CHAPTER 2

Market Forces:
Demand and Supply

Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter Outline

Chapter Overview

Demand

Factors that change quantity demanded and factors that change demand
The demand function
Consumer surplus

Supply

Factors that change quantity supplied and factors that change supply
The supply function
Producer surplus

Market equilibrium
Price restrictions and market equilibrium
Price ceilings
Price floors

Comparative statics

Changes in demand
Changes in supply
Simultaneous shifts in supply and demand
2-2

Demand

Demand

Market demand curve

Illustrates the relationship between the total
quantity and price per unit of a good all
consumers are willing and able to purchase,
holding other variables constant.

Law of demand
The quantity of a good consumers are willing and
able to purchase increases (decreases) as the
price falls (rises).

2-3

Demand

Market Demand Curve

Price ($)
$40

$30
$20

$10

Demand
0

20

40

60

80

Quantity

(thousands per year)

2-4

Changes in Quantity Demanded

Demand

Changing only price leads to changes in

quantity demanded.
This type of change is graphically represented by a
movement along a given demand curve, holding
other factors that impact demand constant.

Changing factors other than price lead to

changes in demand.
These types of changes are graphically
represented by a shift of the entire demand curve.

2-5

Changes in Demand

Demand

Price

Increase
in
demand

Decrease
in
demand

D1
D2
0

D0
Quantity

2-6

Demand Shifters

Demand

Income

Normal good
Inferior good

Prices of related goods

Substitute goods
Complement goods

Advertising and consumer tastes

Informative advertising
Persuasive advertising

Population
Consumer expectations
Other factors
2-7

Demand

Advertising and the Demand for Clothing

Price of
high-style
clothing
Due to an
increase in
advertising

$50
$40

D2
D1
0

50,000 60,000

Quantity of
high-style
clothing
2-8

The Demand Function

Demand

The demand function for good X is a

mathematical representation describing how
many units will be purchased at different
prices for good X, different prices of a related
good Y, different levels of income, and other
factors that affect the demand for good X.

2-9

The Linear Demand Function

Demand

One simple, but useful, representation of a

demand function is the linear demand function:

= 0 + + + +
, where:

is the number of units of good X demanded;

is the price of good X;
is the price of a related good Y;
is income;
is the value of any other variable affecting demand.
2-10

Demand

Understanding the Linear Demand Function

The signs and magnitude of the coefficients
determine the impact of each variable on the
number of units of X demanded.
= 0 + + +
For example:
< 0 by the law of demand;
> 0 if good Y is a substitute for good X;
< 0 if good X is an inferior good.

2-11

Demand

The Linear Demand Function in Action

Suppose that an economic consultant for X Corp. recently
provided the firms marketing manager with this estimate of the
demand function for the firms product:
= 12,000 3 + 4 1 + 2

Question: How many of good X will consumers purchase when

= $200 per unit, = $15 per unit, = $10,000 and
= 2,000? Are goods X and Y substitutes or complements? Is
good X a normal or an inferior good?

Answer:
= 12,000 3 200 + 4 15 1 10,000 + 2 2000 =
5,460 units. Goods X and Y are substitutes. Good X is an inferior
good.
2-12

Inverse Demand Function

Demand

By setting = $15 and = $10,000 and

= 2,000 the demand function is

= 12,000 3 + 4 15 1 10,000 + 2 2,000

the linear demand function simplifies to

= 6,060 3
Solving this for in terms of results in
1
= 2,020
3
, which is called the inverse demand function. This
function is used to construct a market demand
curve.
2-13

Demand

Graphing the Inverse Demand Function in Action

Price
$2,020

1
= 2,020
3

6,060

Quantity

2-14

Consumer Surplus

Demand

Marketing strategies like value pricing and

price discrimination rely on understanding
consumer value for products.
Total consumer value is the sum of the maximum
amount a consumer is willing to pay at different
quantities.
Total expenditure is the per-unit market price
times the number of units consumed.
Consumer surplus is the extra value that
consumers derive from a good but do not pay for.
2-15

Demand

Market Demand and Consumer Surplus in Action

Consumer Surplus
Price per
liter

Consumer Surplus:
0.5($5 - $3)x(2-0) = $2
Total Consumer Value:
0.5($5 - $3)x2+(3-0)(2-0) = $8

$5
$4

Expenditures:
$(3-0) x (2-0) = $6

$3
$2
$1

Demand
0

Quantity
in liters
2-16

Supply

Supply

Market supply curve

Summarizes the relationship between the total
quantity all producers are willing and able to
produce at alternative prices, holding other
factors affecting supply constant.

Law of supply
As the price of a good rises (falls), the quantity
supplied of the good rises (falls), holding other
factors affecting supply constant.

2-17

Changes in Quantity Supplied

Supply

Changing only price leads to changes in

quantity supplied.
This type of change is graphically represented by a
movement along a given supply curve, holding
other factors that impact supply constant.

Changing factors other than price lead to

changes in supply.
These types of changes are graphically
represented by a shift of the entire supply curve.

2-18

Change in Supply in Action

Supply

Price
S1

S0
B

Decrease
in supply

S2

Increase
in supply
A

Quantity

2-19

Supply Shifters

Supply

Input prices
Technology or government regulation
Number of firms
Entry
Exit

Substitutes in production
Taxes
Excise tax
Ad valorem tax

Producer expectations
2-20

Change in Supply in Action

Supply

Excise tax
Price
of
gasoline

S0+t

$1.20

S0
t = 20

t
$1.00

t = per unit tax of 20

Quantity of
gasoline per
week
2-21

Change in Supply in Action

Price Ad valorem tax
of
backpacks

Supply

S1 = 1.20 x S0

$24
S0
$20
$12
$10

1,100

2,450

Quantity of
backpacks per
week
2-22

The Supply Function

Supply

The supply function for good X is a

mathematical representation describing how
many units will be produced at different prices
for X, different prices of inputs W, prices of
technologically related goods, and other
factors that affect the supply for good X.

2-23

The Linear Supply Function

Supply

One simple, but useful, representation of a

supply function is the linear supply function:

= 0 + + + +
, where:
is the number of units of good X produced;
is the price of good X;
is the price of an input;
is price of technologically related goods;
is the value of any other variable affecting
supply.

2-24

Supply

Understanding the Linear Supply Function

The signs and magnitude of the coefficients
determine the impact of each variable on the
number of units of X produced.
= 0 + + +
For example:
> 0 by the law of supply.
< 0 increasing input price.
> 0 technology lowers the cost of producing
good X.

2-25

Supply

The Linear Supply Function in Action

Your research department estimates that the
supply function for televisions sets is given by:
= 2,000 + 3 4 1
Question: How many televisions are produced
when = $400, = $100 per unit, and
= $2,000?

Answer:
= 2,000 + 3 400 4 100 1 2,000 =
800 television sets.

2-26

Inverse Supply Function

Supply

By setting = $2,000 and = $100 in

= 2,000 + 3 4 100 1 2,000

the linear supply function simplifies to
= 3 400

Solving this for in terms of results in

400 1
=
+
3
3
, which is called the inverse supply function.
This function is used to construct a market
supply curve.
2-27

Producer Surplus

Supply

The amount producers receive in excess of the

amount necessary to induce them to produce
the good.

2-28

Producer Surplus in Action

400 1
=
+
3
3

Price
$400

$400
3

800

Supply

Supply

Producer surplus

Quantity

2-29

Market Equilibrium

Market Equilibrium

Competitive market equilibrium

Price of a good is determined by the interactions
of the market demand and market supply for the
good.
A price and quantity such that there is no shortage
or surplus in the market.
Forces that drive market demand and market
supply are balanced, and there is no pressure on
prices or quantities to change.

2-30

Market Equilibrium I
Price

Market Equilibrium

Supply
Surplus

Shortage
0

Demand
1

Quantity

2-31

Market Equilibrium

Market Equilibrium II
Consider a market with demand and supply
functions, respectively, as
= 10 2 and = 2 + 2
A competitive market equilibrium exists at a
price, , such that = . That is,
10 2 = 2 + 2
8 = 4
= $2
= 10 2 $2 = 6 and = 2 + 2 $2 = 6
= 6 units

2-32

Price Restrictions and Market Equilibrium

Price Restrictions

In a competitive market equilibrium, price and

quantity freely adjust to the forces of demand
and supply.
Sometimes the government restricts how
much prices are permitted to rise or fall.
Price ceiling
Price floor

2-33

Price Restrictions and Market Equilibrium

Price Ceiling in Action I

Price

Supply

Nonpecuniary price

Lost social welfare

Priceceiling
Shortage
0

Demand

Quantity

2-34

Price Restrictions and Market Equilibrium

Price Ceiling in Action II

Consider a market with demand and supply

functions, respectively, as
= 10 2 and = 2 + 2
Suppose a $1.50 price ceiling is imposed on the
market.

= 10 2 $1.50 = 7 units.
= 2 + 2($1.50) = 5 units.
Since > a shortage of 7 5 = 2 units exists.
Full economic price of 5 unit is 5 = 10 2 , or
= $2.50. Of this,
$1.50 is the dollar price
$1 is the nonpecuniary price

2-35

Price Restrictions and Market Equilibrium

Price Floor in Action I

Price

Supply
Surplus

Pricefloor

Cost of
purchasing
excess supply
Demand
0

Quantity

2-36

Price Restrictions and Market Equilibrium

Price Floor in Action II

Consider a market with demand and supply

functions, respectively, as
= 10 2 and = 2 + 2
Suppose a $4 price floor is imposed on the
market.
= 10 2 $4 = 2 units
= 2 + 2($4) = 10 units
Since > a surplus of 10 2 = 8 units
exists
The cost to the government of purchasing the
surplus is $4 8 = $32.

2-37

Comparative Statics

Comparative Statics

Comparative static analysis

The study of the movement from one equilibrium
to another.

Competitive markets, operating free of price

restraints, will be analyzed when:
Demand changes;
Supply changes;
Demand and supply simultaneously change.

2-38

Changes in Demand

Comparative Statics

Increase in demand only

Increase equilibrium price

Increase equilibrium quantity

Decrease in demand only

Decrease equilibrium price

Decrease equilibrium quantity

Example of change in demand

Suppose that consumer incomes are projected to

increase 2.5% and the number of individuals over 25
years of age will reach an all time high by the end of
next year. What is the impact on the rental car
market?

2-39

Comparative Statics

Change in Demand in Action

Demand for Rental Cars
Price

Supply

$49

$45

Demand1
Demand0
0

100

104

108

Quantity

(thousands
rented per day)
2-40

Changes in Supply

Comparative Statics

Increase in supply only

Decrease equilibrium price
Increase equilibrium quantity

Decrease in supply only

Increase equilibrium price
Decrease equilibrium quantity

Example of change in supply

Suppose that a bill before Congress would require
all employers to provide health care to their
workers. What is the impact on retail markets?
2-41

Comparative Statics

Change in Supply in Action

Price

Supply1
Supply0

0
Demand

Quantity

2-42

Comparative Statics

Simultaneous Shifts in Supply and Demand

Suppose that simultaneously the following
events occur:
an earthquake hit Kobe, Japan and decreased the
supply of fermented rice used to make sake wine.
the stress caused by the earthquake led many to
increase their demand for sake, and other
alcoholic beverages.

What is the combined impact on Japans sake

market?

2-43

Comparative Statics

Simultaneous Shifts in Supply and Demand in Action

Price

Japans Sake Market

Supply2

Supply1
B

Supply0

Demand1
Demand0
0

2 0

Quantity

2-44

Conclusion
Demand and supply analysis is useful for
Clarifying the big picture (the general impact of
a current event on equilibrium prices and
quantities).
Organizing an action plan (needed changes in
production, inventories, raw materials, human
resources, marketing plans, etc.).

2-45

Demand

Market Demand Curve

Price

(Dollars per Barrel)

International Oil Market

$140
$100
$60
$20

Demandoil
0

80

160

240

280

Quantity

(Millions of Barrels)
2-46

Changes in Quantity Demanded

Price

(Dollars per Barrel)

Demand

International Oil Market

$140
Increase in quantity demanded

$100
$90

Demandoil
0

80 100

280

Quantity

(Millions of Barrels)
2-47

Demand

Change in Demand
International Oil Market

Price

(Dollars per Barrel)

$160
$140
$100
$90

Increase in demand
Demandoil2
Demandoil1
0

80 100

120 140

280 Quantity

(Millions of Barrels)
2-48

Change in Quantity Supplied

Supply

International Oil Market

Price

Supplyoil

(Dollars per Barrel)

$65
$60

Increase in quantity supplied

$20
0

80

90

Quantity

(Millions of Barrels)
2-49

Supply

The Market Supply Curve

International Oil Market
Price

Supplyoil

(Dollars per Barrel)

$140
$100
$60

$20
0

80

160

240

Quantity

(Millions of Barrels)
2-50

Change in Supply in Action

Supply

International Oil Market

Price

(Dollars per Barrel)

Supplyoil2

Decrease in supply

Supplyoil1

$140

$100

$50
$20
0

100

160

180

240

Quantity

(Millions of Barrels)
2-51

Market Equilibrium

Competitive Market Equilibrium I

International Oil Market
Price

(Dollars per Barrel)

Supplyoil

Surplus
160 million barrels

$140

Forces of demand and supply

put downward
pressure on price.
Competitive market equilibrium
Qd(Pe) = Qs(Pe)
Forces of demand and supply
put upward pressure
on price.
Shortage
Demandoil
160 million barrels

$120
Pe = $80
$40
$20
0

40

Qe = 120

200

280 Quantity

(Millions of Barrels)
2-52

Price Restrictions and Market Equilibrium

Price Ceiling in Action I

International Oil Market
Price

Supplyoil

(Dollars per Barrel)

Lost social welfare

Nonpecuniary price

$140
Pf = $120

Competitive market equilibrium

Qd(Pe) = Qs(Pe)

Pe = $80

Priceceiling

Pc = $40
Shortage
160 million barrels

$20
0

40

Qe = 120

Demandoil
200

280 Quantity

(Millions of Barrels)
2-53

Changes in Demand

Comparative Statics

Increase in demand only

Increase equilibrium price
Increase equilibrium quantity

Decrease in demand only

Decrease equilibrium price
Decrease equilibrium quantity

Example of change in demand

Suppose that worldwide demand for automobiles
is projected to decrease by 30% next year. What is
the impact on the international crude oil market?
2-54

Comparative Statics

Change in Demand in Action

International Oil Market
Price

Supplyoil

(Dollars per Barrel)

$140

Pe1 = $80
Pe2 = $54
Demandoil2

$20
0

Qe2 = 68

Qe1 = 120

Demandoil1
280 Quantity

(Millions of Barrels)
2-55

Changes in Supply

Comparative Statics

Increase in supply only

Decrease equilibrium price
Increase equilibrium quantity

Decrease in supply only

Increase equilibrium price
Decrease equilibrium quantity

Example of change in supply

Suppose that war breaks out in a major oilproducing country in the Middle East. What is the
impact on the international crude oil market?
2-56

Comparative Statics

Change in Supply in Action

International Oil Market
Price

Supplyoil2

(Dollars per Barrel)

Supplyoil1

$140
Pe2 = $100
Pe1 = $80

Demandoil

$20
0

Qe2 = 80 Qe1 = 120

280 Quantity

(Millions of Barrels)
2-57

Comparative Statics

Simultaneous Shifts in Supply and Demand

Suppose that simultaneously the following
two events occur:
worldwide demand for automobiles is projected
to decrease by 30% next year.
war breaks out in a major oil-producing country in
the Middle East.

What is the combined impact on the

international crude oil market?

2-58

Comparative Statics

Simultaneous Shifts in Supply and Demand in Action

International Oil Market
Price

Supplyoil2

(Dollars per Barrel)

Supplyoil1

$140
The equilibrium price increases
or decreases depending on the
magnitude of the demand
and supply changes.

Pe1 = $80
Pe2 = $65

$20

Demandoil2
Qe2 = 10

Qe1 = 120

Demandoil1
280 Quantity

(Millions of Barrels)
2-59