Topic 2
Demand, Supply, and How
Prices are Determined
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1
Market demand (1 of 2)
 Market demand: The demand by all the consumers of
a given good or service.
 The law of demand: An increase in price of the
product will lead to a decrease in the quantity
demanded, and a decrease in price will lead to an
increase in the quantity demanded, ceteris paribus.
 Demand curve: An economic model (graph) that
shows the relationship between the price of a product
and the quantity of the product demanded.
– For normal goods, the demand curve is downward
sloping, from left to right.
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2
A market demand curve
Price
P1
0
D
Q1
Quantity
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3
A change in the product’s price causes
a movement along the demand curve
Price
P1
A
B
P2
0
D
Q1
Q2
Quantity
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Market demand (2 of 2)
The five most important variables that SHIFT the
demand curve are:
1. Prices of related goods:
‒ Substitutes
‒ Complements
2. Income
‒ Normal goods
‒ Inferior goods
3. Consumer tastes and preferences
4. Population size and demographics
5. Expected future prices and incomes
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An increase in demand
Price
P
D1
0
Q1
Q2
D2
Quantity
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A decrease in demand
Price
P
D2
0
Q2
Q1
D1
Quantity
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Market supply (1 of 2)
 Market supply: The supply by all the firms of a given
good or service.
 The law of supply: An increase in the price of the
product will lead to an increase in the quantity supplied
and a decrease in the price will lead to a decrease in
the quantity supplied, ceteris paribus.
 Supply curve: A curve that shows the relationship
between the price of a product and the quantity of the
product supplied.
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8
A market supply curve
Supply
Price
P1
0
Q1
Quantity
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9
A change in the product’s price causes
a movement along the supply curve
Supply
Price
B
P2
P1
0
A
Q1
Q2
Quantity
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10
Market supply (2 of 2)
The five most important variables that SHIFT the
supply curve are:
1. Prices of production inputs (wages, raw materials)
2. Technological change
‒ A change in the ability of a firm to produce output
with a given quantity of inputs
‒ Productivity: The output produced per unit of input.
3. Prices of substitutes (alternatives) in production
4. Number of firms in the market
5. Expected future price of the product
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An increase in supply
Price
S1
S2
P
Increase
0
Q1
Q2
Q
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A decrease in supply
S2
Price
S1
P
Decrease
0
Q2
Q1
Q
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Market equilibrium (1 of 3)
 Market equilibrium: A situation in which quantity
demanded equals quantity supplied.
 Competitive market equilibrium: A market
equilibrium with many buyers and many sellers.
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Market equilibrium
Price
Supply
P1
Market equilibrium
Equilibrium price
Equilibrium quantity
0
Q1
Demand
Quantity
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Market equilibrium (2 of 3)
 Surplus: A situation in which the quantity supplied is
greater than the quantity demanded.
 Shortage: A situation in which the quantity demanded
is greater than the quantity supplied.
 In a free market, the price will adjust to eliminate
surpluses and shortages.
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A surplus: a market not in equilibrium
Price
S
P
The price will be
lowered, eliminating
the surplus
Excess
Supply
0
Qd
D
Qs
Quantity
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A shortage: a market not in equilibrium
Price
S
The price will be
raised, eliminating
the shortage
P
Excess
Demand
0
Qs
D
Qd
Quantity
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Market equilibrium (3 of 3)
 Factors that shift the demand curve will lead to a new
equilibrium price and quantity.
 Factors that shift the supply curve will lead to a new
equilibrium price and quantity.
 Simultaneous shifts – changes in factors that shift the
demand curve and the supply curve at the same time.
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