Poe 3

POE Week 3 & 4
• From last lecture:
• Theories are abstract representation of reality

• Models are useful to understand reality
– In Economics we use models to understand
economic phenomenon
1
Demand, Supply and Market
equilibrium
• how the market forces of demand and supply
interact to determine equilibrium prices and
equilibrium quantities of goods and services.
• how prices and quantities adjust to changes in

demand and supply
• how changes in prices serve as signals to buyers and

sellers.
2
Fundamental decision making units
• Firm
– Primary producing units in an economy
– An organization that transforms resources (inputs) into goods and
services (outputs)
– There is demand for these outputs from consumers
Why do firms produce: Theory of Firm

– Firms make decisions in order to maximize profits
• Household
– Consuming units in an economy
3
INPUT MARKETS AND OUTPUT MARKETS:
THE CIRCULAR FLOW
Firms and Households interact in 2 basic kinds of markets:
Product or output markets

The markets in which goods and services are exchanged.
input or factor markets

The markets in which the resources used to produce
products are exchanged.
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THE CIRCULAR FLOW
The Circular Flow of Economic Activities

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THE CIRCULAR FLOW
Input and output markets are connected
The connection is through the interaction of both firms

and households.
Firms determine the quantities of outputs produced and

the types of quantities of inputs demanded.
Households determine the types and quantities of

products demanded and the quantities and types of inputs
supplied.
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THE CIRCULAR FLOW
factors of production
The inputs into the production process.
Land, labor, and capital are the three key factors of
production.
labor market
-The input/factor market in which households supply work for
wages to firms
capital market
- The input/factor market in which households supply their
savings for interest (or for claims to future profits) to firms
land market
The input/factor market in which households supply land in
exchange for rent.
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• Objective:
Theory of how market prices are determined
Market prices are determined by interaction of

demand and supply
• Approach:
Concentrate on how prices influence the behavior of

- Consumers (demand side)
- Producers (supply side)
- Interaction between demand and supply
8
DEMAND IN PRODUCT/OUTPUT MARKETS
quantity demanded
= amount of a good that buyers are willing

and able to purchase
Note: quantity demanded need not be equal

to quantity supplied in the market
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CHANGES IN QUANTITY DEMANDED

VERSUS CHANGES IN DEMAND
The most important relationship in

individual markets is that between market
price and quantity demanded.
Therefore use the ceteris paribus

assumption to concentrate on these two
variables
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Changes in the price of a product affect the quantity demanded per
period.
Eg. an increase in the price of Coke is likely to cause a decrease in the
quantity (of Coke) demanded.
price = 30 : quantity demanded = 3/week
price = 45: quantity demanded = 2/week
Changes in any other factor, such as income or preferences, affect

demand.
- eg. If a household starts earning higher income, it might buy more of a
good at every possible price
Thus an increase in income is likely to cause an increase in demand for
most goods.
11
A consumer/ household’s demand for a particular good/service
depends on a number of factors:
■ The price of the product in question
■ The income available to the household
■ The household’s amount of accumulated wealth

eg. durable products, housing, education
■ The prices of other products
■ The household’s tastes and preferences

eg. Fast food, ready-to-eat meals
■ The household’s expectations about future income,

wealth, and prices
eg. Cars 12
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demand schedule or consumer’s demand schedule

for phone calls
“DEMAND”
QUANTITY DEMANDED
PRICE (PER CALL) (CALLS PER DAY)
Shows how much of a
0 30
product a household .50 25
would be willing to 3.50 7
buy at different prices. 7.00 3
10.00 1
15.00 0
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demand curve
A graph illustrating how much of a given
product a household would be willing to buy
at different prices.
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Demand Curves Slope Downward
law of demand
Ceteris paribus, when the price of a good rises, the
quantity demanded of the good falls.
The negative relationship between price and quantity

demanded
Implication: Demand curves have negative slope.
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Two additional things are notable about

a demand curve.
Intersection with price axis:

As long as households have limited income and wealth, demand
curves will intersect the price axis.
For any commodity, there is always a price above which a

household will not, or cannot, pay. Even if the good or service is
very important, all households are ultimately constrained by income
and wealth.
Intersection with quantity axis:

Quantity demanded in a given period of time is limited, even at a
zero price.
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What does demand curve tell us
• Understand the kind of behavior that consumers are
likely to exhibit if they actually face a higher or lower
price
• Thus we can predict consumer reactions to price

changes
• A certain course of action may be expected from a

group of consumers, under certain circumstances
17
Summary of what we know about the shape of

demand curves:
1. They have negative slope. An increase in price

is likely to lead to a decrease in quantity
demanded, and a decrease in price is likely to
lead to an increase in quantity demanded.
2. They intersect the quantity (X-) axis, a result of

time limitations.
3. They intersect the price (Y-) axis, a result of

limited income and wealth.
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Note:
A single point on the demand curve indicates a single

combination of price and quantity demanded
The whole demand curve shows the complete

relationship between price and quantity
demanded , ceteris paribus
19
Note:
The demand curve and demand schedule are

constructed on the ceteris paribus assumption
Q. What if we change the ceteris paribus

assumption?
20
OTHER DETERMINANTS OF HOUSEHOLD DEMAND
Income and Wealth

income The sum of household’s wages, interest, rents, and
any other forms of earnings in a given period of time.
Note: income is a flow measure: we must specify a time

period to measure income
Eg. Income per month , per year, …
wealth or net worth The total value of what a household

owns minus what it owes.
Note: wealth is a stock measure: it is measured at a given

point of time
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• Households with higher income /wealth can afford to
buy more goods and services
• We expect: As income/wealth increases, at each

price there will be higher quantity demanded
• Leads to shift of demand curve
22
normal goods
Goods for which demand goes up when income is
higher and for which demand goes down when
income is lower.
Eg. Meat, dairy products, shirts, private

education, …
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Note:
In Economics we often cannot generalize
inferior goods
Goods for which demand tends to fall when income rises.
Eg. local brand products (for certain customers),
- With higher income, the demand for local brand goods tend to fall
as consumers are willing to shift to better quality imported products
-Noodles vs. pasta
-Public transport vs private transport
24
Prices of Other Goods and Services
substitutes Goods that can serve as replacements for one

another
Implication:
- when the price of one increases, it becomes relatively more
expensive compared to the substitute product
- demand for the substitute product goes up.
Eg. 42” Samsung and 42”Sony; tea and coffee ; milk and milk
powder;
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Implication for demand curve:
A rise in the price of a substitute of a

product would shift the demand curve for
the product to the ??
26
Complementary goods
Goods that “go together” i.e. are consumed

together
Implication: a decrease in the price of one results

in an increase in demand for the other, and vice
versa.
Eg. car and petrol, digital camera and memory

cards, induction oven and induction compatible
utensils
27
Implication for demand curve:
A fall in the price of a complementary product

would shift the demand curve for the product to
the ??
28
illustrate the difference between changes in quantity
demanded vs changes in demand:
Two goods (A and B) are complementary if using more of

good A requires more of good B.
Eg. printer and ink cartridge
Two goods (C and D) are substitutes if using more of good C

replaces the use of good D.
Eg. Pepsi and Coke

Complementary goods (A,B)
Suppose the price good A goes down
The law of demand tells us that more of good A will be purchased by

moving down the demand curve.
In other words, the quantity demanded for good A will increase.
Since goods A and B are complementary, more good A requires the use
of more good B.
Demand curve for good B shifts to the right
Thus the demand for good B increases
# Suppose the price good A goes up

An price increase in good A will lead to a decrease in quantity demanded
for good A and decrease in demand for good B.
Substitute goods (C and D)
Suppose there is a decrease in the price of good C.
The law of demand tells us that more of good C will be purchased by

moving down the demand curve.
The quantity demanded of good C will increase.
Since goods C and D are substitutes, more good C will replace the use of
good D.
Demand for good D decreases

Demand curve of Good D shifts to the left.
# An increase in price of good C will lead to a decrease in quantity

demanded for good C and an increase in demand for good D.
Summary
Complementary goods
quantity demanded for good A up --> demand for good B up
quantity demanded for good A down --> demand for good B down
Substitute goods
quantity demanded for good C up --> demand for good D down
quantity demanded for good C down --> demand for good D up
SHIFT OF DEMAND VERSUS

MOVEMENT ALONG A DEMAND CURVE
Shift of consumer’s Demand Schedule Due to
increase in Income
SCHEDULE D0 SCHEDULE D1
Quantity Quantity
Demanded Demanded
(Calls Per Month (Calls Per Month
Price at an Income of at an Income of
(Per Call) 300 Per Month) 600 Per Month)
0 30 35
.50 25 33
3.50 7 18
7.00 3 12
10.00 1 7
15.00 0 2
20.00 0 0
Shift of a Demand Curve Following a Rise in
Income 35
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shift of a demand curve The change that takes

place in a demand curve corresponding to a new
relationship between quantity demanded of a
good and price of that good. The shift is brought
about by a change in the ceteris paribus
conditions.
movement along a demand curve The change in
quantity demanded brought about by a change in
price.
Change in price of a good or service
leads to
Change in quantity demanded (movement along the demand curve).
Change in income, preferences, or prices of other goods or services

leads to
Change in demand (shift of the demand curve). 36
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FROM HOUSEHOLD DEMAND TO MARKET DEMAND
Total quantity demanded in a market at a certain price
= sum of all the quantities demanded by all the

households at that price
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Market Demand:
The quantity demanded in a market is the sum of the quantities

demanded by all the buyers.
Graphically,
Horizontal sum of demand curves of all the buyers
Market demand would depend on all those factors that determine

the demand of individual buyers
- price, buyers’ incomes, tastes, expectations, prices of related
goods and also depends on the number of buyers
39
Deriving Market Demand from Individual Demand Curves

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Q. “During Diwali, the market demand for Gold
increases”
• How to interpret this statement?
• More people decide to purchase Gold during Diwali

• More demand curves must be added
• Market demand curve will shift outwards to the right
41
• Recall circular flow of economic activities:
– Households demand output (already discussed)
– Firms supply these outputs ( current focus)
42
SUPPLY IN PRODUCT/OUTPUT MARKETS
Why do firms engage in production/supply of goods and
services?
Successful firms make profits because they are able to sell their
products for more than it costs to produce them.
Profit: The difference between revenue and production costs.
Implication:
Supply decisions are expected to depend on profits
Thus supply decisions depend on revenue and production costs
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• What are the determinants of revenue?
– Price of the product
– How much is sold
• What are the determinants of costs?

– inputs/factors of production being used in the
production process
– Price of inputs
44
PRICE AND QUANTITY SUPPLIED:
quantity supplied
The amount of a particular product that a firm

would be willing and able to sale at a particular
price during a given time period.
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supply schedule of a wheat producer
Producer’s Supply Schedule for wheat
QUANTITY SUPPLIED
PRICE (per unit) (units PER MONTH)
1.50 0
1.75 10,000
2.25 20,000
3.00 30,000
4.00 45,000
5.00 45,000
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supply curve A graph illustrating how much of
a product a firm will sell at different prices.
Observe:
As price of the product increases, the quantity

supplied also tends to increase
But when price rises from 4 to 5, quantity

supplies no longer increases . Why?
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A firm’s ability to increase output is constrained
-Capacity to produce
-Eg. Dell might want to supply more number of

laptops at a certain price.
-It is constrained by the capacity of its contractors
-A farmer might want to supply more wheat, but

-ability to produce more wheat depends on
availability of inputs (eg. fertilizer, water) and the
existing technology of production
48
law of supply
The positive relationship between price and

quantity of a good supplied:
An increase in market price will lead to an

increase in quantity supplied, and a decrease
in market price will lead to a decrease in
quantity supplied, ceteris paribus
Q = S(P) ceteris paribus
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OTHER DETERMINANTS OF SUPPLY
The Cost of Production
Regardless of the price that a firm can receive for its

product, revenue must exceed the cost of producing
the output for the firm to make a profit.
Thus supply decision is likely to change in response to

change in cost of production
Cost of production depends on available technology ,

prices and quantities of inputs
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Technology can have enormous positive impact on
the cost of production over time.
Eg. Modern biotechnological innovations like

Genetically Modified (GM) crops have reduced
production costs
- Less pesticides are required
With reduced cost of production, output supplied

increases
51
Cost of production is also affected by price of inputs:
Eg. With increase in price of oil, airlines face higher

fuel costs
-Reduce/cancel the number of flights

-Thus there is reduction in quantity supplied
52
The Prices of Related Products
An increase in price of wheat may cause farmers to

shift to production of wheat from production of
sugarcane
Thus quantity of sugarcane supplied may reduce
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Summary:
A firm’s decision about what quantity
of output to supply depends on
1. The price of the product/service

2. The cost of producing the product, which in
turn depends on
- price of inputs
- technologies that can be used to produce
the product
3. The prices of related products
54
SHIFT OF SUPPLY VERSUS MOVEMENT ALONG A SUPPLY

CURVE
movement along a supply curve The change in

quantity supplied due to a change in price.
shift of a supply curve The change that takes place

in a supply curve corresponding to a new
relationship between quantity supplied of a good
and the price of that good.
The shift is brought about by a change in the ceteris

paribus conditions.
55
Suppose a breakthrough biotech innovation is available
that can produce disease and pest resistant variety of
wheat
Such technology would enable farmers to supply more

output at each market price
56
Shift of Supply Schedule for wheat
SCHEDULE S0 SCHEDULE S1
Quantity Supplied Quantity Supplied

Price (units Per Year (units Per Year
(Per unit) Using Old Seed) Using New Seed)
1.50 0 5,000
1.75 10,000 23,000
2.25 20,000 33,000
3.00 30,000 40,000
4.00 45,000 54,000
5.00 45,000 54,000
57
As with demand, it is important to distinguish:

movements along supply curves (changes in quantity
supplied) and shifts in supply curves (changes in
supply):
Change in price of a good or service

leads to
Change in quantity supplied (movement along a supply curve).
Change in technology, costs, price of inputs, price of other goods or services

leads to
Change in supply (shift of a supply curve).
58
FROM INDIVIDUAL SUPPLY TO MARKET SUPPLY
market supply
The sum of quantities supplied each period by

all producers of a single product.
59
Deriving Market Supply from Individual Firm Supply Curves

60
The position and shape of the Market supply curve
depend on the positions, shapes, and number of
individual firm’s supply curves.
Q. The popularity of smartphones and the availability

of technology to produce them induced several new
firms to enter the market. What will happen to the
supply curve of smartphones?
61
The determination of price
• So far we have considered demand and supply
separately.
• Now we are equipped to understand how
demand and supply interact to determine
price.
62
• Markets depend on forces of Supply and Demand
– market is a group of buyers and sellers of a particular
good or service
• D and S determine the quantity of each good produced and

the price at which it is sold.
• Useful to examine how any event or policy will affect a market
• Focus: How buyers and sellers behave in a market

• competitive market
– a market in which there are many buyers and many sellers
– so that each buyer/seller has a negligible impact on the market Price
• The price and the quantity sold are not determined by any
single buyer or seller.
• Rather, price and quantity are determined by all buyers and

sellers as they interact in the marketplace.
• Obj: examine how buyers and sellers interact in competitive

markets.
MARKET EQUILIBRIUM
equilibrium
The condition that exists when quantity

supplied and quantity demanded are equal.
At equilibrium, there is no tendency for price

to change: Equilibrium price
At Equilibrium price, consumers willing to buy

exactly the same amount as producers are
willing to supply
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MARKET EQUILIBRIUM
EXCESS DEMAND
excess demand or shortage

demanded exceeds quantity supplied at the
current price.
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MARKET EQUILIBRIUM
Excess Demand, or Shortage
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Excess Demand = QD - QS
When quantity demanded exceeds quantity

supplied, price tends to rise.
Adjustment mechanism:
-When the price in a market rises, quantity
demanded falls (why?)
- and quantity supplied rises (why?)
- until an equilibrium is reached at which
quantity demanded and quantity supplied are
equal.
68
MARKET EQUILIBRIUM
EXCESS SUPPLY
excess supply or surplus

supplied exceeds quantity demanded at the
current price.
69
MARKET EQUILIBRIUM
Excess Supply, or Surplus
70
Excess Supply = QS - QD
= -(QD – QS)
= negative excess demand
If quantity supplied exceeds quantity demanded at the current price
- Producers cannot sell all that they wish to sell at the current price
Implication: the price tends to fall
When price falls, quantity supplied is likely to decrease and quantity

demanded is likely to increase until an equilibrium price is reached
where quantity supplied and quantity demanded are equal.
71
Eg. Demand and Supply Schedules for Eggs and Equilibrium Price
Price Quantity Quantity supplied Excess Demand

[per dozen] demanded [‘000 dozen [‘000 dozen per month]
[‘000 dozen per month]
per month]
0.50 110.0 5.0 105.0
1.00 90.0 46.0 44.0
1.50 77.5 77.5 0.0
2.00 67.5 100.0 -32.5
2.50 62.5 115.0 -52.5
3.00 60.0 122.5 -62.5
72
Equilibrium price is where the demand and supply curves
intersect
- Nobody has incentive to change the price
At all prices above equilibrium there is excess supply and

downward pressure on price.
- Producers have incentive to reduce price
- Hence cannot be eqbm !
At all prices below equilibrium there is excess demand and

upward pressure on price.
- Consumers have incentive to offer higher price
- Hence cannot be eqbm !
73
Predictions of Demand and Supply analysis:
When supply and demand curves shift, the

equilibrium price and quantity change. How?
Method: Comparative Statics
We start from a position of equilibrium;

Then introduce the change to be studied
The new equilibrium position is determined
Compare the new equilibrium with the old
equilibrium
74
(i) shifts in demand
 The original curves are D0 and S : equilibrium at E0.
 Price p0, quantity q0
 An increase in demand shifts the demand curve to D1.
 Price rises to p1 and quantity rises to q1 taking the new equilibrium to
E1.
 A decrease in demand shifts the demand curve to D0.

 Price falls to p0 and quantity falls to q0 taking the new equilibrium to
E0.
 Thus, an increase in demand raises both equilibrium price and
equilibrium quantity while a decrease in demand lowers both
equilibrium price and quantity.
75
shifts in demand
76
(ii) shifts in supply
 The original demand and supply curves are D and S0, which intersect
to produce an equilibrium at E0, price p0 and quantity q0.
 An increase in supply shifts the supply curve to S1. Price falls to p1
and quantity rises to q1, taking the new equilibrium to E1.
 A decrease in supply shifts the supply curve back to S0. Price rises to
p0 and quantity falls to q0 taking the new equilibrium to E0.
 Thus an increase in supply raises equilibrium quantity but lowers
prices while a decrease in supply lowers equilibrium quantity but
raises price.
77
shifts in supply
78
MARKET EQUILIBRIUM
CHANGES IN EQUILIBRIUM
The Coffee Market:

A Shift of Supply and
Subsequent Price Adjustment
79
MARKET EQUILIBRIUM
Examples of Supply and Demand Shifts

for Product X
80
MARKETS AND THE ALLOCATION OF RESOURCES
How markets answer the basic economic questions

of what is produced, how it is produced, and who
gets what is produced.
What is produced?
A firm will produce what is profitable to produce
Thus resources will be allocated towards profitable
opportunities
How is it produced?
Firms want to make profit
Therefore they will choose the best available
technology to produce the output
81
Who gets what is produced?
- Demand curve
- consumers who are willing and able to pay for
the products
- When a good is in short supply, price rises.

As it does, those who are willing and able to buy
will continue to buy; others stop buying.
82
• Will resource allocation change if there is change in consumer
preferences?
Some examples:
– Demand for fuel efficient cars
– Car manufacturers are allocating significant part of their R&D budget
on development of such cars
– McD used to only sell burgers and fries

– Now they have introduced healthier options like Salad
– Resources are no longer allocated to produce camera film rolls, floppy

disks,…
83
• Examine the comparative static effects of the
following events:
• All other things unchanged, what happens to

the demand curve for external hard drives if
there is
(a) an increase in the price of laptops
(b) a decrease in disposable income
(c) an decrease in the price of hard drives
84
• A new technique is discovered for
manufacturing computers that greatly lowers
their production cost. What would happen in
the market for computers, ceteris paribus?
85
• The terrible cyclone that killed more than
50,000 people in Myanmar in 2008 also
destroyed some of the country’s prime rice
growing land
86
• Indian Medical Association announces a new
discovery:
“People who regularly drink green tea live
longer, healthier lives”
• How does this announcement affect the
market for coffee?
• Policymakers often want to reduce the consumption of cigarettes
1) One way: increase price of cigarettes

– government taxes the manufacture of cigarettes
– cigarette companies pass much of this tax on to consumers in the
form of higher prices.
– A higher price encourages smokers to reduce the numbers of
cigarettes they smoke
Other possible policy?

Another way to reduce smoking is to shift the demand
curve for cigarettes
- mandatory health warnings
• Note: when either the demand or the supply curve shifts, the
results are unambiguous; that is, we know what will happen
to both equilibrium price and equilibrium quantity
• However, in practice, several events may occur at around the

same time that cause both the demand and supply curves to
shift.
• To figure out what happens to equilibrium price and

equilibrium quantity, we must know 1) in which direction the
demand and supply curves have shifted and 2) the relative
amount by which each curve shifts.
90
• Consider a decrease in demand for coffee
(caused perhaps by a decrease in the price of
a substitute good, such as tea) and a
simultaneous decrease in the supply of coffee
(caused perhaps by bad weather)
91
• Comparative static effects:
• new equilibrium quantity of coffee is less than
the old equilibrium quantity.
• The effect on the equilibrium price is
ambiguous. Whether the equilibrium price is
higher, lower, or unchanged depends on the
extent to which each curve shifts.
92
Simultaneous shifts
93

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POE Week 3 & 4

• From last lecture:

• Theories are abstract representation of reality

• how prices and quantities adjust to changes in

• how changes in prices serve as signals to buyers and

Why do firms produce: Theory of Firm

Firms and Households interact in 2 basic kinds of markets:

Product or output markets

input or factor markets

The Circular Flow of Economic Activities

Input and output markets are connected

The connection is through the interaction of both firms

Firms determine the quantities of outputs produced and

Households determine the types and quantities of

Theory of how market prices are determined

Market prices are determined by interaction of

Concentrate on how prices influence the behavior of

= amount of a good that buyers are willing

Note: quantity demanded need not be equal

CHANGES IN QUANTITY DEMANDED

The most important relationship in

Therefore use the ceteris paribus

Changes in any other factor, such as income or preferences, affect

■ The price of the product in question

■ The income available to the household

■ The household’s amount of accumulated wealth

■ The prices of other products

■ The household’s tastes and preferences

■ The household’s expectations about future income,

demand schedule or consumer’s demand schedule

Demand Curves Slope Downward

The negative relationship between price and quantity

Implication: Demand curves have negative slope.

Two additional things are notable about

Intersection with price axis:

For any commodity, there is always a price above which a

Intersection with quantity axis:

• Thus we can predict consumer reactions to price

• A certain course of action may be expected from a

Summary of what we know about the shape of

1. They have negative slope. An increase in price

2. They intersect the quantity (X-) axis, a result of

3. They intersect the price (Y-) axis, a result of

A single point on the demand curve indicates a single

The whole demand curve shows the complete

The demand curve and demand schedule are

Q. What if we change the ceteris paribus

Income and Wealth

Note: income is a flow measure: we must specify a time

wealth or net worth The total value of what a household

Note: wealth is a stock measure: it is measured at a given

• We expect: As income/wealth increases, at each

• Leads to shift of demand curve

Eg. Meat, dairy products, shirts, private

Eg. local brand products (for certain customers),

-Noodles vs. pasta

-Public transport vs private transport

substitutes Goods that can serve as replacements for one

A rise in the price of a substitute of a

Goods that “go together” i.e. are consumed

Implication: a decrease in the price of one results

Eg. car and petrol, digital camera and memory

A fall in the price of a complementary product