Theory of Supply and Demand

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

Theory of Supply and Demand

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Theory of Supply and

determine the price of a good and

Role of prices in allocating

resources in the market economy

particular good or service

Perfectly competitive markets have the following two

Other things equal, the

quantity demanded of a good

Determinants of quantity demanded:

Demand schedule and Demand curve

Market Versus Individual

all individual demands for a particular

Shifts Versus Movements Along the

buyers wish to buy at a given price shifts the

Application of law of Demand:

Option #1: Raise prices of

cigarettes by levying a tax

amount that sellers are willing to sell

supplied of a good rises when the price

Market Versus Individual Supply

summing the individual supply curves

SUPPLY AND DEMAND

SUPPLY AND DEMAND

Excess supply- surplus in the market

Free markets reach equilibrium

through the interaction of buyers and

LAW OF SUPPLY AND DEMAND

of any good adjusts to bring the supply

1. Change in demand- shifts in the

How Prices allocate

Prices act as signals that guide

the allocation of scarce resources

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