CHAPTER 2
Market Forces:
Demand and Supply
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter Outline
Chapter Overview
• Demand
– Factors that change quantity demanded and factors that change demand
– The demand function
– Consumer surplus
• Supply
– Factors that change quantity supplied and factors that change supply
– The supply function
– Producer surplus
• Market equilibrium
• Price restrictions and market equilibrium
– Price ceilings
– Price floors
• Comparative statics
– Changes in demand
– Changes in supply
– Simultaneous shifts in supply and demand
2-2
Demand
Demand
• Market demand curve
– Illustrates the relationship between the total
quantity and price per unit of a good all
consumers are willing and able to purchase,
holding other variables constant.
• Law of demand
– The quantity of a good consumers are willing and
able to purchase increases (decreases) as the
price falls (rises).
2-3
Demand
Market Demand Curve
Price ($)
$40
$30
$20
$10
Demand
0
20
40
60
80
Quantity
(thousands per year)
2-4
Changes in Quantity Demanded
Demand
• Changing only price leads to changes in
quantity demanded.
– This type of change is graphically represented by a
movement along a given demand curve, holding
other factors that impact demand constant.
• Changing factors other than price lead to
changes in demand.
– These types of changes are graphically
represented by a shift of the entire demand curve.
2-5
Demand
Changes in Demand
Price
Increase
in
demand
A
Decrease
in
demand
B
D1
D2
0
D0
Quantity
2-6
Demand
Demand Shifters
• Income
– Normal good
– Inferior good
• Prices of related goods
– Substitute goods
– Complement goods
• Advertising and consumer tastes
– Informative advertising
– Persuasive advertising
• Population
• Consumer expectations
• Other factors
2-7
Demand
Advertising and the Demand for Clothing
Price of
high-style
clothing
Due to an
increase in
advertising
$50
$40
D2
D1
0
50,000 60,000
Quantity of
high-style
clothing
2-8
The Demand Function
Demand
• The demand function for good X is a
mathematical representation describing how
many units will be purchased at different
prices for good X, different prices of a related
good Y, different levels of income, and other
factors that affect the demand for good X.
2-9
The Linear Demand Function
Demand
• One simple, but useful, representation of a
demand function is the linear demand function:
𝑑
𝑄𝑋 = 𝛼0 + 𝛼𝑋 𝑃𝑋 + 𝛼𝑌 𝑃𝑌 + 𝛼𝑀 𝑀 + 𝛼𝐻 𝐻
, where:
–
–
–
–
–
𝑄𝑋 𝑑 is the number of units of good X demanded;
𝑃𝑋 is the price of good X;
𝑃𝑌 is the price of a related good Y;
𝑀 is income;
𝐻 is the value of any other variable affecting demand.
2-10
Demand
Understanding the Linear Demand Function
• The signs and magnitude of the 𝛼 coefficients
determine the impact of each variable on the
number of units of X demanded.
𝑄𝑋 𝑑 = 𝛼0 + 𝛼𝑋 𝑃𝑋 + 𝛼𝑌 𝑃𝑌 + 𝛼𝑀 𝑀
• For example:
– 𝛼𝑋 < 0 by the law of demand;
– 𝛼𝑌 > 0 if good Y is a substitute for good X;
– 𝛼𝑀 < 0 if good X is an inferior good.
2-11
Demand
The Linear Demand Function in Action
• Suppose that an economic consultant for X Corp.
recently provided the firm’s marketing manager with
this estimate of the demand function for the firm’s
product:
𝑄𝑋 𝑑 = 12,000 − 3𝑃𝑋 + 4𝑃𝑌 − 1𝑀 + 2𝐴𝑋
Question: How many of good X will consumers
purchase when 𝑃𝑋 = $200 per unit, 𝑃𝑌 = $15 per unit,
𝑀 = $10,000 and 𝐴𝑋 = 2,000? Are goods X and Y
substitutes or complements? Is good X a normal or an
inferior good?
2-12
Inverse Demand Function
Demand
• By setting 𝑃𝑌 = $15 and 𝑀 = $10,000 and 𝐴 =
2,000 the demand function is
𝑄𝑋 𝑑 = 12,000 − 3𝑃𝑋 + 4 15 − 1 10,000 + 2 2,000
the linear demand function simplifies to
𝑑
𝑄𝑋 = 6,060 − 3𝑃𝑋
Solving this for 𝑃𝑋 in terms of 𝑄𝑋 𝑑 results in
1 𝑑
𝑃𝑋 = 2,020 − 𝑄𝑋
3
, which is called the inverse demand function. This
function is used to construct a market demand
curve.
2-13
Demand
Graphing the Inverse Demand Function in Action
Price
$2,020
1
𝑃𝑋 = 2,020 − 𝑄𝑋 𝑑
3
0
6,060
Quantity
2-14
Demand
Consumer Surplus
• Marketing strategies – like value pricing and
price discrimination – rely on understanding
consumer value for products.
– Total consumer value is the sum of the maximum
amount a consumer is willing to pay at different
quantities.
– Total expenditure is the per-unit market price
times the number of units consumed.
– Consumer surplus is the extra value that
consumers derive from a good but do not pay for.
2-15
Demand
Market Demand and Consumer Surplus in Action
Consumer Surplus
Price per
liter
Consumer Surplus:
0.5($5 - $3)x(2-0) = $2
Total Consumer Value:
0.5($5 - $3)x2+(3-0)(2-0) = $8
$5
$4
Expenditures:
$(3-0) x (2-0) = $6
$3
$2
$1
Demand
0
1
2
3
4
5
Quantity
in liters
2-16
Supply
Supply
• Market supply curve
– Summarizes the relationship between the total
quantity all producers are willing and able to
produce at alternative prices, holding other
factors affecting supply constant.
• Law of supply
– As the price of a good rises (falls), the quantity
supplied of the good rises (falls), holding other
factors affecting supply constant.
2-17
Changes in Quantity Supplied
Supply
• Changing only price leads to changes in
quantity supplied.
– This type of change is graphically represented by a
movement along a given supply curve, holding
other factors that impact supply constant.
• Changing factors other than price lead to
changes in supply.
– These types of changes are graphically
represented by a shift of the entire supply curve.
2-18
Change in Supply in Action
Supply
Price
S1
S0
B
Decrease
in supply
S2
Increase
in supply
A
0
Quantity
2-19
Supply Shifters
Supply
• Input prices
• Technology or government regulation
• Number of firms
– Entry
– Exit
• Substitutes in production
• Taxes
– Excise tax (Levied on each unite of output sold)
– Ad valorem tax (percentage tax: sales tax)
• Producer expectations
2-20
Change in Supply in Action
Supply
Excise tax
Price
of
gasoline
S0+t
$1.20
S0
t = 20¢
t
$1.00
t = per unit tax of 20¢
0
Quantity of
gasoline per
week
2-21
Change in Supply in Action
Price Ad valorem tax
of
backpacks
Supply
S1 = 1.20 x S0
$24
S0
$20
$12
$10
0
1,100
2,450
Quantity of
backpacks per
week
2-22
The Supply Function
Supply
• The supply function for good X is a
mathematical representation describing how
many units will be produced at different prices
for X, different prices of inputs W, prices of
technologically related goods, and other
factors that affect the supply for good X.
2-23
The Linear Supply Function
Supply
• One simple, but useful, representation of a
supply function is the linear supply function:
𝑠
𝑄𝑋 = 𝛽0 + 𝛽𝑋 𝑃𝑋 + 𝛽𝑊 𝑊 + 𝛽𝑟 𝑃𝑟 + 𝛽𝐻 𝐻
, where:
– 𝑄𝑋 𝑠 is the number of units of good X produced;
– 𝑃𝑋 is the price of good X;
– 𝑊 is the price of an input;
– 𝑃𝑟 is price of technologically related goods;
– 𝐻 is the value of any other variable affecting
supply.
2-24
Supply
Understanding the Linear Supply Function
• The signs and magnitude of the 𝛽 coefficients
determine the impact of each variable on the
number of units of X produced.
𝑄𝑋 𝑠 = 𝛽0 + 𝛽𝑋 𝑃𝑋 + 𝛽𝑊 𝑊 + 𝛽𝑟 𝑃𝑟
• For example:
– 𝛽𝑋 > 0 by the law of supply.
– 𝛽𝑊 < 0 increasing input price.
– 𝛽𝑟 > 0 technology lowers the cost of producing
good X.
2-25
Supply
The Linear Supply Function in Action
• Your research department estimates that the
supply function for televisions sets is given by:
𝑠
𝑄𝑋 = 2,000 + 3𝑃𝑋 − 4𝑃𝑅 − 1𝑃𝑊
Question: How many televisions are produced
when 𝑃𝑋 = $400, 𝑃𝑅 = $100 per unit, and
𝑃𝑊 = $2,000?
2-26
Inverse Supply Function
Supply
• By setting 𝑃𝑊 = $2,000 and 𝑃𝑟 = $100 in
𝑠
𝑄𝑋 = 2,000 + 3𝑃𝑋 − 4 100 − 1 2,000
the linear supply function simplifies to
𝑄𝑋 𝑠 = 3𝑃𝑋 − 400
𝑠
Solving this for 𝑃𝑋 in terms of 𝑄𝑋 results in
400 1 𝑠
𝑃𝑋 =
+ 𝑄𝑋
3
3
, which is called the inverse supply function.
This function is used to construct a market
supply curve.
2-27
Producer Surplus
Supply
• The amount producers receive in excess of the
amount necessary to induce them to produce
the good.
2-28
Producer Surplus in Action
400 1 𝑆
𝑃𝑋 =
+ 𝑄𝑋
3
3
Price
Supply
Supply
$400
Producer surplus
$400
3
0
800
Quantity
2-29
Market Equilibrium
Market Equilibrium
• Competitive market equilibrium
– Price of a good is determined by the interactions
of the market demand and market supply for the
good.
– A price and quantity such that there is no shortage
or surplus in the market.
– Forces that drive market demand and market
supply are balanced, and there is no pressure on
prices or quantities to change.
2-30
Market Equilibrium I
Price
Market Equilibrium
Supply
Surplus
𝑃𝐻
𝑃𝑒
𝑃𝐿
Shortage
0
𝑄0
𝑄𝑒
Demand
𝑄1
Quantity
2-31
Market Equilibrium
Market Equilibrium II
• Consider a market with demand and supply
functions, respectively, as
𝑄 𝑑 = 10 − 2𝑃 and 𝑄 𝑠 = 2 + 2𝑃
• A competitive market equilibrium exists at a
price, 𝑃𝑒
• 𝑄𝑒
2-32
Price Restrictions and Market Equilibrium
Price Restrictions
• In a competitive market equilibrium, price and
quantity freely adjust to the forces of demand
and supply.
• Sometimes the government restricts how
much prices are permitted to rise or fall.
– Price ceiling (rental control for tenants)
– New York City’s rent control program, which began
in 1943, is among the oldest in the country
– Price floor (minimum wage)
– 7.25 dollar/hour in TX (Jan. 1st 2014)
2-33
Price Restrictions and Market Equilibrium
Price Ceiling in Action I
Price
Supply
Nonpecuniary price
Lost social welfare
𝑃𝐹
𝑃𝑒
𝑃𝑐
Priceceiling
Shortage
0
𝑄𝑠
𝑄𝑒
Demand
𝑄𝑑
Quantity
2-34
Price Restrictions and Market Equilibrium
Price Ceiling in Action II
• Consider a market with demand and supply
functions, respectively, as
𝑄𝑑 = 10 − 2𝑃 and 𝑄 𝑠 = 2 + 2𝑃
• Suppose a $1.50 price ceiling is imposed on the
market.
–
–
–
–
𝑄𝑑 = ? 𝑢𝑛𝑖𝑡𝑠
𝑄 𝑠 = ? 𝑢𝑛𝑖𝑡𝑠
𝑄𝑑 ? 𝑄 𝑠
Full economic price of 5𝑡ℎ unit is 5 = 10 − 2𝑃𝑓𝑢𝑙𝑙 , or
𝑃𝑓𝑢𝑙𝑙 = $2.50. Of this,
• $1.50 is the dollar price
• $1 is the nonpecuniary price
2-35
Price Restrictions and Market Equilibrium
Price Floor in Action I
Price
Supply
Surplus
𝑃𝑓
Pricefloor
𝑃𝑒
Cost of
purchasing
excess supply
Demand
0
𝑄𝑑
𝑄𝑒
𝑄𝑠
Quantity
2-36
Price Restrictions and Market Equilibrium
Price Floor in Action II
• Consider a market with demand and supply
functions, respectively, as
𝑄 𝑑 = 10 − 2𝑃 and 𝑄 𝑠 = 2 + 2𝑃
• Suppose a $4 price floor is imposed on the
market.
– 𝑄 𝑑 =? units
– 𝑄 𝑠 =? units
– Since 𝑄 𝑠 ? 𝑄 𝑑 a surplus of 10 − 2 = 8 units exists
– The cost to the government of purchasing the
surplus is ?
2-37
Comparative Statics
Comparative Statics
• Comparative static analysis
– The study of the movement from one equilibrium
to another.
• Competitive markets, operating free of price
restraints, will be analyzed when:
– Demand changes;
– Supply changes;
– Demand and supply simultaneously change.
2-38
Comparative Statics
Changes in Demand
• Increase in demand only
– Increase equilibrium price
– Increase equilibrium quantity
• Decrease in demand only
– Decrease equilibrium price
– Decrease equilibrium quantity
• Example of change in demand
– Suppose that consumer incomes are projected to
increase 2.5% and the number of individuals over 25
years of age will reach an all time high by the end of
next year. What is the impact on the rental car
market?
2-39
Comparative Statics
Change in Demand in Action
Demand for Rental Cars
Price
Supply
$49
$45
Demand1
Demand0
0
100
104
108
Quantity
(thousands
rented per day)
2-40
Comparative Statics
Changes in Supply
• Increase in supply only
– Decrease equilibrium price
– Increase equilibrium quantity
• Decrease in supply only
– Increase equilibrium price
– Decrease equilibrium quantity
• Example of change in supply
– Suppose that a bill before Congress would require
all employers to provide health care to their
workers. What is the impact on retail markets?
2-41
Comparative Statics
Change in Supply in Action
Price
𝑃
Supply1
Supply0
1
𝑃0
Demand
0
𝑄1
𝑄0
Quantity
2-42
Comparative Statics
Simultaneous Shifts in Supply and Demand
• Suppose that simultaneously the following
events occur:
– an earthquake hit Kobe, Japan and decreased the
supply of fermented rice used to make sake wine.
– the stress caused by the earthquake led many to
increase their demand for sake, and other
alcoholic beverages.
• What is the combined impact on Japan’s sake
market?
2-43
Comparative Statics
Simultaneous Shifts in Supply and Demand in Action
Japan’s Sake Market
Price
Supply2
C
𝑃2
Supply1
B
𝑃1
Supply0
A
𝑃0
Demand1
Demand0
0
𝑄2 𝑄0
𝑄1
Quantity
2-44
Conclusion
• Demand and supply analysis is useful for
– Clarifying the “big picture” (the general impact of
a current event on equilibrium prices and
quantities).
– Organizing an action plan (needed changes in
production, inventories, raw materials, human
resources, marketing plans, etc.).
2-45
Demand
Market Demand Curve
Price
(Dollars per Barrel)
International Oil Market
$140
$100
$60
$20
Demandoil
0
80
160
240
280
Quantity
(Millions of Barrels)
2-46
Demand
Changes in Quantity Demanded
Price
(Dollars per Barrel)
International Oil Market
$140
Increase in quantity demanded
$100
$90
Demandoil
0
80 100
280
Quantity
(Millions of Barrels)
2-47
Demand
Change in Demand
International Oil Market
Price
(Dollars per Barrel)
$160
$140
$100
$90
Increase in demand
Demandoil2
Demandoil1
0
80 100
120 140
280 Quantity
(Millions of Barrels)
2-48
Change in Quantity Supplied
Supply
International Oil Market
Price
Supplyoil
(Dollars per Barrel)
$65
$60
Increase in quantity supplied
$20
0
80
90
Quantity
(Millions of Barrels)
2-49
Supply
The Market Supply Curve
International Oil Market
Price
Supplyoil
(Dollars per Barrel)
$140
$100
$60
$20
0
80
160
240
Quantity
(Millions of Barrels)
2-50
Change in Supply in Action
Supply
International Oil Market
Price
(Dollars per Barrel)
Supplyoil2
Decrease in supply
Supplyoil1
$140
$100
$50
$20
0
100
160
180
240
Quantity
(Millions of Barrels)
2-51
Market Equilibrium
Competitive Market Equilibrium I
International Oil Market
Price
(Dollars per Barrel)
Supplyoil
Surplus
160 million barrels
$140
Forces of demand and supply
put downward
pressure on price.
Competitive market equilibrium
Qd(Pe) = Qs(Pe)
Forces of demand and supply
put upward pressure
on price.
Shortage
Demandoil
160 million barrels
$120
Pe = $80
$40
$20
0
40
Qe = 120
200
280 Quantity
(Millions of Barrels)
2-52
Price Restrictions and Market Equilibrium
Price Ceiling in Action I
International Oil Market
Price
Supplyoil
(Dollars per Barrel)
Lost social welfare
Nonpecuniary price
$140
Pf = $120
Competitive market equilibrium
Qd(Pe) = Qs(Pe)
Pe = $80
Priceceiling
Pc = $40
Shortage
160 million barrels
$20
0
40
Qe = 120
Demandoil
200
280 Quantity
(Millions of Barrels)
2-53
Comparative Statics
Changes in Demand
• Increase in demand only
– Increase equilibrium price
– Increase equilibrium quantity
• Decrease in demand only
– Decrease equilibrium price
– Decrease equilibrium quantity
• Example of change in demand
– Suppose that worldwide demand for automobiles
is projected to decrease by 30% next year. What is
the impact on the international crude oil market?
2-54
Comparative Statics
Change in Demand in Action
International Oil Market
Price
Supplyoil
(Dollars per Barrel)
$140
Pe1 = $80
Pe2 = $54
Demandoil2
$20
0
Qe2 = 68
Qe1 = 120
Demandoil1
280 Quantity
(Millions of Barrels)
2-55
Comparative Statics
Changes in Supply
• Increase in supply only
– Decrease equilibrium price
– Increase equilibrium quantity
• Decrease in supply only
– Increase equilibrium price
– Decrease equilibrium quantity
• Example of change in supply
– Suppose that war breaks out in a major oilproducing country in the Middle East. What is the
impact on the international crude oil market?
2-56
Comparative Statics
Change in Supply in Action
International Oil Market
Price
Supplyoil2
(Dollars per Barrel)
Supplyoil1
$140
Pe2 = $100
Pe1 = $80
Demandoil
$20
0
Qe2 = 80
Qe1 = 120
280 Quantity
(Millions of Barrels)
2-57
Comparative Statics
Simultaneous Shifts in Supply and Demand
• Suppose that simultaneously the following
two events occur:
– worldwide demand for automobiles is projected
to decrease by 30% next year.
– war breaks out in a major oil-producing country in
the Middle East.
• What is the combined impact on the
international crude oil market?
2-58
Comparative Statics
Simultaneous Shifts in Supply and Demand in Action
International Oil Market
Price
Supplyoil2
(Dollars per Barrel)
Supplyoil1
$140
The equilibrium price increases
or decreases depending on the
magnitude of the demand
and supply changes.
Pe1 = $80
Pe2 = $65
$20
Demandoil2
Qe2 = 10
Qe1 = 120
Demandoil1
280 Quantity
(Millions of Barrels)
2-59