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Chapter 2
SUPPLY AND DEMAND: HOW MARKETS WORK
SUPPLY AND DEMAND
Supply and demand are the two words that economists use most often.
Supply and demand are the forces that make market economies work.
Modern microeconomics is about supply, demand, and market equilibrium.
A market is a group of buyers and sellers of a particular good or service.
MARKETS AND COMPETITION
MARKETS AND COMPETITION
Buyers determine demand.
Sellers determine supply
WHAT IS DEMAND?
If I desire a Porsche but don’t have the money tobuy it, is it “demand”?
WHAT IS DEMAND?
Demand is when a person is WILLING and ABLE to buy a good or service.
Demand
The demand schedule is a table that shows the relationship between the price of the good and the quantity demanded in a given time period when all factors other than the product's price remain unchanged.
Individual demand is the demand of just one consumer, while the market demand for a product is the total demand for a product from all its consumers.
Example: Catherine’s Demand Schedule
The Demand Curve
Demand Curve The demand curve is a graph of the
relationship between the price of a good and the quantity demanded.
Quantity demanded is the amount of a good that buyers are willing and able to purchase.
Figure 1 Catherine’s Demand Schedule and Demand Curve
Copyright © 2004 South-Western
Price ofIce-Cream Cone
0
2.50
2.00
1.50
1.00
0.50
1 2 3 4 5 6 7 8 9 10 11 Quantity ofIce-Cream Cones
$3.00
12
1. A decrease in price ...
2. ... increases quantity of cones demanded.
Market Demand versus Individual Demand
Market demand refers to the sum of all individual demands for a particular good or service.
Graphically, individual demand curves are summed horizontally to obtain the market demand curve.
EXERCISE:INDIVIDUAL & MARKET DEMAND
The Ice Cream Café is selling ice cream cones at different prices.
How many ice cream cones would you be prepared to buy in a week at different prices?
How many would your friends buy?
Fill in the table and graph the information in your demand schedule for ice cream cones.
Law of Demand
The law of demand states that, other things equal, the quantity demanded of a good falls when the price of the good rises and vice versa; therefore, there exists an inverse relationship between quantity demanded and price.
THE SUBSTITUTION EFFECT AND INCOME EFFECT
Why do people buy more quantity of a good when its price falls and vice versa?
INCOME EFFECT If the price of a good, e.g., Pepsi Falls then consumers have more purchasing power so they can buy more Pepsi and more of other goods.
SUBSTITUTION EFFECT If the price of a good e.g. Pepsi Falls then consumers willSubstitute the now cheaper product ,Pepsi, for other goods e.g. Coke.
Ceteris Paribus: Other things equal assumption
Economists use the “ceteris paribus”, all other factors held constant, assumption when making generalizations. Only the variable that is under consideration is changed while all other variables are held constant.
For example, the number of cars bought in a year is determined by the price of cars, consumer incomes, gas prices, price of substitutes (i.e. public transport), etc. In order to analyze the effect that a change in the price of gas has on car sales, all other factors that may affect car sales are held constant and only the price of gas is changed.
0
D
Price of Ice-Cream Cones
Quantity of Ice-Cream Cones
A change in the price of ice-cream cones
results in a movement along the demand
curve.
A
B
8
1.00
$2.00
4
Changes in Quantity Demanded
Shifts in the Demand Curve
Change in Quantity Demanded Movement along the demand curve. Caused by a change in the price of the
product.
Shifts in Demand Curve caused by Non-Price Determinates of Demand A change in demand is a SHIFT in the
demand curve, either to the left or right caused by any change that changes quantity demanded at every price.
Fill in the blanks for the exercise when Ice Cream Café increases its advertising.
Non-Price determinants of Demand cause Shifts in the Demand Curve
Consumer income Changes in population/ number of buyers Prices of related goods Tastes and fashion Advertising Expectations about future prices
Note: When we draw the demand curve we assume these non-price determinates are heldconstant.
Shifts in the Demand Curve
Change in Demand A shift in the demand curve, either to the left or
right. Caused by any change that changes the
quantity demanded at every price. Non-price Determinants of Demand cause
Shifts in the Demand Curve/A Change in Demand.
Figure 3 Shifts in the Demand Curve
Copyright©2003 Southwestern/Thomson Learning
Price ofIce-Cream
Cone
Quantity ofIce-Cream Cones
Increasein demand
Decreasein demand
Demand curve, D3
Demandcurve, D1
Demandcurve, D2
0
Consumer Income
As income increases the demand for a normal good will increase.
As income increases the demand for an inferior good will decrease. Examples of inferior goods include second hand clothing and public transportation.
$3.002.50
2.001.501.00
0.50
21 3 4 5 6 7 8 9 10 1211
Price of Ice-Cream Cone
Quantity of Ice-Cream Cones
0
Increasein demand
An increase in income...
D1
D2
Consumer IncomeNormal Good
$3.002.50
2.001.501.00
.50
21 3 4 5 6 7 8 9 10 1211
Price of Public Transport
Quantity of Public
Transport0
Decreasein demand
An increase in income...
D1D2
Consumer IncomeInferior Good
Prices of Related Goods
When a fall in the price of one good reduces the demand for another good, the two goods are called substitutes. For example an increase in the price of margarine will lead to an increase in the demand for butter.
When a fall in the price of one good increases the demand for another good, the two goods are called complements.
Variables That Influence Buyers
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VARIABLE A CHANGE IN THIS VARIABLE WILL CAUSE
Consumer income Change in demand (shift in D curve)
Price of a substitute Change in demand (shift in D curve)
Advertising Change in demand (shift in D curve)
Price Change in Quantity Demanded (Movement)
Change in population Change in demand (shift in D curve)
Price of a complement Change in demand (shift in D curve)
Tastes Change in demand (shift in D curve)
Expectations Change in demand (shift in D curve)
SUPPLY
Quantity supplied is the amount of a good that sellers are willing and able to sell.
Law of Supply The law of supply states that, other things
equal, as price rises the quantity supplied rises when the price of the good rises.
The Supply Curve: The Relationship Supply ice and Quantity Supplied Supply shows the amount of a
good that producers are willing and able to supply at different prices.
The supply curve is the graph of the relationship between the price of a good and the quantity supplied.
The supply schedule is a table that shows the relationship between the price of a good and the quantity supplied.
Ben's Supply Schedule
Price of Ice-Cream Cones ($)
Quantity of Ice-Cream Cones
Supplied
$0.00 0
$0.50 0
$1.00 1
$1.50 2
$2.00 3
$3.00 5
Figure 5 Ben’s Supply Schedule and Supply Curve
Copyright©2003 Southwestern/Thomson Learning
Price ofIce-Cream
Cone
0
2.50
2.00
1.50
1.00
1 2 3 4 5 6 7 8 9 10 11 Quantity ofIce-Cream Cones
$3.00
12
0.50
1. Anincrease in price ...
2. ... increases quantity of cones supplied.
The Law of Supply
The Law of Supply states that as price rises the quantity SUPPLIED falls and vice versa
There exists a positive relationship between quantity supplied and price.
Market Supply versus Individual Supply
Market supply refers to the sum of all individual supplies for all sellers of a particular good or service.
Graphically, individual supply curves are summed horizontally to obtain the market supply curve.
Non-Price determinates of Supply
Input prices/Cost of Production/Price of Factors of Production (eg. Wages, oil prices, prices of raw materials, etc)
Technology Expectations about future sales/economic
situation (optimistic and pessimistic) Taxes All taxes affect S except income taxes) Number of sellers Pollution Regulations Weather Change in Profitability Subsidies
Exercise
Complete Farmer Ahmed’s Crops exercise on the Portal.
Write the answer in your handout.
Movement along the Supply Curve
Change in Quantity Supplied Movement along the supply curve. Caused by a change Price.
1 5
Price of Ice-Cream Cone
Quantity of Ice-Cream Cones0
S
1.00A
C$3.00 A rise in the price
of ice cream cones results in a movement along the supply curve.
Change in Quantity Supplied
Shifts in the Supply Curve
Change in Supply A shift in the supply curve, either to the left
or right. Caused by a change in a determinant other
than price.
Figure 7 Shifts in the Supply Curve
Copyright©2003 Southwestern/Thomson Learning
Price ofIce-Cream
Cone
Quantity ofIce-Cream Cones
0
Increasein supply
Decreasein supply
Supply curve, S3
curve, Supply
S1Supply
curve, S2
Table 2 Variables That Influence Sellers
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MARKET EQUILIBRIUM: SUPPLY & DEMAND
Equilibrium refers to a situation in which the price has reached the level where quantity supplied equals quantity demanded.
At $2.00, the quantity demanded is equal to the quantity supplied!
SUPPLY AND DEMAND TOGETHERDemand Schedule
Supply Schedule
Figure 8 The Equilibrium of Supply and Demand
Copyright©2003 Southwestern/Thomson Learning
Price ofIce-Cream
Cone
0 1 2 3 4 5 6 7 8 9 10 11 12Quantity of Ice-Cream Cones
13
Equilibriumquantity
Equilibrium price Equilibrium
Supply
Demand
$2.00
Figure 9 Markets Not in Equilibrium
Copyright©2003 Southwestern/Thomson Learning
Price ofIce-Cream
Cone
0
Supply
Demand
(a) Excess Supply
Quantitydemanded
Quantitysupplied
Surplus
Quantity ofIce-Cream
Cones
4
$2.50
10
2.00
7
Surplus
When price > equilibrium price, then quantity supplied > quantity demanded.
There is excess supply or a surplus. Suppliers will lower the price to increase
sales, thereby moving toward equilibrium.
Shortage
When price < equilibrium price, then quantity demanded > the quantity supplied.
There is excess demand or a shortage. Suppliers will raise the price due to too many
buyers chasing too few goods, thereby moving toward equilibrium.
Figure 9 Markets Not in Equilibrium
Copyright©2003 Southwestern/Thomson Learning
Price ofIce-Cream
Cone
0 Quantity ofIce-Cream
Cones
Supply
Demand
(b) Excess Demand
Quantitysupplied
Quantitydemanded
1.50
10
$2.00
74
Shortage
Events that affect demand and/or supply Economists use the model of supply and
demand to analyze competitive markets. In a competitive market, there are many
buyers and sellers, each of whom has little or no influence on the market price.
Three Steps to Analyzing Changes in Equilibrium
Decide whether the event shifts the supply or demand curve (or both).
Decide whether the curve(s) shift(s) to the left or to the right.
Use the supply-and-demand diagram to see how the shift affects equilibrium price and quantity.
Figure 10 How an Increase in Demand Affects the Equilibrium
Copyright©2003 Southwestern/Thomson Learning
Price ofIce-Cream
Cone
0 Quantity of Ice-Cream Cones
Supply
Initialequilibrium
D
D
3. . . . and a higherquantity sold.
2. . . . resultingin a higherprice . . .
1. Hot weather increasesthe demand for ice cream . . .
2.00
7
New equilibrium$2.50
10
Figure 11 How a Decrease in Supply Affects the Equilibrium
Copyright©2003 Southwestern/Thomson Learning
Price ofIce-Cream
Cone
0 Quantity of Ice-Cream Cones
Demand
Newequilibrium
Initial equilibrium
S1
S2
2. . . . resultingin a higherprice of icecream . . .
1. An increase in theprice of sugar reducesthe supply of ice cream. . .
3. . . . and a lowerquantity sold.
2.00
7
$2.50
4
Table 4 What Happens to Price and Quantity When Supply or Demand Shifts?
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Price Ceiling and Price Floors
Complete the exercises to learn about price floors and price ceilings.
Summary Demand The demand curve shows how the quantity of
a good depends upon the price. According to the law of demand, as the price
of a good falls, the quantity demanded rises. Therefore, the demand curve slopes downward.
In addition to price, other determinants of how much consumers want to buy include income, the prices of complements and substitutes, tastes, expectations, and the number of buyers.
If one of these factors changes, the demand curve shifts.
Summary Supply
The supply curve shows how the quantity of a good supplied depends upon the price. According to the law of supply, as the price of
a good rises, the quantity supplied rises. Therefore, the supply curve slopes upward.
In addition to price, other determinants of how much producers want to sell include input prices, technology, expectations, and the number of sellers.
If one of these factors changes, the supply curve shifts.
Summary Market Equilibrium
Market equilibrium is determined by the intersection of the supply and demand curves.
At the equilibrium price, the quantity demanded equals the quantity supplied.
The behavior of buyers and sellers naturally drives markets toward their equilibrium.
Summary Market Equilibrium
To analyze how any event influences a market, we use the supply-and-demand diagram to examine how the event affects the equilibrium price and quantity.
In market economies, prices are the signals that guide economic decisions and thereby allocate resources.
Review Exercises
Complete all exercises