Demand and Supply Model

Topic 2: Demand and Supply Model

2.1 Demand

Market and Model Outline

• Market: A mechanism facilitating the exchange of goods or services between buyers and sellers.

  • Buyers: As a group, they determine the demand for a product.

  • Sellers: As a group, they determine the supply of a product.

• Demand and Supply Model: This model is fundamentally based on a specific market structure known as a perfectly competitive market.

Perfectly Competitive Market Characteristics

For the demand and supply model to apply, the market must exhibit the following characteristics:

• Many Buyers and Sellers: A large number of participants on both sides, ensuring no single entity can influence market prices significantly.

• Identical Goods: The product sold in the market is homogenous, meaning consumers perceive all units of the good as perfect substitutes for one another.

• Price Takers: All participants (buyers and sellers) in the market accept the prevailing market price as given; they have no power to set prices.

• No Barriers to Entry: New firms can freely enter or exit the market without significant obstacles.

Definition of Demand

• Demand: Represents the relationship between the price of a particular good and the quantity demanded by buyers, other things equal (ceteris~paribus).

• Quantity Demanded (Qd): Refers to the specific amount of a good that buyers are both willing and able to purchase at a given price.

• Demand Schedule: A tabular representation that systematically displays the quantity demanded at various price levels.

• Demand Curve: A graphical representation of the demand schedule.

  • Vertical axis: Always represents Price (P).

  • Horizontal axis: Always represents Quantity (Demanded) (Q or Qd).

Example: Demand Schedule and Demand Curve

Consider the example of ice-cream cones:

• This table shows that as the price decreases, the quantity demanded increases.

• When graphed, this relationship forms a downward-sloping demand curve, illustrating the inverse relationship between price and quantity demanded.

Law of Demand

• Statement: Other things equal (ceteris~paribus), the quantity demanded of a good falls when its price rises, and conversely, the quantity demanded rises when its price falls.

• Relationship: Price and quantity demanded are negatively or inversely related.

Market Demand as the Sum of Individual Demands

• Concept: The total quantity demanded in a market at any given price is the aggregate sum of the quantities demanded by all individual buyers at that same price.

• Derivation: The market demand curve is derived by horizontally summing the individual demand curves of all buyers.

• Example: If at a price of 2.00:

  • Catherine demands 4 ice-cream cones.

  • Nicholas demands 3 ice-cream cones.

  • The market quantity demanded at 2.00 is 4 + 3 = 7 cones.

Shifts in Demand

Changes in factors other than the good's own price will cause the entire demand curve to shift.

• Increase in Demand: Any event or change that leads to a greater quantity demanded at every possible price.

  • Graphically represented as a rightward shift of the demand curve.

• Decrease in Demand: Any event or change that leads to a smaller quantity demanded at every possible price.

  • Graphically represented as a leftward shift of the demand curve.

Factors That Shift the Demand Curve

These are the other things that, when they change, cause the demand curve to shift:

1. Number of Buyers (Population)

   • An increase in the number of buyers (e.g., population growth) increases market demand (shifts right).

   • A decrease in the number of buyers decreases market demand (shifts left).

2. Income

   • Normal Good: For most goods, other things constant, an increase in income leads to an increase in demand (shifts right). Conversely, a decrease in income leads to a decrease in demand.

   • Inferior Good: For some goods, other things constant, an increase in income leads to a decrease in demand (shifts left). Conversely, a decrease in income leads to an increase in demand.

3. Prices of Related Goods

   • Substitutes: Two goods are substitutes if an increase in the price of one good leads to an increase in the demand for the other good.

     • Example: If the price of coffee rises, the demand for tea (a substitute) might increase.

   • Complements: Two goods are complements if an increase in the price of one good leads to a decrease in the demand for the other good.

     • Example: If the price of hot dogs rises, the demand for hot dog buns (a complement) might decrease.

4. Tastes (or Preferences)

   • A favorable change in consumer tastes for a good will increase demand (shifts right).

   • An unfavorable change in tastes will decrease demand (shifts left).

5. Expectations About the Future

   • Expectation of Future Income Increase: If consumers expect their income to increase in the near future, they might increase their current demand for certain goods (shifts right).

   • Expectation of Higher Future Prices: If consumers expect the price of a good to rise in the future, they might increase their current demand for that good to buy it before the price goes up (shifts right).

   • Expectation of Lower Future Prices: If consumers expect the price of a good to fall, they might decrease their current demand, preferring to wait for the lower price (shifts left).

Summary of Variables Affecting Quantity Demanded

Examples and Practice Questions

Question 1: Given two equations:

1. P = 2500 - 0.25 Q

2. P = 1200 + 0.33 Q
   Which equation could represent a demand function? Why?

• Analysis Focus: A demand function typically shows a negative relationship between price (P) and quantity (Q). When one increases, the other decreases. The coefficient of Q in a demand function when P is the dependent variable (or vice versa) should reflect this inverse relationship.

Question 2: A marketing research firm derived the following equation for firm A based on a research survey:
Qd{A} = 4000 - 0.25 P{A} + 0.004 I + 0.004 P_{B}
where:

• P_{A} is the price of good A

• P_{B} is the price of a related good

• I is average household income based on the survey

2.1. If I = 40000 and P_{B} = 1000, derive the demand function for good A and draw a graph to show it.

• Analysis Focus: Substitute the given values for I and P{B} into the equation to simplify it into a relationship between Qd{A} and P_{A}. Plotting this linear function requires identifying the intercepts or a few points.

2.2. Is good A a normal good or an inferior good? Why?

• Analysis Focus: Examine the coefficient of income (I) in the demand function (+0.004 I). A positive coefficient means that as income increases, demand increases, indicating a normal good. A negative coefficient would indicate an inferior good.

2.3. Are good A and good B complements or substitutes? Why?

• Analysis Focus: Examine the coefficient of the price of the related good (P{B}) in the demand function (+0.004 P{B}$$). A positive coefficient means that as the price of good B increases, the demand for good A increases, indicating they are substitutes. A negative coefficient would indicate complements. A positive correlation typically means they are substitutes.