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6SUPPLY AND DEMAND I: HOW MARKETS WORK

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SUPPLY AND DEMAND

TOGETHER

Equilibrium refers to a situation in which the

price has reached the level where quantity

supplied equals quantity demanded.

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SUPPLY AND DEMAND

TOGETHER Equilibrium Price

The price that balances quantity supplied andquantity 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.

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At $2.00, the quantity demandedis equal to the quantity supplied!

SUPPLY AND DEMAND

TOGETHERDemand Schedule Supply Schedule

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Figure 9 Markets Not in Equilibrium

Price of

Ice-CreamCone

0

Supply

Demand

(a) Excess Supply

Quantity

demandedQuantity

supplied

Surplus

Quantity of

Ice-Cream

Cones

4

$2.50

10

2.00

7

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Equilibrium

Surplus

When price > equilibrium price, then quantitysupplied > quantity demanded.

There is excess supply or a surplus.

Suppliers will lower the price to increase sales, therebymoving toward equilibrium.

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Equilibrium

Shortage

When price < equilibrium price, then quantitydemanded > the quantity supplied.

There is excess demand or a shortage.

Suppliers will raise the price due to too many buyerschasing too few goods, thereby moving toward

equilibrium.

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Figure 9 Markets Not in Equilibrium

Price of

Ice-CreamCone

0 Quantity of

Ice-Cream

Cones

Supply

Demand

(b) Excess Demand

Quantity

suppliedQuantity

demanded

1.50

10

$2.00

74

Shortage

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Equilibrium

Law of supply and demand

The claim that the price of any good adjusts to bringthe quantity supplied and the quantity demanded for

that good into balance.

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Three Steps to Analyzing Changes in

Equilibrium

Decide whether the event shifts the supply or

demand curve (or both). Decide whether the curve(s) shift(s) to the left

or to the right.

Use the supply-and-demand diagram to see how

the shift affects equilibrium price and quantity.

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Figure 10 How an Increase in Demand Affects theEquilibrium

Price of

Ice-Cream

Cone

0 Quantity of

Ice-Cream Cones

Supply

Initial

equilibrium

D

D

3. . . . and a higherquantity sold.

2. . . . resulting

in a higher

price . . .

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

2.00

7

New equilibrium$2.50

10

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Three Steps to Analyzing Changes in

Equilibrium

Shifts in Curves versus Movements along

Curves A shift in the supply curve is called a change in

supply.

A movement along a fixed supply curve is called achange in quantity supplied.

A shift in the demand curve is called a change in

demand.

A movement along a fixed demand curve is called a

change in quantity demanded.

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Figure 11 How a Decrease in Supply Affects theEquilibrium

Price of

Ice-Cream

Cone

0 Quantity of

Ice-Cream Cones

Demand

Newequilibrium

Initial equilibrium

S1

S2

2. . . . resultingin a higherprice of ice

cream . . .

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

3. . . . and a lowerquantity sold.

2.00

7

$2.50

4

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Table 4 What Happens to Price and Quantity When Supplyor Demand Shifts?

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SURPLUSPRODUSEN

DANKONSUMEN

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CONSUMER SURPLUS

Consumer surplus is the buyers

willingness to pay for a good minus the

amount the buyer actually pays for it.

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Figure How the Price Affects Consumer Surplus

Consumer

surplus

Quantity

(a) Consumer Surplus at Price P

Price

0

Demand

P1

Q1

B

A

C

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Figure How the Price Affects Consumer Surplus

Initial

consumer

surplus

Quantity

(b) Consumer Surplus at Price P

Price

0

Demand

A

BC

D E

F

P1

Q1

P2

Q2

Consumer surplus

to new consumers

Additional consumer

surplus to initial

consumers

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PRODUCER SURPLUS Producer surplus is the amount a seller is paid

for a good minus the sellers cost. It measures the benefit to sellers participating in

a market.

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Figure How the Price Affects Producer Surplus

Producersurplus

Quantity

(a) Producer Surplus at Price P

Price

0

Supply

B

A

C

Q1

P1

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Figure How the Price Affects Producer Surplus

Quantity

(b) Producer Surplus at Price P

Price

0

P1B

C

Supply

A

Initialproducer

surplus

Q1

P2

Q2

Producer surplusto new producers

Additional producer

surplus to initialproducers

D EF

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MARKET EFFICIENCYConsumer Surplus

= Value to buyers Amount paid by buyers

and

Producer Surplus

= Amount received by sellers Cost to sellers

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MARKET EFFICIENCYTotal surplus

= Consumer surplus + Producer surplus

or

Total surplus

= Value to buyers Cost to sellers

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MARKET EFFICIENCY Efficiency is the property of a resource

allocation of maximizing the total surplusreceived by all members of society.

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MARKET EFFICIENCY In addition to market efficiency, a social

planner might also care about equity thefairness of the distribution of well-being among

the various buyers and sellers.

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Figure 7 Consumer and Producer Surplus in the MarketEquilibrium

Producersurplus

Consumersurplus

Price

0 Quantity

Equilibrium

price

Equilibrium

quantity

Supply

Demand

A

C

B

D

E

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MARKET EFFICIENCY Three Insights Concerning Market Outcomes

Free markets allocate the supply of goods to thebuyers who value them most highly, as measured by

their willingness to pay.

Free markets allocate the demand for goods to thesellers who can produce them at least cost.

Free markets produce the quantity of goods that

maximizes the sum of consumer and producersurplus.

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Figure 8 The Efficiency of the Equilibrium Quantity

Quantity

Price

0

Supply

Demand

Cost

to

sellers

Costto

sellers

Valueto

buyers

Value

to

buyers

Value to buyers is greater

than cost to sellers.

Value to buyers is less

than cost to sellers.

Equilibrium

quantity

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Evaluating the Market Equilibrium

Because the equilibrium outcome is an efficient

allocation of resources, the social planner canleave the market outcome as he/she finds it.

This policy of leaving well enough alone goes

by the French expression laissez faire.

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Evaluating the Market Equilibrium

Market Power

If a market system is not perfectly competitive,market powermay result.

Market power is the ability to influence prices.

Market power can cause markets to be inefficient becauseit keeps price and quantity from the equilibrium of supply

and demand.

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Evaluating the Market Equilibrium

Externalities

created when a market outcome affects individualsother than buyers and sellers in that market.

cause welfare in a market to depend on more than

just the value to the buyers and cost to the sellers. When buyers and sellers do not take

externalities into account when deciding how

much to consume and produce, the equilibriumin the market can be inefficient.