CHAPTER
2
Supply, Demand,
and Market
Equilibrium
Prepared by: Jamal Husein
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
The Model of Supply and Demand
 The
purpose of the model of supply
and demand is to predict changes in
market quantity and price based on
changes in supply and demand
conditions.

The supply and demand model is
used to explain how a perfectly
competitive market operates.
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Survey of Economics, 2/e
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The Demand Curve
Market
demand shows
how much of a particular
product are consumers
willing to buy during a
particular time period, all
else being equal.
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Variables Affecting Demand
The main determinants of demand
include:






The price of the product
Consumer income
The price of related goods—substitutes and
complements
The number of consumers
Consumer preferences—tastes and
advertising
Consumer expectations about future prices
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The Individual Demand Curve
The
individual
demand curve
shows the
relationship
between the
price of a good
and the quantity
that a single
consumer is
willing to buy, or
quantity
demanded.
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The Individual Demand Curve and
The Law of Demand


The negative slope
of the individual
demand curve
reflects the law of
demand.
Individual
Demand Curve
Law of Demand:
The higher the price,
the smaller the
quantity demanded,
ceteris paribus.
Demand schedule
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The “Ceteris Paribus” Assumption
 To
obtain various
points on the individual
demand curve for
pizzas we assume that
only the price of pizzas
changes, while other
determinants of the
demand for pizzas
(income, tastes and
preferences, the price
of related goods, etc.)
remain constant, or
ceteris paribus.
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A Change in Quantity Demanded

A change in
quantity
demanded is
caused by a
change in the
price of the
good, which
causes a
movement
along the
demand curve.
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Income and Substitution Effect
The reason why the slope of the
individual demand curve is negative,
involves the substitution and income
effects.
 The substitution effect describes a
change in consumption resulting from a
change in the price of one good relative
to the price of other goods.
The lower the price of a good, the
smaller the sacrifice associated with
consumption of a good.

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The Income Effect

The income effect describes the
change in consumption resulting
from an increase in the
consumer’s real income, or the
income in terms of the goods the
money can buy.

Real income is the consumer’s
income measured in terms of the
goods it can buy.
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From Individual to Market Demand
 Market
Demand Curve: A curve
showing the relationship between
price and quantity demanded by all
consumers together, ceteris paribus.
 Market
demand is the sum of the
quantities demanded by all
consumers in the market, or the
sum of individual demand curves.
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From Individual to Market Demand
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The Market Demand Curve and The
Law of Demand

Since the slope of the
individual demand curve
is negative, it follows that
the slope of the market
demand curve is also
negative, reflecting the
law of demand.
Market Demand
Market demand
schedule
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Market Supply
supply curve shows the
relationship between price
and the quantity that
producers are willing to sell
during a particular time
period, all else being equal.
 The
© 2005 Prentice Hall Business Publishing
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Variables Affecting Supply
The main determinants of supply include:

The price of the product

The cost of inputs

The state of production technology

The number of producers

Producer expectations about future prices

Taxes or subsidies from the government
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The Marginal Principle and the Output
Decision

The decision to produce a given quantity
of output is based on the marginal
principle.
Marginal PRINCIPLE
Increase the level of an activity if its
marginal benefit exceeds its marginal cost,
but reduce the level if the marginal cost
exceeds the marginal benefit. If possible,
pick the level at which the marginal
benefit equals the marginal cost.
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The Marginal Principle and the
Output Decision


The optimal quantity of
output is the one that
satisfies the marginal
principle—where
marginal cost equals
marginal benefit.
As price rises, marginal
benefit intersects
marginal cost at a
higher output level.
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Individual Supply and the Law of Supply
 Supply
schedule is a table of numbers
that shows the relationship between price
and quantity supplied, ceteris paribus.


The individual supply curve shows the
relationship between the price and the
quantity supplied by a single firm, ceteris
paribus.
The positive slope of the curve reflects
the law of supply.
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Individual Supply and the Law of
Supply

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Law of Supply:
The higher the
price, the larger
the quantity
supplied, ceteris
paribus.
O’Sullivan & Sheffrin
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Individual Supply to Market Supply

The market supply curve for a
particular good shows the
relationship between the price of
the good and the quantity that
all producers together are
willing to sell, ceteris paribus.
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Individual Supply to Market Supply
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Market Supply and the Law of Supply

Supply
Curve
The market supply
curve is positively
sloped, reflecting the
law of supply. The
higher the price, the
larger the quantity
supplied, ceteris
paribus.
Supply
schedule
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Market Equilibrium
 Market
equilibrium
is a situation in which,
at the current market
price, quantity
supplied equals
quantity demanded.
 When
the market is in
equilibrium, there is
no tendency for the
price to increase or
decrease.
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Shortage: excess quantity demanded

Excess Demand
(Shortage) : A
situation in which
consumers are willing
to buy more than
producers are willing to
sell. It occurs when
market price is lower
than equilibrium price.

An increase in the Price eliminates the shortage by
changing both quantity demanded and quantity supplied until
the original equilibrium is established
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Surplus: excess quantity supplied
 Excess
Supply
(Surplus): A
situation in which
producers are willing
to sell more than
consumers are willing
to buy. It occurs when
market price is above
equilibrium price.

A decrease in the Price eliminates excess supply by
changing both quantity demanded and quantity supplied until
the original equilibrium is established
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Equilibrium and Disequilibria
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A Change in Demand

A change in demand is a change in the amount of
a good demanded resulting from a change in
something other than the price of the good, which
causes a shift of the entire demand curve.

An increase
in
demand
(rightward shift)
results in higher
quantity
demanded at each
price level.
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Shifting the Demand Curve
 Changes
in
determinants of
demand other
than price cause
the demand curve
to shift.

A rightward
shift shows an
increase in
demand and a
leftward shift a
decrease in
demand.
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Causes of an Increase in Demand
An increase in
income (normal
goods) and a
decrease in income
(inferior goods)
 An increase in the
price of a substitute
good
 A decrease in price
of a complementary
good

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
Higher preference
for the good in
question
Favorable
advertising
 An increase in the
number of
consumers
(population)


An expectation of
higher future prices
O’Sullivan & Sheffrin
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Market Effects of A Change in Demand
A Decrease in Demand
An Increase in Demand
Price
Supply
Price
Supply
10
8
8
D2
D3
D3
D2
30
40
Thousands of Pizzas per month
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30
Thousands of Pizzas per month
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Causes of a Decrease in Demand
A decrease in
income (normal
goods) or an
increase in income
(inferior goods)
 A decrease in the
price of a
substitute good
 An increase in the
price of a
complementary
good

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
Less preference for
the good in question
An expectation of
lower future prices
 A decrease in the
number of
consumers

O’Sullivan & Sheffrin
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Normal Versus Inferior Goods
A normal good is a good for which the
demand increases as real income rises.
 An inferior good is a good for which
demand decreases as real income rises.
 For normal goods, the law of demand
makes sense because the substitution
and income effects reinforce each other.
Lower prices result in higher quantity
demanded.

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Normal and Inferior Goods

For inferior goods, the substitution
and income effects conflict with each
other, blurring the law of demand.

The substitution effect tends to
increase consumption while the income
effect tends to decrease it. The law of
demand is correct only as long as the
substitution effect outweighs the
income effect.
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A Change in Quantity Supplied
A
change in
quantity supplied
is caused by a
change in the price
of the good, which
causes a movement
along the supply
curve.
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
34
A Change in Supply

A change in supply
is caused by a change
in something other
than the price of the
good, which causes a
shift of the entire
supply curve.

An increase in supply
results in higher quantity
supplied at each price
level.
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
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35
Shifting the Supply Curve

Changes in
determinants of
supply other than
price cause the
supply curve to
shift.
rightward shift
shows an increase in
supply and a leftward
shift a decrease in
A
supply.
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Causes of an Increase in Supply
 A decrease
in
the cost of
inputs
A
future
prices than
anticipated
 Subsidies
technological
improvement
that decreases
cost of
production
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 Lower
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 An
increase in the
number of
producers (firms)
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Causes of a Decrease in Supply

An increase in
the cost of inputs

A loss of
technology

A decrease in the
number of
producers
(firms)
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
Higher future
prices than
anticipated

Higher taxes
imposed on the
producers of the
good in question
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38
Market Effects of Simultaneous
Changes in Supply and Demand

When the magnitude
of an increase in
demand is smaller
than the magnitude
of an increase in
supply, equilibrium
quantity increases
and market price
decreases.
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Market Effects of A Change in Supply
A decrease in Supply
S2
P*
S1
Price
Price ($)
An increase in Supply
S3
8
S2
10
8
6
D
30 36 45
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D
14
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30
40
Market Effects of Simultaneous Changes in
Supply and Demand

When the
magnitude of an
increase in
demand is larger
than the
magnitude of an
increase in supply,
equilibrium
quantity increases
and market price
increases.
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Applications of Supply and Demand
Market Effects of an
Increase in Demand
An increase in
demand causes a
shortage at the
original price.
To eliminate the
shortage, price
increases from $0.60
to $0.70.
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Applications of Supply and Demand
Market Effects of an
Antismoking
Campaign
A decrease in the
demand for cigarettes
would result in lower
cigarette prices
produced and sold, at
a lower price.
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Applications of Supply and Demand
Effects of
Technological
Innovations on the
Market for Personal
Computers
Technological
innovations decrease
production costs,
shifting the supply
curve to the right.
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Applications of Supply and Demand
Effects of Bad
Weather on the
Coffee Market
Bad weather
decreases the supply
of coffee beans,
shifting the supply
curve to the left.
Price increases and
quantity exchanged
decreases.
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Market Equilibrium, The Invisible
Hand, and Efficiency


The “invisible hand” describes how
the actions of individual buyers and
sellers, each acting on their own self
interest, leads to a market
equilibrium.
But, does this market equilibrium
promote the social interest, or could
society do better?
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Market Equilibrium, The Invisible Hand, and
Efficiency

Four conditions must be met in
order to promote the social
interest:
1. Buyers and sellers must have
enough information to make
informed decisions.
2. The market must be perfectly
competitive.
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Market Equilibrium, The Invisible Hand,
and Efficiency

Four conditions must be met in
order to promote the social
interest:
3. There must be no spillover
benefits.
4. There must be no spillover
costs.
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