Economics 1A: Lectures 4-5

Demand and Supply

Ioana R. Moldovan
University of Glasgow
Outline

1. Demand

2. Supply

3. The determination of price

4. Government intervention in markets: price controls

1. Demand

Demand and quantity demanded

Quantity demanded QD : the amount consumers wish to purchase at a given price. It

depends on the following factors: the price of the product, the price of other products,
the consumers available income, his/her tastes/preferences, and other factors.

Demand: gives the relationship between quantity demanded and price, assuming all
other factors/inuences remain unchanged (ceteris paribus). The curve is labelled D
and it represents the demand curve. The negative slope of the demand curve indicates
that quantity demanded increases as the price falls (the law of demand).

In general the market demand curve is the horizontal sum of the demand curves of all
consumers in the market.

Substitutes versus complements

Substitutes are alternative goods which can satisfy the same needs (e.g. concerts and
movies, fruit and cakes, etc). Complements are goods which are used jointly (e.g. skis
and ski boots, notebooks and pens, computers and adapters, etc.). The demand for a
good is aected by a change in the price of its substitutes and complements.

Normal versus inferior goods

An increase in available income will increase the demand for a normal good (e.g. clothes,
food, travel services, etc) but decrease the demand for an inferior good (e.g. goods of
inferiorquality).

Change in demand versus change in the quantity demanded

A movement along the D curve reects a change in the quantity demanded associated
with a change in the price of the good in question.

A shift in the D curve means a change in demand, as more/less is demanded at each

price. An increase in demand (right shift in D-curve) can be caused by:

* a rise in the price of a substitute

* a fall in the price of a complement

* a rise in income

* a change in tastes that favours the commodity

2. Supply

Supply and the quantity supplied

Quantity supplied QS : the amount rms are able and willing to produce and oer
for sale at a given price: It depends on: the price of the good, the prices of inputs in
production, the available technology.

Supply: the relationship between quantity supplied and price. The supply curve has a
positive slope indicating that quantity supplied increases as price increases (generally
due to increasing costs of producing additional units of output more on this later).

Change in supply versus change in the quantity supply

A movement along the S curve reects a change in the quantity supplied associated
with a change in the price of the good.

A shift in the supply curve indicates more/less is supplied at each price. An increase in
supply can be caused by:

* a fall in the price of inputs that are important in producing the commodity

* improvements in production technologies

3. The determination of price (competitive markets)

Perfectly competitive markets: markets with very many buyers and sellers, so that the
actions of any one individual or rm do not signicantly aect the market price.

The market is in equilibrium when the price is such that it equalizes the quantity de-
manded and the quantity supplied. This price is called equilibrium price (or market-
clearing price) (Pe) and the quantity of goods exchanged is called the equilibrium
quantity (Qe).

At equilibrium, there is no incentive to change: at the equilibrium price, suppliers are

able to sell the quantity they would like to see at that price, while buyers are able to
buy the quantity they wish at that price.

At prices other than the equilibrium price, QD 6= QS and we observe surpluses (excess
supply) or shortages (excess demand). In such cases, prices adjust to eliminate any dis-
crepancies between the quantity demanded and supplied. There is a movement towards
the equilibrium.
 P S
surplus
Equilibrium occurs at (Pe , Qe ) P1

At P1, there is a surplus of goods

(excess supply). Pe

At P2, there is a shortage of goods P2

(excess demand).
D

0 Qe Q
shortage
Changes in supply and demand will induce changes in the equilibrium conditions (Pe; Qe)

An increase in demand leads to Pe " and Qe ". An increase in supply: Pe # and Qe ".
An increase in both demand and supply increases the equilibrium quantity (Qe ") but
has an ambiguous eect on the equilibrum price (Pe ?), depending on which side of the
market increased by more.

P S P S1

S2
P2

P1 P1

D2 P2
D1 D

0 Q1 Q2 Q 0 Q1 Q2 Q

An increase in demand An increase in supply

4. Government intervention in markets: price controls

The government imposes a price on the market. The market is no longer in equilibrium,
leading to excess demand or excess supply.

I. Maximum Price (Price Ceiling):

species highest permissible price: e.g. rent controls

creates shortages

P
S
Potential gains
for black market

Pe

Price Ceiling
(Pmax)
D

QS QD Q
Quantity
sold
Excess Demand (Shortage)
Remarks:

Price ceiling is redundand above Pe.

Allocation of available supply:

sellerspreferences

rst come - rst serve basis

government rationing

black market: high potential gains

Purpose of price ceiling policy:

keep priced down: possible failure (black market)

control production: maybe OK

Eects of an Increase in Demand

P
D+
S
D

Pe2
E2
Pe1 E1

Price Ceiling
(Pmax)

QS QD1 QD2 Q
Quantity
sold

Increased shortage

Shortage worsens if demand increases and/or supply falls.

Shortage is reduced (or even eliminated) if demand decreases and/or supply rises. Check!
II. Minimum Price (Price Floors)

species lowest permissible price: e.g. minumum wages

creates surpluses

P
S
Price Floor
(Pmin)

Pe

QD QS Q
Quantity
sold
Excess Supply (Surplus)

Price oor is redundand below Pe.

Reading material: Lipsey & Chrystal (2011): Chapter 3.