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Supply and Demand
Chapter 4
Demand


Demand means the willingness and capacity
to pay.
Prices are the tools by which the market
coordinates individual desires.
The Law of Demand

Law of demand – there is an inverse
relationship between price and quantity
demanded.
–
–
Quantity demanded rises as price falls, other
things constant.
Quantity demanded falls as prices rise, other
things constant.
The Law of Demand

What accounts for the law of demand?
Substitution

Price too high? Buy something else.
The Demand Curve



The demand curve is the graphic
representation of the law of demand.
The demand curve slopes downward and to
the right.
As the price goes up, the quantity demanded
goes down.
Price (per unit)
A Sample Demand Curve
PA
A
D
0
QA
Quantity demanded (per unit of time)
Other Things Constant

Other things constant places a limitation on
the application of the law of demand.
–
–
–
All other factors that affect quantity demanded are
assumed to remain constant, whether they
actually remain constant or not.
Called parameters
P,Q are called variables
Other Things Constant

Include changing tastes, prices of other
goods, income, even the weather.
Shifts Versus Movements


Shift: change in underlying parameter
Movement along: change in a variable on the
axes.
Shifts in Demand Versus Movements
Along a Demand Curve

Quantity demanded refers to a specific
amount that will be demand per unit of time
at a specific price.

Graphically, it refers to a specific point on the
demand curve.
Shifts in Demand Versus Movements
Along a Demand Curve

A movement along a demand curve is the
graphical representation of the effect of a
change in price on the quantity demanded.
Shifts in Demand Versus Movements
Along a Demand Curve

A shift in demand is the graphical
representation of the effect of anything other
than price on demand.
Price (per unit)
Change in Quantity Demanded
$2
B
Change in quantity demanded
(a movement along the curve)
$1
A
D1
0
100
200
Quantity demanded (per unit of time)
Price (per unit)
Shift in Demand
Change in demand
(a shift of the curve)
$2
$1
B
A
D0
D1
250
100
200
Quantity demanded (per unit of time)
Shift Factors of Demand

Shift factors of demand are factors that
cause shifts in the demand curve:
–
–
–
–
–
Society's income.
The prices of other goods.
Tastes.
Expectations.
Taxes on subsidies to consumers.
Income


An increase in income will increase demand
for normal goods.
An increase in income will decrease demand
for inferior goods.
Price of Other Goods


When the price of a substitute good falls,
demand falls for the good whose price has
not changed.
When the price of a complement good falls,
demand rises for the good whose price has
not changed.
Tastes

A change in taste will change demand with
no change in price.
Expectations


If you expect your income to rise, you may
consume more now.
If you expect prices to fall in the future, you
may put off purchases today.
Taxes and Subsidies


Taxes levied on consumers increase the cost
of goods to consumers, thereby reducing
demand.
Subsidies have an opposite effect.
The Demand Table

The demand table assumes all the following:
–
–
–
As price rises, quantity demanded declines.
Quantity demanded has a specific time dimension
to it.
All the products involved are identical in shape,
size, quality, etc.
The Demand Table

The demand table assumes all the following:
–
The schedule assumes that everything else is
held constant.
From a Demand Table to a
Demand Curve

You plot each point in the demand table on a
graph and connect the points to derive the
demand curve.
From a Demand Table to a
Demand Curve

The demand curve graphically conveys the
same information that is on the demand
table.
From a Demand Table to a
Demand Curve

The curve represents the maximum price
that you will pay for various quantities of a
good – you will happily pay less.
From a Demand Table to a
Demand Curve
A Demand Table
A
B
C
D
E
$0.50
1.00
2.00
3.00
4.00
9
8
6
4
2
Price per DVDs (in dollars)
Price per DVD rentals
cassette demanded per
week
A Demand Curve
$6.00
5.00
4.00
3.50
3.00
E
D
G
2.00
C
1.00
.50
0
F
Demand for
DVDs
B
A
1 2 3 4 5 6 7 8 9 10 11 12 13
Quantity of DVDs demanded (per week)
Individual and Market Demand
Curves

A market demand curve is the horizontal sum
of all individual demand curves.
–
This is determined by adding the individual
demand curves of all the demanders.
Individual and Market Demand
Curves

Sellers estimate total market demand for
their product which becomes smooth and
downward sloping curve.
From Individual Demands
to a Market Demand Curve
A $.0.50
B
1.00
C
1.50
D
2.00
E
2.50
F
3.00
G
3.50
H
4.00
9
8
7
6
5
4
3
2
6
5
4
3
2
1
0
0
(2)
Cathy’s
demand
1
1
0
0
0
0
0
0
(3)
Market
demand
16
14
11
9
7
5
3
2
$4.00
Price per cassette (in dollars)
(1)
(2)
(3)
Price per Alice’s Bruce’s
cassette demand demand
G
3.50
F
3.00
E
2.50
D
2.00
C
1.50
B
1.00
0.50
0
A
Cathy
2
4
Bruce Alice Market demand
6
8 10 12 14 16
Quantity of cassettes demanded per week
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
The Law of Demand

The demand curve is downward sloping for
the following reasons:
–
–
At lower prices, existing demanders buy more.
At lower prices, new demanders enter the market.
Supply


Individuals control the factors of production –
inputs, or resources, necessary to produce
goods.
Individuals supply factors of production to
intermediaries or firms.
Supply

The analysis of the supply of produced
goods has two parts:
–
–
An analysis of the supply of the factors of
production to households and firms.
An analysis of why firms transform those factors of
production into usable goods and services.
The Law of Supply

There is a direct relationship between price
and quantity supplied.
–
–
Quantity supplied rises as price rises, other things
constant.
Quantity supplied falls as price falls, other things
constant.
The Law of Supply

The law of supply is accounted for by two
factors:
–
–
When prices rise, firms substitute production of
one good for another.
Assuming firms’ costs are constant, a higher price
means higher profits.
The Supply Curve



The supply curve is the graphic
representation of the law of supply.
The supply curve slopes upward to the right.
The slope tells us that the quantity supplied
varies directly – in the same direction – with
the price.
Price (per unit)
A Sample Supply Curve
S
PA
0
A
QA
Quantity supplied (per unit of time)
Shifts Versus Movements

Supply refers to a schedule of quantities a
seller is willing to sell per unit of time at
various prices, other things constant.
Shifts in Supply Versus Movements
Along a Supply Curve

Quantity supplied refers to a specific
amount that will be supplied at a specific
price.
Shifts in Supply Versus Movements
Along a Supply Curve

Changes in price causes changes in
quantity supplied represented by a
movement along a supply curve.
Shifts in Supply Versus Movements
Along a Supply Curve

A movement along a supply curve – the
graphic representation of the effect of a
change in price on the quantity supplied.
Shifts in Supply Versus Movements
Along a Supply Curve

If the amount supplied is affected by anything
other than a change in price, there will be a
shift in supply.
Shifts in Supply Versus Movements
Along a Supply Curve

Shift in supply – the graphic representation
of the effect of a change in a factor other
than price on supply.
Shift in Supply
S0
Price (per unit)
S1
$15
A
B
Shift in Supply
(a shift of the curve)
1,250
1,500
Quantity supplied (per unit of time)
Change in Quantity Supplied
S
Price (per unit)
0
B
$15
A
Change in quantity
supplied (a movement
along the curve)
1,250
1,500
Quantity supplied (per unit of time)
Shift Factors of Supply

Other factors besides price affect how much
will be supplied:
–
–
–
–
Prices of inputs used in the production of a good.
Technology.
Suppliers’ expectations.
Taxes and subsidies.
Price of Inputs


When costs go up, profits go down, so that
the incentive to supply also goes down.
If costs go up substantially, the firm may
even shut down.
Technology


Advances in technology reduce the number
of inputs needed to produce a given supply
of goods.
Costs go down, profits go up, leading to
increased supply.
Expectations

If suppliers expect prices to rise in the future,
they may store today's supply to reap higher
profits later.
Taxes and Subsidies


When taxes go up, costs go up, and profits
go down, leading suppliers to reduce output.
When government subsidies go up, costs go
down, and profits go up, leading suppliers to
increase output.
The Supply Table


Each supplier follows the law of supply.
When price rises, each supplies more, or at
least as much as each did at a lower price.
From a Supply Table to a Supply
Curve

To derive a supply curve from a supply table,
you plot each point in the supply table on a
graph and connect the points.
From a Supply Table to a Supply
Curve

The supply curve represents the set of
minimum prices an individual seller will
accept for various quantities of a good.
From a Supply Table to a Supply
Curve

Competing suppliers’ entry into the market
places a limit on the price any supplier can
charge.
Individual and Market Supply
Curves

The market supply curve is derived by
horizontally adding the individual supply
curves of each supplier.
From Individual Supplies to a
Market Supply
(1)
(2)
(3)
(4)
(5)
Quantities
Price
Ann's Barry's Charlie's Market
Supplied (per DVD) Supply Supply Supply Supply
A
B
C
D
E
F
G
H
I
$0.00
0.50
1.00
1.50
2.00
2.50
3.00
3.50
4.00
0
1
2
3
4
5
6
7
8
0
0
1
2
3
4
5
5
5
0
0
0
0
0
0
0
2
2
0
1
3
5
7
9
11
14
15
From Individual Supplies to a
Market Supply
$4.00
Charlie
Barry
Ann
Market Supply
Price per DVD
3.50
H
3.00
G
2.50
F
2.00
E
1.50
D
1.00
0.50
0 A
I
C
B
CA
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Quantity of DVDs supplied (per week)
The Interaction of Supply and
Demand

The English historian Thomas Carlyle once
said:
“Teach any parrot the words supply and
demand and you’ve got an economist.”
Equilibrium

Equilibrium is a concept in which opposing
dynamic forces cancel each other out.
Equilibrium

In a free market, the forces of supply and
demand interact to determine equilibrium
quantity and equilibrium price.
Equilibrium

Equilibrium price – the price toward which
the invisible hand drives the market.

Equilibrium quantity – the amount bought and
sold at the equilibrium price.
What Equilibrium Isn’t


Equilibrium isn’t a state of the world, it is a
characteristic of a model.
Equilibrium isn’t inherently good or bad, it is
simply a state in which dynamic pressures
offset each other.
What Equilibrium Isn’t

When the market is not in equilibrium, you
get either excess supply or excess demand,
and a tendency for price to change.
Excess Supply


Excess supply – a surplus, the quantity
supplied is greater than quantity demanded
Prices tend to fall.
Excess Demand


Excess demand – a shortage, the quantity
demanded is greater than quantity supplied
Prices tend to rise.
Price Adjusts

The greater the difference between quantity
supplied and quantity demanded, the more
pressure there is for prices to rise or fall.
Price Adjusts

When quantity demanded equals quantity
supplied, prices have no tendency to change.
The Graphical Interaction of
Supply and Demand
Price (per
DVD)
Quantity
Supplied
Quantity
Demanded
Surplus (+)
Shortage (-)
$3.50
7
3
+4
$2.50
5
5
0
$1.50
3
7
-4
The Graphical Interaction of
Supply and Demand
$5.00
S
Excess supply
Price per DVD
4.00
3.50
A
3.00
E
2.50
C
2.00
1.50
Excess demand
1.00
1
D
2 3 4 5 6 7 8 9 10 11 12
Quantity of DVDs supplied and demanded
The Graphical Interaction of
Supply and Demand


When price is $3.50 each, quantity supplied
equals 7 and quantity demanded equals 3.
The excess supply of 4 pushes price down.
The Graphical Interaction of
Supply and Demand


When price is $1.50 each, quantity supplied
equals 3 and quantity demanded equals 7.
The excess demand of 4 pushes price up.
The Graphical Interaction of
Supply and Demand


When price is $2.50 each, quantity supplied
equals 5 and quantity demanded equals 5.
There is no excess supply or excess demand,
so price will not rise or fall.
Political and Social Forces and
Equilibrium


Political and social forces can push price
away from a supply/demand equilibrium.
These forces create an equilibrium where
quantity supplied won’t equal quantity
demanded.
Shifts in Supply and Demand

Shifts in either supply or demand change
equilibrium price and quantity.
Increase in Demand


An increase in demand creates excess
demand at the original equilibrium price.
The excess demand pushes price upward
until a new higher price and quantity are
reached.
Increase in Demand
S0
B
$2.50
Excess demand
A
2.25
D0
0
D1
8
9
10
Quantity of DVDs (per week)
Decrease in Supply


A decrease in supply creates excess demand
at the original equilibrium price.
The excess demand pushes price upward
until a new higher price and lower quantity
are reached.
Decrease in Supply
S1
S0
C
$2.50
2.25
B
Excess demand
A
D0
0
8
9
10
Quantity of DVDs (per week)
The Limitations Of Supply And
Demand Analysis


Sometimes supply and demand are
interconnected.
Other things don't remain constant.
The Limitations Of Supply And
Demand Analysis

All actions have a multitude of ripple and
possible feedback effects.

The ripple effect is smaller when the goods are
a small percentage of the entire economy.
The Limitations Of Supply And
Demand Analysis

The other-things-constant assumption is
likely not to hold when the goods represent a
large percentage of the entire economy.
The Fallacy of Composition

The fallacy of composition is the false
assumption that what is true for a part will
also be true for the whole.
The Fallacy of Composition

–
The fallacy of composition is of central
relevance to macroeconomics.
In macroeconomics, the other-things-constant
assumption, central to microeconomic
supply/demand analysis, cannot hold.
Supply and Demand
End of Chapter 4