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CHAPTER
The Market Forces of
Supply and Demand
Economics
PRINCIPLES OF
N. Gregory Mankiw
© 2009 South-Western, a part of Cengage Learning, all rights reserved
In this chapter,
look for the answers to these questions:
 What factors affect buyers’ demand for goods?
 What factors affect sellers’ supply of goods?
 How do supply and demand determine the price of
a good and the quantity sold?
 How do changes in the factors that affect demand
or supply affect the market price and quantity of a
good?
 How do markets allocate resources?
1
Demand
 The quantity demanded of any good is the
amount of the good that buyers are willing and
able to purchase.
 Law of demand: the claim that the quantity
demanded of a good falls when the price of the
good rises, other things equal
THE MARKET FORCES OF SUPPLY AND DEMAND
2
The Market Demand Curve for Lattes
P
Qd
(Market)
$0.00
24
$5.00
1.00
21
$4.00
2.00
18
3.00
15
4.00
12
5.00
9
6.00
6
P
$6.00
$3.00
$2.00
$1.00
$0.00
Q
0
5
10
15
20
25
THE MARKET FORCES OF SUPPLY AND DEMAND
3
Demand Curve Shifters
 The demand curve shows how price affects
quantity demanded, other things being equal.
 These “other things” are non-price determinants
of demand (i.e., things that determine buyers’
demand for a good, other than the good’s price).
 Changes in them shift the D curve…
P
$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
THE MARKET FORCES OF SUPPLY AND DEMAND
0
5
10
15
20
25
30
Q
4
Summary: Variables That Influence Buyers
Variable
A change in this variable…
Price
…causes a movement
along the D curve
# of buyers
…shifts the D curve
Income
…shifts the D curve
Price of
related goods
…shifts the D curve
Tastes
…shifts the D curve
Expectations
…shifts the D curve
THE MARKET FORCES OF SUPPLY AND DEMAND
5
ACTIVE LEARNING
Demand Curve
1
Draw a demand curve for music downloads.
What happens to it in each of
the following scenarios? Why?
A. The price of iPods
falls
B. The price of music
downloads falls
C. The price of CDs falls
6
Supply
 The quantity supplied of any good is the
amount that sellers are willing and able to sell.
 Law of supply: the claim that the quantity
supplied of a good rises when the price of the
good rises, other things equal
THE MARKET FORCES OF SUPPLY AND DEMAND
7
The Market Supply Curve
P
QS
(Market)
$0.00
0
1.00
5
2.00
10
$4.00
3.00
15
$3.00
4.00
20
$2.00
5.00
25
6.00
30
P
$6.00
$5.00
$1.00
Q
$0.00
0
5
10 15
20 25 30
35
THE MARKET FORCES OF SUPPLY AND DEMAND
8
Supply Curve Shifters
 The supply curve shows how price affects
quantity supplied, other things being equal.
 These “other things” are non-price determinants
of supply.
 Changes in them shift the S curve…
$6.00
P
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
0
THE MARKET FORCES OF SUPPLY AND DEMAND
5
10
15
20
25
30
35
Q
9
Summary: Variables that Influence
Sellers
Variable
A change in this variable…
Price
…causes a movement
along the S curve
Input Prices
…shifts the S curve
Technology
…shifts the S curve
# of Sellers
…shifts the S curve
Expectations
…shifts the S curve
THE MARKET FORCES OF SUPPLY AND DEMAND
10
ACTIVE LEARNING
Supply Curve
2
Draw a supply curve for tax
return preparation software.
What happens to it in each
of the following scenarios?
A. Retailers cut the price of
the software.
B. A technological advance
allows the software to be
produced at lower cost.
C. Professional tax return preparers raise the
price of the services they provide.
11
Supply and Demand Together
P
$6.00
D
S
$5.00
$4.00
$3.00
Equilibrium:
P has reached
the level where
quantity supplied
equals
quantity demanded
$2.00
$1.00
$0.00
Q
0
5
10 15 20 25 30 35
THE MARKET FORCES OF SUPPLY AND DEMAND
12
Surplus (a.k.a. excess supply):
when quantity supplied is greater than
quantity demanded
P
$6.00
D
Surplus
S
$5.00
Example:
If P = $5,
then
QD = 9 lattes
$4.00
and
QS = 25 lattes
$3.00
$2.00
resulting in a
surplus of 16 lattes
$1.00
$0.00
Q
0
5
10 15 20 25 30 35
THE MARKET FORCES OF SUPPLY AND DEMAND
13
Surplus (a.k.a. excess supply):
when quantity supplied is greater than
quantity demanded
P
$6.00
D
$5.00
$4.00
Surplus
S
Facing a surplus,
sellers try to increase
sales by cutting price.
This causes
QD to rise and QS to fall…
$3.00
…which reduces the
surplus.
$2.00
$1.00
$0.00
Q
0
5
10 15 20 25 30 35
THE MARKET FORCES OF SUPPLY AND DEMAND
14
Surplus (a.k.a. excess supply):
when quantity supplied is greater than
quantity demanded
P
$6.00
D
$5.00
$4.00
Surplus
S
Facing a surplus,
sellers try to increase
sales by cutting price.
This causes
QD to rise and QS to fall.
$3.00
Prices continue to fall
until market reaches
equilibrium.
$2.00
$1.00
$0.00
Q
0
5
10 15 20 25 30 35
THE MARKET FORCES OF SUPPLY AND DEMAND
15
A Shift in Supply
EXAMPLE 2:
EVENT: New technology
reduces cost of
producing hybrid cars.
P
S1
S2
STEP 1:
S curve shifts
because
STEP 2: event affects
cost of production.
S shifts right
D
curve does
not shift,
because
event
STEP 3: production
because
reduces cost,
The shift causes
technology
is not one
makes production
price
to
fall that
of
the
factors
more profitable at
and quantity
to rise.
affect
demand.
any given price.
P1
P2
D1
Q
Q1 Q2
THE MARKET FORCES OF SUPPLY AND DEMAND
16
EXAMPLE 3:
A Shift in Both Supply
and Demand
EVENTS:
price of gas rises AND
new technology reduces
production costs
STEP 1:
P2
Both curves shift.
P
P
S1
S2
1
STEP 2:
Both shift to the right.
STEP 3:
Q rises, but effect
on P is ambiguous:
If demand increases more
than supply, P rises.
D1
D2
Q
Q1
THE MARKET FORCES OF SUPPLY AND DEMAND
Q2
17
EXAMPLE 3:
EVENTS:
price of gas rises AND
new technology reduces
production costs
STEP 3, cont.
But if supply
increases more
than demand,
P falls.
A Shift in Both Supply
and Demand
P
S1
S2
P1
P2
D1
D2
Q
Q1
Q2
18
Elasticity
 Basic idea:
Elasticity measures how much one variable
responds to changes in another variable.
 One type of elasticity measures how much
demand for your websites will fall if you raise
your price.
 Price elasticity of demand measures how
much Qd responds to a change in P.
 Price elasticity of supply measures how much
Qs responds to a change in P.
19
Price Elasticity of Demand
Price elasticity
of demand
Example:
Price elasticity
of demand
equals
15%
= 1.5
10%
Percentage change in Qd
=
Percentage change in P
P
P rises
P2
by 10%
P1
D
Q2
Q1
Q
Q falls
by 15%
20
The Determinants of Price Elasticity:
A Summary
The price elasticity of demand depends on:
 the extent to which close substitutes are
available
 whether the good is a necessity or a luxury
 how broadly or narrowly the good is defined
 the time horizon – elasticity is higher in the
long run than the short run
21
Price Elasticity of Supply
Price elasticity
of supply
Percentage change in Qs
=
Percentage change in P
P
Example:
Price
elasticity
of supply
equals
S
P rises
P2
by 8%
P1
16%
= 2.0
8%
ELASTICITY AND ITS APPLICATION
Q1
Q2
Q
Q rises
by 16%
22
The Determinants of Supply Elasticity
 The more easily sellers can change the quantity
they produce, the greater the price elasticity of
supply.
 Example: Supply of beachfront property is
harder to vary and thus less elastic than
supply of new cars.
 For many goods, price elasticity of supply
is greater in the long run than in the short run,
because firms can build new factories,
or new firms may be able to enter the market.
ELASTICITY AND ITS APPLICATION
23
The Variety of Curves
 The price elasticity of demand/supply is closely
related to the slope of the demand/supply curve.
 Rule of thumb:
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the elasticity.
24
APPLICATION: Does Drug Interdiction
Increase or Decrease Drug-Related Crime?
 One side effect of illegal drug use is crime:
Users often turn to crime to finance their habit.
 We examine two policies designed to reduce
illegal drug use and see what effects they have
on drug-related crime.
 For simplicity, we assume the total dollar value
of drug-related crime equals total expenditure
on drugs.
 Demand for illegal drugs is inelastic, due to
addiction issues.
25
Policy 1: Interdiction
Interdiction
reduces
the supply
of drugs.
Since demand
for drugs is
inelastic,
P rises proportionally more
than Q falls.
Price of
Drugs
new value of drugrelated crime
D1
S2
S1
P2
initial value of
drug-related
crime
P1
Result: an increase in
total spending on drugs,
and in drug-related crime
ELASTICITY AND ITS APPLICATION
Q2 Q1
Quantity
of Drugs
26
Policy 2: Education
Education
reduces the
demand for
drugs.
Price of
Drugs
new value of drugrelated crime
D2
D1
S
P and Q fall.
initial value of
drug-related
crime
P1
Result:
A decrease in
total spending
on drugs, and
in drug-related
crime.
P2
Q2
Q1
Quantity
of Drugs
27