1. The Basics of Supply and Demand
Chapter 2
The Basics of Supply and Demand

2. 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?
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3. Supply and Demand Supply and demand analysis can:
Help us understand and predict how economic conditions affect market price
Analyze the impact of government price controls, minimum wages, and price supports
Determine how taxes, subsidies, tariffs and import quotas affect consumers and producers
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4. 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
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5. The supply curve slopes upward demonstrating that
Price
($ per unit)
The Supply
Curve Graphically P2 Q2
The supply curve slopes
upward demonstrating that
at higher prices firms
will increase output P1 Q1
Quantity
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6. 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
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7. Change in Supply The cost of raw materials falls
Produced Q1 at P1 and Q0 at P2
Now produce Q2 at P1 and Q1 at P2
Supply curve shifts right to S’ P S S’ Q2 P1 P2 Q1 Q0 Q
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8. The Supply Curve Change in Quantity Supplied Change in Supply
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 price
Change in costs of production
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9. 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
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10. The Demand Curve P2 P1 D Q1 Q2 Quantity 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 Q1 P1 Q2
Quantity
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11. The Demand Curve Other Variables Affecting Demand Income
Consumer Tastes
Price of Related Goods
Substitutes
Complements
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12. Change in Demand Income Increases Purchased Q0, at P2 and Q1 at P1
Now purchased Q1 at P2 and Q2 at P1
Same for all prices
Demand Curve shifts right P Q D’ Q1 P2 Q0 P1 Q2
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13. The Demand Curve Changes in quantity demanded Changes in demand
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
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14. 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
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15. The Market Mechanism S P0 D Q0 Price ($ per unit)
Quantity
Price
($ per unit) D
The curves intersect at
equilibrium, or market-
clearing, price.
Quantity demanded equals quantity supplied at P0 P0 Q0
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16. 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 wished to buy at the current price can and all producers who wish to sell at that price can
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17. 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
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18. The Market Mechanism S Surplus P1 P0 D QD Q0 QS Price ($ per unit)
Quantity
Price
($ per unit) D S
Price is above the market clearing price – P1
Qs > QD
Price falls to the market-clearing price
Market adjusts to equilibrium
Surplus P1 QD QS P0 Q0
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19. The Market Mechanism The market price is below equilibrium:
There is a excess demand - shortage
Upward pressure on prices
Quantity demanded decreases and quantity supplied increases
The market adjusts until the new equilibrium is reached.
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20. The Market Mechanism S D Q3 P3 P2 QS Shortage QD Price ($ per unit)
Quantity
Price
($ per unit) S D
Price is below the market clearing price – P2
QD > QS
Price rises to the market-clearing price
Market adjusts to equilibrium Q3 P3 P2 QS
Shortage QD
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21. 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.
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22. Changes In Market Equilibrium
Equilibrium prices are determined by the relative level of supply and demand.
Changes in supply and/or demand will change in the equilibrium price and/or quantity in a free market.
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23. Changes In Market EquilibriumD
Raw material prices fall
S shifts to S’
Surplus at P1 between Q1, Q2
Price adjusts to equilibrium at P3, Q3 P Q S S’ Q1 P1 Q2 P3 Q3
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24. Changes In Market EquilibriumD D’ P Q S
Income Increases
Demand increases to D1
Shortage at P1 of Q1, Q2
Equilibrium at P3, Q3 Q3 P3 Q1 P1 Q2
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25. Changes In Market EquilibriumD
Income Increases & raw material prices fall
Quantity increases
If the increase in D is greater than the increase in S price also increases P Q S D’ S’ P2 Q2 P1 Q1
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26. Shifts in Supply and Demand
When supply and demand change simultaneously, the impact on the equilibrium price and quantity is determined by:
The relative size and direction of the change
The shape of the supply and demand models
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27. 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
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28. Market for a College Education
Q (millions enrolled)) P
(annual cost
in 1970
dollars)
S2002
D2002
New equilibrium
was reached at $4,573 and a quantity of 12.3 million students
D1970
$3,917
13.2
S1970
$2,530
8.6
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29. 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.
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30. 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.
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31. 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:
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32. 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
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33. Price Elasticity of Demand
The primary determinant of price elasticity of demand is the availability of substitutes.
Many substitutes demand is price elastic
Few substitutes demand is price inelastic
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34. Price Elasticity of Demand
Looking at a linear demand curve, as we move along the curve Q/P 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
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35. 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
The bottom portion of demand curve is inelastic
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36. Price Elasticity of DemandQ
Price 4 8 2
Ep = -1
Ep = 0
EP = -
Elastic
Demand Curve
Q = 8 – 2P
Inelastic
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37. Price Elasticity of Demand
The steeper the demand curve becomes, the more inelastic the good.
The flatter the demand curve becomes, the more elastic the good
Two extreme cases of demand curves
Completely inelastic demand – vertical
Infinitely elastic demand - horizontal
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38. Infinitely Elastic Demand
Quantity
Price
EP =  D P*
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39. Completely Inelastic Demand
Quantity
Price D
EP = 0 Q*
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40. Other Demand Elasticities
Income Elasticity of Demand
Measures how much quantity demanded changes with a change in income.
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41. 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.
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42. Other Demand Elasticities
Complements: Cars and Tires
Cross-price elasticity of demand is negative
Substitutes: Butter and Margarine
Cross-price elasticity of demand is positive
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43. 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.
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44. 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
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45. Effects of Price Controls
Quantity
Price S D
Price is regulated to be no higher than Pmax,
Quantity supplied falls and quantity demanded increases
A shortage results P0 Q0
Pmax QS QD
Shortage
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46. Effects of Price Controls
Excess demand sometimes takes the form of queues
Lines at gas stations during 1974 shortage
Sometimes get curtailments and supply rationing
Natural gas shortage of the mid ’70’s
Producers typically lose, but some consumers gain. Some consumers lose.
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