Chapter 3
Supply,Demand,
and the Market Process
Slides to Accompany “Economics: Public and Private Choice 9th ed.”
James Gwartney, Richard Stroup, and Russell Sobel
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page
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1. Consumer Choice and
the Law of Demand
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Law of Demand

Law of Demand: There is an inverse
relationship between the price of a
good and the quantity consumers are
willing to purchase.
As price of a good rises, consumers
buy less.
 The availability of substitutes --goods
that do similar functions -- explains
this negative relationship.

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Market Demand Schedule



A market demand schedule is a table
that shows the quantity of a good
people will demand at varying prices.
Consider the market for cellular
phones. A market demand schedule
lays out the amount of cell phones that
are demanded in the market for a
spectrum of prices.
We can graph these points (price and
the respective demand) to make a
demand curve for cell phones.
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Market Demand
Schedule
Price
(monthly bill)
140
Millions of
Cell Phone
(monthly bill) Subscribers
Cell Phone
Price
$123
$107
$ 92
$ 79
$ 73
$ 63
$ 56
2.1
3.5
5.3
7.6
11.0
16.0
24.1
120
100
80
Demand
60
5
10
15
20
25 30
Quantity
(of Cell Phone
Subscribers)
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Market Demand
Schedule
Price
(monthly bill)
140
• Notice how the law of
demand is reflected by
the shape of the demand
curve.
• As the price of a good
rises …
• . . . consumers buy less.
120
100
80
Demand
60
5
10
15
20
25 30
Quantity
(of Cell Phone
Subscribers)
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Market Demand
Schedule
Price
(monthly bill)
140
120
• The height of the demand
curve at any quantity shows
the maximum price that
100
consumers are willing to
pay for that additional unit.
80
• Here, for the 11th unit . . .
• . . . consumers are only
willing to pay up to $73 for it. 60
Demand
• While they would be willing
to pay up to $92 for the
5.3 (millionth) unit.
5
10
15
20
25 30
Quantity
(of Cell Phone
Subscribers)
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Consumer Surplus

Consumer Surplus - the area below the
demand curve but above the actual
price paid.


Consumer surplus is the difference
between the amount consumers are
willing to pay and the amount they
have to pay for a good.
Lower market prices will increase
consumer surplus.
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Consumer Surplus
• Lets consider the market for
Price
(monthly bill)
cellular phones again. This time
we will assume that the demand 140
for cell phones is more linear
and that the market price is $100. 120
• If the market price is $100, then
the 25th unit will not sell
because those who demand it are 100
only willing to pay $60 for
cellular phone service.
80
• At $100, the 15th unit will sell
because those who demand it are
60
willing to pay up to $100 for
cellular phone service.
• At $100, the 10th unit will sell
because those who demand it are
willing to pay up to $120 for
cellular phone service.
Market
Price = $100
Demand
5
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10
15
20
25 30
Quantity
(of Cell Phone
Subscribers)
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Consumer Surplus
Price
(monthly bill)
• For all those goods under 15
units, people are willing to
pay more than $100 for service.
• The area, represented by the
distance above the actual price
paid and below the demand
curve, is called consumer
surplus.
• This area represents the net
gains to buyers from market
exchange.
140
120
Market
Price = $100
100
80
Demand
60
5
10
15
20
25 30
Quantity
(of Cell Phone
Subscribers)
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Elastic and Inelastic
Demand Curves

Elastic demand - quantity demanded is
sensitive to small price changes.


Easy to substitute away from good.
Inelastic demand - quantity demanded
is not sensitive to price changes.

Difficult to substitute away from good.
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Elastic and Inelastic
• If the market price for
Demand Curves
gasoline was to rise from
$1.25 to $2.00, the
quantity demanded in the
market decreases
insignificantly
(from 8 to 7 units).
• If the market price for
tacos rises from $1.25 to
$2.00, the quantity
demanded in the market
decreases significantly
(from 8 to 1 unit).
• Taco demand is highly
sensitive to price changes
and can be described as
elastic; gasoline demand
is relatively insensitive
to price changes and can
be described as inelastic.
2.00
Gasoli
ne
1.25
1 2 3 4
5 6 7 8 9 10
2.00
Tacos
1.25
1 2 3 4
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5 6 7 8 9 10
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2. Changes in Demand
Versus Changes in
Quantity Demanded
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Changes in Demand and
Quantity Demanded


Change in Demand - shift in entire
demand curve.
Change in Quantity Demanded movement along the same demand
curve in response to a price change.
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Change in Demand
Price
(dollars)
• If CDs cost $15 each, the CD
demand curve D1 shows that
10 units would be demanded.
• If the price of CDs changed
to $7.50, the quantity
demanded for CDs would
increase to 20 units.
• If, somehow, the preferences
for CDs changed then the
demand for CDs may change.
• Here we will assume that
consumer income increases,
increasing demand for CDs
at all price levels. At $15
15 units are now demanded.
25
20
15
10
5
D1
5
10
15
20
D2
25 30
Quantity
(of Compact
Disks per yr)
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Demand Curve Shifters






Changes in Consumer Income
Change in the Number of Consumers
Change in Price of Related Good
Changes in Expectations
Demographic Changes
Changes in Consumer Tastes and
Preferences
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Questions for Thought:
1. Which of the following do you think would lead
to an increase in the current demand for beef:
(a) higher pork prices,
(b) higher incomes,
(c) higher prices of feed grains used to feed cows,
(d) good weather conditions leading to a bumper
(very good) corn crop,
(e) an increase in the price of beef?
2. What is being held constant when a demand
curve for a specific product (like shoes or
apples, for example) is constructed? Explain
why the demand curve for a product slopes
downward and to the right.
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3. Producer Choice and
the Law of Supply
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Producers


Opportunity Cost of Production - the
sum of the producer’s cost of
employing each resource required to
produce the good.
Firms will not stay in business for long
unless they are able to cover the cost
of all resources employed, including
the opportunity cost of those owned by
the firm.
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Role of Profits and Losses



Profit occurs when revenues are
greater than cost.
Firms supplying goods for which
consumers are willing to pay more
than the opportunity cost of resources
used will make a profit.
Firms making a profit will expand and
those with a loss will contract.
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Law of Supply

Law of Supply - there is a positive
relationship between the price of a
product and the amount of it that will
be supplied.

As the price of a product rises,
producers will be willing to supply
more.
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Market Supply
Schedule
Price
(monthly bill)
Supply
140
Quantity of
Cell Phones
Supplied
(monthly bill)
Cell Phone
Price
$ 60
$ 73
$ 80
$ 91
$107
$120
$135
5.0
11.0
15.1
18.2
21.0
22.5
24.1
120
100
80
60
5
10
15
20
25 30
Quantity
(of Cell Phone
Subscribers)
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Market Supply
Schedule
Price
(monthly bill)
Supply
140
• Notice how the law of
supply is reflected by
the shape of the supply
curve.
• As the price of a good
rises …
• . . . producers supply more.
120
100
80
60
5
10
15
20
25 30
Quantity
(of Cell Phone
Subscribers)
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Market Supply
Schedule
Price
(monthly bill)
Supply
140
• The height of the supply
curve at any quantity shows
the minimum price necessary 120
to induce producers to supply
that next unit to market.
100
• Here, for the 11th unit . . .
• . . . producers require $73 to
80
induce them to supply it.
• The height of the supply
curve at any quantity also
60
shows the opportunity cost
of producing that next unit
of the good.
5
10
15
20
25 30
Quantity
(of Cell Phone
Subscribers)
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Producer Surplus
• Lets consider the market for
Price
Supply
(monthly bill)
cellular phones again. This time
140
we will assume that the supply
for cell phones is more linear
and that the market price is $100. 120
• If the market price is $100,
then the 25th unit will not be
100
produced because the cost of
supplying it exceeds the market
price of $140.
80
• At $100, the 15th unit will be
produced because those who
supply it are willing to do so for
60
for at least $100.
• At $100, the 10th unit will be
produced because those who
supply it are willing to do so
for at least $80.
Market
Price = $100
5
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10
15
20
25 30
Quantity
(of Cell Phone
Subscribers)
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Producer Surplus
Price
Supply
(monthly bill)
• For market outputs of less then
15 units, producers are willing
to supply the good for $100.
• The area represented by the
distance above the supply
curve but below the actual sales
price is called producer surplus.
• This area is the difference
between the minimum amount
required to induce producers to
supply a good and the amount
they actually receive.
140
120
Market
Price = $100
100
80
60
5
10
15
20
25 30
Quantity
(of Cell Phone
Subscribers)
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Elastic and Inelastic
Supply Curves


Elastic supply- quantity supplied is
sensitive to small price changes.
Inelastic supply - quantity supplied is
not sensitive to price changes.
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Elastic and Inelastic
• If the market price for
Supply Curves
motor oil was to rise
from $1.25 to $2.00, the
quantity supplied in the
market increases
insignificantly
(from 7 to 8 units).
• If the market price for
burgers rises from $1.25
to $2.00, the quantity
supplied in the market
increases substantially
(from 1 to 8 units).
• Burger supply is highly
sensitive to price changes
and can be described as
elastic; motor oil supply
is relatively insensitive
to price changes and can
be described as inelastic.
2.00
1.25
1 2 3 4
5 6 7 8 9 10
1 2 3 4
5 6 7 8 9 10
2.00
1.25
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Short Run and Long Run

Short Run - Firms don’t have enough
time to change plant size.


Supply tends to be inelastic in the
short run.
Long Run - Firms have enough time to
change plant size.

Supply tends to be much more elastic
in the long run.
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4. Changes in Supply
Versus Changes in
Quantity Supplied
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Changes in Supply and
Quantity Supplied


Change in Supply - shift in entire
supply curve.
Change in Quantity Supplied movement along the same supply
curve in response to a price change.
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Change in Supply
Price
(dollars)
• If the market price for gas is
$1.50 a gallon, the gasoline
supply curve S1 shows that 20
units would be supplied.
• If the market price of gas
changed to $.75, the
quantity supplied of gasoline
would decrease to 10 units.
• If, somehow, the opportunity
costs for gas manufacturers
changed then the supply of gas
may change.
• Here we will assume that the
cost of crude oil (an input in
gasoline) increases, decreasing
the supply of gas at all price
levels. Now at $1.50, 15 units
of gasoline are supplied.
S2
The Market
for
Gasoline
2.50
2.00
S1
1.50
1.00
.50
5
10
15
20
25 30
Quantity
(Millions of
Gal of Gas)
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Supply Curve Shifters




Changes in Resource Prices
Change in Technology
Elements of Nature and Political
Disruptions
Changes in Taxes
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Questions for Thought:
1. What are profits and losses? What must a firm
do in order to make profit?
2. Define consumer and producer surplus. What is
meant by economic efficiency and how does it
relate to consumer and producer surplus?
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5. How Market Prices
are Determined
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Market Equilibrium
• This table and graph indicate the demand and
supply conditions for oversized playing cards.
• Equilibrium will occur where the quantity
demanded equals the quantity supplied. If the
price in the market exceeds the equilibrium
level, market forces will guide it to equilibrium.
• A price of $12 in this market will result in . . .
quantity demanded of 450 and quantity
supplied of 600 . . . resulting in excess supply.
• With an excess supply present, there will be
downward pressure on price to clear the market.
Demand
13
12
11
10
9
8
7
Price of
Quantity
Quantity Condition Direction
Cards
Supplied
Demanded
in the
of Pressure
(Dollars) (per month) (per month) Market
on Price
>
12
600
450
10
550
550
8
500
650
Excess
Supply
Downward
Supply
350 400 450 500 550 600 650
Quantity Supplied
= 600
Quantity Demanded
= 450
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Market Equilibrium
Demand
• A price of $8 in this market will result in . . .
quantity supplied of 500 and quantity
demanded of 650 . . . resulting in excess demand.
• With an excess demand present, there will be
upward pressure on price to clear the market.
13
12
11
10
9
8
7
Price of
Quantity
Quantity Condition Direction
Cards
Supplied
Demanded
in the
of Pressure
(Dollars) (per month) (per month) Market
on Price
12
600
10
550
8
500
>
450
Excess
Supply
Downward
550
<
650
Excess
Demand Upward
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Supply
350 400 450 500 550 600 650
Quantity Supplied
= 500
Quantity Demanded
= 650
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Market Equilibrium
Demand
• A price of $10 in this market will result in . . .
quantity supplied of 550 and quantity
demanded of 550 . . . resulting in a balance.
• With a balance present, there will be an
equilibrium and the market will clear.
13
12
11
10
9
8
7
Price of
Quantity
Quantity Condition Direction
Cards
Supplied
Demanded
in the
of Pressure
(Dollars) (per month) (per month) Market
on Price
12
600
10
550
8
500
>
=
<
450
550
650
Excess
Supply
Downward
Balance Equilibrium
Excess
Demand Upward
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Supply
350 400 450 500 550 600 650
Quantity Supplied
= 550
Quantity Demanded
= 550
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Market Equilibrium
Demand
• At every price above market equilibrium there
is excess supply and there will be downward
pressure on the price level.
• At every price below market equilibrium there
is excess demand and there will be upward
pressure on the price level.
• It is at equilibrium that prices will rest.
13
12
11
10
9
8
7
Price of
Quantity
Quantity Condition Direction
Cards
Supplied
Demanded
in the
of Pressure
(Dollars) (per month) (per month) Market
on Price
12
600
10
550
8
500
>
=
<
450
550
650
Excess
Supply
excess
supply
Equilibrium
Price
Supply
excess
demand
350 400 450 500 550 600 650
Downward
Balance Equilibrium
Excess
Demand Upward
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Net Gains to Buyers and Sellers
• Returning to the market for cell
Price
Supply
(monthly bill)
phones, if the market price is driven
140
to equilibrium through market
pressures to exist where supply
equals demand, then the market
120
equilibrium in the cell phone market
should be driven to $100 per month.
• If the area above the market price
and below the demand curve is
called consumer surplus . . .
• . . . and the area above the supply
curve but below the market price is
called producer surplus . . .
• . . . Then the combined area
represented in the graph to the right
represents the net gains to buyers
and sellers. It is here that all
potential gains from production and
exchange are realized.
Market Equilibrium
Price = $100
100
80
Demand
60
5
10
15
20
25 30
Quantity
(of Cell Phone
Subscribers)
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6. How Markets Respond
to Changes in
Supply and Demand
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Effects of a Change
in Demand


If Demand decreases, the equilibrium
price and quantity will fall.
If Demand increases, the equilibrium
price and quantity will rise.
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• Consider the market for eggs.
Market Adjustment to an
Increase
in
Demand
Price
($ per doz)
• Prior to Easter season, the market
for eggs produces an equilibrium
1.40
where Supply equals Demand1
at a market price of $ .80 and
1.20
output of Q1.
• When the Easter season arrives, the
demand by consumers for eggs
1.00
increases from Demand1 to
Demand2. What happens to the
equilibrium price and output level?
.80
• At $ .80 a dozen the quantity
demanded exceeds the quantity
supplied. There is upward
.60
pressure on price inducing the
existing suppliers to increase their
quantity supplied to Q2, pushing
the equilibrium price up to $1.00.
• What happens to equilibrium price
and output after the Easter season?
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Supply
`
Demand2
Demand1
Q1
Q2
Quantity
(million doz eggs
per week)
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Effects of a Change
in Supply


If Supply decreases, the equilibrium
price will rise and the equilibrium
quantity will fall.
If Supply increases, the equilibrium
price will fall and the equilibrium
quantity will rise.
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• Consider the market for romaine
lettuce.
• Prior to a season of adverse weather
affecting the yield of the market,
an equilibrium exists where Supply
equals Demand1 with a market
price of $1.80 and output of Q1.
• When the season of adverse weather
arrives the supply of romaine
lettuce falls, decreasing the supply
from supply1 to supply2. What
happens to the equilibrium price
and output level?
• At $1.80 a head the quantity
demanded exceeds the quantity
supplied. There is upward pressure
on price inducing the existing
consumers to decrease their quantity
demanded to Q2, drawing up the
equilibrium price to $2.00.
• What happens to equilibrium price
and output when the weather
returns to normal?
Market Adjustment to a
Decrease
in
Supply
Price
($ per head)
Supply2
2.40
2.20
2.00
Supply1
`
1.80
1.60
Demand1
Q2
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Q1
Quantity
(million heads lettuce
per week)
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7. Time and the
Adjustment Process
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Time and the
Adjustment Process

With the passage of time, the market
adjustments of both producers and
consumers will be more complete.

Both demand and supply are more
elastic in the long run than in the short
run.
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• Consider the market for laptop
computers.
• We begin in the short run in
equilibrium at output level Q1
and price level P1.
• When the demand for laptops
unexpectedly increases from
demand1 to demand2, suppliers do
there best to increase product in the
market, pushing the price level
upward to P2. What happens to the
equilibrium price and output in
the long run, after suppliers have a
chance to change their capacity?
• With time suppliers expand output
pivoting the supply curve to its
long run representation. The new
equilibrium is where demand equals
supply. The result, a further
increase in equilibrium output, to
Q3, and a reduction in the
equilibrium price to P3.
Time and Adjustment to
Increase in Demand
SupplySR
Price
SupplyLR
P2
P3
`
Demand2
P1
Demand1
Q1 Q2Q3
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Quantity
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8. Invisible Hand
Principle
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Invisible Hand

Invisible hand- the tendency of market
prices to direct individuals pursuing
their own interest into productive
activities that also promote the
economic well-being of society.
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Communicating
Information


Product prices communicate up-todate information about the consumers’
valuation of additional units of each
commodity.
Without the information provided by
market price it would be impossible
for decision-makers to determine how
intensely a good was desired relative
to its opportunity cost.
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Coordinating Actions of
Market Participants


Price changes bring the decisions of
buyers and sellers into harmony.
Price changes create profits and losses
which change production levels for
various products.
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Prices and Market Order

Market order is the result of market
prices, not central planning.
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Qualifications

The efficiency of market organization
is dependent upon:
The presence of competitive markets.
 Well-defined and enforced private
property rights.

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Questions for Thought:
1. A drought during the summer of 1988 sharply
reduced the 1988 output of wheat, corn, soybeans,
and hay. Indicate the expected impact of the
drought on the following:
a. Prices of feed grains and hay during the
summer of ‘88.
b. Price of cattle during the fall of ‘88.
(Hint: What has happened to the opportunity cost
of maintaining cattle during the upcoming winter?)
c. Price of cattle during the summer and fall of ‘89.
2. What is the “invisible hand” principle? Does it
indicate that “good intentions” are necessary if
one’s actions are going to be beneficial to others?
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End
Chapter 3
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