Lecture 02
Demand, Supply and
Market Equilibrium
The Basic Decision-Making
Units in the Economy:
Firms and Households
Firms and Households
A firm is an organization that
transforms resources into products
Firms are the primary producing
units in a market economy.
Households are the consuming
units in an economy.
The Entrepreneur
The entrepreneur is the person who
organizes, manages, and assumes
the risks of a firm, taking a new idea
or a new product and turning it into
a successful business.
Markets
Product
Factor
Product or output markets are the
markets in which goods and services
are exchanged.
Input or Factor markets are the
markets in which resources used to
produce products are exchanged.
Labor Markets
Labor markets are the input
markets in which households
supply work for wages to firms
that demand labor.
Capital Markets
Capital markets are the input
markets in which households
supply their savings, for interest
or for claims to future profits, to
firms that demand funds in
order to buy capital goods.
Land Markets
Land markets are the input
markets in which households
supply land or other real
property in exchange for rent.
The Circular Flow
A circular flow diagram
describes the interaction of firms
and households in markets for
outputs and inputs.
The Circular Flow
Supply
Output
Markets
(Goods &
Services)
House
holds
Firms
Input Markets:
Labor (wages)
Demand
Demand
Capital (interest)
Land (rent)
Supply
Demand in the Product Markets
The quantity demanded represents
the amount of a product that a
household buy in a given time
period at the current market price.
A household’s decision about what
quantity of a product to demand
depends on a number of factors...
Determinants of Household
Demand:
PRICE of the product
 INCOME available
 Amount of accumulated WEALTH
 PRICES OF RELATED PRODUCTS
 TASTES and PREFERENCES
 EXPECTATIONS with respect to future
income, wealth, and prices

The Demand Schedule
A demand schedule is a table or
chart showing how much of a
given product a household would
be willing to buy at different
prices.
The Demand Curve
The demand curve is a graph
illustrating how much of a given
product a household would be
willing to buy at different prices.
Demand curves are usually
derived from demand schedules.
The Demand Curve
P
D
0
Q
Anna’s Demand Schedule for
Telephone Calls - (Table 4.1)
Price
(per call)
Quantity
Demanded
(calls per month)
0
30
.50
25
3.50
7
7.00
3
10.00
1
15.00
0
$
Anna’s Demand Curve - (Figure 4.2)
Price
$15.00
$10.00
$7.50
$3.50
$ .50
01
3
7
25 30
Quantity demanded
The Law of Demand
There is a negative, or inverse,
relationship between the
quantity of a good demanded
and its price.
This means that demand curves
typically have a negative slope.
Other Determinants of Household
Demand:
1) Income and Wealth
 Income: The total of all earnings
received by a household in a given
period of time
 Wealth: The total value of what a
household owns less what it owes
Income as a Determinant of
Demand
Normal Goods: Goods for which
demand goes up when income is
higher and for which demand goes
down when income is lower
Inferior Goods: Goods for
which demand falls when income
rises.
Prices of Other Goods and Services
as Determinants of Demand
Substitutes: Goods that can serve as
replacements for one another; when the
price of one increases, demand for the
other goes up - Perfect substitutes are
identical products.
Complements: Goods that ‘go
together’; when the price of one
increases, demand for the other goes
down.
Other Determinants of
Household Demand:
 Tastes and Preferences - These
are quite subjective and tend to
change over time.
 Expectations - With respect to
future income, wealth, prices, and
availability.
Changes in Quantity Demanded
vs. Changes in Demand:
Important Distinction!!
Changes in quantity demanded
imply movement along a demand
curve.
 Changes in demand imply a shift in
the entire demand curve.

Anna’s Demand for Telephone Calls - A
Change in Quantity Demanded
Price
Change in quantity
demanded from 3 to 7
caused by a change in price
from $7.50 to $3.50
$15.00
$10.00
$7.50
$3.50
D
$ .50
01
3
7
25 30
Quantity demanded
Anna’s Demand for Telephone Calls - A
Change in Demand
Change in demand caused
by a change in a demand
factor other than price
$15.00
$10.00
$7.50
$3.50
D2
D1
$ .50
01
3
7
25 30
Quantity demanded
Changes in Demand
- Income Changes Income Rises
P
P
D2
D1
Q
Demand for inferior good
shifts left
D1
D2
Q
Demand for normal good
shifts right
Changes in Demand
- Prices of Related Goods P
Price of
hamburger rises
P
P
Q
Quantity of
hamburger
demanded falls
D2
D1
Q
Demand for complement
good (catsup) shifts left
D1
D2
Demand for substitute Q
good (chicken) shifts right
From Household to Market
Demand
Demand for a good or service can
be defined for an individual
household, or for a group of
households that make up a
market.
Market Demand
- Defined Market demand may be defined as
the sum of all the quantities of a
good or service demanded per
period by all the households
buying in the market for that good
or service.
Deriving market demand from the
individual demand curves:
P
P
DA
$3.50
DB
$3.50
$1.50
0
$1.50
0
4
8 Qd
Price
DC
0
3
Qd
4
Market Demand
$3.50
$1.50
0
8
20 Qd
9
Qd
Supply in Output Markets
A firm’s decision about what
quantity of a product to supply
depends on a number of
factors...
Quantity Supplied
The quantity supplied represents
the number of units of a product
that a firm would be willing and
able to offer for sale at a
particular price during a given
time period
Factors Determining Firm
Supply:
PRICE of the product
 COST of producing the product
- Prices of required inputs
- Technologies used to
produce the product
 PRICES of RELATED products

The Law of Supply
There is a positive, or direct,
relationship between the quantity
of a good supplied and its price.
This means that supply curves
typically have a positive slope.
The Supply Schedule and
Supply Curve
A supply schedule is a table, or
chart, showing how much of a
product firms will supply at
different prices.
A supply curve is the graphical
representation of a supply
schedule.
Clarence Brown’s Soybean Supply
Schedule
Price
Bushels
per bushel
per year
$ 1.50
0
1.75
10,000
2.25
20,000
3.00
30,000
4.00
45,000
Clarence Brown’s Soybean
Supply Curve
Price
$4.00
S
$3.00
$2.25
$1.75
$1.50
0
10 20 30 40
50
Quantity demanded (1,000s)
Changes in Quantity Supplied
vs. Changes in Supply:
IMPORTANT DISTINCTION !
Changes in quantity supplied
imply movement along a supply
curve.
 Changes in supply imply a shift
in the entire supply curve.

A Change in the Quantity Supplied
of Clarence Brown’s Soybeans
P
$4.00
S
Change in quantity
supplied from 10 to 20
caused by a change in
price from $1.75 to
$2.25
$3.00
$2.25
$1.75
$1.50
0
10 20 30 40
50
Quantity demanded (1,000s)
A Shift in Clarence Brown’s Soybean
Supply
Price
$4.00
S1
S2
$3.00
$2.25
Change in supply caused
by a change in a supply
factor other than price
$1.75
$1.50
0
10 20 30 40 50
Quantity demanded (1,000s)
Changes in Quantity Supplied
vs. Changes in Supply:
P
P
S1
S
Q
An increase in the
quantity supplied
S2
Q
An increase in
supply
From Individual Firm to Market
Supply
The supply of a good or service
can be defined for an individual
firm, or for a group of firms that
make up a market or an
industry.
Market Supply
The sum of all the quantities of a
good or service supplied per period
by all the firms selling in the
market for that good or service.
As with market demand, market
supply is the horizontal
summation of the individual
firms’ supply curves.
From Individual Firm to Market
Supply
Firm A’s supply
P
Firm B’s supply
P
SA
3.00
SB
3.00
1.75
1.75
10,000 30,000
Q
5,000 10,000
P
SA+B
3.00
Market
Supply
Curve
1.75
25,000
65,000Q
Q
Market Equilibrium
The operation of the market
depends on the interaction
between suppliers and
demanders.
Market Equilibrium
An equilibrium is the condition
that exists when quantity
supplied is equal to quantity
demanded.
At equilibrium, there is no
tendency for the market price
to change.
Market Equilibrium
P
S
PE
E
D
QE
Q
The market for soybeans in
equilibrium:
P
S
$2.50
D
0
35
Bushels of soybeans
(1,000s)
Excess Demand
Excess Demand is the condition
that exists when quantity
demanded exceeds quantity
supplied at the current price.
At a price of $1.75 there is Excess
Demand in the Soybean Market:
P
S
$2.50
$1.75
D
0
25
35
50
Q
Excess Supply
Excess supply is the condition
that exists when quantity
supplied exceeds quantity
demanded at the current price.
At a price of $3.00 there is Excess
Supply in the Soybean Market:
P
S
$3.00
$2.50
D
0
22
35 40
Q
Changes in Equilibrium
- Demand Shifts/Supply is Constant P
P
S
P2
S
P1
P1
D2
D1
Q
Q1 Q2
Increase in Demand
P2
D1
D2
Q
Q 2 Q1
Decrease in Demand
Changes in Equilibrium
- Supply Shifts/Demand is Constant P
S1
P
S2
S1
S2
P1
P2
P2
D
Q1
Q2
Increase in Supply
Q
P1
D
Q 2 Q1
Decrease in Supply
Q
Changes in Equilibrium
- Supply & Demand both Increase (or Decrease) P
S1
P
S2
P
?
D1
Q1
Q2
Increase in Demand
& Supply
Q
S2
S1
D2 P
?
D1
D2
Q
Q2
Q1
Decrease in Demand
& Supply
Changes in Equilibrium
- Demand & Supply Move Opposite P
S2
S1
P2
P
P1
S1
S2
D2
P1
P2
D1
Q -?
Demand Increases
& Supply Decreases
D1
D2
Q
Q
Q -?
Demand Decreases &
Supply Increases
Review Terms & Concepts
 Capital Market
 Factors of production
 Complements
 Firm
 Demand curve
 Households
 Demand schedule
 Income
 Entrepreneur
 Inferior goods
 Equilibrium
 Input markets
 Excess demand
 labor market
 Excess supply
 land market
Review Terms & Concepts
(continued)
 Law of demand
 Profit
 Law of supply
 Quantity demanded
 Market demand
 Quantity supplied
 Market supply
 Shift of a curve
 Movement along a
 Substitutes
curve
 Normal goods
 Perfect substitutes
 Product markets
 Supply curve
 Supply schedule
 Wealth or net worth