Principles of Microeconomics: Demand and Supply
DEMAND AND SUPPLY
This lecture examines the basic Demand/Supply model that is central to microeconomics.
We do so by defining the relationship between Price and Quantity in Demand and Supply
without analyzing the cause of those relationships. We analyze the cause of the relationships
later in the course. We begin with a definition of Microeconomics and Partial Equilibrium
Analysis before explaining the importance of Demand/Supply for markets.
Definition: Microeconomics is the study of individual units in an economy (households, firms,
markets, etc.) and their relationships. This entails the study of the allocation of resources
and the distribution of income.
Methodology
Modern economics relies heavily on two methodological tools: partial equilibrium analysis
and atomism.
Definition: Equilibrium is a state of rest with no tendency to change given existing forces
(variables)
Definition: Partial Equilibrium Analysis is the analysis of the relationship between two
variables while holding other relevant variables constant (ceteris paribus = other things
equal), then examining the effect of the other variables by systematically examining their
variation.
Example At what temperature does water boil? Most people would answer 100 C but in fact
this is only true holding at least two other variables constant: atmospheric pressure (sea
level) and purity of the water (not salty, for example). Scientists use partial equilibrium
analysis all the time to isolate relationships before they analyze the variations caused by
changes in other variables.
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Definition: General Equilibrium Analysis is the analysis of the relationship between all
variables simultaneously. (We won’t use this approach in this class)
General Equilibrium analysis is highly prized because it analyzes all the variables at once
but this is a disadvantage because it requires more sophisticated mathematics and it doesn’t tell
us about the cause-effect relationships between specific variables. We can approximate general
equilibrium analysis by relaxing successively relaxing the ceteris paribus assumptions of partial
equilibrium analysis.
Definition: Atomism is the perspective that society (whole) is the sum of its parts (households
and firms).
Modern economics builds theory by analyzing the behaviour of the basic components of
consumption (households) and production (firms). Demand is the aggregation of the behaviour
of the individual consumers (households) and Supply is the aggregation of the behaviour of the
individual producers (firms). Late in the course we will examine some of the issues that arise
theoretically because of this methodological approach.
Types of Economic Systems:
There have been various types of economic systems historically, such as patriarchal, slave,
feudal, socialist, and communistic. This course concentrates on the market system.
Definition: Purchase and sale transactions between economic actors (households and firms)
determine the allocation of resources in a market.
=> Price mechanism determines the allocation of resources in a market.
Governments affect the allocation of resources in market economies in 5 ways.
1. Government Spending (roads, education, transfer payments, and wars, for example)
2. Taxation (income, sales, and property taxes, for example
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3. Public Enterprises (e.g., Ontario Hydro, LCBO, TTC, etc.)
4. Regulation (e.g., environmental, building, etc.)
5. Monetary Policy (control of money supply effects prices, interest rates, and exchange rates)
Competitive Markets
Definition: Competition is Price Taking
Analysis of competition dates from at least Aristotle. Adam Smith described competition as
‘many buyers and sellers’ in his revolutionary discussion of the benefits of competitive markets
in his 1876 The Wealth of Nations, but it was only at the end of the nineteenth century that
economists formulated the modern analytic definition. The modern definition captures Smith’s
meaning that buyers or sellers cannot influence price in a competitive market. It also simplifies
the analysis of competitive behaviour since households and firms respond to a given price with
no ability to change that price.
Imperfect competition occurs when a buyer or seller can influence price. The most extreme
examples are monopoly (single seller), which we shall discuss later in the course, and
monopsony (single buyer).
We shall see that Demand and Supply determine price in a competitive market.
DEMAND (function, curve, schedule)
Definition: Demand is the quantities of goods and services demanded by consumers
1
(households) at each market price ceteris paribus.
Demand is the relationship between 2 variables, price (P) and quantity demanded (q for the
household and Q for the market), holding all other variables constant. The most important of the
1 Economists analyse households as the smallest unit of consumption rather than ‘consumers’ because there
are consumers such as babies that do not make economic decisions.
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other variables are prices of other goods (Pi where ‘i’ represents one of n commodities), income
(Y), and preferences (tastes). We can express the Demand for the X commodity as
D(qXor Q X: q Xr Q X f(P |XY, Pi, Preferences) (everything after | is fixed)
NOTE: We analyze Demand as a quantity response to price [Q = f(P)] not as a price response to
quantity [P = f(Q].
(Alfred Marshall, the first economist to depict the Demand/Supply diagram, derived
demand as a quantity response to price. Since price was the dependent variable and quantity was
the independent variable, Marshall put quantity on the horizontal axis and price on the vertical
axis following the mathematical convention of Y = f(X)).
This concept of Demand satisfies our competitive definition that buyers are price takers.
Example. The following table shows the number of kilograms of ground beef demanded by an
individual during a year at given prices of ground beef, ceteris paribus.
Price $5 $4 $3 $2 $1
Quantity 10 15 25 40 60
We graph this relation with Price on the vertical axis and quantity on the horizontal axis.
Price ($s)
5
4
3
2
Demand
1
10 30 Quantity (kilos)
Law of Demand: ((ΔQx/ΔPx < 0 or dQx/dPx < 0 for Qx = quantity of x and Px = price of x)
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The Law of Demand says that an increase in price causes a decrease in quantity demanded
and a decrease in price causes an increase in quantity demanded.
(The change in Qx in response to the change in Px is less than zero)
=> A Demand curve is negatively sloped.
The negative slope can be linear, concave, or convex. I will usually draw convex demand
functions but use linear demand functions for calculations.
Positive sloped demand functions can exist but are rare. Some positively sloped demand
functions are called Giffen goods.
NOTE.Do not confuse Demand and Quantity Demanded. Quantity demanded is the quantity
response to one price whereas Demand is the set of all the prices and quantities.
Perhaps the most common mistake in economics is the statement that the Demand for a
commodity (e.g., gas) falls because of a rise in the price of the commodity. A fall in the
price of a commodity causes a rise in the quantity demanded of the commodity (movement
along the demand curve) but the demand curve itself does not change.
A change in one of the ceteris paribus conditions, however, does change Demand.
CHANGES IN DEMAND (shifts in the Demand Curve)
Factors other than the price of a commodity affected the quantity demanded of a
commodity. Changes in these variables change the Demand function, not merely the quantity
demanded, since the price of the commodity need not change. We now look at the most
common variables affecting Demand.
1. Income
a) Normal Good: Demand is positively related to Income (ΔQd/ΔY > 0 or dQd/dY > 0)
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An increase/decrease in the consumer’s income normally results in an increase in quantity
demanded at every given price of a commodity. Suppose that the consumer’s income was
$2,000/month in our ground beef example above. The table and graph below show the effect on
Demand of an increase in income to $3,000 month.
Price $5 $4 $3 $2 $1
Quantity (Income = $2,000/month) 10 15 25 40 60
Quantity (Income = $3,000/month) 15 21 32 48 69
Price ($s)
5
4
3
2 D 1
1
Do
10 20 30 40 50 Quantity (kilos)
a) Inferior Good: Demand is inversely related to Income (ΔQd/ΔY < 0 or dQd/dY < 0)
Some goods are called ‘inferior’ because an increase (decrease) in income causes a decrease
(increases) in Demand, i.e., a decrease (increase) in quantity demanded at every price. An
inferior good is a poorer quality good purchased by a consumer with relatively low income
because it is affordable. An increase in income causes the consumer to buy more preferred
normal goods and less inferior goods. Students, for example, go to pizza joints rather than better
restaurants or use the TTC rather than a car.
Example: Suppose that margarine is an inferior good (relative to butter) for a consumer. An
increase in income causes the consumer to buy more butter and less margarine at any price of
margarine.
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Inferior Good: Increase in Income
Price ($s)
Po
Do
D1
Q1 Qo Quantity
2. Changes in Prices of related Consumption Goods and Services
a) Substitutes in Consumption: Demand is positively related to the price of a Substitute
(ΔQd/ΔP SubC> 0 or dQd/ΔP SubC> 0)
Substitute goods are goods that are used in place of each other. Honey, saccharine, and
Splendida are common substitutes of refined sugar. Bicycles, walking, or public transportation
are substitutes for travel by car. An increase in the price of a substitute (P ) for good X causes
Sub
the consumer to buy less of the substitute and more of good X. An increase in the price of cars,
for example, would cause an increase in the Demand for public transportation (i.e., an increase in
quantity demanded of public transportation at any given price of transportation). The diagram
below shows an increase in demand for public transportation due to an increase in the prices of
cars (perhaps because a fall in the supply of cars caused a fall in the quantity demanded of cars).
Increase in the Price of Subsitute for Public Transportation
Public Transportation
Price ($s) Cars Price ($s)
S 1So
Po
P 1
Po
D
1
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