Supply and Demand Model Notes

Introduction to Supply and Demand Model

• The supply and demand model is a graphical model used to determine equilibrium price and quantity in a market.
• It involves plotting quantity (Q) on the horizontal axis and price (P) on the vertical axis.
• The supply line (S) and demand line (D) intersect at the equilibrium point (E), which determines the equilibrium quantity and equilibrium price.

Key Components of the Model

• Quantity (Q): Represented on the horizontal axis.
• Price (P): Represented on the vertical axis.
• Supply Line (S): Indicates the quantity supplied at different price levels.
• Demand Line (D): Indicates the quantity demanded at different price levels.
• Equilibrium (E): The point where the supply and demand lines intersect.
  • Equilibrium Quantity: The quantity at the equilibrium point.
  • Equilibrium Price: The price at the equilibrium point.

Understanding Supply and Demand Lines

• Supply Line:
  • Each point on the supply line represents a quantity supplied and a corresponding price.
• Demand Line:
  • Each point on the demand line represents a quantity demanded and a corresponding price.
• Equilibrium:
  • Equilibrium is the specific point where quantity supplied equals quantity demanded.
  • It represents the price level at which the amount produced matches the amount consumed.
    Quantity Supplied = Quantity Demanded

Assumptions of the Model

• Perfect Competition:
  • The model assumes a perfectly competitive market.
  • Perfect competition is characterized by:
    • Many buyers and sellers
    • Firms selling identical products
    • Few or no barriers to entry

Historical Context

• Augustin Cournot (1838):
  • Developed the initial concepts of the supply and demand model.
• Alfred Marshall:
  • Popularized the model in economics publications.

Demand Schedule

• A demand schedule is a table showing the relationship between the price of a product and the quantity demanded.
• Quantity Demanded: The amount of a good or service a consumer is willing and able to purchase at a specific price.

Law of Demand

• The law of demand states that as the price of a product increases, the quantity demanded decreases, assuming all other factors remain constant (ceteris paribus).
• Ceteris Paribus: All else equal; nothing else changes, e.g., the quality of the product remains the same.
  • Example:
    • Price = $100, Quantity Demanded = 10
    • Price = $80, Quantity Demanded = 120
    • Price = $70, Quantity Demanded = more
    • Price = $60, Quantity Demanded = even more

Plotting the Demand Line

• The demand line is created by plotting the points from the demand schedule on a graph with price on the vertical axis and quantity demanded on the horizontal axis.
• The demand line is typically downward sloping, indicating a negative relationship between price and quantity demanded.

Reasons for the Law of Demand

• Substitution Effect:
  • When the price of a product rises, consumers may switch to similar, less expensive products.
• Income Effect:
  • When the price of a product increases, consumers' purchasing power decreases, reducing their ability to buy the same quantity.

Shifts in the Demand Line

• Factors other than price can cause the entire demand line to shift.
• Increase in Demand:
  • The demand line shifts to the right (e.g., from D1 to D2).
• Decrease in Demand:
  • The demand line shifts to the left.

Factors Causing Shifts in Demand

• Income:
  • Normal Goods:
    • An increase in income increases demand.
    • A decrease in income decreases demand.
  • Inferior Goods:
    • An increase in income decreases demand.
    • A decrease in income increases demand.
• Price of Substitutes:
  • An increase in the price of a substitute increases demand for the original product.
• Price of Complements:
  • An increase in the price of a complement decreases demand for the original product.
• Taste for Goods:
  • An increase in taste increases demand.
  • A decrease in taste decreases demand.
• Population or Number of Buyers:
  • An increase in population increases demand.
  • A decrease in population decreases demand.
• Expectations of the Future:
  • If prices are expected to increase in the future, current demand increases.
  • If prices are expected to decrease in the future, current demand decreases.

Market Supply

• Market supply looks at the market from the producer's side.
• Producers aim to increase prices to increase revenue.

Law of Supply

• The law of supply states that when prices increase, the quantity supplied tends to increase.

Supply Schedule

• A supply schedule is a table that lists prices and corresponding quantity supplied.
• Producers produce more when prices are high and less when prices are low.

Plotting the Supply Line

• The supply line is made by plotting points from the supply schedule on a graph.
• The supply line is upward sloping, indicating a positive relationship between price and quantity supplied.

Shifts in the Supply Line

• The supply line can shift due to factors other than price.
• Increase in Supply:
  • The supply line shifts to the right.
• Decrease in Supply:
  • The supply line shifts to the left.

Factors Causing Shifts in Supply

• Price of Inputs (Factors of Production):
  • Land, labor, capital, and entrepreneurship.
  • An increase in the price of an input decreases supply.
  • A decrease in the price of an input increases supply.
• Productivity:
  • An increase in productivity increases supply.
  • A decrease in productivity decreases supply.
• Price of Substitutes in Production (Production Substitutes):
  • Alternative products that can be produced with the same resources.
  • An increase in the price of A may decrease the supply of B.
  • A decrease in the price of A may increase the supply of B.
• Number of Firms:
  • An increase in the number of firms increases supply.
  • A decrease in the number of firms decreases supply.
• Expectations:
  • If prices are expected to increase, current supply decreases.
  • If prices are expected to decrease, current supply increases.

Equilibrium

• Equilibrium is the point where quantity supplied equals quantity demanded.

Determining Equilibrium

• Supply and Demand Schedule:
  • List prices, quantity supplied, and quantity demanded.
• Graphically:
  • Equilibrium is where the supply and demand lines intersect.
• Condition for Equilibrium:
  Quantity Supplied = Quantity Demanded

Importance of Equilibrium

• Equilibrium is important because it represents a stable market condition where there is neither a surplus nor a shortage.

Surplus

• A surplus occurs when the price is above the equilibrium price, leading to quantity supplied being greater than quantity demanded.
• Surplus = Quantity Supplied - Quantity Demanded
• Prices tend to decrease towards equilibrium to eliminate the surplus.

Shortage

• A shortage occurs when the price is below the equilibrium price, leading to quantity demanded being greater than quantity supplied.
• Shortage = Quantity Demanded - Quantity Supplied
• Prices tend to increase towards equilibrium to eliminate the shortage.

Market Tendency Towards Equilibrium

• Prices naturally fluctuate towards equilibrium due to market forces.
  • If prices are too high, sellers lower them to reduce surpluses.
  • If prices are too low, buyers bid prices up to address shortages.

Examples of Supply and Demand in Action

Example 1: Masks During COVID-19 Pandemic

• Increase in demand for masks due to health recommendations.
• Impact:
  • Increase in taste for N95 masks.
  • Demand shifts to the right (D1 to D2).
  • Equilibrium prices increase.
  • Equilibrium quantities increase.

Example 2: Electric Cars

• Increase in technology for the production of electric cars.
• Impact:
  • Supply shifts to the right (S1 to S2).
  • Equilibrium prices decrease.
  • Equilibrium quantities increase.

Example 3: Coca-Cola and Pepsi

• Increase in the price of Pepsi Cola.
• Impact on Coca-Cola Market:
  • Coca-Cola and Pepsi are substitutes.
  • Demand for Coca-Cola shifts to the right (D1 to D2).
  • Equilibrium prices for Coca-Cola increase.
  • Equilibrium quantities for Coca-Cola increase.

Conclusion

• The supply and demand model is a tool for understanding and predicting market outcomes.
• It helps explain how prices and quantities adjust in response to changes in various factors.
• Microeconomics focuses in the difference between perfect competitions an imperfect competition such as monopolies.