Chapter 2
Demand, Supply, and Equilibrium Prices
1
Demand
• “Functional relationship between the price of a good or
service and the quantity demanded by consumers in a
given time period, all else held constant”
• For example, the demand for good x of consumers is
given by the demand function xd :
xd = xd(px, ps, pc, i)
where, px = price of good x
ps = price of substitute of good x
pc = price of complement of good x
i = consumer income
2
Non-price factors affecting
demand
1. Tastes and preferences
2. Income
• Normal good
• Inferior good
3. Prices of related goods
• Substitute goods (x and s goods)
• Complementary goods (x and c goods)
4. Future expectations
5. Number of consumers
3
Sample demand function
Qxd = f(Px, T, I, Py, Pz, Exc, NC, …)
where, Qxd = quantity demanded of good x
Px = price of good x
T = variables for tastes and preferences
I = income
Py, Pz = prices of good y and z
Exc = consumer expectations about future
prices
NC = no. of consumers
4
Demand curves
Change in quantity demanded
Change in demand
P
P1
P
D1
A
D2
P1
B
P2
P2
D
Q
Q1 Q2
A decrease/(increase) in P results to an
increase/(decrease) in Q demanded
holding all other variables constant
Q
Q1 Q1’
A change in factors other than P shifts
the demand curve to the right or left
5
Individual vs market demand
curves
P
DM=D1+D2
D1
Q1
D2
Q2
Q3
Q4
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Sample demand function
Qd = 3 – 2Pc + 0.2I + 1.6TC + 0.04E
where, Qd = quantity demanded of copper (m lbs)
Pc = price of copper ($/lb)
I = consumer income index
TC = telecom index showing uses or tastes
copper in the telecom industry
E = expectations index representing
purchaser’s of a lower price over the next 6
months
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Sample demand function, cont’d
If I = 20, TC = 2.5, and E=100, the Qd demand curve
becomes
Qd = 3 – 2Pc + 0.2(20) + 1.6(2.5) + 0.04(100)
Qd = 15 – 2Pc, or
Pc = 7.5 – 0.5Qd
Note: If I, TC, or E changes, the constant term
changes, and the demand curve Qd shifts → or ←.
8
Supply
• “Functional relationship between the prices of a
good or service and the quantity supplied that
producers are willing and able to supply in a given
time period, all else held constant”
• Example: The quantity supplied of good x by a firm
is given the following function xs :
xs = xs(px, r, w)
where, px = price of good x
r = cost of physical capital
w = cost of labor
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Non-price factors affecting supply
• State of technology
• Input prices
• Prices of goods related in production
• Future expectations
• No. of producers
10
Sample supply function
Qxs = f(Px, Tx, PI, Pa, Pb, Exp, NP)
Where, Qxs = quantity supplied of good x
Px = price of good x
Tx = state of technology
PI = price of the inputs of production
Pa, Pb = prices of A and B, which are related
to the production of good x
Exp = expectations
NP = no. of producers
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Supply curve
Change in quantity supplied
Change in supply
P
P
S
S1
S2
B
P1
A
P2
P2
Q
Q2
Q1
An increase in P results to an increase
in Q supplied holding other variables
constant
Q
Q1
Q3
A change in factors other than P shifts
the supply curve up or down
12
Mathematical example of a supply
function
Qs = -5 + 8Pc – 0.5w + 0.4T + 0.5N
where, Qs = quantity supplied of copper (m lbs)
Pc = price of copper ($/lb)
w = wage index
T = technology index
N = no. of active mines
13
Mathematical example of a supply
function, cont’d
If w = 100, T=50, and N=20, Qs becomes
Qs = -5 + 8Pc – 0.5(100) + 0.4(50) + 0.5(20)
Qs = -25 + 8Pc, or
Pc = 3.125 + 0.125Qs
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Factors affecting market demand
and supply
Demand
Supply
1. Price of the product
1. Price of the product
2. Consumer tastes and preferences
2. State of technology
3. Consumer income
• Normal goods
• Inferior goods
3. Input prices
4. Price of goods related in
consumption
• Substitute goods
• Complementary goods
4. Price of goods related in production
• Substitute goods
• Complementary goods
5. Future expectations
5. Future expectations
6. Number of consumers
6. Number of producers
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Equilibrium price and equilibrium
quantity
P
S
Pe
D
Q
Qe
Pe = equilibrium price at which quantity demanded of the
good is equal to the quantity supplied
Qe = equilibrium quantity
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Lower than equilibrium price
P
S
Pe
P1
D
Q
Qs
Qe Qd
1. Shortage of quantity
supplied at P1 (Qs –
Q d)
2. Consumers bid for
the limited good, and
price goes up.
3. Firms produce more
as price goes up until
it reaches Pe at which
Q e = Q s = Q d.
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Higher than equilibrium price
P
S
P1
Pe
D
Q
Qd
Qe
Qs
1. Excess of quantity
supplied at price P2
(Qs – Qd).
2. There is downward
pressure to sell the
good at lower prices,
and demand for the
good increases.
3. Price falls until Pe at
which Qe = Qs = Qd.
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Mathematical example of
equilibrium
Qd = 15 – 2Pc
Qs = -25 + 8Pc
Qe = ?, Pe = ?
At equilibrium, Qd = Qs.
15 – 2Pc = -25 + 8Pc
Pe = 4
Substitute Pe into Qs or
Qd.
Qe = 15 – 2(4)
Qe = 7
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Change in equilibrium price and
equilibrium quantity
Increase in demand
P
S0
P1
P0
D1
D0
Q
Q0 Q1
1. Initial equilibrium at
P0 and Q0.
2. An increase in
demand shifts D0 to
D1 to the right.
3. The new equilibrium
is at P1 and Q1.
4. Quantity supplied
increases from Q0 to
Q1 along the supply
curve.
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Change in equilibrium price and
equilibrium quantity, cont’d
Increase in supply
P
S0
P0
P1
D0
Q
Q0 Q0
S1
1. Initial equilibrium is at
P0 and Q0.
2. An increase in supply
shifts the supply curve
down from S0 to S1.
3. The new equilibrium is
at P1 and Q1.
4. Quantity demanded
increases from Q0 to Q1
along the demand
curve.
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Change in equilibrium price and
equilibrium quantity, cont’d
Decrease in supply and
increase in demand:
Increase in Qe
Decrease in supply and
increase in demand:
Decrease in Qe
S1
P
S1
S0
P2
P1
P0
D1
P
S0
P2
P1
P0
D1
D0
Q
D0
Q
Q1 Q0 Q2
Q1 Q2 Q0
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Change in equilibrium price and
equilibrium quantity, cont’d
Increase in supply and
increase in demand:
Increase in Pe
Increase in supply and
increase in demand:
Decrease in Pe
P
P
S1
P2
P0
P1
S2
D2
S1 S2
P0
P2
P1
D1
Q
Q0 Q1 Q2
D1
D2
Q
Q0
Q1 Q2
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Mathematical example of change
in equilibrium
Qd2 = 3 – 2Pc + 0.2I + 1.6TC + 0.04E
Qs2 = -5 + 8Pc – 0.5W + 0.4T + 0.5N
Given:
Income index decreases from 20 to 14
Telecom index decreases from 2.5 to 1.875
Expectations decreases from 100 to 80
Wage index decreases from 100 to 98
Technology index increases from 50 to 55
# of suppliers increases from 20 to 28
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Mathematical example of change
in equilibrium, cont’d
Qd2 = 3 – 2Pc + 0.2(14) + 1.6(1.875) + 0.04(80)
Qd2=12-2Pc
Qs2 = -5 + 8Pc – 0.5(98) + 0.4(55) + 0.5(28)
Qs2 = 18 + 8Pc
At the new equilibrium, Qd2=Qs2.
12-2Pc = -18 + 8Pc
Pc = Pe = 3, Qe = 6
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