Supply and Demand

In economics we use a model of supply and demand in an attempt to

understand market outcomes for a good or service. Of particular interest are
two basic questions:
1) What determines the price of a product, and
2) What determines the quantity of a product sold.
Before I get into this I want to present something totally different. I want to
talk about the weather. In particular, I want to talk about the highest
temperature in Wayne, Nebraska on each and every day. At the bottom I
have a graph of the highest temperature on each day for the year 2006 (I
made up the data, but do you think it covers the basic idea?)
Highest
temperature on the
day

J F MAM J JAS O N D

Day of
the year

Notes about graph:

1) The long term we see the highest temperature occurred
sometime in July or August.
2) When you look at any three or four day period (a shorter
time frame than the whole year) you see ups and downs of
the highest temperature.
Why does the highest temperature each day follow the
pattern I have shown?
The accepted answer comes from the science areas of
astronomy and physics. In these sciences there are
theories about how the earth is tilted and how it rotates
around the sun. These ideas provide us with our
understanding of the pattern of daily high temperatures.
3

Now, instead of thinking about the weather we could consider a

market. There is a market for corn, wheat, Mt. Dew in a 20 ounce
bottle, Microsoft stock, and many more. Some folks use a graph
similar to the one I had with the weather example. The vertical
axis variable may be the price of the product or the quantity
(number of units) of the product traded.
Our study of supply and demand is the scientific way folks go
about explaining the pattern of price movements and/or quantity
traded movements.
When we study supply and demand we use a different graph than
the one I have used so far. But it is related. Lets turn to that
graph next.

Price, P

Along this axis we measure the price

per unit of a product. At the bottom we
start at zero and move our way up.

Along this axis we measure quantity in

units of a good or service. On the left
we start at zero and as we go right we
go to larger amounts.

Quantity, Q

Price, P

We could look at any point in

the graph and at that point we
can get a feel for the quantity
at that point and the price at
that point. This point would
correspond to the other graph
in that this point is for a certain
day. On other days we could
be a a different point and we
want to build a theory of that
movement.

Price
at the
point

Quantity, Q

Quantity at the point

Price, P
In economics,
often times the
only point you
need to focus
your attention on
is where two
curves cross.

Quantity, Q

Price, P

If a curve should shift

here the demand
shifts you can focus
your attention on the
new intersection.

D2
D1
Quantity, Q

Price, P
2) Note here that after the
curve shifted, we will move
along the new demand
curve and call the
movement a change in
the quantity demanded.

1) Note here that when the

demand shifted we would
say it shifted because of a
change in demand

D2
D1
Quantity, Q

So, we have gotten warmed up to the model of supply and

demand. Now we want to look at
1) The demand side of the market,
2) The supply side of the market,
3) The interaction of supply and demand and how these
determine the price in the market and the quantity traded in
the market, and
4) Changes in supply and demand and how that leads to price
and quantity traded changes.

10

P
Demand in general refers to how much of a
product consumers want to buy. In the
graph here you should note two things.
1) The demand curve is downward sloping
as you look at the graph from left to right,
and

2) The demand curve is in a certain position

or location that could change.

Lets think about each of these points in more detail.

When we say the demand curve is downward sloping we say this is a reflection
of the law of demand. The law of demand is a statement that when the price of
the product changes the quantity demanded moves in the opposite direction.
So, if the price should rise, the quantity demanded will fall, and if the price
should fall the quantity demanded will rise.

Law of Demand Price and quantity demanded are

inversely related.

11

Lets consider one more thing about the law of demand.

Lets take an example from our life. Any music CD costs
about 15 bucks, give or take a few $s. At that price you
and I could probably buy more than we do, but we would
have to give up other things (like milk and cookies, what
were you thinking?) to get even more CDs. In order to get
us to demand an even greater quantity the price has to be
lowered and we therefore do not have to give up as much
of the other things we enjoy.
It works the other way as well. If the price becomes higher
we have a lower quantity demanded because at the higher
price we have to give up too much of other things we like
and so we reduce our quantity demanded for the CDs.

12

In the graph at P1, although folks

could probably buy more of the
product, quantity demanded is
only Q1 because folks have
decided they do not want to give
up other things to get more of Q.

P1

D
Q1

But, If the price was lower than P1 you see there would be
movement down the demand curve. Some folks would say
that since they do not have to give up as much other stuff
to get more units here, they are happy to demand a greater
quantity.
So, the price of the product is a major determinant of how
much of a product consumers want. But there are other
13
things that have an influence as well.

A few slides back I mentioned

that we need to pay attention to
the position or location of the
demand curve and that maybe
the location could change.

P1

D
Q1

What I now want to make explicit is that Q1 was

demanded at P1 with the understanding that other things
that influence demand are held constant. If these other
things should change then at P1 the amount people want
could change and the demand would shift.
Lets go back to our CD example. We said if the price
was P1 folks would demand Q1 units. But, if people get
more income it is likely they can afford more things and
thus the demand for CDs would shift to the right.

14

So, on the previous slide we see the demand curve would

shift right when a peoples income would go up. Similarly we
would expect the demand curve would shift left if peoples
income should fall.
Peoples income is a factor that leads the demand curve to
be in a certain location. This means if income should
change the demand curve will shift to a new location.
Other factors that lead to a shift in the demand include the
price of related goods, consumer taste and preference, and
the number of consumers in the market.
On the next slide is a table that will list how the demand
curve will shift given a change in a factor of demand. Note
the table does not include the price of the product itself. If
the price changes there is a movement along the demand
curve and we say there is a change in the quantity
15
demanded.

Factor of demand change

demand shifts to
Income increase for normal good
right
Income decrease for normal good
left
Income increase for inferior good
left
Income decrease for inferior good
right
Complementary good price increase
left
Complementary good price decrease
right
Substitute good price increase
right
Substitute good price decrease
left
Increase in consumers in market
right
Decrease in consumers in market
left
Please note that when a factor changes in such a way that
demand shifts to the right we could also say demand has
increased and if a factor changes in such a way that
demand shifts to the left we could also say demand has 16
decreased.

P
Supply in general refers to how much of a
product producers want to sell. In the graph
here you should note two things.

1) The supply curve is upward sloping as

you look at the graph from left to right, and
2) The supply curve is in a certain position
or location that could change.

Lets think about each of these points in more detail.

When we say the supply curve is upward sloping we say this is a reflection of
the law of supply. The law of supply is a statement that when the price of the
product changes the quantity supplied moves in the same direction.
So, if the price should rise, the quantity supplied will rise , and if the price
should fall the quantity supplied will fall.

Law of Supply Price and quantity supplied are directly, or

positively, related.

17

Lets consider the story about why the supply curve is

upward sloping. Production of a good or service takes
time and producers have lots of things they would like to
do. When the price of a good is low producers look at their
options and conclude at a low price that they will make a
few units but then do something else because there is not
a big payoff to production. But, if the price is higher they
do not mind giving up other things to produce here
because they will get more for their efforts.

18

In the graph at P1, although

producers could probably make
more of the product, quantity
supplied is only Q1 because
producers have decided they do
not want to give up other things
to make more of Q.

S
P1

Q1

But, If the price was higher than P1 you see there would be
movement up the supply curve. Some producers would
say that since they get more for producing this item they
give up doing other stuff and they are happy to supply a
greater quantity of this good.
So, the price of the product is a major determinant of how
much of a product producers want to make. But there are
other things that have an influence as well.
19

A few slides back I mentioned

that we need to pay attention to
the position or location of the
supply curve and that maybe the
location could change. What I
now want to make explicit is that
Q1 was supplied at P1 with the

S
P1

Q1

understanding that other things that influence supply are

held constant. If these other things should change then at
P1 the amount producers want to make could change and
the supply would shift.
As an example, say the company is making candy and the
price of sugar, a major input to the product, goes up. Then
at P1, since it costs more to make a unit of candy, the
producer will make less because there is less profit to be
made per unit. Producers would rather do something else.20

So, on the previous slide we see the supply curve would

shift left when the price of an input to the production process
went up. Similarly the supply curve would shift right when
the price of an input falls.
The price of an input is a factor that leads the supply curve
to be in a certain location. This means if the input price
should change the supply curve will shift to a new location.
Other factors that lead to a shift in the supply include the
state of technological sophistication used in production (what
I call the state of technology), the number of sellers and the
price sellers expect to see in the future.
On the next slide is a table that will list how the supply curve
will shift given a change in a factor of supply. Note the table
does not include the price of the product itself. If the price
changes there is a movement along the supply curve and
we say there is a change in the quantity supplied.
21

Factor of supply change

supply shifts to
Input price increase
left
Input price decline
right
Increase in state of technology
right
Decrease in state of technology
left
Increase in expected future price
left
Decrease in expected future price
right
Increase in producers in market
right
Decrease in producers in market
left
Please note that when a factor changes in such a way that
supply shifts to the right we could also say supply has
increased and if a factor changes in such a way that supply
shifts to the left we could also say supply has decreased.
22

Price, P

Now that we
have considered
supply and
demand
separately we
will bring the two
together and
see how buyers
and sellers
interact in a
market.
Quantity, Q

23

Price, P

Notice at this
price P1 the
quantity
demanded
equals the
quantity
supplied.

S1

P1

D1
Quantity, Q
Q1
24

Price, P

S1
Pa

D1

Notice that
when you look
at any price
above where the
curves cross,
like at Pa, the
quantity
supplied is
greater than the
quantity
demanded a
surplus
Quantity, Q

Qd

Qs
25

Price, P

S1

Pb

D1

Notice that
when you look
at any price
below where the
curves cross,
like at Pb, the
quantity
supplied is less
than the quantity
demanded a
shortage
Quantity, Q

Qs

Qd
26

Notice on the previous three slides that I have put the

subscript 1 on the labels for the supply and demand
curves. I do this to have you understand that when we
consider the interaction of supply and demand we initially
have supply and demand located in place because the
factors that can shift these curves are fixed at a certain
level for the time being. Later these curves can shift, but
for now we have them fixed in place.
Theory of Price Change
1) When the price is above P1 in our graphs from the
previous slides we see Qs > Qd, meaning we have a
surplus. All buyers at this price (as recognized by the
amount on the demand curve) would get to buy, but not all
sellers would get to sell. This surplus of items means
some sellers have an incentive to change. They would
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lower the price so that they do not have any left over items.

2) When the price is below P1 in our graphs from the

previous slides we see Qs < Qd, meaning we have a
shortage. All sellers at this price (as recognized by the
amount on the supply curve) would get to sell, but not all
buyers would get to buy. This shortage of items means
some buyers have an incentive to change. They would bid
up the price in an attempt to get the item.
3) When the price is P1 we see Qs = Qd. All buyers and
sellers are able to buy and sell, respectively, what they want
at this price. Neither group has an incentive to change.
Item 3) here defines equilibrium in the market. Take this to
mean you should focus your attention on were the curves
cross. But items 1) and 2) help us understand why the price
will change when conditions in the world change. Lets turn
to this next.

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Price, P

S1

P1

D1

For any market

story this is
where you mind
should be, on
this graph with
all the
knowledge you
have in these
notes. Slides 16
and 22 mention
how supply or
demand could
change.
Quantity, Q

Q1
29

Here we have a
demand
increase. Slide
16 should
remind you how
a demand
increase can
happen. Note at
the initial price
P1 Qs = Q1 but
demand is now
Qd.

Price, P
D2

S1

P1

D1
Quantity, Q
Q1

Qd
30

At P1, since Qd
> Qs, we have a
shortage and
with a shortage
the price will
rise. The price
will rise to P2.

Price, P
D2

S1

P2
P1

D1
Quantity, Q
Q1

Qd
31

Price, P
D2

S1

P2
P1

D1

Note as the
price rises due
to the shortage
both a) the
quantity
supplied rises
from Q1 to Q2
and b) the
quantity
demanded falls
from Qd to Q2.
The shortage is
gone.
Quantity, Q

Q1

Qd
Q2

32

Lets summarize what is on the last 4 slides.

1) We have the market at some starting point. Note the
equilibrium price and quantity traded, P1 and Q1.
2) The demand increases creating a shortage.
3) The shortage means the price will rise.
4) The shortage is eliminated because with the higher
price the a) quantity supplied rises and b) the quantity
demanded falls (from the new higher level).
Overall, the increase in demand resulted in
1) An increase in the market price, and
2) An increase in the quantity traded in the market.
33

From this
starting point
lets now look at
the story of a
supply increase.

Price, P

S1

P1

D1
Quantity, Q
Q1
34

Here we have a
supply increase.
Slide 22 should
remind you how
a supply
increase can
happen. Note at
the initial price
P1 Qd = Q1 but
supply is now
Qs.

Price, P

S1
S2

P1

D1
Quantity, Q
Q1

Qs
35

At P1, since Qs
> Qd, we have a
surplus and with
a surplus the
price will fall.
The price will fall
to P2.

Price, P

S1
S2

P1
P2

D1
Quantity, Q
Q1

Qs
36

Note as the
price falls due to
the surplus both
a) the quantity
supplied falls
from Qs to Q2
and b) the
quantity
demanded rises
from Q1 to Q2.
The surplus is
gone.

Price, P

S1
S2

P1
P2

D1
Quantity, Q
Q1

Qs
Q2

37

Lets summarize what is on the last 4 slides.

1) We have the market at some starting point. Note the
equilibrium price and quantity traded, P1 and Q1.
2) The supply increases creating a surplus.
3) The surplus means the price will fall.
4) The surplus is eliminated because with the lower price
the a) quantity demanded rises and b) the quantity supplied
falls (from the new higher level).
Overall, the increase in supply resulted in
1) An decrease in the market price, and
2) An increase in the quantity traded in the market.

38

What have we learned? Among other things

1) The price and quantity traded in a market are
determined by the interaction of supply and demand.
2) The price and quantity traded in a market will change if
there is a change in supply or demand.

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