Demand and Supply Analysis
CHAPTER
3
© 2003 South-Western/Thomson Learning
1
Demand
Demand indicates how much of a good
consumers are both willing and able to
buy at each possible price during a
given time period, other things constant
Useful to think of demand as the planned
rate of purchase per period at each possible
price
Emphasis on individual being both willing
and able to buy is critical to demand
2
Law of Demand
Says that quantity demanded varies
inversely with price, other things
constant
The higher the price, the smaller the
quantity demanded
The lower the price, the larger the quantity
demanded
3
Demand, Wants, and Needs
Consumer demand and wants are not
the same thing
Wants ignore the importance of ability to
buy as expressed by a person’s budget
Nor is demand the same as need
Need focuses on the willingness and again
ignores the ability to purchase
4
Law of Demand
What explains the law of demand?
Specifically, why is more demanded
when the price is lower?
The explanation begins with unlimited
wants confronting scarce resources
Many goods and services are capable of
satisfying any particular want
5
Law of Demand
Clearly, some ways of satisfying your
wants are more appealing than others
In a world without scarcity, everything
would be free  person would always
choose the most attractive alternative
However, scarcity is a reality  the
degree of scarcity of one good relative
to another helps determine each good’s
relative price
6
Substitution Effect
Recall that the definition of demand
includes the “other things constant”
assumption
Among the “other things” are the prices of
other goods
For example, when the price of pizza
declines while other prices remain
constant, pizza becomes relatively
cheaper  consumers are more willing
to purchase pizza when its relative price
falls  they tend to substitute pizza for
other goods
7
Substitution Effect
Substitution Effect
When the price of a good falls, its relative
price makes consumers more willing to
purchase this good
Alternatively, when the price of a good
increases, its relative price makes
consumers less willing to purchase this
good
Important to remember that it is the
change in the relative price – the price
of one good compared to the prices of
other goods – that causes the
substitution effect
8
Income Effect
Money income is simply the number of
dollars received per period of time
Real income is person’s income
measured in terms of the goods and
services it can buy  purchasing power
When the price of a good decreases, a
person’s real income increases  increased
ability to buy a good  increase in quantity
demanded
When the price of a good increases  real
income declines  reduces the ability to buy
a good  decline in quantity demanded
9
Exhibit 1: Demand Schedule
& Demand Curve for Pizza
(a) Demand Schedule
(b) Demand Curve
a) $15
b)
12
c)
9
d)
6
e)
3
Quantity Demanded
per Week (millions)
8
14
20
26
32
The price is for a 12 inch regular
pizza and the time period is 1 week.
The demand schedule lists possible
prices, along with the quantity
demanded at each price. The
demand curve at the right shows
each price / quantity combination
listed in the demand schedule as a
point on the demand curve.
$18
$15
Price per Pizza
Price per
Pizza
a
$12
b
$9
c
$6
d
$3
e
$0
8
14
20
26
32
Millions of Pizzas per week
10
Demand and Quantity Demanded
An individual point on the demand
curve shows the quantity demanded
at a particular price
a
$15.00
Price per quart
Demand for pizza is not a specific
quantity, but rather the entire
relation between price and
quantity demanded, and is
represented by the entire demand
curve
For example, at a price of $12, the
quantity demanded is 14 million
pizzas per week
The movement from say, b to c, is a change
in quantity demanded and is shown as a
movement along the demand curve and can
only be caused by a change in price
b
12.00
c
9.00
d
6.00
e
3.00
D
0
8
14
20 26
32
Millions of pizzas per week
11
Individual Demand Market Demand
Individual demand refers to the demand
of an individual consumer
Market demand is the sum of the
individual demands of all consumers in
the market
Important: Unless otherwise noted, we
will be referring to market demand
12
Shifts of the Demand Curve
Demand curve focuses on the
relationship between the price of a good
and the quantity demanded when other
factors that could affect demand remain
unchanged
Money income of consumers
Prices of related goods
Consumer expectations
Number and composition of consumers in
the market
Consumer tastes
13
Exhibit 2: Increase in the Market Demand
Suppose income now
increases  some consumers
will now be able to buy more
pizza at each price 
market demand increases
from D to D'.
For example, at a price of
$12, the amount of pizza
demanded increases from 14
to 20 million per week as
shown by the movement from
b on demand curve D to point
f on demand curve D'.
An increase in
demand 
rightward shift
in the demand
curve 
consumers are
willing and able
to buy more at
each price.
Price
The original demand curve
is given as D, and assumes
a certain level of money
income.
$15
b
12
f
9
6
D'
3
D
0
8
14
20
26
Millions of pizzas per week
32
While not shown, a decrease in demand  leftward shift in the demand curve 
means consumers are willing and able to buy less at each price.
14
Changes in Consumer Income
Goods can be classified into two broad
categories depending on how the
demand for the good responds to
changes in money income
Normal goods: the demand increases when
income increases and decreases when
income decreases
Inferior goods: the demand decreases
when income increases and increases when
income decreases
• As income increases, consumers tend to switch
from consuming these goods to consuming
normal goods
15
Changes in the Prices of Related Goods
The prices of other goods are another of
the factors assumed constant along a
given demand curve
Two general relationships
Two goods are substitutes if an increase in
the price of one shifts the demand for the
other rightward and, conversely, if a
decrease in the price of one shifts the
demand for the other good leftward
Two goods are complements if an increase
in the price of one shifts the demand for the
other leftward and a decrease in the price of
one shifts the demand for the other
rightward
16
Changes in Consumer Expectations
A change in consumer expectations with
respect to future prices and future
incomes is another of the factors which
shifts demand
Changes in income expectations
If individuals expect income to increase in
the future, current demand increases and
vice versa
If individuals expect prices to increase in
the future, current demand increases and
decreases if future prices are expected to
decrease
17
Number or Composition of Consumers
Because the market demand curve is the
sum of the individual demand curves, a
change in the number of consumers
changes demand
Increase in the number of consumers 
increase in market demand
Decrease in the number of consumers 
decrease in market demand
Changes in the population that consumes
pizza , for example, will change the
demand for pizza
18
Changes in Consumer Tastes
Tastes are nothing more than a person’s
likes and dislikes as a consumer
Difficult to say what determines tastes
but clearly they are important
And whatever factors change taste will
clearly change demand
19
Reminder
Important to remember the distinction
between a movement along a given
demand curve and a shift of the demand
curve
A change in price, other things constant,
causes a movement along a demand curve
 changing quantity demanded
A change in one of the determinants of
demand other than price causes a shift of a
demand curve  changing demand
20
Supply
Supply indicates how much of a good
producers are willing and able to offer
for sale per period at each possible
price, other things constant
Law of supply states that the quantity
supplied is usually directly related to its
price, other things constant
The lower the price, the smaller the quantity
supplied
The higher the price, the greater the
quantity supplied
21
Exhibit 3: Supply Schedule and Curve for Pizzas
Supply Schedule
Price per
Pizza
$15
12
9
6
3
Quantity Supplied
per Week (millions)
28
24
20
16
12
Both the supply curve and the supply
schedule show the quantities of pizza
supplied per week at various prices by
all the pizza makers in the market.
Price and quantity supplied are directly,
or positively related.
Producers offer more for sale at higher
prices than at lower prices  the supply
curve slopes upward.
S
Price
$15
12
9
6
3
0
12 16 20 24 28
Millions of pizzas per week
22
Law of Supply
Two reasons producers tend to offer
more for sale when the price rises
First, as the price increases, other
things constant, a producer becomes
more willing to supply the good
Prices act as signals to existing and
potential suppliers about the rewards for
producing various goods  higher prices
attract resources from lower-valued uses
23
Law of Supply
Second, higher prices also increase the
producer’s ability to supply the good
The law of increasing opportunity costs 
the marginal cost of production increases as
output increases
Since producers face a higher marginal cost
of production, they must receive a higher
price for that output in order to be able to
increase the quantity supplied
24
Supply and Quantity Supplied
Supply refers to the relation between
the price and quantity supplied as
reflected by the supply schedule or the
supply curve
Quantity supplied refers to a particular
amount offered for sale at a particular
price  particular point on a given
supply curve
25
Individual Supply and Market Supply
Individual supply refers to the supply of
an individual producer
Market supply is the sum of individual
supplies of all producers in the market
Unless otherwise noted, we will be
referring to market supply
26
Shifts of the Supply Curve
Assumed constant along a supply curve
are the determinants of supply other
than the price of the good
State of technology
Prices of relevant resources
Prices of alternative goods
Producer expectations
Number of producers in the market
27
Changes in Technology
If a more efficient technology is
discovered, production costs fall 
suppliers will be more willing and more
able to supply the good  rightward
shift of the supply curve
See Exhibit 4
28
Exhibit 4: An Increase in the Supply of Pizza
The result of the increase
in supply is that more is
supplied at each possible
price. E.g., when the price
is $12, the amount
supplied increases from
24 million to 28 million
pizzas, as shown by the
movement from point g to
point h.
S
S'
$15.00
Price per quart
Suppose we begin with
the initial supply curve
as S. A new high-tech
oven bakes pizza in half
the time, and the impact
of this is that the supply
curve shifts from S to S'.
12.00
g
h
9.00
6.00
3.00
0
12 16 20 24 28
Millions of pizzas per week
29
Changes in the Prices of Relevant Resources
Relevant resources are those employed
in the production of the good in
question
For example, if the price of mozzarella
cheese falls, the cost of pizza
production declines  supply increases
 shifts to the right
Conversely, if the price of some relevant
resource increases  supply decreases
 shifts to the left
30
Prices of Alternative Goods
Nearly all resources have alternative
uses
Alternative goods are those that use
some of the same resources employed
to produce the good under
consideration
For example, as the price of bread increases,
so does the opportunity cost of producing
pizza  the supply of pizza declines
Conversely, a fall in the price of an
alternative good makes pizza production
more profitable  supply increases
31
Changes in Producer Expectations
Changes in producer expectations with
respect to the future can change current
supply
If pizza suppliers expect higher prices in
the future, they may begin to expand
today  current supply shifts rightward
 increases
When a good can be easily stored,
expecting future prices to be higher
may reduce current supply
More generally, any change expected to
affect future profitability could shift the
supply curve
32
Changes in the Number of Producers
Since market supply sums the amounts
supplied at each price by all producers,
the market supply depends on the
number of producers in the market
If that number increases, supply
increases  shifts to the right
If the number of producers decreases,
supply will decrease  shift to the left
33
Reminder
Remember the distinction between a
movement along a supply curve and a
shift of a supply curve
A change in price, other things constant,
causes a movement along a supply
curve, changing the quantity supplied
A change in one of the determinants of
supply other than the price causes a
shift of the supply curve  changing
supply
34
Demand and Supply Create a Market
Demanders and suppliers have different
views of price
Demanders pay the price
Suppliers receive it
Thus, a higher price is bad news for
consumers but good news for producers
As the price rises, consumers reduce
their quantity demanded along the
demand curve and producers increase
their quantity supplied along the supply
curve
35
Markets
A market sorts out the conflicting price
perspectives of individual participants –
buyers and sellers
Market represents all the arrangements
used to buy and sell a particular good or
service
Markets reduce the transaction costs of
exchange – the costs of time and
information required for exchange
The coordination that occurs through
markets occurs because of Adam
Smith’s invisible hand
36
Exhibit 5b: The Market for Pizzas
Suppose the initial
price is $12 
producers supply 24
million pizzas per
week as shown by the
supply curve while
consumers demand
only 14 million 
excess quantity
supplied (or surplus)
of 10 million pizzas
per week
S
Price
$15.00
This surplus and suppliers’
desire to eliminate it put
downward pressure on the
price, as symbolized by the
arrow pointing down in the
graph
Surplus
12.00
c
9.00
6.00
3.00
D
0
16
20
24
Millions of pizzas per week
As the price falls, producers reduce their quantity
supplied and consumers increase their quantity
demanded and the market moves towards
equilibrium at point c
37
Exhibit 5b: The Market for Pizzas
Price
Alternatively, suppose
the price is initially $6
per pizza. At this price $15.00
consumers demand 26
12.00
million pizzas but
producers supply only
9.00
16 million  an excess
quantity demanded (or a
6.00
shortage) of 10 million
pizzas per week.
3.00
Producers quickly notice
that the quantity supplied
has sold out and those
customers still demanding
pizzas are grumbling 
pressures for higher prices
as shown by the arrow
S
c
Shortage
D
0
16
20
26
Millions of pizzas per week
As prices increase, producers increase their quantity
supplied and consumers reduce their quantity demanded
until the equilibrium price of $9 at point c is reached
38
Summary
A surplus creates downward pressure
on the price and a shortage creates
upward pressure
So long as quantity supplied and
quantity demanded differ, prices will
tend to change
Note that a shortage or a surplus must
always be defined at a particular price
39
Equilibrium
When the quantity that consumers are
willing and able to pay equals the
quantity that producers are willing and
able to sell, the market reaches
equilibrium  the independent plans of
both buyers and sellers exactly match
 market forces exert no pressure to
change price or quantity
In our example, this occurs at point c 
price = $9 per pizza and quantity is 20
million pizzas per week
40
Equilibrium
In one sense, the market is personal
because each consumer and each
producer makes a personal decision
regarding how much to buy or sell at a
given price
In another sense, the market is
impersonal because it requires no
conscious coordination among
consumers or producers
Market forces synchronize the personal
and independent decisions of many
individual buyers and sellers
41
Changes in Equilibrium
Once a market reaches equilibrium, that
price and quantity will prevail until one
of the determinants of demand or
supply changes
A change in any one of these
determinants will usually change
equilibrium price and quantity in a
predictable way
42
Exhibit 6: Effects of an Increase in Demand
The initial equilibrium price
is given by D and S  $9 and
20 million pizzas per week.
Price
S
Now suppose that one of
the determinants of
demand changes in a
$12
way that increases
demand  demand
9
shifts from D to D'.
After demand increases
to D', the amount
demanded at the initial
price of $9 is 30 million
pizzas which exceeds the
amount supplied of 20
million pizzas 
shortage  upward
pressure on price.
D'
D
0
20
24
30 Millions of pizzas per week
As the price increases, the quantity demanded decreases along
the new demand curve, D', and the quantity supplied increases
along the existing supply curve S until the two quantities are
again equal to each other at a price of $12 and a quantity of 24
43
million pizzas per week.
Shifts of the Demand Curve
Thus, given an upward-sloping demand
curve, an increase in demand  a
rightward shift of the demand curve
increases both the equilibrium price and
quantity
Alternatively, a decrease in demand  a
leftward shift of the demand curve
reduces both the equilibrium price and
quantity
44
Exhibit 7: Effects of an Increase in Supply
Again, suppose that we begin with S
and D as the initial supply and
demand curves  the amount
demanded at the initial price of
$9.00 is 20 million pizzas.
S
S'
Suppose supply now increases as
shown by the shift from S to S'.
After supply increases, the amount
supplied at the initial price of $9
increases from 20 to 30 million
pizzas per week  a surplus 
downward pressure on the price 
the quantity supplied declines along
the new supply curve and the
quantity demanded increases along
the existing demand curve until the
new equilibrium is reached at $6
and the quantity is 26 million pizzas
per week
$9
6
D
20
26 30
Millions of Pizzas per Week
45
Shifts of the Supply Curve
An increase in supply  a rightward
shift of the supply curve reduces the
equilibrium price but increases
equilibrium quantity
On the other hand, a decrease in supply
 a leftward shift of the supply curve
increases equilibrium price but
decreases equilibrium quantity
46
Shifts of the Supply Curve
Given a downward-sloping demand
curve, a rightward shift of the supply
curve will decrease but increase
quantity
A leftward shift will increase price but
decrease quantity
47
Simultaneous Shifts in Demand and Supply
As long as only one curve shifts, we can
say for sure what will happen to
equilibrium price and quantity
If both curves shift, however, the
outcome is less obvious
This possibility is shown in Exhibit 8
48
Exhibit 8: Indeterminate Effect of an
Increase in Both Supply and Demand
a) Shift in demand dominates
The initial supply and demand
curves are shown as D and S
 p and Q are the initial price
and quantity.
Suppose that supply and
demand both increase 
shift to the right. Further
suppose that demand shifts
more than supply as shown
by D' and S'.
In this instance, price and
quantity both increase to p'
and Q'.
S
S'
p'
p
D'
D
0
Q
Q'
Units per period
Conversely, if both demand and supply were to decrease – for example, from D‘ S‘
to D / S with the decline in demand dominating, the equilibrium quantity would
decrease and price would decline.
49
Exhibit 8: Indeterminate Effect of an
Increase in Both Supply and Demand
b) Shift in supply dominates
Price
S
Again, suppose both supply and
demand increase but in this case,
supply shifts by more than
demand  price decreases from
p to p"and quantity increases.
S"
p
Alternatively, if both supply and
demand decrease with the shift
in supply dominating  price
will increase and quantity will
decrease.
p"
D"
D
0
Q Q"
Units per period
50
Summary
If demand and supply shift in opposite
directions, we can say what will happen
to equilibrium price
It will increase if demand increases and
supply decreases
It will decrease if demand decreases and
supply increases
Without reference to the size of the
shifts, we cannot say what will happen
to equilibrium quantity
Exhibit 9 summarizes these results
51
Exhibit 9: Effects of Changes in Both
Supply and Demand
Change in Demand
Change in Supply
Demand increases
Supply
increases
Supply
decreases
Equilibrium
price change
is indeterminate.
Demand decreases
Equilibrium
price falls.
Equilibrium
quantity increases.
Equilibrium
quantity change
is indeterminate.
Equilibrium
price rises.
Equilibrium price
change is indeterminate.
Equilibrium
quantity change
is indeterminate.
Equilibrium
quantity decreases.
52
Disequilibrium Prices
Markets do not always reach
equilibrium quickly and during the time
required for adjustment, the market is
in disequilibrium
Disequilibrium is usually temporary as
the market gropes for equilibrium
Sometimes, as a result of government
intervention in markets, disequilibrium
can last a long time
53
Exhibit 11a: Effects of a Price Floor
The federal government often regulates the
prices of agricultural commodities in an attempt
to ensure farmers a higher and more stable
income than they would otherwise earn.
S
To achieve higher prices, the federal
government sets a price floor  a minimum
selling price that is above the equilibrium price
Surplus
$2.50
Suppose it places a $2.50 per gallon price floor
for milk. At this price, farmers supply 24 million
gallons per week, but consumers demand only 14
million gallons  a surplus of 10 million gallons
This surplus milk will spoil if it sets on store shelves.
As a result of this price support program, the
government spends billions of dollars buying and
storing surplus agricultural products.
$1.90
D
0
14 19 24
Millions of gallons per month
54
Exhibit 11b: Effects of a Price Ceiling
Sometimes public officials try to keep
prices below the equilibrium levels by
establishing a price ceiling, or a maximum
selling price
A common example is rent control in
some cities. The market-clearing rent
is $1,000 per month with 50,000
apartments being rented.
S
$1000
$600
Shortage
Now suppose the government decides
to set a maximum rent of $600. At this
ceiling price, 60,000 rental units are
demanded, but only 40,000 are
supplied (a shortage).
D
0
40 50 60
Thousands of rental units per month
55
Summary
To have an impact, a price floor must be
set above the equilibrium price and a
price ceiling must be set below the
equilibrium price
Effective price floors and ceilings distort
markets in that they create a surplus
and a shortage, respectively
In these situations, various nonprice
allocation devices emerge to cope with
the disequilibrium resulting from the
intervention
56