1. SUPPLY AND DEMAND: HOW MARKETS WORK
Chapter 2
SUPPLY AND DEMAND: HOW MARKETS WORK

2. SUPPLY AND DEMAND
Supply and demand are the two words that economists use most often.
Supply and demand are the forces that make market economies work.
Modern microeconomics is about supply, demand, and market equilibrium. 2

3. MARKETS AND COMPETITION
A market is a group of buyers and sellers of a particular good or service. 4

4. MARKETS AND COMPETITION
Buyers determine demand.
Sellers determine supply 4

5. WHAT IS DEMAND? If I desire a Porsche but don’t have the money to
buy it, is it “demand”?

6. WHAT IS DEMAND? Demand is when a person is WILLING and ABLE
to buy a good or service.

7. Demand
The demand schedule is a table that shows the relationship between the price of the good and the quantity demanded in a given time period when all factors other than the product's price remain unchanged.
Individual demand is the demand of just one consumer, while the market demand for a product is the total demand for a product from all its consumers. 17

8. Example: Catherine’s Demand Schedule17

9. The Demand Curve Demand Curve
The demand curve is a graph of the relationship between the price of a good and the quantity demanded.
Quantity demanded is the amount of a good that buyers are willing and able to purchase. 17

10. Figure 1 Catherine’s 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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11. 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.

12. EXERCISE: INDIVIDUAL & MARKET DEMAND
The Ice Cream Café is selling ice cream cones at different prices.
How many ice cream cones would
you be prepared to buy in a week at different prices?
How many would your friends buy?
Fill in the table and graph the information in your demand schedule for ice cream cones.

13. 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 and vice versa; therefore, there exists an inverse relationship between quantity demanded and price. 8

14. THE SUBSTITUTION EFFECT AND INCOME EFFECT
Why do people buy more quantity of a good when
its price falls and vice versa?
INCOME EFFECT If the price of a good, e.g., Pepsi
Falls then consumers have more purchasing power so they can buy more Pepsi and more of other goods.
SUBSTITUTION EFFECT If the price of a good
e.g. Pepsi Falls then consumers will
Substitute the now cheaper product ,Pepsi,
for other goods e.g. Coke.

15. Ceteris Paribus: Other things equal assumption
Economists use the “ceteris paribus”, all other factors held constant, assumption when making generalizations. Only the variable that is under consideration is changed while all other variables are held constant.
For example, the number of cars bought in a year is determined by the price of cars, consumer incomes, gas prices, price of substitutes (i.e. public transport), etc. In order to analyze the effect that a change in the price of gas has on car sales, all other factors that may affect car sales are held constant and only the price of gas is changed.

16. Changes in Quantity Demanded
Price of Ice-Cream Cones
A change in 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

17. 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

18. Shifts in Demand Curve caused by Non-Price Determinates of Demand
A change in demand is a SHIFT in the demand curve, either to the left or right caused by any change that changes quantity demanded at every price.
Fill in the blanks for the exercise when Ice Cream Café increases its advertising.

19. Non-Price determinants of Demand cause Shifts in the Demand Curve
Consumer income
Changes in population/ number of buyers
Prices of related goods
Tastes and fashion
Advertising
Expectations about future prices
Note: When we draw the demand curve we assume
these non-price determinates are held
constant. 11

20. 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 changes the quantity demanded at every price.
Non-price Determinants of Demand cause Shifts in the Demand Curve/A Change in Demand. 19

21. 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
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22. Consumer Income
As income increases the demand for a normal good will increase.
As income increases the demand for an inferior good will decrease. Examples of inferior goods include second hand clothing and public transportation.

23. 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

24. Consumer Income Inferior Good
Price of Public Transport
$3.00
2.50
An increase in income...
2.00
Decrease
in demand
1.50
1.00
.50 D2 D1
Quantity of Public Transport 1 2 3 4 5 6 7 8 9 10 11 12

25. 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. For example an increase in the price of margarine will lead to an increase in the demand for butter.
When a fall in the price of one good increases the demand for another good, the two goods are called complements.

26. Variables That Influence Buyers
A CHANGE IN THIS VARIABLE WILL CAUSE
Consumer income
Change in demand (shift in D curve)
Price of a substitute
Advertising
Price
Change in Quantity Demanded (Movement)
Change in population
Price of a complement
Tastes
Expectations
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27. 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, as price rises the quantity supplied rises when the price of the good rises. 25

28. The Supply Curve: The Relationship Supply ice and Quantity Supplied
Supply shows the amount of a good that producers are willing and able to supply at different prices.
The supply curve is the graph of the relationship between the price of a good and the quantity supplied.
The supply schedule is a table that shows the relationship between the price of a good and the quantity supplied. 29

29. Price of Ice-Cream Cones ($) Quantity of Ice-Cream Cones Supplied
Ben's Supply Schedule
Price of Ice-Cream Cones ($)
Quantity of Ice-Cream Cones Supplied
$0.00
$0.50
$1.00 1
$1.50 2
$2.00 3
$3.00 5 29

30. Figure 5 Ben’s 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

31. The Law of Supply
The Law of Supply states that as price rises the quantity SUPPLIED falls and vice versa
There exists a positive relationship between quantity supplied and price.

32. 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.

33. Non-Price determinates of Supply
Input prices/Cost of Production/Price of Factors of Production (eg. Wages, oil prices, prices of raw materials, etc)
Technology
Expectations about future sales/economic situation (optimistic and pessimistic)
Taxes All taxes affect S except income taxes)
Number of sellers
Pollution Regulations
Weather
Change in Profitability
Subsidies 27

34. Exercise Complete Farmer Ahmed’s Crops exercise on the Portal.
Write the answer in your handout.

35. Movement along the Supply Curve
Change in Quantity Supplied
Movement along the supply curve.
Caused by a change Price. 30

36. 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

37. 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

38. Figure 7 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
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39. Table 2 Variables That Influence Sellers
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40. MARKET EQUILIBRIUM: SUPPLY & DEMAND
Equilibrium refers to a situation in which the price has reached the level where quantity supplied equals quantity demanded. 36

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

42. 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

43. Figure 9 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

44. 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.

45. 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.

46. Figure 9 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

47. Events that affect demand and/or supply
Economists use the model of supply and demand to analyze competitive markets.
In a competitive market, there are many buyers and sellers, each of whom has little or no influence on the market price.

48. 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

49. Figure 10 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

50. Figure 11 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

51. Table 4 What Happens to Price and Quantity When Supply or Demand Shifts?
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52. Price Ceiling and Price Floors
Complete the exercises to learn about price floors and price ceilings.

53. Summary Demand
The demand curve shows how the quantity of a good depends upon the price.
According to the law of demand, as the price of a good falls, the quantity demanded rises. Therefore, the demand curve slopes downward.
In addition to price, other determinants of how much consumers want to buy include income, the prices of complements and substitutes, tastes, expectations, and the number of buyers.
If one of these factors changes, the demand curve shifts.

54. Summary Supply
The supply curve shows how the quantity of a good supplied depends upon the price.
According to the law of supply, as the price of a good rises, the quantity supplied rises. Therefore, the supply curve slopes upward.
In addition to price, other determinants of how much producers want to sell include input prices, technology, expectations, and the number of sellers.
If one of these factors changes, the supply curve shifts.

55. Summary Market Equilibrium
Market equilibrium is determined by the intersection of the supply and demand curves.
At the equilibrium price, the quantity demanded equals the quantity supplied.
The behavior of buyers and sellers naturally drives markets toward their equilibrium.

56. Summary Market Equilibrium
To analyze how any event influences a market, we use the supply-and-demand diagram to examine how the event affects the equilibrium price and quantity.
In market economies, prices are the signals that guide economic decisions and thereby allocate resources.

57. Review Exercises
Complete all exercises