2015, Study Session # 4, Reading # 13

DEMAND AND SUPPLY ANALYSIS: INTRODUCTION

1. INTRODUCTION

Economics

Macroeconomics: Study of economy as

a whole i.e. aggregate economic
quantities.

Microeconomics: Study of decisions

made by consumers, businesses as well
as individual markets.

Consumers or households: Consumer

theory deals with consumption (max.
utility).

Firms: Theory of firm deals with supply

of goods & services by firms (max.
profit).

Demand & Supply Analysis: Determination of prices &

quantities through interaction of buyers and sellers.

2. TYPES OF MARKETS

Factor market: (aka input market)

market where factors of production are
sold & purchased.

Goods market (aka product/output

market): output of production (i.e.
goods & services) is exchanged.

Firms use of factors of production to

produce intermediate & final goods.

Firms are seller & both households &

firms are buyers.

Labor market: work is supplied by

households (to earn wages) to firms
that demand labor.

Capital market: households supply their

savings to firms that need funds to buy
capital goods.

Land market: households supply land or

other real property in exchange for rent.

Financial institutions & markets:

facilitate transfer of savings into capital
investments.

3. BASIC PRINCIPLE AND CONCEPTS

Demand:

Willingness & ability of consumers to buy a given
quantity of good/service at a given price.

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2015, Study Session # 4, Reading # 13

Factors Affecting Demand

Product own price.

Consumer income.

Price of related goods

Substitutes:
P

Q (Coke & Pepsi)

Compliments:
P
 Q (Automobile & Gasoline)

Tastes

Expectations about future prices & income.

Number of consumers/buyers.
Quantity Demanded

Amount of goods/services consumer are willing to

purchase at different prices for a given period.

Law of Demand

All else constant,
P
Q

Q
 fP
, P , M, H 
Where
Q
= Quantity demand of goods X.
P
= Price of good X
P = Price of substitute / compliment Y.
M = Consumer income
H = any other variable affecting demand.

Demand Curve

It shows the relationship b/w price of a good & quantity

demanded. The graph below illustrates an inverse demand
function:

     




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2015, Study Session # 4, Reading # 13

Change in Quantity Demanded

It refers to movement along the demand curve (i.e.

change in goods own price).

Change in Demand

It refers to shift of the demand curve. Its due to:

Consumer income.

Price of related goods.

Tastes.

Expectations.

Number of buyers.

Supply: it refers to willingness of sellers to sell a given

quantity of good/service for a given price.

Factors Affecting supply:

Product own price.

Input price.

Technology.

Number of sellers.

Quantity Supplied:
Quantity of good/service sellers are willing to
supply at different price levels at a given time
period.

Law of Supply

All else constant,
P

Q

   ,  , ,  
Where
 = Quantity supplied of good X.
 = Price of good X.
 = Price of related goods.
W = Price of input (e.g. wages).
H = other variables affecting supply.

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2015, Study Session # 4, Reading # 13

Supply Curve

It shows the relationship b/w the price of good and quantity supplied.

      




Change in Quantity Supplied

Change in Supply

It refers to movement along the curve & is due

to change in products price.

It refers to shift in the supply curve &

is due to:

Input price.

Technology.

Market Demand: Its the horizontal sum of all

individual demands 
  at each possible
price level.

 = Demand function number of consumers.

Market Supply: Its the horizontal sum of all

individual supplies   at each possible price
level.
Q
= Supply function no. of sellers/producers.

Market Equilibrium


  

The price level at which equilibrium occurs is known as equilibrium price.

The quantity supplied & demanded at equilibrium price is known as equilibrium
quantity.

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2015, Study Session # 4, Reading # 13

Excess Supply

Excess Demand

Equilibrium

General Equilibrium:

All markets and variables that are related to model
are taken into account.

Partial Equilibrium:

Concentrating on one market, while taking the
exogenous variable values as given.

Stable Equilibrium:

Equilibrium which is restored whenever price is disturbed
away from equilibrium disrupted by an external force.

Demand curve is negatively sloped.

Supply curve is positively sloped. (Or) supply curve is
negatively sloped intersects demand curve from above.

Unstable Equilibrium:

An equilibrium which is not restored if its disrupted by an
external force.

Supply curve intersects demand curve from below.

If supply curve is non-linear, there could be multiple equilibria.

Auctions as a Way to find Equilibrium Price

On basis of value of the item being sold:

Common value auction: value of item being
sold is identical for each bidder.

Private value auction: value of item being
sold unique to each bidder.

Single Price Auction: used for selling U.S. Treasury securities.

Non-competitive bidding: bidders state the total face value that
they are willing to purchase at the ultimate price.

Competitive bidding: bidders state the total face value & price at
which they are willing to purchase securities.

If offering amount = total face value bidders are willing to
purchase at that yield, then all T-bills are sold at that yield.

Demand > supply, bidders will be able to buy a proportionately
smaller amount than they demanded.

Marginal Value Curve: demand curve is also known as marginal

value curve because it shows the highest price that buyers are
willing to pay for each additional unit.

On basis of mechanism to determine price & ultimate buyer:

Ascending price (English) auction.

Starts with low price & than raises until nobody is willing to
raise price any further & item is sold to the highest bidder at
that price.

Reservation price: Minimum (maximum) acceptable price seller
(buyer) is willing to accept (pay), if price < reservation prices,
item is not sold by seller.

Drawback: seller may not receive the max. possible price.

Sealed bid auction:

Bids submitted by potential bidders can only be viewed at the
time of auction process completion.

First price sealed bid auction.

Submitted bids are viewed simultaneously.

Highest bidder wins & pays the price he/she bid in exchange for
auctioned item.

Second price sealed bid (Vickery) auction:

Highest bidder wins & pays the second highest bid submitted.

Descending price (Dutch) auction:

Auction starts at a very high price & then continuously lowers
down until one bidder agrees to buy the item at a specific price.

Single unit format: single price for all units.

Multiple unit formats: auctioneer quotes the per-unit price and
winning bidder buys fewer units than all units sold. To increase
selling units, auctioneer must lower price.

Modified Dutch auctions: its generally used in securities market. It
identifies the minimum acceptable price at which a company will buy
back shares.

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2015, Study Session # 4, Reading # 13

Consumer surplus:
CS = Value that a consumer prices on units consumed price paid
to buy those units.
CS = Value Expenditure

Maximum amount willing to pay

CS = Area = (Base Height) = Q0 (intercept - )

Marginal Cost Curve: lowest price at which sellers are willing to sell
a given amount of a good is represented by MC curve. Thus; it
represents the supply curve for a competitive seller.

Producer Surplus:
PS = Total revenue from selling a given quantity Total variable
cost of producing that quantity.

PS = Area = (Base Height)

= ! "  # $  %

Total Surplus:
TS = PS + CS
TS = Total value Total variable cost.
Society welfare = CS + PS

TS
society welfare (& society gains).
TS is maximized in a competitive market equilibrium (i.e. where P =
MC).
Supply curve is steeper than demand curve, PS > CS.
Demand curve is steeper than supply curve, CS > PS.

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2015, Study Session # 4, Reading # 13

Externality: production cost or benefit of consumption of a

good/service is spilled over to those who are neither
producing nor consuming the good/service.

-ve externality: spill over cost i.e. pollution.

+ve externality: spill over benefit i.e. literacy program.

Price Ceiling:

Maximum legal price that can be charged by sellers.

Buyers prefer to buy more at lower price.

Sellers prefer to sell less at lower price.

Results in deadweight loss.

Price Floor:

Minimum legal price that can be charged by sellers and
paid by buyers.

Buyers prefer to buy less at higher price.

Sellers prefer to sell more at higher price.

Result in deadweight loss.

Taxes

Effect of Taxes on Buyers

Demand curves shifts downward & Qd.

 <   .

 >  &.

Total surplus.

Tax revenue = Tax/unit 
at new price.

 (CS + PS) > Tax revenue collected.

Effects of Taxes on Sellers

Supply curve shifts upward & .

 Total surplus.

Tax revenue = tax/unit 
at new price.

 (CS + PS) > Tax revenue.

Deadweight loss (DWL) depends on two factors.

Size of tax.

Reduction in quantity sold.

More elastic D or S, greater the DWL.

More inelastic D or S, smaller the DWL.

Tax burden:

Demand curve is steeper than supply curve, buyers will
bear greater tax burden.

Demand curve is flatter than supply curve, buyer will
bear lower tax burden.

Total Surplus is maximized when markets operate
freely without govt. intervention.

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2015, Study Session # 4, Reading # 13

4. DEMAND ELASTICITIES

Elasticity: indicates responsiveness of one

variable to another.


Elasticity
responsiveness.

Types of Elasticity

Elasticity of Demand:

Responsiveness of demand to changes in price (all else constant).

' =

%
%

Income Elasticity of Demand:

Responsiveness of demand to changes in income of
consumers:

'

' < 0
Elastic demand |' | > 1
Inelastic demand |' | < 1
Unit elastic |' | = 1
When|' | > 1, price & total expenditure move in opposite
direction.
When|' | < 1, price & total expenditure move in same direction.
When|' | = 1, price & total expenditure are not related.
Total expenditure is max. at point. when |' | = 1
Steeper the curve at a given point, less elastic supply or demand
will be.
Flat supply & demand curve are referred as perfectly elastic. i.e.
|'| = infinity.
Vertical supply & demand curve are referred as perfectly inelastic
i.e. |'| = 0.

Determinants of Elasticity of Demand:

Amount of time taken to respond to price change: longer the time
interval more elastic the demand curve.

Number & closeness of substitutes: greater the number of
substitutes, more elastic the demand curve.

Proportion of income spent on the product: larger (smaller) the
proportion of budget, more (less) elastic the demand will be.

Luxury or necessity: demand for necessities is less elastic,
whereas, demand for luxury goods is more elastic.

%
%

Normal goods:
I
() 

()
'  > 0

I upwards & rightwards shift of demand curve.

Inferior goods:
I
() 
 (
)
'  < 0

I downward & leftwards shift of demand curve.

Cross Price Elasticity:

Responsiveness of demand of one good to changes in the price
of a related good i.e. substitutes or complement (all else
constant).
%

'
=
%

Complements:


P  Q


E
<0

 , shift the demand curve of X downward to the left.

Substitutes:


P
Q


E
>0


 , shifts the demand curves of X upward to the right.

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