Lecture 1- The Market Forces of Supply and

Demand
Introduction
- Theory of Supply and Demand
o The consideration between buyers and sellers and how they interact with other
competitive markets
o It determines the quantity of produced goods/services and the price of what its sold at
through competitive markets. This is shown through the interaction between buyers
and sellers

Markets and Competition

- Markets are a group of buyers and sellers from a good or service
o A market is introduced whenever a group of buyers and sellers interact with trading
their goods and services.
o These interactions can be done physically (shopping centres, paddys market) or
virtually (eBay, Steam)
- A competitive market is when there are so many buyers and sellers that each has a negligible
impact on the market price.
o The smaller the ability of each buyer/seller to affect the market price, the more
competitive the market.
o A Perfect competition (PC) market must have two characteristics (Telstra vs Optus):
The goods being offered for sale are all the same (homogenous)
The buyers and sellers are so numerous that none can influence the market
price.
- Price takers are when buyers and sellers accept the market price as given (Apple, Gucci)
- How competitive are real-world markets?
o There are some markets in which the assumptions of perfect competition apply well
(agricultural markets)
o There are markets with no competition at all. In a market with only one seller (a
Monopoly), the seller sets the price (price setter).
Demand
- Quantity demanded is the amount of a good that buys are willing and able to purchase.
o Willing- A buyer wants to buy that amount (given their tastes and preferences)
o Able- Given the price of the good, a buyer has enough income to buy their good.
- The quantity demanded of a good also depends on many factors such as price, taste, income.
- Law of demand. Other things equal, the quantity demanded of a good falls (rises) when the
price of the good rises (falls).
o Other things equal (or Ceteris Paribus)- Holding constant all other factors (other than
price) that may affect quantity demanded.
o Example- When the price goes down for milk, the quantity consumers buy will increase
- Ways of representing the relationship between price and quantity demanded:
o Demand Schedule- A Table showing the relationship between the price of a good and
the quantity demanded.
o Demand Curve- A Graph showing relationship between the price of a good and the
quantity demanded.

Market Demand vs Individual Demand

- Market Demand is the sum of all individual demands for a good or service. This is needed as in a
competitive market, there are a lot of buyers, to analyse how the market works, a market
demand is needed.
o Graphically, individual demand curves are summed horizontally to obtain the market
demand curve.

Movements along the demand curve

Shifts in the Demand curve
- The D curve shows how the quantity
demanded of a good varies with the price of
the good, holding all other factors constant
(our Ceteris Paribus assumption)
- A change in one or more of these other
factors generates a shift in the demand
curve, either to left or right
- In this case we say that there is a change in
demand (as opposed to a change in quantity
demanded).

What are those factors other than price that

affect demand?
- Income- The relationship between income and demand depends on what type of good the
product is.
o Normal good- A good for which, other things being equal, an increase in income leads to
an increase in demand
o Inferior good- A good for which, other things being equal, an increase in income leads to
a decrease in demand
- Prices of related goods- The relationship between the price of a related good and demand
depends on what type of goods the products are.
o Substitutes- two goods for which a decrease in the price of one good leads to an
decrease in the demand for the other good.
o Complements- two goods for which a decrease in the price of one good leads to an
increase in the demand for the other good.
- Tastes- If customers like a products certain attributes, then they will buy more of it
- Expectations- e.g. About your future income and future prices of goods
- Number of buyers- Market demand is derived from individual demands it positively depends on
the number of buyers
Supply
- Supply is the behaviour of producers/sellers
- Quantity supplied is the amount of a good that sellers are willing and able to sell
o Willing- Producer wants to sell that amount
o Able- The amount is feasible given resources and technology
- Law of supply
o The law of supply states that, other things being equal (ceteris paribus) the quantity
supplied of a good rise when the price of the good rises, and vice versa
- Two ways of representing the relationship between price and quantity supplied:
o Supply Schedule- Table
o Supply Curve- Graph

Market supply vs Individual supply

- A Market supply is the sum of all
individual suppliers for a particular
good or service, this is needed in a
competitive market due to many
sellers.
o Graphically, individual supply
curves are summed
horizontally to obtain the
market supply curve

Shifts in the supply curve

What are those factors other than the price that affect supply?
- Input prices- The quantity supplied is negatively related to the price of inputs used to make the
good: If the price of an input rises (falls), the supply decreases (increases).
- Technology- An improvement in production technology increases productivity: with the same
inputs, the producer can supply more
- Expectations- e.g. If suppliers expect the price to rise they will be more likely to store some of
the good and supply less to the market today
- Number of sellers- Because market supply is derived from individual supply it positively depends
on the number of sellers
 Lecture 2- Equilibrium + Elasticity
Equilibrium D and S together
- Equilibrium- When the supply and demand have been
brought into balance
- Equilibrium price- The price that balances quantity
supplied and demanded (also known as Market-
clearing price)
- Equilibrium quantity- Is both the quantity supplied
and the quantity demanded at the equilibrium price

Markets not in equilibrium- Surplus

- When market price is higher than the equilibrium price,
then there is a surplus (or excess supply):
o Quantity supplied is larger than quantity
demanded
- Suppliers lower price to increase sales, thereby moving
toward equilibrium

Markets not in equilibrium- Shortage

- When market price is lower than the equilibrium price,
then there is a shortage (or excess demand):
o Quantity supplied is smaller than quantity
demanded
- Suppliers raise price due to too many buyers chasing too
few goods, thereby moving toward equilibrium
Equilibrium
- If the market is not in equilibrium, in perfectly competitive markets the actions of buyers and
sellers naturally move the price and hence the market towards equilibrium
o Law of Demand- Claims the price of any good to adjust it and bring the supply and
demand for the good into balance
- Surpluses and shortages may exist over certain period of time- S & D eliminate this later
o Once the equilibrium is reached, all buyers and sellers are satisfied and there is no
upward or downward pressure on price.

Changes in Equilibrium
- Demand and Supply determine a markets equilibrium, e.g. The price and the amount of the
good that buyers purchase, and sellers produce.
- If some event occurs that shifts Demand and/or Supply, the equilibrium changes
o Events that changes D&S is said to be an exogenous(Internal source- natural cause, e.g.
eating natural protein to get gains) events/change
o The subsequent change is equilibrium is said to be an endogenous(External source-
artificial cause, e.g. taking steroids to get gains ) change.
- The analysis of a change in equilibrium is called comparative statics. It is done in three steps:
1. Decide whether the exogenous event shifts the supply or demand curve OR both
2. Decide in which direction the curve shifts
3. Use the supply-and-demand diagram to see how the shift changes the equilibrium

Changes in Equilibrium Increase in demand

Example for ice cream market- Suppose that one summer gets very hot,
how does this exogenous event affect the market for ice-cream?

- Start from an initial equilibrium (point E) and do our comparative

statics exercise:
o Hot weather will affect Demand or Supply?
o Demand will increase or decrease?
o Where is the new equilibrium?
- Conclusion- High temperature in Summer are likely to lead to an
increase in the price of ice-cream as well as in the quantity sold and bought.

Changes in Equilibrium Decrease in supply

Example for what happens to the market of ice-cream if a bushfire destroys
several ice-cream factories

- Always start from an initial equilibrium (point E) and then do our

comparative statics exercise:
o Which side of the market will be affected by a bushfire
destroying several ice-cream factories?
o How will the supply curve shift?
o Where is the new equilibrium?
- Conclusion- A bushfire destroying several ice-cream factories is likely to lead to an increase in
the price of ice-cream and a decrease in the quantity sold and bought.
Changes in Equilibrium All cases
- The following table reports all possible cases
- The most difficult to analyse are those where D and S change simultaneously, draw these out

No change in supply An increase in supply A decreased in supply

No change in demand Price same Price down Price up
Quantity same Quantity up Quantity down
An increase in demand Price up Price ambiguous Price up
Quantity up Quantity up Quantity ambiguous
A decrease in demand Price down Price down Price ambiguous
Quantity down Quantity ambiguous Quantity down

Free Markets and the Role of Prices

- It is important to highlet how prices play two key roles
o Prices co-ordinate the actions of large numbers of buyers and seller, each acting
independently:
For example, when we make our consumption choices, we all look at the same
price
If the price go down (up), we all tend to boy more (less), hence we all tend to0
respond in the same way to a given change in the price of a good
o Prices are a mechanism for allocating scarce resources (rationing function of prices):
The market mechanism of S and D means that any buyer who is willing and able
to pay the equilibrium price can purchase the good
Similarly, any seller who is willing and able to produce and sell the good at the
equilibrium price, will do so.

Elasticity
- Elasticity of demand:
o Measures how much demand responds to changes in its determinants
Price elasticity of demand
Income elasticity of demand
Cross-price elasticity of demand
o Elasticity of supply:
Measures how much supply responds to changes in its determinants
Price elasticity of supply

The price elasticity of demand

- The price elasticity of demand is a measure of how much the quantity demanded of a good
responds to a change in the price of that good
o We conclude whether quantity demanded responds a lot or little to change in price.
- It is calculated as the percentage change in quantity demanded divided by the percentage
change in price:
The price elasticity of demand: An Example
- Say a 10% increase in the price of milk leads to a 20% decrease in quantity demanded for milk.
What is the value of the price elasticity of demand for milk?

Interpreting the price elasticity of demand

- The price elasticity of demand is a number that tells you how quantity demanded changes in
proportion to a given change in price. For example:
o If the price elasticity demand for win is equal to 2, then a given change in price of wine
will lead to a change in quantity demanded for wine that is twice as large
o If the price elasticity of demand of rice is equal to 0.5, then the given change in the price
of rice will lead to a change in quantity demanded for rice that is half as large
- Price elasticity allows us to compare the responsiveness to price changes of goods that are
measured with different units of measurement.
- The higher the price elasticity of demand for a good, the higher the responsiveness of quantity
demanded of that good to a change in its own price.

Elastic and Inelastic demand

- If greater than 1, demand is said to be elastic:
o A given percentage change in price leads to a larger change in quantity demanded
o Buyers respond strongly to a change in price
- If less than 1, demand is said to be inelastic:
o A given percentage change in price leads to a smaller change in quantity demanded
o Buyers do not respond strongly to a change in price
- If equal to 1, demand is said to have unitary elasticity:
o A given percentage change in price leads to an equal change in quantity demanded

Determinants of price elasticity of demand

- Availability of close substitutes
o Price elasticity tends to be higher when there are many close substitutes
- Necessities vs Luxuries
o Elasticity tends to be higher for luxuries
- Definition of the market
o Elasticity tends to be higher when market is defined
narrowly (food vs ice-cream)
- Time horizon
o Elasticity tends to be higher the longer the time
period considered

Price elasticity and demand curves

- Since the price elasticity of demand measures how much quantity demanded responds to a
change in price, it is closely related to the slope of the demand curve ^^^
- Rule of thumb- The steeper (flatter) the demand curve, the lower (greater) the price elasticity.
Elasticity of a linear demand curve, Total revenue and the price elasticity of demand
A demand is needed to know the value of the price elasticity of a good

- Total Revenue (TR) is the product of price and quantity

o TR = P x Q
- It is the
o Amount paid by buyers
o Amount received by sellers
- Graphical representation of TR:
- TR = P x Q
o If P increases, what happens to TR?
- If demand is inelastic an increase in P a less than
proportional decrease in Q increase in TR What happens if there is a decrease in P?
- If demand is elastic an increase in P a proportionally larger decrease in Q decrease in
TR What happens if there is a decrease in P?
- If demand has unit elasticity a change in P proportionally equal change in Q TR are
unaffected

Income elasticity of demand

- Income elasticity of demand measures how much the quantity demanded of a good responds
to a change in consumers income

- Normal goods have positive income elasticity (greater than 0)

- Inferior goods have negative income elasticity (less than 0)
- Among normal goods:
o Goods consumers regard as necessities tend to be income inelastic, i.e. low positive
income elasticity (less than 1)
Examples: food, fuel, clothing, utilities and medical services
o Good consumers regard as luxuries tend to be income elastic, i.e. high positive income
elasticity (greater than 1)
Examples: Porsche cars, lobster, Gucci clothes, yachts

Cross price elasticity of demand

- Cross price elasticity of demand measures how much the quantity demanded of a good (say
good 1) responds to a change in the price of a related good (say good 2)

- Complements (e.g. cars and petrol) have negative cross-price elasticity

- Substitutes (e.g. Pepsi and Coke) have positive cross-price elasticity
Price elasticity of supply
- Price elasticity of supply is a measure of how much the quantity supplied of a good responds to
a change in the price of that good, It is positive

- Supply is said to be:

o Elastic if price elasticity of supply is greater than 1
o Inelastic if price elasticity of supply is smaller than 1
o Unit elastic if price elasticity of supply is equal to 1

Determinants of price elasticity of supply

- Ability of suppliers to change the amount of the good they sell
o The supply of a Picasso painting or beach-front land is inelastic
o The supply of books, cars, or manufactured goods tend to be elastic
- Time period being considered
o Supply is more elastic over longer periods

Applications: Can good news for farming be bad news for farmers?
Assuming that demand for wheat is rather inelastic, what happens to the wheat
market when a new, more productive hybrid wheat is introduced? What happens
to the revenues of farmers?

A. The initial market equilibrium

- Start off representing an initial market equilibrium graphically
- The demand curve is quite steep to reflect the assumption of an inelastic
demand

B. Apply comparative static analysis

- A more productive hybrid allows farmers to increase productivity, thus
supplying more wheat
- Therefore:
o S curve shifts to the right
o A new equilibrium is reached at point B with a lower price and a
higher quantity

C. Study how changes in market equilibrium affect buyers and/or sellers

based on knowledge of elasticity
- Since we know that demand is inelastic, we can conclude that the
decrease in price leads to a proportionally smaller increase in quantity
- Farmers revenues fall
o What is TR at A? $300, At B? $220
- So, good news for farming (i.e. the new hybrid) can in fact be a bad news
for farmers.
Lecture 3-Market and Government Policies
Markets and government policies (Chapter 6)
- So far, we have analysed how free markets work:
o The interaction between demand and supply naturally leads to a market equilibrium
o In achieving the equilibrium, the price mechanism plays a key role.
- The equilibrium thats established by a free market may not be considered a fit to everyone.
- Today we analyse policies that governments can implement to change free market equilibria:
o Price controls, Taxes

Controls on prices
- Price controls are used when policymakers believe the market price is unfair to buyers or sellers
o A price ceiling- A legal maximum on the price at which a good can be sold
o A price floor- A legal minimum on the price at which a good can be sold

How price ceilings affect market outcomes

- Two possible outcomes of a price ceiling:
o If the ceiling is above the equilibrium price (i.e. it is not binding) No effect
o If the ceiling is below the equilibrium price (i.e. it is binding) Shortage and non-price
rationing (long lines and queuing, discrimination by sellers)

Case Study: Lines at the petrol Station

- From 1973 to 1981, there was a price ceiling for petrol in the US. There was a maximum price
- In 1973, OPEC raised the price of crude oil, which led to a reduction in supply of petrol.
o The reduction in S
combined with the
price ceiling led to
a shortage and long
lines.
How price floors affect market outcomes
- Also in this case, two possible outcomes of a price floor:
o If the floor is below the equilibrium price (i.e. it is not binding) No effect
o If the floor is above the equilibrium price (i.e. it is binding) Surplus and non-price
rationing (discrimination by buyers)

Case Study: The minimum wage

- Minimum-wage laws prevent employers offering wages below a certain level
- Potential undesired effect: It can increase unemployment level of unskilled workers

Taxes and market outcomes

- All governments use taxes to raise revenue for public projects and services
- We will consider in turn:
o A tax levied on sellers
o A tax levied on buyers
- And we will study:
o How the introduction of a tax affects the market equilibrium
o Who bears the burden of a tax buyers or sellers?
Tax incidence is the study of who bears the burden of a tax
How is the burden of a tax shared among market participants?
A tax on sellers
- Suppose the government passes a law requiring sellers of ice-cream to send $0.50 to the
government for each ice-cream they sell.
- What is the impact of this law on the market of ice-cream?
- For sellers, the tax is like an additional production cost. At any given quantity, sellers increase
the price by $0.50 in order to cover the extra cost of the tax.
- The supply curve shifts up by an amount equal to the tax
o New equilibrium is at point B, with a lower equilibrium quantity and a higher
equilibrium price (Note the new equilibrium price increased less than the amount of the
tax it did not go up to $3.50).

A tax on sellers: Who pays the tax?

- We can now turn to the issue of tax
incidence. Who effectively pays the tax?
- Market price increases from $3 to $3.30.
o $3.30 is the price buyers pay
- What price do sellers effectively receive?
o $3.30-$0.50 = $2.80
- The tax makes both buyers and sellers
worse off
- Though the sellers physically pay the
$0.50 to the government, they share the
burden of the tax with buyers. In the new
equilibrium buyers pay more for the good and sellers receive less.

A tax on buyers
- Now, suppose the government passes a law
requiring buyers of ice-cream to pay $0.50
to the government for each ice-cream they
buy
- What is the impact of this law on the market
of ice-cream?
- Buyers have to pay the price to the seller
plus any tax to government
- To induce buyers to demand any given
quantity, the market price must now be
$0.50 lower than it was before
- D curve shifts down by an amount equal to
the tax
- The new equilibrium is at point B, with a lower equilibrium quantity and a lower equilibrium
price (note the price did not decrease by the full amount of the tax)
A tax on buyers: Who pays the tax?
- Who effectively pays the tax?
- Market (sellers) price falls from $3 to
$2.80.
o $2.80 is the price sellers
receive
- What price do buyers effectively
pay?
o $2.80+$0.50 = $3.30
- Again, the tax makes both buyers
and sellers worse off
o Though the buyers physically
pay the $0.50 to the government, they share the burden of the tax with sellers. In the
new equilibrium buyers pay more for the good and sellers receive less.

Impact of taxes
- Taxes result in a change in market equilibrium.
o In the new equilibrium, quantity traded is lower regardless whom the tax is levied on.
Taxes discourage market activity!
However they are necessary to raise revenue to finance some projects and
services (there is no such a thing as a free lunch!).
o Buyers pay more and sellers receive less, regardless of whom the tax is levied.
Conclusion: Buyers and sellers share the tax burden regardless of whom the tax
is levied on.
o But in what proportions is the burden of the tax divided?
o The answers to these question depends on the elasticity of demand and the elasticity
of supply

Elasticity and tax incidence

- General Rule: The burden of a tax falls
more heavily on the side of the market
that is less elastic
- Lets first look at the case in which D is less
elastic that S
o A trick: To analyse the burden of a
tax, it is not necessary to know the
side on which the tax is levied
o and thus it is not necessary to
shift either D or S as we did in the
previous slides
o All we need to do is to take two points, one on D and the other on S, whose distance is
exactly equal to the tax.
Elasticity and tax incidence
- Once we have identified the price paid by buyers and that received by sellers, we can easily see
how the burden of the tax is split.
- As seen below, if D is less elastic than S the burden falls more heavily on consumers than on
producers.

Elasticity and tax incidence

- The graph below show the case in which S is less elastic than D
- As the graph shows, in this case the burden falls more heavily producers that on consumers.