Prices & Markets

Lecture 1: Demand & Supply

Martin Byford 2012

Definition: Economics /iknmks, k-/

noun The social science that analyses the production, distribution
and consumption of goods and services given unlimited wants and
scarce resources.
ORIGIN late 16th cent. (denoting the science of household
management): from ta oikonomika, the name of a treatise by
Aristotle (or his student Theophrastus).

Definition: Microeconomics /mkr-/

noun That part of economics concerned with the choices made by
individual economic agents (such as households and firms, or
buyers and sellers) and the interactions of these choices in markets.
eg. In order to undertake a microeconomic analysis it is first
necessary to understand the objectives of the individual economic
agents.

Microeconomics in Business
If you do not understand economics you do not understand
business!
Microeconomics shows us how prices affect the number of sales,
revenue and profits that a firm can realise.
Microeconomics also helps us understand the role of product
variety (differentiation), reputation (brands), contracts (HR &
outsourcing) and government (taxes & regulations).
Microeconomic theory is the foundation for most fields of business
study.

The Language of Economics

Clear communication requires a common understanding of
language.
It is important to be precise and succinct when discussing
economic phenomena.
In economics we use a number of special terms to convey specific
economic meanings; these meanings are not always the same as
the common usage of the words.
You are expected to become fluent in the use of the language of
economics.

Definition: Market /mkt/

noun A collective term for the buyers and sellers of a good or
service, and the institutions and arrangements by which they come
together to trade.
eg. As a result of the large number of farmers producing wheat,
the market for grain is very competitive.
ORIGIN Middle English, via Anglo-Norman French from Latin
mercatus, from mercari buy.

Definition: Consumer /knsjum/

noun A person who purchases a good or service for personal use
(as opposed to purchasing the good or service to assist in the
production of another good or service). plural Consumers.
Synonyms Buyer, customer, end user, client.
eg. The buying habits of consumers depend upon their personal
preferences.

Definition: Firm /fm/

noun A business or enterprise that produces one or more goods or
services for sale to consumers, government or other firms.
eg. Government often seeks to limit the market power of firms.
ORIGIN late 16th cent.: from Latin firmare fix, settle (in late
Latin confirm by signature). The word originally denoted one's
autograph or signature; later the name under which the business of
a firm was transacted, hence the firm itself (late 18th cent).

Three Tricks for Simplifying a Market

Reduce the behaviour of consumers to the number of units

(quantity) of the good or service that they wish to purchase.

Reduce the behaviour of firms to the number of units of the

good or service that they wish to sell.

Consider each factor that can influence the behaviour of

consumers and firms in isolation.

Definition: Demand /dmnd/

noun The number of units of a particular good or service that the
consumers in a market are willing to purchase during a specified
period and under a given set of conditions.
eg. The demand for large vehicles is adversely affected by high
fuel prices.
ORIGIN Middle English (as a noun): from Latin demandare hand
over, entrust (in medieval Latin demand), from de- formally +
mandare to order.

Determinants of Demand

The price of the good or service

The price of competing goods and services

The price of complementary goods and services

Consumer income

Expectations of a price change

Tastes and preferences

Advertising expenditure

Jacks Demand for Bananas

Price
($)

Quantity
(kg/week)

$3.00

$6.00

$9.00

$12.00

Definition: Demand Schedule /dmnd djul/

noun A table listing the quantity of a good or service that is
demand at each of a range of prices. Within a demand schedule all
factors that influence demand are held constant except for the price
of the good or service.

Price ($)

eg. Jake was able to construct his demand schedule by recording

the quantity of bananas he purchased as prices fluctuated over the
course of a year.

12

Price

Quantity

$3.00

$6.00

$9.00

$12.00

3
Jacks Demand Curve
0

Quantity (kg/week)

Definition: Demand Curve /dmnd kv/

noun A curve on a price-quantity graph that illustrates the
relationship between the price of a product and the quantity of the
product demanded. Along a demand curve all factors that
influence demand are held constant except for price.
eg. An increase in consumer income over the last 12 months meant
that Brian had to recalculate the demand curve for his business.

Linear Demand Curves

QD = a bP
Example
QD = 100 2P

Price (Vertical) Intercept

QD = 100

2P

0 = 100

2P

At the price intercept QD = 0

Add 2P to both sides

0 + 2P = 100

2P + 2P

2P = 100

Divide both sides by 2

2P
100
=
2
2
P = 50

Quantity (Horizontal) Intercept

At the quantity intercept P = 0

QD = 100

2P

QD = 100

20

QD = 100

Price

50

Demand
0

100

Quantity

Definition: Law of Demand /l v dmnd/

noun The law of economics that states that holding everything else
constant, when the price of a product falls, the quantity demanded
of the product will increase, and when the price of a product rises,
the quantity demanded of the product will decrease.
eg. From the law of demand Julia knew that she could increase
her firms sales by lowering its prices.

Market Demand
The total market demand for a good or service can be found by
adding together the demands of each individual consumer in the
market.
Holding all else equal as a market grows so too does the demand
for a good or service.

Price

Price

30

Joes Demand
10
Market Demand

Sams Demand
0

3 4

13

Quantity

22

Quantity

Definition: Ceteris Paribus /ketrs parbs/

adverb With other conditions remaining the same.
eg. Increasing the number of firms in a market will, ceteris
paribus, reduce the market price.

Price

ORIGIN early 17th cent.: modern Latin.

Movement along the demand curve

P2
Change in the
quantity demanded

P1

D
0

Q2

Q1

Quantity

Price

Shift of the demand curve

Change in demand

P1

D1
0

Q1

D2

Q2

Quantity

Definition: Substitute /sbsttjut/

noun A good or service that can be consumed in place of another.
Typically a product with a similar function.
eg. As the price of bananas increased many consumers switched to
consuming apples, a relatively cheaper substitute.

Price

ORIGIN late Middle English (denoting a deputy or delegate): from

Latin substitutus put in place of, past participle of substituere,
based on statuere set up.

Price of a substitute good

An increase in the price of a substitute
good causes consumers to switch to the
relatively cheaper alternative.

D1
0

D2
Quantity

Definition: Complement /kmplm()nt/

noun A good or service that is improved when consumed with
another. Includes goods and services that must be consumed
together in order to create a benefit for consumers.
eg. Aaron was annoyed when his parents bought him an X-Box but
failed to provide the complementary product, games.

Price

ORIGIN late Middle English (in the sense completion): from

Latin complementum, from complere fill up.

Price of a complementary good

An increase in the price of a complementary
good makes it more expensive to consume
the two goods bundled together, decreasing
demand.

D2
0

D1
Quantity

Definition: Normal Good /nm()l gd/

noun A product of which consumers demand more as their
incomes increase. Goods that are very sensitive to increases in
income are sometimes referred to as luxury goods.
eg. After her promotion Alison went skiing every year indicating
that for Alison skiing is a normal good.

Price

Income (Normal Good)

An increase in income increases the
quantity of the normal good that consumers
demand at each and every price.

D1

D2

Quantity

Definition: Inferior Good /nfr gd/

noun A product of which consumers demand less as their incomes
increase. Typically an inferior substitute for a more expensive
normal good.

Price

eg. Once Charlie joined the workforce he could afford steak and
no longer ate the inferior good, instant noodles.

Income (Inferior Good)

An increase in income causes consumers to
substitute away from an inferior good
causing the quantity demanded to decrease
at each and every price.

D2
0

D1
Quantity

Price

Taste for the good

As consumers taste (desire) for a good
increases they demand more of the
good at each and every price.

D1

D2

Price

Quantity

Population
An increase in population means that
more individual demand curves are
added together to form market demand.

D1

D2

Price

Quantity

Expected price in the future

If consumers expect the price to rise in
the future they will purchase (demand)
more today so that they can store some
of the good for tomorrow.

D1
0

D2
Quantity

Special Cases
Some economic phenomena do not fit neatly into the standard
market setup that we analyse in this course.
We refer to these as special cases.

Price

Some results and rules must be amended when dealing with special
cases.

Perfectly Elastic Demand

P = 20

Price

Quantity

Perfectly Inelastic Demand

D

QD = 20

Quantity

Feedback Question
Suppose that market demand is given by QD = 100 - 2P. If the
market price is $27 the quantity demanded is,
(a) QD = 46.
(b) QD = 54.
(c) QD = 73.
(d) QD = 127.

Definition: Supply /spl/

noun The number of units of a good or a service that the firms in a
market are willing to supply in a given period and under a given
set of conditions.
eg. An increase in labour costs reduces the supply of plumbing
services.
ORIGIN late Middle English: from Old French soupleer, from
Latin supplere fill up, from sub- from below + plere fill.

Determinants of Supply

The price of the good or service

The prices of raw materials used as inputs in the production

process (eg. labour and capital)

Expectations of the future

Technology

Price ($)

Supply Curve
12

Price

Quantity

$3.00

10

$6.00

20

$9.00

30

$12.00

40

10

20

30

40

Quantity (kg/week)

Describing Supply
The supply schedule is a table listing the quantity of a good or
service that is supplied at each of a range of prices.
The supply curve is a curve on a price-quantity graph that
illustrates the relationship between the price of a product and the
quantity of the product supplied.
Within a supply schedule and along a supply curve all factors that
influence supply are held constant except for price.

Linear Supply Curves

QS = a + bP

Example

QS =

20 + 2P

Price & Quantity Intercepts

At the price intercept QS = 0

QS =

20 + 2P

0=

20 + 2P

Add 20 to both sides

20 = 2P

Divide both sides by 2

10 = P

QS =

20 + 2 0

QS =

20

Price

At the quantity intercept P = 0

Supply

10

-20

Quantity

Definition: Law of Supply /l v spl/

noun The law of economics that states that holding everything else
constant, an increase in the price of a product causes an increase in
the quantity supplied, and a decrease in price causes a decrease in
the quantity supplied.
eg. In accordance with the law of supply farmers increase their
production of bananas when the price of bananas rises.

Price

Price

Dells Supply

Asus Supply

Market Supply

30

10

120

180

Quantity

Price

30
20

50

300

Quantity

Movement along the supply curve

P2
Change in the
quantity supplied

P1

Q1

Q2

Price

Quantity

Shift of the supply curve

S1

S2

P1
Change in supply

Q1

Q2

Quantity

Causes of Shifts in Supply

If the price of inputs to the production process increase firms are
less willing to supply the good or service at each and every price.
If firms expect the price of a product to increase in the future they
will supply less of the product today, storing some for sale
tomorrow.

Price

Improvements in technology reduce the cost (increase the

efficiency) of production and increase the willingness of firms to
supply at each and every price.

Perfectly Elastic Supply

P = 10

Price

Quantity

Perfectly Inelastic Supply

S

QS = 100

Quantity

Feedback Question
Which of the following influences does NOT cause the supply
curve to shift?
(a) A rise in the wages paid to workers.
(b) Development of new technology.
(c) People deciding that they want to buy more of the product.
(d) A decrease in the number of suppliers.

Definition: Equilibrium /ikwlbrm, kw-/

noun A state within a market in which supply is equal to demand
and the market price is stable.
eg. A market equilibrium is characterised by the absence of excess
demand or supply.

Price

ORIGIN early 17th cent. (in the sense well-balanced state of

mind): from Latin aequilibrium, from aequi- equal+ libra
balance.

50

Equilibrium Price
Supply

P*
Equilibrium
Equilibrium Quantity

10

Demand
-20

Q*

100

Quantity

Calculating Equilibrium
QD = 100

2P

QS =

20 + 2P
20 + 2P

In equilibrium QD = QS

100

2P =

Add 20 to both sides

120

2P = 2P

Add 2P to both sides

120 = 4P

Divide both sides by 4

30 = P

Substitute P = 30 into QD

QD = 100

2 30

Price

QD = 40

50
Supply
40
Excess Supply of
40 units

30

Quantity Demanded
Quantity Supplied

10

Demand
0

20

40

100

60

Quantity

Price

-20

50
Supply

Excess Demand of
60 units

30
Quantity
Supplied

Quantity
Demanded

15
10

Demand
-20

10

40

70

100

Quantity

The price adjustment process

If the price in a market is not equal to the equilibrium price then
the market must be experiencing either excess demand or supply.
In the case of a excess supply firms reduce their prices in order to
eliminate excess stock.
This both increases the quantity that consumers demand and
reduces the firms desire to produce.
In the case of excess demand firms raise their prices as consumers
are willing to pay more for the product than the current price.

Price

This both reduces the quantity that consumers demand and

increases the incentive for firms to produce.

Shift of the demand curve

Movement
along the
supply curve

P2
P1

D1
Q1 Q2

Quantity

Price

D2

Shift of the supply curve

S1

S2

Movement
along the
demand curve

P1
P2

D
0

Q1

Q2

Quantity

Price

Perfectly Inelastic Supply

S1

D1

Price

D2
Quantity

Perfectly Elastic Demand

S1

S2

D1

Quantity

Feedback Question
Assume that both the price and quantity traded of wheat increase.
This can be the result of the,
(a) Demand curve for wheat shifting rightward.
(b) Demand curve for wheat shifting leftward.
(c) Supply curve for wheat shifting rightward.
(d) Supply curve for wheat shifting leftward.