Demand and supply

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Price Theory

Lecture 2: Supply & Demand
I. The Basic Notion of Supply & Demand

Supply-and-demand is a model for understanding the determination of the price of quantity of a good sold on the market. The explanation works by looking at two different groups – buyers and sellers – and asking how they interact. II. Types of Competition

The supply-and-demand model relies on a high degree ofcompetition, meaning that there are enough buyers and sellers in the market for bidding to take place. Buyers bid against each other and thereby raise the price, while sellers bid against each other and thereby lower the price. The equilibrium is a point at which all the bidding has been done; nobody has an incentive to offer higher prices or accept lower prices. Perfect competition exists whenthere are so many buyers and sellers that no single buyer or seller can unilaterally affect the price on the market. Imperfect competition exists when a single buyer or seller has the power to influence the price on the market. The supply-and-demand model applies most accurately when there is perfect competition. This is an abstraction, because no market is actually perfectly competitive, but thesupply-and-demand framework still provides a good approximation for what is happening much of the time. III. The Concept of Demand

Used in the vernacular to mean almost any kind of wish or desire or need. But to an economist, demand refers to both willingness and ability to pay. Quantity demanded (Qd) is the total amount of a good that buyers would choose to purchase under given conditions. Thegiven conditions include: • price of the good • income and wealth • prices of substitutes and complements • population • preferences (tastes) • expectations of future prices We refer to all of these things except the price of the good as determinants of demand. We could talk about the relationship between quantity demanded and any one of these things. But when we talk about a demand curve, we arefocusing on the relationship between quantity demanded and price (while holding all the others fixed).

The Law of Demand states that when the price of a good rises, and everything else remains the same, the quantity of the good demanded will fall. In short, ↑P → ↓Qd Note 1: “everything else remains the same” is known as the “ceteris paribus” or “other things equal” assumption. In this context,it means that income, wealth, prices of other goods, population, and preferences all remain fixed. Of course, in the real world other things are rarely equal. Lots of things tend to change at once. But that’s not a fault of the model; it’s a virtue. The whole point is to try to discover the effects of something without being confused or distracted by other things. Note 2: Is the law of demandreally a “law”? Well, there may be some exceedingly rare exceptions. But by and large the law seems to hold. Note 3: I will use the word “normal” to refer to any good for which the law of demand holds. Please note that this is different from the book’s definition of normal. A Demand Curve is a graphical representation of the relationship between price and quantity demanded (ceteris paribus). It is acurve or line, each point of which is a priceQd pair. That point shows the amount of the good buyers would choose to buy at that price. Changes in demand or shifts in demand occur when one of the determinants of demand other than price changes. In other words, shifts occur “when the ceteris are not paribus.” The demand curve’s current position depend on those other things being equal, so when theychange, so does the demand curve’s position. Examples: 1. The price of a substitute good drops. This implies a leftward shift. 2. The price of a complement good drops. This implies a rightward shift. 3. Incomes increase. This implies a rightward shift (for most goods). 4. Preferences change. This could cause a shift in either direction, depending on how preferences change. Demand versus Quantity...