Theory of Supply and Demand How supply and demand determine the price of a good and the quantity sold in the market? Role of prices in allocating resources in the market economy

Types of markets Market is a group of buyers and sellers of a particular good or service Buyers determine the demand for a product and sellers determine the supply of the product Competitive market is a market in which there are many buyers and many sellers in the market so that each has a negligible impact on the market price We assume perfectly competitive markets when we study the theory of demand and supply

Types of Markets Perfectly competitive markets have the following two characteristics: Goods being sold are all the same Both Buyers and sellers are price takers Monopoly is characterized by: One seller and many buyers Seller sets the price Oligopoly is characterized by Few sellers without rigorous competition The sellers get together to set a price Monopolistic competition is characterized by Many sellers, each selling a differentiated product Sellers have some ability to set the price for their own product

Law of Demand Price and quantity demanded are negatively related Other things equal, the quantity demanded of a good falls when the price of the good rises. Price and quantity demanded are negatively related Quantity demanded is the amount of the good that buyers are willing to purchase

Determinants of Demand Determinants of quantity demanded: Income (normal, inferior) Prices of related goods (substitutes, complements) Tastes Expectations Number of buyers (Market demand curve) Demand schedule and Demand curve Demand schedule is a table that shows the relationship between the price of a good and the quantity demanded Demand curve graphs the demand schedule. The demand curve slopes downward

Market Versus Individual Demand Market demand is the horizontal sum of all individual demands for a particular good or service Market demand is derived from individual demands and thus depends on all those factors that determine individual demand (income, expectations, etc) In our case, market demand curve shows the variations in the quantity demanded of a good as price changes

Shifts Versus Movements Along the Demand Curve Any change that varies the quantity that buyers wish to buy at a given price shifts the demand curve Changes in price that varies the quantity that buyers wish to buy is represented as a movement along the demand curve To summarize: Demand curve shows what happens to the quantity demanded of a good when its price varies, holding constant all other determinants of quantity demanded. When one of these determinants changes, the demand curve shifts.

Application of law of Demand: Policy to Reduce Smoking Option #1: Raise prices of cigarettes by levying a tax Option #2: Introduce a public awareness program regarding ill effects of smoking Policy impact on substitutes Policy impact on complements

SUPPLY Quantity supplied of any good is the amount that sellers are willing to sell in the market Determinants of supply: Price Input prices Technology Expectations Number of sellers (Market supply curve)

Law of Supply Other things equal, the quantity supplied of a good rises when the price of the good rises. Quantity supplied is positively related to the price of the good Supply schedule is a table that shows the relationship between the price of a good and the quantity supplied Supply curve graphs the supply schedule. It is upward sloping

Market Versus Individual Supply Market supply is derived by horizontally summing the individual supply curves Market supply curve shows how the quantity supplied varies as the price of the good varies Any change that varies the quantity supplied at a given price shifts the supply curve Changes in price that varies the quantity supplied in the market is represented as a movement along the supply curve

SUPPLY AND DEMAND How do supply and demand combined together determine the quantity and price of a good sold in the market? Supply and demand curves intersect. At this equilibrium price quantity supplied equals quantity demanded Equilibrium is a situation in which supply equals demand Equilibrium price is also called as the market clearing price as quantity supplied equals quantity demanded

SUPPLY AND DEMAND What happens when market price is not equal to the equilibrium price? Excess supply- surplus in the market Excess demand- shortage in the market Free markets reach equilibrium through the interaction of buyers and sellers and price is the tool through which the market is cleared

LAW OF SUPPLY AND DEMAND Other things remaining same, the price of any good adjusts to bring the supply and demand for that good into balance. Shifts versus movements along curves Change in quantity supplied and change in quantity demanded is represented as a movement along the fixed supply and demand curves respectively Change in supply and change in demand is represented as shifts in supply and demand curves respectively

Analyzing Changes in Equilibrium: Application Change in demand- shifts in the demand curve Change in supply- shifts in the supply curve Changes in both supply and demand- Change in equilibrium quantity and price A simple application

Analyzing Changes in Equilibrium: Summary DEMAND/ SUPPLY No change in Supply Increase in supply Decrease in supply No change in demand P same Q same P down Q up P up Q down Increase in demand P ambiguous Q ambiguous Decrease in demand

How Prices allocate Resources Prices act as signals that guide the allocation of scarce resources in a market economy Prices in turn are determined by forces of supply and demand