CHAPTER 2

SUPPLY AND DEMAND

Most requested topics
• game theory
• environment/global warming
• agriculture/food system
• resources/energy
• equity/income distribution
• trade
• others: water, housing…
• many people: anything topical
other issues
• speed
• revisit teaching style in a few weeks
• accessibility to office hours
• worry about math level
• don’t have intro or calculus
Questions or comments
from last time?
Some Big Questions

• What are the effects of import quotas?

• Why is the price of a diamond > the price of water,
which is essential for life?
• When do markets not exist?
• What are the labor market effects of
undocumented workers?
• Should we have a market for human organs?
What is the most important thing you know about
economics?

• many people reply

supply equals demand
• this (imprecisely stated) equation refers to a
simple, yet powerful model
Supply & Demand Model
• most commonly used model
• compare all other models to it because it has desirable welfare
properties
• it is the appropriate model for a competitive market
Outline
• demand
• supply
• equilibrium
• comparative statics
Demand Curves and
Demand Functions
Quantity demanded
is the amount of a good or service that consumers want to buy at a
given price, holding constant other factors that affect demand
Effect of a Change in the Price
• a change in the price causes a movement along the demand curve
• the Law of Demand says that as the price rises, the quantity
demanded falls
• the Law of Demand is an empirical regularity—not theory
• virtually no exceptions exist
Pork Demand Curve

p, $ per kg
Law of Demand: consumers
14.30 demand more of a good the
Demand curve for pork, D1 lower its price, holding
constant all other factors that
influence consumption

3.30
2.30

0 220 240 286

Q, Million kg of pork per year
Demand function
• quantity demanded varies with
• price of this good (p)
• prices of other goods (po)
• income (Y)
• information, government actions,...
• so demand function is Q = D(p, po,Y,…)
• holding other factors constant, the demand function is Q = D(p)
Effect of a Change in a Variable Other Than
Price
• a change in a factor that affects the quantity demanded other than
price causes a shift of the demand curve
Shift of Pork Demand Curve
given a 60¢ increase in the price of beef

p, $ per kg
Effect of a 60¢ increase in the price of beef

3.30

D2
D1

0 176 220 232

Q, Million kg of pork per year
Technical Point about Linear Demand Functions

writing Q1 = D1(p) = 100 – 10p is a shortcut—should write

Q1 = D1(p) = 100 – 10p, if p ≤ 10
= 0, p > 10

p
10

D1
Q
100
Summing Demand Curves
• demand function for Consumer 1 is Q1 = D1(p)
• demand function for Consumer 2 is Q2 = D2(p)
• at price p, Consumer 1 demands Q1 units, Consumer
2 demands Q2 units, so total demand is sum of the
individual quantities demanded:
Q = Q1 + Q2 = D1(p) + D2(p).
• graphically: sum horizontally
Summing Corn Demand Curves
Supply Curves and
Supply Functions
There is no “Law of Supply”
market supply curve may be upward sloping, vertical, horizontal, or
downward sloping
Total Supply: Sum of Domestic and Foreign Supply
• domestic Japanese supply of rice is Sd, and
imported foreign supply is Sƒ
• effect of a ban on foreign imports
Equilibrium
Equilibrium
• intersection of supply and demand curves
determines market price and quantity
• at the market price,
• consumers can buy as much as they want
• firms can sell as much as they want.
• quantity demanded = quantity supplied
(not “demand equals supply”)
Coffee Equilibrium
Price of Coffee
per pound

Supply

e
$3.15

Demand

2.5 Coffee, billion

pounds per year
Diamond-Water Paradox
In 1776, Adam Smith, the father of modern
economics, observed in his book The Wealth of
Nations:
Nothing is more useful than water; but it will purchase
scarce any thing; scarce any thing can be had in exchange
for it. A diamond, on the contrary, has scarce any value in
use; but a very great quantity of other goods may
frequently be had in exchange for it.
Smith is correct
• round, one-carat (0.0070548 ounce) diamond, with excellent polish,
and good color and clarity sells for about $6,100 or $864,660/ounce.
• expensive bottled water goes for about 50¢ an ounce
• Why?
Diamond, Bottled Water Markets
Supply
• diamonds are difficult to mine and cut, so the quantity supplied at
any price is very limited
• water is relatively abundant
• so water supply curve lies to the right of the diamond supply curve
Demand, Equilibrium
• diamond demand curve lies well to the left of the
bottled-water demand curve
• diamond demand curve is far enough to the right
that it intersects the diamond supply curve at a
high price
• price of each good depends on the relative
positions of both its supply curve and its demand
curve
Value vs Price
• each demand curve reflects the value that consumers place on a good
• the value that consumers place on a good alone is not sufficient to
determine its price, which also depends on the supply curve
Invisible hand
at a non-equilibrium price—shortage (excess demand) or excess
supply—consumers or firms change their behavior driving the market
price to the equilibrium level as though by an invisible hand
Shortage: Excess Demand
• at price = $2.15 < Price of Coffee
equilibrium price, per pound
• firms want to sell
1.8 billion pounds
per year, Supply

• but consumers
demand 3.0 billion e
pounds, $3.15

• results in shortage $2.15

(excess demand) of Demand
1.2 (= 3.0 – 1.8) Shortage = 1.2
billion pounds
1.8 2.5 3.0 Coffee, billion
pounds per year
Adjustment
• consumers who Price of Coffee
cannot buy per pound
coffee may offer
to pay more than Supply
$2.15
• or suppliers, e
seeing frustrated $3.15
consumers, may
$2.15
raise their prices Demand

Coffee, billion
pounds per year
Adjustment
Price of Coffee
These actions per pound
cause the market
price to rise—as
though pushed Supply
up by an invisible
hand. e
$3.15

Demand

Coffee, billion
pounds per year
Adjustment
Price of Coffee
These actions per pound
cause the market
price to rise—as
though pushed Supply
up by an invisible
hand. e
$3.15

Demand

Coffee, billion
pounds per year
Adjustment
Price of Coffee
These actions per pound
cause the market
price to rise—as
though pushed Supply
up by an invisible
hand. e
$3.15

Demand

Coffee, billion
pounds per year
Adjustment
Price of Coffee
These actions per pound
cause the market
price to rise—as
though pushed Supply
up by an invisible
hand. e
$3.15

Demand

Coffee, billion
pounds per year
Equilibrium
This upward Price of Coffee
per pound
pressure on
price continues
until it reaches Supply
the equilibrium
price, $3.15.
e
$3.15

Demand

Coffee, billion
pounds per year
Surplus: Excess Supply
• price = $4.15 > Price of Coffee
equilibrium price per pound
• consumers demand
only 2.2 billion
pounds, Supply
Surplus = 0.8
• but firms want to $4.15
sell 3.0 billion
pounds per year, $3.15 e
• result: surplus
(excess supply) of Demand
0.8 (= 3.0 – 1.8)
billion pounds
2.2 2.5 3.0 Coffee, billion
pounds per year
Adjustment
firms that cannot Price of Coffee
sell as much as per pound
they want, lower
their price to
attract additional Supply
customers
$4.15
$3.15 e

Demand

Coffee, billion
pounds per year
Adjustment
firms that cannot Price of Coffee
sell as much as per pound
they want, lower
their price to
attract additional Supply
customers

$3.15 e

Demand

Coffee, billion
pounds per year
Adjustment
firms that cannot Price of Coffee
sell as much as per pound
they want, lower
their price to
attract additional Supply
customers

$3.15 e

Demand

Coffee, billion
pounds per year
Equilibrium
Price of Coffee
per pound

Supply
price falls until
it reaches the
equilibrium
level, $3.15 $3.15 e

Demand

Coffee, billion
pounds per year
Equilibrium
if neither Price of Coffee
buyers nor per pound
sellers want
Supply
to change
their
e
behavior, as $3.15 Equilibrium
at e, the
market is in Demand
equilibrium
2.5 Coffee, billion
pounds per year
Equilibrium Price and Quantity
• price at which
consumers can buy Price of Coffee
as much as they per pound
want and sellers
can sell as much as
they want is the Supply
equilibrium price
Equilibrium
• at equilibrium Price e
price, consumers $3.15 Equilibrium
demand and firms
supply equilibrium
Demand
quantity

2.5 Coffee, billion

Equilibrium pounds per year
Quantity
No Shortages or Surpluses
• in a perfectly competitive market, the price adjusts to eliminate
shortages or surpluses
• however, government interventions can cause shortages or surpluses
(as we’ll see later)
Example: Portland Fish Exchange

Fishing boats unload thousands

of pounds of pollock, hake, cod,
flounder, grey sole, and many
other types of fish at the
Portland Fish Exchange's dock in
Portland, Maine.
Portland Fish Action Warehouse

• fish are weighted and put

on display in the Exchange’s
22,000 square foot refrigerated
warehouse
• each morning buyers inspect
the quality of the day’s catch
Auction
• daily auction is held in a
room overlooking the
warehouse
• fleece-clad buyers
representing fish dealers
and restaurants sit facing a
screen, an auctioneer, and
sellers’ representatives
• bid information is posted
on the screen at the front
of the room
• thousands of pounds of
fish are sold quickly
Possible equilibrium price
Price per pound
of grey sole
Supply Curve
• as shown, equilibrium
price is $4 per pound
• however, if demand $6
curve shifts up, price
rises to $6 $4
Equilibrium

Demand
Curve

8,000 Grey sole,

pounds per
day
U.S. Sugar
• 85% of the sugar Americans consume is produced domestically; rest is
imported from about 40 countries under a quota system.
• due to a quota, 2010 U.S. price of sugar was roughly double the rest-
of-world (ROW) price
• this increase in price is applauded by nutritionists who deplore
amount of sugar a typical American consumes
Shocking the Equilibrium:
Comparative Statics
Shocking the Equilibrium
• if no event occurs that affects supply or demand curves, a market
equilibrium persists because buyers and sellers are satisfied
• a shock—change in tastes, income, government policies, or costs of
production— causes demand curve or supply curve or both to shift
• such shifts affect equilibrium price and quantity
Shock that Shifts the Demand Curve
• people demand more coffee at any given price as they become
wealthier
• an increase in income causes the demand curve to shift to the right,
resulting in a movement along the supply curve
 Initial Equilibrium
Price of Coffee
per pound
Supply

• initial U.S. coffee

bean demand curve is
D1
• equilibrium e1 occurs e1
at intersection of D1 $3.15
and the supply curve

D1

2.5 Coffee, billion

pounds per year
Income Rises
Price of Coffee
Income
per pound rises $5,000
Supply
$5,000 increase
in median
income shifts
coffee bean
demand curve
right to D2 D2

D1

Coffee, billion
pounds per year
 Shortage
• at the initial Price of Coffee
per pound
equilibrium price, Supply
$3.15, consumers
demand 3.0 billion
pounds
• but firms want to e1
supply 2.5 billion $3.15
pounds
D2
• shortage of 0.5 (=
3.0 – 2.5) billion D1
pounds
2.5 3.0 Coffee, billion
pounds per
Shortage = 0.5 year
 Results in New Equilibrium
Price of Coffee
• responses to per pound
shortage cause Supply
equilibrium price to
rise
• equilibrium point
moves along supply e2
curve from e1 to e2 $3.67 e1
• equilibrium price $3.15
rises to $3.67
• equilibrium quantity D2
increases to 2.8
billion pounds D1

2.5 2.8 Coffee, billion

pounds per year
Comparative Statics with Small Change

• demand function is Q = D(p,Y), where Y, income, is an

environmental variable that might change
• supply function is Q = S(p)
• determine equilibrium price by equating the quantities:
D(p,Y) ≡ S(p) (an identity)
• as Y changes, p changes so that this equation continues to
hold: market remains in equilibrium
• thus, equilibrium price is an implicit function of Y:
p = p(Y)
• equilibrium condition is D(p(Y),Y) ≡ S(p(Y))
 p

D(p,Y2)

Supply
p(Y2)
e2
p(Y1) e1

Q
D(p,Y1)
Calculus Comparative Statics
• supply function: Q = 10 + 2p
• demand function: Q = 110 – 3p + 10Y
• in equilibrium: 10 + 2p = 110 – 3p + 10Y
or 5p = 100 + 10Y, or p = p(Y) = 20 + 2Y
• eq. quantity: Q = 10 + 2p = 10 + 2(20 + 2Y), or
Q = Q(Y) = 50 + 4Y
• comparative statics:
• eq. price: dp/dY = 2
• eq. quantity: dQ/dY = 4
Should society permit people
to sell organs for human
transplants?
Transplants
• In 2013, 100,000 Americans were waiting for a
new kidney, the most commonly transplanted
organ.
• Unfortunately, only about 17% received a
transplant operation.
• The situation is getting worse over time.
Deaths
• Thousands of people die while waiting for a
transplant.
• Average wait for a kidney transplant
• 4.5 years today
• 2.9 years a decade ago
• Since 1954—the year of the first kidney
transplant—350,000 U.S. transplants.
• Wait list today is 27% of all the transplants that
occurred over 60 years.
No U.S. Market for Organs

• Today, a recipient cannot buy an organ.

• Because you can live a normal life with a single
kidney, about a third of all transplant kidneys
come from live donors—usually relatives.
• The rest come from deceased people.
Markets
• kidney price:
• Iran $4,000
• proposed price Singapore $36,000
• Becker and Elias estimate U.S. price would be
about $15,000 ($5,000 to $25,000),
• much lower than current $67,000 cost of obtaining
a kidney and total $263,000 cost of a kidney
transplant operation
Dialysis
• dialysis: treatment that uses a machine to act like a kidney and
remove waste
• most people on dialysis cannot work
• cost
• average annual cost of dialysis is $80,000
• total cost over the average 4.5-year waiting period before receiving a kidney
transplant is $350,000
Cost is high
even w/ a market for kidneys, cost of a transplant operation is so high
that only the wealthy or those with excellent health insurance can
afford it
Rich do better today
• some rich people go to countries such as India for transplants in the
underground medical sector
• the late Steve Jobs and other rich people shortened the wait by
having homes in several states, which have different wait times, or by
other means
Objections
• some people feel selling organs is immoral
• rich better able to buy than poor (but the rich are
better off under current system)
• might encourage a black market