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CHAPTER 3
Demand, supply and the
market
©McGraw-Hill Education, 2014
Key concepts in the study of
markets
• Market: a set of arrangements by which
buyers and sellers are in contact to
exchange goods or services
• Demand: the quantity of a good buyers
wish to purchase at each conceivable
price
• Supply: the quantity of a good sellers wish
to sell at each conceivable price
• Equilibrium price: price at which quantity
supplied = quantity demanded.
©McGraw-Hill Education, 2014
The supply curve shows the relation between
price and quantity demanded holding other
things constant
S
Other things include:
• Technology
• Input costs
• Government
regulations
•Business expectations
Quantity
©McGraw-Hill Education, 2014
Market equilibrium
Market equilibrium is at E0
where quantity
demanded equals
quantity supplied . The
equilibrium price is P0
and quantity Q0
Price
S
P0
E0
D
Q0
Quantity
©McGraw-Hill Education, 2014
Behind the demand curve
• It is important to distinguish between
movements (or shifts) in the demand curve
and movements along the demand curve.
• Movements along the demand curve result
from changes in the price of the good itself.
©McGraw-Hill Education, 2014
Movements along the demand
curve
• A movement along the
demand curve from A to B
occurs when price falls
• Here all other
determinants of demand
remain constant.
A
P0
P1
B
D
Q0 Q1 Quantity
©McGraw-Hill Education, 2014
Behind the demand curve
• Movements (or shifts) in the demand curves
are caused by
 Changes in the price of related goods –
either substitutes or complements
 Changes in consumer incomes
 Changes in tastes
 Expectations over future price changes.
©McGraw-Hill Education, 2014
Income changes and demand
• The influence of changes in income on
demand depends on whether the good is
 a normal good or
 an inferior good.
©McGraw-Hill Education, 2014
Movements of or shifts in the
demand curve
P0
P1
C
A
B
F
Q0 Q1 Q2 Q3
• A movement (or shift) of the
demand curve from D0 to
D1leads to an increase in
demand at each and every
price
• e.g., at P0 quantity
demanded increases from
Q0 to Q2: at P1 quantity
demanded increases from
Quantity Q1 to Q3
©McGraw-Hill Education, 2014
A shift in demand
D1
If the price of a substitute
good decreases, then
less will be demanded at
each price.
D0
P0
P1
E0
E1
Q1 Q0
The demand curve shifts
from D0D0 to D1D1.
If price stayed at P0 the
D0 resultant glut would put
D1
downward pressure on the
price.
Quantity
Demand would rise and
supply fall until equilibrium is
©McGraw-Hill Education, 2014restored at E1.
Behind the supply curve (1)
• It is important to distinguish between
movements (or shifts) in the supply curve
and movements along the supply curve.
• Movements along the supply curve result
from changes in the price of the good itself.
©McGraw-Hill Education, 2014
Behind the supply curve (2)
• Movements (or shifts) in the supply curves
are caused by
 Changes in technology
 Changes in input costs
 Changes in government regulations
 Business expectations
©McGraw-Hill Education, 2014
A shift in supply
S1
D
S0
E2
P1
P0
The supply curve
shifts to S1S1
E0
S0
If price stayed at P0, then there
would be excess demand and
upward pressure on price.
D
Q1 Q0
Suppose safety
regulations are tightened,
increasing producers’ costs
Quantity
Demand would fall and
supply increase until market
equilibrium is restored.
©McGraw-Hill Education, 2014
Consumer and producer surplus(1)
• The difference between what a consumer
is willing to pay for a good and the price
actually paid is a measure of the
consumer’s surplus.
• Total consumer surplus in a market is the
sum of all the surpluses enjoyed by all
consumers.
©McGraw-Hill Education, 2014
Consumer and producer surplus (2)
• The difference between the price at
which a firm would be willing to supply a
good and the price actually received by
the firm is a measure of its producer
surplus.
• Total producer surplus in a market is the
sum of all the surpluses enjoyed by all
producers.
©McGraw-Hill Education, 2014
Price
Consumer and producer surplus (3)
For a single consumer, the
consumer surplus is the
difference between the
maximum price that she is
willing to pay for a given
amount of a good or service
and the price she actually
pays.
Consumer
surplus
P*
Producer
surplus
Q*
Quantity
©McGraw-Hill Education, 2014
The producer surplus for sellers
is the amount that sellers
benefit by selling at a market
price that is higher than they
would be willing to sell for.
Consumer and producer surplus
and the gains from trade
• The economic surplus in a market (sum of
consumer and producer surplus) is a
measure of the benefits firms and
consumers derive from trade.
• It is maximized at the equilibrium price.
• Only at this price are all the benefits from
exchange exhausted.
©McGraw-Hill Education, 2014
What, how and for whom
• The market:
– decides how much of a good should be
produced
• by finding the price at which the quantity
demanded equals the quantity supplied
– tells us for whom the goods are produced
• those consumers willing to pay the
equilibrium price
– determines what goods are being produced
• there may be goods for which no consumer
is prepared to pay a price at which firms
would be willing to supply
©McGraw-Hill Education, 2014
Free markets and price controls: a
market in disequilibrium
• Suppose a disastrous harvest
moves the supply curve to SS.
S
P2
E
P0
P1
• The resulting market clearing
or equilibrium price is P0.
A
• Government may try to
protect the poor, setting a
price ceiling at P1.
B
excess
demand
• The result is excess demand.
S
QS Q0
QD Quantity
RATIONING is needed to
cope with the resulting
excess demand.
©McGraw-Hill Education, 2014
Free markets and price controls: a
market in disequilibrium
• Minimum wages are an example of a
price floor and can result in
unemployment.
• Rent caps are an example of a price
ceiling and can result in shortages in
rental markets.
©McGraw-Hill Education, 2014
Exploring the mathematics of
demand and supply (1)
The demand equation:
QD =a - bP
(1)
where QD denotes the quantity demanded, P the
price while a and b are two positive constants.
The supply equation:
QS =c + dP
(2)
where QS s the quantity supplied, while c and d are two
constants. We assume that the constant d is positive.
©McGraw-Hill Education, 2014
Exploring the mathematics of
demand and supply (2)
Market equilibrium is where quantity
demanded equals quantity supplied:
QD = QS
dP  bP  a  c
 P(b  d )  a  c
(a  c)
 P* 
(b  d )
P* is the equilibrium price that equates
quantity demanded and quantity
supplied.
©McGraw-Hill Education, 2014
Uncovering demand and supply
curves
• It is important to understand that demand
and supply curves are not physical
objects that can be seen or touched.
• Rather they are relationships revealed
through the appropriate use of statistical
analyses undertaken by skilled
econometricians.
©McGraw-Hill Education, 2014
Uncovering supply and demand
• We cannot plot ex ante demand curves
and supply curves
• So we use historical data and the
supposition that the observed values are
equilibrium ones
• Since other things are often not constant,
careful use of statistical techniques is
required to isolate the parameters of a
demand or supply curve.
©McGraw-Hill Education, 2014
Concluding comments (1)
• Demand is the quantity that buyers wish to
buy at each price.
• Supply is the quantity of a good sellers wish
to sell at each price.
• The market clears, or is in equilibrium,
when the price equates the quantity
supplied and the quantity demanded, and
there are no shortages or surpluses.
• An increase in the price of a substitute
good (or decrease in the price of a
complementary good) will raise the
quantity demanded at each price.
©McGraw-Hill Education, 2014
Concluding comments (2)
• The consumer surplus is measured by the area
below the market demand and above the
equilibrium price.
• The producer surplus is measured by the area
above the market supply and below the
equilibrium price.
• To be effective, a price ceiling must be imposed
below the free market equilibrium price.
• An effective price floor must be imposed above
the free market equilibrium price.
©McGraw-Hill Education, 2014