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Theory of Supply and

Demand
How supply and demand

determine the price of a good and


the quantity sold in the market?

Role of prices in allocating

resources in the market economy

Types of markets
Market is a group of buyers and sellers of a

particular good or service


Buyers determine the demand for a product
and sellers determine the supply of the product
Competitive market is a market in which there
are many buyers and many sellers in the
market so that each has a negligible impact on
the market price
We assume perfectly competitive markets when
we study the theory of demand and supply

Types of Markets

Perfectly competitive markets have the following two

characteristics:
Goods being sold are all the same
Both Buyers and sellers are price takers
Monopoly is characterized by:
One seller and many buyers
Seller sets the price
Oligopoly is characterized by
Few sellers without rigorous competition
The sellers get together to set a price
Monopolistic competition is characterized by
Many sellers, each selling a differentiated product
Sellers have some ability to set the price for their
own product

Law of Demand

Other things equal, the

quantity demanded of a good


falls when the price of the good
rises.
Price and quantity demanded are
negatively related
Quantity demanded is the amount
of the good that buyers are willing
to purchase

Determinants of Demand

Determinants of quantity demanded:


Income (normal, inferior)
Prices of related goods (substitutes,
complements)
Tastes
Expectations
Number of buyers (Market demand curve)

Demand schedule and Demand curve


Demand schedule is a table that shows the
relationship between the price of a good and the
quantity demanded
Demand curve graphs the demand schedule. The
demand curve slopes downward

Market Versus Individual


Market demand
is the horizontal sum of
Demand

all individual demands for a particular


good or service
Market demand is derived from individual
demands and thus depends on all those
factors that determine individual demand
(income, expectations, etc)
In our case, market demand curve shows
the variations in the quantity demanded
of a good as price changes

Shifts Versus Movements Along the


Any changeDemand
that varies
the quantity that
Curve

buyers wish to buy at a given price shifts the


demand curve
Changes in price that varies the quantity that
buyers wish to buy is represented as a
movement along the demand curve
To summarize: Demand curve shows what
happens to the quantity demanded of a good
when its price varies, holding constant all
other determinants of quantity demanded.
When one of these determinants changes, the
demand curve shifts.

Application of law of Demand:


Policy to Reduce Smoking

Option #1: Raise prices of

cigarettes by levying a tax


Option #2: Introduce a public
awareness program regarding ill
effects of smoking
Policy impact on substitutes
Policy impact on complements

SUPPLY
Quantity supplied of any good is the

amount that sellers are willing to sell


in the market
Determinants of supply:
Price
Input prices
Technology
Expectations
Number of sellers (Market supply curve)

Law of Supply
Other things equal, the quantity

supplied of a good rises when the price


of the good rises.
Quantity supplied is positively related
to the price of the good
Supply schedule is a table that shows
the relationship between the price of a
good and the quantity supplied
Supply curve graphs the supply
schedule. It is upward sloping

Market Versus Individual Supply


Market supply is derived by horizontally

summing the individual supply curves


Market supply curve shows how the
quantity supplied varies as the price of the
good varies
Any change that varies the quantity
supplied at a given price shifts the supply
curve
Changes in price that varies the quantity
supplied in the market is represented as a
movement along the supply curve

SUPPLY AND DEMAND


How do supply and demand combined
together determine the quantity and
price of a good sold in the market?
Supply and demand curves intersect. At
this equilibrium price quantity supplied
equals quantity demanded
Equilibrium is a situation in which supply
equals demand
Equilibrium price is also called as the
market clearing price as quantity supplied
equals quantity demanded

SUPPLY AND DEMAND


What happens when market price
is not equal to the equilibrium
price?

Excess supply- surplus in the market


Excess demand- shortage in the market

Free markets reach equilibrium

through the interaction of buyers and


sellers and price is the tool through
which the market is cleared

LAW OF SUPPLY AND DEMAND


Other things remaining same, the price

of any good adjusts to bring the supply


and demand for that good into balance.
Shifts versus movements along curves
Change in quantity supplied and change
in quantity demanded is represented as a
movement along the fixed supply and
demand curves respectively
Change in supply and change in demand
is represented as shifts in supply and
demand curves respectively

Analyzing Changes in
Equilibrium: Application

1. Change in demand- shifts in the


demand curve
2. Change in supply- shifts in the
supply curve
3. Changes in both supply and
demand- Change in equilibrium
quantity and price
A simple application

Analyzing Changes in
Equilibrium: Summary
DEMAND/
SUPPLY
No change in
demand

No change
in Supply

Increase in Decrease in
supply
supply

Increase in
demand

P same
Q same
P up
Q up

Decrease in
demand

P down
Q down

P down
Q up
P
ambiguous
Q up
P down
Q
ambiguous

P up
Q down
P up
Q
ambiguous
P
ambiguous
Q down

How Prices allocate


Resources

Prices act as signals that guide

the allocation of scarce resources


in a market economy
Prices in turn are determined by
forces of supply and demand