CHAPTER 2

Market Forces:
Demand and
Supply

Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter Outline

Chapter
Overview

Demand
Factors that change quantity demanded and factors that change
demand
The demand function
Consumer surplus

Supply
Factors that change quantity supplied and factors that change supply
The supply function
Producer surplus

Market equilibrium
Price restrictions and market equilibrium
Price ceilings
Price floors

Comparative statics
Changes in demand
Changes in supply
Simultaneous shifts in supply and demand
2-2

Demand

Demand

Market demand curve

Illustrates the relationship between the
total quantity and price per unit of a
good all consumers are willing and able
to purchase, holding other variables
constant.

Law of demand
The quantity of a good consumers are
willing and able to purchase increases
(decreases) as the price falls (rises).
2-3

Demand

Market Demand Curve

Price

($)

$40

$30
$20

$10

Demand
20

40

60

80 Quantity

(thousands per year

2-4

Demand

Changes in Quantity Demanded

Changing only price leads to changes

in quantity demanded.
This type of change is graphically
represented by a movement along a
given demand curve, holding other
factors that impact demand constant.

Changing factors other than price

lead to changes in demand.
These types of changes are graphically
represented by a shift of the entire
demand curve.
2-5

Changes in Demand

Demand

Price

Increase
in
demand

Decrease
in
demand

D1
D2
0

D0
Quantity

2-6

Demand Shifters

Demand

Income
Normal good
Inferior good

Prices of related goods

Substitute goods
Complement goods

Advertising and consumer tastes

Informative advertising
Persuasive advertising

Population
Consumer expectations
Other factors
2-7

Demand

Advertising and the Demand for

Clothing
Price of
high-style
clothing
Due to an
increase in
advertising

$50
$40

D2
D1
0

50,00060,000

Quantity of
high-style
clothing
2-8

The Demand Function

Demand

The demand function for good X is a

mathematical representation
describing how many units will be
purchased at different prices for
good X, different prices of a related
good Y, different levels of income,
and other factors that affect the
demand for good X.

2-9

Demand

The Linear Demand Function

simple, but useful, representation of
One

a demand function is the linear demand

function:
, where:

is the number of units of good X demanded;

is the price of good X;
is the price of a related good Y;
is income;
is the value of any other variable affecting
demand.
2-10

Demand

Understanding the Linear Demand Function

The signs and magnitude of the

coefficients determine the impact of
each variable on the number of units
of X demanded.
For example:
by the law of demand;
if good Y is a substitute for good X;
if good X is an inferior good.
2-11

Demand

The Linear Demand Function in Action

Suppose that an economic consultant for X Corp.

recently provided the firms marketing manager with this

estimate of the demand function for the firms product:

Question: How many of good X will consumers purchase

when per unit, per unit, and ? Are goods X and Y
substitutes or complements? Is good X a normal or an
inferior good?
Answer:
units. Goods X and Y are substitutes. Good X is an inferior
good.

2-12

Demand

Inverse Demand Function

By
setting and and the demand
function is

the linear demand function simplifies to

Solving this for in terms of results in
, which is called the inverse demand
function. This function is used to
construct a market demand curve.
2-13

Demand
Graphing the Inverse Demand Function
in
Action
Price
$2,020

6,060

Quantity

2-14

Consumer Surplus

Demand

Marketing strategies like value pricing

and price discrimination rely on
understanding consumer value for
products.
Total consumer value is the sum of the
maximum amount a consumer is willing to
pay at different quantities.
Total expenditure is the per-unit market price
times the number of units consumed.
Consumer surplus is the extra value that
consumers derive from a good but do not pay
for.
2-15

Demand
Market Demand and Consumer Surplus
in
Action
Consumer Surplus
Price per
liter

Consumer Surplus:
0.5($5 - $3)x(2-0) = $2
Total Consumer Value:
0.5($5 - $3)x2+(3-0)(2-0) = $8

$5
$4

Expenditures:
$(3-0) x (2-0) = $6

$3
$2
$1

Demand
0

5 Quantity
in liters
2-16

Supply

Supply

Market supply curve

Summarizes the relationship between the
total quantity all producers are willing
and able to produce at alternative prices,
holding other factors affecting supply
constant.

Law of supply
As the price of a good rises (falls), the
quantity supplied of the good rises (falls),
holding other factors affecting supply
constant.
2-17

Supply

Changes in Quantity Supplied

Changing only price leads to changes
in quantity supplied.

This type of change is graphically

represented by a movement along a given
supply curve, holding other factors that
impact supply constant.

Changing factors other than price lead

to changes in supply.
These types of changes are graphically
represented by a shift of the entire supply
curve.
2-18

Supply

Change in Supply in Action

Price
S1

S0
B

Decrease
in supply

S2

Increase
in supply
A

Quantity

2-19

Supply Shifters

Supply

Input prices
Technology or government regulation
Number of firms
Entry
Exit

Substitutes in production
Taxes
Excise tax
Ad valorem tax

Producer expectations
2-20

Supply

Change in Supply in Action

Excise tax
Price
of
gasoline

S0+t

$1.20

S0
t = 20

t
$1.00

t = per unit tax of 20

Quantity of
gasoline per
week
2-21

Supply

Change in Supply in Action

Price Ad valorem tax
of
backpacks

S1 = 1.20 x S0

$24
S0
$20
$12
$10

1,100

2,450

Quantity of
backpacks per
week
2-22

The Supply Function

Supply

The supply function for good X is a

mathematical representation
describing how many units will be
produced at different prices for X,
different prices of inputs W, prices of
technologically related goods, and
other factors that affect the supply
for good X.

2-23

Supply

The Linear Supply Function

simple, but useful, representation of a
One

supply function is the linear supply

function:
, where:

is the number of units of good X produced;

is the price of good X;
is the price of an input;
is price of technologically related goods;
is the value of any other variable affecting
supply.
2-24

Understanding the Linear Supply

Supply Function
The signs and magnitude of the
coefficients determine the impact of
each variable on the number of units
of X produced.
For example:
by the law of supply.
increasing input price.
technology lowers the cost of producing
good X.
2-25

Supply
The Linear Supply Function
in Action

Your
research department estimates

that the supply function for televisions

sets is given by:

Question: How many televisions are

produced when , per unit, and ?
Answer:
television sets.
2-26

Supply

Inverse Supply Function

By
setting and in

the linear supply function simplifies to

Solving this for in terms of results in
, which is called the inverse supply
function. This function is used to
construct a market supply curve.
2-27

Producer Surplus

Supply

The amount producers receive in

excess of the amount necessary to
induce them to produce the good.

2-28

Supply

Producer Surplus in Action

Price

Supply

$400
Producer surplus

800

Quantity

2-29

Market Equilibrium

Market
Equilibrium

Competitive market equilibrium

Price of a good is determined by the
interactions of the market demand and
market supply for the good.
A price and quantity such that there is
no shortage or surplus in the market.
Forces that drive market demand and
market supply are balanced, and there
is no pressure on prices or quantities to
change.
2-30

Market Equilibrium I
Price

Market
Equilibrium

Supply
Surplus

Shortage
0

Demand

Quantity

2-31

Market
Equilibrium

Market Equilibrium II

Consider
a market with demand and

supply functions, respectively, as

and
A competitive market equilibrium exists
at a price, , such that . That is,

and
units
2-32

Price Restrictions and Market

Equilibrium

Price Restrictions

In a competitive market equilibrium,

price and quantity freely adjust to
the forces of demand and supply.
Sometimes the government restricts
how much prices are permitted to
rise or fall.
Price ceiling
Price floor

2-33

Price Restrictions and Market

Equilibrium

Price Ceiling in Action I

Nonpecuniary price

Price

Supply
Lost social welfare

Priceceiling

Shortage
0

Demand

Quantity

2-34

Price Restrictions and Market

Equilibrium

Price Ceiling in Action II

a market with demand and
Consider

supply functions, respectively, as

and
Suppose a $1.50 price ceiling is
imposed on the market.

units.
units.
Since a shortage of units exists.
Full economic price of unit is , or . Of this,
$1.50 is the dollar price
$1 is the nonpecuniary price
2-35

Price Restrictions and Market

Equilibrium

Price Floor in Action I

Price

Supply
Surplus

Pricefloor

Cost of
purchasing
excess supply
Demand
0

Quantity

2-36

Price Restrictions and Market

Equilibrium

Price Floor in Action II

Consider a market with demand and

supply functions, respectively, as
and
Suppose a $4 price floor is imposed
on the market.
units
units
Since a surplus of units exists
The cost to the government of
purchasing the surplus is .
2-37

Comparative
Statics

Comparative Statics
Comparative static analysis

The study of the movement from one

equilibrium to another.

Competitive markets, operating free

of price restraints, will be analyzed
when:
Demand changes;
Supply changes;
Demand and supply simultaneously
change.
2-38

Comparative
Statics

Changes in Demand
Increase in demand only
Increase equilibrium price
Increase equilibrium quantity

Decrease in demand only

Decrease equilibrium price
Decrease equilibrium quantity

Example of change in demand

Suppose that consumer incomes are projected to
increase 2.5% and the number of individuals
over 25 years of age will reach an all time high
by the end of next year. What is the impact on
the rental car market?
2-39

Comparative
Statics

Change in Demand in Action

Demand for Rental Cars
Price

Supply

$49

$45
Demand1
Demand0
0

100

104

108 Quantity

(thousands
rented per day)
2-40

Changes in Supply

Comparative
Statics

Increase in supply only

Decrease equilibrium price
Increase equilibrium quantity

Decrease in supply only

Increase equilibrium price
Decrease equilibrium quantity

Example of change in supply

Suppose that a bill before Congress would
require all employers to provide health care
to their workers. What is the impact on retail
markets?
2-41

Comparative
Statics

Change in Supply in Action

Price

Supply1
Supply0

Demand

Quantity

2-42

Simultaneous Shifts in Supply

and Demand

Comparative
Statics

Suppose that simultaneously the

following events occur:
an earthquake hit Kobe, Japan and
decreased the supply of fermented rice
used to make sake wine.
the stress caused by the earthquake led
many to increase their demand for sake,
and other alcoholic beverages.

What is the combined impact on

Japans sake market?
2-43

Comparative
Statics

Simultaneous Shifts in Supply and

Demand in Action
Japans Sake Market
Price
C

Supply2
Supply1
B

Supply0

Demand1
Demand0
0

Quantity

2-44

Conclusion
Demand and supply analysis is useful
for
Clarifying the big picture (the general
impact of a current event on equilibrium
prices and quantities).
Organizing an action plan (needed
changes in production, inventories, raw
materials, human resources, marketing
plans, etc.).

2-45

Demand

Market Demand Curve

Price
(Dollars per Barrel)

International Oil Market

$140
$100
$60
$20

Demandoil
0

80

160

240

280 Quantity
(Millions of Barrels)
2-46

Demand

Changes in Quantity Demanded

Price

International Oil Market

(Dollars per Barrel)

$140
$100
$90

Increase in quantity demanded

Demandoil
0

80 100

280 Quantity
(Millions of Barrels)
2-47

Change in Demand
Price

Demand

International Oil Market

(Dollars per Barrel)

$160
$140
$100
$90

Increase in demand

Demandoil2
Demandoil1
0

80 100

120 140

280Quantity

(Millions of Barrels)
2-48

Supply

Change in Quantity Supplied

International Oil Market
Price

Supplyoil

(Dollars per Barrel)

$65
$60

Increase in quantity supplied

$20
0

80

90

Quantity
(Millions of Barrels)
2-49

Supply

The Market Supply Curve

International Oil Market
Price

Supplyoil

(Dollars per Barrel)

$140
$100
$60

$20
0

80

160

240

Quantity

(Millions of Barrels)
2-50

Supply

Change in Supply in Action

International Oil Market
Price
(Dollars per Barrel)

Decrease in supply

Supplyoil2 Supplyoil1

$140

$100

$50
$20
0

100

160

180

240

Quantity
(Millions of Barrels)
2-51

Competitive Market
Equilibrium I

Market
Equilibrium

International Oil Market

Price
(Dollars per Barrel)

Surplus
160 million barrels

$140

Forces of demand and supply

put downward
pressure on price.
Competitive market equilibrium
Qd(Pe) = Qs(Pe)
Forces of demand and suppl
put upward pressure
on price.
Shortage
Demandoil
160 million barrels

$120
Pe = $80
$40
$20
0

Supplyoil

40

Qe = 120

200

280Quantity

(Millions of Barrels)
2-52

Price Restrictions and Market

Equilibrium

Price Ceiling in Action I

International Oil Market
Price

Supplyoil

Nonpecuniary price

(Dollars per Barrel)

Lost social welfare

$140
Pf = $120

Competitive market equilibrium

Qd(Pe) = Qs(Pe)

Pe = $80

Priceceiling

Pc = $40
Shortage
160 million barrels

$20
0

40

Qe = 120

Demandoil
200

280Quantity

(Millions of Barrels)
2-53

Comparative
Statics

Changes in Demand
Increase in demand only
Increase equilibrium price
Increase equilibrium quantity

Decrease in demand only

Decrease equilibrium price
Decrease equilibrium quantity

Example of change in demand

Suppose that worldwide demand for
automobiles is projected to decrease by 30%
next year. What is the impact on the
international crude oil market?
2-54

Comparative
Statics

Change in Demand in Action

International Oil Market
Price

Supplyoil

(Dollars per Barrel)

$140

Pe1 = $80
Pe2 = $54
Demandoil2

$20
0

Qe2 = 68

Qe1 = 120

Demandoil1
280Quantity

(Millions of Barrels)
2-55

Changes in Supply

Comparative
Statics

Increase in supply only

Decrease equilibrium price
Increase equilibrium quantity

Decrease in supply only

Increase equilibrium price
Decrease equilibrium quantity

Example of change in supply

Suppose that war breaks out in a major oilproducing country in the Middle East. What
is the impact on the international crude oil
market?
2-56

Comparative
Statics

Change in Supply in Action

International Oil Market
Price

Supplyoil2

(Dollars per Barrel)

Supplyoil1

$140
Pe2 = $100
Pe1 = $80

Demandoil

$20
0

Qe2 = 80Qe1 = 120

280Quantity

(Millions of Barrels)
2-57

Simultaneous Shifts in Supply

and Demand

Comparative
Statics

Suppose that simultaneously the

following two events occur:
worldwide demand for automobiles is
projected to decrease by 30% next year.
war breaks out in a major oil-producing
country in the Middle East.

What is the combined impact on the

international crude oil market?

2-58

Comparative
Statics

Simultaneous Shifts in Supply and

Demand in Action
International Oil Market
Price

Supplyoil2

(Dollars per Barrel)

Supplyoil1

$140
The equilibrium price increases
or decreases depending on the
magnitude of the demand
and supply changes.

Pe1 = $80
Pe2 = $65

$20

Demandoil2
Qe2 = 10

Qe1 = 120

Demandoil1
280Quantity

(Millions of Barrels)
2-59