Topic 1 - Supply and Demand

Econ 300 Microeconomics
Topic 1: Supply and Demand
Econ 300: Microeconomics Yang Fan

Intro and The Market Shocks to the Equilibrium
Demand
Supply Supply and Demand
Market Equilibrium
Topic 1: Supply and Demand in an Intermediate Level Framework
The Market
The Demand Side
The Supply Side
Market Equilibrium
Shocks to the Equilibrium

Demand
Market Equilibrium
Economics: A Social Science of “Incentives”
The most important concept in economics, microeconomics,

macroeconomics, subcategories such as labor, health, public policy,
finance…etc all relate to the theory of incentives.
What are economic “incentives”?

A factor, financial or non-financial, that induces or provides an economic
agent(individual, firm, government…etc) the motivation to take a
particular course of action or counts as a reason for preferring one choice
over other alternatives.

Demand
Market Equilibrium
The Market
Market- where buyers and sellers can meet to perform transactions.
In the most basic supply and demand model, we start with the most
restrictive market (lots of assumptions).
Competitive Market
• Large number of buyers
• Large number of sellers
• Everyone is a price-taker.
• Standardized Product
• No Barriers to Entry

Demand
Market Equilibrium
The Demand Curve
The Demand Curve: how the consumer behaves in the market.

How much a consumer will purchase of a good (quantity demanded) given
the price of the good in the market.
Pairwise relationship between Qd and the price.
Inverse Relationship between the price and quantity demanded.

As P, Qd and vice-versa.
All demand for goods follow this inverse relationship:
• The Law of Demand
– All else equal, the price and quantity demanded of a good are inversely related.

Demand
Market Equilibrium
The Demand Curve: Simple Econ200 Representation
P 0.75
Change in Quantity Demanded = Change in own price only
Predictive element to the statement: can predict

0.40 how a consumer behaves at any price level.
0.25
Example: “Coca-Cola”
0.20 As coke prices increases,
Consumers respond by buying less.
Coke demand curve, D1
0 28 40 44 160 Q

Demand
Market Equilibrium
Shifts of the Demand Curve
The Demand Curve: how the consumer behaves in the market.

How much a consumer will purchase of a good given the price of the good
in the market.
Determinants of Demand
Price of the product. (-) related
Information (expectations)
Price of related product (substitutes or complements) (+) or (-) related
Preferences (tastes)
Income (normal or inferior product) (+) or (-) related
Government rules/regulations (taxes) (+) or (-) related

Demand
Market Equilibrium
Shifts of the Demand Curve
Market for Coke: Price of Pepsi rises by 10 cents
P D2, Pepsi
D1, Pepsi
40¢ per $50¢ per can
can Effect of a 10¢ New* relationship
increase in the price between prices and
of Pepsi quantity demanded.
0.25 At every price level, the
consumer buys more coke
0 40 40.1 Q (millions)
Demand
Market Equilibrium
Generalized Demand Function (for Coke)
• The a demand function (for Coke) is:
𝑄𝑑 = 𝐷(𝑝, 𝑝𝑝, 𝑌)
– where 𝑄 is the quantity of Coke demanded in millions

– 𝑝 is the price of own good Coke (dollars per can)
– 𝑝𝑝 is the price of a related good Pepsi (dollars per Pepsi)
– 𝑌 is the average monthly income of consumers (dollars)
The demand for coke is affected by it’s own price, price of

Pepsi, and the average income of it’s consumers.

Demand
Market Equilibrium
Generalized Demand Function (for Coke)
• Using some example parameter values, we have:
𝑄𝑑 = 𝐷 𝑝, 𝑝𝑝 , 𝑌 = 18 − 80𝑝 + 5𝑝𝑝 + 0.01𝑌
• Verify that our demand determinant relationships hold:

𝜕D(p, 𝑝𝑝 , Y) As own price increases, quantity demanded decreases.
o = −80 < 0
𝜕𝑝
𝜕D(p,𝑝𝑝 , Y) As the price of a related good increases, quantity

o =5>0 demanded increases. (substitute)
𝜕 𝑝𝑝
𝜕D(p,𝑝𝑝 , Y) As income increases, quantity demanded increases.

o = 0.01 > 0
𝜕𝑌 (normal good)

Demand
Market Equilibrium
Generalized Demand Function
• In a more generalized sense:
𝑄𝑑 = 𝐷 𝑝, 𝑝𝑟 , 𝑌 = 𝑎 − 𝑏𝑝 + 𝑐𝑝𝑟 + 𝑑𝑌
𝜕D(p, 𝑝𝑟 , Y) As own prices increases, quantity demanded decreases

o <0 Law of Demand
𝜕𝑝

Demand
Market Equilibrium
𝜕D(p,𝑝𝑟 , Y)
o >0 Substitutes
𝜕 𝑝𝑟
o <0 Complements
𝜕 𝑝𝑟
o =0 Not related
𝜕 𝑝𝑟

Demand
Market Equilibrium
𝜕D(p,𝑝𝑝 , Y)
o >0 Normal Good
𝜕𝑌
o <0 Inferior Good
𝜕𝑌
o =0 Not related to income
𝜕𝑌

Demand
Market Equilibrium
A Linear Demand Function (for Coke)
• Using the values 𝑝𝑝 = 0.40 and 𝑌 = 4,000, we have
𝑄𝑑 = 𝐷(𝑝, 𝑝𝑝 , 𝑌) = 18 − 80𝑝 + 5𝑝𝑝 + 0.01𝑌
𝑄𝑑 = 60 − 80𝑝
All else equal (price of a can a Pepsi at $0.40, income at $4000…etc),

the relationship between the price of coke and the demand for
coke is given by the above linear demand function.

Demand
Market Equilibrium
General Linear Demand Curve Form
• Holding income/related goods price the same
𝑄𝑑 = 𝐷(𝑝) = 𝑎– 𝑏𝑝
where 𝑎 is the vertical-intercept

and 𝑏 is the slope of the linear demand curve
𝑝 is the price of the good.

Demand
Market Equilibrium
More Commonly: The Inverse Demand Function
It is frequently “easier” to work with an inverse demand function rather than

a demand function.
𝒂 𝟏
Inverse Demand Function: 𝑷 𝑸𝒅 = − 𝑸𝒅
𝒃 𝒃
𝑎

𝑏
is the vertical intercept or Choke Price (price which consumers of the product buy
quantity=0)
 a is the horizontal intercept – quantity consumers purchase when the price =0.
Solve for 𝑃 in terms of 𝑄𝑑 ,

3 1
𝑄𝑑 = 60 − 80𝑝 is the same as 𝑃= – 𝑄𝑑
4 80
Same interpretation as the Demand curve in a graph (P is the Y-axis)

Demand
Market Equilibrium
Graphical: The Inverse Demand Function
𝑃 𝑄𝑑 𝑎 1
𝑎 Inverse Demand Function: 𝑃 𝑄𝑑 = − 𝑄𝑑
“Choke” 𝑏 𝑏
𝑏
3 1
𝑃= – 𝑄
4 80 𝑑
Δ𝑝 1
𝑆𝑙𝑜𝑝𝑒 = =−
Δ𝑄 𝑏
Inverse Demand D
𝑄𝑑
𝑎
Demand
Market Equilibrium
The Supply Curve
The Supply Curve: how the firm behaves in the market.

How many units a firm is willing to sell (quantity supplied) based on the
current market price of the good.
Pairwise relationship between price and quantity supplied.
Positive Relationship between the price and quantity supplied.

As P, Qs  and vice-versa.
The Law of Supply
• All else equal, the price and quantity supplied are positively related

Demand
Market Equilibrium
The Supply Curve: Simple Econ200 Representation
Change in Quantity Supplied = Change in own price only

P
0.35
Example: “Coca-Cola” Predictive element to the
As coke prices increases, statement: can predict how
Coca-Cola respond by producing more. a consumer behaves at any
price level.
0.25
Coke Supply curve, S1
0 40 55 Q (millions)
Demand
Market Equilibrium
Shifts of the Supply Curve
The Supply Curve: how the firm behaves in the market.
Determinants of Supply
Price of the product. (Quantity Supplied) (+) related
Cost of resources or inputs (-) related
Price of other product produced (-) related
Government rules/regulations (taxes) (+) or (-) related

Demand
Market Equilibrium
Shifts of the Supply Curve (Graphically)
Market for Coke: Price of an input (Aluminum) increases.

P S2, Aluminum S1, Aluminum
$20 per lb $10 per lb
Effect of a $10/lb increase

0.25 in the price of Aluminum
0 20 40 Q (millions)
Demand
Market Equilibrium
A Linear Supply Function (for Coke)
• The a supply function (for Coke) is:
𝑄𝑠 = 𝑆(𝑝, 𝑝𝑎)
– where 𝑄 is the quantity of Coke supplied

– 𝑝 is the price of Coke (dollars per can)
– 𝑝𝑎 is the price of aluminum (dollars per lb.)
The supply for coke is affected by it’s own price and price of
it’s inputs used for production.

Demand
Market Equilibrium
Generalized Supply Function
• Generalized Supply curve form:
𝑄𝑠 = 𝑆(𝑝, 𝑝𝑟) = 𝑔 + ℎ𝑝 − 𝑘𝑝𝑐
Where pc is the cost of an input
𝜕S(p, 𝑝𝑐 )
o >0 Law of Supply
𝜕𝑝
𝜕S(p, 𝑝𝑐 )
o <0 As costs increase, supply decreases (all else equal)
𝜕𝑝𝑐

Demand
Market Equilibrium
Generalized Supply Function (for Coke)
• From our coke supply example: (with some parameter values)
𝑄𝑠 = 𝑆(𝑝, 𝑝𝑎) = 55 + 20𝑝 − 2𝑝𝑎

𝜕S(p, 𝑝𝑎 )
o = 20 > 0
As own price increases, quantity supplied increases.
𝜕𝑝
𝜕S(p, 𝑝𝑎 )
o = −2 < 0 As the price of a an input increases, the quantity
𝜕𝑝𝑎 supplied of Coke decreases.

Demand
Market Equilibrium
Linear Supply Function (for Coke)
• Using the values 𝑝𝑎 = $10 per lb, we have
𝑄𝑠 = 𝑆(𝑝, 𝑝𝑎) = 55 + 20𝑝 − 2𝑝𝑎
𝑄𝑠 = 35 + 20𝑝
All else equal (the price of aluminum at $10/lb…etc),

the relationship between the Price of coke and the Supply for coke
is given by the above linear supply function.

Demand
Market Equilibrium
General Linear Supply Function
• Given some price of the input, the general supply curve is:
𝑄𝑠 = 𝑆(𝑝) = 𝑔 + ℎ𝑝
where 𝑔 is the vertical intercept of the quantity axis.

and ℎ is the slope of the linear supply curve
𝑝 is the price of the good.

Demand
Market Equilibrium
Inverse Supply Function (for Coke)
• Similarly with the supply curve, frequently it is easier to use the

inverse form of the supply curve.
– 𝑄𝑠 = 35 + 20𝑝
1 7
– 𝑃 𝑄𝑠 = 𝑄𝑠 −
20 4
𝑔 1
Inverse Supply Function: 𝑃 𝑄𝑠 = − 𝑄
ℎ ℎ 𝑠

Demand
Market Equilibrium
Graphical: The Inverse Supply Function
𝑔 1
Inverse Supply Function: 𝑃 𝑄𝑠 = − 𝑄𝑠
𝑃 𝑄𝑠 ℎ ℎ
Inverse Supply S
1
𝑆𝑙𝑜𝑝𝑒 = −
ℎ
1 7
𝑃 𝑄𝑠 = 𝑄 −
𝑔 20 𝑠 4
ℎ
𝑄𝑠
Demand
Market Equilibrium
Market Equilibrium
Willingness to Pay = Willingness to Sell
At the margins, the MB of a good

by the consumer is exactly equal
to the MC of the firm.
𝑄𝑠 = 𝑄𝑑 = 𝑄∗

Demand
Market Equilibrium
Market Equilibrium
Willingness to Pay = Willingness to Sell

Equilibrium - a price and quantity pair
in which neither economic agent as any
incentive to change.
𝑄𝑠 = 𝑄𝑑 = 𝑄∗

Demand
Market Equilibrium
Disequilibrium cannot exists
P
Excess supply = 5 S
Market equilibrium,
0.30
𝑃∗ , 𝑄∗
0.25
0.20
Excess demand = 5
D
0 36 39 40 41 44 Q

Demand
Market Equilibrium
Theory of the Invisible Hand
Why P=$0.25 and Q=40 be the equilibrium?

P
Excess supply = 5 S
0.30
𝑄𝑠 > 𝑄𝑑
0.25
0 36 40 41 Q
Demand
Market Equilibrium
Excess Supply
𝑄𝑠 > 𝑄𝑑

Demand
Market Equilibrium
Excess Supply
𝑄𝑠 > 𝑄𝑑

Demand
Market Equilibrium
Theory of the Invisible Hand at Market Equilibrium
The market is at equilibrium

where Price = 𝑃∗ and
Quantity =𝑄 ∗ .
There is no incentive for

either party to deviate.
Solve for P* and Q*
𝑄𝑑 = 60 − 80𝑝
𝑄𝑠 = 𝑄𝑑 = 𝑄∗ 𝑄𝑠 = 35 + 20𝑝

Demand
Market Equilibrium
Simultaneous Equation Solving: Finding the Equilibrium
To solve this problem mathematically: at equilibrium, set 𝑄𝑠 = 𝑄𝑑

𝑄𝑑 = 60 − 80𝑝
𝑄𝑠 = 35 + 20𝑝
60 − 80𝑝 = 35 + 20𝑝
100𝑝 = 25
𝑷∗ = $𝟎. 𝟐𝟓 - equilibrium price
𝑄∗ = 𝑄𝑠 = 𝑄𝑑 at 𝑃∗ (Use the supply or demand function)
𝑸∗ = 60– 80(0.25) = 𝟒𝟎 cans - equilibrium price

𝑄 ∗ = 35 + 20(0.25) = 40 cans

Demand
Market Equilibrium
Why Care About the Equilibrium* (At All)?
If equilibriums in the economy are rarely observed? Why care?

• Equilibriums are rarely observed.
• Most equilibriums are subject to multiple shocks at once.
• Equilibriums are a benchmark.

• When shocks occur, it gives us an idea of how the market will
react.
• If we want to make changes to the economy and want to know hot
the economy changes, we need to know where the equilibrium is
(theoretically)
• Policies can act as shocks.

Demand
Market Equilibrium
Coke Example Equilibrium under Assumptions
𝑄𝑑 = 𝐷(𝑝, 𝑝𝑝 , 𝑌) = 18 − 80𝑝 + 5𝑝𝑝 + 0.01𝑌

𝑄𝑠 = 𝑆(𝑝, 𝑝𝑎 ) = 55 + 20𝑝 − 2𝑝𝑎
When 𝑃𝑎 = $10, 𝑃𝑝 = $0.4, 𝑌 = $4000 the equilibrium Price 𝑃∗ = $0.25 and 𝑄 ∗= 40
P S 𝑃𝑎 = $10
0.25
D 𝑃𝑝 = $0.4, 𝑌 = $4000
0 40 Q

Demand
Market Equilibrium
Demand Shock (income increases)
𝑄𝑑 = 𝐷(𝑝, 𝑝𝑝 , 𝑌) = 18 − 80𝑝 + 5𝑝𝑝 + 0.01𝑌 𝑄𝑑 = 60 − 80𝑝

𝑄𝑠 = 𝑆(𝑝, 𝑝𝑎 ) = 55 + 20𝑝 − 2𝑝𝑎 𝑄𝑠 = 35 + 20𝑝
Suppose a demand shock occurs. Income Y increases to $5,500 from $4,000.

What effect does this have on the equilibrium?
𝑃𝑎 = $10, Pp=$0.4, 𝑌 = $5,500

New Demand Function: 𝑄’𝑑 = 75 − 80𝑝 (demand shifts out)
75 − 80𝑝 = 35 + 20𝑝 Compare w/ old demand
100𝑝 = 40 above, not slope change,
Benchmark ∗
𝑃 = 0.4 only intercept change
∗
𝑃 = 0.25 ∗
𝑄 = 43
𝑄∗ = 40

Demand
Market Equilibrium
Supply Shock (Resource Price Increases)
𝑄𝑑 = 𝐷(𝑝, 𝑝𝑝 , 𝑌) = 18 − 80𝑝 + 5𝑝𝑝 + 0.01𝑌 𝑄𝑑 = 60 − 80𝑝

𝑄𝑠 = 𝑆(𝑝, 𝑝𝑎 ) = 55 + 20𝑝 − 2𝑝𝑎 𝑄𝑠 = 35 + 20𝑝
Now suppose a supply shock occurs. The price of aluminum per lb. increases to
$20 from $10. What effect does this have on the equilibrium?
𝑃𝑎 = $20, 𝑃𝑝 = $0.4, 𝑌 = $4,000

New Supply Function: 𝑄’𝑠 = 15 + 20𝑝 (supply shifts in)
60 − 80𝑝 = 15 − 20𝑝
Compare w/ old supply
Benchmark 100𝑝 = 45
∗ = 0.45 above, not slope change,
∗
𝑃 = 0.25 𝑃 only intercept change
∗ ∗
𝑄 = 24
𝑄 = 40

Demand
Market Equilibrium
Supply Shock (Aluminum price increases)
Increase in costs dis-incentivizes firms

S’, Aluminum/lb from producing the same output level at
Pa=$20 the equilibrium price of 0.25.
P S, Aluminum/lb
Pa=$10 Instead of producing 24 million cans, the
0.45 firm produces only 20 million, causing a
shortage.
0.25
This shortage drives up prices away from
0.25, reduces quantity demanded as
prices rises. However, firms now are
D willing to produces a little bit more as
𝑃𝑝 = $0.4, 𝑌 = $4000 the price rises, so there's a sort of back
and forth adjustment, finally settling at
0 20 24 40 Q $0.45/can.

Demand
Market Equilibrium
Demand and Supply Shocks (income + cost changes)
𝑄𝑑 = 𝐷(𝑝, 𝑝𝑝 , 𝑌) = 18 − 80𝑝 + 5𝑝𝑝 + 0.01𝑌 𝑄𝑑 = 60 − 80𝑝

𝑄𝑠 = 𝑆(𝑝, 𝑝𝑎 ) = 55 + 20𝑝 − 2𝑝𝑎 𝑄𝑠 = 35 + 20𝑝
If we have two shock.

Income increases to $5,500 from $4,000
The price of aluminum per lb. increases to $20 from $10.
What happens to the equilibrium quantity depends on which shock dominates.
𝑃𝑎 = $20, 𝑃𝑝 = $0.4, 𝑌 = $5,500
New Demand Function: 𝑄’𝑑 = 75 − 80𝑝 (demand shifts out)
New Supply Function: 𝑄’𝑠 = 15 + 20𝑝 (supply shifts in)
75 − 80𝑝 = 15 − 20𝑝
Benchmark 100𝑝 = 60
∗
𝑃 = 0.25 𝑃∗ = 0.60
𝑄∗ = 40 𝑄 ∗ = 27 (the supply shock dominates)

Demand
Market Equilibrium
Double Shocks (Aluminum price increases + Income Increases)
Benchmark
𝑃∗ = 0.25 S’, Aluminum/lb
𝑄∗ = 40 $20
Demand
P S, Aluminum/lb
0.60 $10
𝑃∗ = 0.40
0.45
𝑄∗ = 43
0.25
Supply
𝑃∗ = 0.45 D’, Y=$5,500
𝑄∗ = 24
D, Y=$4,000
Dual Shock
𝑃∗ = 0.60 0 24 27 40 Q
𝑄∗ = 27

Example 2: Market Equilibriums and Shocks
Demand Curve: 𝑄𝑑 = 700– 4𝑃 − 5𝑃𝑟 − 0.02𝑌 Where initially income Y=$5,000
Supply Curve: 𝑄𝑠 = −80 + 2𝑃 − 4𝑃𝑐 Related Pr=$20
Input Pc=$5

Topic 1 - Supply and Demand

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Econ 300 Microeconomics

Topic 1: Supply and Demand

Econ 300: Microeconomics Yang Fan

Topic 1: Supply and Demand in an Intermediate Level Framework

Econ 300: Microeconomics Yang Fan

Economics: A Social Science of “Incentives”

The most important concept in economics, microeconomics,

What are economic “incentives”?

Econ 300: Microeconomics Yang Fan

Market- where buyers and sellers can meet to perform transactions.

Econ 300: Microeconomics Yang Fan

The Demand Curve

The Demand Curve: how the consumer behaves in the market.

Inverse Relationship between the price and quantity demanded.

Econ 300: Microeconomics Yang Fan

The Demand Curve: Simple Econ200 Representation

Predictive element to the statement: can predict

Coke demand curve, D1

Econ 300: Microeconomics Yang Fan

Shifts of the Demand Curve

The Demand Curve: how the consumer behaves in the market.

Econ 300: Microeconomics Yang Fan

Shifts of the Demand Curve

Market for Coke: Price of Pepsi rises by 10 cents

Generalized Demand Function (for Coke)

• The a demand function (for Coke) is:

– where 𝑄 is the quantity of Coke demanded in millions

The demand for coke is affected by it’s own price, price of

Econ 300: Microeconomics Yang Fan

Generalized Demand Function (for Coke)

• Using some example parameter values, we have:

𝑄𝑑 = 𝐷 𝑝, 𝑝𝑝 , 𝑌 = 18 − 80𝑝 + 5𝑝𝑝 + 0.01𝑌

• Verify that our demand determinant relationships hold:

𝜕D(p,𝑝𝑝 , Y) As the price of a related good increases, quantity

𝜕D(p,𝑝𝑝 , Y) As income increases, quantity demanded increases.

Econ 300: Microeconomics Yang Fan

Generalized Demand Function

• In a more generalized sense:

• Verify that our demand determinant relationships hold:

𝜕D(p, 𝑝𝑟 , Y) As own prices increases, quantity demanded decreases

Econ 300: Microeconomics Yang Fan

Generalized Demand Function

• In a more generalized sense:

Econ 300: Microeconomics Yang Fan

Generalized Demand Function

• In a more generalized sense:

Econ 300: Microeconomics Yang Fan

A Linear Demand Function (for Coke)

• Using the values 𝑝𝑝 = 0.40 and 𝑌 = 4,000, we have

𝑄𝑑 = 𝐷(𝑝, 𝑝𝑝 , 𝑌) = 18 − 80𝑝 + 5𝑝𝑝 + 0.01𝑌

All else equal (price of a can a Pepsi at $0.40, income at $4000…etc),

Econ 300: Microeconomics Yang Fan

General Linear Demand Curve Form

• Holding income/related goods price the same

where 𝑎 is the vertical-intercept

Econ 300: Microeconomics Yang Fan

More Commonly: The Inverse Demand Function

It is frequently “easier” to work with an inverse demand function rather than

Solve for 𝑃 in terms of 𝑄𝑑 ,

Econ 300: Microeconomics Yang Fan

Graphical: The Inverse Demand Function

The Supply Curve

The Supply Curve: how the firm behaves in the market.