MMPA 508 ECONOMICS

2014 T2 CH 3

Professor Morris Altman Victoria University Wellington

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CHAPTER 3

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Supply & Demand!

Demand side!

Law of Demand

Whats a market?!

Institutional domain!

Protected by law or custom!

Where individuals trade (voluntary exchange)!

Trade and bargaining generate prices and serve to allocate goods and services and factor inputs!

Many types of markets; dierent markets for dierent goods & services and dierent factor inputs!

Also, local, national, and international markets

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Demand-side!

Demand curve derived from demand schedule!

Demand curve and schedule: what individuals would be willing to purchase at alternative prices at a given point in time!

Demand functiondemand is a function of both endogenous (price of the Qx) and exogenous variables (shift factors)!

Demand function includes price of Qx, price of other goods and services, expectations, income, etc.!

Qx=f(Px..)

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Law of demandstatistical regularity!

This yields a negatively-sloped demand curve!

Why the negative slope?!

1. Assume diminishing marginal utility (MU) in consumption or marginal benefits (MB)!

Assume the marginal utility curve represents the willingness to pay!

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Pric

eQuantity

Since MU decreases with more consumption, price (MC in consumption) must fall for more to be consumed (demand)

Demand=WTP=MB

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II We have the income (IE) and substitution (SE) eects!

The SE always generates a negatively sloped demand curve.!

Ceteris paribus (CP), as relatively price increases one substitutes away from the more expensive item.!

But the IE might work against the SE.!

In this case, if SE

Market demand curve!

Derived for the horizontal summation of individual demand curves

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Demand curve!

Changes in Dshift in Demand curve.!

Changes in the quantity Dmovement along the demand curve!

Shift factorsrefers back to the exogenous variables in the demand function, such as change in: income, tastes and preferences, expectations.

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Supply!

Supply curve and schedule refer to alternative quantities that an individual is willing to supply (willingness-to-supply (WTS), at alternative prices at a given point in time.!

Typical supply curve modelled in the text book is positively sloped reflecting the assumption of increasing opportunity cost (OC).!

But the supply curve can take on dierent shapes, especially in the long run.!

Note that OC includes economic profit (normal rate of return)!

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Dierent supply curves

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For the supply curve one also has a supply functionconsists of the dependant variable (Qx) and the independent variables, where the latter include the endogenous variable (Px) and exogenous variables, such as technical change and changes in factor prices.!

Qx = f(Px.)

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Changes in supply refers to shifts in the supply curve (caused by changes in the exogenous variables, such as technological change, changing expectations (aects inventories), and changes in substitutes (sheep vs cows) or compliments (oil and gas) in production.!

Note that changes in the wage rate might shift the supply curve, but this depends on whether productivity (through eort changes) neutralise changes in the wage rateincreasing the wage by 5% has no eect on the supply curve if productivity increases by 5% as a result.!

Change in the quantity supplied refers to movements along a supply curve.

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Price determination!

Supply and demand determine market price and quantity and equilibrium in price and quantity.!

Equilibrium is a point of rest; it is also market clearing; it is a theoretical construct suggesting where P and Q should end up in the long run, especially when market are perfect.!

Law of one price: one market clearing price for each and every market.!

Note that here are dierent markets for similar products: dierent markets for dierent types of apples, wines, juices, bottled water, etc.

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Dynamics of Market Clearing!

The simply S and D framework illustrates the process through which markets can clear.!

Above equilibrium prices yields a surplus.!

With a surplus price is bid downwards.!

Below equilibrium price yields a shortage!

With a shortage price is bid upwards!

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Surplus

Shortage

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Dynamics when curves shift.!

Example of shift in demand curve.!

Initially old eq price does not change.!

This yields a shortage.!

Price is bid up along the new D-curve; supply is increased along the S-curve a price increases.!

The shortage is eliminated and a new eq P and Q are established.!

New eq P is higher and new eq Q is higher.!

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D0D1

P0

Shortage

S0

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Supply & Demand Together!

When S & D move simultaneously the direction of new P & Q equilibrium is not always easily determined.!

When S increases & D increases equilibrium price cannot be easily determined unless one knows the extent of the shiftshere the change in D works against the change in S.!

One example: technical change reduces prices, but increases demand for computers or foodstus subject to technical changes serves to increase price.

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Math and Equilibrium Price and Quantity!

Demand equation: Pd=200-0.1Qd!

Supply equation: Ps=40+0.1Qs!

Eq Qd=QsQ*!

200-0.1Q*=40+0.1Q*!

160=0.2Q*!

Q*=800!

P* (eq P)= 200-0.1(800)= 200-80=120!

or!

P* (eq P)= 40+0.1(800)= 40+80=120

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