Theory of Supply and

Demand

Overview

Market (who, what, how)

Supply and demand is an economic
model

Designed to explain how prices are

determined in certain types of markets

What you will learn in this chapter

How the model of supply and demand

1.
2.
3.
4.

works and how to use it

The law of demand
The law of supply
The determination of market equilibrium
Factors shifting demand or supply curves

Markets
In economics, a market is not a place

but rather a group of buyers and sellers

with the potential to trade with each
other
Market is defined not by its location but by its

participants
First step in an economic analysis is to define
and characterize the market or collection of
markets to analyze
Economists think of the economy as a

collection of individual markets

How Broadly Should We Define The

Market
Defining the market often requires

economists to group things together

Aggregation is the combining of a group of

distinct things into a single whole

Markets can be defined broadly or

narrowly, depending on our purpose

How broadly or narrowly markets are defined

is one of the most important differences

between Macroeconomics and
Microeconomics
4

Defining Macroeconomic
Markets

Goods and services are aggregated to the

highest levels
Macro models lump all consumer goods into

the single category consumption goods

Macro models will also analyze all capital
goods as one market
Macroeconomists take an overall view of the
economy without getting bogged down in
details

Defining Microeconomic
Markets
Markets are defined narrowly

Focus on models that define much more

specific commodities
Always involves some aggregation
But stops it reaches the highest level of

generality that macroeconomics investigates

Buyers and Sellers

Buyers and sellers in a market can be
Households
Business firms
Government agencies

All three can be both buyers and sellers in the same

market, but are not always

For purposes of simplification this text

will usually follow these guidelines

In markets for consumer goods, well view

business firms as the only sellers, and

households as only buyers
In most of our discussions, well be leaving
out the middleman
7

Competition in Markets
In imperfectly competitive markets, individual

buyers or sellers can influence the price of the

product
In perfectly competitive markets (or just
competitive markets), each buyer and seller takes
the market price as a given
What makes some markets imperfectly competitive
and others perfectly competitive?
Perfectly competitive markets have many small buyers and

sellers

Each is a small part of the market, and the product is

standardized

Imperfectly competitive markets have just a few large

buyers and sellers

Or else the product of each seller is unique in some way

8

Using Supply and Demand

Supply and demand model is designed

to explain how prices are determined in

perfectly competitive markets
Perfect competition is rare but many markets

come reasonably close

Perfect competition is a matter of degree
rather than an all or nothing characteristic

Supply and demand is one of the most

versatile and widely used models in the

economists tool kit

Demand
A households quantity demanded of a

good

Specific amount household would choose to buy

over some time period, given

A particular price that must be paid for the good

All other constraints on the household

Market quantity demanded (or quantity

demanded) is the specific amount of a

good that all buyers in the market would
choose to buy over some time period, given
A particular price they must pay for the good
All other constraints on households

10

Quantity Demanded
Implies a choice
How much households would like to buy when they take
into account the opportunity cost of their decisions?
Is hypothetical
Makes no assumptions about availability of the good
How much would households want to buy, at a specific

price, given real-world limits on their spending power?

Stresses price
Price of the good is one variable among many that
influences quantity demanded
Well assume that all other influences on demand are
held constant, so we can explore the relationship
between price and quantity demanded
11

The Law of Demand

The price of a good rises and everything

else remains the same, the quantity of the

good demanded will fall
Ceteris Paribus
The words, everything else remains the

same are important

In the real world many variables change

simultaneously
However, in order to understand the economy we
must first understand each variable separately
Thus we assume that, everything else remains the
same, in order to understand how demand reacts to
price

12

The Demand Schedule

Demand schedule
A list showing the quantity of a good that

consumers would choose to purchase at

different prices, with all other variables held
constant

Demand V.S. Quantities demanded

- demand is the entire relationship

between price and quantity
- quantities demanded are specific
amount of goods buyers want to buy

13

The Demand Curve

The market demand curve (or just demand

curve) shows the relationship between the

price of a good and the quantity demanded
, holding constant all other variables that
influence demand
Each point on the curve shows the total

buyers would choose to buy at a specific

price
Law of demand tells us that demand curves

virtually always slope downward

14

Figure 1: The Demand Curve

Price per
Bottle

Php4.00

When the price is

Php4.00 per bottle,
40,000 bottles are
demanded (point A).

2.00

At Php2.00 per bottle,

60,000 bottles are
demanded (point B).

D
40,000
15

60,000

Number of Bottles
per Month

Shifts vs. Movements Along

The Demand Curve
Move along the demand curve
From a change in the price of the good
we analyze
In maple syrup example, Figure 1
A fall in price would cause a movement to the right

along the demand curve (point A to B)

See figure 3(a)

16

Figure 3(a): Movements Along

and Shifts of The Demand Curve
Price
Price increase moves us
leftward along demand
curve
P2
Price increase moves us
rightward along demand
curve
P1
P3

Q2
17

Q1

Q3

Quantity

Shifts vs. Movements Along

The Demand Curve
Shift of demand curve
a change in other things than price of the
good causes a shift in the demand curve
itself, for example, income
In Figure 2
Demand curve has shifted to the right of the
old curve (from Figure 1) as income has risen
A change in any variable that affects demand
except for the goods pricecauses the
demand curve to shift

18

Figure 2: A Shift of The Demand

Curve
Price per
Bottle

An increase in income
shifts the demand curve for
maple syrup from D1 to D2.
At each price, more bottles
are demanded after the
shift

Php2.00

60,000
19

C
D1

D2

80,000

Number of Bottles
per Month

Change in Quantity Demanded vs.

Change in Demand
Language is important when discussing

demand

Quantity demanded means

A particular amount that buyers would choose to buy at a
specific price
It is a number represented by a single point on a demand
curve
When a change in the price of a good moves us along a
demand curve, it is a change in quantity demand
The term demand means
The entire relationship between price and quantity
demandedand represented by the entire demand curve
When something other than price changes, causing the
entire demand curve to shift, it is a change in demand

20

Income: Factors That Shift The

Demand Curve
An increase in income has effect of shifting

demand for normal goods to the right

However, a rise in income shifts demand for

inferior goods to the left

A rise in income will increase the demand

for a normal good, and decrease the

demand for an inferior good
Normal good and inferior good are defined
by the relation between demand and
income

21

Wealth: Factors That Shift The

Demand Curve
Your wealthat any point in timeis the

total value of everything you own minus

the total dollar amount you owe
- Example
An increase in wealth will
Increase demand (shift the curve rightward)

for a normal good

Decrease demand (shift the curve leftward)
for an inferior good

22

Prices of Related Goods: Factors

that Shift the Demand Curve
Substitutegood that can be used in place

of some other good and that fulfills more or

less the same purpose
Example
A rise in the price of a substitute increases the

demand for a good, shifting the demand curve to

the right

Complementused together with the good

we are interested in

Example
A rise in the price of a complement decreases the

demand for a good, shifting the demand curve to

the left

23

Other Factors That Shift the

Demand Curve
Population
As the population increases in an area
Number of buyers will ordinarily increase
Demand for a good will increase

Expected Price
An expectation that price will rise (fall) in the future
shifts the current demand curve rightward (leftward)
Tastes
Combination of all the personal factors that go into
determining how a buyer feels about a good
When tastes change toward a good, demand
increases, and the demand curve shifts to the right
When tastes change away from a good, demand
decreases, and the demand curve shifts to the left

24

Small Summary
-- Factors Affecting Demand
Income (depends on goods nature: normal

or inferior)
Wealth (depends on goods nature)
Prices of substitutes (positively related)
Prices of complements (negatively related)
Population (positively related)
Expected price (positively related)
Tastes (positively related)

25

Figure 3(b): Movements Along

and Shifts of The Demand Curve
Price

Entire demand curve shifts

rightward when:
income or wealth
price of substitute
price of complement
population
expected price
tastes shift toward good

D2
D1
Quantity
26

Figure 3(c): Movements Along

and Shifts of The Demand Curve
Price

Entire demand curve shifts

leftward when:
income or wealth
price of substitute
price of complement
population
expected price
tastes shift toward good

D1
D2
Quantity
27

Supply
A firms quantity supplied of a good is the

specific amount its managers would choose

to sell over some time period, given
A particular price for the good
All other constraints on the firm

Market quantity supplied (or quantity

supplied) is the specific amount of a good

that all sellers in the market would choose
to sell over some time period, given
A particular price for the good
All other constraints on firms

28

Quantity Supplied
Implies a choice
Quantity that gives firms the highest possible profits when
they take account of the constraints presented to them by the
real world
Is hypothetical
Does not make assumptions about firms ability to sell the
good
How much would firms managers want to sell, given the price
of the good and all other constraints they must consider?
Stresses price
The price of the good is just one variable among many that
influences quantity supplied
Well assume that all other influences on supply are held
constant, so we can explore the relationship between price
and quantity supplied

29

The Law of Supply

States that when the price of a good rises

and everything else remains the same, the

quantity of the good supplied will rise
The words, everything else remains the

same are important

In the real world many variables change

simultaneously
However, in order to understand the economy we
must first understand each variable separately
We assume everything else remains the same in
order to understand how supply reacts to price

30

The Supply Schedule and The

Supply
SupplyCurve
scheduleshows quantities of a
good or service firms would choose to
produce and sell at different prices, with all
other variables held constant
Supply curvegraphical depiction of a
supply schedule
Shows quantity of a good or service supplied

at various prices, with all other variables held

constant

31

Figure 4: The Supply Curve

Price per
Bottle

When the price is $2.00

per bottle, 40,000 bottles
are supplied (point F).

Php4.00

2.00

G
At $4.00 per bottle,
quantity supplied is
60,000 bottles (point G).

40,000
32

60,000

Number of Bottles
per Month

Shifts vs. Movements Along the

Supply
Curve

A change in the price of a good causes a

movement along the supply curve
In Figure 4
A rise (fall) in price would cause a rightward
(leftward) movement along the supply curve

A drop in transportation costs will cause

a shift in the supply curve itself

In Figure 5
Supply curve has shifted to the right of the old curve
(from Figure 4) as transportation costs have dropped
A change in any variable that affects supplyexcept
for the goods pricecauses the supply curve to shift

33

Figure 5: A Shift of The Supply

Curve
Price per
Bottle

A decrease in transportation
costs shifts the supply curve for
maple syrup from S1 to S2.

S1

S2

At each price, more bottles

are supplied after the shift
$4.00

60,000
34

80,000

Number of Bottles
per Month

Factors That Shift the Supply

Curve
Input prices
A fall (rise) in the price of an input causes an
increase (decrease) in supply, shifting the supply
curve to the right (left)
Price of Related Goods
When the price of an alternate good rises (falls),

the supply curve for the good in question shifts

leftward (rightward)
Technology
Cost-saving technological advances increase the

supply of a good, shifting the supply curve to the

right
35

Factors That Shift the Supply

Curve
Number of Firms
An increase (decrease) in the number of

sellerswith no other changesshifts the

supply curve to the right (left)
Expected Price
An expectation of a future price increase

(decrease) shifts the current supply curve to

the left (right)

36

Factors That Shift the Supply

Curve
Changes in weather
Favorable weather
Increases crop yields
Causes a rightward shift of the supply curve for that

crop

Unfavorable weather
Destroys crops
Shrinks yields
Shifts the supply curve leftward

Other unfavorable natural events may

effect all firms in an area

Causing a leftward shift in the supply curve
37

Figure 6(a): Changes in Supply

and in Quantity Supplied
Price

Price increase moves

us rightward along
supply curve

P2

P1

Price increase moves

us leftward along
supply curve

P3

38

Q3

Q1

Q2

Quantity

Figure 6(b): Changes in Supply

and in Quantity Supplied
Price

39

Entire supply curve shifts

rightward when:
price of input
price of alternate good
number of firms
expected price
technological advance
favorable weather

S1
S2

Quantity

Figure 6(c): Changes in Supply

and in Quantity Supplied
Price

40

Entire supply curve shifts

rightward when:
price of input
price of alternate good
number of firms
expected price
unfavorable weather

S2
S1

Quantity

Summary: Factors That Shift

The Supply Curve
The short list of shift-variables for supply

that we have discussed is far from

exhaustive
In some cases, even the threat of such
events can cause serious effects on
production
Basic principle is always the same
Anything that makes sellers want to sell more

or less of a good at any given price will shift

supply curve
41

Equilibrium: Putting Supply and

Demand Together
When a market is in equilibrium
Both price of good and quantity bought and
sold have settled into a state of rest
The equilibrium price and equilibrium
quantity are values for price and quantity in
the market but, once achieved, will remain
constant

Unless and until supply curve or demand curve shifts

The equilibrium price and equilibrium

quantity can be found on the vertical

and horizontal axes, respectively

At point where supply and demand curves

cross

42

Figure 7: Market Equilibrium

Price per
Bottle

2. causes the price

to rise . . .

3. shrinking the
excess demand . . .
S

E
Php3.00

1.00

1. At a price of $1.00 per

bottle an excess demand
of 50,000 bottles . . .
43

H
Excess Demand

4. until price reaches its

equilibrium value of $3.00
.
J

25,000 50,000 75,000

D
Number of Bottles
per Month

Excess Demand
Excess demand
At a given price, the excess of quantity

demanded over quantity supplied

Price of the good will rise as buyers

compete with each other to get more of the

good than is available

44

Figure 8: Excess Supply and

Price Adjustment
Price per
Bottle

1. At a price of $5.00 per

bottle an excess supply
of 30,000 bottles . . .
Excess Supply at $5.00 S

$5.00
2. causes the
price to drop,
3.00

K
E

3. shrinking the
excess supply . . .

4. until price reaches its

equilibrium value of
$3.00.
D

35,000 50,000 65,000

45

Number of Bottles
per Month

Excess Supply
Excess Supply
At a given price, the excess of quantity

supplied over quantity demanded

Price of the good will fall as sellers compete

with each other to sell more of the good

than buyers want

46

Solve for Equilibrium

Algebraically

Suppose that demand is given by the

D
Q
equation
, where
Q 140 10 P
is quantity
demanded, P is the price of the
s
good.QSupply is given by
where
is quantity supplied.
What is the
S equilibrium price and quantity?

Q 80 5 P

47

Income Rises: What Happens

When Things Change
Income rises, causing an increase in

demand
Rightward shift in the demand curve causes

rightward movement along the supply curve

Equilibrium price and equilibrium quantity
both rise
Shift of one curve causes a movement

along the other curve to new equilibrium

point

48

Figure 9
Price per
Bottle

4. Equilibrium
price
increases

3. to a new
equilibrium.
S
F'

Php4.00
3.00

2. moves us along
the supply
curve . . .

1. An increase in
demand . . .
D2
D1

5. and equilibrium quantity

increases too.
49

50,000 60,000

Number of Bottles of
Maple Syrup per Period

A Storm Hits: What Happens When

Things Change
A storm causes a decrease in supply
Weather is a shift variable for supply curve
Any change that shifts the supply curve leftward in a
market will increase the equilibrium price
And decrease the equilibrium quantity in that
market

50

Figure 10: A Shift of Supply and

A New Equilibrium
Price per
Bottle
Php5.00

3.00

S2

S1

E'

D
35,000 50,000
51

Number of Bottles

Using Supply and Demand: The

Invasion of Kuwait
Why did Iraqs invasion of Kuwait cause the

price of oil to rise?

Immediately after the invasion, United States

led a worldwide embargo on oil from both

Iraq and Kuwait
A significant decrease in the oil industrys
productive capacity caused a shift in the
supply curve to the left
Price of oil increased

52

Figure 12: The Market For Oil

Price per
Barrel of Oil

S2
S1
E'

P2
E

P1

D
Q2
53

Q1

Barrels of Oil

Using Supply and Demand: The

Invasion of Kuwait
Why did the price of natural gas rise as

well?
Oil is a substitute for natural gas
Rise in the price of a substitute increases

demand for a good

Rise in price of oil caused demand curve for
natural gas to shift to the right
Thus, the price of natural gas rose

54

Figure 13: The Market For

Natural Gas
Price per Cubic
Foot of Natural
Gas

F'
P4
P3

D2
D1

Q3
55

Q4

Cubic Feet of
Natural Gas

Figure 11: Changes in the

Market for Handheld PCs
Price per
Handheld
PC

3. moved the market to

a new equilibrium.
2. and a decrease
in demand . . .

4. Price
decreased . . .

Php500

1. An increase in
supply . . .

Php400

D2002

5. and quantity
decreased as well.

D2003
2.45 3.33

56

S2002
S2003

Millions of Handheld PCs

per Quarter

Both Curves Shift

When just one curve shifts (and we

know the direction of the shift) we can

determine the direction that both
equilibrium price and quantity will move
When both curves shift (and we know
the direction of the shifts) we can
determine the direction for either price
or quantitybut not both
Direction of the other will depend on which

curve shifts by more

57

The Three Step Process

Key Step 1Characterize the Market
Decide which market or markets best suit
problem being analyzed and identify decision
makers (buyers and sellers) who interact there
Key Step 2Find the Equilibrium
Describe conditions necessary for equilibrium in

the market, and a method for determining that

equilibrium

Key Step 3What Happens When Things

Change

Explore how events or government polices

change market equilibrium

58

Example: rental apartment

Demand & Supply

Diagram
Equilibrium P & Q
Why Php1000 can
not be equilibrium?
Effects from a
tornado destroying
some apartments.

rent(Peso)

quantity
demanded

quantity
supplied

800

30

10

1000

25

14

1200

22

17

1400

19

19

1600

17

21

1800

15

22
59

Demand for two bedroom rental

apartment

60

Summaries
Through the study of the chapter, you will be able to
Characterize a market.
Use a demand schedule and a demand curve to

demonstrate the law of demand.

Explain the difference between a change in demand (shift
of the curve) and a change in quantity demanded
(movement along the curve).
List the factors that will lead to a change in demand, and
give examples of each.
Similar analysis for supply side.
Explain how equilibrium price and quantity are
determined in a competitive market.
Explain what will happen in a competitive market after a
shift in the supply curve, the demand curve, or both.
Describe the three steps economists take to answer
almost any question about the economy.
61