1. Lecture 3: Demand and Supply Text: Principles of Economics, Chapter 3
AAEC 2305 Shaikh M Rahman
Lecture 3: Demand and Supply
Text: Principles of Economics, Chapter 3

2. Learning Objectives
Describe how the demand and supply curves summarize the behavior of buyers and sellers in the marketplace.
Discuss how the supply and demand curves interact to determine equilibrium price and quantity.
Illustrate how shifts in supply and demand curves cause prices and quantities to change
Explain and apply the Efficiency Principle and the Equilibrium Principle (also called the “No-Cash-on-the-Table Principle”).

3. What, How, and For Whom?
Every society answers three basic questions

4. Central Planning versus the Market
Decisions by individuals or small groups
Agrarian societies
Government programs
Sets prices and goals for the group
Individual influence is limited
The Market
Buyers and sellers signal wants and costs
Resources and goods are allocated accordingly
Interaction of supply and demand answer the three basic questions
Mixed economies use both the market and central planning

5. Buyers and Sellers in the Market
The market for any good consists of all the buyers and sellers of the good
Buyers and sellers jointly determine outcome
Buyers and sellers have different motivations
Buyers want to benefit from the good
The buyer’s reservation price is the highest price an individual is willing to pay for a good
Sellers want to make a profit
Market price balances two forces
Value buyers derive from the good
Cost to produce one more unit of the good

6. Demand
Demand for a good refers to the different quantities buyers would purchase at different prices
Law of Demand
Consumers buy less at higher prices
Consumers buy more at lower prices
This behavior can be depicted graphically by a downward sloping curve – called the demand curve $4 $2 8 16 Q P D
Demand for Pizzas
(1000s of slices/day)

7. Quantity Demanded (cups)
Law of Demand
When price of a good goes up, people buy less of that good
Leads to downward sloping demand curve
Price ($/cup)
Quantity Demanded (cups)
0.50 5
0.75 4
1.00 3
1.25 2
1.50 1

8. Demand versus Quantity Demanded
Amount of a good consumed at a given price
Change in price means a change in quantity demanded
Movement along the demand curve
Demand
A family of numbers that lists the quantity demanded corresponding to each possible price
Demand Schedule
Demand Curve

9. Demand Schedule and Demand Curve
Demand Schedule - Refers to the demand table that shows quantity demanded at each price
Price ($/cup)
Quantity Demanded (cups)
0.50 5
0.75 4
1.00 3
1.25 2
1.50 1

10. Demand Schedule and Demand Curve
Demand Curve - Graph illustrating demand - Graphical representation of the demand schedule
Price on the vertical axis
Quantity demanded on the horizontal axis

11. Changes in Demand Income Price of related goods Taste Sales Tax
Price change does not lead to change in demand
Change in anything other than price lead to demand changes - Entire curve shifts
Income
Price of related goods
Substitutes
Complements
Taste
Sales Tax

12. Changes (Shift) in Demand
Fall in Demand
Decision made by demanders to buy a smaller quantity at each given price
Leftward shift of demand curve
Rise in Demand
Decision made by demanders to a buy a larger quantity at each given price
Rightward shift of demand curve

13. Changes (Shift) in Demand
Price change does not lead to change in demand
Factors that lead to demand changes - Entire curve shifts
Consumer’s income
Consumer’s taste (preference)
Price of related goods
Substitutes
Complements
Excise Tax

14. Market (Aggregate) Demand
Aggregate quantity of a good demanded by all consumers in a community (market) at each given price
Market Demand reflects the entire market, not one consumer
Lower prices bring more buyers into the market
Lower prices cause existing buyers to buy more
The aggregate or market demand is obtained by the horizontal summation of all individual consumer’s demand curves.
Similar to the individual demand curve - Slopes downward

15. Market (Aggregate) Demand
Suppose, there are 10,000 SB coffee consumers in Lubbock
Each individual consumer’s demand for SB coffee is the same
Price ($/cup)
Ind. Quantity (cups)
Ag. Quantity (cups)
0.50 5
50,000
0.75 4
40,000
1.00 3
30,000
1.25 2
20,000
1.50 1
10,000

16. Market Demand
The quantity buyers would purchase at each possible price
Market Demand curve
Negative slope
Consumers buy less at higher prices
Consumers buy more at lower prices $4 $2 8 16 Q P D
Demand for Pizzas
(000s of slices/day)

17. Interpreting the (Market) Demand Curve
Horizontal interpretation of demand
Given price, how much will buyers buy?
Vertical interpretation of demand
Given the quantity to be bought, what will the price be? $4 $2 8 16 Q P D
Demand for Pizzas
(000s of slices/day)

18. Income and Substitution Effects
Buyers buy more at lower prices and buy less at higher prices
What happens when price goes up?
The substitution effect - Buyers switch to substitutes when price goes up
The income effect - Buyers' overall purchasing power goes down
What happens when price goes down?
The substitution effect - Buyers switch from substitutes
The income effect - Buyers' overall purchasing power goes up

19. Supply
Supply of a good refers to the different quantities sellers would sell at different prices
Law of Supply
Seller sells more at higher prices
Seller sells less at lower prices
This behavior can be depicted graphically by a upward sloping curve – called the supply curve

20. Law of Supply
When the price of a good goes up, the quantity supplied goes up
Leads to a upward sloping supply curve
Price ($/cup)
Quantity (cups)
0.25
0.50
100
0.75
200
1.00
300
1.25
400
1.50
500

21. Supply versus Quantity Supplied
Amount of a good that suppliers will provide at a given price
Changes if the price changes
Movement along the curve
Supply
Family of numbers giving the quantities supplied at each price
Change in anything other than price changes supply
Shifts the entire curve

22. Changes (Shift) in Supply
Rise in Supply
Increase in quantities that supplier will provide at each price
Rightward shift of supply
Fall in Supply
Decrease in quantities that supplier will provide at each price
Leftward shift of supply

23. Changes (Shift) in Supply
Price change does not lead to change in supply
Factors that lead to supply changes - Entire curve shifts
Production costs
Improvement in production technology
Change in the wage rate
Weather condition
Excise Tax

24. Market (Aggregate) Supply
Aggregate quantity of a good supplied by all producers in a community (market) at each given price
The aggregate or market supply is obtained by the horizontal summation of all individual producer’s supply curves.
Similar to the individual producer’s supply curve – Market supply curve slopes upward

25. Market (Aggregate) Supply
Suppose, there are 10 Starbucks (SB) coffee sellers in Lubbock
Each individual seller’s supply for SB coffee is the same
Price ($/cup)
Ind. Quantity (cups)
Ag. Quantity (cups)
0.50
1,000
10,000
0.75
2,000
20,000
1.00
3,000
30,000
1.25
4,000
40,000
1.50
5,000
50,000

26. Interpreting the Market Supply Curve
Horizontal interpretation of supply
Given price, how much will suppliers offer?
Vertical interpretation of supply
Given the quantity to be sold, what will the price be?

27. Market Equilibrium
Equilibrium Point – The point where the market demand and supply curves intersect
Equilibrium Price – The price at which quantity demanded equals quantity supplied
Equilibrium Quantity – the quantity of the good that buyers and sellers exchange at the equilibrium price
Actual price and Quantity determined by interactions between demanders (consumers) and suppliers (sellers)
Buyers cannot purchase more than sellers willing to sell
Sellers cannot sell more than buyers willing to buy
Buyers and sellers both are satisfied
Able to behave as one wants to, taking market prices as given

28. Market Equilibrium for SB Coffee
Equilibrium price – $1.00 per cup
Equilibrium quantity – 30,000 cups per day
Price ($/cup)
Ag. Quantity Demanded
Ag. Quantity Supplied
0.50
50,000
10,000
0.75
40,000
20,000
1.00
30,000
1.25
1.50

29. Quantity supplied equals quantity demanded AND
Market Equilibrium
Quantity supplied equals quantity demanded AND
Price is on supply and demand curves
No tendency to change P or Q
Buyers are on their demand curve
Sellers are on their supply curve
Market for Pizzas P S $3 D Q 12
(000s of slices/day)

30. Excess Supply and Excess Demand
At $4, 16,000 slices supplied and 8,000 slices demanded
Excess Demand
At $2, 8,000 slices supplied 16,000 slices demanded
Market for Pizzas
Market for Pizzas P P
Surplus S S $4
Shortage $2 D D Q Q 8 16 8 16
(000s of slices/day)
(000s of slices/day)

31. Incentive Principle: Excess Supply at $4
Each supplier has an incentive to decrease the price in order to sell more
Lower prices decrease the surplus
As price decreases:
the quantity offered for sale decreases along the supply curve
the quantity demanded increases along the demand curve
Market for Pizzas P S $4
$3.50 $3
Equilibrium D Q 8 12 16
(000s of slices/day)

32. Incentive Principle: Excess Demand at $2
Each supplier has an incentive to increase the price in order to sell more
Higher prices decrease the shortage
As price increases
the quantity offered for sale increases along the supply curve
As price increases, the quantity demanded decreases along the demand curve.
Market for Pizzas P S $3
Equilibrium
$2.50 $2 D Q 8 12 16
(000s of slices/day)

33. Rent Controls Are Price Ceilings
Rent controls set a maximum price that can be charged for a given apartment
If the controlled price is below equilibrium, then
Quantity demanded increases and
Quantity supplied decreases
A shortage results
Market for NYC Apartments P S
$1,600
$800 D Q 1 2 3
(millions of apartments/day)

34. Changes in the Equilibrium Point
The only way that anything can affect the equilibrium price and quantity is by causing a shift in either the supply curve or the demand curve
Never look at price and quantity
Look at the effect of the change has on demand curve and/or supply curve
The factors that shifts the demand and supply curves affect the equilibrium price and quantity

35. The Effects of Supply and Demand Shifts

36. Movement along the (market) Demand Curve
When price goes up, quantity demanded goes down
When price goes down, buyers move to a new, higher quantity demanded
A change in quantity demanded results from a change in the price of a good.
Demand for Canned Tuna P $2 $1 D Q 8 10
(000s of cans/day) 36

37. Shift in (Market) Demand
If buyers are willing to buy more at each price, then demand has increased
Move the entire demand curve to the right
Increase in demand
If buyers are willing to buy less at each price, then demand has decreased
Demand for Canned Tuna P $2 D' D Q 8 10
(000s of cans/day)

38. Causes of Shifts in Demand
Price of complementary goods
Tennis courts and tennis balls
Price of substitute goods
Internet and overnight delivery
Income: normal or inferior goods?
Preferences
Dinosaur toys after Jurassic Park movie
Number of buyers in the market
Expectations about the future
Price changes never cause a shift in demand

39. Tennis Market
If rent for tennis court decreases, demand for tennis balls increases
Tennis courts and tennis balls are complements P Q
Tennis Court Rentals $7
$10 D
(00s rentals/day) 4 11
Tennis Ball Sales P Q
$1.00 D
(millions of balls/day) 40 58 D' S
$1.40

40. Apartments Near DC Metro
If government wages rise, demand for apartments near Metro stations increases
Demand increases
Price increases
Quantity increases
Demand for a normal good increases when income increases
Demand for an inferior good increases when income decreases
Convenient Apartments P D D' S P' P Q Q Q'
(units/month) 40

41. Movement along the (market) Supply Curve Changes in Quantity Supplied
When the price of a good changes, move to a new quantity supplied
Assumes everything except price is held constant $4 $2 8 16 Q P S
Supply of Pizzas
(000s of slices/day)

42. Changes in (Market) Supply
Supply increases when sellers are willing to offer more for sale at each possible price
Moves the entire supply curve to the right
Supply decreases when sellers are willing to offer less for sale at each possible price
Moves the entire supply curve to the left $2 8 Q P S
Supply of Pizzas
(000s of slices/day) S' 9 $2 8 Q P S*
Supply of Tuna
(000s of cans/day) S 9

43. Causes of Shifts in Supply
A change in the price of an input
Fiberglass for skateboards, construction wages
A change in technology
Desktop publishing and term papers
Internet distribution of products (e-commerce)
Weather (agricultural commodities and outdoor entertainment)
Number of sellers in the market
Expectation of future price changes
Price changes never cause a shift in supply

44. Shifts in Supply: Skateboards
Costs of production affect the supply of a product
Cost of fiberglass for skateboards increases
Supply decreases
With no change in demand, the price of skateboards increases to $80 and quantity decreases to 800
$80
800
$60 P S
Supply of Skateboards
1,000 D S'
600 Q
(skateboards/month)

45. Shift in Supply: Home Construction
Cost of labor used to produce houses decreases
Supply increases
Demand is constant
The price of houses decreases to $90,000 per house
Quantity increases to 50
$120 40
$90 Q P S'
The Market for New Houses 50 D S
(houses/month)

46. Supply and Demand Shifts: Four Rules
An increase in demand will lead to an increase in both equilibrium price and quantity P S P' P D' D Q Q' Q

47. Supply and Demand Shifts: Four Rules
An decrease in demand will lead to a decrease in both equilibrium price and quantity P S P P' D D' Q' Q Q 47

48. Supply and Demand Shifts: Four Rules
An increase in supply will lead to a decrease in the equilibrium price and an increase in the equilibrium quantity. P S S' P P' D Q Q' Q 48

49. Supply and Demand Shifts: Four Rules
A decrease in supply will lead to an increase in the equilibrium price and a decrease in the equilibrium quantity. S' P S P' P D Q' Q Q 49

50. Supply and Demand Both Change: Tortilla Chips
Oils used for frying are harmful AND the price of harvesting equipment decreases S S' P
Price ($/bag) P' D D' Q' Q
Millions of bags per month

51. Changes in Supply and Demand
Increases
Decreases
P Depends
Q Increases
P Increases
Q Depends
P Decreases
Q Decreases

52. Efficiency and Equilibrium
Markets communicate information effectively
Value buyers place on the product
Opportunity cost of producing the product
Markets maximize the difference between benefits and costs
Market outcomes are the best provided that
The market is in equilibrium AND
No costs or benefits are shared with the public

53. Cash on the Table
Buyer's surplus: buyer's reservation price minus the market price
Seller's surplus: market price minus the seller's reservation price
Total surplus = buyer's surplus + seller's surplus
Total surplus is buyer's reservation price – seller's reservation price
No cash on the table when surplus is maximized
No opportunity to gain from additional sales or purchases

54. Efficiency Principle
Socially optimal quantity maximizes the total surplus for the economy from producing and selling a good
Economic efficiency -- all goods at their socially optimal level
Efficiency Principle: equilibrium price and quantity are efficient if
Sellers pay all the costs of production
Buyers receive all the benefits of their purchase
Efficiency: marginal cost equals marginal benefit
Production is efficient if total surplus is maximized

55. Smart for One, Dumb for All
Producers sometimes shift costs to others
Pollution is like getting free waste disposal services
Total marginal cost = seller's marginal cost plus marginal cost of pollution
When costs are shifted, supply is greater than socially optimal
Buyers may create benefits for others
Marginal benefit is less than the full social benefit
Vaccinations, my neighbor's landscaping
The demand for these goods is less than socially optimal

56. Equilibrium Principle
Equilibrium Principle: no unexploited opportunities for individuals
BUT it may not exploit all gains achievable through collective action
Only when the seller pays the full cost of production and the buyer captures the full benefit of the good is the market outcome socially optimal
Regulation, taxes and fines, or subsidies can move the market to optimal level

57. The Algebra of Supply and Demand
Chapter 3 Appendix
The Algebra of Supply and Demand

58. From Graphs to Equations …
Sample equations
P = 16 – 2 Qd
is a straight-line demand curve with intercept 16 on the vertical (P) axis and a slope of – 2
P = Qs
is a straight-line supply curve with intercept 4 and a slope of 4

59. … To Equilibrium P and Q
Equilibrium is where P and Q are the same for demand and supply
Set the two equations equal to each other (P = P) and solve for Q (Qs = Qd = Q*)
16 – 2 Q* = Q*
6 Q* = 12
Q* = 2
Use either the supply or demand curve and Q* = 2 to find price
P = 16 – 2 Q*
P = $12
P = Q*
P = $12