PART 2

THE PRICE MECHANISM

Chapter 3
Demand, supply and equilibrium

Demand Supply

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Lecture Plan
• Demand curve
• The law of demand
• The law of supply
• Supply curve
• Equilibrium
• Disequilibrium
• Conditions of demand
• Conditions of supply

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Demand
• A market consists of:
– Buyers (demand)
– Sellers (supply)
– Exchange
• Effective demand = the quantity of a commodity
which consumers will purchase at a given price
per time period

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The Demand Schedule
• A table showing the quantity demanded of a
product at various prices
• Example: Demand schedule for Big Macs
Price Qty demanded
$1 500
$2 400
$3 300
$4 200
$5 100

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The Demand Curve
• Graphical representation of demand schedule

Example: Demand curve for Big Macs

Price
5
$
4
3
2
1
100 200 300 400 500
Quantity
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The Law of Demand
• As price increases the quantity demanded
decreases
Conversely:
• As price decreases the quantity demanded
increases

(cont.)

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The Law of Demand (cont.)
• Reflects an inverse relationship, i.e.
as price , quantity demanded

as price , quantity demanded

• The law of demand is caused by:
– The income effect
– The substitution effect

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The Income Effect
• As prices increase, consumers will purchase
fewer goods and services. Their purchasing
power (or real income) decreases
Quantity demanded decreases
• As prices decrease, the purchasing power of
consumers increases
Quantity demanded increases

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PPT Slides t/a Economics for Business 3e by Fraser, Gionea and Fraser 3-8
The Substitution Effect
• As prices increase, consumers generally purchase
more of a substitute product whose price is lower
• A substitute product is a product that performs a
similar function and satisfies the same consumer
need/want e.g.:
– Tea/coffee
– Butter/margarine
• If the price of butter increases, the quantity
demanded will fall as consumers will substitute
butter with margarine

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PPT Slides t/a Economics for Business 3e by Fraser, Gionea and Fraser 3-9
Supply
• Definition: the quantity of a product which
producers offer to the market at a certain price
per unit of time

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PPT Slides t/a Economics for Business 3e by Fraser, Gionea and Fraser 3-10
The Law of Supply
• As price increases the quantity supplied increases
conversely
as price decreases the quantity supplied decreases
• The law of supply is a direct relationship between
price and quantity supplied
• As price , quantity supplied
• As price , quantity supplied
• The logic of the law of supply:
– Producers will seek to maximise their profits i.e.: supplying
more at higher prices and less at lower prices

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PPT Slides t/a Economics for Business 3e by Fraser, Gionea and Fraser 3-11
The Supply Schedule
• A table showing the quantity supplied at various
prices
• Example: Supply schedule for Big Macs
Price Qty supplied
$1 200
$2 300
$3 400
$4 500
$5 600

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PPT Slides t/a Economics for Business 3e by Fraser, Gionea and Fraser 3-12
The Supply Curve
• A graphic representation of the supply schedule
Example: Supply curve for Big Macs

5
Price Supply curve
4
$ 3
2
1
Quantity
200 300 400 500 600

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PPT Slides t/a Economics for Business 3e by Fraser, Gionea and Fraser 3-13
Market Equilibrium
• Supply and demand can now be brought together
to form the price mechanism
P S

Pe Equilibrium point (Pe)

D
Q
Qe (cont.)

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Market Equilibrium (cont.)

Market equilibrium (E) is where:

• Quantity demanded = quantity supplied
(intersection of demand and supply curves)
• The market is cleared (no shortages or surpluses)
• Price (Pe) is stable

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Market Disequilibrium
= where quantity demanded is NOT EQUAL to
quantity supplied
• Types:
1. Market shortage: where
quantity demanded > quantity supplied
2. Market surplus (oversupply): where
quantity supplied > quantity demanded

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Market Shortage
• Caused by setting price BELOW the equilibrium

P S

Pe
Shortage D
Q
Qs Qd

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Market Surplus

• Caused by setting price ABOVE the equilibrium

P S

D
Q
Qd Qs
Surplus

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Changes in Demand
• Certain factors (other than price changes) affect the
absolute level of demand
• These factors are called conditions of demand
• Changes to the conditions of demand cause
changes in demand and this results in shifts of the
demand curve

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An Increase in Demand
• The entire demand curve shifts to the right

P
E1 S
Pe
1

E
Pe
D D1
EQ EQ1
Q

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A Decrease in Demand
• The entire demand curve shifts to the left
• Caused by a factor other than price
P S
E
Pe
E1
Pe1
D1
D
Q
Qe1 Qe

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Conditions of Demand
• Change in tastes
• Improvements in technology
• Real income
• Change in population
• Change in the price of substitutes
• Change in the price of other goods
• Expectations of the future
• Advertising

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PPT Slides t/a Economics for Business 3e by Fraser, Gionea and Fraser 3-22
Changes in Supply
• Certain factors (other than price changes) affect the
absolute level of supply
• These factors are called conditions of supply and
they result in shifts of the supply curve (not
movements along it)

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PPT Slides t/a Economics for Business 3e by Fraser, Gionea and Fraser 3-23
An Increase in Supply
• Supply curve shifts to the right

P S S1
E
Pe E1
Pe1
D
Q
Qe Qe1

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A Decrease in Supply
• Supply curve shifts to the left

P
S1 S
E1
Pe
1

Pe E
D
Q
Qe1 Qe

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PPT Slides t/a Economics for Business 3e by Fraser, Gionea and Fraser 3-25
Conditions of Supply
• Improvements in technology
• A change in production costs
• A change in the price of alternative products
• Weather and seasons

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