Supply and Demand
Chapter 3
McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
The Market
• How do market mechanisms decide WHAT,
HOW, and FOR WHOM to produce?
– What determines the price of a good or service?
– How does the price of a product affect its
production or consumption?
– Why do prices and production levels often change?
3-2
Market Participants
• A good way to start learning how markets
work is to see who participates in them
– Over 310 million consumers, 25 million firms, and
tens of thousands of government agencies
participate directly in the U.S. economy
– Millions of international buyers and sellers also
participate in U.S. markets
3-3
Maximizing Behavior
• All participants have limited resources and
strive to maximize outcomes
– Consumers seek to maximize utility
– Businesses try to maximize profits through
efficient production
– Government seeks to maximize general welfare
3-4
Specialization and Exchange
• We interact in markets because:
– Individuals are not capable of producing
everything they need or want
– We face limits on time, energy, and other
resources, so it makes sense to specialize in
production and trade for other goods and services
3-5
The Circular Flow
• Four different groups participate in our
economy:
–
–
–
–
Consumers
Business firms
Government
International participants
3-6
The Two Markets
• Factor markets: Any place factors of
production (e.g., land, labor, capital) are
bought and sold
• Product Markets: Any place finished goods
and services are bought and sold
3-7
The Circular Flow
Goods and services
demanded
Consumers
Product
markets
Governments
International
participants
Goods and services
supplied
Business
Firms
Factors of
production supplied
International
participants
Factor
markets
Factors of
production demanded
3-8
Dollars and Exchange
• A market exists wherever and whenever an
exchange takes place
• Every market transaction involves an exchange
of dollars for goods or resources
• Money is critical in facilitating market
exchanges and the specialization it permits
3-9
Supply and Demand
• There must be a buyer and a seller in every
market transaction
– The seller is on the supply side of the market
– The buyer is on the demand side
3-10
Supply and Demand
• Supply: The ability and willingness to sell
specific quantities of a good at alternative
prices in a given time period, ceteris paribus
• Demand: The ability and willingness to buy
specific quantities of a good at alternative
prices in a given time period, ceteris paribus
3-11
Individual Demand
• Demand exists only if someone is willing and
able to pay for a good or service
• An individual must consider the opportunity
cost associated with a purchase, since it
involves a tradeoff due to limited resources
3-12
Individual Demand
• Demand schedule: A table showing quantities
of a good a consumer is willing and able to
buy at alternative prices in a given time period,
ceteris paribus
– “Demand” is an expression of consumer buying
intentions – of a willingness to buy – not a
statement of actual purchases
3-13
The Demand Curve
• Demand curve: A curve describing quantities
of a good a consumer is willing and able to
buy at alternative prices in a given time period,
ceteris paribus
– A graphical illustration of a demand schedule
• Demand curves are downward sloping
3-14
The Law of Demand
• Law of Demand: The quantity of a good
demanded in a given time period increases as
its price falls, ceteris paribus
3-15
Demand Schedule and Curve
Demand Schedule
Quantity
Price
Demanded
$50
1
45
2
40
3
35
5
30
7
25
9
20
12
15
15
10
20
PRICE
$50
45
40
35
30
25
20
15
10
5
0
A
B
C
D
E
F
G
H
I
2 4 6 8 10 12 14 16 18 20
Quantity
3-16
Determinants of Demand
• Determinants of market demand include:
–
–
–
–
–
Consumer tastes
Consumer income
Availability and prices of other goods
Consumer expectations
Number of buyers in the market
3-17
Types of Other Goods
• Substitute goods substitute for each other
– When the price of good x rises, the demand for
good y increases, ceteris paribus
• Complementary goods are frequently
consumed together
– When the price of good x rises, the demand for
good y falls, ceteris paribus
3-18
Ceteris Paribus
• Recall that to simplify their models economists
focus on only one or two forces at a time and
assume nothing else changes
• Ceteris paribus: The assumption of nothing
else changing
3-19
Shifts in Demand
• A demand curve (schedule) is valid only if its
underlying determinants remain constant
• Determinants of demand can and do change
• Shift in demand: A change in the quantity
demanded at any given price
3-20
Movements vs. Shifts
• Changes in quantity demanded: Movements
along a demand curve in response to changes
in price for the good
• Changes in demand: Shifts of the demand
curve due to changes in the determinants of
demand, which change the relationship
between price and quantity demanded
3-21
Movements vs. Shifts
PRICE
Shift in
demand
$45
d2
40
d1
35
30
25
g1
Movement
along curve
20
D2
15
Increased
demand
D1
Initial demand
10
5
0
2
4
6
8
10
12
14
16
18
20
22
Quantity
3-22
Market Demand
• Market demand: Total quantities of a good or
service people are willing and able to buy at
alternative prices in a given time period
– The sum of individual demands, as determined by
the number of potential buyers, their respective
tastes and incomes, other goods, and expectations
3-23
Construction of the Market
Demand Curve
Quantity Demanded
Price
Tom
+ George +
Lisa
+
Me
= Market Demand
A
50
1
4
0
0
5
B
45
2
6
0
0
8
C
40
3
8
0
0
11
D
35
5
11
0
0
16
E
30
7
14
1
0
22
F
25
9
18
3
0
30
G
20
12
22
5
0
39
H
15
15
26
6
0
47
I
10
20
30
7
0
57
3-24
Construction of the Market
Demand Curve
Tom’s demand
curve
George’s demand
curve
Lisa’s
demand
curve
$50
My demand
curve
Price
40
30
+
20
+
+
=
10
0
4 8 12 16
0
4 8 12 16 20 24 28
0
4 8 12
0
4 8 12
Quantity Demanded
3-25
Construction of the Market
Demand Curve
The market demand curve
$50
A
B
=
Price
40
C
D
30
E
F
20
G
H
10
0
4
12
20
28
36
I
Quantity Demanded
3-26
Supply
• Market supply: The total quantities of a good
that sellers are willing and able to sell at
alternative prices in a given time period,
ceteris paribus
3-27
Determinants of Supply
• The determinants of market supply include:
– Technology
– Factor costs
– Other goods
– Taxes and subsidies
– Expectations
– Number of sellers
3-28
Law of Supply
• Law of Supply: The quantity of a good
supplied in a given time period increases as its
price increases, ceteris paribus
• Supply curves are upward-sloping to the right
3-29
Market Supply
• The market supply curve is just a summary of
the supply intentions of all producers.
• Market supply is an expression of sellers’
intentions – an offer to sell – not a statement of
actual sales.
3-30
Market Supply
Quantity Supplied By:
Price
Ann
+
Bob
+
Cory
=
Market
j
$50
94
35
19
148
i
45
93
33
14
140
h
40
90
30
10
130
g
35
86
28
0
114
f
30
78
12
0
90
e
25
53
9
0
62
d
20
32
7
0
39
c
15
20
0
0
20
b
10
10
0
0
10
3-31
Market Supply
Price
Ann’s supply
curve
Bob’s supply
curve
+
Cory’s supply
curve
+
=
Quantity Supplied
3-32
Market Supply
=
Price
Quantity supplied
increases as price rises
Quantity Supplied
3-33
Shifts of Supply
• A supply curve is valid only if its underlying
determinants remain constant
• Determinants of supply can and do change
• Shift in supply: A change in the quantity
supplied at any given price
3-34
Movements vs. Shifts
• Changes in quantity supplied: Movements
along the supply curve due to changes in price
• Changes in supply: Shifts in the supply curve
due to changes in the determinants of supply
– An increase in supply is a rightward shift
– A decrease in supply is a leftward shift
3-35
Equilibrium
• Only one price/quantity combination is
compatible with buyer’s and seller’s intentions
• Equilibrium price: The price at which the
quantity of a good demanded equals the
quantity supplied in a given time period
– Equilibrium occurs at the intersection of the supply
and demand curves
3-36
Equilibrium Price
Price
Quantity
Supplied
Quantity
Demanded
$50
148
surplus
5
45
140
surplus
8
40
130
surplus
11
35
114
surplus
16
30
90
surplus
22
25
62
surplus
30
20
39
equilibrium
39
15
20
shortage
47
10
10
shortage
57
3-37
Equilibrium Price
Price
$50
45
40
35
Market demand
Market supply
At the equilibrium price:
quantity demanded = quantity supplied
30
25
20
15
Equilibrium price
10
5
0
25
39
50
75
100
125
Quantity
3-38
Market Clearing
• The equilibrium price reflects a compromise
between buyers and sellers
– Not everyone is happy, as the price is too high for
some buyers and too low for some sellers
• The unique outcome at market equilibrium is
efficient
3-39
The Invisible Hand
• Market mechanism: The use of market prices
and sales to signal desired outputs (or resource
allocations)
• Adam Smith characterized this market
mechanism as the invisible hand
3-40
Market Surplus
• Market surplus: The amount by which the
quantity supplied exceeds the quantity
demanded at a given price – excess supply
• A market surplus will emerge when the market
price is above the equilibrium price
3-41
Market Shortage
• Market shortage: The amount by which the
quantity demanded exceeds the quantity
supplied at a given price – excess demand
• A market shortage will emerge when the
market price is below the equilibrium price
3-42
Surplus and Shortage
Price
$50
Market demand
45
40
35
Surplus
30
25
Market supply
x
y
20
15
10
5
0
Shortage
25
39
50
75
100
125
Quantity
3-43
Self-Adjusting Prices
• Buyers and sellers will change their behavior
to overcome a surplus or shortage
• Only at the equilibrium price will no further
adjustments be required
3-44
Surplus and Shortage
Price
$50
Market demand
45
40
35
30
25
Surplus
x
y
20
15
10
5
0
Market supply
Equilibrium price
Shortage
25
39
50
75
100
125
Quantity
3-45
Changes in Equilibrium
• No equilibrium price is permanent
• Equilibrium price and quantity will change
whenever the supply or demand curve shifts
– Shifts are due to a change in supply or demand
resulting from a change in any of the underlying
determinants
3-46
Change in Equilibrium: Demand Shift
Price
$50
Market supply
40
E2
30
New demand
E1
20
10
0
Initial demand
25
50
75
100
Quantity
3-47
Change in Equilibrium: Supply Shift
Price
$50
Market supply
40
E3
30
E1
20
10
0
Initial demand
25
50
75
100
Quantity
3-48
Market Outcomes
• The market mechanism resolves the basic
economic questions:
– WHAT we produce is determined by equilibriums
– HOW we produce is determined by profit seeking
behavior and efficient use of resources
– FOR WHOM we produce is determined by those
willing and able to pay equilibrium prices
3-49
Optimal, Not Perfect
• Although outcomes of the marketplace are not
perfect, they are often optimal – the best
possible given our incomes and scarce
resources
3-50
Supply and Demand
End of Chapter 3
McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.