Chapter THREE Price Theory (Demand & Supply)

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1 Chapter THREE Price Theory (Demand & Supply) Chapter Overview The price and quantity demanded and supplied of a good is determined by the interaction of market s sides: demand side and supply side. The objectives of both buyer and supplier are different. The main objective of a buyer is to maximize his / her satisfaction (utility) from buying and consuming goods and services. Whereas, the main objective of the seller (producer) is to maximize his / her profits. So, the factors effect on quantity demanded and quantity supplied are different. The chapter is devoted to explain both demand theory and supply theory. Market sides: A market has two sides: buyers (demand side) and sellers (supply side). Markets side may be meet face to face to determine the price and the quantity and they may never meet face to face but by other method like phone, fax, ,. etc. Types of Markets: The markets can be classified according to the product into: goods and services markets, factors of production markets, money markets and capital markets 1. The markets can be classified according to degree of competition into: perfect competitive market, monopolistic competitive market, oligopolistic market and monopolistic market. What is difference between Money price / Relative price? Money price is the number of dollars (or any currency) paid to (given up) exchange for it. For example, if you pay BD 2 for a cheese sandwich. The two Dinnars are the money price of the sandwich. Relative Price is a ratio between two prices. For instance, if price of apple is BD 2 per Kg and the price of orange is BD 1 per Kg. The relative price between the two goods are BD 2 / BD1 (the relative price of apple) OR BD 1/ BD 2 (the relative price of orange) Note that: 1- The relative price is an opportunity cost. 2- Demand and supply theory determine relative price (NOT money price) 1 Each one of these markets can be divided into sub- markets. For instance apple market, TV market, health market, short term money market, labor market, stock market and so on. 1

2 First: Demand Theory Demand for something includes: 1- want 2- can afford it 3- plan to buy What is the difference between Wants & demands? Wants are unlimited and involve no specific plan to acquire the good. Demands reflect a decision about which wants to satisfy and a plan to buy the good (s). Define quantity demanded. Quantity demanded: the amount that consumer (s) plan to buy during a given period of time at a particular price. The quantity demanded is NOT necessarily the same amount as the quantity actually bought. What are factors effect on quantity demanded for a good? Factors effect on quantity demanded: 1- Price of a good (Negative) 2- Expected future price (Positive) 3- consumer s income (normal inferior) 4- expected future income (Positive) 5- population (No. of consumers) (Positive) 6- preferences (taste = like / dislike) (Positive) 7- price of other goods Substitutes (Positive) Complements (Negative) Unrelated The relationship between quantity demanded of a good and its price Economists start to study the relationship between quantity demanded for a good and its price assuming other effected factors are remain the same (ceteris paribus). Demand law Demand law states.. (complete) Demand equation The relationship between quantity demanded and the price of a good can be expressed as follows: 2

3 Qd = A - B P Where A refers to the intercept or quantity demanded value at price equals zero, Qd refers to quantity demanded, B refers to the slope of the equation or the ratio of change in Qd to the change in P and P refers the price. Example: The following equation reflects the relationship between quantity demanded for apple and its price per Kg.: Qd = 40 2P Where Qd refers to quantity demanded and P refers the price 1- the intercept is 2- the slope of the equation is 3- the negative sign refers to... What is the reason of the inverse relationship between Price & Quantity demanded? The negative relationship between quantity demanded and price because of two reasons: 1- Income effect: rise of the price of a good leads to decrease real consumer s income so the consumer CANNOT buy the previous amount so he/ she must reduce quantity demanded for a good. 2- Substitution effect: increase the price of a good means this good becomes more expensive compared to another good. i.e. its relative price (its opportunity cost) rises. The consumer will reduce quantity demanded for this good. Demand schedule Reflects (shows or represents) the inverse (negative) relationship between quantity demanded for a good at different possible prices (ceteris paribus) Each row in the demand schedule represents a quantity demanded whereas; the whole schedule represents the demand for a good. Example: by using the demand equation above, please construct the demand schedule for apple. Price / Kg Quantity demanded Demand curve Reflect (shows or represents) the inverse (negative) relationship between quantity demanded for a good at different possible prices (ceteris paribus) Shows the highest price someone is willing to pay for that unit. 3

4 The highest price is the marginal benefit a consumer receives from the unit. To draw a demand curve, we measure quantity demanded on horizontal axis (although it is the dependent variable) and prices on vertical axis (although it s the independent variable). Example: by using the demand schedule above, please draw demand curve for apple. What is the difference between: 1. demand and quantity demanded 2. change in demand and change in quantity demanded Quantity demanded is amount demanded for a good at specific (particular) price. It is represented by ONE row in the demand schedule and ONE point on the demand curve. Demand is all amounts demanded for a good at all different possible price. It is represented by the whole demand schedule and the whole demand curve. Change in quantity demanded is a change (increase or decrease) of amount demanded when the price of the good change (increases or decreases). It leads to movement from ONE row to another in the same demand schedule and from ONE point to another along the same demand curve. Change in demand is a change (increase or decrease) in all amount demanded when one or more of other effected factors change (increase or decrease). It leads to change the whole demand schedule and shift the whole demand curve to the right (in case of increase in demand) OR to the left (in case of decrease in demand). For example, 4

5 increase in consumer s income will lead to increase demand for a normal good and this leads to increase all amount demanded at the different prices and shift demand curve to the right. Example: use the above demand schedule and demand curve to explain the difference between quantity demanded and demand in one side and change in quantity demanded and change in demand on the other side. Secondly: Supply Theory If a firm supplies a good then the firm: 1- Has resources and technology to produce it, 2- Can profit from producing it, 3- plan to produce and sell it. Quantity supplied is amount that producer (s) plans to sell during a given period of time at a particular price. The quantity supplied is NOT necessarily the same amount as the quantity actually sold. What are factors effects on quantity supplied of a good? Factors effect on quantity supplied: 1- Price of a good (Positive) 2- Expected future price (Negative) 3- Technology (Positive) 4- Price of resources (costs or production costs) (Negative) 5- No. of suppliers (Positive) 6- Price of other goods Substitutes (Negative) Complements (Positive) Unrelated The relationship between quantity supplied of a good and its price Economists start to study the relationship between quantity supplied of a good and its price assuming other effected factors are remain the same (ceteris paribus). Supply law States the positive relationship between quantity supplied of a good and its price (ceteris paribus). Supply equation The relationship between quantity supplied and the price of a good can be expressed as follows: Qs = C + D P 5

6 Where C refers to the intercept or quantity supplied value at price equals zero, Qs refers to quantity supplied, D refers to the slope of the equation or the ratio of change in Qs to the change in P and P refers the price. Example: The following equation reflects the relationship between quantity supplied of apple and its price per Kg.: Qs = 5 + 3P Where Qs refers to quantity supplied and P refers the price 1- the intercept is 2- the slope of the equation is 3- the positive sign refers to... Supply schedule Reflects (shows or represents) the direct (positive) relationship between quantity supplied of a good at different possible prices (ceteris paribus) Each row in the supply schedule represents a quantity supplied whereas; the whole schedule represents the supply of a good. Example: by using the supply equation above, please construct the supply schedule for apple. Price / Kg Quantity supplied Supply curve Reflect (shows or represents) the direct (positive) relationship between quantity supplied of a good at different possible prices (ceteris paribus) Shows the minimum price a supplier must receive in order to produce that unit. To draw a supply curve, we measure quantity supplied on horizontal axis (although it is the dependent variable) and prices on vertical axis (although it s the independent variable). Example: by using the supply schedule above, please draw supply curve for apple. 6

7 What is the difference between: 1- supply and quantity supplied 2- change in supply and change in quantity supplied. Quantity supplied is amount supplied of a good at specific (particular) price. It is represented by ONE row in the supply schedule and ONE point on the supply curve. Supply is all amounts supplied for a good at all different possible price. It is represented by the whole supply schedule and the whole supply curve. Change in quantity supplied is a change (increase or decrease) of amount supplied when the price of the good change (increases or decreases). It leads to movement from ONE row to another in the same supply schedule and from ONE point to another along the same supply curve. Change in supply is a change (increase or decrease) in all amount supplied when one or more of other effected factors change (increase or decrease). It leads to change the whole supply schedule and shift the whole supply curve to the right (in case of increase in supply) OR to the left (in case of decrease in supply). For example, if the price of a good expected to rise in the future, all amount supplied at the different prices decrease (decrease in supply) and supply curve shifts to the left. 7

8 Example: use the above supply schedule and supply curve to explain the difference between quantity supplied and supply on one side and change in quantity supplied and change in supply on the other side. Thirdly: Market Equilibrium Equilibrium position: is a situation in which quantity demanded equals quantity supplied. It contains three components: equilibrium point, equilibrium price and equilibrium quantity. Equilibrium point is the intersected point between demand curve and supply curve. Equilibrium price is the price at which quantity demanded equals quantity supplied. Equilibrium quantity is the quantity bought and sold at equilibrium price. We can reach the equilibrium position by three methods: 1-By using equations: demand equation and supply equation In this method, we solve both demand equation and supply equation together to find the equilibrium price and quantity. Example: by using the demand and supply equations above, Qd = 40 2P Qs = 5 + 3P At equilibrium position, Qd = Qs 40 2P = 5 + 3P 40 5 = 3P + 2P 35 = 5P P = 7 By substitution in either demand equation or supply equation, Q = 40 2 (7) Q = 26 So, equilibrium price is 7 and equilibrium quantity is By using schedules (tables): demand schedule and supply schedule In this method we use demand and supply schedules of a good to find both equilibrium price and quantity. Example: use the above demand and supply schedules to find equilibrium price and quantity 8

9 Price Qd Qs 3- By using curves: demand curve and supply curve In this method we draw both demand and supply curves of a good in one graph to find both equilibrium price and quantity. Example: use the above demand and supply curves to find equilibrium price and quantity. Note that: 1- At equilibrium price quantity demanded equals to quantity supplied so, there is NO shortage or surplus in the market. 2- At any price above equilibrium price, quantity supplied is bigger than quantity demanded so, there is a surplus in the market. 3- At any price below equilibrium price, quantity demanded is bigger than quantity supplied so, there is a shortage in the market. 4- A surplus forces the price down. Whereas a shortage forces the price up. 9

10 Changes in demand and supply Change in demand or l and supply will cause shift in demand or/ and supply so, the initial equilibrium position (point, price and quantity) will change. These changes can be classified as follows: 1- Change in demand ONLY A- Increase in demand (increase in both equilibrium price and quantity) B- Decrease in demand (decrease in both equilibrium price and quantity) 2- Change in supply ONLY A- Increase in supply (increase in equilibrium quantity and decrease in equilibrium price) B- Decrease in supply (decrease in equilibrium quantity and increase in equilibrium price) 3- Change in both demand and supply A- Both demand and supply change in the same direction 1- Increase in demand and supply (quantity increases BUT the price might increase, decrease or remain the same) 2- Decrease in demand and supply (quantity decreases BUT the price might increase, decrease or remain the same) B- Both demand and supply change in opposite direction 1- Increase in demand and decrease in supply (the price increases, BUT quantity might increase, decrease or remain the same) 2- Decrease in demand and increase in supply (the price decreases, BUT quantity might increase, decrease or remain the same) The action First: Change in demand ONLY 1- increase in demand 2- decrease in demand Second: Change in supply ONLY 1- increase in supply 2- decrease in supply Third: Change in BOTH demand and supply 1- in the SAME direction a- increase in demand and supply b- decrease in demand and supply 2- in OPPOSITE direction a- increase in demand and decrease in supply b- decrease in demand and increase in supply Best Wishes The effect on equilibrium quantity The effect on equilibrium price 10

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