Chap2

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Chapter 2

DEMAND, SUPPLY & MARKET

EQUILIBRIUM

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Chapter Outline

• 1.1 Introduction: Market and the Circular Flow• 1.2 Demand (DD)• 1.3 Supply (SS)

• 1.4 Market Equilibrium• 1.5 Change in Equilibrium

(SS & DD)• 1.6 SS/DD Analysis:

Example

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1.1 INTRODUCTION1.1 INTRODUCTION

Demand & supply

interaction

Economics decision-making units

Market & the circulation flow

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Markets

• A market is a group of buyers and sellers of a particular goods and services.

• A market may be local, national or international in scope.

• This chapter concern purely competitive market with a large number of independent buyers and sellers.

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1.2 DEMAND1.2 DEMAND

• Quantity consumers are both willing and able to buy at each possible price during a given time period, other things constant.

• can be defined as the purchase of product

How many packs of ‘ai yu bing’ will student

buy at a price of RM2? What if the price is

RM1.50?

Relationship between price & quantity demanded

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Law of Demand– Says that quantity demanded varies inversely, or

negatively, to the price, other things constant.– Negative relationship between price and quantity

demanded.– The higher the price, the smaller the quantity

demanded.

Figure: Price & Quantity Demanded: The Law of Demand

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Demand Schedule & Demand Curve

– The demand schedule is a table that shows the relationship between the price of the good and the quantity demanded.

– The demand curve is a graph of the relationship between the price of a good and the quantity demanded.

• Downward sloping & to the right because law of demand.

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May’s Demand Schedule and May’s Demand Schedule and Demand CurveDemand Curve

Price ofIce-Cream Cone

0

2.50

2.00

1.50

1.00

0.50

1 2 3 4 5 6 7 8 9 10 11 Quantity ofIce-Cream Cones

$3.00

12

1. A decrease in price ...

2. ... increases quantity of cones demanded.

Example

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Individual Demand & Market demand

– The individual demand is the relationship between the quantity demanded by a single buyer and its prices

– The market demand is the relationship between the total quantity demanded by all consumers in the market and its price.

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Price of Ice-Cream Cone

Price of Ice-Cream Cone

Price of Ice-Cream Cone

2.00 2.00 2.00

4 3 7

1.00 1.001.00

8 5 13

Quantity of Ice-Cream Cones Quantity of Ice-Cream Cones Quantity of Ice-Cream Cones

Catherine’s Demand Nicholas’s Demand Market Demand+ =

When the price is $2.00, Catherine will demand 4 ice-cream cones.

When the price is $2.00, Nicholas will demand 3 ice-cream cones.

The market demand at $2.00 will be 7 ice-cream cones.

When the price is $1.00, Catherine will demand 8 ice-cream cones.

When the price is $1.00, Nicholas will demand 5 ice-cream cones.

The market demand at $1.00, will be 13 ice-cream cones.

ExampleThe market demand curve is the horizontal The market demand curve is the horizontal

sum of the individual demand curves!sum of the individual demand curves!

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Changes in Quantity Demanded Changes in Quantity Demanded & Changes in Demand& Changes in Demand

– Changes in quantity demanded result in movement along the demand curve due a change in price while other factors remain constant. (upward/downward movement)

– Change in demand is the shift of the demand curve due a change in other factors while price remains constant. (leftward/ rightward shift)

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D

Price of Ice-Cream Cones

Quantity of Ice-Cream Cones

A tax on sellers of ice-cream cones raises

the price of ice-cream cones and results in a movement along the

demand curve.

A

B

8

1.00

$2.00

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Changes in Quantity Changes in Quantity DemandedDemanded

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Change in DemandChange in Demand

• A shift in the demand curve either to the left or right caused by any changes that alters the quantity demanded at every price. Such as: Income Prices of related goods Tastes Expectations Number of buyers

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Shifts in The Demand Shifts in The Demand CurveCurve

Price ofIce-Cream

Cone

Quantity ofIce-Cream Cones

Increasein demand

Decreasein demand

Demand curve, D3

Demandcurve, D1

Demandcurve, D2

0

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Changes in Consumer Income

• Goods can be classified into two broad categories: Normal goods: the demand

increases when income increases and decreases when income decreases

Inferior goods: the demand decreases when income increases and increases when income decreases

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Changes in Price of Related Good

(i) Substitute Goods- A product that can be used in

place of another product- A change in the price of

substitute products affect the demand for the product in the same direction in which the price change.

- E.g: tea vs coffee; a bus ride vs an LRT ride

( Pcoffee↑ Qdd coffee↓ DDtea↑)

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Changes in Price of Related Good

(ii) Complementary Goods- A product that is used in

conjunction with another product.

- The change in the price of a complementary product affects the demand for the product in the opposite direction to the change price.

- E.g: a disk and computer, pen and ink.

( Ppen↑ Qdd pen↓ DDink↓ )

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Taste & PreferenceTaste & Preference

– Tastes and preferences of consumers change significantly.

– If a product become more fashionable, the demand for it will increase and if the same product becomes outdated, the demand for it will fall.

– E.g: Changes in music, apparel or recreation.

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ExpectationsExpectations

– The higher the expected future price of a product, the higher the current demand for that product and vice versa.

– E.g: When the government plans to increase the price of sugar the following week, the demand for sugar will immediately increase.

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Population or Number of Population or Number of BuyersBuyers

– A larger population with a high rate of growth creates greater demand for goods and services.

– E.g: An increase in the population of UTAR would increase the demand for houses, F & B, and other goods and services.

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• Taste / preference

Summary for Movement/Shift in Demand

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1.31.3 SUPPLYSUPPLY

• Supply indicates how much of a good producers are willing and able to offer for sale per period at each possible price, other things constant

• Law of supply states that the quantity supplied is usually directly related to its price, other things constant The lower the price, the smaller the quantity

supplied The higher the price, the greater the quantity

supplied

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Supply Schedule & Supply Curve

– The supply schedule is a table that showing how much of a product firms will set at different prices.

– The supply curve is a graph illustrating how much of a product a firm will set at different prices.

• Upward slopping & to the right due to the law of supply.

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Ben’s Supply Schedule and Supply Curve

Price ofIce-Cream

Cone

0

2.50

2.00

1.50

1.00

1 2 3 4 5 6 7 8 9 10 11 Quantity ofIce-Cream Cones

$3.00

12

0.50

1. Anincrease in price ...

2. ... increases quantity of cones supplied.

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Individual Supply & Market Supply

– The individual supply is the relationship between price of good and the quantity an individual producer is willing and able to sell per period, other things constant.

– The market supply is the sum of all that is supplied each period by all producers of a single product.

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Market Supply CurveMarket Supply Curve

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Changes in Quantity Supplied Changes in Quantity Supplied & Changes in Supplied& Changes in Supplied

– A changes in quantity changes in quantity suppliedsupplied result in the movement along the supply curve due a change in price while other factors remain constant.

– Change in supplyChange in supply is shift of supply curve resulting from a change in one of the determinants of supply other than price of the goods.

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Price of Ice-Cream Cone

Quantity of Ice-Cream Cones0

S

1.00A

C$3.00 A rise in the price

of ice cream cones results in a movement alongmovement along the supply curve.

Change in Quantity Change in Quantity SuppliedSupplied

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Changed in SupplyChanged in Supply

• A shift of the supply curve, either to the left or right.

• Determinants of supply other than the price of the good Cost of production Technology Prices of related goods Expectation Number of sellers

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Shifts in The Supply Shifts in The Supply CurveCurve

Price ofIce-Cream

Cone

Quantity ofIce-Cream Cones

Increasein supply

Decreasein supply

Supplycurve, S1

Supplycurve, S3

0

Supplycurve, S2

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The Cost of ProductionThe Cost of Production– Response to the factor of production

(labor, land, capita, energy, and so on).– Supply of a goods are negatively related

to the price of the inputs used to make the good.

– Objective is to maximize profit.– Example: to produce ice-cream, sellers use

various inputs such as cream, sugar, flavoring, ice-cream machines. When price of one or more of these inputs rises, producing ice-cream is less profitable & firm supply less ice-cream.

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TechnologyTechnology– Represents the economy’s knowledge

about how to combine resources efficiently.

– If a better technology is discovered, production costs will fall. Thus, suppliers will be more willing & able to supply the good at each price.

– Example: when new technology are introduced in the production of sushi, supply of sushi will increase and shift the supply curve.

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Price of Related GoodsPrice of Related Goods– Substitutes Goods

• If there is an increase in the price of substitute goods in production, supply of a good will decrease.

• Example: Pepsi and Coke

( Ppepsi ↑QSS pepsi↑ SScoke↓ )

– Complementary Goods• An increase in the price of complementary

goods will increase the supply of a good & vice versa.

• Example: Pen and Ink

( Ppen ↑QSS pen↑ SSink ↑ )

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ExpectationsExpectations– Expectation of price in the

future could either increase or decrease current supply.

– Example: when government announced an increase in the price of petrol, current supply will decrease because the supplier wants to sell after the price hike to gain profit with new price.

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Number of SellersNumber of Sellers– Market supply sums the amount

supplied at each price by all producers, market supply depends on the number producers in the market.

– Example: if there are more than one economic rice shop at New Town, there will be more economic rice supplied.

Shift of SS curve

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Summary for Movement/Shift in Supply

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DD & SS Interaction

Output (Product) MarketOutput (Product) Market

1.4 MARKET EQUILIBRIUM1.4 MARKET EQUILIBRIUM

3 set of market condition / effect:

(a) The quantity demanded equal the quantity supplied at the current price. This situation called “equilibrium”

(b) The quantity demanded exceeds the quantity supplied at the current price. This situation called “excess demand” or “shortage”

(c) The quantity supplied exceeds the quantity demanded at the current price. This situation called “excess supply” or “surplus”

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EquilibriumEquilibrium

Price ofIce-Cream

Cone

0 1 2 3 4 5 6 7 8 9 10 11 12Quantity of Ice-Cream Cones

13

Equilibriumquantity

Equilibrium price Equilibrium

Supply

Demand

$2.00

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Market EquilibriumMarket Equilibrium– The condition that exists in a market

when the plans of buyers match those of sellers, so quantity demanded equals quantity supplied and the market clears. There is no tendency for price to change.

DD = SS

• Equilibrium price– The price that balances quantity

supplied and quantity demanded.

• Equilibrium quantity– The quantity supplied and the quantity

demanded at the equilibrium price.

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Excess SupplyExcess Supply(Surplus)(Surplus)

Price ofIce-Cream

Cone

0

Supply

Demand

Quantitydemanded

Quantitysupplied

Surplus

Quantity ofIce-Cream

Cones

4

$2.50

10

2.00

7

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Excess Supply (Surplus)Excess Supply (Surplus)

– When: PriPrice > Equilibrium Price,

then Qs > Qd - There is excess supplyexcess supply or a

surplussurplus. - Suppliers will lower the price to

increase sales, thereby moving toward equilibrium.

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Excess Demand Excess Demand (Shortage)(Shortage)

Price ofIce-Cream

Cone

0 Quantity ofIce-Cream

Cones

Supply

Demand

Quantitysupplied

Quantitydemanded

1.50

10

$2.00

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Shortage

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Excess Demand (Shortage)Excess Demand (Shortage)– When: Price < Equilibrium PricePrice < Equilibrium Price, then Qd > QsQd > Qs

- There is excess demandexcess demand or a shortageshortage.

- Suppliers will raise the priceraise the price due to too many buyers chasing too few goods, thereby moving toward equilibrium.

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1.5 CHANGE IN 1.5 CHANGE IN EQUILIBRIUMEQUILIBRIUM

• The market equilibrium will change when there is a shift in the demand or supply curve.

• We will see what happens when:The demand curve shifts and

supply remains constant.The supply curve shifts and

demand remains constant.Both the demand and supply

curves shift.

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Three Steps for Analyzing Changes in Equilibrium

1. Decide whether the events shifts the supply or demand curve (or both)

2. Decide in which directiondirection the curve shifts.

3. Use the supply-and-demand supply-and-demand diagramdiagram to see how the shift changes the equilibrium price equilibrium price and quantityand quantity..

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Effect of Change in Effect of Change in DemandDemand

• Change in DD can arise from a number of factors; change in income, tastes, etc.

Quantity

PriceSS

D0 D1

E0

E1

•Suppose there is an increase in the demand for ‘Pilot’ pens, the demand curve will demand curve will shift rightwardsshift rightwards, to D1.

• Equilibrium price will Equilibrium price will increaseincrease, and equilibrium equilibrium quantity will also increase.quantity will also increase.

Note: If there is a decrease in the demand, the effect will be vice versa.

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Effect of Change in Effect of Change in SupplySupply

• Change in SS can arise from a number of factors; change in cost, technology, etc.

Quantity

Price S0 S1 •Suppose there is an increase in the supply for ‘Pilot’ pens, the supply curve will supply curve will shift rightwardsshift rightwards, to S1.

• Equilibrium price will Equilibrium price will decreasedecrease, and equilibrium equilibrium quantity will increase.quantity will increase.

Note: If there is a decrease in the supply, the effect will be vice versa.

DD

E0

E1

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Effect of Changes in Both Effect of Changes in Both Demand and SupplyDemand and Supply

(a) Supply change > demand change (b) Supply change < demand change

• As long as only one curve shifts, equilibrium price and quantity will change.

• If both curve shift, the outcome is obvious.

• For example:

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1.6 ACTIVITY

?

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Supply and Demand AnalysisSupply and Demand Analysis

(a) Proton Berhad decreases the price of its car model, Proton Persona from P0 to P1.

Explain the law of demand and based on it, explain what will happen to the quantity

demanded for Proton Persona car. Sketch a graph to illustrate your explanation.

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(b) What will happen to the Perodua Nautica (substitutes) when the price of Proton Persona car drop? Sketch a graph to illustrate your explanation

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(c) Assume that Proton Persona cars need a specific regular maintenance service to bring out the performance of the car. Based on situation in (a), what will happen to the demand of that specific regular maintenance service?

End

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