ECONOMICS FOR MANAGEMENT

LECTURE 2 - MARKET EQUILIBRIUM AND GOVERNMENT INTERVENTIONS

Prof. THIAGU RANGANATHAN

AGENDA

• DEMAND

• SUPPLY

• EQUILIBRIUM

• EFFICIENCY

• GOVERNMENT INTERVENTIONS
DEMAND – Law of Demand

 Law of Demand: Price and Quantity

PRICE
Demanded are inversely related. As
price increases quantity demanded will
A D1 decrease (keeping other things
constant)

D0
 Keeping other things constant, when
price changes there is a movement
B along the demand curve (movement
from A to B)
 When other factors change, the demand
curve shifts (change in demand with the
QUANTITY shift from D0 to D1
DEMAND – Factors Influencing Demand

 The other factors include:

PRICE
 Income
 When demand increases with income, it is
D1 called a normal good
 When demand decreases with income, it is
called an inferior good
 Prices of Substitutes and Complements
D0
 As prices of substitutes increases (decreases),
the demand for a product increases
(decreases)
 As prices of complements increases
(decreases) the demand for the product
decreases (increases)
 Advertising and Consumer Tastes
 Population
QUANTITY
 Consumer Expectations
 Other Factors
DEMAND - Example

 Example:
PRICE  Consider the demand for coffee (in Tonnes):
=12000 - 3+4-1+2
Where is the amount of Coffee (in Tonnes)
demanded in a year, is the Price of Coffee (in
Rs./Kg), is the Price of Tea (in Rs./Kg), is the
average annual income of the individuals in the
country, and is the number of minutes of Coffee
D0
Advertisements shown in the TV in a year

 How much coffee will be demanded when

the price of tea is 75, the price of coffee is
200, Income is 10000, and Advertisements
is 2000?
QUANTITY  If the quantity demanded increased to
6000, what was the change in Price
(keeping other things constant)?
SUPPLY – Law of Supply

 Law of Supply: Price and Quantity

PRICE
Supplied are directly related. As price
S0 increases quantity supplied will increase
(keeping other things constant)
D

 Keeping other things constant, when

C S1 price changes there is a movement
along the supply curve (movement from
C to D)
 When other factors change, the supply
curve shifts (change in supply with the
shift from S0 to S1 )
QUANTITY
SUPPLY – Factors Influencing Supply

 The other factors include:

PRICE

S0
 Input Prices

 Technology or Government Regulations

S1

 Number of Firms

 Producer Expectations

QUANTITY  Other Factors

SUPPLY - Example

 Example:
PRICE
 Consider the supply of Burgers in a month (in
lakhs):
=2000 + 4-2
Where is the amount of Burgers (in lakhs)
S0
supplied in a month, is the Price of Burger (in
Rs.), is the Price of Wheat Flour (in Rs./Kg)

 How much burgers will be supplied when

the price of burger is 75, and that of
wheat is 25?

QUANTITY
 If the price of wheat becomes Rs.50 per
kg, what is the price at which the supply
will remain the same as above?
EQUILIBRIUM – Movement along a Curve

 Competitive markets converge to an

S
PRICE equilibrium at which quantity supplied and
quantity demanded are the same (Point E)
PH
F G

PE E
 At a price higher than this one (PH ), firms
would want to supply more than what the
I consumers demand and this will create a
PL
surplus (Qc-QA ). Prices will reduce in
H
D response to this surplus

QA QB QE QC QD
 At a price lower than this one (PL ),
QUANTITY consumers will demand more good than what
will be supplied by the firms and this will
create a shortage (QD-QB ). Prices will
increase in response to this shortage
EQUILIBRIUM – Shift of a Curve

PRICE S1  Consider a market in equilibrium

S0
 Consider a scenario where a change in
market conditions leads to a shift in
PA
F supply curve towards left. Eg: Blight
PE
G
E disease in apple orchards impacts the
supply of apple

 The supply curve shifts first. At the

current equilibrium, there is a shortage
QB QA QE (QE-QB ). The price rises in response to
QUANTITY
that to PA at which price the quantity
demanded equals quantity supplied
EFFICIENCY – Consumer and Producer Surplus

 Consumer surplus is the excess of

S
PRICE consumers willingness to pay over the
A market valuation
 Producer Surplus is the excess of market
P E
price over the reservation price of the
suppliers
 In Equilibrium (E), the Consumer Surplus
D is given by A(APE) while producer surplus
is given by A(FPE). The sum of these two
F
is the total surplus.
Q
QUANTITY  An Efficient market is the one that
maximizes the total surplus
GOVERNMENT INTERVENTION – Price Floor

 Price Floor is the minimum price that the

S
PRICE commodity can be traded in the market

PF  When the Government sets a price floor

F G
above the equilibrium price, there is
excess supply in the market
PE E

 A typical example is the Minimum

Support Price of agricultural commodity
D set by the Government or Minimum
H Wages for Employees
 In a scenario like Minimum Support Price,
QA QE QC
QUANTITY the Government might have to procure
the excess supply unsold in the market
and the costs to the Government in
those cases will be FGQAQB
 SUMMARY

S
PRICE S
A  Supply Equals Demand at Equilibrium PRICE
A
and the Total Surplus is Maximum at B J G

P E
this Equilibrium
E

C
H
D
D

F
 At other points, the producer surplus I

QH QB QL
QUANTITY
or consumer surplus could be higher, E
QH
but the total surplus will be lesser
QB
QUANTITY
EQUILIBRIUM
causing deadweight loss DEADWEIGHT LOSS

S
PRICE
S
PRICE

PD
J
 Government interventions like price PF
F G

PE E floors and ceilings could cause losses PE E

PC I in efficiency, but might be required for PG

H
D
equity purposes and also at times D

when correction is needed for

H

Externalities QA QE QC
QUANTITY
QB QE QD
QUANTITY

PRICE CEILING PRICE FLOOR

BACKUP SLIDES
EFFICIENCY – Deadweight Loss

 When markets are not in equilibrium,

S
PRICE there is loss of efficiency, referred to as
A deadweight loss
B J G

E
 At point B, the consumer surplus is
A(ABJ), producer surplus is A(IEBJ) and
C
H the deadweight loss to society is A(EIJ)
D
I

F
 At point C, the consumer surplus is
QH QB
QUANTITY A(CAGH), the producer surplus is A(FCH)
and the deadweight loss to society is
A(EGH)
GOVERNMENT INTERVENTION – Price Ceiling

 Government interventions can affect

S
PRICE market efficiency in unexpected manner
 A typical intervention is when the
J
PD Government imposes a price ceiling
PE E
 A typical example is the rent control
I where the rents for the households are
PC
H
capped at PC. At this price, there is a
D shortage of houses (QD-QB) and also a
welfare loss given by A(HEJ)

 This could lead to either hidden deals by

QB QE QD
QUANTITY
lessors with people who wish to pay rents
more than the ceiling price. It could also
lead to owners shifting the maintenance
expenditure to lessees