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Theory of Supply and Demand § How supply and demand determine the price of 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 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 theory of demand supply

Types of Markets § Perfectly competitive markets have the following two § § characteristics: 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 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 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 Demand § Market demand is the horizontal sum of all individual Market Versus Individual Demand § Market demand is the horizontal sum of 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 Demand Curve § Any change that varies the quantity Shifts Versus Movements Along the Demand Curve § Any change that varies the quantity that 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 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 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 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 § § § 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 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 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 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 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 Analyzing Changes in Equilibrium: Summary DEMAND/ SUPPLY No change in demand No change in Increase in Supply supply Decrease in supply Increase in demand P same Q same P up Q up P up Q down P up Q ambiguous Decrease in demand P down Q down P down Q up P ambiguous Q up P down Q ambiguous P ambiguous Q down

How Prices allocate Resources § Prices act as signals that guide the allocation of 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