Microeconomics

Sultan Qaboos University

Lecture 4

Learning Objectives

Discuss the essential features of the price

system

Evaluate the effects of changes in demand

and supply on the market price and
equilibrium quantity

Discuss the Policy of Government-Imposed

Price Controls

Explain the effects of price ceilings

Explain the effects of price floors

Review

The law of demand says that prices and

quantity demanded are inversely
related:

At a higher price people buy less, at a lower

price people buy more

Review(cont'd)

A change in quantity demanded versus a

change in demand

A change in quantity demanded is a

movement along the same demand curve

A change in demand is a shift of the whole

demand curve

Review(cont'd)

The law of supply states that price and

quantity supplied are directly related

Firms offer more at a higher price; firms

offer less at a lower price

Review(cont'd)

A change in quantity supplied versus a

change in supply

A change in quantity supplied is a

movement along the same supply curve
A change in supply is a shift of the whole
supply curve

Putting a Market Together

The interaction of buyers and

sellers makes a market.
Equilibrium: only one price
and quantity combination is
compatible with the
intentions of both buyers and
sellers.
Equilibrium is located where
the demand curve and supply
curve intersect.
All the points on the graph
except the equilibrium point
represent situations where
the buyers and sellers
disagree.

Pe

D
Qe

Equilibrium

No shortage exists.
No surplus exists.
Qd = Qs = Qe.
The price will not
change until there is a
shift in demand or in
supply.

Pe

D
Qe

Equilibrium

Markets reach equilibrium because buyers have

a demand behavior (raise price, buy less, and
vice versa) and sellers have a supply behavior
(raise price, supply more, and vice versa).

The market mechanism (Adam Smiths invisible hand)

leads the market to equilibrium.

At equilibrium, quantity demanded (Qd) equals

quantity supplied (Qs) at the equilibrium price
(Pe).

We say that the market mechanism signals the desired

outcome at Pe.

The Invisible Hand

Theory

According to Adam Smith

People are motivated by self-interest.

The goal of profit maximization will serve societys

collective interest.

In other words, the theory for the Invisible Hand

states that if each consumer is allowed to choose
freely what to buy and each producer is allowed to
choose freely what to sell, the market will settle on
a product distribution and prices that are efficient.

Putting Demand and Supply Together,

Panel (a)

Resolving a Market Surplus

Market surplus: the

amount by which
quantity supplied (Qs)
exceeds quantity
demanded (Qd) at a
given price; excess
supply.

Price is too high.

Qs > Qd, a surplus.

Buyer and seller

behaviors kick in.
Price will fall to
equilibrium price, Pe.

Phigh

S
Surplus

Pe

D
Qd

Qe

Qs

Resolving a Market Shortage

Market shortage: The

amount by which
quantity demanded (Qd)
exceeds quantity
supplied (Qs) at a given
price; excess demand.

Price is too low.

Qs < Qd, a shortage.

Buyer and seller

behaviors kick in.

Price will rise to

equilibrium price, Pe.

Pe
Plow
Shortage

Qs

Qe

D
Qd

What Causes the Price to

Change?

Price changes when equilibrium is upset.

due to a shift in demand (a change in

buyers behavior), or
due to a shift in supply (a change in
sellers behavior).

After the shift, a surplus or a shortage is

created, and the market mechanism
goes into effect to find the new
equilibrium.

Demand Increases

Buyers behavior
changes.
Demand shifts right.

Old equilibrium is upset.

Creates a shortage.
Price rises.

P2
P1

Shortage

D2

A new equilibrium is
established.

D1

Price rises from P1 to P2.

Quantity rises from Q1 to
Q2.

Q1 Q2

Demand Decreases

Buyers behavior
changes.
Demand shifts left.
Old equilibrium is
upset.

Creates a surplus.
Price falls.

A new equilibrium is
established.

Price falls from P1 to P2.

Quantity falls from Q1
to Q2

Surplus

P1
P2
D1
D2
Q2 Q1

Supply Increases

Sellers behavior
changes.
Supply shifts right.

Old equilibrium is upset

Creates a surplus.
Price falls.

S1
Surplus

S2
P1
P2

A new equilibrium is
established.

Price falls from P1to P2.

Quantity rises from Q1 to
Q2.

Q1 Q2

Supply Decreases
Sellers behavior
changes.
Supply shifts left.

Old equilibrium is upset

Creates a shortage.
Price rises.

P1

A new equilibrium is
established.

Shortage

S2

P2

Price rises from P1to P2.

Quantity falls from Q1 to
Q2.

S1

Q2 Q1

Summary: When Do Prices Change?

Only when a market is in disequilibrium.

Shortage? Price rises.

Surplus? Price falls.

A shift in either demand or supply causes

the price to change, BUT.
A price change does NOT cause

the demand curve to shift or

the supply curve to shift.

Exercise

right
If income increases, demand shifts
rise will
and the price
left
If tastes decrease, demand shifts
fall
and the price
will
left
If cost of inputs rise, supply shifts
rise
and the price
will
right
If the number of sellers increase, supply
fall the price will
shifts
and

Changes in Demand and Supply (cont'd)

Summary

Increases in demand increase

equilibrium price and quantity

Decreases in demand decrease

equilibrium price and quantity

Changes in Demand and Supply (cont'd)

Summary

Increases in supply decrease equilibrium

price and increase equilibrium quantity

Decreases in supply increase equilibrium

price and decrease equilibrium quantity

Changes in Demand and Supply (cont'd)

Example

Incomes increase. In a graph of the

market for iPod we would expect:

a. The demand curve to shift to the left

b. The demand curve to shift to the right.

c. The supply curve to shift upwards.

d. The supply curve to shift downwards.

e. Neither the supply nor the demand curve

shifts.

Changes in Demand and Supply (cont'd)

Example

Income rises. We should expect to see that

price will and quantity will in the new
equilibrium in the market for iPod.
a. increase increase

e. increase be uncertain

b. increase decrease

f. be uncertain - increase

c. decrease increase
uncertain

g. decrease be

d. decrease decrease

h. be uncertain decrease

Changes in Demand and Supply (cont'd)

Example

The price of computer memory chips

increases. In the market for computers, we
would expect to see:

a. The demand curve to shift to the left

b. The demand curve to shift to the right.

c. The supply curve to shift upwards.

d. The supply curve to shift downwards.

e. Neither the supply nor the demand curve

shifts.

Changes in Demand and Supply (cont'd)

Example

The price of computer memory chips increases.

In the market for computers, we would expect
price will and quantity will in the new
equilibrium.
a. increase increase

e. increase be uncertain

b. increase decrease

f. be uncertain - increase

c. decrease increase

g. decrease be uncertain

d. decrease decrease

h. be uncertain decrease

Changes in Demand and Supply (cont'd)

Changes in Demand and Supply

Example
What happens to the equilibrium price and
quantity of an iPod when simultaneously:

Buyers incomes rise,

and
Technology to make the
iPods improves?

What happens to the price and quantity bought/sold

of iPods if incomes rise and technology advances?

1. Price down; quantity

up
2. Price same; quantity
up
3. Price up; quantity up
4. Price down; quantity
down
5. None of the above

Changes in Demand and Supply (cont'd)

Changes in Demand and Supply

Example Answer
An increase in incomes will increase demand
(price and quantity increase).
An advance in technology will increase supply
(price decreases and quantity increases).
The combined effect is that price
change is indeterminate and
equilibrium quantity increases.

Changes in Demand and Supply (cont'd)

Changes in Demand and Supply

Example
What happens to the equilibrium price and
quantity of cars when simultaneously:

Buyers incomes rise,

and
Sellers cost increases?

Example: The Effects of a Decrease in the Supply of

Cars in Conjunction With an Increase in the
Demand

Changes in Demand and Supply (cont'd)

When both demand and supply

change

If both the supply and demand curves

shift simultaneously, the outcome is
indeterminate for either equilibrium
price or equilibrium quantity

The resulting effect depends upon how

much each curve shifts

Simultaneous Shifts in Supply and

Demand
Price

Supply2

Supply1
B

Supply0

Demand1
Demand0
0

Quantity

Changes in Demand and Supply (cont'd)

When both demand & supply increase

Change in equilibrium price is

indeterminate

Equilibrium quantity increases

unambiguously

When both demand & supply decrease

Change in equilibrium price is

indeterminate

Equilibrium quantity decreases

unambiguously

Changes in Demand and Supply (cont'd)

When supply decreases & demand

increases

Equilibrium price increases

The change in the equilibrium quantity is
uncertain without more information

When supply increases & demand

decreases

Equilibrium price decreases

The change in the equilibrium quantity is
uncertain without more information

Price Controls

Governments may impose an arbitrary

maximum price (price ceiling) or a
minimum price (price floor) on a market.

The result is that the market cannot reach

equilibrium.

Price Ceiling

Government imposes a
maximum price less than
Pe .

This generates a shortage

(Qd > Qs).

The market mechanism

cannot clear the market.
A permanent shortage
exists.
Examples:

rent controls
price controls during
wartime

Shortage

Pe
Price
ceiling

D
Qs

Qe

Qd

Price Floor

Government imposes a
minimum price greater
than Pe.

This generates a surplus

(Qs > Qd).

The market mechanism

cannot clear the market.
A permanent surplus
exists.

Surplus

Price
floor

Pe

Examples:

agricultural price
supports
minimum wage laws

Qd

Qe

Qs

Summary Discussion

Determining market price and

equilibrium quantity

The demand and supply curves intersect at

the market clearing, or equilibrium point

Surpluses exist if the price of the good is

greater than the market price

Shortages exist when the price of a good is

below the market price

Summary Discussion (cont'd)

How changes in demand and supply affect

market price and equilibrium quantity

If supply does not change, increases in demand

increase equilibrium price and quantity;
decreases in demand decrease equilibrium
price and quantity

If demand does not change, increases in supply

decrease market price and increase equilibrium
quantity; decreases in supply increase market
price and decrease equilibrium quantity

Summary Discussion (cont'd)

How changes in demand and supply

affect equilibrium price and equilibrium
quantity

When both demand and supply shift at the

same time, the outcome is indeterminate
for either equilibrium price or equilibrium
quantity

Summary Discussion (cont'd)

How government price controls affect

market outcomes.

The effects of price ceilings

A price ceiling set below the market

clearing price results in a shortage
The

resulting shortage can lead to black

markets (A marketin which goods or services
are traded illegally)

Summary Discussion (cont'd)

The effects of price floors

If the price floor is set above the market

clearing price, a surplus results
A

price floor can take the form of a

government-imposed price support or minimum
wage