Understanding the Market Mechanism

Demand

Introduction

• Want of goods & services accompanied by willingness and ability to purchase

• The amount of goods and services that consumers in a market are willing and able to purchase during a given period of time (e.g., week, month) is called Quantity Demanded

Generalized Demand Function

• Six principal variables that influence the quantity demanded

1. Price of product

2. Income of consumers

3. Price of related product

4. Tastes & preference pattern of consumers

5. Expected price of product in future periods

6. Number of consumers in market

Generalized…………….

• Relation between quantity demanded and these 6 factors is referred to as Generalized Demand Function and is expressed as follows:

Qd= f (P, M, PR, T, Pe, N)

Qd : quantity demanded of the product

P : price of the product

M : consumers’ income

PR : price of related product

T : taste & preference patterns of consumers

Pe : expected price of the product in some future period

N : number of consumers in the market

Relation between Variables and Quantity Demanded

• Quantity demanded – Price of goods

When price rises, quantity demanded falls

When price falls, quantity demanded rises

=> Inverse or negative relation

Relation………

• Quantity demanded – Consumer’s incomeWhen income rises, Qd may rise or fall

Qd rises – normal goods

Qd falls – inferior goods

When income falls, Qd may fall or rise

Qd falls – normal goods

Qd rises – inferior goodsDirect relation for normal goodsInverse relation for inferior goods

Relation………

• Quantity demanded – Price of related goods

Commodities may be related in consumption in either of two ways:

Substitute goods (one good can be used in place of other)

Complement goods (they are used in conjunction with each other)

Independent goods

Relation………Substitute goodsIncrease in price of good Y will lead to increase

in demand for good XDecrease in price of good Y will lead to

decrease in demand for good X=> Direct relation in case of substitute goods

Complement goodsIncrease in price of good Y will lead to decrease

in demand for good XDecrease in price of good Y will lead to

increase in demand for good X => Inverse relation in case of complementary goods

Relation………

• Quantity demanded – Expected Future price of goods

If price is expected to rise in future, current demand may rise

If price is expected to fall in future, current demand may fall

=> Direct relation

Relation………

• Quantity demanded – Consumer taste pattern

Increase in taste/preference for the good, demand will increase

Decrease in taste/preference for the good, demand will decrease

=> Direct relation

Relation………

• Quantity demanded – Number of consumers

Increase in number of consumers for the good, demand will increase

Decrease in number of consumers for the good, demand will decrease

=> Direct relation

Linear form of Generalized Demand Function

Qd = a + bP + cM + dPR + eT + fPe + gN

a is intercept parameter which shows the value of Qd when all variables are simultaneously equal to zero.

b, c, d, e, f, g are slope parameters. They measure the effect on quantity demanded of changing one of the variables while holding the rest of variables constant.

Summary of relationships

Variable

Relation to Qd Sign of slope parameter

P Inverse b = ∆Qd/∆P is negative

M Direct for normal good c = ∆Qd/∆M is positive

Inverse for inferior good

c = ∆Qd/∆M is negative

PR Direct for substitute goods

d = ∆Qd/∆PR is positive

Inverse for complementary goods

d = ∆Qd/∆PR is negative

Summary……

Variable Relation to Qd Sign of slope parameter

T Direct e = ∆Qd/∆T is positive

Pe Direct f = ∆Qd/∆Pe is positive

N Direct g = ∆Qd/∆N is positive

Simplified version of generalized demand function

• Consumer tastes (T), Expected future price (Pe)and number of consumers (N) are excluded

Qd = a + bP + cM + dPR

Demand Function

• The relation between price and quantity demanded per period of time, when all other factors that affect consumer demand are held constant, is called a demand function or simply demand.

• Demand gives, for various prices of a good, the corresponding quantities that consumers are willing and able to purchase at each of those prices, all other things held constant.

Demand Function….

• A demand function can be expressed as an equation, a schedule/table, or a graph.

• A demand function can be expressed in the most general form as the equation

Qd = f(P)

which means that the quantity demanded is a function of (depends on) the price of the good, holding all other variables constant

Demand Function….

• Such demand function is obtained by holding all the variables in the generalized demand function constant except price

Qd = f(P, M, PR) = f(P)

Derivation of demand function from generalized demand function

• Suppose generalized demand function is

Qd = 1800 - 20P + 0.6M – 50PR

To derive a demand function, Qd = f(P), the variables M and PR must be assigned fixed values.

Derivation ………..

Suppose M (consumer income) is Rs. 20000 and PR (price of related good) is Rs. 250.

To find the demand function, fixed values of M and PR are substituted into the generalized demand function:

Qd = 1800 – 20P + 0.6(20000) – 50(250) = 1800 – 20P + 12000 – 12500 = 1300 – 20P

Derivation ………..

Thus, the demand function is expressed in the form of a linear demand equation.

Intercept parameter (1300) is the amount of the good consumers will demand if price is zero.

Slope (-20) indicates that a Re. 1 increase in price causes quantity demanded to decrease by 20 units.

Derivation ………..

Demand equation can be converted into demand schedule by changing values of P in the equation, Qd = 1300 – 20P.

Price Qd

65 0

60 100

50 300

40 500

30 700

20 900

10 1100

0 1300

Demand Curve

0, 65100, 60

300, 50

500, 40

700, 30

900, 20

1100, 10

1300, 00

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Quantity demanded

Pri

ceDemand schedule can be converted into a graph.

A graphical demand function is called a demand curve.

Demand…..

• Note that in the graph of the demand function, Qd = 1300 – 20P, the independent variable P is plotted along the vertical axis and the dependent variable Qd is plotted along the horizontal axis.

• Thus the equation plotted in the figure is the inverse of the demand equation and is called inverse demand function since price is expressed as a function of quantity demanded: P = 65 – 1/20Qd.

Demand…..

• The vertical intercept is 65, indicating that at a price of 65, consumers will demand zero units of the good.

• The horizontal intercept is 1300, which is the maximum amount of the good buyers will take when the good is given away (P = 0)

• Slope of the graphed inverse demand function is -1/20, indicating that if quantity demanded rises by one unit, price must fall 1/20 of a Re.

Demand…..

• A point on a demand curve can be interpreted as in either of two ways:

(1) The maximum amount of a good that will be purchased if a given price is charged

(2) The maximum price that consumers will pay for specific amount of a good.

Law of demand

• Quantity demanded increases when price falls and quantity demanded decreases when price rises, other things held constant. (Law of demand)

• Once a demand function, Qd = f(P), is derived from a generalized demand function, a change in quantity demanded can be caused only by a change in price.

Dynamics

• Change in quantity demanded

Increase (caused by fall in price)

Decrease (caused by rise in price)

• Change in demand (Shift in demand)

Increase (caused by change in non-price variables)

Decrease (caused by change in non-price variables)

Shifts/Change in Demand

• When any one of the five variables held constant while deriving a demand function from the generalized demand relation changes value, a new demand function results, causing the entire demand curve to shift to a new location

• Change in demand can be understood from simplified version of generalized demand function

Change in demand caused by change in income

Initial demand function

Qd = 1800 - 20P + 0.6M – 50PR

Qd = 1800 – 20P + 0.6(20000) – 50(250)

Qd = 1800 – 20P + 12000 – 12500

Qd = 1300 – 20P (D0)

Now, suppose income increases by 500

Qd = 1800 – 20P + 0.6(20500) – 50(250)

Qd = 1800 – 20P + 12300 – 12500

Qd = 1600 – 20P (D1)

Change………

Now, suppose income decreases by 500

Qd = 1800 – 20P + 0.6(19500) – 50(250)

Qd = 1800 – 20P + 11700 – 12500

Qd = 1000 – 20P (D2)

Price D0: 1300-20P

[M=20000]

D1: 1600-20P

[M=20500]

D2: 1000-20P

[M=19500]

65 0 300 0

60 100 400 0

50 300 600 0

40 500 800 200

30 700 1000 400

20 900 1200 600

10 1100 1400 800

0 1300 1600 1000

Changing Demand Curves

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0 200 400 600 800 1000 1200 1400 1600

Change in demand caused by change in price of related good

Initial demand function

Qd = 1800 - 20P + 0.6M – 50PR

Qd = 1800 – 20P + 0.6(20000) – 50(250)

Qd = 1800 – 20P + 12000 – 12500

Qd = 1300 – 20P (D0)

Now, suppose PR increases by 10

Qd = 1800 – 20P + 0.6(20000) – 50(260)

Qd = 1800 – 20P + 12000 – 13000

Qd = 800 – 20P (D3)

Change………

Now, suppose PR decreases by 10

Qd = 1800 – 20P + 0.6(20000) – 50(240)

Qd = 1800 – 20P + 12000 – 12000

Qd = 1800 – 20P (D4)

Price D0: 1300-20P

[PR=250]

D3: 800-20P

[PR=260]

D4: 1800-20P

[PR=240]

65 0 0 500

60 100 0 600

50 300 0 800

40 500 0 1000

30 700 200 1200

20 900 400 1400

10 1100 600 1600

0 1300 800 1800

Changing demand curves

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0 200 400 600 800 1000 1200 1400 1600 1800

Quantity demanded

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Summary of Demand ShiftsDeterminants of demand

Demand increases

Demand decreases

Sign of slope parameter

Income (M)

Normal good M rises M falls c > 0

Inferior good M falls M rises c < 0

Price of related goods (PR)

Substitute goods PR rises PR falls d > 0

Complement goods PR falls PR rises d < 0

Summary of Demand Shifts

Determinants of demand

Demand increases

Demand decreases

Sign of slope parameter

Consumer tastes (T)

T rises T falls e > 0

Expected Price (Pe) Pe rises Pe falls f > 0

Number of consumer (N)

N rises N falls g > 0

Understanding the Market Mechanism

Supply

Introduction

• The amount of goods and services offered for sale in a market during a given period of time (e.g., week, month) is called Quantity Supplied

Generalized Supply Function

• Six principal variables that influence the quantity supplied

1. Price of goods itself

2. Price of inputs used to produce the good

3. Price of goods related in production

4. Level of available technology

5. Expectations of producers concerning future price of the good

6. Number of firms or the amount of productive capacity in the industry

Generalized…………….• Relation between quantity supplied and these 6

factors is referred to as Generalized Supply Function and is expressed as follows:

Qs= g (P, PI, Pr, Tech, Pe, F)Qs quantity of a good or service offered for saleP price of the good or service

PI Prices of inputs used in production

Pr price of goods or service related in productionTech level of available technology

Pe expectations of producers concerning future price of the good

F number of firms or amount of productive capacity in the industry

Relation between Variables and Quantity supplied

• Quantity supplied – Price of the good

When price rises, quantity supplied rises

When price falls, quantity supplied falls

=> Direct relation

Relation………

• Quantity supplied – Price of inputsWhen input price rises, Qs falls

When input price falls, Qs rises

Inverse relation

Relation………

• Quantity supplied – Price of goods related in production

Depends on whether goods are substitutes or complements in production:

Substitutes in productionTwo goods X and Y are substitutes in production if

an increase in the price of good X relative to good Y causes producers to increase production of good X and decrease production of good Y

=> Inverse relation

Relation………

Complements in production

Two goods X and Y are complements in production if an increase in the price of good X relative to good Y causes producers to increase production of good Y also

=> Direct relation

Relation………

• Quantity supplied – Level of Technology

When technology improves, Qs increases

When technology deteriorates, Qs decreases

=> Direct relation

Relation………

• Quantity supplied – Future price expectations

If price is expected to rise in future, current supply may fall

If price is expected to fall in future, current supply may rise

=> Inverse relation

Relation………

• Quantity supplied – Number of firms or productive capacity of industry

Increase in number of firms or productive capacity, Qs will increase

Decrease in number of firms or productive capacity, Qs will decrease

=> Direct relation

Linear form of Generalized Demand Function

Qd = h + kP + lPI + mPr + nTech + rPe + sF

h is intercept parameter

k, l, m, n, r, s are slope parameters. They measure the effect on quantity supplied of changing one of the variables while holding the rest of variables constant.

Summary

Variable

Relation to Qs Sign of slope parameter

P Direct k = ∆Qs/∆P is positive

PI Inverse l = ∆Qs/∆PI is negative

Pr Inverse for substitutes in production

m = ∆Qs/∆Pr is negative

Direct for complements in production

m = ∆Qs/∆Pr is positive

Summary

Variable

Relation to Qs Sign of slope parameter

Tech Direct n = ∆Qs/∆Tech is positive

Pe Inverse r = ∆Qs/∆Pe is negative

F Direct s = ∆Qs/∆F is positive

Simplified version of generalized supply function

• Technology (Tech), expected future price (Pe) and price of related goods (Pr) are omitted for simplification

Qs = h + kP + lPI + sF

Supply Function

• The relation between price and quantity supplied per period of time, when all other factors that affect supply are held constant, is called a supply function or simply supply.

• Supply gives, for various prices of a good, the corresponding quantities that producers are willing to supply at each of those prices, all other things held constant.

Supply Function….

• A supply function can be expressed as an equation, a schedule or table, or a graph.

• A supply function can be expressed in the most general form as the equation

Qs = f(P)

which means that the quantity supplied is a function of (depends on) the price of the good, holding all other variables constant

Supply Function….

• A supply function is obtained by holding all the variables in the generalized supply function constant except price

Qs = f(P, PI, F) = f(P)

Derivation of supply function from generalized supply function

• Suppose generalized supply function is

Qs = 50 + 10P - 8PI + 5F

To derive a supply function, Qs = f(P), the variables PI and F must be assigned fixed values.

Derivation ………..

Suppose PI (Input price) is Rs. 50 and F (number of firms) is 90.

To find the supply function, fixed values of PI and F are substituted into the generalized supply function:

Qs = 50 + 10P - 8(50) + 5(90) = 50 + 10P - 400 + 450 = 100 + 10P

Derivation ………..

Linear supply function gives the quantity supplied for various product prices, holding constant the other variables that affect supply.

Derivation ………..

Supply equation can be converted into supply schedule by changing values of P in the equation, Qs = 100 + 10P.

Price Qs

65 750

60 700

50 600

40 500

30 400

20 300

10 200

Derivation ………..

Supply schedule can be converted into a graph. A graphical supply function is called a supply curve.

Supply curve

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0 100 200 300 400 500 600 700 800

Quantity supplied

Pri

ce

Supply…..

• Note that in the graph of the supply function, Qs = 100 + 10P, the independent variable P is plotted along the vertical axis and the dependent variable Qs is plotted along the horizontal axis.

• Thus the equation plotted in the figure is the inverse of the supply equation and is called inverse supply function since price is expressed as a function of quantity supplied: P = - 10 + 1/10Qs.

Supply…..

• A point on a supply curve can be interpreted as in either of two ways:

(1) The maximum amount of a good that will be offered for sale at a specific price

(2) The minimum price necessary to induce producers to offer a given quantity for sale.

Supply….

• Once a supply function, Qs = f(P), is derived from a generalized supply function, a change in quantity supplied can be caused only by a change in price.

Dynamics

• Change in quantity supplied

Increase (caused by rise in price)

Decrease (caused by fall in price)

• Change in supply (Shift in supply)

Increase (caused by change in non-price variables)

Decrease (caused by change in non-price variables)

Shifts/Change in supply

• When any one of the five variables held constant while deriving a supply function from the generalized supply relation changes value, a new supply function results, causing the entire supply curve to shift to a new location

• Change in supply can be understood from simplified version of generalized supply function

Change in supply caused by change in price of input, number of firms

Initial supply function

Qs = 50 + 10P - 8(50) + 5(90) = 50 + 10P - 400 + 450

= 100 + 10P (S0)

Suppose, input price decreases to 31.25

Qs = 50 + 10P - 8(31.25) + 5(90) = 50 + 10P - 250 + 450

= 250 + 10P (S1)

Change………

Suppose, number of firms decreases to 30

Qs = 50 + 10P - 8(50) + 5(30)

= 50 + 10P - 400 + 150

= - 200 + 10P (S2)

Price S0: 100 + 10P

[PI=50, F=90]

S1: 250 + 10P

[PI=31.25, F=90]

S2: - 200 + 10P

[PI=50, F=30]

65 750 900 450

60 700 850 400

50 600 750 300

40 500 650 200

30 400 550 100

20 300 450 0

10 200 350 0

0 100 250 0

Changing Supply Curve

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0 200 400 600 800 1000

Quantity supplied

Pri

ce

Summary of Supply Shifts

Determinants of supply Supply increases

Supply decreases

Sign of slope parameter

Price of Inputs (PI) PI falls PI rises l < 0

Price of goods related in production (Pr)

Substitute goods Pr falls Pr rises m < 0

Complement goods Pr rises Pr falls m > 0

Summary of Supply …..

Determinants of Supply

Supply increases

Supply decreases

Sign of slope parameter

State of Technology (Tech)

Tech rises Tech falls n > 0

Expected Price (Pe) Pe falls Pe rises r < 0

Number of firms (F)

F rises F falls s > 0

Understanding the Market Mechanism

Market Equilibrium

Defined• Market equilibrium is a situation in which, at the

prevailing price, consumers can buy all of a good they wish and producers can sell all of the good they wish.

• In other words, equilibrium occurs when price is at a level for which quantity demand demanded equals quantity supplied.

• In equilibrium, the price is called equilibrium price and the quantity sold is called equilibrium quantity

Market equilibrium - Table

Price Qs

[Qs = 100 + 10P]

Qd

[Qd = 1300 + 20P]

Qs - Qd

65 750 0 +750

60 700 100 +600

50 600 300 +300

40 500 500 0

30 400 700 -300

20 300 900 -600

10 200 1100 -900

Market equilibrium - Equation

Qd = 1300 – 20P

Qs = 100 + 10P

Equilibrium requires, Qd = Qs

i.e., 1300 – 20P = 100 + 10P

Solving this equation for equilibrium price,

1300 – 100 = 10P + 20P

1200 = 30P

P = 1200/30 = 40

Market equilibrium - Equation

Thus, 40 is market clearing price

At this price (40),

Qd = 1300 – 20P = 1300 – (20 *40) = 500

Qs = 100 + 10P = 100 + (10*40) = 500

Equilibrium price: 40

Equilibrium quantity demanded: 500

Equilibrium quantity supplied: 500

Market equilibrium - Graph

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Quantity demanded/supplied

Pri

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Supply

Demand

Market equilibrium…When the current price is above the equilibrium price,

quantity supplied exceeds quantity demanded. The resultant excess supply induces sellers to reduce price in order to sell the surplus.

If the current price is below equilibrium price, quantity demanded exceeds quantity supplied. Resultant excess demand causes the unsatisfied consumers to bid up price.

Since prices below equilibrium are bid up by consumers and prices above equilibrium are lowered by producers, the market will converge to the equilibrium price-quantity combination.

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0 200 400 600 800 1000 1200 1400 1600

Quantity demanded/supplied

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Change in Demand (Supply Constant)When Demand increases and Supply is constant, equilibrium price and quantity both rise.When Demand decreases and Supply is constant, equilibrium price and quantity both fall

A

B

C

Supply

DemandD0

D1

D2

XY

S0

Change in Supply (Demand Constant)When Supply increases and Demand is constant, equilibrium price falls and equilibrium quantity rises.When Supply decreases and Demand is constant, equilibrium price rises and equilibrium quantity falls

0

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0 200 400 600 800 1000 1200 1400

Quantity demanded/supplied

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TR

S

Demand

S0S1

S2

XY

D0

Simultaneous shifts in both Demand and Supply

When demand and supply both shift simultaneously, if the change in quantity can be predicted, the change in price is indeterminate. If the change in price can be predicted, the change in quantity is indeterminate.

The change in equilibrium quantity or price is indeterminate when the variable can either rise of fall depending upon the relative magnitude by which demand and supply shift.

Demand increases & Supply IncreasesQ rises; P may rise, fall, remain constant

D0

D1

S0S1

S2S3

P0/P2

P1

P3

Q0 Q1 Q2 Q3

AB

C

D

Demand increases & Supply DecreasesP rises; Q may rise, fall, remain constant

D0D1

S0

P0

P1

P3

Q0/Q1Q2

Q3

S1S2

P2

S2

A

BC

D

Demand decreases & Supply IncreasesP falls; Q may rise, fall, remain constant

P0

P2

P1

Q0/Q1Q1

Q2 Q3

D0

D1

S0

A

S1

B

S2

C

S3

P3 D

Demand decreases & Supply decreasesQ falls; P may rise, fall, remain constant

D0

D1

S0

A

Q0

P0/P1

S1

Q1

B

S2

Q2

P2C

S3

P3

Q3

D