Lecture 4 - Price output determination

1. Supply and Demand

Supply and demand are fundamental concepts in economics that describe how prices are determined in a market economy. They explain the interaction between buyers and sellers for a particular product or service.

1.1 Demand

Demand refers to the quantity of a good or service that consumers are willing and able to purchase at various prices during a specific period. The Law of Demand states that, all else being equal (ceteris paribus), as the price of a good or service increases, the quantity demanded decreases, and vice versa. This inverse relationship can be shown as a downward-sloping demand curve.

Determinants of Demand (Factors that shift the demand curve):

  • Price of the good/service: Movement along the demand curve. A change in price changes quantity demanded.

  • Income of consumers: For normal goods, an increase in income increases demand; for inferior goods, an increase in income decreases demand.

  • Tastes and preferences: Increased preference for a good increases demand.

  • Expectations: Future expectations about price or availability can affect current demand.

  • Prices of related goods:

    • Substitutes: If the price of a substitute good increases, demand for the original good increases.

    • Complements: If the price of a complementary good increases, demand for the original good decreases.

  • Number of buyers: An increase in the number of consumers increases overall market demand.

1.2 Supply

Supply refers to the quantity of a good or service that producers are willing and able to offer for sale at various prices during a specific period. The Law of Supply states that, all else being equal (ceteris paribus), as the price of a good or service increases, the quantity supplied increases, and vice versa. This direct relationship can be shown as an upward-sloping supply curve.

Determinants of Supply (Factors that shift the supply curve):

  • Price of the good/service: Movement along the supply curve. A change in price changes quantity supplied.

  • Cost of inputs (resources): An increase in the cost of labor, raw materials, etc., decreases supply.

  • Technology: Improvements in technology tend to increase supply.

  • Expectations: Producers' expectations about future prices can affect current supply decisions.

  • Government policies: Taxes decrease supply; subsidies increase supply.

  • Number of sellers: An increase in the number of producers increases market supply.

2. Price Output Determination (Market Equilibrium)

Price output determination, also known as market equilibrium, is the point where the quantity demanded by consumers equals the quantity supplied by producers. At this point, there is no tendency for the price to change.

  • Equilibrium Price (P_e): The price at which quantity demanded equals quantity supplied.

  • Equilibrium Quantity (Q_e): The quantity demanded and supplied at the equilibrium price.

How Equilibrium is Reached:

  1. Surplus (Excess Supply): If the market price is above the equilibrium price (P > Pe), the quantity supplied will exceed the quantity demanded (Qs > Q_d). Producers will have unsold goods, leading them to lower prices to clear inventory. As prices fall, quantity demanded increases and quantity supplied decreases, moving the market back towards equilibrium.

  2. Shortage (Excess Demand): If the market price is below the equilibrium price (P < Pe), the quantity demanded will exceed the quantity supplied (Qd > Q_s). Consumers will compete for limited goods, bidding up prices. As prices rise, quantity demanded decreases and quantity supplied increases, moving the market back towards equilibrium.

Graphically, the equilibrium price and quantity are determined by the intersection of the demand curve and the supply curve. At this intersection, the forces of supply and demand are balanced, and the market is cleared.