# Sotiris Georganas City University London

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Sotiris Georganas City University London
EC 1008 Introduction to Microeconomics Lecture 2: Analyzing markets: supply and demand

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
Number of buyers and sellers Level of information Knowledge about the product and different prices 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 Numerous (many!) buyers and sellers Perfect information Free entry and exit

Demand, supply and (goods) markets
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
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? Substitution effect - as price rises consumers have an incentive to switch to cheaper alternatives 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 substitutes “inferior” “normal”

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
Technology Good’s price Other goods’ prices

Supply simple supply functions Qs =a+bP
more complex supply functions Qs =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

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