The Basics of Supply and Demand

1. Chapter 2

The Basics of Supply
and Demand

2. Introduction

What are supply and demand?
What is the market mechanism?
What are the effects of changes in
market equilibrium?
What are elasticities of supply and
demand?
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Chapter 2
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3. Supply and Demand

Supply and demand analysis can:
1. Help us understand and predict how real
world economic conditions affect market
price and production
2. Analyze the impact of government price
controls, minimum wages, price supports,
and production incentives on the economy
3. Determine how taxes, subsidies, tariffs and
import quotas affect consumers and
producers
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4. Supply and Demand

The Supply Curve
The relationship between the quantity of a
good that producers are willing to sell and the
price of the good
Measures quantity on the x-axis and price on
the y-axis
Q S Q S (P)
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5. The Supply Curve

S
Price
($ per unit)
The Supply Curve,
Graphically Depicted
P2
The supply curve slopes
upward, demonstrating that
at higher prices firms
will increase output
P1
Q1
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Q2
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Quantity
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6. The Supply Curve

Other Variables Affecting Supply
Costs of Production
Labor
Capital
Raw
Materials
Lower costs of production allow a firm to
produce more at each price and vice versa
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7. Change in Supply

P
The cost of raw
materials falls
Produced Q1 at P1
and Q0 at P2
Now produce Q2 at P1
and Q1 at P2
Supply curve shifts
right to S’
S
P1
P2
Q0
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S’
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Q1
Q2
Q
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8. The Supply Curve

Change in Quantity Supplied
Movement along the curve caused by a
change in price
Change in Supply
Shift of the curve caused by a change in
something other than the price of the good
Change
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in costs of production
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9. Supply and Demand

The Demand Curve
The relationship between the quantity of a
good that consumers are willing to buy and
the price of the good
Measures quantity on the x-axis and price on
the y-axis
QD QD(P)
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10. The Demand Curve

Price
($ per unit)
The demand curve slopes
downward, demonstrating
that consumers are willing
to buy more at a lower price
as the product becomes
relatively cheaper.
P2
P1
D
Q1
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Q2
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Quantity
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11. The Demand Curve

Other Variables Affecting Demand
Income
Increases
in income allow consumers to
purchase more at all prices
Consumer Tastes
Price of Related Goods
Substitutes
Complements
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12. Change in Demand

Income Increases
P
D
D’
Purchased Q0, at P2
P2
and Q1 at P1
Now purchased Q1 at
P2 and Q2 at P1
Same for all prices P1
Demand curve shifts
right
Q0
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Q1
Q2
Q
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13. The Demand Curve

Changes in quantity demanded
Movements along the demand curve caused
by a change in price
Changes in demand
A shift of the entire demand curve caused by
something other than price
Income
Preferences
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14. The Market Mechanism

The market mechanism is the tendency
in a free market for price to change until
the market clears
Markets clear when quantity demanded
equals quantity supplied at the prevailing
price
Market clearing price – price at which
markets clear
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15. The Market Mechanism

S
Price
($ per unit)
The curves intersect at
equilibrium, or marketclearing, price.
Quantity demanded
equals quantity
supplied at P0
P0
D
Q0
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Quantity
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16. The Market Mechanism

In equilibrium
There is no shortage or excess demand
There is no surplus or excess supply
Quantity supplied equals quantity demanded
Anyone who wants to buy at the current price
can and all producers who want to sell at that
price can
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17. Market Surplus1

The market price is above equilibrium
There is excess supply - surplus
Downward pressure on price
Quantity demanded increases and quantity
supplied decreases
The market adjusts until new equilibrium is
reached
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18. The Market Mechanism

Price
($ per unit)
S
1.
Surplus
P1
2.
3.
P0
4.
D
Q
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D
Q0
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QS
At P1, price is
above the
market clearing
price
Qs > QD
Price falls to
the marketclearing price
Market adjusts
to equilibrium
Quantity
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19. The Market Mechanism

The market price is below equilibrium:
There is excess demand - shortage
Upward pressure on prices
Quantity demanded decreases and quantity
supplied increases
The market adjusts until the new equilibrium
is reached
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20. The Market Mechanism

Price
($ per unit)
1.
2.
3.
P3
4.
P2
D
Shortage
QS
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Q
3
Chapter 2
At P2, price is
below the
market
clearing price
Q D > QS
Price rises to
the marketclearing price
Market adjusts
to equilibrium
QD
Quantity
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21. The Market Mechanism

Supply and demand interact to determine
the market-clearing price
When not in equilibrium, the market will
adjust to reduce a shortage or surplus
and return the market to equilibrium
Markets must be competitive for the
mechanism to be efficient
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22. Changes in Market Equilibrium

Equilibrium prices are determined by the
relative level of supply and demand
Changes in supply and/or demand will
cause change in the equilibrium price
and/or quantity in a free market
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23. Changes in Market Equilibrium

Raw material prices
fall
P
D
S
S’
S shifts to S’
Surplus at P1 between
Q1, Q2
P1
Price adjusts to
equilibrium at P3, Q3 P3
Q1 Q3Q2
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Q
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24. Changes in Market Equilibrium

P
Income Increases
D
D’
S
Demand increases to
D’
Shortage at P1 of Q1 P3
to Q2
P1
Equilibrium at P3 and
Q3
Q1 Q3 Q
Q
2
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25. Changes in Market Equilibrium

Income increases
and raw material
prices fall
Quantity increases
If the increase in D is
greater than the
increase in S price
also increases
P
D
D’
S S’
P2
P1
Q1
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Q2
Q
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26. Shifts in Supply and Demand

When supply and demand change
simultaneously, the impact on the
equilibrium price and quantity is
determined by:
1. The relative size and direction of the
change
2. The shape of the supply and demand
models
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27. Elasticities of Supply and Demand

Not only are we concerned with what direction
price and quantity will move when the market
changes, but we are concerned about how
much they change
Elasticity gives a way to measure by how much
a variable will change with the change in
another variable
Specifically, it gives the percentage change in
one variable resulting from a one percent
change in another
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28. Price Elasticity of Demand

Measures the sensitivity of quantity
demanded to price changes
It measures the percentage change in the
quantity demanded of a good that results
from a one percent change in price
% Q D
E
% P
D
P
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29. Price Elasticity of Demand

The percentage change in a variable is
the absolute change in the variable
divided by the original level of the
variable
Therefore, elasticity can also be written
as:
Q Q P Q
E
P P Q P
D
P
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30. Price Elasticity of Demand

Usually a negative number
As price increases, quantity decreases
As price decreases, quantity increases
When |EP| > 1, the good is price elastic
|% Q| > |% P|
When |EP| < 1, the good is price inelastic
|% Q| < |% P|
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31. Price Elasticity of Demand

The primary determinant of price
elasticity of demand is the availability of
substitutes
Many substitutes, demand is price elastic
Can
easily move to another good with price
increases
Few substitutes, demand is price inelastic
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32. Price Elasticity of Demand

Looking at a linear demand curve, as we
move along the curve Q/ P is constant,
but P and Q will change
Price elasticity of demand must therefore
be measured at a particular point on the
demand curve
Elasticity will change along the demand
curve in a particular way
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33. Price Elasticity of Demand

Given a linear demand curve
Elasticity depends on slope and on the
values of P and Q
The top portion of demand curve is elastic
Price
is high and quantity small
The bottom portion of demand curve is
inelastic
Price
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is low and quantity high
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34. Price Elasticity of Demand

Price
4
EP = -
Demand Curve
Q = 8 – 2P
Elastic
Ep = -1
2
Inelastic
4
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Q
Ep = 0
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35. Price Elasticity of Demand

The steeper the demand curve, the more
inelastic the demand for the good
becomes
The flatter the demand curve, the more
elastic the the demand for the good
becomes
Two extreme cases of demand curves
Completely inelastic demand – vertical
Infinitely elastic demand – horizontal
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36. Infinitely Elastic Demand

Price
EP =
D
P*
Quantity
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37. Completely Inelastic Demand

Price
D
EP = 0
Q*
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38. Other Demand Elasticities

Income Elasticity of Demand
Measures how much quantity demanded
changes with a change in income
Q/Q I Q
EI
I/I Q I
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39. Other Demand Elasticities

Cross-Price Elasticity of Demand
Measures the percentage change in the
quantity demanded of one good that results
from a one percent change in the price of
another good
EQb Pm
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Qb Qb Pm Qb
Pm Pm Qb Pm
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40. Other Demand Elasticities

Complements: Cars and Tires
Cross-price elasticity of demand is negative
Price
of cars increases, quantity demanded of
tires decreases
Substitutes: Butter and Margarine
Cross-price elasticity of demand is positive
Price
of butter increases, quantity of margarine
demanded increases
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41. Price Elasticity of Supply

Measures the sensitivity of quantity
supplied given a change in price
Measures the percentage change in quantity
supplied resulting from a 1 percent change in
price
% Q S
E
% P
S
P
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42. Point vs. Arc Elasticities

Point elasticity of demand
Price elasticity of demand at a particular
point on the demand curve
Arc elasticity of demand
Price elasticity of demand calculated over a
range of prices
E PD
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ΔQ
P
ΔP Q
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43. Short-Run Versus Long-Run Elasticity

Price elasticity varies with the amount of
time consumers have to respond to a
price
Short-run demand and supply curves
often look very different from their longrun counterparts
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44. Short-Run Versus Long-Run Elasticity

Demand
In general, demand is much more price
elastic in the long run
Consumers
take time to adjust consumption
habits
Demand might be linked to another good that
changes slowly
More substitutes are usually available in the
long run
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45. Gasoline: Short-Run and Long-Run Demand Curves

Price
DSR
• People cannot easily
adjust consumption in
the short run.
• In the long run, people
tend to drive smaller and
more fuel efficient cars.
DLR
Quantity of Gas
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46. Short-Run Versus Long-Run Elasticity

Demand and Durability
For some durable goods, demand is more
elastic in the short run
If goods are durable, then when price
increases, consumers choose to hold on to
the good instead of replacing it
But in long run, older durable goods will have
to be replaced
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47. Cars: Short-Run and Long-Run Demand Curves

Price
DLR
• Initially, people may put
off immediate car
purchase
• In long run, older cars
must be replaced
DSR
Quantity of Cars
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48. Short-Run Versus Long-Run Elasticity

Income elasticity also varies with the
amount of time consumers have to
respond to an income change
For most goods and services, income
elasticity is larger in the long run
When income changes, it takes time to
adjust spending
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49. Short-Run Versus Long-Run Elasticity

Income elasticity of durable goods
Income elasticity is less in the long run than
in the short run
Increases
in income mean consumers will want
to hold more cars
Once older cars are replaced, purchases will
only be to replace old cars
Less purchases from income increase in long
run than in short run
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50. Short-Run Versus Long-Run Elasticity

Most goods and services:
Long-run price elasticity of supply is greater
than short-run price elasticity of supply
Other Goods (durables, recyclables):
Long-run price elasticity of supply is less
than short-run price elasticity of supply
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51. Short-Run Versus Long-Run Elasticity

SSR
Price
SLR
Due to limited
capacity, firms
are limited by
output constraints
in the short run.
In the long run, they
can expand.
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Quantity Primary Copper
51

52. Predicting the Effects of Changing Market Conditions

Supply and demand analysis can be
used to predict the effects of changing
market conditions
Linear demand and supply must be fit to
market data
Given
equilibrium price and quantity along with
elasticities of supply and demand, we can
calculate the curves that fit the information
We can then calculate changes in the market
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53. Predicting the Effects of Changing Market Conditions

We know
Equilibrium Price, P*
Equilibrium Quantity, Q*
Price elasticity of supply, ES
Price elasticity of demand, ED
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54. Predicting the Effects of Changing Market Conditions

Let’s begin with the equations for supply,
demand, elasticity:
Demand: PD = a – bQ
Supply: PS = c + dQ
Elasticity: (P/Q)( Q/ P)
We must calculate numbers for a, b, c,
and d.
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55. Predicting the Effects of Changing Market Conditions

The slope of the demand curve above
equals Q/ P which equals -b
The slope of the supply curve above
equals Q/ P which equals d
Demand: ED = -b(P*/Q*)
Supply: ES = d(P*/Q*)
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56. Predicting the Effects of Changing Market Conditions

We have written supply and demand so
that they only depend upon price
Demand could also depend upon other
variables such as income
Demand would then be written as:
Q a bP fI
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57. Effects of Price Controls

Markets are rarely free of government
intervention
Imposed taxes and granted subsidies
Price controls
Price controls usually hold the price
above or below the equilibrium price
Excess demand – shortage
Excess supply – surplus
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58. Effects of Price Controls

Price
S
• Price is regulated to
be no higher than Pmax
• Quantity supplied
falls and quantity
demanded increases
• A shortage results
P0
Pmax
Shortage
QS
©2005 Pearson Education, Inc.
Q0
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D
QD Quantity
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59. Effects of Price Controls

Excess demand sometimes takes the
form of queues
Lines at gas stations during 1974 shortage
Sometimes get curtailments and supply
rationing
Natural gas shortage of the mid ’70’s
Producers typically lose, but some
consumers gain. Some consumers lose.
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