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Chapter 2
The Basics of Supply
and Demand
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?
Chapter 2
Topics to Be Discussed
How do short-run and long-run
elasticities differ?
How do we understand and predict the
effects of changing market conditions?
What are the effects of government
intervention – price controls?
Chapter 2
Supply and Demand
Supply and demand analysis can:
1.
2.
3.
Help us understand and predict how real world
economic conditions affect market price and
production
Analyze the impact of government price controls,
minimum wages, price supports, and production
incentives on the economy
Determine how taxes, subsidies, tariffs and
import quotas affect consumers and producers
Chapter 2
Supply and Demand
The Supply Curve


The relationship between the quantity of a
good that producers are willing to sell and
the price of the good
Measures quantity on the x-axis and price
on the y-axis
Q S  Q S (P)
Chapter 2
The Supply Curve
S
Price
($ per unit)
The Supply Curve,
Graphically Depicted
P2
The supply curve slopes
upward, demonstrating that
at higher prices firms
will increase output
P1
Q1
Q2
Chapter 2
Quantity
The Supply Curve
Other Variables Affecting Supply

Costs of Production
 Labor
 Capital
 Raw Materials

Lower costs of production allow a firm to
produce more at each price and vice versa
Chapter 2
Change in Supply
The cost of raw
materials falls



P
Produced Q1 at P1
and Q0 at P2
Now produce Q2 at
P1 and Q1 at P2
Supply curve shifts
right to S’
S
S’
P1
P2
Q0
Chapter 2
Q1
Q2
Q
The Supply Curve
Change in Quantity Supplied

Movement along the curve caused by a
change in price
Change in Supply

Shift of the curve caused by a change in
something other than the price of the good
 Change in costs of production
Chapter 2
Supply and Demand
The Demand Curve


The relationship between the quantity of a
good that consumers are willing to buy and
the price of the good
Measures quantity on the x-axis and price
on the y-axis
QD  QD(P)
Chapter 2
The Demand Curve
Price
($ per unit)
The demand curve slopes
downward, demonstrating
that consumers are willing
to buy more at a lower price
as the product becomes
relatively cheaper.
P2
P1
D
Q1
Q2
Chapter 2
Quantity
The Demand Curve
Other Variables Affecting Demand

Income
 Increases in income allow consumers to
purchase more at all prices


Consumer Tastes
Price of Related Goods
 Substitutes
 Complements
Chapter 2
Change in Demand
Income Increases




P
D
D’
Purchased Q0, at P2
P2
and Q1 at P1
Now purchased Q1
at P2 and Q2 at P1 P1
Same for all prices
Demand curve
shifts right
Q0
Chapter 2
Q1
Q2
Q
The Demand Curve
Changes in quantity demanded

Movements along the demand curve
caused by a change in price
Changes in demand

A shift of the entire demand curve caused
by something other than price
 Income
 Preferences
Chapter 2
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
The Market Mechanism
S
Price
($ per unit)
The curves intersect at
equilibrium, or marketclearing, price.
Quantity demanded
equals quantity
supplied at P0
P0
D
Q0
Chapter 2
Quantity
The Market Mechanism
In equilibrium




There is no shortage or excess demand
There is no surplus or excess supply
Quantity supplied equals quantity
demanded
Anyone who wants to buy at the current
price can and all producers who want to
sell at that price can
Chapter 2
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
The Market Mechanism
Price
($ per unit)
S
1.
Surplus
P1
2.
3.
P0
4.
D
Q
D
Q0
Chapter 2
QS
Quantity
At P1, price is
above the
market clearing
price
Qs > QD
Price falls to
the marketclearing price
Market adjusts
to equilibrium
Market Shortage
The market price is below equilibrium:




There is 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
The Market Mechanism
Price
($ per unit)
1.
2.
3.
P3
4.
P2
D
Shortage
QS
Q
3
Chapter 2
QD
Quantity
At P2, price is
below the
market
clearing price
Q D > QS
Price rises to
the marketclearing price
Market adjusts
to equilibrium
The Market Mechanism
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
Changes in Market Equilibrium
Equilibrium prices are determined by
the relative level of supply and demand
Changes in supply and/or demand will
cause change in the equilibrium price
and/or quantity in a free market
Chapter 2
Changes in Market Equilibrium
Raw material
prices fall



S shifts to S’
Surplus at P1
between Q1, Q2
Price adjusts to
equilibrium at P3,
Q3
P
D
S
S’
P1
P3
Q1 Q3Q2
Chapter 2
Q
Changes in Market Equilibrium
P
Income Increases



D
D’
S
Demand increases
to D’
P3
Shortage at P1 of
P1
Q1 to Q2
Equilibrium at P3
and Q3
Q1 Q3 Q
2
Chapter 2
Q
Changes in Market Equilibrium
P
Income increases
and raw material
prices fall


Quantity increases
If the increase in D
is greater than the
increase in S price
also increases
D
D’
S S’
P2
P1
Q1
Chapter 2
Q2
Q
Shifts in Supply and Demand
When supply and demand change
simultaneously, the impact on the
equilibrium price and quantity is
determined by:
1.
2.
The relative size and direction of the
change
The shape of the supply and demand
models
Chapter 2
The Price of a College
Education
The real price of a college education
rose 55 percent from 1970 to 2002
Increases in costs of modern
classrooms and wages increased costs
of production – decrease in supply
Due to a larger percentage of high
school graduates attending college,
demand increased
Chapter 2
Market for a College Education
S2002
P
(annual cost
in 1970
dollars)
$3,917
S1970
$2,530
D1970
8.6
13.2
Chapter 2
D2002
Q (millions
enrolled))
The Long-Run Behavior
of Natural Resource Prices




Consumption of copper has increased
about a hundredfold from 1880 through
2002
The long term real price for copper has
remained relatively constant
Increased demand as world economy grew
Decreased production costs increased
supply
Chapter 2
Resource Market Equilibrium
Price
S1900
S1950
S2002
Long-Run Path of
Price and Consumption
D1900
Chapter 2
D1950
D2002
Quantity
Resource Market
Conclusion

Decreases in the costs of production have
increased the supply by more than enough
to offset the increase in demand
Chapter 2
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
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
%QD
E 
%P
D
P
Chapter 2
Price Elasticity of Demand
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
D
EP 

P P Q P
Chapter 2
Price Elasticity of Demand
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
Price Elasticity of Demand
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
Price Elasticity of Demand
Looking at a linear demand curve, as
we move along the curve Q/P is
constant, but P and Q 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
Price Elasticity of Demand
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
Price Elasticity of Demand
Price
4
EP = -
Demand Curve
Q = 8 – 2P
Elastic
Ep = -1
2
Inelastic
4
8
Chapter 2
Q
Ep = 0
Price Elasticity of Demand
The steeper the demand curve, the more
inelastic the demand for the good becomes
The flatter the demand curve, the more
elastic the the demand for the good becomes
Two extreme cases of demand curves


Completely inelastic demand – vertical
Infinitely elastic demand – horizontal
Chapter 2
Infinitely Elastic Demand
Price
EP = 
D
P*
Quantity
Chapter 2
Completely Inelastic Demand
Price
D
EP = 0
Q*
Chapter 2
Quantity
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
Other Demand Elasticities
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
Other Demand Elasticities
Complements: Cars and Tires

Cross-price elasticity of demand is negative
 Price of cars increases, quantity demanded of
tires decreases
Substitutes: Butter and Margarine

Cross-price elasticity of demand is positive
 Price of butter increases, quantity of margarine
demanded increases
Chapter 2
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
%Q S
E 
%P
S
P
Chapter 2
Point vs. Arc Elasticities
Point elasticity of demand

Price elasticity of demand at a particular
point on the demand curve
Arc elasticity of demand

Price elasticity of demand calculated over a
range of prices
E PD

 ΔQ

P 
ΔP  Q 
Chapter 2
Elasticity: An Application
During the 1980s and 1990s, the
market for wheat went through changes
that had great implications for American
farmers and U.S. agricultural policy
Using the supply and demand curves
for wheat, we can analyze what
occurred in this market
Chapter 2
Elasticity: An Application
QD = QS
1800 + 240P = 3550 – 266P
506P = 1750
P = $3.46 per bushel
Q = 1800 + (240)(3.46) = 2630 million
bushels
Chapter 2
Elasticity: An Application
We can find the elasticities of demand
and supply at these points
P QD
3.46
E 

(266)  .35
Q P
2,630
D
P
P QS
3.46
E 

(240)  .32
Q P
2,630
S
P
Chapter 2
Elasticity: An Application
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
Elasticity: An Application
In 2002, the supply and demand for
wheat were:


Supply: QS = 1439 + 267P
Demand: QD = 2809 – 226P
Chapter 2
Elasticity: An Application
QD = QS
2809 - 226P = 1439 + 267P
P = $2.78 per bushel
Q = 2809 - (226)(2.78) = 2181 million
bushels
Chapter 2
Short-Run Versus Long-Run
Elasticity
Price elasticity varies with the amount
of time consumers have to respond to a
price
Short-run demand and supply curves
often look very different from their
long-run counterparts
Chapter 2
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
Gasoline: Short-Run and LongRun Demand Curves
Price
DSR
• People cannot easily
adjust consumption in
the short run.
• In the long run, people
tend to drive smaller and
more fuel efficient cars.
DLR
Quantity of Gas
Chapter 2
Short-Run Versus Long-Run
Elasticity
Demand and Durability



For some durable goods, demand is more
elastic in the short run
If goods are durable, then when price
increases, consumers choose to hold on to
the good instead of replacing it
But in long run, older durable goods will
have to be replaced
Chapter 2
Cars: Short-Run and Long-Run
Demand Curves
Price
DLR
• Initially, people may put
off immediate car
purchase
• In long run, older cars
must be replaced
DSR
Quantity of Cars
Chapter 2
Short-Run Versus Long-Run
Elasticity
Income elasticity also varies with the
amount of time consumers have to
respond to an income change


For most goods and services, income
elasticity is larger in the long run
When income changes, it takes time to
adjust spending
Chapter 2
Short-Run Versus Long-Run
Elasticity
Income elasticity of durable goods

Income elasticity is less in the long run
than in the short run
 Increases in income mean consumers will want
to hold more cars
 Once older cars are replaced, purchases will
only be to replace old cars
 Less purchases from income increase in long
run than in short run
Chapter 2
Short-Run Versus Long-Run
Elasticity
Most goods and services:

Long-run price elasticity of supply is
greater than short-run price elasticity of
supply
Other Goods (durables, recyclables):

Long-run price elasticity of supply is less
than short-run price elasticity of supply
Chapter 2
Short-Run Versus Long-Run
Elasticity
SSR
Price
SLR
Due to limited
capacity, firms
are limited by
output constraints
in the short run.
In the long run, they
can expand.
Chapter 2
Quantity Primary Copper
Short-Run Versus Long-Run
Elasticity
SLR
Price
SSR
Price increases
provide an incentive
to convert scrap
copper into new supply.
In the long run, this
stock of scrap copper
begins to fall.
Quantity Secondary Copper
Chapter 2
Short-Run vs. Long-Run
Elasticity – An Application
Why are coffee prices very volatile?




Most of the world’s coffee is produced in
Brazil
Many changing weather conditions affect
the crop of coffee, thereby affecting price
Price following bad weather conditions is
usually short-lived
In long run, prices come back to original
levels, all else equal
Chapter 2
Price of Brazilian Coffee
Chapter 2
Short-Run vs. Long-Run
Elasticity – An Application
Demand and supply are more elastic in
the long run
In the short run, supply is completely
inelastic

Weather may destroy part of the fixed
supply, decreasing supply
Demand is relatively inelastic as well
Price increases significantly
Chapter 2
An Application - Coffee
Price
S’
S
A freeze or drought
decreases the supply
of coffee
Price increases
significantly due to
inelastic supply and
demand
P1
P0
D
Q1
Q0
Chapter 2
Quantity
An Application - Coffee
Price
S’
S
Intermediate-Run
1) Supply and demand are
more elastic
2) Price falls back to P2.
P2
P0
D
Q2 Q0
Chapter 2
Quantity
An Application - Coffee
Price
Long-Run
1) Supply is extremely elastic
2) Price falls back to P0.
3) Quantity back to Q0.
S
P0
D
Q0
Chapter 2
Quantity
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
Predicting the Effects of
Changing Market Conditions
We know




Equilibrium Price, P*
Equilibrium Quantity, Q*
Price elasticity of supply, ES
Price elasticity of demand, ED
Chapter 2
Predicting the Effects of
Changing Market Conditions
Let’s 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
Predicting the Effects of
Changing Market Conditions
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
Predicting the Effects of
Changing Market Conditions
Price
Supply: Q = c + dP
a/b
ED = -bP*/Q*
ES = dP*/Q*
P*
Demand: Q = a - bP
-c/d
Q*
Chapter 2
Quantity
Predicting the Effects of
Changing Market Conditions
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
Predicting the Effects of
Changing Market Conditions
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
Predicting the Effects of
Changing Market Conditions
We now have equations for supply and
demand
Supply: Q = –4.5 + 16P
Demand: Q = 13.5 – 8P
Setting them equal will give us
equilibrium price and quantity with
which we began
Chapter 2
Predicting the Effects of
Changing Market Conditions
Price
Supply: QS = -4.5 + 16P
a/b
.75
Demand: QD = 13.5 - 8P
-c/d
7.5
Chapter 2
Mmt/yr
Predicting the Effects of
Changing Market Conditions
We have written supply and demand so
that they only depend upon price
Demand could also depend upon other
variables such as income
Demand would then be written as:
Q  a  bP  fI
Chapter 2
Predicting the Effects of
Changing Market Conditions
We know the following information
regarding the copper industry:





I = 1.0
P* = 0.75
Q* = 7.5
b=8
Income elasticity: EI= 1.3
Chapter 2
Predicting the Effects of
Changing Market Conditions
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
Chapter 2
Declining Demand and the
Behavior of Copper Prices
Copper has gone through difficult
market changes leading the significantly
reduced prices most from decreased
demand from


A decrease in the growth rate of power
generation
The development of substitutes: fiber
optics and aluminum
Chapter 2
Real versus Nominal
Prices of Copper 1965 - 2002
Chapter 2
Declining Demand and the
Behavior of Copper Prices
Given producers’ concerns about
further declines in demand, we can
calculate by how much prices will fall
with future declines in demand
Assume that demand will fall by 20%


What is the resulting decrease in price?
Demand curve will shift to left by 20%
Chapter 2
Declining Demand and the
Behavior of Copper Prices
We want to consider 80% of the past
demand
Q = (0.80)(13.5 - 8P)
Q = 10.8 - 6.4P
Recall the equation for supply:
Q = -4.5 + 16P
Chapter 2
Declining Demand and the
Behavior of Copper Prices
Setting supply equal to demand:
-4.5 + 16P = 10.8 - 6.4P
-16P + 6.4P = 10.8 + 4.5
P = 15.3/22.4
P = 68.3 cents/pound
A decline in demand of 20% will lead to
a drop in price about 7%
Chapter 2
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
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
Shortage
QS
Q0
Chapter 2
D
QD Quantity
Effects of Price Controls
Excess demand sometimes takes the
form of lines (queues)

Lines at gas stations during 1974 shortage
Sometimes get curtailments and supply
rationing

Natural gas shortage of the mid 1970s
Producers typically lose, but some
consumers gain. Some consumers lose.
Chapter 2
Price Controls and
Natural Gas Shortages
In 1954, the federal government began
regulating the wellhead price of natural
gas
In 1962, the ceiling prices that were
imposed became binding and shortages
resulted
Chapter 2