MMPA 508

ECONOMICS
2014 T2
CH 3
Professor Morris Altman
Victoria University Wellington

CHAPTER 3

Supply & Demand!

Demand side!
Law of Demand

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Whats a market?!
Institutional domain!
Protected by law or custom!
Where individuals trade (voluntary exchange)!
Trade and bargaining generate prices and serve to allocate goods
and services and factor inputs!
Many types of markets; dierent markets for dierent goods &
services and dierent factor inputs!
Also, local, national, and international markets
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Demand-side!
Demand curve derived from demand schedule!
Demand curve and schedule: what individuals would be willing
to purchase at alternative prices at a given point in time!
Demand functiondemand is a function of both endogenous
(price of the Qx) and exogenous variables (shift factors)!
Demand function includes price of Qx, price of other goods
and services, expectations, income, etc.!
Qx=f(Px..)
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Law of demandstatistical regularity!

This yields a negatively-sloped demand curve!
Why the negative slope?!
1. Assume diminishing marginal utility (MU) in consumption or marginal benefits
(MB)!

Price

Assume the marginal utility curve represents the willingness to pay!

Since MU decreases with more
De
ma
consumption, price (MC in
nd
=W
!
consumption)
must fall for more to be
TP
=M
consumed (demand)
B

Quantity
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II We have the income (IE) and substitution (SE) eects!

The SE always generates a negatively sloped demand curve.!
Ceteris paribus (CP), as relatively price increases one substitutes away from the more expensive
item.!
But the IE might work against the SE.!
In this case, if SE<IE, we would have a positively sloped demand.!
The IE represents how individuals respond to changes in their real income or purchasing power as
price changes.!
The SE hold the change in real income constant.!
For normal goods if price increases and real income falls, demand falls (reinforces the SE eect).!
For an inferior good if price increases and real income falls, demand increases because the lower
income means that one cant aord preferred items (goes against the SE eect).!
Note that the Snob eect also works against the IEyou buy more at higher prices.
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Market demand curve!

Derived for the horizontal summation of
individual demand curves

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Demand curve!
Changes in Dshift in Demand curve.!
Changes in the quantity Dmovement along the
demand curve!
Shift factorsrefers back to the exogenous
variables in the demand function, such as change
in: income, tastes and preferences, expectations.
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Supply!
Supply curve and schedule refer to alternative quantities that an individual is willing
to supply (willingness-to-supply (WTS), at alternative prices at a given point in time.!
Typical supply curve modelled in the text book is positively sloped reflecting the
assumption of increasing opportunity cost (OC).!
But the supply curve can take on dierent shapes, especially in the long run.!
Note that OC includes economic profit (normal rate of return)!

Dierent supply curves

!
!

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For the supply curve one also has a supply

functionconsists of the dependant variable (Qx)
and the independent variables, where the latter
include the endogenous variable (Px) and
exogenous variables, such as technical change and
changes in factor prices.!
Qx = f(Px.)

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Changes in supply refers to shifts in the supply curve

(caused by changes in the exogenous variables, such as
technological change, changing expectations (aects
inventories), and changes in substitutes (sheep vs cows) or
compliments (oil and gas) in production.!
Note that changes in the wage rate might shift the supply
curve, but this depends on whether productivity (through
eort changes) neutralise changes in the wage rate
increasing the wage by 5% has no eect on the supply curve
if productivity increases by 5% as a result.!
Change in the quantity supplied refers to movements along
a supply curve.
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Price determination!
Supply and demand determine market price and quantity and
equilibrium in price and quantity.!
Equilibrium is a point of rest; it is also market clearing; it is a
theoretical construct suggesting where P and Q should end up in
the long run, especially when market are perfect.!
Law of one price: one market clearing price for each and every
market.!
Note that here are dierent markets for similar products:
dierent markets for dierent types of apples, wines, juices,
bottled water, etc.
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Dynamics of Market Clearing!

The simply S and D framework illustrates the process through which
markets can clear.!
Above equilibrium prices yields a surplus.!
With a surplus price is bid downwards.!
Below equilibrium price yields a shortage!
With a shortage price is bid upwards!

Surplus

!
Shortage

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Dynamics when curves shift.!

Example of shift in demand curve.!
Initially old eq price does not change.!
This yields a shortage.!
Price is bid up along the new D-curve; supply is increased along the S-curve a price increases.!
The shortage is eliminated and a new eq P and Q are established.!
New eq P is higher and new eq Q is higher.!
D1

D0

S0

!
P0

!
Shortage
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Supply & Demand Together!

When S & D move simultaneously the direction of
new P & Q equilibrium is not always easily determined.!
When S increases & D increases equilibrium price
cannot be easily determined unless one knows the
extent of the shiftshere the change in D works
against the change in S.!
One example: technical change reduces prices, but
increases demand for computers or foodstus subject
to technical changes serves to increase price.
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Math and Equilibrium Price and Quantity!

Demand equation: Pd=200-0.1Qd!
Supply equation: Ps=40+0.1Qs!
Eq Qd=QsQ*!
200-0.1Q*=40+0.1Q*!
160=0.2Q*!
Q*=800!
P* (eq P)= 200-0.1(800)= 200-80=120!
or!
P* (eq P)= 40+0.1(800)= 40+80=120
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