1. Supply and Demand: How Markets Work
Chapter 8
Supply and Demand: How Markets Work

2. Market Exchange
An enormous amount of activity is conducted through an interesting human invention: the market
In fact, the definition of concepts such as the GDP of an economy is output that is produced but exchanged through markets.
A lot of production takes place outside this form of organization (consider your home)

3. Different kinds of markets
There are ways in which markets differ, but a very important way is in the number of buyers and sellers in a market
Competitive markets consist of many potential buyers and sellers, each acting independently, with no one participant having enough power to dictate terms to any other

4. Types of Markets One firm = 2-12 firms many firms many, many firms
Monopoly Oligopoly Monopolistic Perfect
Competition Competition

5. What happens on a market
A market exchange is a transfer of title to a piece of property (a good or a service) to another party in return for some form of payment on mutually accepted terms. It is mostly a voluntary action
The term market refers to the buying and selling activities of all those who want to trade (buy or sell) a particular good or service

6. What gets determined on markets
Markets work to determine two basic economic outcomes: the price at which a good or service is exchanged and the quantity of it that will be bought and sold.
Alternative ways to do this?

7. A demand curve
A demand curve is a graphical representation of the buyers' side of the market. It shows how much of a particular commodity the demanders of this product will want to purchase at each possible price, given their taste for the product and the amount of money they have at their disposal and other such factors which determines demand.
Demand refers to ability to purchase. Not need or desire.

8. DEMAND
Quantity demanded is the amount of a good that buyers are willing and able to purchase.
Law of Demand
The law of demand states that, other things equal, the quantity demanded of a good falls when the price of the good rises. 8

9. The Demand Curve: The Relationship between Price and Quantity Demanded
Demand Schedule
The demand schedule is a table that shows the relationship between the price of the good and the quantity demanded. 17

10. Demand Schedule 17

11. The Demand Curve: The Relationship between Price and Quantity Demanded
The demand curve is a graph of the relationship between the price of a good and the quantity demanded. 17

12. Demand Schedule and Demand Curve
Price of
Ice-Cream Cone
$3.00
2.50
1. A decrease
in price
...
2.00
1.50
1.00
0.50 1 2 3 4 5 6 7 8 9 10 11 12
Quantity of 2.
...
increases quantity
of cones demanded.
Ice-Cream Cones
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13. Market Demand versus Individual Demand
Market demand refers to the sum of all individual demands for a particular good or service.
Graphically, individual demand curves are summed horizontally to obtain the market demand curve.
Sum up individual demand curves.
Assume A wants 2 cones at $10 and A wants 1 cone at $20, B wants and $20. Total market demand is 5 cones at $10, 3
Demand curves are usually downward sloping (why only usually?)

14. Shifts in the Demand Curve
Change in Quantity Demanded
Movement along the demand curve.
Caused by a change in the price of the product. 19

15. Changes in Quantity Demanded
Price of Ice-Cream Cones
A tax that raises the price of ice-cream cones results in a movement along the demand curve. B
$2.00 A
1.00 D 4 8
Quantity of Ice-Cream Cones

16. Shifts in the Demand Curve
Consumer income
Prices of related goods
Tastes
Expectations
Number of buyers 11

17. Shifts in the Demand Curve
Change in Demand
A shift in the demand curve, either to the left or right.
Caused by any change that alters the quantity demanded at every price. 19

18. Figure 3 Shifts in the Demand Curve
Price of
Ice-Cream
Cone
Increase
in demand
Decrease
in demand
Demand
curve, D 2
Demand
curve, D 1
Demand curve, D 3
Quantity of
Ice-Cream Cones
Copyright©2003 Southwestern/Thomson Learning

19. Shifts in the Demand Curve
Consumer Income
As income increases the demand for a normal good will increase.
As income increases the demand for an inferior good will decrease.

20. Consumer Income Normal Good
Price of Ice-Cream Cone
$3.00
An increase in income...
2.50
Increase
in demand
2.00
1.50
1.00
0.50 D2 D1
Quantity of Ice-Cream Cones 1 2 3 4 5 6 7 8 9 10 11 12

21. Consumer Income Inferior Good
Price of Mac and Cheese
$3.00
2.50
An increase in income...
2.00
Decrease
in demand
1.50
1.00
0.50 D2 D1
Quantity of Mac and Cheese 1 2 3 4 5 6 7 8 9 10 11 12

22. Shifts in the Demand Curve
Prices of Related Goods
When a fall in the price of one good reduces the demand for another good, the two goods are called substitutes.
When a fall in the price of one good increases the demand for another good, the two goods are called complements.

23. Variables That Influence Buyers
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24. SUPPLY
Quantity supplied is the amount of a good that sellers are willing and able to sell.
Law of Supply
The law of supply states that, other things equal, the quantity supplied of a good rises when the price of the good rises. 25

25. The Supply Curve: The Relationship between Price and Quantity Supplied
Supply Schedule
The supply schedule is a table that shows the relationship between the price of the good and the quantity supplied. 29

26. Supply Schedule
Supplied 29

27. The Supply Curve: The Relationship between Price and Quantity Supplied
The supply curve is the graph of the relationship between the price of a good and the quantity supplied. 29

28. Supply Schedule and Supply Curve
Price of
Ice-Cream
Cone
$3.00
2.50
1. An
increase
in price
...
2.00
1.50
1.00
0.50 1 2 3 4 5 6 7 8 9 10 11 12
Quantity of
Ice-Cream Cones 2.
...
increases quantity of cones supplied.
Copyright©2003 Southwestern/Thomson Learning

29. Market Supply versus Individual Supply
Market supply refers to the sum of all individual supplies for all sellers of a particular good or service.
Graphically, individual supply curves are summed horizontally to obtain the market supply curve.

30. Shifts in the Supply Curve
Input prices
Technology
Expectations
Number of sellers 27

31. Shifts in the Supply Curve
Change in Quantity Supplied
Movement along the supply curve.
Caused by a change in anything that alters the quantity supplied at each price. 30

32. Perfectly Competitive Firm’s Supply Curve
The perfectly competitive firm’s supply curve is its Marginal Cost Curve.
Marginal Cost=Cost of Producing one more unit of a good.
Why?
At every point along a market supply curve
If price>marginal cost, a supplier would produce . If price< marginal Cost, firm would not produce.
Thus P=MC in a competitive market.

33. Change in Quantity Supplied
Price of Ice-Cream Cone S C
$3.00
A rise in the price of Ice Cream cones results in a movement along the supply curve. A
1.00
Quantity of Ice-Cream Cones 1 5 30

34. Shifts in the Supply Curve
Change in Supply
A shift in the supply curve, either to the left or right.
Caused by a change in a determinant other than price. 30

35. Shifts in the Supply Curve
Price of
Supply curve, S 3
Ice-Cream
curve,
Supply S 1
Cone
Supply
curve, S 2
Decrease
in supply
Increase
in supply
Quantity of
Ice-Cream Cones
Copyright©2003 Southwestern/Thomson Learning

36. Variables That Influence Sellers
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37. SUPPLY AND DEMAND TOGETHER
Equilibrium refers to a situation in which the price has reached the level where quantity supplied equals quantity demanded. 36

38. SUPPLY AND DEMAND TOGETHER
Equilibrium Price
The price that balances quantity supplied and quantity demanded.
On a graph, it is the price at which the supply and demand curves intersect.
Equilibrium Quantity
The quantity supplied and the quantity demanded at the equilibrium price.
On a graph it is the quantity at which the supply and demand curves intersect. 36

39. SUPPLY AND DEMAND TOGETHER
Demand Schedule
Supply Schedule
At $2.00, the quantity demanded is equal to the quantity supplied! 36

40. Figure 8 The Equilibrium of Supply and Demand
Price of
Ice-Cream
Cone
Supply
Demand
Equilibrium
Equilibrium price
$2.00
Equilibrium
quantity 1 2 3 4 5 6 7 8 9 10 11 12 13
Quantity of Ice-Cream Cones
Copyright©2003 Southwestern/Thomson Learning

41. Markets Not in Equilibrium
(a) Excess Supply
Price of
Ice-Cream
Supply
Cone
Surplus
Demand
$2.50 10 4
2.00 7
Quantity of
Quantity
demanded
Quantity
supplied
Ice-Cream
Cones
Copyright©2003 Southwestern/Thomson Learning

42. Equilibrium
Surplus
When price > equilibrium price, then quantity supplied > quantity demanded.
There is excess supply or a surplus.
Suppliers will lower the price to increase sales, thereby moving toward equilibrium.

43. Equilibrium
Shortage
When price < equilibrium price, then quantity demanded > the quantity supplied.
There is excess demand or a shortage.
Suppliers will raise the price due to too many buyers chasing too few goods, thereby moving toward equilibrium.

44. Markets Not in Equilibrium
(b) Excess Demand
Price of
Ice-Cream
Supply
Cone
Demand
$2.00 7
1.50 10 4
Shortage
Quantity of
Quantity
supplied
Quantity
demanded
Ice-Cream
Cones
Copyright©2003 Southwestern/Thomson Learning

45. Equilibrium Law of supply and demand
The claim that the price of any good adjusts to bring the quantity supplied and the quantity demanded for that good into balance.

46. Three Steps to Analyzing Changes in Equilibrium
Decide whether the event shifts the supply or demand curve (or both).
Decide whether the curve(s) shift(s) to the left or to the right.
Use the supply-and-demand diagram to see how the shift affects equilibrium price and quantity. 45

47. How an Increase in Demand Affects the Equilibrium
Price of
Ice-Cream
1. Hot weather increases
the demand for Ice Cream
Cone D D
Supply
New equilibrium
$2.50 10
resulting
in a higher
price . . .
2.00 7
Initial
equilibrium
Quantity of 3.
. . .
and a higher
quantity sold.
Ice-Cream Cones
Copyright©2003 Southwestern/Thomson Learning

48. How a Decrease in Supply Affects the Equilibrium
Price of
1. An increase in the
price of sugar reduces
the supply of Ice Cream. . .
Ice-Cream
Cone S2 S1
Demand
New
equilibrium
$2.50 4
resulting
in a higher
price of ice
cream . . .
Initial equilibrium
2.00 7
Quantity of 3.
. . .
and a lower
quantity sold.
Ice-Cream Cones
Copyright©2003 Southwestern/Thomson Learning

49. What Happens to Price and Quantity When Supply or Demand Shifts?
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50. Price, Income and Cross Elasticity

51. Elasticity – the concept
The responsiveness of one variable to changes in another
When price rises, what happens to demand?
Demand falls
BUT!
How much does demand fall?

52. Elasticity – the concept
If price rises by 10% - what happens to demand?
We know demand will fall
By more than 10%?
By less than 10%?
Elasticity measures the extent to which demand will change

53. Elasticity 4 basic types used: Price elasticity of demand
Price elasticity of supply
Income elasticity of demand
Cross elasticity

54. Elasticity Price Elasticity of Demand
The responsiveness of demand to changes in price
Where % change in demand is greater than % change in price – elastic
Where % change in demand is less than % change in price - inelastic

55. Elasticity The Formula: % Change in Quantity Demanded
___________________________
Ped =
% Change in Price
If answer is between 0 and -1: the relationship is inelastic
If the answer is between -1 and infinity: the relationship is elastic
Note: PED has – sign in front of it; because as price rises
demand falls and vice-versa (inverse relationship between
price and demand)

56. Elasticity Price (£) Quantity Demanded
The demand curve can be a range of shapes each of which is associated with a different relationship between price and the quantity demanded.
Quantity Demanded

57. Elasticity Total Revenue Price $5 D 100 Quantity Demanded (000s)
Total revenue is price x quantity sold. In this example, TR = $5 x 100,000 = $500,000.
This value is represented by the grey shaded rectangle.
The importance of elasticity is the information it provides on the effect on total revenue of changes in price. $5
Total Revenue D
100
Quantity Demanded (000s)

58. Elasticity D Total Revenue Price $5 $3 100 140
If the firm decides to decrease price to (say) $3, the degree of price elasticity of the demand curve would determine the extent of the increase in demand and the change therefore in total revenue. $5 $3
Total Revenue D
100
140
Quantity Demanded (000s)

59. Elasticity % Δ Price = -50% % Δ Quantity Demanded = +20%
Producer decides to lower price to attract sales 10
% Δ Price = -50%
% Δ Quantity Demanded = +20%
Ped = -0.4 (Inelastic)
Total Revenue would fall 5
Not a good move! D 5 6
Quantity Demanded

60. Elasticity Producer decides to reduce price to increase sales
% Δ in Price = - 30%
% Δ in Demand = + 300%
Ped = - 10 (Elastic)
Total Revenue rises 10
Good Move! 7 D 5 20
Quantity Demanded

61. Elasticity If demand is price elastic:
Increasing price would reduce TR (%Δ Qd > % Δ P)
Reducing price would increase TR
(%Δ Qd > % Δ P)
If demand is price inelastic:
Increasing price would increase TR
(%Δ Qd < % Δ P)
Reducing price would reduce TR (%Δ Qd < % Δ P)

62. Elasticity Income Elasticity of Demand:
The responsiveness of demand to changes in incomes
Normal Good – demand rises as income rises and vice versa
Inferior Good – demand falls as income rises and vice versa

63. Estimated Price Elasticities of Demand for Various Goods and Services
Inelastic
Salt
0.1
Coffee
0.25
Fish (cod) consumed at home
0.5
Tobacco products, short-run
0.45
Physician services
0.6
Approximately Unitary Elasticity
Movies
0.9
Housing, owner occupied, long-run
1.2
Elastic
Restaurant meals
2.3
Foreign travel, long-run
4.0
Chevrolet automobiles
Fresh tomatoes
4.6

64. Elasticity Income Elasticity of Demand:
A positive sign denotes a normal good
A negative sign denotes an inferior good

65. Elasticity For example:
Yed = - 0.6: Good is an inferior good but inelastic – a rise in income of 3% would lead to demand falling by 1.8%
Yed = + 0.4: Good is a normal good but inelastic – a rise in incomes of 3% would lead to demand rising by 1.2%
Yed = + 1.6: Good is a normal good and elastic – a rise in incomes of 3% would lead to demand rising by 4.8%
Yed = - 2.1: Good is an inferior good and elastic – a rise in incomes of 3% would lead to a fall in demand of 6.3%

66. Determinants of Elasticity
Time period – the longer the time under consideration the more elastic a good is likely to be
Number and closeness of substitutes – the greater the number of substitutes, the more elastic
The proportion of income taken up by the product – the smaller the proportion the more inelastic
Luxury or Necessity - for example, addictive drugs

67. Importance of Elasticity
Relationship between changes in price and total revenue
Importance in determining what goods to tax (tax revenue)
Influences the behaviour of a firm