Lecture3

Demand, Supply and Equilibrium

INSPIRING CREATIVE AND INNOVATIVE MINDS

Demand

• A market consists of:– Buyers (demand)– Sellers (supply)– Exchange

• Effective demand = the quantity of a commodity which consumers will purchase at a given price per time period.

The Demand Schedule

• A table showing the quantity demanded of a product at various prices

• E.g. Demand Schedule for Big MacsPrice Qty demanded$1 500$2 400$3 300$4 200$5 100

• Graphical representation of demand schedule

Price

Quantity

$ 5

2

1

3

4

100 200 300 400 500

The Demand Curve

The Demand For Big Mac

The Law of Demand

• As price increases the quantity demanded decreases, conversely,

as price decreases the quantity demanded increases.

• Reflects an inverse relationship ie

As Price , quantity demanded

As Price , quantity demanded

• The law of demand is caused by:– The Income Effect

– The Substitution Effect

The Law of Demand

• As prices increase, consumers will purchase fewer goods and services. Their purchasing power (or real income) decreases

Quantity demanded decreases.

• As prices decrease, the purchasing power of consumers increases

Quantity demanded increases.

The Income Effect

The Substitution Effect

• As prices increase, consumers generally purchase more of a substitute product whose price is lower.

• A substitute product is a product that performs a similar function and satisfies the same consumer need/want e.g. Tea/ Coffee

Butter/Margarine• If the price of butter increases, the quantity

demanded will fall as consumers will substitute butter with margarine.

Supply

• Definition: the quantity of a product which producers offer to the market at a certain price per unit of time.

The Law of Supply

• As price increases the quantity supplied increases, conversely

as price decreases the quantity supplied decreases.

• The law of supply is a direct relationship

between price and quantity supplied.

• As P Quantity supplied

As P Quantity supplied

The Law of Supply

• Producers will seek to maximise their profits.

ie Supplying more at higher prices and less at lower prices.

The Logic of the law of supply

The Supply Schedule

• A table showing the quantity supplied at various prices.

• Example: Supply Schedule for Big Macs

Price Qty Supplied$1 200$2 300$3 400$4 500$5 600

Price

Quantity

$

Supply Curve

1

2

3

4

5

200 300 400 500 600

The Supply Curve

Price

Quantity

S

D

Equilibrium point (E)EP

Market Equilibrium

• Supply and Demand can now be brought together, to form the price mechanism.

Market Equilibrium (E) is where:

Qty demanded = Qty supplied (intersection of demand and supply

curves) the market is cleared (no shortages or surpluses)

Price (EP) is stable

Market Disequilibrium

= where Qty Demanded is NOT EQUAL to Qty Supplied.Types:1. Market Shortage: where

Qty demanded > Qty supplied2. Market Surplus (oversupply): where

Qty supplied > Qty demanded

Price

Qty

S

DP

QS QDShortage

Market Shortage

•Caused by price being set BELOW the equilibrium.

P

Q

S

D

QD QSSurplus

Market Surplus

Caused by price being set ABOVE the equilibrium.

Changes in Demand

Certain factors (other than price changes) affect the absolute level of demand.These factors are called Conditions of Demand.Changes to the Conditions of Demand cause changes in demand and this results in shifts of the Demand curve.

Qty

Price

D D1

S

E

E1

EP

EP1

EQ EQ1

An Increase in Demand

• The entire demand curve shifts to the Right.

Price

Qty

S

DD1

E

E1

EP

EP1

EQ1 EQ

A Decrease in Demand

The entire demand curve shifts to the LeftCaused by a factor other than price

Conditions of Demand

•Change in tastes•Improvements in Technology•Real Income •Change in Population•Change in the price of Substitutes•A change in the price of other goods•Expectations of the future•Advertising

Changes in Supply

Certain factors (other than price changes) affect the absolute level of supply.These factors are called CONDITIONS OF SUPPLY and they result in shifts of the supply curve (not movements along it).

Price

Qty

S

D

S1E

E1EPEP1

EQ EQ1

An Increase in Supply

Supply curve shifts to the right.

Price

Qty

S

D

S1

E

E1EP1

EP

EQ1 EQ

A Decrease in Supply

•Supply curve shifts to the left

Conditions of Supply

•Improvements in technology•A change in production costs•A change in the price of alternative

products•Weather and seasons