AAEC 2305
Shaikh M Rahman
Lecture 3: Demand and Supply
Text: Principles of Economics, Chapter 3
Learning Objectives
1. Describe how the demand and supply curves
summarize the behavior of buyers and sellers in the
marketplace.
2. Discuss how the supply and demand curves interact
to determine equilibrium price and quantity.
3. Illustrate how shifts in supply and demand curves
cause prices and quantities to change
4. Explain and apply the Efficiency Principle and the
Equilibrium Principle (also called the “No-Cash-onthe-Table Principle”).
What, How, and For Whom?
• Every society answers three basic questions
Central Planning versus the Market
Central Planning
• Decisions by individuals or
small groups
• Agrarian societies
• Government programs
– Sets prices and goals for the group
• Individual influence is limited
The Market
– Buyers and sellers signal wants
and costs
• Resources and goods are
allocated accordingly
– Interaction of supply and
demand answer the three basic
questions
Mixed economies use both the market and central planning
Buyers and Sellers in the Market
• The market for any good consists of all the buyers and
sellers of the good
• Buyers and sellers jointly determine outcome
• Buyers and sellers have different motivations
– Buyers want to benefit from the good
• The buyer’s reservation price is the highest price an
individual is willing to pay for a good
– Sellers want to make a profit
• Market price balances two forces
– Value buyers derive from the good
– Cost to produce one more unit of the good
Demand
• Demand for a good refers to
the different quantities
buyers would purchase at
different prices
• Law of Demand
– Consumers buy less at
higher prices
– Consumers buy more at
lower prices
• This behavior can be depicted
graphically by a downward
sloping curve – called the
demand curve
Demand for Pizzas
P
$4
$2
D
8
16
(1000s of slices/day)
Q
Law of Demand
• When price of a good goes up, people buy less of that good
• Leads to downward sloping demand curve
Price
($/cup)
Quantity
Demanded
(cups)
0.50
5
Individual Consumer’s demand for coffee
1.75
1.50
0.75
4
Price ($)
1.25
1.00
1.00
3
1.25
2
0.50
1.50
1
0.25
0.75
1
2
3
4
Quantity Demanded (cups per day)
5
Demand versus Quantity Demanded
• Quantity Demanded
– Amount of a good consumed at a given price
– Change in price means a change in quantity
demanded
• Movement along the demand curve
• Demand
– A family of numbers that lists the quantity
demanded corresponding to each possible price
• Demand Schedule
• Demand Curve
Demand Schedule and Demand Curve
• Demand Schedule Refers to the demand
table that shows
quantity demanded
at each price
Price
($/cup)
Quantity
Demanded
(cups)
0.50
5
0.75
4
1.00
3
1.25
2
1.50
1
Demand Schedule and Demand Curve
Individual Consumer’s demand for coffee
• Demand Curve 1.75
1.50
1.25
Price ($)
Graph illustrating
demand - Graphical
representation of the
demand schedule
– Price on the
vertical axis
– Quantity
demanded on the
horizontal axis
1.00
0.75
0.50
0.25
1
2
3
4
Quantity Demanded (cups per day)
5
Changes in Demand
• Price change does not lead to change in demand
• Change in anything other than price lead to demand
changes - Entire curve shifts
– Income
– Price of related goods
• Substitutes
• Complements
– Taste
– Sales Tax
Changes (Shift) in Demand
• Fall in Demand
– Decision made by demanders to buy a smaller
quantity at each given price
– Leftward shift of demand curve
• Rise in Demand
– Decision made by demanders to a buy a larger
quantity at each given price
– Rightward shift of demand curve
Changes (Shift) in Demand
• Price change does not lead to change in demand
• Factors that lead to demand changes - Entire curve shifts
– Consumer’s income
– Consumer’s taste (preference)
– Price of related goods
• Substitutes
• Complements
– Excise Tax
Market (Aggregate) Demand
• Aggregate quantity of a good demanded by all consumers in a
community (market) at each given price
• Market Demand reflects the entire market, not one consumer
– Lower prices bring more buyers into the market
– Lower prices cause existing buyers to buy more
• The aggregate or market demand is obtained by the
horizontal summation of all individual consumer’s demand
curves.
• Similar to the individual demand curve - Slopes downward
Market (Aggregate) Demand
• Suppose, there are 10,000 SB coffee consumers in Lubbock
• Each individual consumer’s demand for SB coffee is the same
Aggregate (market) demand for coffee
Ind. Quantity
(cups)
Ag. Quantity
(cups)
1.75
0.50
5
50,000
1.50
0.75
4
40,000
1.00
3
30,000
Price ($/cup)
Price
($/cup)
1.25
1.00
0.75
0.50
1.25
2
20,000
1.50
1
10,000
0.25
0.00
10,000
20,000
30,000
40,000
50,000
Agg. Quantity Demanded (cups per day)
Market Demand
• The quantity buyers would
purchase at each possible price
• Market Demand curve
– Negative slope
• Consumers buy less at
higher prices
• Consumers buy more at
lower prices
Demand for Pizzas
P
$4
$2
D
8
16
(000s of slices/day)
Q
Interpreting the (Market) Demand Curve
• Horizontal interpretation
of demand
• Given price, how
much will buyers
buy?
• Vertical interpretation of
demand
– Given the quantity to
be bought, what will
the price be?
Demand for Pizzas
P
$4
$2
D
8
16
(000s of slices/day)
Q
Income and Substitution Effects
• Buyers buy more at lower prices and buy less at higher prices
• What happens when price goes up?
– The substitution effect - Buyers switch to substitutes
when price goes up
– The income effect - Buyers' overall purchasing power goes
down
• What happens when price goes down?
– The substitution effect - Buyers switch from substitutes
– The income effect - Buyers' overall purchasing power goes
up
Supply
• Supply of a good refers to the
different quantities sellers would
sell at different prices
• Law of Supply
– Seller sells more at higher
prices
– Seller sells less at lower prices
• This behavior can be depicted
graphically by a upward sloping
curve – called the supply curve
Law of Supply
• When the price of a good goes up, the quantity supplied goes up
• Leads to a upward sloping supply curve
Quantity
(cups)
0.25
0
0.50
100
Supply of Coffee
1.75
1.50
Price ($/cup)
Price
($/cup)
1.25
1.00
0.75
200
1.00
300
1.25
400
0.25
1.50
500
0.00
0.75
0.50
0
100
200
300
400
Quantity Supplied (cups per day)
500
Supply versus Quantity Supplied
• Quantity Supplied
– Amount of a good that suppliers will provide at a given
price
– Changes if the price changes
• Movement along the curve
• Supply
– Family of numbers giving the quantities supplied at each
price
– Change in anything other than price changes supply
• Shifts the entire curve
Changes (Shift) in Supply
• Rise in Supply
– Increase in quantities that supplier will provide at
each price
– Rightward shift of supply
• Fall in Supply
– Decrease in quantities that supplier will provide at
each price
– Leftward shift of supply
Changes (Shift) in Supply
• Price change does not lead to change in supply
• Factors that lead to supply changes - Entire curve shifts
– Production costs
• Improvement in production technology
• Change in the wage rate
• Weather condition
– Excise Tax
Market (Aggregate) Supply
• Aggregate quantity of a good supplied by all
producers in a community (market) at each given
price
• The aggregate or market supply is obtained by the
horizontal summation of all individual producer’s
supply curves.
• Similar to the individual producer’s supply curve –
Market supply curve slopes upward
Market (Aggregate) Supply
• Suppose, there are 10 Starbucks (SB) coffee sellers in Lubbock
• Each individual seller’s supply for SB coffee is the same
Price
($/cup)
Ind. Quantity
(cups)
Market (Aggregate) Supply Curve
Ag. Quantity
(cups)
0.50
1,000
10,000
0.75
2,000
20,000
1.00
3,000
30,000
Price ($/cup)
1.75
1.50
1.25
1.00
0.75
1.25
4,000
40,000
1.50
5,000
50,000
0.50
0.25
10,000
20,000
30,000
40,000
50,000
Quantity Supplied (cups per day)
Interpreting the Market Supply Curve
• Horizontal interpretation of
supply
• Given price, how much
will suppliers offer?
• Vertical interpretation of
supply
– Given the quantity to be
sold, what will the price
be?
Market Equilibrium
• Equilibrium Point – The point where the market demand and
supply curves intersect
• Equilibrium Price – The price at which quantity demanded
equals quantity supplied
• Equilibrium Quantity – the quantity of the good that buyers
and sellers exchange at the equilibrium price
• Actual price and Quantity determined by interactions
between demanders (consumers) and suppliers (sellers)
– Buyers cannot purchase more than sellers willing to sell
– Sellers cannot sell more than buyers willing to buy
• Buyers and sellers both are satisfied
– Able to behave as one wants to, taking market prices as
given
Market Equilibrium for SB Coffee
• Equilibrium price – $1.00 per cup
• Equilibrium quantity – 30,000 cups per day
Equilibrium in the Market
Ag. Quantity
Demanded
Ag. Quantity
Supplied
1.75
0.50
50,000
10,000
1.50
0.75
40,000
20,000
1.00
30,000
Price ($/cup)
Price
($/cup)
1.25
1.00
30,000
0.75
1.25
20,000
40,000
1.50
10,000
50,000
0.50
0.25
10,000
20,000
30,000
40,000
Quantity (cups per day)
50,000
Market Equilibrium
 Quantity supplied equals
quantity demanded AND
 Price is on supply and
demand curves
 No tendency to change P
or Q
• Buyers are on their
demand curve
• Sellers are on their
supply curve
Market for Pizzas
P
S
$3
D
12
(000s of slices/day)
Q
Excess Supply and Excess Demand
Excess Supply
• At $4, 16,000 slices supplied
and 8,000 slices demanded
Excess Demand
• At $2, 8,000 slices supplied
16,000 slices demanded
Market for Pizzas
P
Market for Pizzas
P
Surplus S
S
$4
Shortage
$2
D
D
8
16
(000s of slices/day)
Q
8
16
(000s of slices/day)
Q
Incentive Principle: Excess Supply at $4
• Each supplier has an
incentive to decrease
the price in order to
sell more
• Lower prices decrease
the surplus
• As price decreases:
• the quantity offered
for sale decreases
along the supply
curve
• the quantity
demanded increases
along the demand
curve
Market for Pizzas
P
S
$4
$3.50
$3
Equilibrium
D
8 12 16
(000s of slices/day)
Q
Incentive Principle: Excess Demand at $2
Market for Pizzas
P
S
$3
$2.50
$2
Equilibrium
D
8 12 16
(000s of slices/day)
Q
• Each supplier has an incentive
to increase the price in order to
sell more
• Higher prices decrease the
shortage
• As price increases
• the quantity offered for sale
increases along the supply
curve
• As price increases, the
quantity demanded
decreases along the demand
curve.
Rent Controls Are Price Ceilings
• Rent controls set a
maximum price that can
be charged for a given
apartment
• If the controlled price is
below equilibrium, then
• Quantity demanded
increases and
• Quantity supplied
decreases
• A shortage results
Market for NYC Apartments
P
S
$1,600
$800
D
1
2
3
(millions of apartments/day)
Q
Changes in the Equilibrium Point
• The only way that anything can affect the equilibrium
price and quantity is by causing a shift in either the supply
curve or the demand curve
• Never look at price and quantity
• Look at the effect of the change has on demand curve
and/or supply curve
• The factors that shifts the demand and supply curves
affect the equilibrium price and quantity
The Effects of
Supply and
Demand Shifts
Movement along the (market) Demand Curve
 When price goes up,
quantity demanded goes
down
 When price goes down,
buyers move to a new,
higher quantity demanded
 A change in quantity
demanded results from a
change in the price of a
good.
Demand for Canned Tuna
P
$2
$1
D
8 10
(000s of cans/day)
Q
Shift in (Market) Demand
 If buyers are willing to buy
more at each price, then
demand has increased
• Move the entire demand
curve to the right
• Increase in demand
 If buyers are willing to buy
less at each price, then
demand has decreased
Demand for Canned Tuna
P
$2
D
D'
8 10
(000s of cans/day)
Q
Causes of Shifts in Demand
• Price of complementary goods
• Tennis courts and tennis balls
• Price of substitute goods
• Internet and overnight delivery
• Income: normal or inferior goods?
• Preferences
• Dinosaur toys after Jurassic Park movie
• Number of buyers in the market
• Expectations about the future
Price changes never cause a shift in demand
Tennis Market
• If rent for tennis court decreases, demand for tennis
balls increases
• Tennis courts and tennis balls are complements
P
Tennis Court Rentals
P
Tennis Ball Sales
S
$10
$1.40
$1.00
$7
D'
D
D
4
11
(00s rentals/day)
Q
40
58
(millions of balls/day)
Q
Apartments Near DC Metro
Convenient Apartments
P
D
D'
S
P'
P
Q Q'
(units/month)
Q
• If government wages rise,
demand for apartments near
Metro stations increases
• Demand increases
• Price increases
• Quantity increases
• Demand for a normal good
increases when income
increases
• Demand for an inferior
good increases when
income decreases
Movement along the (market) Supply Curve
Changes in Quantity Supplied
 When the price of a good
changes, move to a new
quantity supplied
• Assumes everything
except price is held
constant
P
Supply of Pizzas
S
$4
$2
8
16
(000s of slices/day)
Q
Changes in (Market) Supply
 Supply increases when sellers are
willing to offer more for sale at
each possible price
• Moves the entire supply curve
to the right
 Supply decreases when sellers
are willing to offer less for sale
at each possible price
• Moves the entire supply
curve to the left
Supply of Pizzas
P
S
Supply of Tuna
P
S*
S
S'
$2
$2
8
9
(000s of slices/day)
Q
8
9
Q
(000s of cans/day)
Causes of Shifts in Supply
• A change in the price of an input
• Fiberglass for skateboards, construction wages
• A change in technology
• Desktop publishing and term papers
• Internet distribution of products (e-commerce)
• Weather (agricultural commodities and outdoor
entertainment)
• Number of sellers in the market
• Expectation of future price changes
Price changes never cause a shift in supply
Shifts in Supply: Skateboards
• Costs of production affect the supply of a product
• Cost of fiberglass for skateboards increases
• Supply decreases
• With no change in demand,
Supply of Skateboards
the price of skateboards
P
increases to $80 and quantity
S'
S
$80
decreases to 800
$60
D
600 800 1,000
(skateboards/month)
Q
Shift in Supply: Home Construction
• Cost of labor used to produce houses decreases
• Supply increases
• Demand is constant
• The price of houses
decreases to $90,000
per house
• Quantity increases to 50
The Market for New Houses
P
S
$120
$90
S'
D
40 50
(houses/month)
Q
Supply and Demand Shifts: Four Rules
An increase in demand will lead to an increase in
both equilibrium price and quantity
P
S
P'
P
D'
D
Q
Q'
Q
Supply and Demand Shifts: Four Rules
An decrease in demand will lead to a decrease in
both equilibrium price and quantity
P
S
P
P'
D
D'
Q'
Q
Q
Supply and Demand Shifts: Four Rules
An increase in supply will lead to a decrease in the
equilibrium price and an increase in the equilibrium
quantity.
P
S
S'
P
P'
D
Q
Q'
Q
Supply and Demand Shifts: Four Rules
A decrease in supply will lead to an increase in the
equilibrium price and a decrease in the equilibrium
quantity.
S'
P
S
P'
P
D
Q'
Q
Q
Supply and Demand Both Change:
Tortilla Chips
• Oils used for frying are harmful AND the price of
harvesting equipment decreases
Price ($/bag)
S
S'
P
P'
D
D'
Q' Q
Millions of bags per month
Changes in Supply and Demand
Supply
Demand
Increases
Decreases
Increases
P
Q
Depends
Increases
P
Q
Increases
Depends
Decreases
P
Q
Decreases
Depends
P
Q
Depends
Decreases
Efficiency and Equilibrium
• Markets communicate information effectively
• Value buyers place on the product
• Opportunity cost of producing the product
• Markets maximize the difference between benefits
and costs
• Market outcomes are the best provided that
• The market is in equilibrium AND
• No costs or benefits are shared with the public
Cash on the Table
• Buyer's surplus: buyer's reservation price minus the
market price
• Seller's surplus: market price minus the seller's
reservation price
• Total surplus = buyer's surplus + seller's surplus
• Total surplus is buyer's reservation price – seller's
reservation price
• No cash on the table when surplus is maximized
• No opportunity to gain from additional sales or
purchases
Efficiency Principle
• Socially optimal quantity maximizes the total
surplus for the economy from producing and selling
a good
• Economic efficiency -- all goods at their socially optimal
level
• Efficiency Principle: equilibrium price and quantity
are efficient if
• Sellers pay all the costs of production
• Buyers receive all the benefits of their purchase
• Efficiency: marginal cost equals marginal benefit
• Production is efficient if total surplus is maximized
Smart for One, Dumb for All
• Producers sometimes shift costs to others
• Pollution is like getting free waste disposal services
• Total marginal cost = seller's marginal cost plus marginal
cost of pollution
• When costs are shifted, supply is greater than socially
optimal
• Buyers may create benefits for others
• Marginal benefit is less than the full social benefit
• Vaccinations, my neighbor's landscaping
• The demand for these goods is less than socially optimal
Equilibrium Principle
• Equilibrium Principle: no unexploited opportunities
for individuals
• BUT it may not exploit all gains achievable through
collective action
• Only when the seller pays the full cost of production and
the buyer captures the full benefit of the good is the
market outcome socially optimal
• Regulation, taxes and fines, or subsidies can move the market
to optimal level
Chapter 3 Appendix
The Algebra of Supply and Demand
From Graphs to Equations …
• Sample equations
P = 16 – 2 Qd
is a straight-line demand curve with intercept 16 on
the vertical (P) axis and a slope of – 2
P = 4 + 4 Qs
is a straight-line supply curve with intercept 4 and a
slope of 4
… To Equilibrium P and Q
• Equilibrium is where P and Q are the same for
demand and supply
• Set the two equations equal to each other (P = P) and
solve for Q (Qs = Qd = Q*)
16 – 2 Q* = 4 + 4 Q*
6 Q* = 12
Q* = 2
• Use either the supply or demand curve and Q* = 2
to find price
P = 16 – 2 Q*
P = $12
P = 4 + 4 Q*
P = $12