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Chapter 2
Demand, Supply, and
Market Equilibrium

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No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
 Learning Objectives
 Identify demand functions and distinguish between a
change in demand and a change in quantity demanded.
 Identify supply functions and distinguish between a
change in supply and a change in quantity supplied.
 Explain why market equilibrium occurs at the price for
which quantity demanded equals quantity supplied.
 Measure gains from market exchange using consumer
surplus, producer surplus, and social surplus.
 Predict the impact on equilibrium price and quantity of
shifts in demand or supply.
 Examine the impact of government imposed price ceilings
and price floors.

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 Demand

Quantity demanded (Qd)

• Amount of a good or service consumers are
willing & able to purchase during a given
period of time

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 General Demand Function
Six variables that influence Qd
• Price of good or service (P)
• Incomes of consumers (M)
• Prices of related goods & services (PR)
• Taste patterns of consumers (T)
• Expected future price of product (PE)
• Number of consumers in market (N)
General demand function:
Qd = f(P, M, PR, T, PE , N)
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 Slope Parameters
Qd = a + bP + cM + dPR + eT + fPE + gN
b, c, d, e, f, & g are slope parameters
• Measure effect on Qd of changing one of the variables
while holding the others constant
Sign of parameter shows how variable is
related to Qd
• Positive sign indicates direct relationship
• Negative sign indicates inverse relationship

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 Normal vs. Inferior Goods

Normal good
• A good or service for which an increase
(decrease) in income causes consumers to
demand more (less) of the good, holding all other
variables in the general demand function constant.
Inferior good
• A good or service for which an increase
(decrease) in income causes consumers to
demand less (more) of the good, all other factors
held constant.
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 Substitute vs. Complement Goods

Substitutes
• Two goods are substitutes if an increase
(decrease) in the price of one good causes
consumers to demand more (less) of the other
good, holding all other factors constant.
Complements
• Two goods are complements if an increase
(decrease) in the price of one good causes
consumers to demand less (more) of the other
good, all other things held constant.
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 Table 2.1: Summary of the General (Linear)
Demand Function

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 Direct Demand Function
The direct demand function, or simply
demand, shows how quantity demanded,
Qd , is related to product price, P, when all
other variables are held constant:
Qd = f(P)

A demand schedule is a table showing a list of

possible product prices and the
corresponding quantities demanded.
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 Table 2.2: Demand Schedule for the
Demand Function D0: Qd = 1,400 – 10P

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 Demand Curve

The demand curve is a graph showing the relation

between quantity demanded and price when all
other variables influencing quantity demanded
are held constant.

A point on a direct demand curve shows either:

• Maximum amount of a good that will be purchased for
a given price
• Maximum price consumers will pay for a specific
amount of the good (demand price)
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 Law of Demand
Law of Demand
• Qd increases when P falls, all else constant

• Qd decreases when P rises, all else constant

• Qd /P must be negative

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 Figure 2.1: A Demand Curve,
Qd = 1,400 – 10P

Figure 2.1

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 Inverse Demand Function
Traditionally, price (P) is plotted on the vertical
axis & quantity demanded (Qd) is plotted on
the horizontal axis
• The equation plotted is the inverse demand
function, P = f(Qd)

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 Graphing Demand Curves

Change in quantity demanded

• Occurs when price changes
• Movement along demand curve
Change in demand
• Occurs when one of the other variables, or
determinants of demand, changes
• Demand curve shifts rightward or leftward

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 Table 2.3: Three Demand Schedules

Table 2.3

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 Figure 2.2: Shifts in Demand

Figure 2.2

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 Table 2.4: Summary of Demand Shifts

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 Supply
Quantity supplied (Qs)
• Amount of a good or service offered for
sale during a given period of time

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 General Supply Function
Six variables that influence Qs
• Price of good or service (P)

• Input prices (P )
I
• Prices of goods related in production (P )
r
• Technological advances (T)

• Expected future price of product (P )

e
• Number of firms producing product (F)
General supply function
Qs = f(P, PI, Pr, T, Pe, F)
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 Slope Parameters

Qs = h + kP + lPI + mPr + nT + rPe + sF

k, l, m, n, r, & s are slope parameters
• Measure effect on Qs of changing one of the
variables while holding the others constant
Sign of parameter shows how variable is
related to Qs
• Positive sign indicates direct relationship
• Negative sign indicates inverse relationship
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 Substitutes vs. Complements
in Production
Substitutes in production
• Goods for which an increase in the price of one
good relative to the price of another good causes
producers to increase production of the now higher-
priced good and decrease production of the other
good.
Complements in production
• Goods for which an increase in the price of one
good, relative to the price of another good, causes
producers to increase production of both goods.
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 Technology

The state of knowledge concerning the

combination of resources to produce
goods and services.

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 Table 2.5: Summary of the General (Linear)
Supply Function

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 Direct Supply Function
The direct supply function, or simply supply,
shows how quantity supplied, Qs , is related to
product price, P, when all other variables are
held constant:
Qs = f(P)

The supply schedule is a table showing a list of

possible product prices and the
corresponding quantities supplied.

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 Table 2.6: The Supply Schedule for the Supply
Function S0: Qs = –400 + 20P

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 Supply Curve

A supply curve is a graph showing the relation

between quantity supplied and price, when all
other variables influencing quantity supplied are
held constant.

A point on a supply curve shows either:

• Maximum amount of a good that will be offered for
sale at a given price
• Minimum price necessary to induce producers to
voluntarily offer a given quantity for sale (supply price)
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 Figure 2.3: A Supply Curve, Qs = –400 + 20P

Figure 2.3

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 Inverse Supply Function

Traditionally, price (P) is plotted on the vertical

axis & quantity supplied (Qs) is plotted on the
horizontal axis
• The equation plotted is the inverse supply
function, P = f(Qs)

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 Graphing Supply Curves

Change in quantity supplied

• Occurs when price changes
• Movement along supply curve
Change in supply
• Occurs when one of the other variables, or
determinants of supply, changes
• Supply curve shifts rightward or leftward

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 Table 2.7: Three Supply Schedules

Table 2.7

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 Figure 2.4: Shifts in Supply

Figure 2.4

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 Table 2.8: Summary of Supply Shifts

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 Market Equilibrium

Equilibrium price & quantity are

determined by the intersection of
demand & supply curves
• At the point of intersection, Qd = Qs
• Consumers can purchase all they wish &
producers can sell all they wish at the
market-clearing price, or equilibrium price

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 Table 2.9: Market Equilibrium

Table 2.9

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 Figure 2.5: Market Equilibrium

Figure 2.5

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 Excess Supply and Excess Demand

Excess supply (surplus)

• Exists when quantity supplied exceeds
quantity demanded
Excess demand (shortage)
• Exists when quantity demanded exceeds
quantity supplied

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 Value of Market Exchange

Typically, consumers value the goods they

purchase by an amount that exceeds
the purchase price of the goods.
Economic value:
• Maximum amount any buyer in the market
is willing to pay for the unit, which is
measured by the demand price for the unit
of the good

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 Measuring the Value of Market Exchange

Consumer suplus
• Difference between the economic value of a good (its
demand price) & the market price the consumer must pay
Producer surplus
• For each unit supplied, difference between market price &
the minimum price producers would accept to supply the
unit (its supply price)
Social surplus
• Sum of consumer & producer surplus
• Area below demand & above supply over the relevant range
of output
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 Figure 2.6: Measuring the Value of Market
Exchange

Figure 2.6

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 Changes in Market Equilibrium

Qualitative forecast
• Predicts only the direction in which an
economic variable will move
Quantitative forecast
• Predicts both the direction and the
magnitude of the change in an economic
variable

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 Figure 2.7: Demand Shifts (Supply Constant)

Figure 2.7

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 Figure 2.8: Supply Shifts (Demand Constant)

Figure 2.8

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 Simultaneous Shifts
When demand & supply shift simultaneously
• We can predict either the direction in which
price changes or the direction in which
quantity changes, but not both.
• The change in equilibrium price or quantity is
said to be indeterminate when the direction of
change depends on the relative magnitudes
by which demand and supply shift.

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 Figure 2.9: Shifts in Both Demand and Supply,
Demand and Supply Both Increase

Figure 2.9

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 Figure 2.10: Summary of Simultaneous Shifts in
Demand and Supply, The Four Possible Cases

Figure 2.10

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 Figure 2.11: Demand and Supply for Air Travel

Figure 2.11

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 Ceiling and Floor Prices
Ceiling price
• Maximum price government permits sellers to
charge for a good
• When ceiling price is below equilibrium, a
shortage occurs
Floor price
• Minimum price government permits sellers to
charge for a good
• When floor price is above equilibrium, a surplus
occurs
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 Figure 2.12: Ceiling and Floor Prices

Figure 2.12

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 Summary (1 of 2)
• Six variables influence demand: good’s price, income, prices of
related goods, consumers’ tastes, expected future price, and
number of consumers.
• Law of demand states that quantity demanded increases
(decreases) when price falls (rises), all else constant.
• Six variables influence supply: good’s price, input prices, prices
of goods related in production, producers’ expectation of future
price, number of firms.
• Equilibrium price and quantity are determined by intersection of
supply and demand curves.
• Consumer surplus arises because the equilibrium price
consumers pay is less than the value they place on the units
they purchase.
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 Summary (2 of 2)

• Producer surplus arises because equilibrium price is

greater than the minimum price producers would be
willing to accept to produce.
• Social surplus: sum of consumer surplus and producer
surplus.
• When both supply and demand shift simultaneously,
one can predict either the direction of change in price
or the direction of change in quantity, but not both.
• A ceiling price (below equilibrium) results in a shortage;
a floor price (above equilibrium) results in a surplus.

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© 2020 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom.
No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.