Chapter 4 Supply, Demand, and Market Equilibrium This chapter is a general analysis of how a market is supplied and how

consumers and producers interact in a market setting in order to determine the overall market outcome. A. Demand 1. Def: Demand is the relationship between price and quantity that consumers are willing and able to purchase. -If someone does not have the ability or is not really in the market for a good they are not included 2. Demand Schedule: a table showing the actual quantities that are demanded at each price.
Ex: Table 1 P 0 1 2 3 Qd 20 18 16 14 P 4 5 6 7 Qd 12 10 8 6 P 8 9 1 0 Qd 4 2 0

Note: The table could be much longer (i.e. continue on showing each relationship at each price) or could be on a different scale. 3. Law of Demand: As the price of a good goes up, all else constant, the quantity demanded goes down or the other way around (i.e. price down Qd up). This is intuitive since it basically states the relationship that consumers like lower prices.
4. Graphically:

The entire curve is a demand curve. It is the graphical representation of the law of demand and a demand schedule. It can generally be shown in functional form.

D Q Note: This is an individual demand curve. To get the market demand curve you simply horizontally sum all the individual demand curves to get the market totals.

5. Mathematically: Generally it can be represented in a simple linear function of the form: Qd = b a P a = slope; note it is negative which is consistent with a downward sloping demand curve b = P intercept; where the Demand Curve hits the p-axis 6. Determinants of Demand: Recall from the math/stat primer, there are many things that we know affect certain variables. Determinants of demand are all the main things that we have found affect the amount of demand for a particular good. The main determinant is price, this is why we primarily look at the way price affects Qd. Other determinants of demand are level of income, personal tastes/preferences, the price of related goods, the population (or also called market size), and expectations. If we go back to the math stat primer we can note that: Movers: P and Qd Shifters: Income (I), Tastes/Preferences (T), Price of related goods (substitutes and complements Pr ), Population (N), and price expectations (Pexp ). B. Supply 1. Def: Supply is the relationship between price and quantity that suppliers are willing and able to supply at each price. -If someone does not have the ability or is not really in the market for a good they are not included 2. Supply Schedule: a table showing the actual quantities that are supplied at each price.
P 0 1 2 3 Ex: Table 2 Qs 0 2 4 6 P 4 5 6 7 Qs 8 10 12 14 P 8 9 1 0 Qs 16 18 20

Note: the table could be much longer (i.e. continue on showing each relationship at each price) or could be on a different scale. 3. Law of Supply: As the price of a good goes up, all else constant, the quantity supplied goes up or the other way around (i.e. price up Qs up). In general it states that suppliers like higher prices. S 2
The entire curve is a supply curve. It is the graphical representation of the law of supply and a supply schedule. It can generally be shown in functional form (see below).

4. Graphically:

Note: Just as in the case of demand, to get the market supply you must horizontally sum the supply curves to get the market supply. 5. Mathematically: Generally it can be represented in a simple linear function of the Q s form: Q = d + c P c = slope; note it is positive which is consistent with a upward sloping supply curve d = P intercept; where the supply curve hits the p-axis when Qs= 0 6. Determinants of Supply: Recall from the math/stat primer, there are things that we know affect certain variables. Determinants of supply are all the things that we have found affect the amount of supply for a particular good. The main determinant is price, this is why we primarily look at the way price affects Qs. Other determinants of supply are unit costs of production, profitability of alternate activities, nature, and expectations of future prices. If we go back to the math/stat primer we can note that: Movers: P and Qs Shifters: Unit Costs, Profitability of Alt. Activities, Nature, Technology, Number of Sellers and Price Expectations. C. Market Equilibrium: 1. Def: This is where the supply and demand curve meet each other. At this price, all that is supplied is demanded at this pint the market clears. Once we deal with market it is appropriate to drop the superscripts from Qd and Qs and simply deal with Q or Quantity. This is because at equilibrium we have Qs = Qd.
2. Graphically:

PE

Equilibrium

D Q Q
E

3. Using a table P 0 1 2 3 4 5 6 7 8 9 10 Qd 20 18 16 14 12 10 8 6 4 2 0 Qs 0 2 4 6 8 10 12 14 16 18 20

Note: It is clear from the table above that the price where Qd = Qs is at a price of 5. At this price all that is supplied is demanded. So we get Qd = Qs = 10 4. Mathematically: Example: Qd = 2000-4p & Qs = 400 + 4p. Solve for equilibrium P and Q. Step 1: Set Qs and Qd equal to each other and solve for P Qd = 2000-4p = 400 + 4p = Qs 2000-4p = 400 + 4p 1600 = 8p p = 200 Step 2: Plug solution to P into either equation to get Q. To check plug into both and make sure the solutions are consistent. Qd = 2000-4p 2000 4 (200) = 1200 Qs = 400 + 4p 400 + 4 (200) =1200 -So $200 truly is the price that suppliers and demanders in the market come to an agreement on and at this price we get market clearing. 5. Disequilibria: Prices Placed Above and Below Market Price These are not mandated, they are simply put at a price above or below equilibrium. We have now defined what occurs when we are at equilibrium, but why arent other prices and quantities equilibrium? More importantly, what would happen if suppliers tried to impose a price that was above or below the equilibrium? This is something that occurs fairly regularly in the market place when suppliers are trying to find the equilibrium price in the market. So now we analyze what occurs when this happens.

a. Price above Equilibrium Imposed

-Ex: when a firm tries to sell a good for more than its market value.

Surplus or Excess Supply P S Artificial P

D Q Qd Qs
Recall: The intersection of the two graphs (called equilibrium) is the combination of p and q that both demanders and suppliers agree upon. At PE consumers demand QE and producers supply QE. At this price the market clears (all that is supplied is demanded). If the price were higher than PE , as we have shown above, then there would be a surplus in the market. Suppliers would want to supply more of the good than demanders would want to purchase at that price. Producers would drop the price until all that they wanted to sell at the market was bought, and this would occur at PE. Note: This can be seen in the table that we have above which shows that prices higher than P E we get the quantity supplied greater than quantity demanded, which is what we showed above. Ex: Suppose that we imposed a price of $300 with our equation from (4) above. Calculate both Qd and Qs and show that we get an excess supply

Qd = 2000-4p 2000 4 (300) = 800 Qs = 400 + 4p 400 + 4 (300) =1600

Here we can clearly see that at this price we get Qs >> Qd, which produces surplus in the market. To get back to equilibrium suppliers will have to lower their price.

b. Price below Equilibrium Imposed

Ex: A firm charges a price that is below true market value (they have underestimated market price)

S Shortage or Excess Demand Artificial P D Q

If the price were lower than PE , as we have shown above, then there would be a shortage in the market. Suppliers would want to supply less of the good than demanders would want to purchase at that price. Producers would increase the price until all that they wanted to sell at the market was bought, and this would occur at PE.

Qs

Qd

Note: we could do the same thing mathematically that we did for prices above equilibrium, but we could show the opposite case by imposing a price below equilibrium and show that it results in excess demand. To do this we would simply impose a price below $200 with our equations from (4). 6. Single Shift Results What Happens to P & Q When S or D Shift
a. Demand Shift i. The determinants of demand must change in order to get a shift in the demand curve. Otherwise we just get a movement along the previously defined curve. When we get a shift in demand we are interested in what happens to (P, Q) at equilibrium. ii. Shift out of Demand Graphically Graph 1: Affect on Equilibrium when Demand Shifts Out

P PE2 PE1

S
E2 E1

D1

D2

Results: If the demand curve shifts out we get P increasing and Q increasing. This can be seen in the graph where we let demand shift out from D1 to D2. We get PE1 < QE1above QE2 PE2 and QE1 < QE2, which verifies the above results. We can simply write: D P Q Note: We dont need to do the opposite case we can simply just think of the first curve being D2 and shifting in from that point. Consequently for D P Q b. Supply Shift i. The determinants of supply must change in order to get a shift in the supply curve. Otherwise we just get a movement along the previously defined curve. When we get a shift in supply we are interested in what happens to (P,Q) at equilibrium just as before, but we get different results than if we get a shift of demand. ii. Shift out of Supply Graphically Results: If the supply curve shifts out we get P dropping and Q increasing. This can be seen in the graph below where we let supply shift out from S1 to S2. We get PE1 > PE2 and QE1 < QE2, which verifies the above results. We can simply write: S P Q Note: We dont need to do the opposite case we can simply just think of the first curve being S2 and shifting in from that point and note that the opposite case is also true. So for S P Q
Graph 2: Affect on Equilibrium when Supply Shifts Out

P PE1 PE2

S1

S2
E1 E2

D Q Q1 Q2

7. Double Shift Cases If we have a double shift we can't solely use graphical analyses to describe what happens to P and Q at equilibrium. If we do, the way in which the graphs are drawn as well as the magnitude of the shift will determine the outcome. We dont want this. We want to come up with a way to get the same results no matter how we draw the curves. So, we must use our single shift components to do a complete analysis. We will draw one case and finish the explanation explaining what would happen completely with variable analysis. a. 4 Possible Cases with Double Shifts Table 1: Possible Outcome Possible Shifts for S/D Demand Up D Demand Down D Supply Up S SD SD Supply Down S SD SD

b. Now We Use Variables to Analyze So now we will analyze what happens with the above cases. We will do one of the cases above to illustrate the techniques we must use to get the overall results. Variable Analysis: Step 1: Break up into single shift components Lets do S D -S P Q -D P Q So we know that P goes up for sure since it goes up in both cases. We also know Qun det er min ed . We can have 3 cases for Q depending on the magnitude of the shifts of each curve.

(1) magnitude of supply shift greater than demand Q (2) magnitude of demand shift greater than supply Q (3) magnitude of each offset each other Qsame Graph 3: Illustration of Case (3) Above

P PE2

S2

S1

PE1

D1 Qsame

D2