Chapter 2 Supply and Demand

This chapter outlines the basics of the supply and demand model. We first introduce the concept of the
demand curve, which embodies consumers desires for goods, and then move on to the supply
curve, which embodies producers willingness to make those goods available.
Standard approach to Economics is to simplify a problem until it becomes manageable.
Market is defined by
-

Specific product being bought and sold

A particular location
Point in time

Often times we use more broadly defined markets

-

Supply-the combined amount of a

good that all the producers in a
market are willing to sell
Demand- The combined amount of a
good that all consumers are willing to
buy.

Pros: more interest, more data to analyze

Cons: makes the assumptions of the supply and demand model less likely to hold

Key Assumptions of the Supply and Demand Model (later we will examine how changing the models assumptions
influence its predictions in market outcomes)

1. Restrict Focus to Supply and Demand in a Single Market

o Ignore the possibility that changes in the market were studying might have spillover
effects on other markets.
2. All Goods Bought and Sold are Identical
o Treat groups of goods as though they are identical (differences in Automobiles)
o Commodities- (products traded in markets in which consumer view different
varieties of the good as essentially interchangeable) best reflect this assumption
Examples of commodities: wheat, soybeans, crude oil, nails, gold
3. All Goods Sold in the Market Sell for the Same Price, and Everyone Has the Same Information
o Implies that there are no special deals for particular buyers and no quantity
discounts
4. There are Many Producers and Consumers in the Market
o Assumption that no particular consumer or producer has a noticeable impact on
anything that occurs in the market and the price level in particular.
Factors that Influence Demand
-

Price
Number of Consumers
Consumer Income and Wealth
Consumer Tastes
Prices of other goodso Substitute A good that can be used in place of another

When the price of a substitute falls, consumers will by more of it and less of
the original good.
Compliment = A good that is purchased and used in a combination with another
good.
When the price of a compliment falls, consumers will want to buy more if it
and less of the initial good.

Graphical Representation of the Demand

*note* - A demand curve is drawn with the assumption that there is no change in any factor other than price.
One reason that the demand curve is downward sloping is that (all else being equal) the lower the price of a good
the more of it consumers will buy.

Mathematical Representation of the demand Curve

The demand curve in the figure above can be represented by
Q = 1,000 200P

Q- Quantity demanded in pounds

P- Price (dollars per pound)

Inverse Demand Curve A demand curve written in the form of price as a function of quantity
demanded

Demand Choke Price The price at which no consumer is willing to buy a good and quantity demanded
is zero; the vertical intercept of the inverse demand curve.

Shifts in Demand Curves-

Change in Quantity Demanded A movement along the demand curve that occurs as a result of a
change in the goods price.
Change in demand A shift of the demand curve caused by a change in the determinant of demand
other than the goods own price.

The observed decline in demand for cigarettes reflects both movements along the demand curve (the
rising price) and shifts in the demand curve (awareness that smoking is dangerous).

Why is Price Treated Differently from the Other Factors that Affect Demand?
1. Price is typically on of the most important factors that influence demand.
2. Price can usually be changed frequently and easily.
3. Price is the only factor that has a direct influence on the other side of the market the quantity
of the good that producers are willing to supply.
o Price serves as the critical element that tie together supply and demand

Supply the combined amount of a good that all producers in a market are willing to sell.
Factors that Influence Supply
-

Price
Suppliers Costs of Production prices of inputs of production
o Production Technology- The processes used to make, distribute, and sell a good.
More efficient processes are, the lower the costs to sellers of providing
tomatoes for sale.
Number of sellers more sellers raise supply
Sellers Outside Options what else could the seller be producing and selling?

Graphical Representation of the Supply Curve

Supply Curve - The relationship between the quantities supplied of a good and the goods price, holding
all other factors constant.
-

Sloped upward holding everything else equal, produces are willing to supply more of a
good as price rises.

Mathematical Representation of the Supply Curve

Q = 200P 200

Q- Quantity supplied (pounds of

tomatoes)
P- Price (Dollars per pound)

Inverse Supply Curve A supply curve written in the form of price as a function of quantity supplied.

Supply Choke Price The price at which no firm is willing to produce a good and quantity supplied is
zero; the vertical intercept of the inverse supply curve.

Shift in the Supply Curve

-

When one of the other (nonprice) factors that affect supply changes, the change affects the
quantity of a good that suppliers want to sell at every price.

Change in Quantity Supplied Movement along the supply curve that occurs as a result of a change in
the goods price.
Change in Supply- A shift of the entire supply curve caused by a change in a determinant of supply other
than the goods price.
Prices roles in both the demand and supply sides of a market mean that prices can adjust freely to make
the quantity demanded by consumers equal to the quantity supplied by producers. When this
happens, we have a market in which everyone who wants to buy at the current price can do so, and
everyone who wants to sell at the current market price can do so as well.

Market Equilibrium

Market Equilibrium- The point at which the quantity demanded by consumers exactly equals the
quantity supplied by producers.
Equilibrium Price The only price at which quantity supplied equals quantity demanded.

Mathematics of Market Equilibrium

To find the equilibrium quantity Qe, we plug this value of Pe back into the equation for either the
demand or supply curve, because both quantity demanded and quantity supplied will be the same at
the equilibrium price:
Qe = 1,000 200Pe = 1,000 200(3) = 1,000 600 = 400

A simple trick will ensure that you have the right answer, and it takes only a few seconds. Take the
equilibrium price that you obtain and plug it into both the demand and supply curves (you should get
the same answer).

Why Markets Move toward Equilibrium

-

If the current price is higher than the equilibrium price, there will be excess supply. If the
price is lower, there will be excess demand.

Excess Supply
Surplus The amount by which quantity supplied exceeds quantity demanded when market price is
higher than equilibrium price.
-

Quantity Supplied at High Price Quantity Demanded at High Price

Excess Demand
Shortage The amount by which quantity demanded exceeds quantity supplied when market price is
lower than the equilibrium price.
-

Quantity Demanded at Low Price Quantity Demanded at Low Price

Shifts in Demand

Solve numerically by equating the new demand curve with the old supply curve.

Q2 = 500 200(1.75) = 150

Shifts in Supply

To calculate numerically equate the new supply curve and the old demand curve.

What determines the size of price and quantity changes?

Size of Shift
-

The larger the shift, larger the change in equilibrium price or quantity.

Slopes of the Curves-

If the demand curve shifts, then the slope of the supply curve determines whether the shift leads to a
relatively large equilibrium price change and a relatively small equilibrium quantity change, or vice
versa. If the supply curve shifts, its the slope of the demand curve that matters.

Changes in Market Equilibrium When both Curves Shit

As a general rule, when both curves shift at the same time, we will know with certainty the
direction of change of either the equilibrium price or quantity, but never both.

Elasticity
Steeper curves mean that price changes are correlated with relatively small quantity changes. When
demand curves are steep, this implies that consumers are not very price-sensitive and wont change
their quantity demanded much in response to price changes. Similarly, steep supply curves mean that
producers quantities supplied are not particularly sensitive to price changes. Flatter demand or supply
curves, on the other hand, imply that price changes are associated with large quantity changes. Markets
with flat demand curves have consumers whose quantities demanded change a lot as price
varies. Markets with flat supply curves will see big movements in quantity supplied as prices change.
Elasticity The ratio of the percentage change in one value to the percentage change in another
Price Elasticity of Demand The percentage change in quantity demanded resulting from a 1% change
in price.

Slope and Elasticity are NOT the same

Using elasticities to express responsiveness avoids these tricky issues, because

everything is expressed in relative percentage changes. That eliminates the units
problem (a 10% change is a 10% change regardless of what units the thing changing
is measured in) and makes magnitudes comparable across markets.

Price elasticity of demand = (% change in quantity demanded)/(% change in price)

Price elasticity of supply = (% change in quantity supplied)/(% change in price)

Price Elasticity of Demand Always Negative (Non positive) can be thought of as the
percentage change in quantity demanded for a 1% price increase.
Price Elasticity of Supply Always Positive (Non Negative) can be thought of as the
percentage change in quantity supply in response to a 1% price increase.

Markets with Large-magnitude price elasticities of demand

-

Markets where consumers have a lot of ability to substitute toward or away from
the good in question
o Example: Apples in a supermarket people can just purchase other fruits

Markets with less price- responsive demand

-

Circus candy

Markets with large price elasticities of supply where quantity supplied is sensitive to price
differences.
-

Where it is easy to vary their amount of production as price changes

o Example: Software New CDs can easily be made or download provided.

Markets with low price elasticities of supply have quantities supplied that are fairly
unresponsive to change in price.
-

Superbowl seating- even if the price increases a lot they cant just go and add more
seats.

The availability of substitutes is one of the key determinants of the price elasticity of demand.
In the long run (over a larger time horizon) the magnitude of the elasticity for a demand for a
product is larger than the elasticity of demand over the short term.
The same logic holds for producers and supply elasticities. The longer the horizon, the more scope
they have to adjust output to price changes.
For these reasons, the price elasticities of demand and supply for most products are larger in
magnitude (i.e., more negative for demand and more positive for supply) in the long run than in the
short run.
Elastic A price elasticity with and absolute value greater than 1.
Inelastic A price elasticity with an absolute value equal to 1.
Unit Elastic A price elasticity with an absolute value equal to 1.
Perfectly Inelastic A price elastic that is equal to zero there is no change in quantity demanded
or supplied or any change in price.
Perfectly Elastic A price elasticity that is infinite; any change in price leads to an infinite change
in quantity demanded or supplied.

Elasticities and Linear Demand and Supply Curves

The price elasticity of demand changes from to zero as we move down and to the right along a
linear demand curve.

Therefore, the price elasticity of supply wont drop to zero. (Because supply wont intercept the xaxis)

Because the price elasticity of supply equals (1/slope) (P/Q), such supply curves approach becoming
unit elastic at high prices and quantities supplied, but never quite get there. Also, because P/Q never
falls to zero, the only way a supply curve can have an elasticity of zero is if its inverse slope is zerothat
is, if it is vertical.

Perfect Inelasticity price elasticity = 0.

-

A perfectly inelastic demand curve is vertical.

o A vertical demand curve indicates that the quantity demanded by consumers is
completely unchanged regardless of price.
o Any change in price will induce a 0% change in quantity demanded.
Examples Diabetics for insulin no substitutes
Any shift in market supply will only change the market equilibrium price, not the quantity.

Perfect Elasticity Price elasticity is infinite

-

Small price change from above to below a horizontal supply curve would shift producers
quantity supplied from infinite to zero.
Shift in the Demand or Shifts in the Supply curve, only change the equilibrium quantity and
not the price.

If demand is inelastic, then the percentage drop in quantity (the numerator) will be smaller than the
percentage increase in price (the denominator). This means the direct effect of price outweighs the
quantity effect, and expenditures rise.

If demand is elastic (the elasticity is greater than 1 in absolute value) on the other hand, then the
percentage drop in quantity (the numerator) will be larger than the percentage increase in price (the
denominator). In this case, the indirect effect of the price increase is larger than the direct effect, and
total expenditures fall.
For unit elastic demand (an elasticity of 1), the percentage increase in price exactly equals the
percentage decrease in quantity demanded, so expenditure doesnt change.

Income Elasticity of Demand The percentage change in quantity demanded associated with a 1%
change in consumer income.

Inferior Good A good for which quantity demanded rises when income rises.
-

Goods with an income elasticity that is negative

Normal Good- A good for which quantity demanded rises when income rises
-

Goods with a positive income elasticity

Luxury Good A good with an income elasticity greater than 1.

Cross-Price Elasticity of Demand The percentage change in the quantity demanded of one good
associated with a % change in the price of another good.

When a good has a positive cross-price elasticity with another good, that means consumers demand a
higher quantity of it when the other goods price rises. In other words, the good is a substitute for the
other good.
When a good has a negative cross-price elasticity with another good, consumers demand less of it when
the other goods price increases. This indicates that the goods are complements. Complements tend to
be goods that are consumed together.