shifting the supply
curve to the right.
• Similarly, the supply curve shifts to the left when
firms exit the market.

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Market Supply
• Variables that influence Qs
• Price of good or service (P)
• Input prices (PI )
• Prices of goods related in production (Pr)
• Technological advances (T)
• Expected future price of product (Pe)
• Number of firms producing product (F)
• General supply function
• Q  f ( P, P , P , T , P , F )
s I r e
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General Supply Function
Qs  h  kP  lPI  mPr  nT  rPe  sF
• k, l, m, n, r, & s are slope parameters
• Measure effect on Qs of changing one of the
variables while holding the others constant
• Sign of parameter shows how variable is
related to Qs
• Positive sign indicates direct relationship
• Negative sign indicates inverse relationship

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Supply Function

• Quantity supplied (Qs) is expressed as a


mathematical function of price (P). The supply
function may thus be written as:

Qs = c + dP
where
• c is the horizontal intercept of the equation or the
quantity demanded when price is zero
• d is the slope of the function.
• Example: Qs = 0 + 0.02P
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(III) MARKET EQUILIBRIUM
• Market equilibrium is that state in which the
quantity that firms want to supply equals the
quantity that consumers want to buy.
• The price that clears the market is called the
equilibrium price and the quantity (sold and
bought) is called the equilibrium quantity.
• The market is said to be "at rest" since the
equilibrium price and equilibrium quantity will
stay at those levels until either demand or supply
changes.
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Market Equilibrium

• 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.

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Market Equilibrium
TABLE 3.3. Market for Denim Pants
Quantity Demanded Quantity Supplied
Price of Denim Pants per month per month
(in pesos) (No. of pairs) (No. of pairs)
0 8 0
Equilibrium
Price=200 50 7 1
100 6 2
150 5 3
200 4 4
250 3 5
300 2 6
350 1 7
400 0 8 Equilibrium
Quantity=4

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Market Equilbrium
• At prices above the equilibrium price, quantity supplied
is greater than quantity demanded, resulting in a
temporary surplus.
• In a surplus situation, producers will try to reduce price to
entice consumers to buy more denim pants. Actions by both
producers and the public will wipe out the temporary surplus
• At prices below the equilibrium price, consumers desire
to buy more denim pants than are available, creating a
temporary shortage.
• Consumers will try to outbid each other, thus pushing up the
price. As price rises, firms increase their production while
some consumers reduce their purchases.
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Market Disequilibria

• Excess demand, or
shortage, is the condition
that exists when quantity
demanded exceeds quantity
supplied at the current price.

• When quantity demanded


exceeds quantity supplied,
price tends to rise until
equilibrium is restored.

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Market Disequilibria
• Excess supply, or surplus, is
the condition that exists
when quantity supplied
exceeds quantity demanded
at the current price.

• When quantity supplied


exceeds quantity demanded,
price tends to fall until
equilibrium is restored.

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Market Equilibrium

400 S

Surplus
Price (in pesos)

300

200

100
Shortage
0 2 4 6 8 Q

Quantity

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Example 1
Using Math to Determine the Equilibrium

• Algebraic solution: equate the demand and supply


equations (Qd=Qs).
Qd = 8 - 0.02P
Qs = 0 + 0.02 P
• Step by step solution:
• 8 - 0.02P = 0 + 0.02 P
• 0.04P = 8
• P* = 8/0.04 = 200
• Qd = 8 – 0.02(200) = 8 – 4 = 4
• P* =200 per unit, Q* = 4 per month
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Example 2
Using Math to Determine the Equilibrium

• Demand: Qd = 286 − 20p


• Supply: Qs = 88 + 40p
• Equilibrium:
Qd = Q s
286 − 20p = 88 + 40p
60p = 198
P = $3.30
Q = 286 – 20(3.3) = 220
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Example 3
Using Math to Determine the Equilibrium
Demand QD = 50 – P (i)
Supply QS = – 10 + 2P (ii)

Set QD = QS find market equilibrium P and


Q P
50
• 50 – P = – 10 + 2P
• 3P = 60 S
• P = 20

Knowing P, find Q 20
• Q = 50 – P
• = 50 – 20 = 30
5
D
Check the solution
• i) 30 = 50 – 20 and (ii) 30 = – 10 + 40 -10 0 30 50 Q

In both equations if P=20 then Q=30

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Increases in Demand and Supply

• Higher demand leads to higher • Higher supply leads to lower


equilibrium price and higher equilibrium price and higher
equilibrium quantity. equilibrium quantity.
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Decreases in Demand and Supply

• Lower demand leads to lower • Lower supply leads to higher


price and lower quantity price and lower quantity
exchanged. exchanged.
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Relative Magnitudes of Change

• The relative magnitudes of change in supply and demand


determine the outcome of market equilibrium.
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Relative Magnitudes of Change

• When supply and demand both increase, quantity will


increase, but price may go up or down.
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The Effects Of Simultaneous Shifts In
Supply And Demand

The Market for Corn Tortilla Chips


Price
($/bag)
S S’
S’ after reduction in price of
corn harvesting equipment
P
D’ after discovery that oils are
harmful to people’s health
P’

D
D’
Millions of bags per
month
Q’ Q

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