copyright 2008 the mcgraw-hill companies 3-1 3 demand, supply, and market equilibrium

Copyright 2008 The McGraw-Hill Companies3-1

3Demand, Supply, and Market Equilibrium


Chapter Objectives

• Demand Defined and What Affects It• Supply Defined and What Affects It• How Supply & Demand Together Determine

Market Equilibrium• How Changes in Supply and Demand Affect

Equilibrium Prices and Quantities• Government-Set Prices and their Implications for

Surpluses & Shortages


Markets Defined

• Markets bring together buyers (demanders) and sellers Markets bring together buyers (demanders) and sellers (suppliers) of particular goods and services. They take many (suppliers) of particular goods and services. They take many forms.forms.

• A market may be local (A market may be local (fishfish), national (), national (houseshouses), or ), or international (international (oiloil) in scope.) in scope.

• Some markets are highly personal, face-to-face exchanges Some markets are highly personal, face-to-face exchanges ((fishfish); others are impersonal and remote (); others are impersonal and remote (internet marketinginternet marketing).).

• There are two types of marketsThere are two types of markets– product market (product market (fishfish) involves goods and services.) involves goods and services.– resource market (resource market (labor marketlabor market) involves factors of production) involves factors of production


DemandDemand Defined• Demand is a schedule or a curve that shows the various

amounts of a product that consumers are willing and able to buy at each of a series of possible prices during a specified time period. Example look at the following schedule.

• The schedule shows the relationship between various prices and the quantity a consumer is willing and able to purchase at each of these prices. We say willing an able because willingness is not effective in the market. The table does not tell us which of the 5 prices would exist in the market. This depends on demand and supply.

• To be meaningful, the demand schedule must have a period of time associated with it, example a day, a week or a month.

P 5 4 3 2 1

QD 10 20 35 55 80


Individual Demand

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0 10 20 30 40 50 60 70 80 Quantity Demanded (bushels per week)

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Law of Demand• Law of demand “other things being equal, as price increases,

the corresponding quantity demanded falls and as price falls, the quantity demanded rises”.

• The law of demand can be restated as, “there is an negative or inverse relationship between price and quantity demanded”.

• Note the “other-things-equal” assumption refers to consumer income, tastes, prices of related goods, and other things besides the price of the product being discussed.

Explanation of the law of demanda. Diminishing marginal utility

The consumer will derive less satisfaction (utility) form each additional units of the product consumed, e.g., the second “Big Mac” yields less extra satisfaction (or utility) than the first, i.e. consumption is subject to diminishing marginal utility. A consumer will only buy it if its price is less.


b. Income effect A lower price increases the purchasing power of money income, enabling the consumer to buy more at a lower price. A higher price has the opposite effect.

c. Substitution effectAt a lower price buyers have the incentive to substitute what is now a less expensive product for similar products that are now relatively more expensive.

The demand curve

• A simple graph illustrates the inverse relationship between price and quantity.

• The downward slope indicates lower quantity (horizontal axis) at higher price (vertical axis) and higher quantity at lower price, reflecting the Law of Demand.

Market demand• By adding the quantities demanded by all consumers at each of the

various prices, we can get from individual demand to market demand (the demand of all consumers in the market).


Determinants of DemandDeterminants of Demand• There are several determinants of demand or the “other There are several determinants of demand or the “other

things,” besides price, which affect demand. A change in one things,” besides price, which affect demand. A change in one or more of the determinants of demand will cause the or more of the determinants of demand will cause the demand data and therefore demand data and therefore the location of the demand curve the location of the demand curve to changeto change. A shift in the demand curve is called a change in . A shift in the demand curve is called a change in demanddemand

a.a. TastesTastes• A favorable change in consumer tastes for a product means A favorable change in consumer tastes for a product means

that more of it will be demanded at each (current) price. that more of it will be demanded at each (current) price. Demand will increase i.e., shifts rightward. Unfavorable Demand will increase i.e., shifts rightward. Unfavorable change will decrease demand (a shift leftward).change will decrease demand (a shift leftward).

b.b. Number of buyersNumber of buyers• An increase in the number of buyers is likely to increase An increase in the number of buyers is likely to increase

demand; fewer buyers will probably decrease demand.demand; fewer buyers will probably decrease demand.


c.c. IncomeIncome• for most products a rise in income causes an increase in for most products a rise in income causes an increase in

demand for superior or normal goods. Less leads to a demand for superior or normal goods. Less leads to a decrease in demand for decrease in demand for normalnormal goods. The rare case of goods. The rare case of goods whose demand varies inversely with income is called goods whose demand varies inversely with income is called inferiorinferior goods, e.g., used cars. goods, e.g., used cars.

d.d. Prices of related goodsPrices of related goods::• A change in the price of related goods may either increase or A change in the price of related goods may either increase or

decrease the demand for a product depending on whether decrease the demand for a product depending on whether the related good is a substitute or a complement. the related good is a substitute or a complement.

i.i. SubstitutesSubstitutes (can be used in place of another good): if two (can be used in place of another good): if two goods are substitutes, an increase in the price of one will goods are substitutes, an increase in the price of one will increase the demand for the other (i.e., increase the demand for the other (i.e., directlydirectly related). related).

ii.ii. ComplementsComplements (goods that are used together, they are (goods that are used together, they are demanded jointly): if the price of a complement increase, the demanded jointly): if the price of a complement increase, the demand for the related good will decline, i.e., there is an demand for the related good will decline, i.e., there is an inverseinverse relationship between the price of one and the relationship between the price of one and the demand for the other. demand for the other.


iii.iii. Unrelated goodsUnrelated goods (independent goods). A change in the (independent goods). A change in the price of one has little or no effect on the demand for the price of one has little or no effect on the demand for the other. other.

e.e. Consumer expectationsConsumer expectations• A newly formed expectations of higher A newly formed expectations of higher futurefuture pricesprices may may

cause consumers to buy now in order to beat the anticipated cause consumers to buy now in order to beat the anticipated price rises, this will shift the demand rightward, e.g., the real price rises, this will shift the demand rightward, e.g., the real estates market.estates market.

• A change in expectations concerning A change in expectations concerning futurefuture incomeincome may may prompt consumers to change their current spending. prompt consumers to change their current spending. Demand shifts rightward (in case of expected higher income) Demand shifts rightward (in case of expected higher income) or leftward (in case of expected lower income). or leftward (in case of expected lower income).


Individual Demand

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Demand Can Increase or Decrease

Increase in Demand

Decrease in Demand

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D3


Individual Demand

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Demand Can Increase or Decrease

Decrease in Demand

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An Increase in DemandMeans a shiftof the Line

A Movement BetweenAny Two Points on a

Demand Curve is Called a Change in

QuantityDemanded


A summary of what can cause an increase in demandA summary of what can cause an increase in demand

a.a. Favorable change in consumer tastes.Favorable change in consumer tastes.b.b. Increase in the number of buyers.Increase in the number of buyers.c.c. Rising income if product is a normal good.Rising income if product is a normal good.d.d. Falling incomes if product is an inferior good.Falling incomes if product is an inferior good.e.e. Increase in the price of a substitute good.Increase in the price of a substitute good.f.f. Decrease in the price of a complementary good.Decrease in the price of a complementary good.g.g. Consumer expectation of higher prices or incomes in the future.Consumer expectation of higher prices or incomes in the future.

A summary of what can cause a decrease in demand.A summary of what can cause a decrease in demand.

a.a. Unfavorable change in consumer tastes.Unfavorable change in consumer tastes.b.b. Decrease in number of buyers.Decrease in number of buyers.c.c. Falling income if product is a normal good.Falling income if product is a normal good.d.d. Rising income if product is an inferior good.Rising income if product is an inferior good.e.e. Decrease in price of a substitute good.Decrease in price of a substitute good.f.f. Increase in price of a complementary good.Increase in price of a complementary good.g.g. Consumers expectation of lower prices or incomes in the future.Consumers expectation of lower prices or incomes in the future.


Distinction between a change in quantity demanded and a Distinction between a change in quantity demanded and a change in demand change in demand

1.1. A A change in demandchange in demand is a shift of the demand curve. It occurs is a shift of the demand curve. It occurs due to changes in one of the demand determinants. It will due to changes in one of the demand determinants. It will shift the whole demand curve to the right (an increase in shift the whole demand curve to the right (an increase in demand) or to the left (a fall in demand).demand) or to the left (a fall in demand).

2.2. A A change in quantity demandedchange in quantity demanded is a movement from on point is a movement from on point to another on a fixed demand schedule. It is caused by price to another on a fixed demand schedule. It is caused by price changes.changes.


SupplySupply

Supply DefinedSupply Defined• Supply is a schedule or a curve that shows the various Supply is a schedule or a curve that shows the various

amounts of a product that producers are amounts of a product that producers are willing and ablewilling and able to to make available for sale at each of a series of possible prices make available for sale at each of a series of possible prices during a specified time period.during a specified time period.

Law of supply.Law of supply.• All else equal, there is a positive or direct relationship All else equal, there is a positive or direct relationship

between price and quantity supplied. A supply schedule tells between price and quantity supplied. A supply schedule tells us that firms will produce and offer for sale more of their us that firms will produce and offer for sale more of their product at a high price that at a low price.product at a high price that at a low price.

Explanation:Explanation: 1.1. Revenue Implications.Revenue Implications. For a supplier price represents a For a supplier price represents a

revenuerevenue, which serves as an , which serves as an incentiveincentive to produce and sell to produce and sell a product. The higher the price, the greater the incentive and a product. The higher the price, the greater the incentive and the greater the quantity supplied. the greater the quantity supplied.


2.2. Marginal Cost. Marginal Cost. beyond some quantity of production beyond some quantity of production manufacturers usually encounter manufacturers usually encounter increasing marginal costincreasing marginal cost (the added cast of producing one more unit of output). (the added cast of producing one more unit of output). Certain productive resources (e.g., machinery) cannot be Certain productive resources (e.g., machinery) cannot be expanded quickly, producers will increase other resources expanded quickly, producers will increase other resources such as labor. As more labor are used the added output will such as labor. As more labor are used the added output will be less, and the marginal cost of successive units rises be less, and the marginal cost of successive units rises accordingly. The producer will not produce more costly units accordingly. The producer will not produce more costly units unless it receives a higher price for them. unless it receives a higher price for them.

The supply curveThe supply curve• It shows a direct relationship between the price and quantity It shows a direct relationship between the price and quantity

supplied. The upward slop of the curve reflects the law of supplied. The upward slop of the curve reflects the law of supply – producers offer more of a good or a service or supply – producers offer more of a good or a service or resource for sale as its price rises.resource for sale as its price rises.


Individual SupplyIndividual Supply

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Market SupplyMarket Supply• The sum of quantities supplied by each producer at each The sum of quantities supplied by each producer at each

price. It is obtained by horizontally adding the supply curves price. It is obtained by horizontally adding the supply curves of individual producers in the market. of individual producers in the market.

Determinants of supplyDeterminants of supply• A change in any of the supply determinants causes a A change in any of the supply determinants causes a

change in supply and a shift in the supply curve. An change in supply and a shift in the supply curve. An increase in supply involves a rightward shift, and a increase in supply involves a rightward shift, and a decrease in supply involves a leftward shift. decrease in supply involves a leftward shift.

1.1. Resource prices. Resource prices. • A higher resource prices raises production costs and A higher resource prices raises production costs and

squeeze profits. The reduction in profits reduces the squeeze profits. The reduction in profits reduces the incentive to supply output at each product price, supply incentive to supply output at each product price, supply shifts leftward. shifts leftward.

• In contrast lower resource prices will reduce production In contrast lower resource prices will reduce production costs and increase profits, causing an increase in supply or costs and increase profits, causing an increase in supply or rightward shift in the supply curve.rightward shift in the supply curve.


2.2. TechnologyTechnologyA technological improvement means more efficient A technological improvement means more efficient production and lower costs, so an increase in supply or production and lower costs, so an increase in supply or rightward shift in the curve results.rightward shift in the curve results.

3.3. Taxes and subsidiesTaxes and subsidiesA business tax is treated as a cost, so decreases supply; a A business tax is treated as a cost, so decreases supply; a subsidy lowers cost of production, so increases supply.subsidy lowers cost of production, so increases supply.

4.4. Prices of related goodsPrices of related goodsIf the price of substitute production good rises, producers If the price of substitute production good rises, producers might shift production toward the higher-priced good might shift production toward the higher-priced good (alternative), causing a decrease in supply of the original (alternative), causing a decrease in supply of the original good.good.


5.5. Producer expectationsProducer expectations• Expectations about the future price of a product can cause Expectations about the future price of a product can cause

producers to increase or decrease current supply.producers to increase or decrease current supply.

6.6. Number of sellersNumber of sellers• Generally, the larger the number of sellers the greater the Generally, the larger the number of sellers the greater the

supplysupply..

Changes in quantity supplied and changes in supplyChanges in quantity supplied and changes in supply• Distinction between a change in quantity supplied (due to Distinction between a change in quantity supplied (due to

price changes) and a change or shift in supply (due to price changes) and a change or shift in supply (due to change in determinants of supply).change in determinants of supply).



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Supply Can Increase or DecreaseSupply Can Increase or Decrease

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An Increase in SupplyMeans a shiftof the Line

A Movement BetweenAny Two Points on a

Supply Curve is Called a Change in Quantity

Supplied

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Market EquilibriumMarket Equilibrium

• Market Equilibrium: where Market Equilibrium: where quantity supplied equals the quantity supplied equals the quantity demanded: quantity demanded:

• Equilibrium priceEquilibrium price• Equilibrium quantityEquilibrium quantity

• At prices above this equilibrium, note that there is an At prices above this equilibrium, note that there is an excess quantity supplied or surplusexcess quantity supplied or surplus..

• At prices below this equilibrium, note that there is an At prices below this equilibrium, note that there is an excess quantity demandedexcess quantity demanded or shortageor shortage..

• Market clearing or market price is another name for Market clearing or market price is another name for equilibrium price.equilibrium price.


Market Equilibrium

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200 BuyersP Qs

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200 Sellers

200 Buyers & 200 Sellers

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S6,000 BushelSurplus

7,000 BushelShortage


• Graphically, note that the equilibrium price and quantity are Graphically, note that the equilibrium price and quantity are where the supply and demand curves intersect. where the supply and demand curves intersect. Note also that Note also that it is NOT correct to say it is NOT correct to say supply equals demand!supply equals demand!

The rationing function of pricesThe rationing function of prices• Is the ability of competitive forces of supply and demand to Is the ability of competitive forces of supply and demand to

establish a establish a priceprice at which selling and buying decisions are at which selling and buying decisions are consistentconsistent. .

Efficient allocationEfficient allocation• A competitive market forces producers to use the best A competitive market forces producers to use the best

technology and the right mix of productive resources. The technology and the right mix of productive resources. The result is result is productive efficiencyproductive efficiency: the production of any particular : the production of any particular product in the product in the least costly wayleast costly way. .

• Competitive markets also produce Competitive markets also produce allocative efficiencyallocative efficiency: to : to produce the particular mix of goods and services produce the particular mix of goods and services most valuedmost valued by the society.by the society.


Changes in Supply and Demand, and EquilibriumChanges in Supply and Demand, and Equilibrium

Changing demand Changing demand (with supply held constant).(with supply held constant).• Increase in demandIncrease in demand will have effect of increasing equilibrium will have effect of increasing equilibrium

price and quantityprice and quantity• Decrease in demandDecrease in demand will have effect of decreasing will have effect of decreasing

equilibrium price and quantityequilibrium price and quantity

Changing supply Changing supply (with demand held constant).(with demand held constant).• Increase in supplyIncrease in supply will have effect of decreasing equilibrium will have effect of decreasing equilibrium

price and increasing quantityprice and increasing quantity• Decrease in supplyDecrease in supply will have effect of increasing equilibrium will have effect of increasing equilibrium

price and decreasing quantityprice and decreasing quantity


Complex casesComplex cases

• when both supply and demand shift:when both supply and demand shift:

1.1. Supply increases and demand decreasesSupply increases and demand decreases, price declines, , price declines, but the new equilibrium quantity depends on relative sizes of but the new equilibrium quantity depends on relative sizes of shifts in demand and supply.shifts in demand and supply.

2.2. Supply decreases and demand increasesSupply decreases and demand increases, price rises, but , price rises, but the new equilibrium quantity depends again on relative sizes the new equilibrium quantity depends again on relative sizes of shifts in demand and supply.of shifts in demand and supply.

3.3. Supply increases and demand increasesSupply increases and demand increases. If the increase in . If the increase in supply is greater than the increase in demand the price falls supply is greater than the increase in demand the price falls and vice versaand vice versa

4.4. Supply decreases demand decreases. Supply decreases demand decreases. If the decrease in If the decrease in supply is greater than the decrease in demand, equilibrium supply is greater than the decrease in demand, equilibrium price will rise and vice versa.price will rise and vice versa.


Application: Government-Set Prices (Ceilings and Floors).Application: Government-Set Prices (Ceilings and Floors).• Government-set prices prevent the market from reaching the Government-set prices prevent the market from reaching the

equilibrium price and quantity.equilibrium price and quantity.

A. Price ceilings A. Price ceilings • The maximum legal price a seller may charge, typically placed The maximum legal price a seller may charge, typically placed

below equilibrium. Shortages result as quantity demanded below equilibrium. Shortages result as quantity demanded exceeds quantity supplied. Examples: Rent controls and exceeds quantity supplied. Examples: Rent controls and gasoline price controlsgasoline price controls

Rationing problemRationing problem• Since price ceilings does not lead to an equitable distribution Since price ceilings does not lead to an equitable distribution

of the product, the government must establish some formal of the product, the government must establish some formal system for rationing, e.g., ration couponssystem for rationing, e.g., ration coupons

Black MarketsBlack Markets• Since the demand is greater than supply, buyers will be willing Since the demand is greater than supply, buyers will be willing

to pay a higher price, which creates a black market where the to pay a higher price, which creates a black market where the product is illegally traded in at price above the ceiling price.product is illegally traded in at price above the ceiling price.


B. Price floorsPrice floors..• The minimum legal price a seller may charge, typically placed The minimum legal price a seller may charge, typically placed

below equilibrium. Surpluses result as quantity supplied below equilibrium. Surpluses result as quantity supplied exceeds quantity demanded.exceeds quantity demanded.

• Examples: Minimum wage and farm price supports. Examples: Minimum wage and farm price supports.

• Note: The minimum wage, for example, will be below Note: The minimum wage, for example, will be below equilibrium in some labor markets (large cities as the demand equilibrium in some labor markets (large cities as the demand for labor is already high). In that case the price floor has no for labor is already high). In that case the price floor has no effect.effect.

(Flash film 7)(Flash film 7)


Government set prices

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$4 Price Floor

6,000 BushelSurplus

$2 Price Ceiling

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Application: Market Equilibrium

Qd = a1 + b1 P; a1>0, b1<0 (1)

Qs = a2 + b2 P; a2<0, b2>0 (2)

Qd = Qs (3) Equilibrium Condition

Solution

At equilibrium

a1 + b1 P = a2 + b2 P

b1 P - b2 P = a2 - a1

P* = ( a2 - a1 ) ÷ ( b1 - b2 )


Example. Given the following information:

Qd = 45 - 2 P; a1>0, b1<0 (1)Qs = -15 + 3P;Calculate the equilibrium price and quantity;

Solution:

At equilibrium: 45-2p = -15 + 3p5p = 60P* = 60/5 = 12Q* = 45 – 2(12) = 21

1. Suppose that the government set a floor price 13, what will happen to the market?

2. Suppose that the government set a ceiling price 10, what will happen to the market?


A Legal Market for Human Organs

• Waiting List for Transplants• Demand for Organs• Vertical Supply of Organs• Incentive Role of Market and Up-Sloping

Supply• Increases Quantity• Decreases Price• Moral Objections• Increase the Cost of Health Care• Better to Legalize and Regulate?

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A Legal Market for Human Organs

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Supply of Organs

Demand for Organs

Shortage at Zero PriceQ1 – Q3

Supply With Price Incentive

At Price P1 theShortage is ReducedBy Q1 – Q2


Key Terms Page• demand• demand schedule• law of demand• diminishing marginal utility• income effect• substitution effect• demand curve• determinants of demand• normal goods• inferior goods• substitute good• complementary good• change in demand• change in quantity demanded

• supply• supply schedule• law of supply• supply curve• determinants of supply• change in supply• change in quantity supplied• equilibrium price• equilibrium quantity• surplus• shortage• price ceiling• price floor


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The U.S. Economy: Public and Private Sectors

copyright 2008 the mcgraw-hill companies 3-1 3 demand, supply, and market equilibrium

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