Lecture 2

MIT OCW 14.01SC L2 - Application of Supply and Demand

MIT OCW 14.01SC - Lec 2 (Youtube)

• Supply and Demand

  • Demand Q_d = D(P)
    • dQ_d / dP < 0
    • Demand curve may shift due to changes in variables other than price.
    • Market demand is equal to sum of consumer demand.
      • Q_m = \sum Q_i
  • Supply Q_s = S(P)
    • dQ_s / dP > 0
    • Also influenced by other variables, like input costs, technology.
  • Market Equlibrium
    • Q_d (P*) = Q_s (P*)
    • P* is optimal price.

• Equilibrium shocks

  • What happens when you change the equilibrium (through supply or demand shock)?
  • Understand every concept on three levels: intuitive, graphical, mathematical.
  • Example 1. Price of substitute product increases, demand for good also increases. Demand curve shifts up (outward). There is new eqm.
    • Initially: Excess demand.
    • Slide up the supply curve to higher price at new eqm.
    • General eqm: Markets may affect prices in other markets. Feedback effect where it affects the original price. (not in scope within this course).
  • Where does supply curve come from? Producer theory - discussed later. (from firms trying to maximise their profits).
  • Example 2. Price of producing good increases. Supply curve shifts upward (inward).
    • Less ability to produce at the same price. Reduced supply.
    • New eqm at higher price.
  • In both situations (increased demand and decreased supply), the same thing happened! The price went up.
    • From looking at the price alone it is not possible to tell which of these happened.
    • However the volume was affected differently, in one the qty went up, in other qty went down.

• Government Intervention

  • Example: Minimum wage
  • Consider market for Labour
    • Labour is an input to the production process
    • Firms demand labour, People supply labour. (flipped wrt. previous example of goods)
    • At wage W_ (above W*), workers are delighted to work L_s hours, but firms need only L_d hours.
      • Excess supply.
      • Under perfectly competitive market conditions -> excess supply would cause demand to increase and wages would fall.
      • But you can't do that now because of the govt.
      • We call the excess supply 'unemployment'.
      • Disequilibrium -> market condition still exists at (L_d, W_) -> determined by constraint.
  • Example 2: Gas price ceiling.
    • Price capped at p1, eqm was at p2.
    • Excess demand now. Eqm shifts to new point with lower qty being supplied at lower price.
  • Markets are robust and will do whatever they can to restore equilibrium!
  • Welfare economics of this restriction?
    • Costs:
      • Efficiency loss: A trade that could have made both parties better off is not made.
      • Allocation inefficiency: Lines at the gas station. Gas shortage. (Hoarding?)
    • Benefit:
      • Equity: Fairness
    • Direct effects (what voters see) and indirect effects (what economists see).
    • Equity-Efficiency tradeoffs.
    • Secondary markets can arise to evade government regulation.