Basics of Demand, Supply,
& Market Equilibrium
Demand, Supply & Market Equilibrium
For Good “x”
Demand, Supply and Market Equlibrium
• Demand shows how much consumers are able and
willing to purchase at different prices
• Supply shows how much firms are able and willing to
sell at different prices
• In a free market, the prices of goods, services,
financial assets, etc. are determine by forces of
demand and supply
• Basic understanding of demand are essential to make
informed predictions about price changes
Law of Demand
The law of demand states that a decrease in the price
of a good, all other things constant, will cause an
increase in the quantity demanded for that good. Or ,
an increase in the price of a good, all other things
constant, will cause a decrease in the quantity
demanded of the good.
Key Assumption: Other things held constant (income, price of other
products, advertising, taste and preferences, etc. are assumed constant)
𝑸𝒅 = 𝑸𝒅 (𝑷𝒙 , 𝐼, 𝑃𝑦 , 𝑇 … )
A Graphic Representation of the Law of Demand
An increase in price other things constant,
causes a decrease in
quantity demanded (law
of demand).
Price
P1
P0
Q1
Q0
Quantity
Change in Qty. Demanded vs. Change in Demand
Change in quantity demanded refers to a movement
along the demand curve. It is caused by changes in the
price of the product when other things are held constant.
Change in demand refers to a shift in the demand curve.
It is caused when factors other than price change.
Increase in Demand
Increase in demand refers to a
rightward shift in the demand
curve.
Price
The quantity demanded increases at a
given price (caused by changes in
factors other than the price itself –
income, price of other products,
advertising, etc.
P0
Q0
Q1
Quantity
Factors that Cause Increase in Demand
Price
P0
Possible causes of an increase in demand, include:
• Increases in income, for normal goods
• Decreases in income, for inferior goods
• Increases in the price of substitutes
• Decreases in the price of complements
• Increases in taste and preferences
• Expectations of future price increase
•Increases in the # of consumers
Q0
Q1
Quantity
Decrease in Demand
Price
Decrease in demand refers to a
leftward shift in the market
demand curve.
P0
Q0
Q1
Quantity
Factors that Cause Decrease in Demand
Price
P0
Possible causes of an increase in demand, include:
•Decreases in income, for normal goods
•Increases in income, for inferior goods
•Increases in the price of complements
•Decreases in the price of substitutes
•Decreases in taste and preferences
• Expectations future price decrease
•Decrease in the # of consumers
Q0
Q1
Quantity of good x
Higher Income and Normal Goods
Price
When income increases, the demand for
normal goods also increase
Definition of normal goods: A good for which
demand increases when income increases and
decreases when income decreases (other things
constant).
P0
Does your company produce any
normal good? What?
Q0
Q1
Quantity of x (normal good)
Higher Income and Inferior Goods
Price
When income increases, the demand for
inferior goods decreases (shift to the left)
Definition of inferior good: A good for which
demand decreases when income increases and
demand increases when income decreases. For
example, bus rides.
P0
Does your company produce any
inferior good? What?
Q1
Q0
Quantity of x (inferior good)
Higher Price of Substitute Goods
Goods “x” and “y” are substitutes: The
increase price of good “y” causes an
increase in demand for good “x”.
Price
Definition of substitutes: Two goods are
substitute if an increase in the price of one
good causes an increase in the demand for
the other good and vice versa. Example,
Pepsi and Coke. If the price of Pepsi
increases, people by more Coke.
P0
Q0
Q1
Quantity of “x”
Higher Price of Complement Goods
Good “x” and “y” are complements, if an
increase in price of good “y” causes an
decrease in demand for good “x”.
Price
Definition complement goods: Two goods are
complements if an increase in price of one good
causes decrease in the demand for the other good
and vice versa. Example, SUVs and Gasoline. If
the price of SUVs increases, people by less
gasoline.
P0
Q1
Q0
Quantity of x
The Law of Supply
• A decrease in the price of a good, all other
things held constant, will cause a decrease in
the quantity supplied of the good.
• An increase in the price of a good, all other
things held constant, will cause an increase in
the quantity supplied of the good.
Change in Quantity Supplied
A decrease in price
causes a decrease in
quantity supplied
Price
(law of supply – movement
along the supply curve).
P0
P1
Q1
Q0
Quantity
Change in Quantity Supplied
An increase in price
causes an increase in
quantity supplied
Price
(law of supply – movement
P1
along the supply curve).
P0
Q0
Q1
Quantity
Changes in Supply
Factors that change supply includes:
• Change in cost of production (input prices, wages, weather
condition, technology, etc…)
• Change in price of related products
• Change in expectations (about future prices)
• Change in the number of producers (sellers)
𝑸𝒔 = 𝑸𝒔 (𝑷𝒙 , 𝐶𝑥
𝑤𝑎𝑔𝑒𝑠
𝑐𝑜𝑠𝑡 𝑜𝑓 𝑚𝑎𝑡𝑒𝑟𝑖𝑎𝑙𝑠 , 𝑃𝑦 , 𝐸, # 𝑠𝑒𝑙𝑙𝑒𝑟𝑠, 𝑤𝑒𝑎𝑡ℎ𝑒𝑟 …)
𝑡𝑒𝑐ℎ𝑛𝑜𝑙𝑜𝑔𝑦
Increase in Supply
Price
An increase in supply refers to
a rightward (downward) shift in
the market supply curve.
Possible Factors
•Improvements in technology
•Lower cost of inputs
•Increase in the number of
producers
P0
Q0
Q1
Quantity
Decrease in Supply
Price
A decrease in supply refers
to a leftward (upward) shift
in the market supply curve.
Possible Factors
•Increase in cost of inputs
•Decrease in the number of
suppliers
•Droughts, floods, etc…
P0
Q1
Q0
Quantity
Market Equilibrium
• Market equilibrium is determined at the
intersection of the market demand curve and
the market supply curve.
• The equilibrium price causes quantity
demanded to be equal to quantity supplied.
Market Equilibrium
Price
D
S
P
Q
Quantity of x
Price Adjustments
Price
S
E
$3.00
Excess
Demand
1.00
300
400
When the price is
below the market
equilibrium price,
there is an excess
demand and the price
increases (there is not
enough product in the
market, consumers
are willing to pay
more to get the
product)
D
500
Quantity of x
Price Adjustments
Price
Excess Supply
at $5.00
S
$5.00
E
3.00
When the price is
above the market
equilibrium price,
there is an excess
supply and the
price decreases
(firms have to
decrease price to
sell excess supply)
D
300
400
500
Quantity of x
Predicting Changes in Prices
Price
D0
D1
P1
P0
S0
Any factor that
causes an increase
in demand will
cause the
equilibrium price
and quantity to
increase.
Review factors that cause
increase in demand
Q0 Q1
Quantity of x
Predicting Changes in Prices
Price
D1
D0
P0
P1
S0
Any factor that
causes a decrease in
demand will cause
the equilibrium price
and quantity to
decrease.
Review factors that cause
decrease in demand
Q1 Q0
Quantity of x
Predicting Changes in Prices
Price
S0
D0
P0
S1
Any factor that causes
an increase in supply
will cause the market
equilibrium price to
decrease and quantity
to increase.
Review factors that cause
increase in supply
P1
Q0 Q1
Quantity of x
Predicting Changes in Prices
Price
S1
D0
P1
S0
Any factor that causes a
decrease in supply will
cause the market
equilibrium price to
increase and quantity to
decrease.
Review factors that cause
decrease in supply
P0
Q1 Q0
Quantity of x
Thinking it Over
• How could we use demand in supply to study
economic inequality?
• How social media affect prices?
• Why not require zero pollution emission?
• Should we all buy only goods produced in
America?
• Can the Fed keep interest rates low forever?
A Public Policy Question
The U.S. government administers two programs that affect the market
for cigarettes. First, media campaigns and labeling requirements are
aimed at making the public aware of the dangers of cigarettes. Second,
the Department of Agriculture maintains a program of price supports for
tobacco (an input in the production of Cigarettes). Under this program,
farmers can sell tobacco at a price that is above the market equilibrium
price, but the government limits the amount of land that can be devoted
to tobacco production in order to eliminate surpluses.
1. Are these two programs at odds with respect to the goal of reducing
cigarette consumption?
2. Illustrate the effects of both policies on the market for cigarettes
using the demand and supply model
Effects on the Market for Cigarettes
Price
S1
S0
P0
P0
1. Price support increase the
cost of tobacco – a material
to produce cigarettes (shift
the supply to the left.
2. Marketing campaigns shift
the demand to the left.
Result: equilibrium quantity of
cigarettes consumed decrease.
The effect on the price is
uncertain.
D0
Q0 Q0 Q 0
Quantity of x
Effects of Government Intervention
— Price Controls (price ceiling & price floor)
Price ceiling – the
government sets the
maximum price that can be
charged for a product of
service – It causes excess
demand (shortages)
Pmax
Qs
Qd
Effects of Government Intervention
— Price Controls (price ceiling & price floor)
Price floor – the government
sets the minimum price that
must be paid for a product of
service – It causes excess
demand (shortages)
Pmin
Qd
Qs
Discuss 4: Is the Supply and Demand Outcome
Unfair? (10 minutes).
Download instructions from course site