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© 2007 Thomson South-Western
Demand, Supply and Market Equilibrium
Allocation Mechanisms
How does society allocate the goods and services produced among those who want them?– First come first serve.– Divide them equally.– Allocate them to a certain group.– Give only to the poorest individuals– To the highest bidder.
Each allocation mechanism creates incentives for people to behave in a certain way.
For example, the First come first serve mechanism creates incentives for people to be the first in line.
Allocation Mechanisms
What incentives does the market mechanism create?
A market is a group of buyers and sellers of a particular good or service.
The terms supply and demand refer to the behavior of people . . . as they interact with one another in markets.
What is a Market?
Buyers determine demand.
Sellers determine supply.
What is a Market?
What Is Competition?
A competitive market is a market in which
The product is homogenous Numerous buyers and sellers so that each
has no influence over price Buyers and Sellers are price takers there are
many buyers and sellers so that each has a negligible impact on the market price.
Free entry and exit
DEMAND
Quantity demanded is the amount of a good that buyers are willing and able to purchase at a given price.
Law of Demand– The law of demand states that the
quantity demanded of a good falls when the price of the good rises, ceteris paribus.
The Demand Curve: The Relationship between Price and
Quantity Demanded Demand Curve
– The demand curve is a graph of the relationship between the price of a good and the quantity demanded.
Price ofIce-Cream Cone
0
2.50
2.00
1.50
1.00
0.50
1 2 3 4 5 6 7 8 9 10 11 Quantity ofIce-Cream Cones
$3.00
12
1. A decrease in price ...
2. ... increases quantity of cones demanded.
Market Demand versus Individual Demand
Market demand refers to the sum of all individual demands for a particular good or service.
Graphically, individual demand curves are summed horizontally to obtain the market demand curve.
Price of Ice-Cream Cone
Price of Ice-Cream Cone
Price of Ice-Cream Cone
2.00 2.00 2.00
4 3 7
1.00 1.001.00
8 5 13
Quantity of Ice-Cream Cones Quantity of Ice-Cream Cones Quantity of Ice-Cream Cones
Catherine’s Demand Nicholas’s Demand Market Demand+ =
When the price is $2.00, Catherine will demand 4 ice-cream cones.
When the price is $2.00, Nicholas will demand 3 ice-cream cones.
The market demand at $2.00 will be 7 ice-cream cones.
When the price is $1.00, Catherine will demand 8 ice-cream cones.
When the price is $1.00, Nicholas will demand 5 ice-cream cones.
The market demand at $1.00, will be 13 ice-cream cones.
The market demand curve is the horizontal sum of the individual demand curves!
Change in Quantity Demanded
Change in Quantity Demanded– This refers to a change in the quantity
that a consumer wants to buy as a result of a change in its price
– Graphically represented by a movement along the demand curve.
0
D
Price of Ice-Cream Cones
Quantity of Ice-Cream Cones
A rise in the price of ice-cream cones
results in a movement along the demand
curve.
A
B
8
1.00
$2.00
4
Changes in Quantity Demanded
This happens as the buying behavior changes, which can be due to change in– income– Prices of related goods– Tastes– Expectations– Number of buyers
Shifts in the Demand Curve
$3.002.50
2.001.501.00
0.50
21 3 4 5 6 7 8 9 10 1211
Price of Ice-Cream Cone
Quantity of Ice-Cream Cones
0
Increasein demand
An increase in income...
D1D2
Consumer Income Normal Good
$3.002.50
2.001.501.00
0.50
21 3 4 5 6 7 8 9 10 1211
Price of Ice-Cream Cone
Quantity of Ice-Cream
Cones0
Decreasein demand
An increase in income...
D1D2
Consumer Income Inferior Good
Related Goods
Prices of Related Goods– When two goods are substitutes , a fall
in the price of one good reduces the demand for the other good.
– When two goods are complements , a fall in the price of one good increases the demand for the other good.
Variables that Influence Buyers
SUPPLY
Quantity supplied is the amount of a good that sellers are willing and able to sell.
Law of Supply– The law of supply states that, other
things equal, the quantity supplied of a good rises when the price of the good rises.
The Supply Curve: The Relationship between Price and
Quantity Supplied
Supply Curve– The supply curve is the graph of the
relationship between the price of a good and the quantity supplied.
Price ofIce-Cream
Cone
0
2.50
2.00
1.50
1.00
1 2 3 4 5 6 7 8 9 10 11 Quantity ofIce-Cream Cones
$3.00
12
0.50
1. Anincrease in price ...
2. ... increases quantity of cones supplied.
Changes in Quantity Supplied
Movement along the supply curve. Caused by a change in the price.
1 5
Price of Ice-Cream Cone
Quantity of Ice-Cream Cones0
S
1.00A
C$3.00 A rise in the price
of ice cream cones results in a movement along the supply curve.
Change in Quantity Supplied
Input prices Technology Expectations Number of sellers
Shifts in the Supply Curve
Shifts in the Supply CurvePrice of
Ice-CreamCone
Quantity ofIce-Cream Cones
0
Increase in supply due to improved technology
Decreasein supply due to a rise in input prices
Supply curve, S3
curve, Supply
S1Supply
curve, S2
Variables That Influence Sellers
The Equilibrium concept.
Equilibrium in general refers to a situation where each agent is satisfied with the decision he made given everyone else’s choices.
Thus, equilibrium refers to a state where there is no tendency for change.
Market equilibrium refers to a situation in which the price has reached the level where quantity supplied equals quantity demanded.
SUPPLY AND DEMAND TOGETHER
SUPPLY AND DEMAND TOGETHER
Equilibrium Price– The price that balances quantity
supplied and quantity demanded. – On a graph, it is the price at which the
supply and demand curves intersect. Equilibrium Quantity
– The quantity supplied and the quantity demanded at the equilibrium price.
– On a graph it is the quantity at which the supply and demand curves intersect.
At $2.00, the quantity demanded is equal to the quantity supplied!
SUPPLY AND DEMAND TOGETHER
Demand Schedule
Supply Schedule
The Equilibrium of Supply and Demand
Price ofIce-Cream
Cone
0 1 2 3 4 5 6 7 8 9 10 11 12Quantity of Ice-Cream Cones
13
Equilibriumquantity
Equilibrium price Equilibrium
Supply
Demand
P*2.00
Why not a Price Higher Than P*?
Price ofIce-Cream
Cone
0
Supply
Demand
(a) Excess Supply
Quantitydemanded
Quantitysupplied
Surplus
Quantity ofIce-Cream
Cones
4
$2.50
10
2.00
7
For all prices higher than P*:
• the quantity supplied > quantity demanded.
• there is excess supply or a Surplus.
• Suppliers will lower the price to increase sales.
Why not a Price Lower Than P*?
Price ofIce-Cream
Cone
0 Quantity ofIce-Cream
Cones
Supply
Demand
(b) Excess Demand
Quantitysupplied
Quantitydemanded
1.50
10
$2.00
74
Shortage
For all prices lower than P*:• the quantity
demanded > the quantity supplied.
• There is excess demand or a shortage.
• Suppliers will raise the price due to too many buyers chasing too few goods.
Three Steps for Analyzing Changes in Equilibrium
How an Increase in Demand Affects the Equilibrium
Price ofIce-Cream
Cone
0 Quantity of Ice-Cream Cones
Supply
Initialequilibrium
D
D
3. . . . and a higherquantity sold.
2. . . . resultingin a higherprice . . .
1. Hot weather increasesthe demand for ice cream . . .
2.00
7
New equilibrium$2.50
10
How a Decrease in Supply Affects the Equilibrium
Price ofIce-Cream
Cone
0 Quantity of Ice-Cream Cones
Demand
Newequilibrium
Initial equilibrium
S1
S2
2. . . . resultingin a higherprice of icecream . . .
1. An increase in theprice of sugar reducesthe supply of ice cream. . .
3. . . . and a lowerquantity sold.
2.00
7
$2.50
4
What Happens to Price and Quantity When Supply or
Demand Shifts?