Demand and Supply

• consider the demand for second hand books among students. It depends on your willingness to pay (WTP), which tells about the value you attach to the book.

Figure 1. Shows demand curve

• Demand represents the willingness to pay, whereas supply depends on the willingness to accept

Figure 2. Shows supply curve

• Think how a situation that you are trying to sell the book. There will be a minimum thereshold that you would be willing to accept and if the offer price is below this, you won’t sell.

Question

• As a student representative, one of your roles is to organize a second-hand textbook market between the current and former first-year students. After a survey, you estimate the demand and supply curves to be the ones shown in Figures 8.1 and 8.2. For example, you estimate that pricing the book at $7 would lead to a supply of 20 books and a demand of 26 books. Which of the following statements is correct?

  • choice a. A rumour that the textbook may be required again in Year 2 would change the supply curve, shifting it upwards.
  • choice b. Doubling the price to $14 would double the supply.
  • choice c. A rumour that the textbook may no longer be on the reading list for the first-year students would change the demand curve, shifting it upwards.
  • choice d. Demand would double if the price were reduced sufficiently.

The market and the equilibrium price

• buyers and sellers come together and interact in a market to buy corn (as an example)

• the price that equates supply and demand together is called the equlibrium price.

• at the equilibrium, there is one price, say \(P^{*}\) that makes quantity demanded equal to the quantity supplied.

  • we also say that the market clears at the equilibrium price.

• if the price is above the equilibrium price, then there will be an excess supply. Similarly, if the actual price is below the equilibrium price, sellers will wait before the price moves up to sell.

• here, the assumption is that all of the corn in the market is identical (the same)

Putting the demand and supply together

Figure 3. Demand and Supply together

• Note that \(P^{*}\) is $8. At price below $8, there will be more buyers in the market, the market will suffer from shortage.

• At price above $8, the market will have excess supply

• The market clears at $8, where the equilibrium quantity \(Q^{*}=25\).

Price taking

• In the second hand book market, individual students have to accept the prevailing equilibrium price, determined by the demand and supply.

• If you (as a seller) are asking for a higher price, me (as a buyer) will move to a different seller who is charging an equilibrium price.

• In this sense, sellers are price takers. However, we have seen where market participants are not price takers (for example monopolists set their own price)

  • if you have a differentiated goods with no close substitute then you gain market power, which gives liberty to set pries.

• However, if there are a lot of sellers and buyers for one identical type of product, the participants will just take the market price.

• The equilibrium in this kind of market is known as a competitive equilibrium.

Question

• The diagram shows the demand and the supply curves for a textbook. The curves intersect at (Q, P) = (24, 8). Which of the following is correct?

Figure 4. Demand and Supply together

- choice a. At price $10, there is an excess demand for the textbook.
- choice b. At $8, some of the sellers have an incentive to increase their selling price to $9.
- choice c. At $8, the market clears.
- choice d. 40 books will be sold in total.

Price-taking firms

• In lecture 8 we saw how firms choose their price and quantity when producing differentiated products (cars)

• However, if the firms are producing identical products, then firms will be a price taker in the market

• Lets explore how a price taking firm behaves. Say, you own a bakery store in a city where there are many bakeries. The market demand curve for bread is

Figure 5. Market demand for bread

• As a baker, you are deciding what price to charge. Say, your neighboring bakeries are selling a identical loaves for €2.35 and if this is a market price, you won’t be able to sell for a higher price than €2.35. Why?

Firm’s decision in a competitive market

• Note that as a baker (among many other bakers selling identical product), you will be a price-taker.
  • So, you’ll set €2.35 for a loaf of bread.
• Figure 6 shows your marginal cost and average cost curves. The average cost includes the opportunity cost of having a capital (eg. an oven to bake bread)

Figure 6. Firm’s decision

• The average cost curve shows the zero economic profit (if price is equal to AC, economic profit is zero)
  • The marginal cost curve (MC) intersects AC at the lowest point
  • MC intersects isoprofit curves at the lowest point as well
• Here, you are a price taker, so any point below the market price is feasible in Figure 6.
  • Again this is a constrained maximization problem, except that the firm’s demand curve is flat. This means that for price greater than \(P^{*}\) you’ll have no customers but for price less than \(P^{*}\) you can sell as much as you want.
• In this case, the profit maximization price is \(P^{*}\), when the firm’s demand curve is tangential to the isoprofit line.
  • This is also when \(P^{*}\) is equal to MC
• So one important realization is that at the profit maximization point, \(P^{*}=MC\).
  • This is because if \(P>MC\) one should sell more to increase profit
  • if \(P<MC\), one should decrease selling
• Hence, A price-taking firm maximizes profit by choosing a quantity where the marginal cost is equal to the market price (MC = P) and selling at the market price P.

Question

Question. Choose the correct answer(s)

Figure 6 shows a price-taking bakery’s marginal and average cost curves, and its isoprofit curves. The market price for bread is P*= €2.35. Which of the following statements is correct?

- choice a. The firm’s supply curve is horizontal.
- choice b. At the market price of €2.35, the firm will supply 62 loaves, at the point where the firm makes zero profit.
- choice c. At any market price, the firm’s supply is given by the corresponding point on the average cost curve.
- choice d. The marginal cost curve is the firm’s supply curve.

As the market price changes

• Your firm will react to changes in the market price by picking an output such that price (P*)=MC.

Figure 7. Firm’s decision

Market Supply and Equilibrium

• Each baker will have its own supply curve. Let’s suppose that there are 50 bakeries in the market. If you add the total quantity that all the bakers will supply at the given price, you get the market supply curve. This is shown in Figure 8.

Figure 8. Market Supply Curve

• if the market price is €2.75, total market supply is 7,000.
  • The cost of producing one more loaf is €2.75, which is the marginal cost
  • Hence, the marginal cost is also the supply curve
    

    Figure 9. Equilibrium in the market for bread

• Figure 9 shows the demand and supply for the bread market as a whole
• The equilibrium market price is €2.00, and 5,000 loaves are traded.
  • From Figure 8, you should find that the avereage cost per loaf at 5,000 loaves is less than €2.00. This means that the bakery owners are receiving economic rents.
  • Economic rent is likely to attract other ponteial bakers into the bakery market.

Question

There are two different types of producers of a good in an industry where firms are price-takers. The marginal cost curves of the two types are given below:

Figure 10

Type A is more efficient than Type B: for example, as shown, at the output of 20 units, the Type A firms have a marginal cost of \(\$2\), as opposed to a marginal cost of \(\$3\) for the Type B firms. There are 10 Type A firms and 8 Type B firms in the market. Which of the following statements is correct?

At price $2, the market supply is 450 units.
The market will supply 510 units at price $3.
At price $2, the market’s marginal cost of supplying one extra unit of the good will depend on the type of the firm that produces it.
With different types of firms, we cannot determine the marginal cost curve for the market.

Changes in Demand and Supply

• In the second hand book market, the buyers are new students taking the course and sellers are older students who finished the course

Figure 11. A new equilibrium point

• The supply and the older demand curve sets the price at \(\$8\).

• Say, the course got more popular one semester.

  • This shifts the demand to the right (new demand curve), which gives the equilibrium price of \(\$10\).

• When we say ‘increase in demand’, it’s important to be careful about exactly what we mean:

  • Demand is higher at each possible price, so the demand curve has shifted.
  • In response to this shift there is a change in the price.
  • This leads to an increase in the quantity supplied.
  • This change is a movement along the supply curve.
  • But the supply curve itself has not shifted (the number of sellers and their reserve prices have not changed), so we do not call this ‘an increase in supply’.

• In Figure 11, an increase in demand raised both equilibrium price and quantity.

Figure 12. A new equilibrium point due to shift in supply

• Increase in supply due to an increased productivity (new and improved machine) shifts the supply to the right in Figure 12.
  • Note that this lowers the equilibrium price but increases quantity.

Question. Choose the correct answer(s)

• Figure 9 shows the equilibrium of the bread market to be 5,000 loaves per day at price €2. A year later, we find that the market equilibrium price has fallen to €1.50. What can we conclude?

  • choice a. The fall in the price must have been caused by a downward shift in the demand curve.
  • choice b. The fall in the price must have been caused by a downward shift in the supply curve.
  • choice c. The fall in price could have been caused by a shift in either curve.
  • choice d. At a price of €1.50, there will be an excess demand for bread.

Question

• Which of the following statements are correct?

  • choice a. A fall in the mortgage interest rate would shift up the demand curve for new houses.
  • choice b. The launch of a new Sony smartphone would shift up the demand curve for existing iPhones.
  • choice c. A fall in the oil price would shift up the demand curve for oil.
  • choice d. A fall in the oil price would shift down the supply curve for plastics.