Handout 1 Demand, Supply & Equilibrium Dr. Subir Sen, Assistant Professor, HT Roorkee ‘The problems are adapted from various textbooks. 1 Demand and Supply For any particular good there are in general a number of potential consumers and the quantity which each consumer buys depends, at least in part, upon the price at which the product is offered on the market, A typieal demand function looks like ) a) Qe = Mery LT, where, pris own price of the good x, p, is prices of other goods (may be either substitute or a complement 6 both), [is for income of the consumer (or wealth), T represents taste or preferences of the consumers, and soon, Please note carefully: the prices p. represents unit price but Q, represents total quantity. Following Alfred Marshall, the Law of Demand states that. quantity demanded decreases as the price The quantity demanded by convention is represented along the horizontal axis, the demand equation written algebraically in the form aa = fp) = 04 bp 2) The inverse demand function is written as: 1 P55 Li a competitive market, when there are large number of independent suppliers for a good, the number of suppliers and the quantity of goods produced or supplied is determined by the cost of production and the price at which the product would be bonght in the market, The objective of the supplier or producer any day is to mutsin profits and therefore they would be willing to supply more as price inereases Algebraically this can be represented as = fp) = e+ dp (3) The invesre supply function is written as The Market equilibrium is at the point where the demand and supply intersect each other. ‘The following example is going to demoustrate the determination of market equilibrium¢ Example: For the following demand and supply fimctions of » product, what are the equilibrium price and quantity? Carefully explain why the price you obtained is the equilibrinn price i+ 3p gq! = 20-2» Solution: The market equilibrium, given the demand and supply functions is at the point where = qt and p* = pf =o > W—»®=-543p > —hp= 25 or p=5 herefore, g° = g" = q = 10 Example; Information on a coffee market. is given as 4g = 2p ~ 100 and ¢ = "H! where p is the price of coffer per tin and q is the quantity of coffee in tins, 1. Obtain the market equilibrium. What accws if the price of coffee per tin is 15? 2. Suppose the demand function has changed to g! =, Provide an economic explanation of this change and list a few reasons as to why it might have occurred. 3, Obtain the new market cquilibrimi, What would happen if the price of coffee per tin stayed the same as the equilibrium price you obtained in (b)? Solution: 1. The market equilibrium is at g4 = q° = 20p — 100 = 6000/p => 20p? — 100p — 6000 = 01 =p 5p —300=0 => p? = 20p + 15p — 300 = 0 = wp ~ 20) + 15(p — 30) =0 > (p= 20Mp + 15) = 0 20 or—15 =p Price eaunot be negative, therefore, p = 20 and g = 300. If the price is 15 per tin, implying a lower price than the market equilibrium, there would be excess demand in the market. 2. As we observe the new qf is equal to 1/2 of old qi! indicating a fall in the demand for coffee in the market, Few plausible reasons could be: (a) Change in the taste of the consumer (b) Lower prices of substitute, say tea (c) Lower earnings of the consumer but substantially higher price of coffee 3. The new market equilibrium is at the point where new q! = g° = 2p — 100 = 3000/p = 20p — 1p — 3000 = 0 =p? —5p~ 150=0 > p15 + 10p — 150 = 0 > pkp— 15) + 10(p — 15) =0 => (p—15)(p-+ 10) = 0 = p=15 or~ 10Equilibrium price is now 15 per tin of coffee and equilibrium quantity is 200, If prices remained at the old level p = 20, there will be excess supply leading to surplus coffee being supplied in the market, thereby forcing prices to come dow. 2 Price Controls by Government Goverment policies such as taxes, price ceilings, price floors, aud tariffs that create a wedge be- tween the supply and demand curves reduce the equilibrim quantity, raise the equilibrium price to consumers, and lower we With a binding price ceiling, the supply-and-demand model predicts an equilibrimin w age, In this equilibrium, the quantity demanded does not equal the quantity supplied. ha short he reason that we call this situation an equilibrium, even though a shortage exists. is that mo consumers or firms want to act differently, given the law, Without the price controls. constmers facing a shortage would try to get more ontput by offering to pay more, or firms would raise prices. With effective government price controls, they know that they eant drive up the price, so they live with the shortage. Example: Suppose that the demand curve is g? = 100 — Ip and the supply curve is g® = 10p. The goverument imposes a price ceiling of p ~ 3. Describe how the equilibrium changes, Solution: The market equilibrium is at g = q and at the point (50,5), Clearly the price ceiling p= 3 g%, there is excess demand leading to shortage in the market. In such a situation, black marketeers beuctit, Consider a hypotlictical scenario. All the good supplied is bought by the black marketcers. ‘The TC, total cost of procuring the entite supply is 90{p * q). Because of shortage. consumers are willing to pay higher priees. To buy the 30 available goods, the price they are willing to pay is 30 = 100 ~ lp => p~ 7 (obtained cousidering the demand function is true) The black marketers now sell 30 units at 7 per unit carning a TR, total revenue of 210 The profit the black marketeers make is x = TR— TC = 210 — 90 = 120, The rent control ageney has found the aggregate demand for housing is Qo = 100 ~5P, where quantity is measnred in tens of thousands of apartments and price, the average monthly rental rates, ineasured in hnuidreds of Rupees. ‘The hoard of realtors ac true and based on that the supply funetion is Q* = 50 + 5P. Suppose now the rent control agency sets a rental at Rs. 900 per month on all apartmnents to allow landlords a fair rate of return, Analyse the effect of this price floor on the market wowledges that the demand function is Sohution: The market equilibrium is at 2° = Q% and at the point (75,5), fovernments also commonly use price floors. One of the mast important examples of « price floor is the minimum wage in labor markets, Note, if the market price is above the support price or price floor (with special reference to smiaimum support price programme in agriculture), the intervention is irrelevant The rent at Rs. 900 per months is more than the market clearing price, i.e., Rs.500, Apartments demanded at p= 9 => Q? = 1005 x9 = Q? =55 Apartments supplied at p = 9 = Q° = 50 =5 x 9 = Q? = 95 Since the supply is greater than the demand at the controlled prices, there will be excess supply in the market