© 2007 Thomson South-Western

Demand, Supply and Market Equilibrium

Allocation Mechanisms

How does society allocate the goods and services produced among those who want them?– First come first serve.– Divide them equally.– Allocate them to a certain group.– Give only to the poorest individuals– To the highest bidder.

Each allocation mechanism creates incentives for people to behave in a certain way.

For example, the First come first serve mechanism creates incentives for people to be the first in line.

Allocation Mechanisms

What incentives does the market mechanism create?

A market is a group of buyers and sellers of a particular good or service.

The terms supply and demand refer to the behavior of people . . . as they interact with one another in markets.

What is a Market?

Buyers determine demand.

Sellers determine supply.

What is a Market?

What Is Competition?

A competitive market is a market in which

The product is homogenous Numerous buyers and sellers so that each

has no influence over price Buyers and Sellers are price takers there are

many buyers and sellers so that each has a negligible impact on the market price.

Free entry and exit

DEMAND

Quantity demanded is the amount of a good that buyers are willing and able to purchase at a given price.

Law of Demand– The law of demand states that the

quantity demanded of a good falls when the price of the good rises, ceteris paribus.

The Demand Curve: The Relationship between Price and

Quantity Demanded Demand Curve

– The demand curve is a graph of the relationship between the price of a good and the quantity demanded.

Price ofIce-Cream Cone

0

2.50

2.00

1.50

1.00

0.50

1 2 3 4 5 6 7 8 9 10 11 Quantity ofIce-Cream Cones

$3.00

12

1. A decrease in price ...

2. ... increases quantity of cones demanded.

Market Demand versus Individual Demand

Market demand refers to the sum of all individual demands for a particular good or service.

Graphically, individual demand curves are summed horizontally to obtain the market demand curve.

Price of Ice-Cream Cone

Price of Ice-Cream Cone

Price of Ice-Cream Cone

2.00 2.00 2.00

4 3 7

1.00 1.001.00

8 5 13

Quantity of Ice-Cream Cones Quantity of Ice-Cream Cones Quantity of Ice-Cream Cones

Catherine’s Demand Nicholas’s Demand Market Demand+ =

When the price is $2.00, Catherine will demand 4 ice-cream cones.

When the price is $2.00, Nicholas will demand 3 ice-cream cones.

The market demand at $2.00 will be 7 ice-cream cones.

When the price is $1.00, Catherine will demand 8 ice-cream cones.

When the price is $1.00, Nicholas will demand 5 ice-cream cones.

The market demand at $1.00, will be 13 ice-cream cones.

The market demand curve is the horizontal sum of the individual demand curves!

Change in Quantity Demanded

Change in Quantity Demanded– This refers to a change in the quantity

that a consumer wants to buy as a result of a change in its price

– Graphically represented by a movement along the demand curve.

0

D

Price of Ice-Cream Cones

Quantity of Ice-Cream Cones

A rise in the price of ice-cream cones

results in a movement along the demand

curve.

A

B

8

1.00

$2.00

4

Changes in Quantity Demanded

This happens as the buying behavior changes, which can be due to change in– income– Prices of related goods– Tastes– Expectations– Number of buyers

Shifts in the Demand Curve

$3.002.50

2.001.501.00

0.50

21 3 4 5 6 7 8 9 10 1211

Price of Ice-Cream Cone

Quantity of Ice-Cream Cones

0

Increasein demand

An increase in income...

D1D2

Consumer Income Normal Good

$3.002.50

2.001.501.00

0.50

21 3 4 5 6 7 8 9 10 1211

Price of Ice-Cream Cone

Quantity of Ice-Cream

Cones0

Decreasein demand

An increase in income...

D1D2

Consumer Income Inferior Good

Related Goods

Prices of Related Goods– When two goods are substitutes , a fall

in the price of one good reduces the demand for the other good.

– When two goods are complements , a fall in the price of one good increases the demand for the other good.

Variables that Influence Buyers

SUPPLY

Quantity supplied is the amount of a good that sellers are willing and able to sell.

Law of Supply– The law of supply states that, other

things equal, the quantity supplied of a good rises when the price of the good rises.

The Supply Curve: The Relationship between Price and

Quantity Supplied

Supply Curve– The supply curve is the graph of the

relationship between the price of a good and the quantity supplied.

Price ofIce-Cream

Cone

0

2.50

2.00

1.50

1.00

1 2 3 4 5 6 7 8 9 10 11 Quantity ofIce-Cream Cones

$3.00

12

0.50

1. Anincrease in price ...

2. ... increases quantity of cones supplied.

Changes in Quantity Supplied

Movement along the supply curve. Caused by a change in the price.

1 5

Price of Ice-Cream Cone

Quantity of Ice-Cream Cones0

S

1.00A

C$3.00 A rise in the price

of ice cream cones results in a movement along the supply curve.

Change in Quantity Supplied

Input prices Technology Expectations Number of sellers

Shifts in the Supply Curve

Shifts in the Supply CurvePrice of

Ice-CreamCone

Quantity ofIce-Cream Cones

0

Increase in supply due to improved technology

Decreasein supply due to a rise in input prices

Supply curve, S3

curve, Supply

S1Supply

curve, S2

Variables That Influence Sellers

The Equilibrium concept.

Equilibrium in general refers to a situation where each agent is satisfied with the decision he made given everyone else’s choices.

Thus, equilibrium refers to a state where there is no tendency for change.

Market equilibrium refers to a situation in which the price has reached the level where quantity supplied equals quantity demanded.

SUPPLY AND DEMAND TOGETHER

SUPPLY AND DEMAND TOGETHER

Equilibrium Price– The price that balances quantity

supplied and quantity demanded. – On a graph, it is the price at which the

supply and demand curves intersect. Equilibrium Quantity

– The quantity supplied and the quantity demanded at the equilibrium price.

– On a graph it is the quantity at which the supply and demand curves intersect.

At $2.00, the quantity demanded is equal to the quantity supplied!

SUPPLY AND DEMAND TOGETHER

Demand Schedule

Supply Schedule

The Equilibrium of Supply and Demand

Price ofIce-Cream

Cone

0 1 2 3 4 5 6 7 8 9 10 11 12Quantity of Ice-Cream Cones

13

Equilibriumquantity

Equilibrium price Equilibrium

Supply

Demand

P*2.00

Why not a Price Higher Than P*?

Price ofIce-Cream

Cone

0

Supply

Demand

(a) Excess Supply

Quantitydemanded

Quantitysupplied

Surplus

Quantity ofIce-Cream

Cones

4

$2.50

10

2.00

7

For all prices higher than P*:

• the quantity supplied > quantity demanded.

• there is excess supply or a Surplus.

• Suppliers will lower the price to increase sales.

Why not a Price Lower Than P*?

Price ofIce-Cream

Cone

0 Quantity ofIce-Cream

Cones

Supply

Demand

(b) Excess Demand

Quantitysupplied

Quantitydemanded

1.50

10

$2.00

74

Shortage

For all prices lower than P*:• the quantity

demanded > the quantity supplied.

• There is excess demand or a shortage.

• Suppliers will raise the price due to too many buyers chasing too few goods.

Three Steps for Analyzing Changes in Equilibrium

How an Increase in Demand Affects the Equilibrium

Price ofIce-Cream

Cone

0 Quantity of Ice-Cream Cones

Supply

Initialequilibrium

D

D

3. . . . and a higherquantity sold.

2. . . . resultingin a higherprice . . .

1. Hot weather increasesthe demand for ice cream . . .

2.00

7

New equilibrium$2.50

10

How a Decrease in Supply Affects the Equilibrium

Price ofIce-Cream

Cone

0 Quantity of Ice-Cream Cones

Demand

Newequilibrium

Initial equilibrium

S1

S2

2. . . . resultingin a higherprice of icecream . . .

1. An increase in theprice of sugar reducesthe supply of ice cream. . .

3. . . . and a lowerquantity sold.

2.00

7

$2.50

4

What Happens to Price and Quantity When Supply or

Demand Shifts?