1ECON1010
Introductory Microeconomics
LECTURE 3
Topic 2.
Demand and Supply
Q1. Which of the following is true?
a. Under free (unrestricted) international trade, the economically
stronger country gains at the expense of the economically weaker
country.
b. If absolute advantage determines who produces what, efficiency
is maximised.
d. If Ralph can produce 2 units of X per hour while Pat can only
produce 1 unit of X per hour, it is more efficient for Ralph to
produce X and for Pat to produce something else.
e. Both b) and d).
Last lecture feedback
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c. To maximise total output, comparative advantage identifies who
should specialise in producing what.
Lecture 3 ECON1010
Q2. To say some person has a comparative advantage in the
writing of an economics textbook means they:
a. can write a textbook faster than anyone else.
b. have the best word-processing technology.
c. will have more features in the textbook.
d. the textbook will be the easiest to read.
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e. they have a low opportunity cost for writing an economics
textbook.
Lecture 3 ECON1010 Lecture 3 ECON1010
How Decisions are Coordinated.
Topic 1: Thinking like an Economist.
Rational self-interested decision-makers and
how they make, or should make, choices.
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Topic 2: Supply and Demand.
How an economic system coordinates many
rational choices of self-interested decision-makers.
Lecture 3 ECON1010
Second half
2. Economic efficiency of competitive markets.
- a look at consumer and producer surplus
- deadweight loss
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Plan of Lecture 3.
First half
1. Understanding Demand and Supply theory.
Lecture 3 ECON1010
How Decisions are Coordinated.
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All economic systems must address:
1. What should be produced?
2. How should it be produced?
3. For whom will it be produced?
Central Planning (eg: Cuba, North Korea)
vs
Decentralised Planning (Market System)
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individual preferences and purchasing power
Market System.
costs of production
+
generate prices
guide resource allocation in the economy
act as signals that coordinate decision making
Lecture 3 ECON1010 8
Market System.
Decentralised market economies often
outperform centrally planned economies in
terms of efficiently allocating resources.
sometimes they fail
BUT, not always
Lecture 3 ECON1010
The Market System – setting a price?
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▪ Transactions take place in a market, where
consumers have a willingness to pay (demand)
and suppliers have a willingness to sell (supply)
▪ Note that there are TWO sides to any transaction
involving a buyer and a seller.
Demand and consumers Supply and producers
Demand and the Individual Consumer
A Real World Observation:
As the price a product (or service) decreases, given that
we live in a world where the scarcity principle applies,
we tend to consume more.
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Note: an inverse relationship between price and
quantity demanded.
Demand in economics is represented as a relationship
between price and quantity demanded.
Lecture 3 ECON1010
Developing Individual Demand.
Individuals will consume different quantities of a
product for the same price. We are all different!
Individual Demand (a simplified approach)
Price ($/kg)
Quantity
(kg)
John Sue Tim
1 8 12 18
2 7 10 15
3 6 8 12
4 5 6 9
Developing Individual Demand curves
John TimSue
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
0 5 10 15 20
P
r
ic
e
(
$
/k
g
)
Quantity Demanded (kg)
12
3Developing Individual Demand
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Points to note:
1. Demand is a relationship between prices and the
quantities demanded at those prices, sometimes
referred to as a “willingness to pay curve”.
2. Demand is a downward sloping relationship.
3. As price increases, the quantity demanded by
consumers decreases.
4. The area under the demand curve is the amount of
money a consumer spends.
Developing Individual Demand
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5. The “Ceteris paribus” assumption in Latin
meaning “all else being equal”.
▪ needed to develop the demand model.
▪ when analysing two variables (such as price and
quantity), it is assumed all other variables are
held constant (not able to be changed).
Lecture 3 ECON1010
15
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
0 2 4 6 8 10
P
r
ic
e
(
$
/k
g
)
Quantity Demanded (kg)
Developing Individual Demand curves
Consumer Expenditure
= $3 /kg * 6 kg
= $18
Developing Market Demand
All individuals’ behaviours combine to create a
market. The sum of all individual demand results in
the market demand for a product (or service).
Market Demand Table (John + Sue + Tim = Market)
Price
($/kg)
Quantity
(kg)
John Sue Tim Market
1 8 12 18 38
2 7 10 15 32
3 6 8 12 26
4 5 6 9 20
Developing Market Demand
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
0 5 10 15 20 25 30 35 40
P
r
ic
e
(
$
/k
g
)
Quantity Demanded (kg)
Sue Tim
Market
Demand
17 Lecture 3 ECON1010 18
Used to explain how individuals make choices
Individual Demand and Market Demand
Demand relationship is an economic model.
Using Economic Models
4Lecture 3 ECON1010
1. What do economists mean by the statement:
“movement along a demand curve”.
Two important concepts to get clear!
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Both fundamental concepts required in
understanding and applying economic models.
2. What do economists mean by the statement:
“a shift in demand”.
Lecture 3 ECON1010
1. “movement along a demand curve”.
Two important concepts to get clear!
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An individual consumer faces a price rise in the
product they consume.
Response: consume less.
Move upward and to the left along the demand
curve.
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0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
0 2 4 6 8 10
P
r
ic
e
(
$
/k
g
)
Quantity Demanded (kg)
Effect of a Price Rise
7
2
1
Move along the
Demand Curve
Lecture 3 ECON1010
2 . “a shift in demand”
Two important concepts to get clear!
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A bit more complicated than a change in price.
This will be discussed in detail later.
Supply and the Individual Producer.
A Real World Observation:
As the price a product (or service) increases, and
assuming ceteris parabis, producers will supply
more.
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Supply in economics is represented as a
relationship between price and quantity supplied.
Note: there is an upward sloping (positive) relationship
between price and quantity supplied. A change in price
results in a movement along the supply curve.
Developing Individual Supply
Some firms will be able to produce different
quantities of a product (service) for the same price.
Why?
Price ($/kg)
Quantity
(kg)
A B C
1 3 6 11
2 5 9 12
3 7 12 13
4 9 15 14
Individual Supply (a simplified approach)
5Developing Market Supply
All individual producers’ quantities supplied add to
create a market supply for a product (or service).
Market Supply Table
Price
($/kg)
Quantity
(kg)
A B C Market
1 3 6 11 20
2 5 9 12 26
3 7 12 13 32
4 9 15 14 38
25
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
0 5 10 15 20 25 30 35 40
P
r
ic
e
(
$
/k
g
)
Quantity supplied (kg)
Individual and Market
Supply Curves
Market
Supply
A CB
The interaction of Supply and Demand.
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
0 10 20 30 40
P
r
ic
e
(
$
/k
g
)
Quantity Demanded and Supplied (kg)
Market Equilibrium
(market clearing point)
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$2.50/kg
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The interaction of supply and demand.
▪ The intersection of the supply and demand curves so
i) quantity supplied = quantity demanded
ii) selling price = purchase price
▪ A point where suppliers are happy to sell a given
quantity at a certain price, and this exactly matches
the price consumers are willing to pay for this
quantity supplied.
▪ a situation where there is no tendency for the price to
change (both consumers and suppliers are happy).
Arriving at the Market Clearing Point
Competitive market
▪ has many buyers and many sellers.
▪ Prices and quantities continue to adjust until a market
clearing point is reached, eliminating shortages and
surpluses.
▪ note the market clearing point and the model
suggests equilibrium is a static point. In reality, it
can continually move. ie: the point is dynamic.
29Lecture 3 ECON1010
Impacts of Government Intervention on
competitive markets – an introduction.
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What happens if governments aim to control
prices in an otherwise competitive market?
Price can be set higher than market clearing
price floor
Price can be set lower than market clearing
price ceiling
631Lecture 3 ECON1010
Impacts of Government Intervention.
1. Price floor
= a price set by law makers (government) that
is HIGHER than the market clearing price.
Why a higher price?
(eg: milk prices for dairy farmers, minimum wages)
Use the supply and demand model to explain the logic
and problems of doing this.
Price Floor.
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
0 10 20 30 40
P
r
ic
e
(
$
/k
g
)
Quantity Demanded and Supplied (kg)
Consumer Expenditure
= 3.5 * 23
= $80.50
Supplier Revenue
= 3.5 * 35
= $122.50
Qd = 23 Qs = 35
Supply
Demand
Legal Price = $3.5/kg
33Lecture 3 ECON1010
Impacts of Government Intervention.
Price floor
▪ used by governments to set a legally determined
price to protect suppliers.
▪ the price is set above the market clearing price,
and becomes a minimum price for suppliers
▪ this minimum price is then guaranteed by the
government
▪ What about the excess quantity supplied ????
34Lecture 3 ECON1010
Impacts of Government Intervention.
2. Price ceiling
= a price set by law makers (government) that
is LOWER than the market clearing price.
Why a lower price?
Use the supply and demand model to explain the logic
and problems of doing this.
Qs = 26
Price Ceiling
(and a shortage in quantity demanded).
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
0 10 20 30 40
P
r
ic
e
(
$
/k
g
)
Quantity Demanded and Supplied (kg)
Supplier Revenue
= 2 * 26
= $52
Legal Price = $2/kg
Qd = 32
Supply
Demand
Shortage and consumer
expenditure NOT possible
$12
Impacts of Government Intervention.
Price ceiling
▪ used by governments to set a legally determined
price to protect consumers (eg: tenants who rent,
petrol “price caps” when oil prices rising fast)
▪ the price is set below the market clearing price,
to help protect consumers from higher prices.
▪ the legal price is a maximum that can be charged
by suppliers.
▪ What about illegally paying higher prices for the
quantity that is available? Black Markets?
7Black Markets - Supply and Demand Model.
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
0 10 20 30 40
P
r
ic
e
(
$
/k
g
)
Quantity Demanded and Supplied (kg)
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Debate: (at the onset of the GFC):
“ Let free markets rule and governments just
stay out of it! The market is always right and
will always sort things out”.
Market Failure:
= an inefficient allocation of goods and
services in a market.
eg: traffic congestion (view as a market failure)
solved by imposing a peak travel time tax.
Definitions.
To assess impacts of government intervention into
competitive markets, economists introduced
consumer surplus and producer surplus.
Consumer Surplus.
The maximum price an individual consumer is
prepared to pay less the clearing price set by the
market = an individual’s consumer surplus.
Producer Surplus.
The market clearing price less the minimum price a
supplier would have been willing to accept in a sale.
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Defining individual consumer surplus
Quantity
(packets of chips)
Price
($/packet)
$3.00
$1.80
1
Supply
Demand
Individual consumer surplus for the
first packet of chips
= (3-1.80)*1 = $1.20
0
Defining individual consumer surplus
Quantity
(packets of chips)
Price
($/packet)
$3.00
$1.80
1
Supply
Demand
Individual consumer surplus for the
second packet of chips
= (2.80-1.80)*1 = $1.00
0
2
$2.80
Lecture 3 ECON1010
Total Consumer Surplus
Quantity
(packets of chips)
Price
($/packet)
Mkt Price
= $1.80
Supply
Demand
Total consumer surplus for the market
of interest = the area under the demand
curve and above the market price.
0
$$$$
Lecture 3 ECON1010
8Individual Producer Surplus
Quantity
(packets of chips)
Price
($/packet)
$1.80
Supply
Demand
0
Individual producer surplus for the first
packet of chips
= (1.80 -1.00)*1 = $0.80
$1.00
1 Lecture 3 ECON1010
Individual Producer Surplus
Quantity
(packets of chips)
Price
($/packet)
$1.80
Supply
Demand
0
Individual producer surplus for the second
packet of chips
= (1.80 -1.20)*1 = $0.60
$1.20
1 2 Lecture 3 ECON1010
Total Producer Surplus
Quantity
(packets of chips)
Price
($/packet)
$1.80
= Mkt Price
Supply
Demand
Total producer surplus for the market
of interest = the area above the supply
curve and below the market price.
0
$$$$
Lecture 3 ECON1010
45
$$$$
Economic Surplus in a competitive Market
Quantity
(packets of chips)
Price
($/packet)
Market
clearing
price
Supply
Demand
Total Economic surplus
= total consumer surplus + total producer surplus
(maximised in competitive markets)
0
$$$$
Market clearing quantity
Economic Surplus in a competitive Market
(no government restrictions imposed)
Economic efficiency
(where MB = MC, more later)
Competitive markets, lots of buyers and sellers.
Economic surplus is maximised.
A market clearing price and quantity reached
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Government Intervention in Markets
Do competitive markets make every individual
better off ?
Competitive markets maximise the economic
surplus for society overall, BUT
Any individual consumer would like to pay
less, and any individual supplier would like to
charge more, than the market clearing price.
Lobby/pressure governments to intervene!
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9Government Intervention in Markets
Lobby/pressure governments to intervene!
Causes a move away from the competitive
market equilibrium price output quantity
Results in economic inefficiency (a reduction
in total surplus called dead weight loss)
a. Dead weight loss from Price Floor
Quantity
(units)
Supply
Demand
Price Floors to protect producers
price above market clearing price
(wheat & wool farmers, minimum wages)
0
Price
($/unit)
Market
clearing
price
A
D
B
Legal price
floor
Qd Qs
C
Qequil
E
Dead Weight Loss from a Price Floor
Lecture 3 ECON1010
When at the market clearing point:
Consumer surplus = A + B + C
Producer surplus = D + E
Economic Surplus = A + B + C + D + E
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Dead weight loss from Price Floor
Lecture 3 ECON1010
When Government intervenes and sets price
above the market clearing price:
Consumer surplus = A
Producer surplus = B +D
Economic Surplus = A + B + D
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Dead weight loss from Price Floor
Lecture 3 ECON1010
Reduction in Total Surplus once government
intervenes is:
Total Surplus (before interv) = A+B+C+D+E
Total Surplus (after interv) = A +B + D
Loss of Economic Surplus = C + E
Dead weight loss = C + E economic
inefficiency from government intervention.
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Conclusions.
▪ The interaction of supply and demand determines
market clearing price and quantity.
54Lecture 3 ECON1010
▪ a competitive market equilibrium exists when there
are many buyers and many sellers, who reach a price
and quantity for an exchange to take place, leaving
both parties happy.
▪ Governments can influence market equilibrium.
▪ Supply and demand model useful predictive tool to
assess changes in equilibrium prices and quantities.
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Lecture 3 ECON1010
Next Lecture
▪ Lecture 4.
Demand and Supply (Part 2)