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Sotiris Georganas City University London

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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

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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

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Differ in a number of important ways 1. Number of buyers and sellers 2. 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?

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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 information 3. Free entry and exit

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Market Consumer demand Supply by firms

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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

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What?

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Demand IncomePreferences Goods price Other goods prices

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Market demand function: relationship between quantity demanded of a particular product and all factors that influence demand Q dx = f(P x, P y, I,....) Quantity demanded is the dependent (endogenous) variable Price, income etc are the independent variables

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Isolate the impact of price Q dx = f(P x ) 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 Cournots work 30 years earlier), with price as the dependent variable Today we use Walrasian theory, but the Marshallian representation

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Since price is the vertical axis we use the inverse demand for graphs Inverse demand : P x = g(Q dx ) Price as a function of quantity Direct demand : Q dx = f(P x ) Where g=f -1

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Isolate the impact of price P x Q dx (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

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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

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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?

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normal inferior substitutes

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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 Q sx = f(P x ) ceteris paribus Inverse supply curve: P x =g(Q sx ) As before, g=f -1

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Supply Technology Goods price Other goods prices

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simple supply functions Q s =a+bP more complex supply functions Q s =a+bP+dP i –eP j a simple demand function Q d =a-bP

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P x Q sx (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.

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Demand and supply curves are: Q d = a-bP (1) Q s = 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

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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

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