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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
10

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.
Ex: Table 2

P
0
1
2
3

Qs
0
2
4
6

P
4
5
6
7

Qs
8
10
12
14

P
8
9
10

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.
4. Graphically:

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).

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
form: Qs = 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

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
Qs

Qd

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.

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

PE2

E2

PE1

E1

D1

QE1

D2

QE2
6

Results: If the demand curve shifts out we get P increasing and Q increasing. This can
be seen in the graph above where we let demand shift out from D1 to D2. We get PE1 <
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

S1

S2
E1

PE1

E2

PE2
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 Q same
Graph 3: Illustration of Case (3) Above

S2

S1

PE2

PE1

D1

D2

Qsame