Supply Demand

Chapter 2
The Basics of Supply and

Demand
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?
©2005 Pearson Education, Inc. Chapter 2 2

Topics to Be Discussed
 How do short-run and long-run

elasticities differ?
 How do we understand and predict the
effects of changing market conditions?
 What are the effects of government
intervention – price controls?

Supply and Demand
 Supply and demand analysis can:
1. Help us understand and predict how world
economic conditions affect market price and
production
2. Analyze the impact of government price
controls, minimum wages, price supports,
and production incentives on the economy
3. Determine how taxes, subsidies, tariffs and
import quotas affect consumers and
producers

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
Q S  Q S (P)

The Supply Curve
Price S
($ per unit)
The Supply
Curve Graphically
P2
The supply curve slopes
P1 upward demonstrating that
at higher prices firms
will increase output
Q1 Q2 Quantity

The Supply Curve
 Change in Quantity Supplied

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

Change in Supply
 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

Change in Supply
 The cost of raw P
S S’
materials falls
 Produced Q1 at P1
and Q0 at P2
 Now produce Q2 at
P1 and Q1 at P2 P1
 Supply curve shifts
right to S’ P2
Q0 Q1 Q2 Q
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
QD  QD(P)

The Demand Curve
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
P1
Q1 Q2 Quantity
The Demand Curve
 Changes in quantity demanded

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

Change in Demand
 Other Variables Affecting Demand

Income
 Increasesin income allow consumers to
purchase more at all prices
Consumer Tastes
Price of Related Goods
 Substitutes
 Complements

Change in Demand
D
 Income Increases P D’
 Purchased Q0, at P2
and Q1 at P1 P2
 Now purchased Q1 at
P2 and Q2 at P1
 Same for all prices P1
 Demand Curve shifts
right
Q0 Q1 Q2 Q
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

Price S
($ per unit)
The curves intersect at

equilibrium, or market-
clearing, price.
Quantity demanded
P0 equals quantity
supplied at P0
Q0 Quantity

 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

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

Price
($ per unit) S
1. Price is above
Surplus
the market
P1 clearing price –
P1
2. Qs > QD
P0 3. Price falls to
the market-
clearing price
4. Market adjusts
to equilibrium
D
Q Q0 QS Quantity
D
 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.

Price
($ per unit)
1. Price is below
the market
clearing price
– P2
2. Q D > QS
3. Price rises to
P3 the market-
clearing price
4. Market adjusts
P2 to equilibrium
Shortage D
QS Q QD Quantity
3
 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.

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.

P D
 Raw material prices
S
fall S’
 S shifts to S’
 Surplus at P1
between Q1, Q2
 Price adjusts to P1
equilibrium at P3, Q3 P3
Q1 Q3Q2 Q
D D’
P
S
 Income Increases
 Demand increases to
D1
 Shortage at P1 of Q1, P3
Q2 P1
 Equilibrium at P3, Q3
Q1 Q3 Q Q
2
P D
 Income Increases & D’ S S’
raw material prices
fall
 Quantity increases
 If the increase in D is P2
greater than the P1
increase in S price
also increases
Q1 Q2 Q
Shifts in Supply and Demand
 When supply and demand change

simultaneously, the impact on the
equilibrium price and quantity is
determined by:
1. The relative size and direction of the
change
2. The shape of the supply and demand
models

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

Market for a College Education
P S2002
(annual cost
in 1970 New
dollars)
equilibrium
was reached
$3,917 at $4,573 and
S1970 a quantity of
12.3 million
students
$2,530
D1970 D2002
Q (millions enrolled))
8.6 13.2
The Long-Run Behavior
of Natural Resource Prices
Consumption of copper has increased about
a hundred fold from 1880 through 2002.
The long term real price for copper has
remained relatively constant.
Increased demand as world economy grew
Decreased production costs increased
supply

Resource Market Equilibrium
S1900
Price S1950
S2002
Long-Run Path of
Price and Consumption
D1900
D1950 D2002
Quantity
Resource Market
 Conclusion
Decreases in the costs of production have
increased the supply by more than enough to
offset the increase in demand.

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.

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.
%Q D
D
EP 
%P

 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:
Q Q P Q
E 
D

P P Q P
P

 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

 The primary determinant of price

elasticity of demand is the availability of
substitutes.
Many substitutes demand is price elastic
 Can easily move to another good with price
increases
Few substitutes demand is price inelastic

 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

 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
 Price is high and quantity small
The bottom portion of demand curve is
inelastic
 Price is low and quantity high

Price EP = -
Demand Curve
4
Q = 8 – 2P
Elastic
2 Ep = -1
Inelastic
Ep = 0
4 8 Q
 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

Infinitely Elastic Demand
Price
EP = 
P* D
Quantity
Completely Inelastic Demand
Price
D
EP = 0
Q* Quantity
Other Demand Elasticities
 Income Elasticity of Demand

Measures how much quantity demanded
changes with a change in income.
Q/Q I Q
EI  
I/I Q I

 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.
Qb Qb Pm Qb
EQb Pm  
Pm Pm Qb Pm

 Complements: Cars and Tires

Cross-price elasticity of demand is negative
 Price of cars increases, quantity demanded of
tired decreases
 Substitutes: Butter and Margarine
Cross-price elasticity of demand is positive
 Price
of butter increases, quantity of margarine
demanded increases

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.
S
% ΔQ
S
EP 
% ΔP

Point v. Arc Elasticities
 Point elasticity of demand

Price elasticity of demand at a particular
point on the demand curve
 Arc elasticity of demand
Price elasticity of demand calculated over a
range of prices
E PD 
 ΔQ P  
ΔP  Q 

Elasticity: An Application
 During 1980’s and 1990’s, market for

wheat went through changes that had
great implications for American farmers
and US agricultural policy
 Using the supply and demand curves for
wheat, we can analyze what occurred in
this market

 Supply: QS = 1900 + 240P

 Demand: QD = 3550 – 266P

QD = QS
1800 + 240P = 3550 – 266P
506P = 1750
P = $3.46 per bushel
Q = 1800 + (240)(3.46) = 2630 million

bushels

 We can find the elasticities of demand

and supply at these points
P QD 3.46
E D
 (266)  .035
Q P
P
2,630
P QS 3.46
E  S
 (240)  .032
Q P
P
2,630

 Assume the price of wheat is

$4.00/bushel due to decrease in supply
QD  3,550  (266)(4.00)  2,486
4.00
E D
P (266)  0.43
2,486

 In 2002, the supply and demand for

wheat were:
Supply: QS = 1439 + 267P
Demand: QD = 2809 – 226P

QD = QS
2809 - 226P = 1439 + 267P
P = $2.78 per bushel
Q = 2809 - (226)(2.78) = 2181 million

bushels
Price of wheat fell in nominal terms.

Short-Run Versus Long-Run
Elasticity
 Price elasticity varies with the amount of

time consumers have to respond to a
price.
 Short run demand and supply curves
often look very different from their long-
run counterparts.

Elasticity
 Demand
In general, demand is much more price
elastic in the long run
 Consumers take time to adjust consumption
habits
 Demand might be linked to another good that
changes slowly
 More substitutes are usually available in the
long run

Gasoline: Short-Run and Long-Run
Demand Curves
Price DSR •People cannot easily
adjust consumption in
short run.
•In the long run, people
tend to drive smaller and
more fuel efficient cars.
DLR
Quantity of Gas
Elasticity
 Demand and Durability

For some durable goods, demand is more
elastic in the short run
If goods are durable, then when price
increases, consumers choose to hold on to
the good instead of replacing it so its quantity
demanded fall sharply.
But in long run, older durable goods will have
to be replaced

Cars: Short-Run and Long-Run
Demand Curves
Price DLR
•Initially, people may put
off immediate car
purchase
•In long run, older cars
must be replaced.
DSR
Quantity of Cars
Elasticity
 Income elasticity also varies with the

amount of time consumers have to
respond to an income change.
For most goods and services, income
elasticity is larger in the long run
When income changes, it takes time to
adjust spending

Elasticity
 Income elasticity of durable goods

Income elasticity is less in the long-run than
in the short-run.
 Increases in income mean consumers will want
to hold more cars.
 Once older cars replaced, purchases will only to
be to replace old cars.
 Less purchases from income increase in long
run than in short run

Demand for Gasoline

Demand for Automobiles

Elasticity
 Most goods and services:

Long-run price elasticity of supply is greater
than short-run price elasticity of supply.
 Other Goods (durables, recyclables):
Long-run price elasticity of supply is less
than short-run price elasticity of supply

Elasticity
SSR
Price
SLR
Due to limited
capacity, firms
are limited by
output constraints
in the short-run.
In the long-run, they
can expand.
Quantity Primary Copper

Elasticity
Price SLR SSR
Price increases
provide an incentive
to convert scrap
copper into new supply.
In the long-run, this
stock of scrap copper
begins to fall.
Quantity Secondary Copper

Supply of Copper

Short-Run v. Long-Run
Elasticity – An Application
 Why are coffee prices very volatile?

Most of the world’s coffee produced in Brazil.
Many changing weather conditions affect the
crop of coffee, thereby affecting price
Price following bad weather conditions is
usually short-lived
In long run, prices come back to original
levels, all else equal

Price of Brazilian Coffee

Short-Run v. Long-Run
Elasticity – An Application
 Demand and supply are more elastic in

the long run
 In short-run, supply is completely
inelastic
Weather may destroy part of the fixed
supply, decreasing supply
 Demand relatively inelastic as well
 Price increases significantly

An Application - Coffee
S’ S
Price
A freeze or drought
decreases the supply
of coffee
Price increases
P1 significantly due to
inelastic supply and
demand
P0
Q1 Q0 Quantity
S’ S
Price Intermediate-Run
1) Supply and demand are
more elastic
2) Price falls back to P2.
P2
P0
Q2 Q0 Quantity
Price
Long-Run
1) Supply is extremely elastic.
2) Price falls back to P0.
3) Quantity back to Q0.
P0 S
Q0 Quantity
Predicting the Effects of
Changing Market Conditions
 Supply and demand analysis can be

used to predict the effects of changing
market conditions
Linear demand and supply must be fit to
market data
 Given equilibrium price and quantity along with
elasticities of supply and demand, we can
calculate the curves that fit the information
 We can then calculate changes in the market

 We know
Equilibrium Price, P*=$0.75
Equilibrium Quantity, Q*=7.5
Price elasticity of supply, ES=1.6
Price elasticity of demand, ED=-0.8

 Let’s begin with the equations for supply,

demand, elasticity:
Demand: Q = a – bP
Supply: Q = c + dP
Elasticity: (P/Q)(Q/P)
 We must calculate numbers for a, b, c,
and d.

 The slope of the demand curve above

equals Q/P which equals –b
 The slope of the supply curve above
equals Q/P which equals d
Demand: ED = -b(P*/Q*)
Supply: ES = d(P*/Q*)

Price
Supply: Q = c + dP
a/b
ED = -bP*/Q*
P* ES = dP*/Q*
-c/d Demand: Q = a - bP
Q* Quantity
 Using P*, Q* and the elasticities, we can
solve for d and c from supply
ES = d(P*/Q*)
1.6 = d(0.75/7.5) = 0.1d
d = 16
Q = c + dP
7.5 = c + (16)(0.75) = c + 12
c = -4.5

 Using P*, Q* and the elasticities, we can
solve for a and b from demand
ED = –b(P*/Q*)
-0.8 = -b(0.75/7.5) = –0.1b
b=8
Q = a – bP
7.5 = a – (8)(0.75) = a – 6
a = 13.5

 We now have equations for supply and

demand
Supply: Q = –4.5 + 16P
Demand: Q = 13.5 – 8P
 Setting them equal will give up
equilibrium price and quantity with which
we began

Price
Supply: QS = -4.5 + 16P
a/b
.75
-c/d Demand: QD = 13.5 - 8P
7.5 Mmt/yr
 We have written supply and demand so

that they only depend upon price
 Demand could also depend upon other
variable such as income
 Demand would then be written as:
Q  a  bP  fI

 We know the following information

regarding the copper industry:
I = 1.0
P* = 0.75
Q* = 7.5
b = 8
Income elasticity: E I= 1.3

 Using the elasticity of income formula, we

can solve for f
EI = (I/Q)(Q/I)
1.3 = (1.0/7.5)(f)
f = 9.75
 Substituting back into demand equation
gives a = 3.75

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

Price
S
•Price is regulated to
be no higher than Pmax,
•Quantity supplied
falls and quantity
P0 demanded increases
•A shortage results
Pmax
Shortage
D
QS Q0 QD Quantity
 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.

Price Controls and
Natural Gas Shortages
 In 1954, the federal government began

regulating the wellhead price of natural
gas.
 In 1962, the ceiling prices that were
imposed became binding and shortages
resulted.
 Price controls created an excess demand
of 7 trillion cubic feet.

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Chapter 2

The Basics of Supply and

 What are supply and demand?

©2005 Pearson Education, Inc. Chapter 2 2

 How do short-run and long-run

©2005 Pearson Education, Inc. Chapter 2 3

©2005 Pearson Education, Inc. Chapter 2 4

 The Supply Curve

©2005 Pearson Education, Inc. Chapter 2 5

©2005 Pearson Education, Inc. Chapter 2 6

 Change in Quantity Supplied

©2005 Pearson Education, Inc. Chapter 2 7

 Other Variables Affecting Supply

©2005 Pearson Education, Inc. Chapter 2 8

 The Demand Curve

©2005 Pearson Education, Inc. Chapter 2 10

 Changes in quantity demanded

©2005 Pearson Education, Inc. Chapter 2 12

 Other Variables Affecting Demand

©2005 Pearson Education, Inc. Chapter 2 13

 The market mechanism is the tendency

©2005 Pearson Education, Inc. Chapter 2 15

The curves intersect at

©2005 Pearson Education, Inc. Chapter 2 16

©2005 Pearson Education, Inc. Chapter 2 17

 The market price is above equilibrium

©2005 Pearson Education, Inc. Chapter 2 18

 The market price is below equilibrium:

©2005 Pearson Education, Inc. Chapter 2 20

 Supply and demand interact to determine

©2005 Pearson Education, Inc. Chapter 2 22

 Equilibrium prices are determined by the

©2005 Pearson Education, Inc. Chapter 2 23

 When supply and demand change

©2005 Pearson Education, Inc. Chapter 2 27

 The real price of a college education rose

©2005 Pearson Education, Inc. Chapter 2 28

©2005 Pearson Education, Inc. Chapter 2 30

©2005 Pearson Education, Inc. Chapter 2 32

 Not only are we concerned with what direction

©2005 Pearson Education, Inc. Chapter 2 33

 Measures the sensitivity of quantity

©2005 Pearson Education, Inc. Chapter 2 34

 The percentage change in a variable is

©2005 Pearson Education, Inc. Chapter 2 35

 Usually a negative number

©2005 Pearson Education, Inc. Chapter 2 36

 The primary determinant of price

©2005 Pearson Education, Inc. Chapter 2 37

 Looking at a linear demand curve, as we

©2005 Pearson Education, Inc. Chapter 2 38

 Given a linear demand curve

©2005 Pearson Education, Inc. Chapter 2 39

 The steeper the demand curve becomes,

©2005 Pearson Education, Inc. Chapter 2 41

 Income Elasticity of Demand

©2005 Pearson Education, Inc. Chapter 2 44

 Cross-Price Elasticity of Demand

©2005 Pearson Education, Inc. Chapter 2 45

 Complements: Cars and Tires

©2005 Pearson Education, Inc. Chapter 2 46

 Measures the sensitivity of quantity

©2005 Pearson Education, Inc. Chapter 2 47

 Point elasticity of demand