EC 1008Introduction to Microeconomics

Lecture 2: Analyzing markets: supply and demand

Sotiris GeorganasCity University London

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

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

Markets

Differ in a number of important ways 1. Number of buyers and sellers2. Level of information ▪ Knowledge about the product and different

prices

3. How easy it is to set up in business ▪ Barriers to entry▪ Can service/product be easily copied?

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

1. Numerous (many!) buyers and sellers 2. Perfect information3. Free entry and exit

Demand, supply and (goods) markets

Market

Consumer

demand

Supply by firms

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

Determinants of demand by consumers for goods and services

What?

Determinants of demand by consumers for goods and services

Demand

Income

Preferences

Good’s price

Other goods’ prices

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

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

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

Example: demand for potatoes

Monthly market demand for potatoes

Law of demand

Isolate the impact of price ↑ Px ⇒ ↓ Qdx (Ceteris paribus) ↓ Px ⇒ ↑ Qdx (Ceteris paribus)

Why? a. Substitution effect - as price rises

consumers have an incentive to switch to cheaper alternatives

b. Income effect - a rise in price reduces consumers’ `real’ income so they purchase less of a `normal’ good

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

Movement along the demand curve

An increase in demand

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?

Examples

“normal”

“inferior”

substitutes

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

Determinants of supply

Supply

Technology

Good’s price

Other goods’ prices

Supply

simple supply functionsQs =a+bP

more complex supply functionsQs =a+bP+dPi –ePj

a simple demand function Qd =a-bP

Example: supply of potatoes

Monthly market supply of potatoes

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.

Shifts in the supply curve

Market equilibrium

Market equilibrium: undersupply

Market equilibrium: oversupply

Market equilibrium: all clear

Effect of a shift in the demand curve on equilibrium

Effect of a shift in the supply curve on equilibrium

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

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