CH 02

Topic 2
BASIC DEMAND, SUPPLY

AND MARKET EQUILIBRIUM
Introduction
What are supply and demand?
What is the market mechanism?
What are the effects of changes in
market equilibrium?
What are elasticities of supply and
demand?
2005 Pearson Education, Inc.
Chapter 2
Supply and Demand

Supply and demand analysis can:
1. Help us understand and predict how world
economic conditions affect market price and
production
2. Analyze the impact of government price
controls, minimum wages, price supports,
and production incentives on the economy
3. Determine how taxes, subsidies, tariffs and
import quotas affect consumers and
producers
Chapter 2
Supply
Chapter 2
Definition
Supply is defined as the quantity of a
product or service that will be offered for
sale at a given price in a given market
and a given period of time assuming
other things remain the same.
Law of Supply
When price fall, quantity supplied will
also fall and vice versa or the higher
the price, the greater will be the
quantity supplied
Price (RM)
$40
$30
$20
$10
10
20
30
40
Quantity
(Kg)
Example: The supply of Eggs

Price (RM)
Quantity (Units)
0.16
80
0.14
60
0.12
50
0.10
40
Price (RM)
SUPPLY CURVE OF EGGS
$0.16
$0.14
$0.12
$0.10
40
50
60
80
Quantit
y
(Kg)
A change in quantity Supply

VS a change in Supply
A change in quantity supply
Referring to a
movement along the
same supply curve due
to the change in its
own price while other
thing remain the same.
(Ceteris peribus)
The curve will move
either upward or
downward.
A change in supply
Referring to the shift of
the entire supply curve
due to the change in
other factors such as
price of other goods,
price of raw material, etc
The price itself remain
unchanged.
The curve will shift either
to the left or to the right.
Price (RM)
The Change in quantity

supply
$0.16
$0.14
$0.12
$0.10
40
50
60
80
Quantity
(Kg)
Price (RM)The Change in
Supply
$0.16
S0
$0.14
$0.12
S1
$0.10
40 48 50
60
80
Quantit
y
(Kg)
Determinants of Supply
1. Price of other goods.
2. Price of raw materials or cost of
production.
3. Producers / Seller objectives.
4. Technological Development.
5. Governments policies.
1. Prices of other goods

Prices of other goods which use the
same raw materials or input.
For example, the supply of rubber is also
influenced by the price of palm oil.
When the price of palm oil increases, the
farmers will produce more palm oil than
rubber. As such the supply of rubber
decreases and the supply of palm oil
increase.
2. Cost of production
The price of raw material (Input)
determine the cost of producing the
product.
As the raw material are expensive, cost
of production increase and the supply will
decrease.
3. Producers Objectives
Even though profit maximization is the
most important objective of a seller or
producer, other objective sometimes can
become more important.
If the welfare of the societies or their
promotion strategies become the main
objective, the supply will increase.
4. Technological Development
Technology development reduces the
use of inputs and cost of producing the
product.
Hence more output can be produced and
supply will increase.
5. Governments policies
Tax imposed by the government on
certain goods such as imported cars will
reduce their supply on the market.
The subsidies given by government to
the farmers will increase the supply of
agricultural product in the market.
Demand
Chapter 2
19
Definition of demand
The quantity of various goods that
people are willing and able to buy at a
particular time and at a given range of
prices.
The desire to buy goods and services
with the ability to pay.
* Hashim Ali
20
The Individual Demand Curve and

the Law of Demand
Als Demand Schedule for Pizza
Price ($)
2
4
6
8
10
Quantity of pizzas per

month
13
10
7
4
1
21
The demand schedule is a

table of numbers that shows the
relationship between price and
quantity demanded by a
consumer, ceteris paribus (Other
thing remain constant).
22
The Demand Curve and the Law of Demand

The individual demand curve
shows the relationship between
the price of a good and the
quantity that a consumer is
willing to buy, or quantity
demanded.
The law of demand states
that the higher the price, the
smaller the quantity
demanded, ceteris paribus
(Other thing remain
constant).
23
IMPORTANT - KNOW
THE DIFFERENCE
BETWEEN A CHANGE
IN THE QUANTITY
DEMANDED AND A
CHANGE IN DEMAND
25
Change in quantity demanded

A change in quantity
demanded is a change
in the amount of a good
demanded resulting from
a change in the price of
the good, represented
graphically by a
movement along the
demand curve.
The curve does not
shift.
26
Determinant of Demand
Price of the goods
Price of related goods
Consumers income
Taste and preference
The number of buyers in the market
Expectation about the future price
Weather
Availability of credit facilities
28
A Change in Demand Versus a

Change in Quantity Demanded
To summarize:
Change in price of a good or service
leads to Change in quantity
demanded
(Movement along the curve).
Change in income, preferences, or
prices of other goods or services
leads to change in demand
(Shift of curve).
29
The Impact of a Change in Income

Higher income
decreases the demand
for an inferior good
Higher income
increases the
demand for a normal
good
30
The Impact of a Change in the

Price of Related Goods
Demand for complement good
(ketchup) shifts left
Demand for substitute good (chicken)

shifts right
Price of hamburger rises

Quantity of hamburger
demanded falls
31
Market Equilibrium
Chapter 2
32
The Market Mechanism

The market mechanism is the tendency
in a free market for price to change until
the market clears
Markets clear when quantity demanded
equals quantity supplied at the prevailing
price
Market Clearing price price at which
markets clear
Chapter 2
33

S
Price
($ per unit)
The curves intersect at

equilibrium, or marketclearing, price.
Quantity demanded
equals quantity
supplied at P0
P0
Q0
Chapter 2
Quantity
34

In equilibrium
There is no shortage or excess demand
There is no surplus or excess supply
Quantity supplied equals quantity demanded
Anyone who wished to buy at the current
price can and all producers who wish to sell
at that price can
Chapter 2
35
Market Surplus
The market price is above equilibrium
There is excess supply - surplus
Downward pressure on price
Quantity demanded increases and quantity
supplied decreases
The market adjusts until new equilibrium is
reached
Chapter 2
36

Price
($ per unit)
S
1.
Surplus
P1
2.
3.
P0
4.
D
QD
Q0
Chapter 2
QS
Price is above
the market
clearing price
P1
Q s > QD
Price falls to
the marketclearing price
Market adjusts
to equilibrium
Quantity
37

The market price is below equilibrium:
There is a excess demand - shortage
Upward pressure on prices
Quantity demanded decreases and quantity
supplied increases
The market adjusts until the new equilibrium
is reached.
Chapter 2
38

Price
($ per unit)
1.
2.
3.
P3
4.
P2
Shortage
QS
Q
3
Chapter
2
QD
Price is below
the market
clearing price
P2
QD > Q S
Price rises to
the marketclearing price
Market adjusts
to equilibrium
D
Quantity
39

Supply and demand interact to determine
the market-clearing price.
When not in equilibrium, the market will
adjust to alleviate a shortage or surplus
and return the market to equilibrium.
Markets must be competitive for the
mechanism to be efficient.
Chapter 2
40
Changes In Market Equilibrium

Equilibrium prices are determined by the
relative level of supply and demand.
Changes in supply and/or demand will
change in the equilibrium price and/or
quantity in a free market.
Chapter 2
41

Raw material prices
fall
D
S
S shifts to S
Surplus at P1
between Q1, Q2
P1
Price adjusts to
equilibrium at P3, Q3 P3
Q1 Q3Q2
Chapter 2
Q
42

P
Income Increases
Demand increases to
D1
Shortage at P1 of Q1, P3
Q2
P1
Equilibrium at P3, Q3
Q1 Q3 Q
Chapter 2
Q
43

Income Increases &
raw material prices
fall
Quantity increases
If the increase in D is
greater than the
increase in S price
also increases
S S
P2
P1
Q1
Chapter 2
Q2
Q
44
Shifts in Supply and Demand

When supply and demand change
simultaneously, the impact on the
equilibrium price and quantity is
determined by:
1. The relative size and direction of the
change
2. The shape of the supply and demand
models
Chapter 2
45
Elasticities
Chapter 2
46
Elasticities of Supply and Demand

Not only are we concerned with what direction
price and quantity will move when the market
changes, but we are concerned about how
much they change.
Elasticity gives a way to measure by how much
a variable will change with the change in
another variable.
Specifically, it gives the percentage change in
one variable resulting from a one percent
change in another.
Chapter 2
47
Price Elasticity of Demand

Measures the sensitivity of quantity
demanded to price changes.
It measures the percentage change in the
quantity demanded of a good that results
from a one percent change in price.
D
EP
% Q D
% P
Chapter 2
48

The percentage change in a variable is
the absolute change in the variable
divided by the original level of the
variable.
Therefore, elasticity can also be written
as:
Q Q P Q
E
P P Q P
D
P
Chapter 2
49

Usually a negative number
As price increases, quantity decreases
As price decreases, quantity increases
When EP > 1, the good is price elastic

%Q > % P
When EP < 1, the good is price inelastic

%Q < % P
Chapter 2
50

The primary determinant of price
elasticity of demand is the availability of
substitutes.
Many substitutes demand is price elastic
Can
easily move to another good with price

increases
Few substitutes demand is price inelastic
Chapter 2
51

Looking at a linear demand curve, as we
move along the curve Q/P will change
Price elasticity of demand must therefore
be measured at a particular point on the
demand curve
Elasticity will change along the demand
curve in a particular way
Chapter 2
52

Given a linear demand curve
Elasticity depends on slope and on the
values of P and Q
The top portion of demand curve is elastic
Price
is high and quantity small
The bottom portion of demand curve is

inelastic
Price
is low and quantity high
Chapter 2
53

Price
4
EP = -
Demand Curve
Q = 8 2P
Elastic
Ep = -1
Inelastic
4
8
Chapter 2
Ep = 0
54

The steeper the demand curve becomes,
the more inelastic the good.
The flatter the demand curve becomes,
the more elastic the good
Two extreme cases of demand curves
Completely inelastic demand vertical
Infinitely elastic demand - horizontal
Chapter 2
55
Infinitely Elastic Demand

Price
EP =
D
P*
Quantity
Chapter 2
56
Completely Inelastic Demand

Price
EP = 0
Q*
Chapter 2
Quantity
57
Other Demand Elasticities

Income Elasticity of Demand
Measures how much quantity demanded
changes with a change in income.
Q/Q
I Q
EI
I/I
Q I
Chapter 2
58

Cross-Price Elasticity of Demand
Measures the percentage change in the
quantity demanded of one good that results
from a one percent change in the price of
another good.
EQb Pm
Qb Qb Pm Qb
Pm Pm Qb Pm
Chapter 2
59

Complements: Cars and Tires
Cross-price elasticity of demand is negative
Price
of cars increases, quantity demanded of

tired decreases
Substitutes: Butter and Margarine

Cross-price elasticity of demand is positive
Price
of butter increases, quantity of margarine

demanded increases
Chapter 2
60
Price Elasticity of Supply

Measures the sensitivity of quantity
supplied given a change in price
Measures the percentage change in quantity
supplied resulting from a 1 percent change in
price.
S
EP
% Q
% P
Chapter 2
61
Elasticity: An Application
During 1980s and 1990s, market for
wheat went through changes that had
great implications for American farmers
and US agricultural policy
Using the supply and demand curves for
wheat, we can analyze what occurred in
this market
Chapter 2
62
Supply: QS = 1800 + 240P
Demand: QD = 3550 266P
Chapter 2
63
QD = QS
1800 + 240P = 3550 266P
506P = 1750
P = $3.46 per bushel
Q = 1800 + (240)(3.46) = 2630 million
bushels
Chapter 2
64
We can find the elasticities of demand
and supply at these points
D
EP
P Q D
3.46
( 2.66 ) .035
Q P
2,630
S
EP
P QS
3.46
( 2.40 ) .032
Q P
2,630
Chapter 2
65
Assume the price of wheat is
$4.00/bushel due to decrease in supply
QD 3,550 ( 266)(4.00) 2,486
4.00
Q
( 266) 0.43
2,486
D
P
Chapter 2
66
In 2002, the supply and demand for
wheat were:
Supply: QS = 1439 + 267P
Demand: QD = 2809 226P
Chapter 2
67
QD = QS
2809 - 226P = 1439 + 267P
P = $2.78 per bushel
Q = 2809 - (226)(2.78) = 2181 million
bushels
Price of wheat fell in nominal terms.
Chapter 2
68
Short-Run Versus Long-Run

Elasticity
Demand
In general, demand is much more price
elastic in the long run
Consumers
take time to adjust consumption
habits
Demand might be linked to another good that
changes slowly
More substitutes are usually available in the
long run
Chapter 2
69
Predicting the Effects of

Changing Market Conditions
Supply and demand analysis can be
used to predict the effects of changing
market conditions
Linear demand and supply must be fit to
market data
Given
equilibrium price and quantity along with

elasticities of supply and demand, we can
calculate the curves that fit the information
We can then calculate changes in the market
Chapter 2
70

We know
Equilibrium Price, P*
Equilibrium Quantity, Q*
Price elasticity of supply, ES
Price elasticity of demand, ED
Chapter 2
71

Lets begin with the equations for supply,
demand, elasticity:
Demand: Q = a bP
Supply: Q = c + dP
Elasticity: (P/Q)(Q/P)
We must calculate numbers for a, b, c,

and d.
Chapter 2
72

The slope of the demand curve above
equals Q/P which equals b
The slope of the supply curve above
equals Q/P which equals d
Demand: ED = -b(P*/Q*)
Supply: ES = d(P*/Q*)
Chapter 2
73

Price
Supply: Q = c + dP
a/b
ED = -bP*/Q*
ES = dP*/Q*
P*
-c/d
Demand: Q = a - bP
Q*
Chapter 2
Quantity
74

Using P*, Q* and the elasticities, we can
solve for b and c from supply
ES = d(P*/Q*)
1.6 = d(0.75/7.5) = 0.1d
d = 16
Q = c + dP
7.5 = c + (16)(0.75) = c + 12
c = -4.5
Chapter 2
75

Using P*, Q* and the elasticities, we can
solve for a and b from demand
ED = b(P*/Q*)
-0.8 = -b(0.75/7.5) = 0.1b
b=8
Q = a bP
7.5 = a (8)(0.75) = a 6
a = 13.5
Chapter 2
76

We now have equations for supply and
demand
Supply: Q = 4.5 + 16P
Demand: Q = 13.5 8P
Setting them equal will give up
equilibrium price and quantity with which
we began
Chapter 2
77

Price
Supply: QS = -4.5 + 1
a/b
.75
-c/d
Demand: QD = 13.5 - 8
7.5
Chapter 2
Mmt/yr
78

We have written supply and demand so
that they only depend upon price
Demand could also depend upon other
variable such as income
Demand would then be written as:
Q a bP fI
Chapter 2
79

We know the following information
regarding the copper industry:
I = 1.0
P* = 0.75
Q* = 7.5
b = 8
Income elasticity: E I= 1.3
Chapter 2
80

Using the elasticity of income formula,
we can solve for f
EI = (I/Q)(Q/I)
1.3 = (1.0/7.5)(f)
f = 9.75
Substituting back into demand equation
gives a = 3.75
Chapter 2
81
Effects of Price Controls

Markets are rarely free of government
intervention
Imposed taxes and granted subsidies
Price controls
Price controls usually hold the price

above or below the equilibrium price
Excess demand shortage
Excess supply - surplus
Chapter 2
82
Effects of Price Controls

Price
S
Price is regulated to
be no higher than Pmax,
Quantity supplied
falls and quantity
demanded increases
A shortage results
P0
Pmax
Shortag
e
Q
2005 Pearson Education, Inc. S
Q0
Chapter 2
D
QDQuantity
83
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Topic 2

BASIC DEMAND, SUPPLY

2005 Pearson Education, Inc.

Supply and Demand

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

Example: The supply of Eggs

SUPPLY CURVE OF EGGS

A change in quantity Supply

The Change in quantity

Price (RM)The Change in

1. Prices of other goods

2005 Pearson Education, Inc.

The Individual Demand Curve and

Quantity of pizzas per

The demand schedule is a

The Demand Curve and the Law of Demand

Change in quantity demanded

A Change in Demand Versus a

The Impact of a Change in Income

The Impact of a Change in the

Demand for substitute good (chicken)

Price of hamburger rises

2005 Pearson Education, Inc.

The Market Mechanism

The Market Mechanism

The curves intersect at

The Market Mechanism

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

The Market Mechanism

The Market Mechanism

2005 Pearson Education, Inc.

The Market Mechanism

The Market Mechanism

2005 Pearson Education, Inc.

Changes In Market Equilibrium

2005 Pearson Education, Inc.

Changes In Market Equilibrium

Changes In Market Equilibrium

Changes In Market Equilibrium

Shifts in Supply and Demand

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

Elasticities of Supply and Demand

Price Elasticity of Demand

2005 Pearson Education, Inc.

Price Elasticity of Demand

2005 Pearson Education, Inc.

Price Elasticity of Demand

When EP > 1, the good is price elastic

When EP < 1, the good is price inelastic

2005 Pearson Education, Inc.

Price Elasticity of Demand

easily move to another good with price

Few substitutes demand is price inelastic

2005 Pearson Education, Inc.

Price Elasticity of Demand

2005 Pearson Education, Inc.

Price Elasticity of Demand

is high and quantity small

The bottom portion of demand curve is

2005 Pearson Education, Inc.