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Chapter 2: Demand, Supply,
and Market Equilibrium
McGraw-Hill/Irwin
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
Demand
• Quantity demanded (Qd)
• Amount of a good or service consumers are
willing & able to purchase during a given
period of time
2-2
General Demand Function
• Six variables that influence Qd
• Price of good or service (P)
• Incomes of consumers (M)
•
•
•
•
Prices of related goods & services (PR)
Taste patterns of consumers (T)
Expected future price of product (Pe)
Number of consumers in market (N)
• General demand function
Qd = f(P, M, PR, T, Pe , N)
2-3
General Demand Function
Qd = a + bP + cM + dPR + eT + fPe + gN
• b, c, d, e, f, & g are slope parameters
• Measure effect on Qd of changing one of the
variables while holding the others constant
• Sign of parameter shows how variable is
related to Qd
• Positive sign indicates direct relationship
• Negative sign indicates inverse relationship
2-4
General Demand Function
Variable
Relation to Qd
Sign of Slope Parameter
b = Qd/P is negative
P
Inverse
M
c = Qd/M is positive
Direct for normal goods
Inverse for inferior goods c = Qd/M is negative
PR
Direct for substitutes
Inverse for complements
d = Qd/PR is positive
d = Qd/PR is negative
T
Direct
e = Qd/T is positive
Pe
Direct
f = Qd/Pe is positive
N
Direct
g = Qd/N is positive
2-5
Substitutes
•
•
•
•
•
Orange Juice—Grapefruit Juice
Cab rides—Subway rides
Chicken—Pork
DVDs—Blue Ray disks
Cane Sugar—Beet Sugar
2-6
Complements
•
•
•
•
Game Consoles—Video Games
Blue Ray Plays—High Definition TVs
Airline Service—Rental Cars
Bagels—Cream Cheese
2-7
Normal and Inferior Goods
•A normal good is a good for which demand
increases (shifts right) when income increases.
Examples: Scotch whiskey, Swiss-made watches,
lobster, air travel, vacations abroad.
•An inferior good is a good for which demand
decreases (shifts left) when income increases.
Examples: macaroni, used clothing, bus service.
2-8
Direct Demand Function
• The direct demand function, or simply
demand, shows how quantity demanded,
Qd , is related to product price, P, when all
other variables are held constant
• Qd = f(P)
• Law of Demand
• Qd increases when P falls, all else constant
• Qd decreases when P rises, all else constant
• Qd/P must be negative
2-9
Inverse Demand Function
• Traditionally, price (P) is plotted on the
vertical axis & quantity demanded (Qd) is
plotted on the horizontal axis
• The equation plotted is the inverse demand
function, P = f(Qd)
2-10
Graphing Demand Curves
• A point on a direct demand curve shows
either:
• Maximum amount of a good that will be
purchased for a given price
• Maximum price consumers will pay for a
specific amount of the good
2-11
A Demand Curve
(Figure 2.1)
2-12
Graphing Demand Curves
• Change in quantity demanded
• Occurs when price changes
• Movement along demand curve
• Change in demand
• Occurs when one of the other variables, or
determinants of demand, changes
• Demand curve shifts rightward or leftward
2-13
Shifts in Demand
(Figure 2.2)
2-14
Supply
• Quantity supplied (Qs)
• Amount of a good or service offered for
sale during a given period of time
2-15
Supply
• Six variables that influence Qs
•
•
•
•
•
•
Price of good or service (P)
Input prices (PI )
Prices of goods related in production (Pr)
Technological advances (T)
Expected future price of product (Pe)
Number of firms producing product (F)
• General supply function
• Qs = f(P, PI, Pr, T, Pe, F)
2-16
General Supply Function
Qs = h + kP + lPI + mPr + nT + rPe + sF
• k, l, m, n, r, & s are slope parameters
• Measure effect on Qs of changing one of the
variables while holding the others constant
• Sign of parameter shows how variable is
related to Qs
• Positive sign indicates direct relationship
• Negative sign indicates inverse relationship
2-17
General Supply Function
Variable
Relation to Qs
Sign of Slope Parameter
P
Direct
k = Qs/P is positive
PI
Inverse
l = Qs/PI is negative
Pr
Inverse for substitutes
Direct for complements
m = Qs/Pr is negative
m = Qs/Pr is positive
T
Direct
n = Qs/T is positive
Pe
Inverse
r = Qs/Pe is negative
F
Direct
s = Qs/F is positive
2-18
Direct Supply Function
• The direct supply function, or simply
supply, shows how quantity supplied, Qs ,
is related to product price, P, when all
other variables are held constant
•
Qs = f(P)
2-19
Inverse Supply Function
• Traditionally, price (P) is plotted on the
vertical axis & quantity supplied (Qs) is
plotted on the horizontal axis
• The equation plotted is the inverse supply
function, P = f(Qs)
2-20
Graphing Supply Curves
• A point on a direct supply curve shows
either:
• Maximum amount of a good that will be
offered for sale at a given price
• Minimum price necessary to induce producers
to voluntarily offer a particular quantity for sale
2-21
A Supply Curve
(Figure 2.3)
2-22
Graphing Supply Curves
• Change in quantity supplied
• Occurs when price changes
• Movement along supply curve
• Change in supply
• Occurs when one of the other variables, or
determinants of supply, changes
• Supply curve shifts rightward or leftward
2-23
Shifts in Supply
(Figure 2.4)
2-24
Market Equilibrium
• Equilibrium price & quantity are
determined by the intersection of
demand & supply curves
• At the point of intersection, Qd = Qs
• Consumers can purchase all they want &
producers can sell all they want at the
“market-clearing” or “equilibrium” price
2-25
Market Equilibrium
(Figure 2.5)
2-26
Market Equilibrium
• Excess demand (shortage)
• Exists when quantity demanded exceeds
quantity supplied
• Excess supply (surplus)
• Exists when quantity supplied exceeds
quantity demanded
2-27
Value of Market Exchange
• Typically, consumers value the goods
they purchase by an amount that
exceeds the purchase price of the goods
• Economic value
• Maximum amount any buyer in the market
is willing to pay for the unit, which is
measured by the demand price for the unit
of the good
2-28
Measuring the Value of
Market Exchange
• Consumer surplus
• Difference between the economic value of a
good (its demand price) & the market price the
consumer must pay
• Producer surplus
• For each unit supplied, difference between
market price & the minimum price producers
would accept to supply the unit (its supply
price)
• Social surplus
• Sum of consumer & producer surplus
• Area below demand & above supply over the
relevant range of output
2-29
Measuring the Value of
Market Exchange (Figure 2.6)
2-30
Changes in Market Equilibrium
• Qualitative forecast
• Predicts only the direction in which an
economic variable will move
• Quantitative forecast
• Predicts both the direction and the
magnitude of the change in an economic
variable
2-31
Demand Shifts (Supply Constant)
(Figure 2.7)
2-32
Supply Shifts (Demand Constant)
(Figure 2.8)
2-33
Simultaneous Shifts
• When demand & supply shift
simultaneously
• Can predict either the direction in which
price changes or the direction in which
quantity changes, but not both
• The change in equilibrium price or quantity
is said to be indeterminate when the
direction of change depends on the relative
magnitudes by which demand & supply
shift
2-34
Simultaneous Shifts: (D, S)
P
S
S′
S′′
B
P′
P
P′′
A
•
•
•C
D′
D
Q
Q
Q′
Q′′
Price may rise or fall; Quantity rises
2-35
Simultaneous Shifts: (D, S)
P
S
S′
S′
A
•
P
B
P′
•
•C
P′′
D
D′
Q
Q′ Q
Q′′
Price falls; Quantity may rise or fall
2-36
Simultaneous Shifts: (D, S)
P
S′′
S′
P′′
•
S
C
B
•
P′
A
•
P
D′
D
Q
Q′′
Q Q′
Price rises; Quantity may rise or fall
2-37
Simultaneous Shifts: (D, S)
P
S′′
S′
S
P′′
P
P′
•C
A
•
B
•
D
D′
Q′′
Q
Q′
Q
Price may rise or fall; Quantity falls
2-38
Ceiling & Floor Prices
• Ceiling price
• Maximum price government permits sellers to
charge for a good
• When ceiling price is below equilibrium, a
shortage occurs
• Floor price
• Minimum price government permits sellers to
charge for a good
• When floor price is above equilibrium, a
surplus occurs
2-39
Ceiling & Floor Prices (Figure 2.12)
Px
Sx
2
1
Price (dollars)
Px
Sx
3
2
Dx
Dx
22
50 62
Quantity
Panel A – Ceiling price
Qx
32 50
84
Qx
Quantity
Panel B – Floor price
2-40
The rental housing
market in New York
City
Monthly
Rent
S
If the Rent
Control Board
sets a ceiling of
$900 per month,
3,000 apartmentseekers won’t be
able to find one.
$1,120
$900
Shortage
D
0
4,000 5,700 7,000
Rental Units 2-41
P/BU
A price floor of
$3.20 per bushel will
produce a surplus
of 300 bushels.
But what if
the floor were set
at $2.35?
#2 Hard KC Wheat
Surplus
S
$3.20
$2.52
D
0
550 700 850
bushels
2-42