Chapter 3: Demand and Supply 9/8/2016

In our market-based economy, the interaction

of demand and supply in markets determines
the prices of goods and services and the
quantity produced and consumed.
 Changes in demand and/or supply lead to
changes in the price of the good or service
and in the quantity produced and
consumed.

Markets and Prices

Markets vary in the intensity of competition. We

will assume a competitive market.

 For now we need to know that a competitive

market has many buyers and sellers, so that no
single buyer or seller can influence price. This

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 structure will be discussed in detail later in the
course.
The money price of a good or service is the
number of dollars that must be given up for it.

The ratio of one (money) price to another is

called a relative price.

The relative price is an opportunity cost. The

theory of demand and supply determines
relative prices.
 When we use the word “price” we mean
“relative price.”

For example, suppose that turkey is 40¢ a

pound.

Would you say that turkey is a good buy?

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Yes

Also suppose rib eye steak is 8¢ a pound.

What do you think of the price of turkey now?

Too high

Notice that the relative price of turkey is

___5___ pounds of steak per pound of turkey.

Relatively speaking the price of turkey is

actually much higher than steak.
 In terms of forgone steak, it costs __5__
pounds of steak per pound of turkey.

 In terms of buying steak it only costs _1/5_

of a pound of turkey per pound of steak.

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Notice that the money price of steak is only
__1/5__ the money price of turkey (__8/40__)

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The Law of Demand is the principle that there
is an inverse relationship between the price of a
good and the quantity buyers are willing to
purchase it in a defined time period, ceteris
paribus.

Demand is a curve or schedule showing the

various quantities of a product consumers are
willing to purchase at possible prices during a
specified period of time, ceteris paribus.
 The coordinates of the demand curve are also
the maximum willingness-to-pay curve.
oMaximum willingness-to-pay curve
shows the highest price a consumer is
willing to pay for a quantity of a good
or service.
 The coordinates of the demand curve are also
the marginal benefit to the buyer for each unit
consumed. (maximum willingness to pay is
determined by marginal benefit)
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 Suppose Jill’s individual demand schedule for
pints of ice cream per month is given below.
Pric Quantity demanded
e (per month)
1 22
2 14
3 8
4 4
5 2
Plotting the Demand Schedule
Price
Quantity always on x-axis
51 Price always on y-axis
4
3
2
1
Quantity
2 4 8 14 24 (per month)
Can’t connect dots b/c continuous demand schedule means by unit
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Discrete quantities and Continuous Quantities

When you cannot reasonably represent a good in a

way that you can buy/produce any fraction of a
whole unit then you need to plot diagram with
unconnected points. (Discrete)
 In the case of demand, it means that you can
only buy a whole unit.

When you can reasonably represent a good in a

way that you can analyze the market as if you can
obtain a fraction of a whole unit then you have a
continuous curve in your diagram (the points of the
demand schedule plot here are connected).
 For most circumstances it is appropriate to
illustrate and consider your demand curve as
continuous.
 The important exception is if the goods are
discrete and the quantities in the schedule are
very small, i.e. no more than 10 units in total.
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For illustration let’s assume the good is
continuous in quantity such that Jill can buy any
fraction of a pint of ice cream that she may want.

How would you illustrate continuous in quantity in

the below diagram?

Jill’s Individual Demand Curve

Price
51
4
3
2 Demand Curve
Quantity
2 4 8 14 24 (per month)

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Market Demand (for a private good) is found by
horizontally adding all of the individual buyers’ demand
curves. For example, suppose we have two consumers.

= Horizontal summation

4+3=
When only the price changes we see a change
in the quantity demanded. This is called a
movement along the demand curve. See curve
D0 and the price change from $2 to $4.
Changes in Demand results in shifts in the
demand curve. See the change in demand from
D0 to D1, which shows an increase in demand.

Price>Quantity
Demand>Curve
 Non-price Determinants of Demand
(Shift factors of Demand)

(1) Number of Buyers: If the number of

buyers in the market changes
significantly, then the demand curve will
shift in the direction of the change.
 If more buyers enter the market,
demand will shift to the right
(implying it increases).

 If less buyers enter the market,

demand will shift to the left (implying
it decreases).
For example, suppose we added one more
buyer to our earlier two consumers in our
very small market for ice cream (this means
that our buyers increase by 50% as the
number of buyers go from 2 to 3).
Market Demand (for a private good) is found by
horizontally adding all of the individual buyers’ demand
curves. Suppose we have now have 3 consumers.

+ +

=
New Demand Curve
Continue: Non-price Determinants of Demand (Shift factors
of Demand)
11 27
(2) Tastes and Preferences
 Consumers are changing the quantities that they are
willing to buy at any given price. This change then
shifts the demand curve.

For example: If consumers taste for a good increases, then

we are saying that consumers’ marginal benefit for a good
has increased for all quantities and the demand curve shifts to
the right.
(3) Income

 Normal Goods: Any good for which there is a direct

relationship between changes in income and its demand
curve shifts.

If consumer income increases than demand shifts to the

right for normal goods.
 Inferior Goods: Any good for which there is an inverse
relationship between changes in income and its demand
curve.

If consumer income increases than demand shifts to the

left for inferior goods (the opposite of a normal good).
Price

D1 D0
Quantity
Continue: Non-price Determinants of Demand (Shift factors
of Demand)

(4) Expectations of Buyers

 Expected Future Prices: If the price of a good is expected

to raise in the future, the demand for the good today
increases.

 Expected Future Income: When expected future income

increases, demand today increases.
For example, suppose in the boat market that consumers expect
the price of boats will increase next month. Illustrate what
would happen in that market.
Continue: Non-price Determinants of Demand (Shift factors
of Demand) 9/13/2016
(5) Prices of Related Goods In Consumption

 Substitute Goods: A good that competes with another

good for consumer purchases. As a result, there is a
direct relationship between a price change for one good
and the demand for its “competitor” good.

 Complementary Goods: A good that is jointly

consumed with another good. As a result, there is an
inverse relationship between a price change for one
good and the demand for the complementary good.
For example, if the price of tablets decreased due only to a change in
the tablets’ supply, what would happen to the demand of laptops, in
the market for laptop computers?

Assume that the public at large sees tablets as substitutes (in

consumption) for laptops.

Laptops (per month)

Price
 D0
Quantity
Demand of laptops would decrease
Income and Substitution Effects and the Law of Demand

We are not talking about

shift factors anymore

These effects will be covered in detailed later in the course,

but for now know the definitions.

 Income Effect is the change in quantity demanded of a good

or service caused by a change in real income (purchasing
power).
 Substitution Effect is the change in quantity demanded of a
good or service caused by the change in its price relative to
substitutes. Always substitute towards the cheaper thing
 The Supply Side of the Market

The “Law of Supply”: The principle that there is a direct

relationship between the price of a good and the quantity sellers are
willing to offer for sale in a defined time period, ceteris paribus.

Supply: A curve or schedule showing the various quantities of a

product sellers are willing to produce and offer for sale at possible
prices during a specified period of time, ceteris paribus.

 The points on a supply curve are also the coordinates of the

minimum-supply-price curve—for each quantity.

oThe minimum-supply-price curve shows the lowest price a

producer must receive in order to produce a particular amount
of output.
  The points on a supply curve are also the coordinates of the
marginal cost paid by sellers in the market
Individual Producer’s Supply Schedule for Pints of Ice Cream
Quantity Supplied
Price (per month 1,000s)
1 2
2 5
3 9
4 14
5 20
Plotting the Supply Schedule
Price
51
4
3
2
2 5 9 14 20
Market Supply: To construct a market supply
curve, horizontally sum the various individual
producers’ supply curves.
All quantities in 1,000s
Firm A's
Pric Firm B's Market
Quantity
e Quantity Quantity
Supplie
($) Supplied Supplied
d
1 2 4 6
2 5 + 6 = 11
3 9 8 17
4 14 10 24
5 20 12 32

Price Market Supply Curve

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4
3
2
1
6 111 17 24 32
When only the price changes we see a change
in the quantity supplied. This is called a
Quantity (1,000s of pints)
movement along the supply curve. See curve S0
and the price change from $2 to $4.
Changes in Supply results in shifts in the
supply curve. See the change in supply from S0
to S1.
 Non-price Determinants of Supply
(Or shift factors of Supply)

(1) Number of Sellers: If the number of

sellers in the market changes
significantly, then the supply curve will
shift in the direction of the change.
 If more sellers enter the market,
supply will shift to the right (implying
it increases or shifts to the right).

 If sellers leave the market, supply will

shift to the left (implying it decreases).
(2) Changes in technology
 If there is an increase in technology, we
are saying that it is less costly to
produce the good or service and the
supply curve will increase (shift to the
right as seen below).

 If there is a decrease in technology, we

are saying that it is more costly to
produce the good or service and the
 supply curve will decrease (shifts to the
left).
(3) Changes in resource or input Prices
 If there is a decrease in the prices of
inputs, then it is less costly to produce
the good or service and the supply curve
will increase (shift to the right).

 If there is an increase in the prices of

inputs, then it is more costly to produce
the good or service and the supply curve
will decrease (shift to the left).
(4) Changes in the expectations of Producers
 Expected Future Prices: If the price of a
good is expected to raise in the future,
the supply of the good today decreases
(so supply of good can increase later).

(5) Changes in the prices of Related Goods

Produced
 A substitute in production is a good that
can be produced using the same
resources. A fall in the price of a
substitute in production increases the
supply of the good.
 A complement in production is a good
that must be produced with the initial
 good. A rise in the price of a complement
in production increases the supply of the
good being considered.
Subst/comp. goods: determine side of production!
 Supply and Demand Analysis

A market is any arrangement in which buyers

and sellers interact to determine the price and
quantity of goods and services exchanged.

A surplus (or excess supply) is a market

condition existing at any price where the quantity
supplied is greater than the quantity demanded.

A shortage (or excess demand) is a market

condition existing at any price where the quantity
supplied is less than the quantity demanded.

Equilibrium is a market condition that occurs at

any price and quantity where quantity demanded
and the quantity supplied are equal. (no tendency to
change)
Price System is a mechanism that uses the forces of
supply and demand to create equilibrium through
rising and falling prices.

 The price of a good regulates the quantities

demanded and supplied.
 The price continues to adjust until the
quantity supplied equals quantity demanded.
Assume the supply and demand curves for a good
are given by the following equations:
 Qd = 1000 - 20P
 Qs = 5P

What is the equilibrium price and quantity?

1000-20P=5P P=40 Q=5P=200
Draw a diagram to illustrate a supply and demand
model with these functions. Indicate the
equilibrium point in your diagram.
Ps=0+.2Q Pd=50-.05Q
 Predicting Changes in Price and Quantity
Suppose we are looking at the corn market and the
price of seed doubles. What is your predictions
about the equilibrium price, quantity demanded,
quantity supplied, demand, and supply in this
market?

Price Corn (per year)

Supply

P0

Demand

Q0 Quantity
Set your problem up with a diagram like the above
to clarify your thoughts. Once set up just make the
correct shifts on the diagram and read off the
answer. (demand doesn’t change)