Supply and Demand
Chapter 3
Supply and Demand
1
Markets and Prices
 Why do diamonds cost more than water?
2
Markets and Prices
 Why do Picasso’s paintings sell for more than Leroy
Nieman’s?
3
Markets and Prices
 Why do QiBaiShi’s (齊白石) crabs sell for more than the
real ones?
4
Markets and Prices
 Is it cost of production
that determines prices
(as Adam Smith thought)?
5
Markets and Prices
 Or is it willingness to pay
that determines prices (as
Stanley Jevons thought)?
6
Markets and Prices
 Alfred Marshall (Principles
of Economics, 1890) was
the first to explain clearly
how both costs and
willingness to pay interact
to determine market
prices.
7
Markets and Prices
 The market for any good or service
consists of all (actual or potential)
buyers or sellers of that good or
service.
8
The market for lobsters
 The market for lobsters in Portland, Maine, on July 20,
2004.
9
The demand for lobsters
 The demand curve is the set of all price-quantity pairs
for which buyers are satisfied. ("Satisfied" means being
able to buy the amount they want to at any given price.)
Price ($/lobster) D
10
8
6
4
2
D
0
1
2
3
4
5
Quantity
(1000s of lobsters/day)
10
Horizontal interpretation of the demand curve
 If buyers face a price of $4/lobster, they will wish to
purchase 4000 lobsters a day.
Price ($/lobster) D
10
8
6
4
2
D
0
1
2
3
4
5
Quantity
(1000s of lobsters/day)
11
Vertical interpretation of the demand curve
 If buyers are currently buying 4000 lobsters a day, the
demand curve tells us that buyers would be willing to
pay at most $4 for one additional lobster.
Price ($/lobster) D
10
8
6
4
2
D
0
1
2
3
4
5
Quantity
(1000s of lobsters/day)
12
Demand curves slope downward for two
reasons
1. As the good becomes more expensive, people switch
to substitutes. (Substitution effect)

The Substitution Effect is the change in the quantity
demanded of a good that results because buyers switch to
substitutes when the price of the good changes
2. As the good becomes more expensive, people can’t
afford to buy as much of it. (Income effect)

Income effect is the change in the quantity demanded of a
good that results because a change in the price of a good
changes the buyer’s purchasing power
13
The supply of lobsters
 The supply curve is the set of price-quantity pairs for
which sellers are satisfied. ("Satisfied" means being
able to sell the amount they want to at any given price.)
Price ($/lobster)
10
S
8
6
4
2
S
0
1
Quantity
(1000s of lobsters/day)
2
3
4
5
6
14
Horizontal interpretation of the supply curve
 If sellers face a price of $4/lobster, they will wish to sell
2000 lobsters a day.
Price ($/lobster)
10
S
8
6
4
2
S
0
1
Quantity
(1000s of lobsters/day)
2
3
4
5
6
15
Vertical interpretation of the supply curve
 If sellers are currently selling 2000 lobsters a day, the
marginal cost of a lobster is $4.
Price ($/lobster)
10
S
8
6
4
2
S
0
1
Quantity
(1000s of lobsters/day)
2
3
4
5
6
16
Supply curves slope upward for one reason
 The low-hanging-fruit principle.
 Harvest the lobsters closest to shore first.
 More generally, as we expand the production of any
good, we turn first to those whose opportunity costs of
producing that good are lowest, and only then to
others with higher opportunity costs.
17
Market Equilibrium Quantity and Price
 Equilibrium occurs at the price-quantity pair for which
both buyers and sellers are satisfied.
Price ($/lobster)
10
D
S
8
6
4
2
D
S
0
1
At the market equilibrium
price of $6 per lobster,
buyers and sellers are each
able to buy or sell as many
lobsters as they wish to.
2
3
4
5
Quantity
(1000s of lobsters/day)
18
Excess supply
 A situation in which price exceeds its equilibrium value
is called one of excess supply, or surplus.
Price ($/lobster)
10
excess
supply
D
S
8
6
At $8, there is an excess
supply of 2000 lobsters
in this market.
4
2
D
S
0
1
2
3
4
5
Quantity
(1000s of lobsters/day)
19
Excess Demand
 A situation in which price lies below its equilibrium value
is referred to as one of excess demand.
Price ($/lobster)
10
D
S
8
excess
dem and
6
4
2
D
S
0
1
At a price of $4 in this
lobster market, there is
an excess demand of
2000 lobsters.
2
3
4
5
Quantity
(1000s of lobsters/day)
20
Zero excess supply and demand
 Equilibrium occurs at the price-quantity pair for which
both buyers and sellers are satisfied.
Price ($/lobster)
10
D
S
8
6
4
2
D
S
0
1
At the market
equilibrium price of $6,
both excess demand
and excess supply are
exactly zero..
2
3
4
5
Quantity
(1000s of lobsters/day)
21
Example 3.1.
 At a price of $2 in this hypothetical lobster market, how
much excess demand for lobsters will there be? How
much excess supply will there be at a price of $10?
Price ($/lobster)
10
D
S
8
6
4
2
D
S
0
1
2
3
4
5
Quantity
(1000 lobsters/day)
22
The Trading Locus
 When price differs from the equilibrium price, trading in
the marketplace will be constrained-- by the behavior of
buyers if the price lies above equilibrium, by the
behavior of sellers if below.
Price ($/lobster)
10
D
S
S
D
Trading locus
8
6
4
2
0
1
2
3
4
5
Quantity
(1000s of lobsters/day)
23
From disequilibrium to equilibrium
Price ($/lobster)
10
D
S
S
D
8
6
At prices above equilibrium,
sellers are not selling as
much as they want to.
The impulse of a
dissatisfied seller is to
reduce his price.
4
2
0
1
2
3
4
5
Quantity
(1000s of lobsters/day)
24
From disequilibrium to equilibrium
Price ($/lobster)
10
D
S
S
D
8
6
4
2
0
1
2
3
4
5
At prices below the
equilibrium value, buyers
cannot obtain the
quantities they wish to
purchase. Some buyers
adjust by offering slightly
higher prices.
Quantity
(1000s of lobsters/day)
25
From disequilibrium to equilibrium
 An extraordinary feature of this equilibrating process is
that no one consciously plans or directs it.
 The actual steps that consumers and producers must
take to move toward equilibrium are often indescribably
complex.
 Suppliers looking to expand their operations, for
example, must choose from a bewilderingly large
menu of equipment options.
 Buyers, for their part, face literally millions of choices
about how to spend their money.
26
From disequilibrium to equilibrium
 And yet the adjustment toward equilibrium results more
or less automatically from the natural reactions of selfinterested individuals facing either surpluses or
shortages.
27
Example 3.2.
Should Collegetown Rents Be Regulated?
 Suppose the supply and demand curves for twobedroom Collegetown rental apartments are as shown.
Monthly Rent
($/apartment)
S upply
1000
0
2
Demand
Quantity
(thousands of apartments per month)
28
Example 3.2.
Should Collegetown Rents Be Regulated?
 The city council is concerned that many students cannot
afford the equilibrium rent of $1000 per month and is
considering a regulation forbidding landlords from
charging more than $500.
 What will be the likely consequences of adopting this
regulation?
29
Example 3.2.
Should Collegetown Rents Be Regulated?
 Rent Controls Produce Excess Demand in the Housing
Market.
Monthly Rent
($/apartment)
1500
Supply
Excess demand= 2000 apartments per month
1000
Controlled rent= 500
0
1
2
3
Demand
Quantity
(thousands of apartments per month)
30
Example 3.2.
Should Collegetown Rents Be Regulated?
 Responses to excess demand in a regulated housing
market:
finder’s fees
key deposits
required furniture rental
excessive damage deposits
curtailed maintenance
apartment conversion
31
Alternative to helping the poor (students?)
 There are much more effective ways to help poor
people than to give them apartments and other goods
at artificially low prices.
For example, income transfers:
Wage subsidies
Public service jobs
32
Cash on the Table
 When a regulation prevents the price of an apartment,
or any other good, from reaching its equilibrium level,
the total economic surplus (economic benefits less
opportunity costs) available for buyers and sellers is
diminished.
 Mutually beneficial exchanges are always possible when
a market is out of equilibrium.
 When people have failed to take advantage of all
mutually beneficial exchanges, there is "cash on the
table."
33
Cash on the Table
 At a rent of $500 in the rent-control example, there were tenants
willing to pay as much as $1500 for an apartment.
 Similarly, there were landlords for whom the opportunity cost of
supplying an additional apartment was only $500.
 The difference— $1000 per apartment— is the additional economic
surplus that would accrue to any seller who could rent an
additional apartment for the price that tenants would be willing to
pay.
Monthly Rent
($/apartment)
1500
Supply
Excess demand= 2000 apartments per month
1000
Controlled rent= 500
0
1
2
3
Demand
Quantity
(thousands of apartments per month)
34
Social optimality
 The socially optimal quantity of any good is the quantity
that maximizes the total economic surplus that results
from producing and consuming the good.
 Cost-benefit principle
 keep expanding production of the good as long as its
marginal benefit is at least as great as its marginal
cost.
 Socially optimal quantity is that level for which the
marginal cost and marginal benefit of the good are the
same.
35
Social optimality
 Does the market equilibrium quantity also maximize
total economic surplus?
 In market equilibrium, the cost to the seller of
producing an additional unit of the good is the same as
the benefit to the buyer of having an additional unit.
 The equilibrium quantity also maximizes total economic
surplus
 if all costs of producing the good are borne directly
by sellers, and
 if all benefits from the good accrue directly to buyers.
36
Social optimality
 At the equilibrium quantity of 2000 apartments/month,
the marginal cost to the seller of supplying an additional
apartment ($1000) is the same as the benefit to the
buyer of the next apartment (also $1000) .
Monthly Rent
($/apartment)
S upply
1000
0
2
Demand
Quantity
(thousands of apartments per month)
37
The Equilibrium Principle
 A market in equilibrium leaves no unexploited
opportunities for individuals, but may not exploit all
gains achievable through collective action.
38
Examples of price control in Hong Kong?
 Rent control
 Cheung, S.N.S. (1979), “Rent Control and Housing Reconstruction: The
Postwar Experience of Prewar Premises in Hong Kong”, Journal of Law
& Economics, 22 (1), pp. 27-53.




Designated LPG pump stations
Brokerage fee of trading stock
Public housing
Taxi fare
39
Taxi regulations
 Taxi is in excess supply at the regulated taxi fare.
 Every day, a lot of taxi line up at the airport for
customers. Some of them have to wait several hours
for business.
 Some offer discount to customers.
 Number of taxi license is also regulated.
40
Taxi Fare
Taxi Fare
S
Economy in a recession:
Excess supply
Economy in a boom:
Excess demand
Regulated fare
D2
(economy in a boom)
D1 (economy in a recession)
Taxi services
41
When market equilibrium is not social optimal
 The market equilibrium price and quantity are socially
optimal
 when all relevant production costs are incurred by
sellers, and
 when all relevant product benefits accrue to buyers.
 Production of some goods entails costs that fall on
people other than those who sell the good.
 In other cases, some of the benefits of producing a
good accrue to persons other than the buyers.
42
When market equilibrium is not social optimal
 Goods whose production generates toxic smoke
43
When market equilibrium is not social optimal
 Goods whose production generates noise.
44
When market equilibrium is not social optimal
 In the market equilibrium for such goods whose production
generate pollution, the benefit to buyers of the last good
produced is, as before, equal to the cost incurred by sellers to
produce that good.
 But since producing that good also resulted in the costs of the
associated pollution, we know that the full marginal cost of the
last unit produced—the seller’s private marginal cost plus the
marginal pollution cost borne by others—must be higher than the
benefit of the last unit produced.
Social marginal cost = private marginal cost + marginal pollution cost
45
When market equilibrium is not social optimal
 So when costs fall on people other than sellers,
market equilibrium quantity > socially optimal quantity.
 Total economic surplus would be higher if output of
the good were lower.
 Yet neither sellers nor buyers have any incentive to
alter their behavior.
Potentially, some public policy can be implemented to
discourage the production of this kind of goods.
46
When market equilibrium is not social optimal
 Increases in production of some goods benefit people
other than those who buy them.
More apple trees
=> more honey
More bees
=> more apples
47
When market equilibrium is not social optimal
 But since producing such goods yields benefits in addition to
those received by buyers, we know that the full marginal benefit
of the last unit produced—the price paid by the marginal buyer
plus the benefit received by nonbuyers—must be higher than the
marginal cost of the last unit produced.
 Market equilibrium results in too little production of goods that
generate external benefits.
Social marginal benefit = private marginal benefit
+ marginal benefit received by nonbuyers
Potentially, some public policy can be implemented to encourage
the production of this kind of goods.
48
Newspaper story
 “Producers raised prices, and the resulting fall in
demand caused prices to fall back to their original level.”
True or False?
49
“Change in demand” vs. “Change in the
quantity demanded”
Price D'
Price
Increase in dem and
D
D
10
Increase in the
quantity dem anded
8
6
4
D
0
D'
Quantity
D
2
0
1
2
3
4
5
Quantity
50
Newspaper story
 “Producers raised prices, and the resulting fall in
demand caused prices to fall back to their original level.”
WRONG!!
 A rise in price causes a fall in the quantity demanded,
not a fall in demand.
51
“Change in supply” vs. “Change in the quantity
supplied”
Price
S
S’
Quantity
“An increase in supply”: At every price, there is an
increase in the quantity supplied.
52
“Change in supply” vs. “Change in the quantity
supplied”
Price ($/lobster)
S
10
8
6
4
2
0
1
2
3
4
5
Quantity
(1000 lobsters/day)
“ An increase in the quantity supplied”: For an
upward sloping supply curve, an increase in price
leads to an increase in the quantity supplied.
53
Impact of an increase in demand
 An increase in demand will lead to an increase in both
the equilibrium price and the equilibrium quantity.
Price
S
P’
P
D
Q
Q’
D’
Quantity
54
Impact of a decrease in demand
 A decrease in demand will lead to a reduction in both
the equilibrium price and the equilibrium quantity.
Price
S
P
P’
D’
Q’
Q
D
Quantity
55
Impact of an increase in supply
 An increase in supply will lead to a decrease in the
equilibrium price and an increase in the equilibrium
quantity.
S
S’
P
P’
D
Q
Q’
Quantity
56
Impact of a decrease in supply
 A decrease in supply will lead to an increase in the
equilibrium price and a reduction in the equilibrium
quantity.
S’
S
P’
P
D
Q’
Q
Quantity
57
Determinants of Demand
1. Incomes
 For most goods, the quantity demanded at any price
will rise with income. Goods that have this property are
called normal goods.
P
P
D1
D0
D1
D0
Q
Income rises, norm al good
Q
Income falls, norm al good
58
Determinants of Demand
1. Incomes
 For inferior goods, the quantity demanded at any
price will fall with income. Example: Ground beef with
high fat content.
P
Consumers abandon inferior goods
in
favor
of
higher
quality
substitutes (such as leaner grades
of meat in the ground beef case)
as soon as they can afford to.
D0
D1
Q
Incom e rises, inferior good
59
Determinants of Demand
2. Tastes
 Example: Following the release of Jurassic Park and The
Lost World, tastes in children’s toys shifted toward
designs involving prehistoric reptiles.
P
D1
D0
Q
Tastes shift in favor
60
Determinants of Demand
3. Prices of substitutes
61
Determinants of Demand
3. Prices of substitutes
Price of coffee falls
Price
of tea
S
P
P’
D
D’
Q’
Q
Quantity
of tea
62
Determinants of Demand
3. Prices of substitutes
Price of coffee rises
Price
of tea
S
P’
P
D’
D
Q
Q’
Quantity
of tea
63
Determinants of Demand
4. Prices of complements
64
Determinants of Demand
4. Prices of complements
Price of cream falls
Price of
coffee
S
P’
P
D’
D
Q
Q’
Quantity
of coffee
65
Determinants of Demand
4. Prices of complements
Price of cream rises
Price of
coffee
S
P
P’
D
D’
Q’
Q
Quantity
of coffee
66
Determinants of Demand
A summary
 Factors That Cause an Increase (rightward or upward
shift) in Demand
1. A decrease in the price of complements to the good
or service
2. An increase in the price of substitutes for the good
or service
3. An increase in income (for a normal good)
4. An increased preference by demanders for the good
or service
5. An increase in the population of potential buyers
6. An expectation of higher prices in the future
67
Determinants of supply
1. Technology
Example: A more efficient lobster trap is invented.
Price
S'
S
Quantity
A more efficient lobster trap
shifts supply to the right
68
Determinants of supply
2. Factor prices
Example: The price of gasoline rises.
Price
S'
S
Quantity
Rising factor prices shift supply to the left.
69
Determinants of supply
2. Factor prices
Example: Interest rates fall.
Price
S
S'
Quantity
70
Determinants of supply
A summary
 Factors That Cause an Increase (rightward or upward
shift) in Supply
1. A decrease in the cost of materials, labor, or other
inputs used in the production of the good or service
2. An improvement in technology that reduces the
cost of producing the good or service
3. An improvement in the weather, especially for
agricultural products
4. An increase in the number of suppliers
5. An expectation of lower prices in the future
71
Example 3.3
 Why do the prices of some goods, like apples, go down
during the months of heaviest consumption, while
others, like beachfront cottages, go up?
72
Example 3.3
 The seasonal consumption increase is the result of a
supply increase in the case of apples, a demand
increase in the case of cottages.
P
P
Sw
Ss
S
Pw
Ps
Ps
Pw
Ds
D
S
Dw
Q
Q
Qw Qs
Qw Qs
Apples
Beachfront Cottages
73
Example 3.4
 What will happen to the equilibrium price and quantity
in the fresh seafood market if both of the following
events occur:
 a scientific report is issued saying that fish contains
mercury, which is toxic to humans; and
 the price of diesel fuel falls significantly?
74
Example 3.4
 The equilibrium price will go down, but the equilibrium
quantity may go either up (right panel) or down (left
panel)
P
P
S
S S'
S'
S
S
S'
D'
D
S'
Q
D'
D
Q
75
More Hong Kong examples
 Impact of X on the price and quantity various kinds of
meat, and on the price of wine and quantity of wine
 Fishing holiday
 Avian Flu
 Mad-cow disease
 The impact of development of genetic modified food
 The expansion of HKU on the housing prices in the
Western District.
76
Example 3.5. Sales Tax
 The Hong Kong government is considering to introduce
a sales tax. What is the effect of a sales tax to the
market equilibrium?
S’
Price
tax
P’
Buyer’s
burden
P
Seller’s
burden
S
Sales tax paid by sellers.
Tax burden?
Tax Revenue?
D
Q’
Q
Quantity
77
Example 3.5. Sales Tax
 The Hong Kong government is considering to introduce
a sales tax. What is the effect of a sales tax to the
market equilibrium?
S
Price
Buyer’s
burden
Sales tax paid by buyers.
tax
P
Tax burden?
Seller’s P’
burden
Tax Revenue?
D’
Q’
Q
D
Quantity
78
Example 3.6

Suppose there is a world-wide frenzy to buy the newly invented
robot pets. The robot pets are made in Japan. Before this
invention, the exchange rate of Japanese yen per US dollar was
117 yen for each US dollar. Other things being equal, what is
more likely to happen to the exchange rate?
a. The exchange rate will remain unchanged.
b. The exchange rate will rise (say, to 118 yen per US dollar).
c. The exchange rate will fall (say, to 116 yen per US dollar).
d. The exchange rate will be more unpredictable.
79
Example 3.6
Suppose there is a world-wide frenzy to buy the newly invented
robot pets. The robot pets are made in Japan. Before this
invention, the exchange rate of Japanese yen per US dollar was
117 yen for each US dollar. Other things being equal, what is
more likely to happen to the exchange rate?
S’
S
Yen/USD

117
The exchange rate will fall (say,
to 116 yen per US dollar).
116
D
Q
Q’
USD
80
Example 3.7.
An important determinant of the amount of grains harvested next
year by Ethiopian farmers is the amount of seeds planted this year.
Given that Western nations have guaranteed to donate five
hundred tons of grain next year, this year the Ethiopian farmers
will:
A. plant more seeds as the food aid established a minimum price for
grain.
B. plant more seeds as the farmers’ confidence is restored.
C. plant the same amount of seeds as they would have without the
food aid.
D. plant less seeds as consumers demand for grain is completely price
elastic.
E. plant less seeds as the price of grain will be lower with the food
aid.
81
Example 3.7
 Donate five hundred tons of grain next year means that
the demand for domestic production of grain will be
lowered by the same amount at all prices?
Price
500 tons
S
Anticipating a lower market
equilibrium price next year, farmer
would want to supply less quantity
next year.
P
P’
D’
Q’
Q
D
They do so by planting less
seeds this year.
Quantity (tons of grain)
82
Example 3.7.
An important determinant of the amount of grains harvested next
year by Ethiopian farmers is the amount of seeds planted this year.
Given that Western nations have guaranteed to donate five
hundred tons of grain next year, this year the Ethiopian farmers
will:
A. plant more seeds as the food aid established a minimum price for
grain.
B. plant more seeds as the farmers’ confidence is restored.
C. plant the same amount of seeds as they would have without the
food aid.
D. plant less seeds as consumers demand for grain is completely price
elastic.
E. plant less seeds as the price of grain will be lower with the food
aid.
83
End
84