Understanding the Market Mechanism

Demand

Introduction
Want of goods & services accompanied by willingness and ability to purchase The amount of goods and services that consumers in a market are willing and able to purchase during a given period of time (e.g., week, month) is called Quantity Demanded

Generalized Demand Function

Six principal variables that influence the quantity demanded
1. 2. 3. 4. 5. 6. Price of product Income of consumers Price of related product Tastes & preference pattern of consumers Expected price of product in future periods Number of consumers in market

Generalized.
Relation between quantity demanded and these 6 factors is referred to as Generalized Demand Function and is expressed as follows: Qd= f (P, M, PR, T, Pe, N)
Qd : quantity demanded of the product P : price of the product M : consumers income PR : price of related product T : taste & preference patterns of consumers Pe : expected price of the product in some future period N : number of consumers in the market

Relation between Variables and Quantity Demanded

Quantity demanded Price of goods
When price rises, quantity demanded falls When price falls, quantity demanded rises => Inverse or negative relation

Relation
Quantity demanded Consumers income
When income rises, Qd may rise or fall Qd rises normal goods Qd falls inferior goods
When income falls, Qd may fall or rise Qd falls normal goods Qd rises inferior goods Direct relation for normal goods Inverse relation for inferior goods

Relation
Quantity demanded Price of related goods
Commodities may be related in consumption in either of two ways:
Substitute goods (one good can be used in place of other) Complement goods (they are used in conjunction with each other) Independent goods

Relation
Substitute goods Increase in price of good Y will lead to increase in demand for good X Decrease in price of good Y will lead to decrease in demand for good X => Direct relation in case of substitute goods Complement goods Increase in price of good Y will lead to decrease in demand for good X Decrease in price of good Y will lead to increase in demand for good X => Inverse relation in case of complementary goods

Relation
Quantity demanded Expected Future price of goods
If price is expected to rise in future, current demand may rise If price is expected to fall in future, current demand may fall => Direct relation

Relation
Quantity demanded Consumer taste pattern
Increase in taste/preference for the good, demand will increase Decrease in taste/preference for the good, demand will decrease => Direct relation

Relation
Quantity demanded Number of consumers
Increase in number of consumers for the good, demand will increase Decrease in number of consumers for the good, demand will decrease => Direct relation

Linear form of Generalized Demand Function

Qd = a + bP + cM + dPR + eT + fPe + gN a is intercept parameter which shows the value of Qd when all variables are simultaneously equal to zero. b, c, d, e, f, g are slope parameters. They measure the effect on quantity demanded of changing one of the variables while holding the rest of variables constant.

Summary of relationships
Vari Relation to Qd able P Inverse M Sign of slope parameter

b = Qd/P is negative

Direct for normal good c = Qd/M is positive

PR

Inverse for inferior good Direct for substitute goods Inverse for complementary goods

c = Qd/M is negative
d = Qd/PR is positive d = Qd/PR is negative

Summary
Variable Relation to Qd Sign of slope parameter

T Pe N

Direct Direct Direct

e = Qd/T is positive f = Qd/Pe is positive g = Qd/N is positive

Simplified version of generalized demand function

Consumer tastes (T), Expected future price (Pe)and number of consumers (N) are excluded
Qd = a + bP + cM + dPR

Demand Function The relation between price and quantity demanded per period of time, when all other factors that affect consumer demand are held constant, is called a demand function or simply demand. Demand gives, for various prices of a good, the corresponding quantities that consumers are willing and able to purchase at each of those prices, all other things held constant.

Demand Function. A demand function can be expressed as an equation, a schedule/table, or a graph. A demand function can be expressed in the most general form as the equation Qd = f(P) which means that the quantity demanded is a function of (depends on) the price of the good, holding all other variables constant

Demand Function. Such demand function is obtained by holding all the variables in the generalized demand function constant except price Qd = f(P, M, PR) = f(P)

Derivation of demand function from generalized demand function

Suppose generalized demand function is Qd = 1800 - 20P + 0.6M 50PR

To derive a demand function, Qd = f(P), the variables M and PR must be assigned fixed values.

Derivation .. Suppose M (consumer income) is Rs. 20000 and PR (price of related good) is Rs. 250. To find the demand function, fixed values of M and PR are substituted into the generalized demand function: Qd = 1800 20P + 0.6(20000) 50(250) = 1800 20P + 12000 12500 = 1300 20P

Derivation .. Thus, the demand function is expressed in the form of a linear demand equation. Intercept parameter (1300) is the amount of the good consumers will demand if price is zero. Slope (-20) indicates that a Re. 1 increase in price causes quantity demanded to decrease by 20 units.

Derivation ..
Demand equation can be converted into demand schedule by changing values of P in the equation, Qd = 1300 20P.
Price 65 60 50 40 30 20 10 0 Qd 0 100 300 500 700 900 1100 1300

Demand Curve
Demand schedule can be converted into a graph. A graphical demand function is called a demand curve.
70 60 50 0, 65 100, 60 300, 50 500, 40 700, 30 900, 20 1100, 10 0 200 400 600 800 1000 1200 1300, 0 1400

Price

40 30 20 10 0

Quantity demanded

Demand..
Note that in the graph of the demand function, Qd = 1300 20P, the independent variable P is plotted along the vertical axis and the dependent variable Qd is plotted along the horizontal axis. Thus the equation plotted in the figure is the inverse of the demand equation and is called inverse demand function since price is expressed as a function of quantity demanded: P = 65 1/20Qd.

Demand..
The vertical intercept is 65, indicating that at a price of 65, consumers will demand zero units of the good. The horizontal intercept is 1300, which is the maximum amount of the good buyers will take when the good is given away (P = 0) Slope of the graphed inverse demand function is -1/20, indicating that if quantity demanded rises by one unit, price must fall 1/20 of a Re.

Demand..
A point on a demand curve can be interpreted as in either of two ways:
(1) The maximum amount of a good that will be purchased if a given price is charged (2) The maximum price that consumers will pay for specific amount of a good.

Law of demand
Quantity demanded increases when price falls and quantity demanded decreases when price rises, other things held constant. (Law of demand) Once a demand function, Qd = f(P), is derived from a generalized demand function, a change in quantity demanded can be caused only by a change in price.

Dynamics
Change in quantity demanded Increase (caused by fall in price) Decrease (caused by rise in price)

Change in demand (Shift in demand) Increase (caused by change in non-price variables) Decrease (caused by change in non-price variables)

Shifts/Change in Demand
When any one of the five variables held constant while deriving a demand function from the generalized demand relation changes value, a new demand function results, causing the entire demand curve to shift to a new location

Change in demand can be understood from simplified version of generalized demand function

Change in demand caused by change in income

Initial demand function Qd = 1800 - 20P + 0.6M 50PR Qd = 1800 20P + 0.6(20000) 50(250) Qd = 1800 20P + 12000 12500 Qd = 1300 20P (D0) Now, suppose income increases by 500 Qd = 1800 20P + 0.6(20500) 50(250) Qd = 1800 20P + 12300 12500 Qd = 1600 20P (D1)

Change
Now, suppose income decreases by 500 Qd = 1800 20P + 0.6(19500) 50(250) Qd = 1800 20P + 11700 12500 Qd = 1000 20P (D2)

Price
65 60 50 40 30 20 10

D0: 1300-20P [M=20000] 0

100 300 500 700 900 1100

D1: 1600-20P [M=20500] 300

400 600 800 1000 1200 1400

D2: 1000-20P [M=19500] 0

0 0 200 400 600 800

1300

1600

1000

Changing Demand Curves

80 70 60 50 40 30 20 10 0 0 200 400 600 800 1000 1200 1400 1600

D0

1 Qd= :[

20 00-

P]

1:

[Qd =16

D2 :[

002

Qd =1

0P]

000

- 20

P]

Change in demand caused by change in price of related good

Initial demand function Qd = 1800 - 20P + 0.6M 50PR Qd = 1800 20P + 0.6(20000) 50(250) Qd = 1800 20P + 12000 12500 Qd = 1300 20P (D0) Now, suppose PR increases by 10 Qd = 1800 20P + 0.6(20000) 50(260) Qd = 1800 20P + 12000 13000 Qd = 800 20P (D3)

Change
Now, suppose PR decreases by 10 Qd = 1800 20P + 0.6(20000) 50(240) Qd = 1800 20P + 12000 12000 Qd = 1800 20P (D4)

Price
65 60 50 40 30 20 10

D0: 1300-20P [PR=250] 0

100 300 500 700 900 1100

D3: 800-20P [PR=260] 0

0 0 0 200 400 600

D4: 1800-20P [PR=240] 500

600 800 1000 1200 1400 1600

1300

800

1800

Changing demand curves

70 60 50

D0 : D3 : Qd =

Qd =

D4 : 13 00 -2 0P

Qd =

Price

40 30 20 10 0 0

18

00

-2

0P

80

0-

20

200

400

600

800

1000

1200

1400

1600

1800

Quantity demanded

Summary of Demand Shifts

Determinants of demand Income (M) Normal good Inferior good Price of related goods (PR) M rises M falls M falls M rises c>0 c<0 Demand increases Demand decreases Sign of slope parameter

Substitute goods
Complement goods

PR rises
PR falls

PR falls
PR rises

d>0
d<0

Summary of Demand Shifts

Determinants of demand Consumer tastes (T) Demand increases T rises Demand decreases T falls Sign of slope parameter e>0

Expected Price (Pe)

Number of consumer (N)

Pe rises
N rises

Pe falls
N falls

f>0
g>0

Understanding the Market Mechanism

Supply

Introduction
The amount of goods and services offered for sale in a market during a given period of time (e.g., week, month) is called Quantity Supplied

Generalized Supply Function

Six principal variables that influence the quantity supplied
1. 2. 3. 4. 5. Price of goods itself Price of inputs used to produce the good Price of goods related in production Level of available technology Expectations of producers concerning future price of the good 6. Number of firms or the amount of productive capacity in the industry

Generalized.
Relation between quantity supplied and these 6 factors is referred to as Generalized Supply Function and is expressed as follows: Qs= g (P, PI, Pr, Tech, Pe, F)
Qs quantity of a good or service offered for sale P price of the good or service PI Prices of inputs used in production Pr price of goods or service related in production Tech level of available technology Pe expectations of producers concerning future price of the good F number of firms or amount of productive capacity in the industry

Relation between Variables and Quantity supplied

Quantity supplied Price of the good
When price rises, quantity supplied rises When price falls, quantity supplied falls => Direct relation

Relation
Quantity supplied Price of inputs
When input price rises, Qs falls When input price falls, Qs rises Inverse relation

Relation
Quantity supplied Price of goods related in production
Depends on whether goods are substitutes or complements in production:

Substitutes in production Two goods X and Y are substitutes in production if an increase in the price of good X relative to good Y causes producers to increase production of good X and decrease production of good Y => Inverse relation

Relation
Complements in production Two goods X and Y are complements in production if an increase in the price of good X relative to good Y causes producers to increase production of good Y also => Direct relation

Relation
Quantity supplied Level of Technology
When technology improves, Qs increases When technology deteriorates, Qs decreases => Direct relation

Relation
Quantity supplied Future price expectations
If price is expected to rise in future, current supply may fall If price is expected to fall in future, current supply may rise => Inverse relation

Relation
Quantity supplied Number of firms or productive capacity of industry
Increase in number of firms or productive capacity, Qs will increase Decrease in number of firms or productive capacity, Qs will decrease => Direct relation

Linear form of Generalized Demand Function

Qd = h + kP + lPI + mPr + nTech + rPe + sF h is intercept parameter k, l, m, n, r, s are slope parameters. They measure the effect on quantity supplied of changing one of the variables while holding the rest of variables constant.

Summary
Vari Relation to Qs able P Direct PI Inverse Sign of slope parameter

k = Qs/P is positive
l = Qs/PI is negative

Pr

Inverse for substitutes in production Direct for complements in production

m = Qs/Pr is negative
m = Qs/Pr is positive

Summary
Vari Relation to Qs able Tech Direct Pe Inverse Sign of slope parameter

n = Qs/Tech is positive
r = Qs/Pe is negative

Direct

s = Qs/F is positive

Simplified version of generalized supply function

Technology (Tech), expected future price (Pe) and price of related goods (Pr) are omitted for simplification
Qs = h + kP + lPI + sF

Supply Function The relation between price and quantity supplied per period of time, when all other factors that affect supply are held constant, is called a supply function or simply supply. Supply gives, for various prices of a good, the corresponding quantities that producers are willing to supply at each of those prices, all other things held constant.

Supply Function. A supply function can be expressed as an equation, a schedule or table, or a graph. A supply function can be expressed in the most general form as the equation Qs = f(P) which means that the quantity supplied is a function of (depends on) the price of the good, holding all other variables constant

Supply Function. A supply function is obtained by holding all the variables in the generalized supply function constant except price Qs = f(P, PI, F) = f(P)

Derivation of supply function from generalized supply function

Suppose generalized supply function is Qs = 50 + 10P - 8PI + 5F

To derive a supply function, Qs = f(P), the variables PI and F must be assigned fixed values.

Derivation .. Suppose PI (Input price) is Rs. 50 and F (number of firms) is 90. To find the supply function, fixed values of PI and F are substituted into the generalized supply function: Qs = 50 + 10P - 8(50) + 5(90) = 50 + 10P - 400 + 450 = 100 + 10P

Derivation .. Linear supply function gives the quantity supplied for various product prices, holding constant the other variables that affect supply.

Derivation ..
Supply equation can be converted into supply schedule by changing values of P in the equation, Qs = 100 + 10P.
Price 65 60 50 40 30 20 10 Qs 750 700 600 500 400 300 200

Derivation .. Supply schedule can be converted into a graph. A graphical supply function is called a supply curve.

Supply curve
70 60 50

Price

40 30 20 10 0 0 100 200 300 400 500 600 700 800 Quantity supplied

Supply..
Note that in the graph of the supply function, Qs = 100 + 10P, the independent variable P is plotted along the vertical axis and the dependent variable Qs is plotted along the horizontal axis. Thus the equation plotted in the figure is the inverse of the supply equation and is called inverse supply function since price is expressed as a function of quantity supplied: P = - 10 + 1/10Qs.

Supply..
A point on a supply curve can be interpreted as in either of two ways:
(1) The maximum amount of a good that will be offered for sale at a specific price (2) The minimum price necessary to induce producers to offer a given quantity for sale.

Supply.
Once a supply function, Qs = f(P), is derived from a generalized supply function, a change in quantity supplied can be caused only by a change in price.

Dynamics
Change in quantity supplied Increase (caused by rise in price) Decrease (caused by fall in price)

Change in supply (Shift in supply) Increase (caused by change in non-price variables) Decrease (caused by change in non-price variables)

Shifts/Change in supply
When any one of the five variables held constant while deriving a supply function from the generalized supply relation changes value, a new supply function results, causing the entire supply curve to shift to a new location

Change in supply can be understood from simplified version of generalized supply function

Change in supply caused by change in price of input, number of firms

Initial supply function Qs = 50 + 10P - 8(50) + 5(90) = 50 + 10P - 400 + 450 = 100 + 10P (S0) Suppose, input price decreases to 31.25 Qs = 50 + 10P - 8(31.25) + 5(90) = 50 + 10P - 250 + 450 = 250 + 10P (S1)

Change
Suppose, number of firms decreases to 30 Qs = 50 + 10P - 8(50) + 5(30) = 50 + 10P - 400 + 150 = - 200 + 10P (S2)

Price
65 60 50 40 30 20 10

S0: 100 + 10P [PI=50, F=90] 750

700 600 500 400 300 200

S1: 250 + 10P [PI=31.25, F=90] 900

850 750 650 550 450 350

S2: - 200 + 10P [PI=50, F=30] 450

400 300 200 100 0 0

100

250

Changing Supply Curve

70 60 50

Price

40 30 20 10 0 0

S2

Qs :

-2 0 =

0 +1

S0

= Qs :

0 10

0 +1

P
s :Q 1 5 =2 0

0 +1

200

400

600

800

1000

Quantity supplied

Summary of Supply Shifts

Determinants of supply Price of Inputs (PI) Price of goods related in production (Pr) Substitute goods Supply increases PI falls Supply Sign of slope decreases parameter PI rises l<0

Pr falls

Pr rises

m<0

Complement goods

Pr rises

Pr falls

m>0

Summary of Supply ..
Determinants of Supply State of Technology (Tech) Supply increases Tech rises Supply decreases Tech falls Sign of slope parameter n>0

Expected Price (Pe)

Number of firms (F)

Pe falls
F rises

Pe rises
F falls

r<0
s>0

Understanding the Market Mechanism

Market Equilibrium

Defined
Market equilibrium is a situation in which, at the prevailing price, consumers can buy all of a good they wish and producers can sell all of the good they wish. In other words, equilibrium occurs when price is at a level for which quantity demand demanded equals quantity supplied. In equilibrium, the price is called equilibrium price and the quantity sold is called equilibrium quantity

Market equilibrium - Table

Price 65 Qs
[Qs = 100 + 10P]

Qd
[Qd = 1300 + 20P]

Qs - Qd +750

750

60 50
40 30 20 10

700 600
500 400 300 200

100 300
500 700 900 1100

+600 +300
0 -300 -600 -900

Market equilibrium - Equation

Qd = 1300 20P Qs = 100 + 10P Equilibrium requires, Qd = Qs

i.e., 1300 20P = 100 + 10P Solving this equation for equilibrium price, 1300 100 = 10P + 20P 1200 = 30P P = 1200/30 = 40

Market equilibrium - Equation

Thus, 40 is market clearing price At this price (40), Qd = 1300 20P = 1300 (20 *40) = 500 Qs = 100 + 10P = 100 + (10*40) = 500 Equilibrium price: 40 Equilibrium quantity demanded: 500 Equilibrium quantity supplied: 500

Market equilibrium - Graph

70 60 50

Supply

Price

40 30 20 10 0 0 200 400 600 800 1000 1200 Quantity demanded/supplied

Demand

Market equilibrium
When the current price is above the equilibrium price, quantity supplied exceeds quantity demanded. The resultant excess supply induces sellers to reduce price in order to sell the surplus. If the current price is below equilibrium price, quantity demanded exceeds quantity supplied. Resultant excess demand causes the unsatisfied consumers to bid up price.

Since prices below equilibrium are bid up by consumers and prices above equilibrium are lowered by producers, the market will converge to the equilibrium price-quantity combination.

Change in Demand (Supply Constant)

When Demand increases and Supply is constant, equilibrium price and quantity both rise. When Demand decreases and Supply is constant, equilibrium price and quantity both fall
80 70 60
B

S0

Supply

Price

50 40 30 20 10 0 0

Y
C

X D1 D0 D2 Demand

200

400

600

800

1000

1200

1400

1600

Quantity demanded/supplied

Change in Supply (Demand Constant)

When Supply increases and Demand is constant, equilibrium price falls and equilibrium quantity rises. When Supply decreases and Demand is constant, equilibrium price rises and equilibrium quantity falls

80 70 60 50 40 30 20 10 0 0 200 400 600

D0 T Y

S2

S0 S1

Price

R S

Demand

800

1000

1200

1400

Quantity demanded/supplied

Simultaneous shifts in both Demand and Supply

When demand and supply both shift simultaneously, if the change in quantity can be predicted, the change in price is indeterminate. If the change in price can be predicted, the change in quantity is indeterminate. The change in equilibrium quantity or price is indeterminate when the variable can either rise of fall depending upon the relative magnitude by which demand and supply shift.

Demand increases & Supply Increases

Q rises; P may rise, fall, remain constant
D1 D0 S0 S1 S2 S3 P1 P0/P2 P3 A B C D

Q0

Q1 Q2 Q3

Demand increases & Supply Decreases

P rises; Q may rise, fall, remain constant
S2 D P2 S1 S2 S0

B
P1 P3 C

P0 A

D1 Q3 Q2 Q0/Q1 D0

Demand decreases & Supply Increases

P falls; Q may rise, fall, remain constant
S0 S2 S1

S3
P0 P3 A

P2 P1

D B

D0 D1 Q2 Q0/Q1 Q3

Q1

Demand decreases & Supply decreases

Q falls; P may rise, fall, remain constant
S3 S1 S2 D P3 B P0/P1 C A S0

P2

D0 D1 Q3 Q1 Q2 Q0