1. Demand and supply analysis – part 1
Econ 100
Lecture 4
The determination of prices and quantities of goods purchased by large numbers of buyers and sold by large numbers of sellers:
Demand and supply analysis – part 1 1

2. We have already seen that in any economy it must be decided what to produce, how to produce, and for whom to produce.
These involve the determination of prices and quantities produced and sold of goods and services.
As quantities are determined, the question of what (which goods in what quantities) is decided.
As prices are determined, not only the allocation of resources (the question of how) is directed,
but also, since prices include wages and salaries, rents, and interest rates, income distribution is determined. 2

3. In many economies, except for those that are ruled by central planning at all levels, markets play a very important (or, at least some) role in the determination of quantities and prices.
Markets are where buyers and sellers meet and interact and it is through this interaction that prices and quantities take on their values.
Therefore, we have to examine how markets work, and how buyers and sellers behave. The behavior of buyers is captured by the concept of demand and that of the sellers by supply. 3

4. Therefore, these are the topics that we will take up in this lecture:
Markets (competitive markets and others)
Demand (buyer side of a competitive market)
Supply (seller side of a competitive market)
Equilibrium (determination of price and quantity as a result of the interaction between demand and supply)
Changes in equilibrium (changes in price and quantity) 4

5. What is a market?
any medium through which the buyers and sellers of the same good or service can meet, bargain or not, agree or disagree on the price and quantities to be sold of that good in particular exchanges, and engage in exchanges
A physical market place or highly developed organization is not necessary for a market to exist
... although some markets are highly developed, functioning even with officers acting as auctioneers 5

6. Markets can be classified by different criteria, two of which would be:
The number of buyers and sellers in the market
Only one seller, many buyers – monopoly
A few sellers, many buyers – oligopoly
Many sellers, many buyers – competitive
The similarity of the goods sold in the market
All goods exactly the same – homogeneous goods
All goods similar but different – differentiated goods 6

7. Competitive markets If a market with many buyers is characterized by
a large number of sellers
and
all the units of the goods sold in that market being almost exactly the same regardless of the producer
we talk about a perfectly competitive market.
If the number of sellers is still relatively large but the goods sold by different sellers are differentiated, that is a monopolistically competitive market. 7

8. The numbers of buyers and sellers in a monopolistically competitive market are also large, but they are so large in a perfectly competitive market and the goods sold so similar, no single buyer or seller has the ability to affect significantly the market price all by his or her actions alone.
In particular,
If a seller sets a price higher than his competitors, all buyers will move to other sellers, so it will not be reasonable to do it.
If a seller sets a price lower than his competitors, all buyers will rush to him making him unable to meet all the orders selling what he could sell anyway at an unnecessarily low price and again it will not be reasonable to charge a different price than others. 8

9. instead of being price-setters (which monopolistic sellers are).
For this reason, the buyers and sellers in a perfectly competitive market are said to be price-takers (in the sense that their behavior can be analyzed as if they are following an auctioneer)
instead of being price-setters (which monopolistic sellers are).
You see that a perfectly competitive market is a bit of an imaginary construct, and
the larger the number of buyers and sellers in an actual market and the more similar the products sold there, the more closely does that market resemble a perfectly competitive market. 9

10. The demand and supply analysis as we will discuss it applies as a whole to a perfectly competitive market
(although parts of this analysis are useful or even necessary also to understand other markets – for example, the monopolistic market will have a demand side because of the large number of buyers there).
So let us continue by starting to examine the demand side of a perfectly competitive market. 10

11. But, first, a question:
Why do we have to separate the buyers and sellers sides of the market if we are trying to understand how the quantity produced and sold in that market is determined? 11

12. Because there is actually not one but two quantities that are involved here:
Quantity demanded = the number of units of the good that the buyers are willing (and able with available means to them, such as their income) to buy over a given period of time
Quantity supplied = the number of units of the good that the sellers are willing (and able with available means to them, such as their inventories or production capacity) to sell over a given period of time 12

13. Demand
The discussion of the demand side of the market deals with the factors that affect / determine the quantity demanded.
We can talk about two different quantities demanded:
Individual quantity demanded – quantity demanded by an individual buyer
Market quantity demanded – quantity demanded by all buyers in the market which is the sum of all individual quantities demanded
Either of these are determined by a number of factors. 13

14. Quantity demanded of a good is determined by...
Price of the good itself
Income (the individual QD is affected by the income of the individual buyer, the market QD is affected by the income of all buyers)
Tastes or preferences of (all) the individual(s)
Prices of other goods
Expectations (expected future price of the good, expected future income, …)
Population and the age profile of the population (if it is the market quantity demanded)
... 14

15. The relationship between individual quantity demanded and the price of the good
For most of the goods (except for those that are called “Giffen goods” in economics), the quantity demanded by an individual is negatively related to the price of the good.
In other words, individual quantity demanded (qD)
decreases as the price (P) of the good increases and
increases as the price of the good decreases.
The exact properties of this relationship may be different depending on the good and the individual in the sense that...

16. as P changes, the change in qD may be
continuous or stepwise
large or small
but the fact remains that as P goes in one direction, qD will go in the other direction.
What is the reason behind this negative relationship?

17. As P increases and the good becomes relatively more expensive, the individual will switch to other goods that will fulfill the same need or more or less the same need or serve similar purposes. We say the individual substitutes other goods for the one whose price has increased.
If substitute goods are available or not so available, it will be easier or more difficult to switch to those and the change in qD as a result of a change in P will be relatively larger or smaller.

18. One can draw the graph of this relationship in general by
Using the horizontal axis to measure qD
Using the vertical axis to measure P
Drawing a negatively sloped curve
This graph will display the relationship in a general way because for a specific good and a certain individual we may actually have a continuous curve or a stepwise function descending like a staircase in the + direction along the horizontal axis, or a relatively flat or a relatively steep curve.

19. Sticking with the general case, we see that if A, B, and C are three points on this curve, it shows that
as the price of the good is equal to PA, the quantity demanded by the individual will be equal to qDA,
and if P increases to PB, qD will decrease to qDB,
and if P decreases to PC, qD will increase to qDC.
so that as P changes we move from one point on the curve onto another one.

20. The negative relationship between qD and P is called the demand (for a specific good by a certain individual) and
the negatively sloped curve which is the graph of the relationship between qD and P is called the demand curve (for a ...).
In order that the demand curve really displays the relationship between qD and P, it has to show the effect on qD of P only.
In other words, it has to show how qD changes as P and only P changes without any change in any one of the other factors that can affect qD.

21. This means that all factors other than P must remain constant along the demand curve.
In other words, the demand curve must be drawn such that, if for example the income of the individual is equal to 2500 TL per month at one point on the demand curve, it has to be also equal to 2500 TL per month at another point on the demand curve.
So the demand curve shows the effect of P on qD everything else remaining the same or constant.

22. Factors that remain constant along an individual demand curve
Not the price of the good itself, of course, but
Income of the individual
Tastes or preferences of the individual
Prices of other goods
Expectations (expected future price of the good, expected future income, ...) by the individual
...

23. Individual demands and market demand
Consider two individuals A and B and their individual quantities demanded resulting in the market quantity demanded (assuming there are only two buyers):
Price Quantity demanded (no of units)
(TL/unit) by A by B market

24. Market demand is the horizontal sum of individual demands.
Compared to the individual demand curves, the market demand curve is relatively
flatter
shifted out more
Almost everything we noticed about individual demand (curve) applies to market demand (curve) as well.

25. The relationship between market quantity demanded and the price of the good
For most of the goods, the market quantity demanded is negatively related to the price of the good.
In other words, market quantity demanded (QD)
decreases as the price (P) of the good increases and
increases as the price of the good decreases.
The negative relationship between QD and P is called the demand (for a specific good by all individuals in the market) and
the negatively sloped curve which is the graph of the relationship between QD and P is called the demand curve (for a ...).

26. In order that the demand curve really displays the relationship between QD and P, it has to show the effect on QD of P only.
This means that all factors other than P must remain constant along the demand curve.
So the demand curve shows the effect of P on QD everything else remaining the same or constant.

27. Factors that remain constant along a market demand curve
Not the price of the good itself, of course, but
Income of all individuals (buyers)
Tastes or preferences of all individuals
Prices of other goods
Expectations (expected future price of the good, expected future income, …) by all individuals
Population and the age profile of the population
...

28. We have seen that as P changes, (individual or market) quantity demanded changes along the demand curve. So we can see the effect of a change in P as a movement along the demand curve.
What if one of the other factors, for example income, changes?

29. The relationship between quantity demanded and income
Changes in income can affect the quantity demanded in two ways:
positively: normal goods (most goods)
negatively: inferior goods (some goods)
In other words, for a normal good, the quantity demanded will
increase as income increases and
decrease as income decreases.
Again, the graph of this relationship can be drawn. But how exactly should we do it?

30. One possibility would be as follows:
use the horizontal axis to measure quantity demanded
use the vertical axis to measure income
draw a positively sloped curve
Along this curve, all factors other than income (including the price of the good among those other factors) will remain constant so that the curve shows the effect on quantity demand of a change in income only.
But what if we prefer to see the effect of a change in income on the same diagram as the demand curve?

31. Then we would have to
use the horizontal axis to measure quantity demanded as before, but
use the vertical axis to measure price of the good instead of income, and
draw the demand curve.
Now since we are trying to see the effect of a change in income only, everything else, including the price of the good, will have to remain the same.
This implies that, if the good is a normal good and the quantity demanded increases as income increases, it increases at the same price.

32. which in turn implies that we move onto a new demand curve or
the demand curve shifts (and it shifts right if quantity demanded increases).
We see that the effect of a change in any factor other than the price of the good is seen as a shift in the demand curve.
We can summarize that there are two types of changes:

33. Either
the price of the good changes
causing the quantity demanded to change
which is seen as a movement along the same demand curve. or
any factor other than the price changes
causing the demand to change
which is seen as a shift in the demand curve.

34. Notice that the following three are equivalent expressions (they express the same thing):
Quantity demanded increases at any price
Demand increases
Demand curve shifts out
Also, it is equivalent to say the demand curve shifts
out
right up

35. Effects of some of the other factors on quantity demanded
Income
Normal good (+) (As income increases, QD increases at any P or D increases or D curve shifts out) Inferior good (–) (As income increases, QD decreases at any P or D decreases or D curve shifts in)
Prices of other goods
Price of a substitute good (+) Price of a complement good (–)
Expectations
Expected future price (+) Expected future income (+)