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Macroeconomics 201 Lecture #3: Supply, Demand, and Equilibrium

1. What are the assumptions behind the market demand curve?

Because we only want to know the relationship between price and quantity demanded, we must hold all other factors constant or unchanging. This includes incomes, tastes or preferences, price and availability of related goods

(complements and substitutes), and expectations about all of the above. If we don’t hold these things constant, then we won’t know for sure if a change in quantity demanded was due to a change in price or due to one of these other factors (income affects ability, tastes affect willingness).

2. What are the assumptions behind the market supply curve?

Because we only want to know the relationship between price and quantity supplied, we must hold all other factors constant or unchanging. This includes costs of production (determined by both input prices and technology), the number of sellers, and expectations of future prices and the previous factors. If we don’t hold these things constant, then we won’t know for sure if a change in quantity supplied was due to a change in price or due to one of these other factors.

3. Draw a market supply curve and a market demand curve for a hypothetical widget market. Label the equilibrium price p* and the equilibrium quantity q*.

4. For a hypothetical widget market, label a price p1 that is above the equilibrium price. Using dotted lines, indicate the quantity demand qd1 and the quantity supplied qs1, corresponding to price p1. How would you describe this market situation?

Market surplus or excess supply

5. Suppose there was excess demand in the widget market. Explain thoroughly the process by which the market would move from that disequilibrium position to the equilibrium.

Excess demand means that too many buyers are chasing too few goods, so buyers are competing with one another for the goods that are in relatively low supply.  In order to make sure that they can get a hold of some of the product, buyers will offer to pay a little bit more for the good. As they bid up the price, sellers will respond to the higher offer by increasing their supply, while some buyers will respond to the higher price by withdrawing some of their demand (less willing and able to buy at the higher price).  As long as qs < qd, buyers will continue to bid up prices, stimulating supply and causing demand to contract, until p = p* and qs = qd.

6. Suppose there was a market surplus in the widget market. Explain thoroughly the process by which the market would move to the equilibrium.

If there were a market surplus, firms with excess inventories competing with one another for the relatively low demand will slash prices to capture some of the limited demand. As they cut prices, buyers will increase their willingness and ability to buy while some sellers’ willingness and ability to supply will fall at the lower prices. As long as qs > qd, firms will continue to slash prices, stimulating demand and causing supply to contract, until p = p* and qs = qd.

7. Use a graph with market supply and demand functions to demonstrate the impact of an increase in income.

8. Use a graph with market supply and demand functions to demonstrate the impact of outlawing some technology used by firms in that market that increased productivity, and for which there is no substitute.

9. What is own price elasticity of demand and what are the factors that determine it?

Own price elasticity of demand is the sensitivity or responsiveness of the demand for good x to a change in the price of good x.  The factors that determine how elastic or inelastic demand will be for a good are:

1. number and availability of close substitutes. If there are lots of substitutes,

demand will be elastic, as a small price change will cause people to switch to a substitute. If there are little or no substitutes, demand will be inelastic, as even a substantial price change means people have no alternative.

1. proportion of budget devoted to the good. If only a small part of your total budget is spent on the good, then even a large % change in price doesn’t effect your pocketbook that much, so demand is inelastic. But if you spend a large part of your budget on the good, even a small % change will mean a large absolute impact on your pocketbook, so demand will be elastic.

1. In the short run, there is no time to search out alternatives, make adjustments to one’s habits, investigate substitutes, etc. so demand will be inelastic. In the long run, one can do these thing, so demand will be elastic.

Firms care about own price elasticity of demand because they want to know what will happen to total revenue when there is a price change.