3
Demand, Supply, and
Market Equilibrium
3-1
Copyright 2008 The McGraw-Hill Companies
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
3-2
Copyright 2008 The McGraw-Hill Companies
Markets Defined
• Markets bring together buyers (demanders) and sellers
(suppliers) of particular goods and services. They take many
forms.
• A market may be local (fish), national (houses), or
international (oil) in scope.
• Some markets are highly personal, face-to-face exchanges
(fish); others are impersonal and remote (internet marketing).
• There are two types of markets
– product market (fish) involves goods and services.
– resource market (labor market) involves factors of production
3-3
Copyright 2008 The McGraw-Hill Companies
Demand
Demand 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.
P
QD
5
10
4
20
3
35
2
55
1
80
• 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.
3-4
Copyright 2008 The McGraw-Hill Companies
Individual Demand
P
6
P
$5
Qd
10
4
20
3
35
2
55
1
80
5
Price (per bushel)
Individual
Demand
4
3
2
1
0
D
10
20
30
40
50
60
70
80
Quantity Demanded (bushels per week)
3-5
Copyright 2008 The McGraw-Hill Companies
Q
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 demand
a. 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.
3-6
Copyright 2008 The McGraw-Hill Companies
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 effect
At 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).
3-7
Copyright 2008 The McGraw-Hill Companies
Determinants of Demand
• There are several determinants of demand or the “other
things,” besides price, which affect demand. A change in one
or more of the determinants of demand will cause the
demand data and therefore the location of the demand curve
to change. A shift in the demand curve is called a change in
demand
a. Tastes
• A favorable change in consumer tastes for a product means
that more of it will be demanded at each (current) price.
Demand will increase i.e., shifts rightward. Unfavorable
change will decrease demand (a shift leftward).
b. Number of buyers
• An increase in the number of buyers is likely to increase
demand; fewer buyers will probably decrease demand.
3-8
Copyright 2008 The McGraw-Hill Companies
c. Income
• for most products a rise in income causes an increase in
demand for superior or normal goods. Less leads to a
decrease in demand for normal goods. The rare case of
goods whose demand varies inversely with income is called
inferior goods, e.g., used cars.
d. Prices of related goods:
• A change in the price of related goods may either increase or
decrease the demand for a product depending on whether
the related good is a substitute or a complement.
i.
Substitutes (can be used in place of another good): if two
goods are substitutes, an increase in the price of one will
increase the demand for the other (i.e., directly related).
ii. Complements (goods that are used together, they are
demanded jointly): if the price of a complement increase, the
demand for the related good will decline, i.e., there is an
inverse relationship between the price of one and the
demand for the other.
3-9
Copyright 2008 The McGraw-Hill Companies
iii. Unrelated goods (independent goods). A change in the
price of one has little or no effect on the demand for the
other.
e. Consumer expectations
• A newly formed expectations of higher future prices may
cause consumers to buy now in order to beat the anticipated
price rises, this will shift the demand rightward, e.g., the real
estates market.
•
A change in expectations concerning future income may
prompt consumers to change their current spending.
Demand shifts rightward (in case of expected higher income)
or leftward (in case of expected lower income).
3-10
Copyright 2008 The McGraw-Hill Companies
Individual Demand
Demand Can Increase or Decrease
P
6
P
$5
Qd
10
4
20
3
35
2
55
1
80
5
Price (per bushel)
Individual
Demand
Increase in Demand
4
3
2
1
0
D2
Decrease in Demand
2
4
6
8
10
D1
D3
12
14
16
18 Q
Quantity Demanded (bushels per week)
3-11
Copyright 2008 The McGraw-Hill Companies
Individual Demand
Demand Can Increase or Decrease
An Increase in Demand
Means a shift
of the Line
P
6
P
$5
Qd
10
4
20
3
35
2
55
1
80
5
Price (per bushel)
Individual
Demand
A Movement Between
Any Two Points on a
Demand Curve is
Called a Change in
Quantity
Demanded
4
3
2
1
0
D2
Decrease in Demand
2
4
6
8
10
D1
D3
12
14
16
18 Q
Quantity Demanded (bushels per week)
3-12
Copyright 2008 The McGraw-Hill Companies
A summary of what can cause an increase in demand
a.
b.
c.
d.
e.
f.
g.
Favorable change in consumer tastes.
Increase in the number of buyers.
Rising income if product is a normal good.
Falling incomes if product is an inferior good.
Increase in the price of a substitute good.
Decrease in the price of a complementary good.
Consumer expectation of higher prices or incomes in the future.
A summary of what can cause a decrease in demand.
a.
b.
c.
d.
e.
f.
g.
Unfavorable change in consumer tastes.
Decrease in number of buyers.
Falling income if product is a normal good.
Rising income if product is an inferior good.
Decrease in price of a substitute good.
Increase in price of a complementary good.
Consumers expectation of lower prices or incomes in the future.
3-13
Copyright 2008 The McGraw-Hill Companies
Distinction between a change in quantity demanded and a
change in demand
1. A change in demand is a shift of the demand curve. It occurs
due to changes in one of the demand determinants. It will
shift the whole demand curve to the right (an increase in
demand) or to the left (a fall in demand).
2. A change in quantity demanded is a movement from on point
to another on a fixed demand schedule. It is caused by price
changes.
3-14
Copyright 2008 The McGraw-Hill Companies
Supply
Supply Defined
• Supply is a schedule or a curve that shows the various
amounts of a product that producers are willing and able to
make available for sale at each of a series of possible prices
during a specified time period.
Law of supply.
• All else equal, there is a positive or direct relationship
between price and quantity supplied. A supply schedule tells
us that firms will produce and offer for sale more of their
product at a high price that at a low price.
Explanation:
1. Revenue Implications. For a supplier price represents a
revenue, which serves as an incentive to produce and sell
a product. The higher the price, the greater the incentive
and the greater the quantity supplied.
3-15
Copyright 2008 The McGraw-Hill Companies
2. Marginal Cost. beyond some quantity of production
manufacturers usually encounter increasing marginal cost
(the added cast of producing one more unit of output).
Certain productive resources (e.g., machinery) cannot be
expanded quickly, producers will increase other resources
such as labor. As more labor are used the added output will
be less, and the marginal cost of successive units rises
accordingly. The producer will not produce more costly units
unless it receives a higher price for them.
The supply curve
• It shows a direct relationship between the price and quantity
supplied. The upward slop of the curve reflects the law of
supply – producers offer more of a good or a service or
resource for sale as its price rises.
3-16
Copyright 2008 The McGraw-Hill Companies
Individual Supply
P
6
P
$5
Qs
60
4
50
3
35
2
20
1
5
S1
5
Price (per bushel)
Individual
Supply
4
3
2
1
0
10
20
30
40
50
60
70
Quantity Supplied (bushels per week)
3-17
Copyright 2008 The McGraw-Hill Companies
Q
Market Supply
•
The sum of quantities supplied by each producer at each
price. It is obtained by horizontally adding the supply curves
of individual producers in the market.
Determinants of supply
•
A change in any of the supply determinants causes a
change in supply and a shift in the supply curve. An
increase in supply involves a rightward shift, and a
decrease in supply involves a leftward shift.
1.
•
•
Resource prices.
A higher resource prices raises production costs and
squeeze profits. The reduction in profits reduces the
incentive to supply output at each product price, supply
shifts leftward.
In contrast lower resource prices will reduce production
costs and increase profits, causing an increase in supply or
rightward shift in the supply curve.
3-18
Copyright 2008 The McGraw-Hill Companies
2.
Technology
A technological improvement means more efficient
production and lower costs, so an increase in supply or
rightward shift in the curve results.
3.
Taxes and subsidies
A business tax is treated as a cost, so decreases supply; a
subsidy lowers cost of production, so increases supply.
4.
Prices of related goods
If the price of substitute production good rises, producers
might shift production toward the higher-priced good
(alternative), causing a decrease in supply of the original
good.
3-19
Copyright 2008 The McGraw-Hill Companies
5.
•
Producer expectations
Expectations about the future price of a product can cause
producers to increase or decrease current supply.
6.
•
Number of sellers
Generally, the larger the number of sellers the greater the
supply.
Changes in quantity supplied and changes in supply
•
Distinction between a change in quantity supplied (due to
price changes) and a change or shift in supply (due to
change in determinants of supply).
3-20
Copyright 2008 The McGraw-Hill Companies
Individual Supply
Supply Can Increase or Decrease
P
6
P
$5
Qs
60
4
50
3
35
2
20
1
5
S1
5
Price (per bushel)
Individual
Supply
S3
S2
4
3
2
1
0
2
4
6
8
10
12
14
Quantity Supplied (bushels per week)
3-21
Copyright 2008 The McGraw-Hill Companies
Q
Individual Supply
Supply Can Increase or Decrease
P
6
P
$5
Qs
60
4
50
3
35
2
20
1
5
5
Price (per bushel)
Individual
Supply
A Movement Between
Any Two Points on a
Supply Curve is Called
a Change in Quantity
Supplied
S3
S1
S2
4
3
2
An Increase in Supply
Means a shift
of the Line
1
0
2
4
6
8
10
12
14
Quantity Supplied (bushels per week)
3-22
Copyright 2008 The McGraw-Hill Companies
Q
Market Equilibrium
•
•
•
Market Equilibrium: where quantity supplied equals the
quantity demanded:
Equilibrium price
Equilibrium quantity
•
At prices above this equilibrium, note that there is an
excess quantity supplied or surplus.
•
At prices below this equilibrium, note that there is an
excess quantity demanded or shortage.
•
Market clearing or market price is another name for
equilibrium price.
3-23
Copyright 2008 The McGraw-Hill Companies
Market Equilibrium
200 Buyers & 200 Sellers
Market
Demand
200 Buyers
Qd
$5
2,000
4
4,000
3
7,000
2
11,000
1
6
6,000 Bushel
Surplus
5
Price (per bushel)
P
Market
Supply
200 Sellers
S
4
3
Qs
$5
12,000
4
10,000
3
7,000
2
4,000
1
1,000
2
16,000
7,000 Bushel
Shortage
1
0
2
4
6 7 8
10
D
12
14
16
18
Bushels of Corn (thousands per week)
3-24
P
Copyright 2008 The McGraw-Hill Companies
• Graphically, note that the equilibrium price and quantity are
where the supply and demand curves intersect. Note also that
it is NOT correct to say supply equals demand!
The rationing function of prices
• Is the ability of competitive forces of supply and demand to
establish a price at which selling and buying decisions are
consistent.
Efficient allocation
• A competitive market forces producers to use the best
technology and the right mix of productive resources. The
result is productive efficiency: the production of any particular
product in the least costly way.
• Competitive markets also produce allocative efficiency: to
produce the particular mix of goods and services most valued
by the society.
3-25
Copyright 2008 The McGraw-Hill Companies
Changes in Supply and Demand, and Equilibrium
Changing demand (with supply held constant).
• Increase in demand will have effect of increasing equilibrium
price and quantity
• Decrease in demand will have effect of decreasing
equilibrium price and quantity
Changing supply (with demand held constant).
• Increase in supply will have effect of decreasing equilibrium
price and increasing quantity
• Decrease in supply will have effect of increasing equilibrium
price and decreasing quantity
3-26
Copyright 2008 The McGraw-Hill Companies
Complex cases
•
when both supply and demand shift:
1. Supply increases and demand decreases, price declines,
but the new equilibrium quantity depends on relative sizes of
shifts in demand and supply.
2. Supply decreases and demand increases, price rises, but
the new equilibrium quantity depends again on relative sizes
of shifts in demand and supply.
3. Supply increases and demand increases. If the increase in
supply is greater than the increase in demand the price falls
and vice versa
4. Supply decreases demand decreases. If the decrease in
supply is greater than the decrease in demand, equilibrium
price will rise and vice versa.
3-27
Copyright 2008 The McGraw-Hill Companies
Application: Government-Set Prices (Ceilings and Floors).
• Government-set prices prevent the market from reaching the
equilibrium price and quantity.
A. Price ceilings
• The maximum legal price a seller may charge, typically placed
below equilibrium. Shortages result as quantity demanded
exceeds quantity supplied. Examples: Rent controls and
gasoline price controls
Rationing problem
• Since price ceilings does not lead to an equitable distribution
of the product, the government must establish some formal
system for rationing, e.g., ration coupons
Black Markets
• Since the demand is greater than supply, buyers will be willing
to pay a higher price, which creates a black market where the
product is illegally traded in at price above the ceiling price.
3-28
Copyright 2008 The McGraw-Hill Companies
B. Price floors.
• The minimum legal price a seller may charge, typically placed
below equilibrium. Surpluses result as quantity supplied
exceeds quantity demanded.
• Examples: Minimum wage and farm price supports.
• Note: The minimum wage, for example, will be below
equilibrium in some labor markets (large cities as the demand
for labor is already high). In that case the price floor has no
effect.
(Flash film 7)
3-29
Copyright 2008 The McGraw-Hill Companies
Government set prices
6
6,000 Bushel
Surplus
Price (per bushel)
5
S
$4 Price Floor
4
3
$2 Price Ceiling
2
7,000 Bushel
Shortage
1
0
2
4
6 7 8
10
D
12
14
16
18
Bushels of Corn (thousands per week)
3-30
Copyright 2008 The McGraw-Hill Companies
Application: Market Equilibrium
Qd = a1 + b1 P;
Qs = a2 + b2 P;
Qd = Qs
a1>0, b1<0
a2<0, b2>0
Solution
At equilibrium
a1 + b1 P = a2 + b2 P
b1 P - b2 P = a2 - a1
P* = ( a2 - a1 ) ÷ ( b1 - b2 )
3-31
Copyright 2008 The McGraw-Hill Companies
(1)
(2)
(3) Equilibrium Condition
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 + 3p
5p = 60
P* = 60/5 = 12
Q* = 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?
3-32
Copyright 2008 The McGraw-Hill Companies
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?
3-33
Copyright 2008 The McGraw-Hill Companies
A Legal Market for Human
Organs
S1
P
Supply With Price Incentive
S2
Supply of Organs
Demand for Organs
Shortage at Zero Price
Q1 – Q3
P1
At Price P1 the
Shortage is Reduced
By Q1 – Q2
P0
3-34
Copyright 2008 The McGraw-Hill Companies
D1
Q1
Q2
Q3
Q
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
3-35
Copyright 2008 The McGraw-Hill Companies
•
•
•
•
•
•
•
•
•
•
•
•
•
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
Next Chapter Preview…
The U.S. Economy:
Public and Private
Sectors
3-36
Copyright 2008 The McGraw-Hill Companies