Demand, Supply, and

Market Equilibrium
 The Basic Decision-Making Units

• A firm is an organization that transforms

resources (inputs) into products (outputs).
Firms are the primary producing units in a
market economy.
• An entrepreneur is a 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.
• Households are the consuming units in an
economy.
The Circular Flow of Economic Activity

• The circular flow of

economic activity shows
the connections between
firms and households in
input and output markets.
 Input Markets and Output Markets

• Output, or product,
markets are the markets
in which goods and
services are exchanged.
• Input markets are the
markets in which
resources—labor, capital,
• Payments flow in the opposite and land—used to
direction as the physical flow of produce products, are
resources, goods, and services
(counterclockwise).
exchanged.
 Input Markets

Input markets include:

• The labor market, in which households supply
work for wages to firms that demand labor.
• The capital market, in which households supply
their savings, for interest or for claims to future
profits, to firms that demand funds to buy capital
goods.
• The land market, in which households supply
land or other real property in exchange for rent.
 Quantity Demanded

• Quantity demanded is the amount

(number of units) of a product that a
household would buy in a given time
period if it could buy all it wanted at
the current market price.
 Determinants of Household Demand

A household’s decision about the quantity of a particular

output to demand depends on:
• The price of the product in question.
• The income available to the household.
• The household’s amount of accumulated wealth.
• The prices of related products available to the
household.
• The household’s tastes and preferences.
• The household’s expectations about future
income, wealth, and prices.
 Demand And Supply
Demand
Demand for a particular
product or service Market demand curve
represents how much people
are willing to purchase at
various prices. Demand is
represented graphically as a
downward sloping curve
with price on the vertical
axis and quantity on the
horizontal axis
Demand in Output Markets

• A demand schedule
is a table showing
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

• The demand curve is

a graph illustrating
how much of a given
product a household
would be willing to
buy at different prices.
The Law of Demand

• The law of demand

states that there is a
negative, or inverse,
relationship between
price and the quantity
of a good demanded
and its price.
• This means that
demand curves slope
downward.
 Factors that Shift the Demand Curve

1. Change in consumer real incomes. Because a

consumer's demand for goods and services is limited
by income, higher income levels allow the consumer
to purchase more products, when this happens the
demand curve shifts to the right. When the opposite
occurs, a decrease in real income, this shifts the
demand curve to the left. When the economy enters
a recession and more people become unemployed,
the demand for many goods and services shifts to
the left.
 Related Goods and Services

• Normal Goods are goods for which

demand goes up when income is
higher and for which demand goes
down when income is lower.
• Inferior Goods are goods for which
demand falls when income rises.
 Related Goods and Services

• Substitutes are 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 are goods that “go
together”; a decrease in the price of one
results in an increase in demand for the
other, and vice versa.
Shift of Demand Versus Movement Along a
Demand Curve

• A change in demand is
not the same as a change
in quantity demanded.
• In this example, a higher
price causes lower
quantity demanded.
• Changes in determinants
of demand, other than
price, cause a change in
demand, or a shift of the
entire demand curve, from
DA to DB.
A Change in Demand Versus a Change in Quantity
Demanded

• When demand shifts to

the right, demand
increases. This causes
quantity demanded to be
greater than it was prior to
the shift, for each and
every price level.
A Change in Demand Versus a Change in Quantity
Demanded

To summarize:
Change in price of a good or service
leads to

Change in quantity demanded

(Movement along the curve).

Change in income, preferences, or

prices of other goods or services
leads to

Change in demand
(Shift of curve).
 The Impact of a Change in Income

• Higher income • Higher income

decreases the demand increases the demand
for an inferior good for a normal good
 The Impact of a Change in the Price
of Related Goods
• Demand for complement good
(ketchup) shifts left

• Demand for substitute good (chicken)

shifts right

• Price of hamburger rises

• Quantity of hamburger
demanded falls
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 is 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.
From Household Demand to Market
Demand

• Assuming there are only two households in the

market, market demand is derived as follows:
Supply in Output Markets

• A supply schedule is a table

showing how much of a product
firms will supply at different
prices.

• 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.
 The Supply Curve and
the Supply Schedule

• A supply curve is a graph illustrating how much

of a product a firm will supply at different prices.
The Law of Supply

• The law of supply

states that there is a
positive relationship
between price and
quantity of a good
supplied.
• This means that
supply curves
typically have a
positive slope.
 Determinants of Supply

• The price of the good or service.

• The cost of producing the good, which in turn
depends on:
• The price of required inputs (labor,
capital, and land),
• The technologies that can be used to
produce the product,
• The prices of related products.
 A Change in Supply Versus
a Change in Quantity Supplied

• A change in supply is
not the same as a
change in quantity
supplied.
• In this example, a higher
price causes higher
quantity supplied, and
a move along the
demand curve.
• In this example, changes in determinants of supply, other
than price, cause an increase in supply, or a shift of the
entire supply curve, from SA to SB.
 A Change in Supply Versus
a Change in Quantity Supplied

• When supply shifts

to the right, supply
increases. This
causes quantity
supplied to be
greater than it was
prior to the shift, for
each and every price
level.
 A Change in Supply Versus
a Change in Quantity Supplied

To summarize:
Change in price of a good or service
leads to

Change in quantity supplied

(Movement along the curve).

Change in costs, input prices, technology, or prices of

related goods and services
leads to

Change in supply
(Shift of curve).
 From Individual Supply
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 is 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.
 Market Supply

• As with market demand, market supply is the

horizontal summation of individual firms’ supply
curves.
 Market Equilibrium

• The operation of the market

depends on the interaction
between buyers and sellers.
• An equilibrium is the condition
that exists when quantity supplied
and quantity demanded are equal.
• At equilibrium, there is no tendency
for the market price to change.
Market Equilibrium

• Only in equilibrium is
quantity supplied
equal to quantity
demanded.
• At any price level
other than P0, the
wishes of buyers
and sellers do not
coincide.
Market Disequilibria

• Excess demand, or
shortage, is the condition
that exists when quantity
demanded exceeds
quantity supplied at the
current price.
• When quantity demanded
exceeds quantity
supplied, price tends to
rise until equilibrium is
restored.
Market Disequilibria

• Excess supply, or
surplus, is the condition
that exists when quantity
supplied exceeds quantity
demanded at the current
price.
• When quantity supplied
exceeds quantity
demanded, price tends to
fall until equilibrium is
restored.
 Increases in Demand and Supply

• Higher demand leads to • Higher supply leads to

higher equilibrium price and lower equilibrium price and
higher equilibrium quantity. higher equilibrium quantity.
 Decreases in Demand and Supply

• Lower demand leads to • Lower supply leads to

lower price and lower higher price and lower
quantity exchanged. quantity exchanged.
 Relative Magnitudes of Change

• The relative magnitudes of change in supply and

demand determine the outcome of market equilibrium.
 Elasticity

• A measure of the responsiveness of one

variable (usually quantity demanded or
supplied) to a change in another variable
• Most commonly used elasticity: price elasticity
of demand, defined as:

Price elasticity of demand =

 Price elasticity of demand

• Demand is said to be:

• elastic when Ed > 1,
• unit elastic when Ed = 1, and
• inelastic when Ed < 1.
Perfectly elastic demand
 Perfectly Elastic Demand
- Elasticity equals infinity
Price
1. At any price
above $4, quantity
demanded is zero.

$4 Demand

2. At exactly $4,
consumers will
buy any quantity.

3. At a price below $4, Quantity

quantity demanded is infinite.
Perfectly inelastic demand
• The Inelastic Demand for Cigarettes
• The price of cigarettes in vending machines is
presently 25 Rs per pack. If the price were to
double to 50 rs per pack, how many of you
would quit smoking?
• If price falls to Rs 60 per pack how many
will smoke three times?
• Non smokers will u start smoking?
Relatively In-Elastic

UK universities in the wake of a tripling of tuition fees

are in and they show a drop in applications. The limit
on tuition fees in September 2012 is projected to rise to
up to 9,000 pounds per year up from about 3,350
pounds for an increase of about 169 percent.
University applications in the UK have dropped from
506,388 in 2011 to 462,507 - a drop of 8.7 percent.
This would suggest that the overall price elasticity of
demand for university applications in the UK is quite
inelastic at -0.051
 Elasticity

• Happy hours and Pubbing

 Elasticity & slope

• a price increase from $1 to $2 represents a 100%

increase in price,
• a price increase from $2 to $3 represents a 50%
increase in price,
• a price increase from $3 to $4 represents a 33%
increase in price, and
• a price increase from $10 to $11 represents a 10%
increase in price.
• Notice that, even though the price increases by $1 in
each case, the percentage change in price becomes
smaller when the starting value is larger.
Elasticity along a linear demand curve
Elasticity along a linear demand curve
 Arc elasticity measure

where:
 Example

• Suppose that quantity demanded falls from 60

to 40 when the price rises from $3 to $5. The
arc elasticity measure is given by:

In this interval, demand is inelastic (since elasticity < 1).

 Elasticity and total revenue

• Total revenue = price x quantity

• What happens to total revenue if the price rises?

Price elasticity of demand =

 Elasticity and TR (cont.)

Price elasticity of demand =

• A reduction in price will lead to:

• an increase in TR when demand is elastic.
• a decrease in TR when demand is inelastic.
• an unchanged level of total revenue when demand
is unit elastic.
 Elasticity and TR (cont.)

Price elasticity of demand =

• In a similar manner, an increase in price will

lead to:
• a decrease in TR when demand is elastic.
• an increase in TR when demand is inelastic.
• an unchanged level of total revenue when demand
is unit elastic.
 The Total Revenue Test for Elasticity

Increase in Decrease in
Total Revenue Total Revenue

Increase in INELASTIC ELASTIC

Price DEMAND DEMAND

Decrease in ELASTIC INELASTIC

Price DEMAND DEMAND

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
University Press, 1966,1970); Douglas R. Bohi, Analyzing Demand
Elasticity
Behavior (Baltimore: and
Johns Hopkins TR (cont.)
University Press, 1981); Hsaing-tai
Cheng and Oral Capps, Jr., "Demand for Fish" American Journal of
Agricultural Economics, August 1988; and U.S. Department of
Agriculture
Estimated Price Elasticities of Demand for Various Goods and Services
Goods Estimated Elasticity of Demand
Inelastic

Salt 0.1
Matches 0.1
Toothpicks 0.1
Airline travel, short-run 0.1
Gasoline, short-run 0.2
Gasoline, long-run 0.7
Residential natural gas, short-run 0.1
Residential natural gas, long-run 0.5
Coffee 0.25
Fish (cod) consumed at home 0.5
Tobacco products, short-run 0.45
Legal services, short-run 0.4
Physician services 0.6
Taxi, short-run 0.6
Automobiles, long-run 0.2
Approximately Unitary Elasticity
Movies 0.9
Housing, owner occupied, long-run 1.2
Shellfish, consumed at home 0.9
Oysters, consumed at home 1.1
Private education 1.1
Tires, short-run 0.9
Tires, long-run 1.2
Radio and television receivers 1.2
Fresh tomatoes 4.6
Elastic

Restaurant meals 2.3

Foreign travel, long-run 4.0
Airline travel, long-run 2.4
Fresh green peas 2.8
Automobiles, short-run 1.2 - 1.5
Chevrolet automobiles 4.0

Source: Economics: Private and Public Choice, James D. Gwartney and Richard L. Stroup,
eighth edition 1997, seventh edition 1995; primary sources: Hendrick S. Houthakker and
Lester D. Taylor, Consumer Demand in the United States, 1929-1970 (Cambridge: Harvard
University Press, 1966,1970); Douglas R. Bohi, Analyzing Demand Behavior (Baltimore:
Johns Hopkins University Press, 1981); Hsaing-tai Cheng and Oral Capps, Jr., "Demand
for Fish" American Journal of Agricultural Economics, August 1988; and U.S.
Department of Agriculture.
 Factors of elastcity
• Number of close substitutes within the market - The more (and closer) substitutes available in the
market the more elastic demand will be in response to a change in price. In this case, the
substitution effect will be quite strong.
• 2. Luxuries and necessities - Necessities tend to have a more inelastic demand curve, whereas
luxury goods and services tend to be more elastic. For example, the demand for opera tickets is
more elastic than the demand for urban rail travel. The demand for vacation air travel is more
elastic than the demand for business air travel.
• 3. Percentage of income spent on a good - It may be the case that the smaller the proportion of
income spent taken up with purchasing the good or service the more inelastic demand will be.
• 4. Habit forming goods - Goods such as cigarettes and drugs tend to be inelastic in demand.
Preferences are such that habitual consumers of certain products become de-sensitised to price
changes.
• 5. Time period under consideration - Demand tends to be more elastic in the long run rather than
in the short run. For example, after the two world oil price shocks of the 1970s - the "response" to
higher oil prices was modest in the immediate period after price increases, but as time passed,
people found ways to consume less petroleum and other oil products. This included measures to
get better mileage from their cars; higher spending on insulation in homes and car pooling for
commuters. The demand for oil became more elastic in the long-run.
 Determinants of price elasticity

Price elasticity is relatively high when:

• close substitutes are available,
• the good or service is a large share of the
consumer's budget, and
• a longer time period is considered.
Country long run price short run price
elasticity elasticity
UK
WG
fRANCE
• finds that while gasoline demand may be inelastic in the short run it is less so in
• the long run and these results are consistent with those of the previous studies he
reviews.
• However, Drollas believes his estimates give evidence that the ‘true’ long run price
• elasticities, particularly for European countries, may well be above unity. He
attributes
• these higher than expected long run elasticities to substitute types of transport fuels
• (diesel, liquefied petroleum gas), substitute forms of transport, and the fact that
• consumers can switch expenditure to activities or goods that compete with transport.
• Other important findings of this study are that similarity rather than diversity exists
• between countries in the characteristics of fuel demand, and that inertia in gasoline
• consumption can be explained by the slowly changing vehicle stock and by the

• persistence of inefficient habits .

The table below shows estimated price and income elasticity of demand
for a selection of foods:
Income elasticity of demand

• A good is a luxury good if income elasticity >

1.
• A good is a necessity good if income elasticity
< 1.
 Share of budget Price elasticity Income elasticity
Product (% of household of demand of demand
income) (Ped) (Yed)

All Foods 15.1 n/a 0.2

Fruit juices 0.19 -0.55 0.45
Tea 0.19 -0.37 -0.02
Instant coffee 0.17 -0.45 0.16
Source: DEFRA www.defra
• the income elasticity for a good is positive we call them
normal goods.
• It can be between 0 and 1, and we call it income
inelastic demand for goods such as food, clothing,
newspaper.
• If it is above 1, we call it income elastic demand.
Examples are the red wine, cruises, jewelry, art, etc.

If the income elasticity is negative, this means that as

income increases, the quantity demanded for those
goods actually decreases, we call those goods inferior
goods. Examples are "Ramen noodles", cheap red wine,
potatoes, rice. etc.
 Cross-price elasticity of demand

• The cross-price elasticity of demand between

two goods j and k is defined as:
 Cross-price elasticity (cont.)

• cross-price elasticity is positive if and only if

the goods are substitutes….(coke and pepsi)
• cross-price elasticity is negative if and only if
the goods are complements.
 Substitutes

Sales of digital music downloads have

been soaring with the growth of
broadband and falling prices for
downloads. As a result, sales of
traditional music CDs are declining at a
steep rate.
 Complements
• Popcorn, soft drinks and cinema tickets have a high negative value
for cross elasticity– they are strong complements. Popcorn has a
high mark up i.e. pop corn costs pennies to make but sells for more
than a pound. If firms have a reliable estimate for CPed they can
estimate the effect, say, of a two-for-one cinema ticket offer on the
demand for popcorn.
• The additional profit from extra popcorn sales may more than
compensate for the lower cost of entry into the cinema. For some
movie theatres, the revenue from concessions stalls selling
popcorn; drinks and other refreshments can generate as much as
40 per cent of their annual turnover.
Price elasticity of supply
Perfectly inelastic supply
Perfectly elastic supply
 Determinants of supply elasticity

• short run - period of time in which capital is

fixed
• all inputs are variable in the long run
• supply will be more elastic in the long run than
in the short run since firms can expand or
contract their capital in the long run.
 Price Elasticity of Demand

In part (b), as the

quantity increases
from 0 to 25, demand
is elastic, and total
revenue increases.
 Price Elasticity of Demand

At 25, demand is unit

elastic, and total
revenue is at its
maximum.
As the quantity increases
from 25 to 50, demand is
inelastic, and total revenue
decreases.
• The incidence of a tax depends on the
responsiveness of buyers and sellers to a
change in price. The burden of a tax - it's
incidence - tends to fall more heavily on
whichever side of the market has the least
attractive options else
 Tax Incidence

• The economic burden of a tax is called the tax

incidence.

• The percent of the tax incidence that falls on

consumers versus producers depends on the
elasticity of demand and the elasticity of supply.
 Perfectly Inelastic Demand

1) Supply curve shifts up

S by T.
P `
S
2) Quantity demanded
T stays the same.
P
* 3) Price increases by T.

D 4) The price producers get

Q Q (P* - T) remains the
* same
 Perfectly Inelastic Supply

1) Supply curve shifts up

S= by T.
P S`
2) Quantity demanded
stays the same.
P
*

D
Q Q
*
 Perfectly Inelastic Supply

1) Supply curve shifts up

S= by T.
P S`
2) Quantity demanded
stays the same.
P
*
P*- 3) Price remains the same.
T
D 4) The price producers get
Q Q (P* - T) falls.
*
 Review

• It’s not who you tax, but what you tax that
matters.
• Demand inelastic goods see higher price increases
and consumers face more of the incidence.
• Supply inelastic goods see lower price increases and
producers face more of the incidence.
• Efficacy versus Efficiency.
• Quantity “decreases more” with elastic curves.
• Tax revenue is greater with inelastic curves