Theory of Supply and Demand
Presentation by Said Cherkaoui, Ph.D.
Overview


Market (who, what, how)
Supply and demand is an economic model

Designed to explain how prices are determined in
certain types of markets
 What you will learn in this chapter

How the model of supply and demand works and how
to use it
1.
2.
3.
4.
The law of demand
The law of supply
The determination of market equilibrium
Factors shifting demand or supply curves
2
Summaries
 Through the study of the chapter, you will be able to
 Characterize a market.
 Use a demand schedule and a demand curve to demonstrate the law






of demand.
Explain the difference between a change in demand (shift of the curve)
and a change in quantity demanded (movement along the curve).
List the factors that will lead to a change in demand, and give
examples of each.
Similar analysis for supply side.
Explain how equilibrium price and quantity are determined in a
competitive market.
Explain what will happen in a competitive market after a shift in the
supply curve, the demand curve, or both.
Describe the three steps economists take to answer almost any
question about the economy.
3
Markets
 In economics, a market is not a place but rather
a group of buyers and sellers with the potential
to trade with each other


Market is defined not by its location but by its
participants
First step in an economic analysis is to define and
characterize the market or collection of markets to
analyze
 Economists think of the economy as a
collection of individual markets
4
How Broadly Should We Define The Market
 Defining the market often requires economists
to group things together

Aggregation is the combining of a group of distinct
things into a single whole
 Markets can be defined broadly or narrowly,
depending on our purpose

How broadly or narrowly markets are defined is one
of the most important differences between
Macroeconomics and Microeconomics
5
Defining Macroeconomic Markets
 Goods and services are aggregated to
the highest levels



Macro models lump all consumer goods
into the single category “consumption
goods”
Macro models will also analyze all capital
goods as one market
Macroeconomists take an overall view of
the economy without getting bogged down
in details
6
Defining Microeconomic Markets
 Markets are defined narrowly

Focus on models that define much more
specific commodities
 Always involves some aggregation

But stops it reaches the highest level of
generality that macroeconomics
investigates
7
Buyers and Sellers
 Buyers and sellers in a market can be
 Households
 Business firms
 Government agencies
 All three can be both buyers and sellers in the same
market, but are not always
 For purposes of simplification this text will usually
follow these guidelines


In markets for consumer goods, we’ll view business firms
as the only sellers, and households as only buyers
In most of our discussions, we’ll be leaving out the
“middleman”
8
Competition in Markets
 In imperfectly competitive markets, individual buyers or
sellers can influence the price of the product
 In perfectly competitive markets (or just competitive
markets), each buyer and seller takes the market price as
a given
 What makes some markets imperfectly competitive and
others perfectly competitive?

Perfectly competitive markets have many small buyers
and sellers


Each is a small part of the market, and the product is
standardized
Imperfectly competitive markets have just a few large
buyers and sellers

Or else the product of each seller is unique in some way
9
Using Supply and Demand
 Supply and demand model is designed to
explain how prices are determined in perfectly
competitive markets


Perfect competition is rare but many markets come
reasonably close
Perfect competition is a matter of degree rather
than an all or nothing characteristic
 Supply and demand is one of the most versatile
and widely used models in the economist’s tool
kit
10
Demand
 A household’s quantity demanded of a good

Specific amount household would choose to buy
over some time period, given
 A particular price that must be paid for the good
 All other constraints on the household
 Market quantity demanded (or quantity
demanded) is the specific amount of a good
that all buyers in the market would choose to
buy over some time period, given


A particular price they must pay for the good
All other constraints on households
11
Quantity Demanded
 Implies a choice

How much households would like to buy when they take
into account the opportunity cost of their decisions?
 Is hypothetical


Makes no assumptions about availability of the good
How much would households want to buy, at a specific
price, given real-world limits on their spending power?
 Stresses price


Price of the good is one variable among many that
influences quantity demanded
We’ll assume that all other influences on demand are
held constant, so we can explore the relationship
between price and quantity demanded
12
The Law of Demand
 The price of a good rises and everything
else remains the same, the quantity of
the good demanded will fall

The words, “everything else remains the
same” are important
 In
the real world many variables change
simultaneously
 However, in order to understand the economy
we must first understand each variable
separately
 Thus we assume that, “everything else
remains the same,” in order to understand
how demand reacts to price
13
The Demand Schedule
 Demand schedule

A list showing the quantity of a good that
consumers would choose to purchase at
different prices, with all other variables
held constant
 Demand V.S. Quantities demanded
- demand is the entire relationship between
price and quantity
- quantities demanded are specific amount of
goods buyers want to buy
14
The Demand Curve
 The market demand curve (or just
demand curve) shows the relationship
between the price of a good and the
quantity demanded , holding constant all
other variables that influence demand

Each point on the curve shows the total
buyers would choose to buy at a specific
price
 Law of demand tells us that demand
curves virtually always slope downward
15
Figure 1: The Demand Curve
Price per
Bottle
When the price is $4.00
per bottle, 40,000 bottles
are demanded (point A).
$4.00
A
B
2.00
At $2.00 per bottle,
60,000 bottles are
demanded (point B).
D
40,000
60,000
Number of Bottles
per Month
16
“Shifts” vs. “Movements Along”
The Demand Curve
 Move along the demand curve
 From a change in the price of the good we
analyze
 In maple syrup example, Figure 1

A fall in price would cause a movement to the right along
the demand curve (point A to B)
 See figure 3(a)
17
Figure 3(a): Movements Along and
Shifts of The Demand Curve
Price
Price increase moves us
leftward along demand
curve
P2
Price increase moves us
rightward along demand
curve
P1
P3
Q2
Q1
Q3
Quantity
18
“Shifts” vs. “Movements Along”
The Demand Curve
 Shift of demand curve
 a change in other things than price of the good
causes a shift in the demand curve itself, for
example, income
 In Figure 2
 Demand curve has shifted to the right of the old
curve (from Figure 1) as income has risen
 A change in any variable that affects demand—
except for the good’s price—causes the demand
curve to shift
19
Figure 2: A Shift of The Demand
Curve
Price per
Bottle
An increase in income
shifts the demand curve for
maple syrup from D1 to D2.
At each price, more bottles
are demanded after the
shift
B
C
$2.00
60,000
D1
D2
80,000
Number of Bottles
per Month
20
“Change in Quantity Demanded” vs.
“Change in Demand”
 Language is important when discussing demand
 “Quantity demanded” means
 A particular amount that buyers would choose to buy at a
specific price
 It is a number represented by a single point on a demand
curve
 When a change in the price of a good moves us along a
demand curve, it is a change in quantity demand
 The term demand means
 The entire relationship between price and quantity
demanded—and represented by the entire demand curve
 When something other than price changes, causing the entire
demand curve to shift, it is a change in demand
21
Income: Factors That Shift The
Demand Curve
 An increase in income has effect of shifting
demand for normal goods to the right

However, a rise in income shifts demand for
inferior goods to the left
 A rise in income will increase the demand for a
normal good, and decrease the demand for an
inferior good
 Normal good and inferior good are defined by
the relation between demand and income
22
Wealth: Factors That Shift The
Demand Curve
 Your wealth—at any point in time—is the
total value of everything you own minus
the total dollar amount you owe
- Example
 An increase in wealth will


Increase demand (shift the curve rightward)
for a normal good
Decrease demand (shift the curve leftward)
for an inferior good
23
Prices of Related Goods: Factors
that Shift the Demand Curve
 Substitute—good that can be used in place of some
other good and that fulfills more or less the same
purpose


Example
A rise in the price of a substitute increases the demand for
a good, shifting the demand curve to the right
 Complement—used together with the good we are
interested in


Example
A rise in the price of a complement decreases the demand
for a good, shifting the demand curve to the left
24
Other Factors That Shift the
Demand Curve
 Population

As the population increases in an area


Number of buyers will ordinarily increase
Demand for a good will increase
 Expected Price

An expectation that price will rise (fall) in the future shifts the
current demand curve rightward (leftward)
 Tastes



Combination of all the personal factors that go into determining
how a buyer feels about a good
When tastes change toward a good, demand increases, and the
demand curve shifts to the right
When tastes change away from a good, demand decreases,
and the demand curve shifts to the left
25
Small Summary
-- Factors Affecting Demand
 Income (depends on good’s nature: normal or
inferior)
 Wealth (depends on good’s nature)
 Prices of substitutes (positively related)
 Prices of complements (negatively related)
 Population (positively related)
 Expected price (positively related)
 Tastes (positively related)
26
Figure 3(b): Movements Along and
Shifts of The Demand Curve
Price
Entire demand curve shifts
rightward when:
• income or wealth ↑
• price of substitute ↑
• price of complement ↓
• population ↑
• expected price ↑
• tastes shift toward good
D2
D1
Quantity
27
Figure 3(c): Movements Along and
Shifts of The Demand Curve
Price
Entire demand curve shifts
leftward when:
• income or wealth ↓
• price of substitute ↓
• price of complement ↑
• population ↓
• expected price ↓
• tastes shift toward good
D1
D2
Quantity
28
Supply
 A firm’s quantity supplied of a good is the specific
amount its managers would choose to sell over some
time period, given


A particular price for the good
All other constraints on the firm
 Market quantity supplied (or quantity supplied) is the
specific amount of a good that all sellers in the market
would choose to sell over some time period, given


A particular price for the good
All other constraints on firms
29
Quantity Supplied
 Implies a choice

Quantity that gives firms the highest possible profits when they
take account of the constraints presented to them by the real world
 Is hypothetical


Does not make assumptions about firms’ ability to sell the good
How much would firms’ managers want to sell, given the price of
the good and all other constraints they must consider?
 Stresses price


The price of the good is just one variable among many that
influences quantity supplied
We’ll assume that all other influences on supply are held constant,
so we can explore the relationship between price and quantity
supplied
30
The Law of Supply
 States that when the price of a good rises and
everything else remains the same, the quantity
of the good supplied will rise

The words, “everything else remains the same” are
important
 In
the real world many variables change simultaneously
 However, in order to understand the economy we must
first understand each variable separately
 We assume “everything else remains the same” in
order to understand how supply reacts to price
31
The Supply Schedule and The Supply
Curve
 Supply schedule—shows quantities of a good
or service firms would choose to produce and
sell at different prices, with all other variables
held constant
 Supply curve—graphical depiction of a supply
schedule

Shows quantity of a good or service supplied at
various prices, with all other variables held
constant
32
Figure 4: The Supply Curve
Price per
Bottle
When the price is $2.00
per bottle, 40,000 bottles
are supplied (point F).
$4.00
2.00
S
G
At $4.00 per bottle,
quantity supplied is
60,000 bottles (point G).
F
40,000
60,000
Number of Bottles
per Month
33
Shifts vs. Movements Along the Supply
Curve
 A change in the price of a good causes a movement
along the supply curve

In Figure 4
 A rise (fall) in price would cause a rightward (leftward)
movement along the supply curve
 A drop in transportation costs will cause a shift in the
supply curve itself

In Figure 5
 Supply curve has shifted to the right of the old curve (from
Figure 4) as transportation costs have dropped
 A change in any variable that affects supply—except for the
good’s price—causes the supply curve to shift
34
Figure 5: A Shift of The Supply Curve
Price per
Bottle
A decrease in transportation
costs shifts the supply curve for
maple syrup from S1 to S2.
S1
S2
At each price, more bottles
are supplied after the shift
$4.00
G
60,000
J
80,000
Number of Bottles
per Month
35
Factors That Shift the Supply Curve
 Input prices

A fall (rise) in the price of an input causes an increase
(decrease) in supply, shifting the supply curve to the
right (left)
 Price of Related Goods

When the price of an alternate good rises (falls), the
supply curve for the good in question shifts leftward
(rightward)
 Technology

Cost-saving technological advances increase the
supply of a good, shifting the supply curve to the right
36
Factors That Shift the Supply Curve
 Number of Firms

An increase (decrease) in the number of sellers—
with no other changes—shifts the supply curve to the
right (left)
 Expected Price

An expectation of a future price increase (decrease)
shifts the current supply curve to the left (right)
37
Factors That Shift the Supply Curve
 Changes in weather


Favorable weather
 Increases crop yields
 Causes a rightward shift of the supply curve for that crop
Unfavorable weather
 Destroys crops
 Shrinks yields
 Shifts the supply curve leftward
 Other unfavorable natural events may effect all firms in
an area

Causing a leftward shift in the supply curve
38
Figure 6(a): Changes in Supply and in
Quantity Supplied
Price
S
Price increase moves
us rightward along
supply curve
P2
P1
Price increase moves
us leftward along
supply curve
P3
Q3
Q1
Q2
Quantity
39
Figure 6(b): Changes in Supply and in
Quantity Supplied
Price
Entire supply curve shifts
rightward when:
• price of input ↓
• price of alternate good ↓
• number of firms ↑
• expected price ↑
• technological advance
• favorable weather
S1
S2
Quantity
40
Figure 6(c): Changes in Supply and in
Quantity Supplied
Price
Entire supply curve shifts
rightward when:
• price of input ↑
• price of alternate good ↑
• number of firms ↓
• expected price ↑
• unfavorable weather
S2
S1
Quantity
41
Summary: Factors That Shift The
Supply Curve
 The short list of shift-variables for supply that we have
discussed is far from exhaustive
 In some cases, even the threat of such events can
cause serious effects on production
 Basic principle is always the same

Anything that makes sellers want to sell more or less of a
good at any given price will shift supply curve
42
Figure 7: Market Equilibrium
Price per
Bottle
2. causes the price
to rise . . .
3. shrinking the
excess demand . . .
S
E
$3.00
1.00
H
4. until price reaches its
equilibrium value of $3.00
.
J
Excess Demand
D
1. At a price of $1.00 per
bottle an excess demand
of 50,000 bottles . . .
25,000 50,000 75,000
Number of Bottles
per Month
43
Excess Demand
 Excess demand

At a given price, the excess of quantity
demanded over quantity supplied
 Price of the good will rise as buyers
compete with each other to get more of
the good than is available
44
Figure 8: Excess Supply and Price
Adjustment
Price per
Bottle
1. At a price of $5.00 per
bottle an excess supply
of 30,000 bottles . . .
Excess Supply at $5.00 S
$5.00
2. causes the
price to drop,
3.00
3. shrinking the
excess supply . . .
L
K
E
4. until price reaches its
equilibrium value of
$3.00.
D
35,000 50,000 65,000
Number of Bottles
per Month
45
Excess Supply
 Excess Supply

At a given price, the excess of quantity
supplied over quantity demanded
 Price of the good will fall as sellers
compete with each other to sell more of
the good than buyers want
46
Figure 9
Price per
Bottle
4. Equilibrium
price
increases
3. to a new
equilibrium.
S
F'
$4.00
3.00
2. moves us along
the supply
curve . . .
E
1. An increase in
demand . . .
D2
D1
5. and equilibrium quantity
increases too.
50,000 60,000
Number of Bottles of
Maple Syrup per Period
47
An Ice Storm Hits: What Happens When
Things Change
 An ice storm causes a decrease in
supply

Weather is a shift variable for supply curve
 Any
change that shifts the supply curve
leftward in a market will increase the
equilibrium price

And decrease the equilibrium quantity in that
market
48
Figure 10: A Shift of Supply and A
New Equilibrium
Price per
Bottle
$5.00
3.00
S2
S1
E'
E
D
35,000 50,000
Number of Bottles
49
Using Supply and Demand: The
Invasion of Kuwait
 Why did Iraq’s invasion of Kuwait cause
the price of oil to rise?


Immediately after the invasion, United
States led a worldwide embargo on oil
from both Iraq and Kuwait
A significant decrease in the oil industry’s
productive capacity caused a shift in the
supply curve to the left
 Price
of oil increased
50
Figure 12: The Market For Oil
Price per
Barrel of Oil
S2
S1
E'
P2
E
P1
D
Q2
Q1
Barrels of Oil
51
Using Supply and Demand: The
Invasion of Kuwait
 Why did the price of natural gas rise as
well?



Oil is a substitute for natural gas
Rise in the price of a substitute increases
demand for a good
Rise in price of oil caused demand curve
for natural gas to shift to the right
 Thus,
the price of natural gas rose
52
Figure 13: The Market For Natural
Gas
Price per Cubic
Foot of Natural
Gas
S
F'
P4
F
D2
P3
D1
Q3
Q4
Cubic Feet of
Natural Gas
53
Figure 11: Changes in the Market for
Handheld PCs
Price per
Handheld
PC
3. moved the market to
a new equilibrium.
2. and a decrease
in demand . . .
4. Price
decreased . . .
A
$500
B
S2002
S2003
1. An increase in
supply . . .
$400
D2002
5. and quantity
decreased as well.
D2003
2.45 3.33
Millions of Handheld PCs
per Quarter
54
Both Curves Shift
 When just one curve shifts (and we know the
direction of the shift) we can determine the
direction that both equilibrium price and quantity
will move
 When both curves shift (and we know the
direction of the shifts) we can determine the
direction for either price or quantity—but not
both

Direction of the other will depend on which curve
shifts by more
55
The Three Step Process
 Key Step 1—Characterize the Market
 Decide which market or markets best suit problem
being analyzed and identify decision makers
(buyers and sellers) who interact there
 Key Step 2—Find the Equilibrium
 Describe conditions necessary for equilibrium in the
market, and a method for determining that
equilibrium
 Key Step 3—What Happens When Things
Change

Explore how events or government polices change
market equilibrium
56
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57