Chapter 2: Demand, Supply, and Market Equilibrium

McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

2-2

Demand

• Quantity demanded (Qd)

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

2-3

Definitions

• Demand function• Quantity demand as a function of the independent

variables that influence the quantity demanded• Direct demand

• The direct relationship between the quantity demanded and price (other independent variables held constant)

• Inverse demand• The direct relationship between price and quantity

demanded• Demand curve

• A graphical presentation of inverse demand

2-4

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)

2-5

General Demand Function

• 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

Qd = a + bP + cM + dPR + eT + fPe + gN

2-6

Variable Relation to Qd Sign of Slope Parameter

General Demand Function

Inverse for complements

P

Pe

N

M

PR

Inverse

Direct

Direct

Direct

Direct for normal goods

Inverse for inferior goods

Direct for substitutes

b = Qd/P is negative

c = Qd/M is positive

c = Qd/M is negative

d = Qd/PR is positive

d = Qd/PR is negative

f = Qd/Pe is positive

g = Qd/N is positive

e = Qd/T is positiveT

2-7

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)

• Law of Demand• Qd increases when P falls, all else constant

• Qd decreases when P rises, all else constant

• Qd/P must be negative

2-8

Direct Demand Function

pQ

ypp

yqpqpQ

ypppQ

YpppfQ

d

c

cbd

cbd

cbd

b

20286

13,3,4

2/,3/,20/

232020171

),,( ,

Demand for Pork

2-9

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)

2-10

Inverse Demand Function

• How much consumers are willing to pay as a function of quantity

05./

05.030.14

20286

Qp

Qp

pQ

2-11

Graphing Demand Curves

• 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

2-12

Direct Demand Function

d

d

d

R

Rd

R

Q/-P

MQ

PQ

PM

PMpQ

PMpDQ

101140

function demand Inverse

05./

10400,1

200,000,60

2405.10200,3

),,(

2-13

Demand Schedule

2-13

2-14

A Demand Curve (Figure 2.1)

2-15

Graphing Demand Curves

• Change in quantity demanded• Occurs when only 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

2-16

Three Demand Shifts

2-17

2-18

Shifts in Demand (Figure 2.2)

2-19

Supply

• Quantity supplied (Qs)

• Amount of a good or service offered for sale during a given period of time

2-20

• Six variables that influence Qs

• Price of good or service (P)• Input prices (PI )• Prices of goods related in production (Pr)• Technological advances (T)• Expected future price of product (Pe)• Number of firms producing product (F)

• General supply function

• Qs = f(P, PI, Pr, T, Pe, F)

Supply

2-21

General Supply Function

• 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

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

2-22

Variable Relation to Qs Sign of Slope Parameter

General Supply Function

Direct for complements

P

Pe

F

PI

Pr

Direct

Direct

Direct

Inverse

Inverse

Inverse for substitutes

k = Qs/P is positive

l = Qs/PI is negative

m = Qs/Pr is negative

m = Qs/Pr is positive

r = Qs/Pe is negative

s = Qs/F is positive

n = Qs/T is positiveT

2-23

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)

2-24

Direct Supply Function

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p

ppQ

ppSQ

h

h

h

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50.1$

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pork ofSupply

2-25

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)

2-26

Inverse Supply Function

s

s

Qp

pQ

025.2.2

4088

2-27

Graphing Supply Curves

• A point on a direct 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 particular quantity for sale

2-28

Direct Supply Function

s

s

I

Is

Is

QP

PQ

FP

FPPQ

FPPSQ

20/120

Supply Inverse

20400

25,100

201020100

),,(

2-29

A Supply Curve (Figure 2.3)

2-30

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

2-31

Three Supply Functions

10/

201020100

Is

Is

PQ

FPPQ

2-32

Shifts in Supply (Figure 2.4)

2-33

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 want & producers can sell all they want at the “market-clearing” or “equilibrium” price

2-34

Market Equilibrium

800

60$

2040010400,1

20400

10400,1

e

e

sd

s

d

Q

P

PP

QQ

PQ

PQ

2-35

Market Equilibrium (Figure 2.5)

2-36

Market Equilibrium

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

quantity supplied

• Excess supply (surplus)• Exists when quantity supplied exceeds

quantity demanded

2-37

Ceiling & 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

2-38

Ceiling & Floor Prices (Figure 2.12)

Qx

Quantity

Qx

Px Px

Quantity

Pri

ce (

dolla

rs)

Sx

Dx

2

50

1

6222

3

32 84

Panel A – Ceiling price

Sx

Dx

2

50

Panel B – Floor price

2-39

Market Equilibrium

800

60$

2040010400,1

20400

10400,1

e

e

sd

s

d

Q

P

PP

QQ

PQ

PQ

2-40

$50 Price Ceiling

300demand Excess

600

)50(20400

20400

900

)50(10400,1

10400,1

sd

s

s

s

d

d

d

QQ

Q

Q

PQ

Q

Q

PQ

A price ceiling is only effective when it is set below the equilibrium price

2-41

Marginal Valuation

pricemarket black Highest

80

10400,1600

600

10400,1

P

P

Q

PQ

s

d

2-42

$80 Price Floor

600supply Excess

200,1

)80(20400

20400

600

)80(10400,1

10400,1

ds

s

s

s

d

d

d

QQ

Q

Q

PQ

Q

Q

PQ

2-43

500 Unit Quota

90

10400,1500

500

800

10400,1

Quota

sd

s

e

d

P

P

QQ

Q

Q

PQ

2-44

The amount exchanged

• Above equilibrium price the amount exchanged is determined by the demand curve

• Below equilibrium price the amount exchanged is determined by the supply curve

2-45

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

2-46

Measuring the Value of Market Exchange

• Consumer surplus• 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

2-47

Measuring the Value of Market Exchange (Figure 2.6)

2-48

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

2-49

Demand Shifts (Supply Constant) (Figure 2.7)

2-50

Supply Shifts (Demand Constant) (Figure 2.8)

2-51

Simultaneous Shifts

• When demand & supply shift simultaneously• 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 & supply shift

2-52

S′′

Simultaneous Shifts: (D, S)

S

D′

S′

D

Q

Price may rise or fall; Quantity rises

P

•A

Q

P

B•P′

Q′ Q′′

C•P′′

2-53

S′

Simultaneous Shifts: (D, S)

D

S

D′

S′

Q

Price falls; Quantity may rise or fall

P

•A

Q

P

B•P′

Q′ Q′′

C•P′′

2-54

Simultaneous Shifts: (D, S)

S′′

D

S

D′

S′

Q

Price rises; Quantity may rise or fall

P

•A

Q

P

B

•P′

Q′Q′′

C•P′′

2-55

Simultaneous Shifts: (D, S)

S′′

D

S

D′

S′

Q

Price may rise or fall; Quantity falls

P

•A

Q

PB•P′

Q′Q′′

C•P′′