UNIT 2: PRICE

DETERMINATION
1 ECN200 – Principles of Microeconomics
OBJECTIVE

 What is a Market
 Is Demand different from Quantity Demanded?

 Is Supply different from Quantity Supplied?

 What is Market Equilibrium and Disequilibrium

 Calculates Equilibrium Price and Quantity

 Equilibrium Analysis/Comparative Static

2
READINGS
 Baumol and Blinder
 Chapter 4
 Frank and Bernanke
 Chapters 3 and 10
 Case and Fair
 Chapters 3 and 4

Please
do your readings from EARLY!!
Remember the 3:3 Rule!!
3
THE DEFINITION OF A MARKET
 A market for a good is
comprised of actual and
potential buyers and sellers of
that good.

 Market – a process of regular

exchange
 Need not be in a specific place,
but often is
 Need not take place at a specific
time, but generally there are time
limits 4
THE DEFINITION OF A MARKET

Traditional Markets:
 Barter refers to the exchange of goods for goods or
services.
 Non-monetary exchange

 Problem: Double coincidence of wants

Modern Markets:
 In modern markets goods or services are exchanged for
money.
5
THE DIAGRAM OF A MARKET
There are two main components to a market:
 (1) The buyers
 (2) The sellers

 Buyers demand goods and services. That is, at each

price, buyers are willing and able to buy a given quantity

 Sellers supply goods and services. That is, at each price,

sellers are willing and able to supply a given quantity

6
DETERMINING PRICE

 The price is the amount of money that has to be given up

to purchase a unit of a good (or service)

 Price is determined in the market based on the

interactions between the demand and supply of goods
and services

7
DEFINITION OF DEMAND
Demand
 Refers to how much of a product or service is desired by
buyers

Quantity Demanded
 This is the amount that a consumer wishes to buy at a
particular price.
 Each possible price has a quantity demanded associated with
it.

8
DETERMINANTS OF DEMAND
 Factors that determine demand:
S.I.T.E
 Substitute and Complements

 Income

 Tastes (or Preferences)

 Expectations

9
DETERMINANT OF QUANTITY
DEMANDED
 The ONLY factor that determines Qd:

PRICE

10
THE DIAGRAM OF A MARKET – THE
DEMAND CURVE
 The Demand Schedule
 A demand schedule is a
table showing how much
Price per kilo of Quantity
Rice ($) Demanded (kilos)
of a given product a
household would be
250 20 willing to buy at different
200 40 prices.

170 50
 Demand curves are
90 65 usually derived from
demand schedules.
75 80

11
THE DIAGRAM OF A MARKET – THE
DEMAND CURVE
 The Demand Curve that is drawn from the previous demand schedule
would look like:

Price per kilo ($)

250

200

170 The Demand Curve

for Rice

90

75

0
Quantity
20 40 50 60 85 12
demanded (kilos)
THE DIAGRAM OF A MARKET – THE
DEMAND CURVE
 What do we mean by a Downward Sloping Demand
Curve?

 The law of demand states that there is a negative or

inverse, relationship between the price of a good and the
quantity that is demanded

 Quantity demanded will be higher at lower prices than at

higher prices.
 As price falls, quantity demanded rises.
 As price rises, quantity demanded falls.
13
 SHIFT OF DEMAND VERSUS
MOVEMENT ALONG A DEMAND CURVE
• A change in demand is not
the same as a change in
quantity demanded.
Price
($)
• In this example, a higher price
causes lower quantity
$10
demanded, and a move along
the demand curve.

$5
D2
 Changes in determinants of
demand, other than price,
D1 cause a change in demand, or
a shift of the entire demand
100 150 14
curve, from D1 to D2
Quantity Demanded
DEFINITION OF SUPPLY
Supply
 Refers to how much products or services firms are
willing and able to supply

Quantity Supplied
 This is the amount that a firm wishes to sell at a
particular price.
 Each possible price has a quantity supplied associated with it.

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DETERMINANTS OF SUPPLY
Factors that determine supply:
 C.T.W.G

1. The Cost of producing the good, which in turn depends

on:
• The price of required inputs (labour, capital, and land),

2. Weather conditions.

3. The Technology use to develop the product

16
DETERMINANT OF QUANTITY
SUPPLIED
 The ONLY factor that determines Qs:

PRICE

17
THE DIAGRAM OF A MARKET – THE
SUPPLY CURVE
 The Supply Schedule

Price per kilo of Quantity

Sugar ($) Supplied
(kilos)
• A supply schedule is a table
250 95
showing how much of a
product firms will supply at
200 70
different prices.
170 55

90 35

45 18
18
THE DIAGRAM OF A MARKET – THE
SUPPLY CURVE

 The Supply Curve may be drawn from the Supply Schedule.

Price per kilo ($)

250

200

170 The Supply

Curve for Sugar

90

45

0 Quantity Supplied
18 35 55 70 95 (Kilos)
19
THE DIAGRAM OF A MARKET – THE
SUPPLY CURVE
• What do we mean by an Upward Sloping Supply Curve?

 The law of supply states that there is a positive relationship between

the price of a good and the quantity of the good supplied.

• This means that if the price of the good increases, then the quantity
supplied also increases.

• If the price of the good falls, then the quantity supplied will also
fall.

• This is because suppliers will always want to sell more at a higher

price.
20
 SHIFT OF SUPPLY VERSUS
MOVEMENT ALONG A SUPPLY CURVE
• A change in supply is not the
same as a change in quantity
S1
supplied.
$4 S2
Price of Rice

• In this example, a higher price

causes higher quantity
supplied, and a move along
$3 the supply curve.

• Changes in the determinants

of supply, other than price,
300 400 cause an increase in supply,
Quantity of Rice or a shift of the entire supply
21
curve, from S1 to S2.
THE CONCEPT OF EQUILIBRIUM
An equilibrium is where there is no need or any likelihood of
there being a change.

In the context of markets;

 Market Equilibrium: This is where the quantity demanded by
the buyers and the quantity supplied by the sellers are equal at
a specific price.

 The Market Equilibrium is characterized by an equilibrium

price (P*) and an equilibrium quantity (Q*).

22
 THE CONCEPT OF EQUILIBRIUM
Price ($)
 Only in equilibrium is
quantity supplied equal
to quantity demanded.
S1

 The equilibrium price is

$3
$2 and the equilibrium
quantity is 150.
$2

 At any price level other

D1 than $2, the wishes of
buyers and sellers do 23
100 150 200
not coincide.
Quantity Bought and Sold
 MARKET DISEQUILIBRIUM
 Excess demand, or shortage, is
the condition that exists when the
Price ($) price is below equilibrium and the
quantity demanded exceeds
quantity supplied (D>S).
S1

$3  The shortage in the market would

drive up prices as some
$2
consumers are prepared to pay
more.
$1
Shortage
D1  The price will continue to rise until
the shortage has been competed
100 150 200 away and a new equilibrium 24

Quantity Bought and Sold (000s) position has been reached.

 MARKET DISEQUILIBRIUM
 Excess supply, or surplus, is the
condition that exists when price
Price ($) above equilibrium and the
quantity supplied exceeds
quantity demanded (S>D).
S1

$3
 In an attempt to get rid of surplus
Surplus stock, producers will accept lower
prices. Lower prices in turn
$2 attract some consumers to buy.

 The process continues until the

D1 surplus disappears and
equilibrium is once again
100 150 200 reached. 25

Quantity Bought and Sold

CALCULATING EQUILIBRIUM
QUANTITY AND PRICE

 Now the demand curve is: QD  100  0.75 P

 The supply curve is given by: QS  80  0.25 P

Find the equilibrium price and quantity.

26
CALCULATING EQUILIBRIUM
QUANTITY AND PRICE

 There is an inverse relationship between quantity

demanded and price
 so the negative (-) sign in the first equation tells you it is the
equation for the demand curve.

 There is a positive relationship between price and

quantity supplied.
 The positive (+) sign thus tells you that the second equation
is the one for the supply curve.

27
THE DIAGRAM OF THE MARKET AND
EQUILIBRIUM ANALYSIS/COMPARATIVE
STATIC

 This is simply the comparison of two equilibrium states, before

and after a change in one of the factors that affect demand
and/or supply.

 So the main idea is that we are looking at how the diagram of

the market changes when we adjust the factors that impact the
market.
 Examples of such factors include the price of the good, the price of
other goods, income etc.

28
THE DIAGRAM OF THE MARKET AND
EQUILIBRIUM ANALYSIS

Process of economic analysis analysis

 Begin by assuming that the model is in equilibrium.
 Introduce a change in the model (For example, assume that
there is a change income). In so doing, a condition of
disequilibrium is created.
 Find the new point at which equilibrium is restored.
 Compare the new equilibrium point with the original one.

29
THE DIAGRAM OF THE MARKET AND
EQUILIBRIUM ANALYSIS
 Change in Demand/Supply VS Change in Quantity
Demanded/Supplied

 A change in demand or supply refers to a shift of the

demand or the supply curve.
 There are many factors which cause a shift of the demand and
supply curves.

 A change in quantity demanded or quantity supplied,

refers to a movement along the demand or the supply
curves.
 A movement along the demand and supply curves of a good 30
occurs ONLY when the price of that good changes.
EQUILIBRIUM ANALYSIS– THE DEMAND
CURVE
 Factors that shift the demand curve

(1) Price of a complement.

Complements are goods that are consumed together, i.e. you can
consider a good and its complement as one entity.
 An example of complements is milk and coffee, bun and cheese.

(2) Price of a substitute.

Substitutes are goods that can be used in place of each other.
 Example: butter and margarine.

31
 EQUILIBRIUM ANALYSIS– THE DEMAND
CURVE

(3) Income
(for a normal good).
A normal good is one whose demand increases when income
increases and vice versa.
 An example of a normal good is a car.

( for an inferior good).

An inferior good is one whose demand decreases as income
increases and vice versa.
 An example of an inferior good is public transportation.

32
EQUILIBRIUM ANALYSIS – THE DEMAND
CURVE

(4) Preference by demanders for the good.

The good may decline in popularity among users, for example VCRs.

(5) Expectations

33
 IMPACT OF A CHANGE IN DEMAND
ON EQUILIBRIUM
Price of Sugar ($)  When demand
increases (curve
shifts right), the
S1
market moves to a
E2 new equilibrium point
$3 (E1toE2).
E1
$2 D2
 In this case, the result
is a higher price and
D1 larger output.
150 200 34
Quantity of Sugar Bought and Sold
 IMPACT OF A CHANGE IN DEMAND
ON EQUILIBRIUM
Price ($)
 When demand
decreases (curve
S1
shifts left), the
E1 market moves to a
$3 new equilibrium
E2 point (E1toE2).
$2 D1

 In this case, the

D2 result is a lower
price and smaller
35
150 200
output.
Quantity of Sugar Bought and Sold
EQUILIBRIUM ANALYSIS – THE SUPPLY CURVE

 Factors that shift the supply curve

(1) Cost of inputs used in production of the good/service.

(2) Technological progress.

(3) Weather conditions - In the case of the Caribbean, hurricanes tend to

damage crops and reduce their supplies on the market.

(4) Government Policies.

36
 IMPACT OF A CHANGE IN SUPPLY ON
EQUILIBRIUM
Price ($)  When supply increases
(curve shifts), the market
moves to a new
S1 equilibrium point
(E1toE2).
E1 S2
$2  In this case, the result is
E2
a lower price and
$1
larger output.
D1

150 200 37
Quantity of Sugar Bought and Sold
 IMPACT OF A CHANGE IN SUPPLY ON
EQUILIBRIUM
Price ($)  When supply
decreases (curve shifts
left), the market moves
S2 to a new equilibrium
point (E1toE2).
E2 S1
$3  In this case, the result is
E1
a higher price and
$1
smaller output.
D1

150 200 38
Quantity of Sugar Bought and Sold
THE DIAGRAM OF THE MARKET AND
EQUILIBRIUM ANALYSIS

 So to summarize: Shifts in Demand and Supply

 D  P*,  Q *  S  P*,  Q *

 D  P*,  Q *  S  P*,  Q *
39
THE DIAGRAM OF THE MARKET AND
EQUILIBRIUM ANALYSIS

What happens when both curves shift at the same

time?

Let us look at a few scenarios below

40
 SCENARIO 1: AN INCREASE IN
DEMAND AND SUPPLY

 Recall that:  D  P*,  Q *  S  P*,  Q *

 The common factor is that equilibrium quantity is increasing.

 However, the impact on the equilibrium price is uncertain-
 it could increase due to the increase in demand, or it could decrease
(from the increase in supply).

 Therefore:

 D,  S  P*,  Q * 41
 SCENARIO 1: AN INCREASE IN DEMAND
AND SUPPLY

 S  D  Q, P
Price ($)
S1
S2

E1 E2  When the increase in

$5 demand is equal to the
increase in supply:
 The result is an
D2 increase in output while
price remains constant.
D1

450 600 42
Quantity of Sugar Bought and Sold
 SCENARIO 1: AN INCREASE IN DEMAND
AND SUPPLY
 S  D  Q,  P
Price ($)
 When supply
increases more than
S1
the increase in
S2 demand:
 The result is an
E1 increase in output
$5 E2 and a decrease in
$3 price.

D2
D1
450 600 43
Quantity of Sugar Bought and Sold
 SCENARIO 1: AN INCREASE IN DEMAND
AND SUPPLY

 S  D  Q,  P
Price ($)

S1
S2
E2  When demand
$5 increases more than
E1
$3
the increase in supply:
 The result is an
D2 increase in output and
an increase in price.
D1
450 600 44
Quantity of Sugar Bought and Sold
 SCENARIO 2: AN INCREASE IN DEMAND
AND A DECREASE IN SUPPLY

 Recall that:  D  P*,  Q *  S  P*,  Q *

 We have an increase in the equilibrium price.

 However, the change in equilibrium quantity is uncertain.

 Therefore:  D,  S  P*, Q *
45
 SCENARIO 2: AN INCREASE IN DEMAND
AND A DECREASE IN SUPPLY

Price ($)  S  D  Q,  P

S2 S1  When the decrease in

$5 E2 supply is equal to the
increase in demand:
$3 E1  Output will remain
D2 constant while price will
increase.
D1

600 46
Quantity of Sugar Bought and Sold
 SCENARIO 2: AN INCREASE IN DEMAND
AND A DECREASE IN SUPPLY

 S  D  Q,  P
Price ($)

S2 S1
 When supply
E2 decreases more than
$5 the increase in
$3 demand:
E1  The result is an
D2
increase in price and a
D1 decrease in output.
450 600 47

Quantity of Sugar Bought and Sold

 SCENARIO 2: AN INCREASE IN
DEMAND AND A DECREASE IN
SUPPLY
Price ($)  S  D  Q,  P

S2
S1
E2  When supply
$5 decreases less than
the increase in
E1 demand:
$3
D2  The result is an
increase in price and a
D1 decrease in output.
450 600 48
Quantity of Sugar Bought and Sold
 SCENARIO 3: A DECREASE IN DEMAND AND
SUPPLY

 Recall that:  D  P*,  Q *  S  P*,  Q *

 We can say that the equilibrium quantity will fall.

 However, the change in equilibrium price depends on the
magnitudes of the changes in the demand and the supply.

 Thus:  D,  S  P*,  Q * 49
 SCENARIO 3: A DECREASE IN DEMAND
AND SUPPLY

Price ($)
 S  D  P,  Q

S2 S1  When the decrease in

supply is equal to the
$3
E2
E1 decrease in demand:
 Price will remain
D1 constant while output
will fall.
D2

450 600 50
Quantity of Sugar Bought and Sold
 SCENARIO 3: A DECREASE IN DEMAND
AND SUPPLY

 S  D  P,  Q
Price ($)

S2 S1
 When supply
decreases more than
$5 E2 the decrease in
$3 E1
demand:
 The result is an
D1
increase in price and a
D2 decrease in output.
450 600 51

Quantity of Sugar Bought and Sold

 SCENARIO 3: A DECREASE IN
DEMAND AND SUPPLY
Price ($)  S  D  P,  Q

S2
E1 S1
 When supply
decreases less than
$5
the decrease in
$3
E2 demand:
D1  The result is a decrease
in price and a decrease
D2 in output.
450 600 52
Quantity of Sugar Bought and Sold
 SCENARIO 4: A DECREASE IN DEMAND AND
AN INCREASE IN SUPPLY

 Recall that:  D  P*,  Q *  S  P*,  Q *

 There will be a decrease in equilibrium price.

 However, the change in equilibrium quantity is uncertain.

 Thus:  D,  S  P*, Q *
53
 SCENARIO 4: A DECREASE IN DEMAND
AND AN INCREASE IN SUPPLY

Price ($)
 S  D  Q,  P

S1
S2
E1  When the increase in
$5 supply is equal to the
E2 decrease in demand:
$3  Output will remain
D1 constant while price will
decrease.
D2

600 54
Quantity of Sugar Bought and Sold
 SCENARIO 4: A DECREASE IN DEMAND
AND AN INCREASE IN SUPPLY

 S  D  Q,  P
Price ($)

S1
S2
 When supply
E1 increases more than
$5
decrease in demand:
$3
 The result is an
E2 increase in output and a
decrease in price.
D1
D2
450 600 55

Quantity of Sugar Bought and Sold

 SCENARIO 4: A DECREASE IN DEMAND
AND AN INCREASE IN SUPPLY

Price ($)  S  D  Q,  P

S1
E1 S2
 When supply
$5
increases less than
the decrease in
E2 demand:
$3 D1  The result is a decrease
in output and a
D2 decrease in price.
450 600 56
Quantity of Sugar Bought and Sold
END OF PRESENTATION

57