Theory of Supply and

Demand
Hall and Lieberman, 3rd edition, Thomson South-Western, Chapter 3
 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 works and how
to use it
1. The law of demand
2. The law of supply
3. The determination of market equilibrium
4. Factors shifting demand or supply curves

2
 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

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 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

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 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

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 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, we’ll view business
firms as the only sellers, and households as only buyers
– In most of our discussions, we’ll be leaving out the
“middleman”

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 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 economist’s tool kit

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 Demand
 A household’s 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

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 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
– We’ll assume that all other influences on demand are held constant, so
we can explore the relationship between price and quantity demanded

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 The Law of Demand
 The price of a good rises and everything else
remains the same, the quantity of the good
demanded will fall
– 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

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 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

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 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

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 Figure 1: The Demand Curve
Price per
Bottle

When the price is $4.00

per bottle, 40,000 bottles
are demanded (point A).
A
$4.00
At $2.00 per bottle,
60,000 bottles are
B demanded (point B).
2.00

40,000 60,000 Number of Bottles

per Month

15
 “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)

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 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 Q1 Q3 Quantity

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 “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 good’s price—causes the demand curve to shift

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 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

B C
$2.00

D1 D2

60,000 80,000 Number of Bottles

per Month

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 “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 demanded
—and 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

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 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

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 Wealth: Factors That Shift The
Demand Curve
 Your wealth—at any point in time—is 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

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 Prices of Related Goods: Factors
that Shift the Demand Curve
 Substitute—good 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
 Complement—used 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

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 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

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 Small Summary
-- Factors Affecting Demand
 Income (depends on good’s nature: normal or
inferior)
 Wealth (depends on good’s nature)
 Prices of substitutes (positively related)
 Prices of complements (negatively related)
 Population (positively related)
 Expected price (positively related)
 Tastes (positively related)

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 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

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 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 firm’s 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

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 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
– We’ll 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
Curve
 Supply schedule—shows quantities of a good
or service firms would choose to produce and
sell at different prices, with all other variables
held constant
 Supply curve—graphical depiction of a supply
schedule
– Shows quantity of a good or service supplied at
various prices, with all other variables held constant

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 Figure 4: The Supply Curve
Price per When the price is $2.00
Bottle per bottle, 40,000 bottles
S
are supplied (point F).

$4.00 G

At $4.00 per bottle,

2.00 F quantity supplied is
60,000 bottles (point G).

40,000 60,000 Number of Bottles

per Month

32
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 supply—except for the good’s
price—causes the supply curve to shift

33
 Figure 5: A Shift of The Supply Curve

Price per A decrease in transportation

Bottle 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 J
G

60,000 80,000 Number of Bottles

per Month

34
 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

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 Factors That Shift the Supply Curve

 Number of Firms
– An increase (decrease) in the number of sellers
—with no other changes—shifts 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)

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 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

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 Figure 6(a): Changes in Supply
and in Quantity Supplied
Price Price increase moves S
us rightward along
supply curve

P2

P1
Price increase moves
us leftward along
P3 supply curve

Q3 Q1 Q2 Quantity
38
 Figure 6(b): Changes in Supply
and in Quantity Supplied
Price Entire supply curve shifts S1
rightward when: S2
• price of input ↓
• price of alternate good ↓
• number of firms ↑
• expected price ↑
• technological advance
• favorable weather

Quantity
39
 Figure 6(c): Changes in Supply
and in Quantity Supplied
Price
Entire supply curve shifts S2
rightward when: S1
• price of input ↑
• price of alternate good ↑
• number of firms ↓
• expected price ↑
• unfavorable weather

Quantity
40
 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 2. causes the price 3. shrinking the
Bottle to rise . . . excess demand . . .

E
4. until price reaches its
$3.00 equilibrium value of $3.00
.
H
1.00 J
Excess Demand
D
25,000 50,000 75,000 Number of Bottles
1. At a price of $1.00 per
per Month
bottle an excess demand
of 50,000 bottles . . .
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 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
1. At a price of $5.00 per
Price per bottle an excess supply
Bottle of 30,000 bottles . . .

Excess Supply at $5.00 S 3. shrinking the

excess supply . . .
$5.00 L
K
2. causes the
price to drop, E
3.00 4. until price reaches its
equilibrium value of
$3.00.

D
35,000 50,000 65,000 Number of Bottles
per Month
45
 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
equationQ  140  10 P ,
D D
where Q is
quantity demanded, P is the price of the
good. Supply is given by Q S  80  5 P
where Q s is quantity supplied.
 What is the equilibrium price and quantity?

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
4. Equilibrium 3. to a new
Price per price equilibrium.
Bottle increases
2. moves us along
S the supply
curve . . .
$4.00 F'
1. An increase in
E demand . . .
3.00

D2

D1

50,000 60,000 Number of Bottles of

5. and equilibrium quantity Maple Syrup per Period
increases too.

49
 An Ice Storm Hits: What Happens
When Things Change
 An ice 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 S2 S1

$5.00 E'

3.00 E

35,000 50,000 Number of Bottles

51
 Using Supply and Demand: The
Invasion of Kuwait
 Why did Iraq’s 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 industry’s
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

P1 E

Q2 Q1 Barrels of Oil

53
 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 S

F'
P4
F
P3 D2

D1

Q3 Q4 Cubic Feet of
Natural Gas

55
 Figure 11: Changes in the
Market for Handheld PCs
Price per 3. moved the market to
Handheld a new equilibrium.
PC
2. and a decrease
in demand . . .
4. Price
decreased . . . S2002
S2003
A
$500 1. An increase in
B supply . . .
$400

5. and quantity D2002

decreased as well. D2003
2.45 3.33 Millions of Handheld PCs
per Quarter
56
 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 quantity—but not both
– Direction of the other will depend on which curve shifts
by more

57
 The Three Step Process
 Key Step 1—Characterize the Market
– Decide which market or markets best suit problem being
analyzed and identify decision makers (buyers and
sellers) who interact there
 Key Step 2—Find the Equilibrium
– Describe conditions necessary for equilibrium in the
market, and a method for determining that equilibrium
 Key Step 3—What Happens When Things Change
– Explore how events or government polices change
market equilibrium

58
 Example: rental apartment
 Example: problem 4, quantity quantity
rent($) demanded supplied
chapter 3 in textbook.
 Demand & Supply Diagram 800 30 10

 Equilibrium P & Q
1000 25 14
 Why $1000 can not be
equilibrium? 1200 22 17

 Effects from a tornado 1400 19 19

destroying some
apartments. 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