HISTORY OF SUPPLY AND DEMAND
The Question to be Addressed:
What Determines the Price of
the Good?
WHAT DETERMINES THE PRICE OF A
GOOD?
 An Answer from David Ricardo and Karl Marx…
 The Labor Theory of Value - The price of a good is
determined by the cost of production, and the cost of
production is dictated by the quantity and quality of labor
utilized.
 What of the other factors of production?
 Capital: Capital is simply stored up labor.
 Land: Ricardo argued that the price of corn determined
the price of land, rather than the price of land
determining the price of corn. In other words, the price
of land is price determined, not price determining.
 What about demand? In the long-run, assuming
competition, price will equal the cost of production. This
comes directly from the work of Adam Smith
MORE ON THE LABOR THEORY OF VALUE
 Karl Marx wished to show that even if capitalism
worked exactly as Ricardo believed, capitalism
was still a very poor economic system.
 Consequently, Marx utilized the labor theory of
value to explain prices.
 Given this explanation, Marx offered the
following argument: If the value of labor
determines value, and value mostly is given to
the owners of capital, is it not the case that labor
is exploited?
UTILITY THEORY
 Karl Marx published Das Kapital in 1867. In the
early 1870s, three different writers – Stanley
Jevons, Leon Walras, Carl Menger – offered a
different answer to “what determines prices?”
 Utility - the satisfaction one receives from a good.
 “The fact is, that labor once spent has no
influence on the future value of any article: it is
gone and lost forever. In commerce, bygones are
for ever bygones.” W.S. Jevons, 1871
THE MARSHALLIAN CROSS
 Marshall addressed the issue of what determines prices by
considering the impact of time:
 If one considered the very short-run, where supply was
fixed, Jevons, Menger and Walras were correct. Prices were
solely determined by demand.
 If one considers the long-run, where firms can enter and
exit the industry, the price of the good will equal the cost of
production. Hence, Ricardo and Marx are mostly correct.
 If one considers the short-run, where firms can alter
supply in response to price changes, then both supply and
demand will determine prices.
 Hence we have the Marshallian Cross, or what we call
today the basic model of supply and demand
Demand (definitions)
Market - group of buyers and sellers of a particular good or service.
Demand - To be considered in demand for a good you must be able and
willing to purchase the good in various quantities at various prices.
The Law of Demand - Quantity demanded rises as price falls, ceteris
paribus. Quantity demanded falls as price rises, ceteris paribus
Quantity demanded - refers to a specific amount that will be demanded
per unit of time at a specific price, ceteris paribus.
Law of Diminishing Marginal Utility - states that for a given time period,
the marginal (additional) utility or satisfaction gained by consuming
equal successive units of a good will decline as the amount consumed
increases.
Demand curve - a curve relating how much a good is demanded at
various prices.
McGraw-Hill/Irwin
THE DEMAND CURVE

P
A demand curve is the graphic representation of
the relationship between price and quantity demanded
The demand curve is
downward sloping
P1
As price increases,
quantity demanded
decreases
P0
Demand
Q1
Q0
Q
Colander, Economics
7
Demand Shift Factors
Normal good - a good the demand for which rises as
income rises.
Inferior goods - a good the demand for which falls as
income rises.
Substitutes - two goods that satisfy similar needs or
desires. If two goods are substitutes then as the price of
one rises, demand for the other good will increase.
Complements - two goods that are used jointly in
consumption. If two goods are complements then as the
price of one rises, demand for the other good will
decrease.
More Demand Shift Factors
Number of buyers and sellers in a market
Tastes and Preferences
Expectations
and… taxes (more on this later)
P
$2
Movement along a demand curve
McGraw-Hill/Irwin
SHIFTS IN DEMAND VERSUS MOVEMENTS ALONG A DEMAND
CURVE
A change in price
causes a movement along
the demand curve
B
A
$1
Demand
100
Q
200
Colander, Economics
10
P
Shift in demand
McGraw-Hill/Irwin
SHIFTS IN DEMAND VERSUS
MOVEMENTS ALONG A DEMAND CURVE
A change in a shift factor
causes a shift in demand
$1
B
150
A
200
Demand0
Demand1
Q
11
Colander, Economics
Supply
Supply -To be considered to supply a good you must be able
and willing to produce (and sell) the good in various
quantities at various prices.
Law of Supply – as the price of a good rises, producers will
supply more of the good, ceteris paribus.
Supply curve - a curve relating how much a good is supplied
at various prices.
Supply Shift Factors
Prices of a factor of production (labor, land, capital)
Number of sellers
Price of a substitute in production (i.e. something else a producer can
produce)
Technology
and… taxes (more on this later)
McGraw-Hill/Irwin
THE SUPPLY CURVE
A supply curve is the graphic representation of the
relationship between price and quantity supplied
P

Supply
The supply curve is
upward sloping
P1
As price increases,
quantity supplied
increases
P0
Q0
Q
1
Q
Colander, Economics
14
Movement along a supply curve
P
McGraw-Hill/Irwin
SHIFTS IN SUPPLY VERSUS
MOVEMENTS ALONG A SUPPLY CURVE
Supply
C
$80
$50
A change in price
causes a movement along
the supply curve
B
4.1
4.3
Q
Colander, Economics
15
P
Shift in Supply
McGraw-Hill/Irwin
SHIFTS IN SUPPLY VERSUS
MOVEMENTS ALONG A SUPPLY CURVE
S0
S1
A change in a shift factor
causes a shift in supply
Q
Colander, Economics
16
Equilibrium and Disequilibrium
Equilibrium- when opposing dynamic forces cancel each
other out.
Equilibrium Price - The price at which the quantity
demanded of the good equals the quantity supplied.
Market Surplus - The amount by which the quantity
supplied exceeds the quantity demanded at a given price.
Market Shortage - The amount by which the quantity
demanded exceeds the quantity supplied at a given price.
P
Excess
supply
Supply
P1
P*
McGraw-Hill/Irwin
THE INTERACTION OF SUPPLY AND DEMAND
Excess supply
causes downward
pressure on price
Excess demand
causes upward
pressure on price
P0
Excess
demand
Demand
Q
18
Colander, Economics
Supply and Demand Example
Given: Income in a market increases for a normal good.
Impact
1.
2.
3.
4.
5.
6.
Demand for the good will increase.
At the current price quantity demand exceeds quantity supplied. Hence
there is a shortage.
Producers will raise price.
As price rises, producers will increase quantity supplied.
As price rises, consumers will decrease quantity demanded.
Producers will produce more and consumers will demand less until the
price of the good equates quantity supplied and quantity demanded.
Conclusion
◦
◦
Price of the good will rises.
Quantity produced and sold will also rise.
Limitations of Supply and Demand
1.
Other things do not remain constant: Simplistic, two dimensional, analysis
has problems.
2.
The Fallacy of Composition - the false assumption that what is true for a
part will also be true for the whole.
If one firm changes supply, demand is unaffected. If all firms increase
output, income also increases, thus changing demand.
If one firm changes price, quantity demand will change. If all firms
change prices, no change in demand is expected.
Absolute (money) price - the price of a good in money terms
Relative prices - the price of a good in terms of another good.
Demand is dictated by changes in relative prices, not changes in money
prices. i.e. if all prices change, demand is unchanged.
◦
◦
◦
◦
◦
CONSUMER SURPLUS
Willingness to Pay – the maximum amount
that a buyer will pay for a good.
Consumer Surplus – a buyer’s willingness to
pay minus the amount the buyer actually pays.
Use the demand curve to measure consumer
surplus.
NOTE: Consumer surplus measures the
benefits that buyers receive from a good as the
buyer themselves perceive it.
PRODUCER SURPLUS
Cost – the value of everything a seller must give up to produce a
good.
Producer Surplus – the amount a seller is paid for a good minus
the seller’s cost.
Using the supply curve to measure producer surplus.
TAXES
Tax Incidence – the study of who bears the burden
of taxation
A Tax on Buyers or Sellers
 A tax on buyers will shift the demand curve downward
by the size of the tax.
 A tax on sellers will shift the supply curve upward by the
size of the tax.
Lessons
 Taxes reduce output in the market
 Buyers and sellers share the burden of the tax
 The decision to tax depends upon a comparison of the
cost of taxation with the benefits of government
spending.
THE DEADWEIGHT LOSS
OF TAXATION
The tax may shift supply or demand,
depending upon whether the tax is placed on
the producers or the buyers.
To understand the cost of the tax, compare
welfare without the tax to welfare with the
tax.
After the tax, note the size of consumer
surplus, producer surplus, tax revenue and
deadweight loss.
The Effects of a Tax...
From a text by Gregory Mankiw
Price
Supply
Price buyers
pay
Size of tax
Price
without tax
Price sellers
receive
Demand
0
Quantity
with tax
Quantity
without tax
Quantity
Tax Revenue...
From a text by Gregory Mankiw
Price
Supply
Price buyers
pay
Size of tax (T)
Tax
Revenue
(T x Q)
Price sellers
receive
Quantity
sold (Q)
0
Quantity
with tax
Demand
Quantity
without tax
Quantity
How a Tax Affects Welfare...
From a text by Gregory Mankiw
Price
Price
buyers
pay = PB
Tax reduces consumer surplus by (B+C)
and producer surplus by (D+E)
A
B
Price
without = P1
tax
Price = PS
sellers
receive
0
Tax revenue = (B+D)
C
Deadweight Loss = (C+E)
E
D
Supply
F
Demand
Q2
Q1
Quantity
DEADWEIGHT LOSS OF
TAXATION, CONT.
Deadweight Loss and Tax Revenue as Taxes Vary
 The smaller the tax, the less deadweight loss will be created.
 The larger the tax, the greater the deadweight loss.
A Review of the Laffer Curve and Supply Side Economics
Deadweight Loss and Tax Revenue...
From a text by Gregory Mankiw
(a) Small Tax
Price
Supply
Deadweight
loss
PB
PS
Tax revenue
Demand
0
Q2 Q1
Quantity
Deadweight Loss and Tax Revenue...
From a text by Gregory Mankiw
(b) Medium Tax
Price
Supply
Deadweight
loss
PB
Tax
revenue
PS
Demand
0
Q2
Q1
Quantity
Deadweight Loss and Tax Revenue...
From a text by Gregory Mankiw
(c) Large Tax
Price
Supply
PB
Deadweight
loss
Demand
PS
0
Q2
Q1
Quantity
Deadweight Loss and Tax Revenue Vary with the Size of the Tax...
From a text by Gregory Mankiw
(a) Deadweight Loss
Deadweight
Loss
0
Tax Size
Deadweight Loss and Tax Revenue Vary with the Size of the Tax...
From a text by Gregory Mankiw
Tax
Revenue
0
(b) Revenue (the Laffer curve)
Tax Size