DEMAND, SUPPLY AND EQUILIBRIUM (CONTINUEDâ€¦â€¦..):Equilibrium

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Introduction to Economics ECO401

Lesson 2.3

DEMAND, SUPPLY AND EQUILIBRIUM (CONTINUED........)

Equilibrium:

Equilibrium is a state in which there are no shortages and surpluses; in other words the

quantity demanded is equal to the quantity supplied.

Equilibrium price is the price prevailing at the point of intersection of the demand and supply

curves; in other words, it is the price at which the quantity demanded is equal to the quantity

supplied.

Equilibrium quantity is the quantity that clears the market; in other words, it is it is the quantity

at which the quantity demand is equal to the quantity supplied.

Algebraic Representation of Equilibrium:

If we have following demand and supply functions,

Qd = 100 10 P

Qs = 40 + 20 P

In equilibrium,

Qd = Qs

Therefore

100 - 10P = 40 + 20P

20P + 10P = 100 - 40

30P = 60

P = 60/30

P=2

Putting the value of price in any of demand and supply equation,

Q = 100 10x2 (or 40 + 20x2)

Q = 100 20

Q = 80

The equilibrium price is 2 and the equilibrium quantity is 80.

Equilibrium can shift if:

· Demand Curve Shifts.

· Supply Curve Shifts.

· Both Shift.

This gives rise to eight possibilities. These eight possibilities can be summarized as following:

, S ~,

D~,S

,S~,

D~,S

Introduction to Economics ECO401

The symbol " " or " " shows increase and the symbol " " and " " shows a decrease

while the symbol "~" shows that the particular thing remains same.

Government and Price-Determination:

The government may intervene in the market and mandate a maximum price (price ceiling) or

minimum price (price floor) for a good or service.

A price ceiling is the maximum price limit that the government sets to ensure that prices don't

rise above that limit (medicines for e.g.).

A price floor is the minimum price that a Government sets to support a desired commodity or

service in a society (wages for e.g.).

Social cost is the cost of an economic decision, whether private or public, borne by the society

as a whole.

Marginal social cost is the change in social costs caused by a unit change in output.

Introduction to Economics ECO401

END OF UNIT 2 - Exercises

Asif and Aasia's "monthly" demand schedules for potatoes are given. Roughly draw

these demand schedules on the same graph. Assume that there are 200 consumers in the

market. Of these, 100 have schedules like Asif's and 100 have schedules like Aasia's.

Complete the Total market demand ("monthly") column in the table below?

Price

Asif

Aasia

Total

market

demand

(pence

(Qd in

(kg)

per kg)

kg)

4400

2600

1400

800

100

600

100

Asif's

demand

Aasia's

demand

Quantity demanded (kg per month)

Assuming that demand does not change from month to month, how would you plot the

annual market demand for potatoes?

The amount demanded would be 12 times higher at each price. If the scale of the horizontal

axis were unaltered, the curve would shift way out to the right. A simple way of showing the new

curve, therefore, would be to compress the scale of the horizontal axis. (If each of the numbers

on the axis were multiplied by 12, the curve would remain in physically the same position.)

At what price is their demand the same?

The two curves cross at a price of Rs50 per kg and at a demand of 10 kg per month.

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What explanations could there be for the quite different shapes of their two demand

curves?

One explanation could be that Asif is quite happy to eat rice, pasta or bread instead of potatoes.

Thus when the price of potatoes goes up she switches to these other foods, and switches to

potatoes when the price of potatoes comes down. Aasia, by contrast, may not see these other

foods as close substitutes and thus her demand for potatoes will be less price sensitive.

Do all these the determinants of demand affect both an individual's demand and the

market demand for a product?

All except the distribution of income in the economy.

You are given a market demand curve for apples. Assume that the price of apples

increases by 20 per cent at each price due, say, to substantial increases in the prices of

other substitute fruits. Plot the new demand curve for apples. Is the new curve parallel

to the old one?

See below. As you can see, the curves are not parallel. A constant percentage increase in

quantity demanded gives a bigger and bigger absolute increase as quantity increases.

100

New

demand

Old

demand

100

200

300

400

500

600

700

800

900

Quantity demanded (kg per month)

The price of lamb meat rises and yet it is observed that the sales of lamb meat increase.

Does this mean that the demand curve for lamb meat is upward sloping? Explain.

No not necessarily. For example, the price of substitutes such as beef or chicken may have

risen by a larger amount. In such cases the demand curve for lamb meat will have shifted to the

right. Thus although a rise in the price of lamb meat will cause a movement up along this new

demand curve, more lamb meat will nevertheless be demanded because lamb meat is now

relatively cheaper than the alternatives.

A demand function is given by Qd = 10000 200P. Draw this in P-Qd space. What is it

about the demand function equation that makes the demand curve in P- Qd space

(a) downward sloping; (b) a straight line?

Introduction to Economics ECO401

a) The fact is that the 200P term has a negative sign attached to it. This means that as P

rises, Qd falls.

b) The fact is that there is no P to a power term. The demand curve thus has a constant

slope of 1/200.

A demand function is given by Qd = a + bY, where Y is total income. If the term "a" has a

value of 50 000 and the term "b" a value of 0.001, construct a demand schedule with

respect to Y. Do this for incomes between Rs100 million and Rs300 million at Rs50

million intervals.

Y (in Rs

Qd (in

millions)

000s)

100

150

100

200

150

250

200

300

250

Now use this schedule to plot a demand curve with respect to income. Comment on its

shape.

The curve will be an upward-sloping straight line, crossing the horizontal axis at 50 000. It

would rise by 100 000 units for each Rs100 million rise in income.

300

Demand

250

200

150

100

150

200

250

300

Quantity demanded

Market dem and (with respec t to incom e)

What are the reasons which cause the market supply of potatoes to fall?

Examples include:

· The cost of producing potatoes rises.

· The profitability of alternative crops (e.g. carrots) rises.

· A poor potato harvest.

· Farmers expect the price of potatoes to rise (short-run supply falls).

For what reasons might the supply of leather rise?

Examples include:

Introduction to Economics ECO401

· The cost of producing leather falls.

· The profitability of producing mutton and chicken decreases.

· The price of beef rises (goods in joint supply).

· A long-running industrial dispute involving leather workers is resolved.

· Producers expect the price of leather to fall (short-run supply increases).

This question is concerned with the supply of gas for home and office heating in winters.

In each case consider whether there is a movement along the supply curve (and in which

direction) or a shift in it (left or right). (a) New gas fields start up in production. (b) The

demand for home heating rises. (c) The price of electric heating falls. (d) The demand for

CNG for cars (produced in joint supply) rises. (e) New technology decreases the costs of

gas production.

(a) Shift right. (b) Movement up along (as a result of a rise in price). (c) Movement down along

(as a result of a fall in price resulting from a fall in demand as people switch to electric heating).

(d) Shift right (more of a good in joint supply is produced). (e) Shift right.

A supply function is given as Qs = c + dP, where "c" is 500 and "d" is 1000. Draw the

schedule (table) and graph for equation for prices from Rs1 to Rs10. What is it in the

equation that determines the slope of the supply `curve'?

Supply

2 000

4 000

6000

8000

100 00

Q u antity supp lie d

P (in

Rs)

(units)

1500

2500

3500

4500

5500

6500

7500

8500

9500

10500

The graph is an upward sloping straight line crossing the horizontal axis at 500 units. The slope

is given by the value of the d term: i.e. the slope is 1/1000 (for every Re1 increase in price,

quantity supplied increases by 1000 units).

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Explain the process by which the price of houses would rise if there were a shortage.

People with houses to sell would ask a higher price than previous sellers of similar houses

(probably with the advice of an estate agent). Potential purchasers would be prepared to pay a

higher price than previously in order to obtain the type of house they wanted.

With a typical upward sloping market supply curve and downward sloping market

demand curve, what would happen to equilibrium price and quantity if the demand curve

shifted to the left?

Both price and quantity will fall. You should be able to label two demand curves (e.g. D1 and

D2), two equilibrium points (e.g. e1 and e2) corresponding prices Pe2 and Pe1 (Pe2 < Pe1), and

quantities Qe2 and Qe1 (Qe2 > Qe1).

What will happen to the equilibrium price and quantity of butter in each of the following

cases? You should state whether demand or supply (or both) have shifted and in which

direction. (In each case assume ceteris paribus.)

(a) A rise in the price of margarine; (b) A rise in the demand for yoghurt; (c) A rise in the

price of bread; (d) A rise in the demand for bread; (e) An expected rise in the price of

butter in the near future; (f) A tax on butter production; (g) The invention of a new, but

expensive, process for removing all cholesterol from butter plus the passing of a law

which states that all butter producers must use this process.

a) Price rises, quantity rises (demand shifts to the right: butter and margarine are

substitutes).

b) Price falls, quantity rises (supply shifts to the right: butter and yoghurt are in joint supply).

c) Price falls, quantity falls (demand shifts to the left: bread and butter are complementary

goods).

d) Price rises, quantity rises (demand shifts to the right: bread and butter are

complementary goods).

e) Price rises, quantity rises or falls depending on relative sizes of the shifts in demand and

supply (demand shifts to the right as people buy now before the price rises; supply shifts

to the left as producers hold back stocks until the price does rise).

f)Price rises, quantity falls (supply shifts to the left).

g) Price rises, quantity rises or falls depending on the relative size of the shifts in demand

and supply (demand shifts to the right as more health-conscious people start buying

butter; supply shifts to the left as a result of the increased cost of production).

Are there any factors on the supply side that influence house prices?

Yes. Although they are usually less important than demand-side factors, they are, nevertheless

important in determining changes in house prices. The two most important are the expectations

of the construction industry. If house building firms (contractors) are confident that demand will

continue to rise, and with it house prices, they are likely to start building more houses. The

resulting increase in the supply of houses (after the time taken to build them) will help to dampen

the rise in prices.

The other major supply-side factor is the expectations of house owners. If people think that

prices will rise in the near future and are thinking of selling their house, they are likely to delay

selling and wait until prices have risen. This (temporary) reduction in supply will help to push up

prices even further.

Draw a supply and demand diagram with the price of labour (the wage rate) on the

vertical axis and the quantity of labour (the number of workers) on the horizontal axis.

What will happen to employment if the government raises wages from the equilibrium to

some minimum wage above the equilibrium?

Introduction to Economics ECO401

Firms' demand for labour will shrink at the new higher wage rate. The supply of workers will rise

as more workers would be willing to work (and work more hours) at the higher wage rate. There

will thus be unemployment (a surplus of workers) at the minimum wage set.

All economies have black markets in goods; whether this poses a serious problem is

another matter. What would be the effect on black-market prices of a rise in the official

price?

Other things being equal, there would probably be a fall in the black-market price. A rise in the

official price would cause an increase in the quantity supplied and a reduction in the quantity

demanded and hence less of a shortage. There would therefore be less demand for black-

market products.

Will a system of low official prices plus a black market be more equitable or less

equitable than a system of free markets?

More equitable if the supplies at official prices were distributed fairly (e.g. by some form of

rationing). If, however, supplies were allocated on a first-come, first-served basis, then on

official markets there would still be inequity between those who are lucky enough or queue long

enough to get the product and those who do not get it. Also, the rich will still be able to get the

product on the black market!

Think of some examples where the price of a good or service is kept below the

equilibrium (e.g. rent controls). In each case consider the advantages and disadvantages

of the policy.

Two examples are:

· Rent controls. Advantages: makes cheap housing available to those who would otherwise

have difficulty in affording reasonable accommodation. Disadvantages: causes a

reduction in the supply of private rented accommodation; causes demand to exceed

supply and thus some people will be unable to find accommodation.

· Tickets for a concert. Advantages: allows the price to be advertised in advance and

guarantees a full house; makes seats available to those who could not afford the free-

market price. Disadvantages: causes queuing or seats being only available to those

booking well in advance.

Primary and secondary schooling is free in state schools in most countries. If parents

are given a choice of schools for their children, there will be a shortage of places at

popular schools. What methods could be used for dealing with this shortage? What are

their relative merits?

Some form of rationing (selection) will have to be applied. This could be done on the basis of

ability. If the objective is to have schools that cater for the full range of abilities, then this

objective will not be met. If the objective is to recruit the most able children, then selection by

ability is consistent with this goal. An alternative is to select by geographical location, with the

students living nearer to the school being given preference over those living further away. This

is the system used by most state schools. It could well disadvantage children with particular

needs, however, for whom the school would be particularly suitable. Other methods include the

`sibling' rule, whereby children who have older brothers or sisters already at the school are given

preference. This, however, could lead to children living nearer the school being deprived of a

place.

Under what circumstances would making a product illegal (a) cause a fall in its price; (b)

cause the quantity sold to fall to zero.

a) Where the shift in demand was greater than the shift in supply (perhaps because of very

`law abiding' consumers, or where consumers faced harsher penalties than suppliers.

Introduction to Economics ECO401

b) Where the penalties were very harsh and the law was strictly enforced, and/or where

people were very law abiding.

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