Supply-Demand Diagrams

6/4/2020 Supply–Demand Diagrams | Lecture 2: Applying Supply and Demand | 14.
100x Courseware | edX
Course  Week 1…  Lecture…  Supply…
Supply–Demand Diagrams
Markets
Professor Gruber begins the next lecture by talking about supply and demand, so let's
have a quick primer about them.
Supply and demand jointly determine the quantity of each good produced, and the
price at which it is sold.
We usually think in terms of market supply and market demand, where a market is
everyone who wants to buy a certain good and everyone who wants to sell that same
good. Each good has an associated market. The buyers alone determine the market
demand for that good. The sellers alone determine the market supply for that good.
Furthermore, we'll start by usually assuming that these markets are perfectly

competitive. That is, there are so many buyers and sellers that no single buyer or seller
can in uence the price of the good unilaterally. If there are many sellers of a good,
then any seller who charges a higher price will not attract any buyers, and the price of
actual goods sold will remain unchanged. We call these sellers price takers because they
take the market price as given. A good example of a perfectly competitive market is a
commodity market, such as wheat. There are many wheat sellers, many wheat buyers,
and all wheat (up to a certain grade) is pretty much interchangeable. We'll relax the
assumption of perfect competition in the second third of this course, when we learn
about the production side of the market.
One last general note: supply and demand are invisible. Like the laws of physics, they
(usually) can't be directly observed, but we can understand and quantify them by
observing the things they act on, such as prices and quantities. However, as we learn
economics, we'll often make the simplifying assumption that we know supplies and
demands with mathematical certainty. This will make our calculations simpler.
Demand
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6/4/2020 Supply–Demand Diagrams | Lecture 2: Applying Supply and Demand | 14.100x Courseware | edX
Quantity demanded is the amount of a good or service that buyers are willing and able
to buy at a speci c price. It is usually negatively related to price. We call this negative
relationship the law of demand. (We will talk about exceptions later, but unless we are
discussing those exceptions you should assume that at higher prices, quantity
demanded is smaller.)
For example, when gasoline prices are low, buyers are willing and able to buy more
gasoline. When gasoline prices are high, buyers are unwilling or unable to buy more
gasoline. This might be due to each buyer buying less gasoline, or due to some buyers
ceasing to buy gasoline at all and dropping out of the market. Suppose that when
gasoline costs $2/gallon, US buyers demand 5 million gallons/day. Suppose that when
gasoline costs $4/gallon, US buyers only demand 2.5 million gallons/day. (Gasoline and
oil aren't the same thing, but in this exercise we'll look at the market for oil. For
simplicity, let's assume that a gallon of oil can be re ned into a gallon of gasoline at no
cost, i.e. let's assume that gasoline and oil are basically the same thing.)
Let's show this in a demand schedule, with some additional ctitious datapoints:
Price Quantity demanded
$1/gal. 10.0M gal.
$2/gal. 5.0M gal.
$3/gal. 3.3M gal.
$4/gal. 2.5M gal.
$5/gal. 2.0M gal.
Let's plot this data to build a graphical intuition:
Demand is the set of all quantities demanded over the range of all possible prices. It
describes the entire relationship between price and quantity demanded, and is
graphically represented as the demand curve. Perhaps the demand curve for oil looks
something like this:
Supply
Quantity supplied is the amount of a good or service that sellers are willing and able to
sell at a speci c price. It is usually positively related to price. We call this
positive relationship the law of supply. (We will talk about exceptions later, but unless
we are discussing those exceptions you should assume that at higher prices, quantity
supplied is larger.) To build intuition for the law of supply, think of sellers entering the
market only when they can pro tably sell their good.
For example, it is very cheap to pump crude oil out of the ground, but very expensive
to extract it from tar sands. Sellers who extract their product from tar sands will only
supply oil to the market when the price of oil is high, but those who pump it out of the
ground will supply oil to the market even when the price is pretty low. The higher the
price, the more sellers are willing and able to supply. Suppose that when gasoline costs
$2/gallon, US sellers supply 4 million gallons/day. Suppose that when gasoline costs
$4/gallon, US sellers supply 8 million gallons/day.
Let's show this in a supply schedule, with some additional ctitious datapoints:
Price Quantity supplied
$1/gal. 2.0M gal.
$2/gal. 4.0M gal.
$3/gal. 6.0M gal.
$4/gal. 8.0M gal.
$5/gal. 10.0M gal.
Let's plot this data to build a graphical intuition:
Supply is the set of all quantities supplied over the range of all possible prices. It
describes the entire relationship between price and quantity supplied, and is
graphically represented as the supply curve. Perhaps the supply curve for gasoline looks
something like this:
Equilibrium: Combining Supply and Demand

As you may have guessed by this point, we can gain additional insight by plotting both
curves at once. We call the resulting plot a supply–demand diagram.
Notice that the curves cross at exactly one point, that is, at a speci c price and a
speci c quantity. What is special about this price? At this price, buyers demand exactly
as much as sellers supply. This point is the market equilibrium, the price is the
equilibrium price, often designated P ∗ , and the quantity is the equilibrium quantity,
often designated Q∗ .
The equilibrium price and quantity are also sometimes called the market-clearing price
and quantity. If all the buyers and sellers gathered together in a single marketplace,
and buyers purchased as much as they were willing and able to at the equilibrium
price, then the each buyer and seller would nish their business and go home for the
day. There would be nobody left in the market trying fruitlessly to buy or sell additional
goods at that price. Thus, this market is said to have cleared.
Consider a price below the equilibrium price. (That is, consider a price level below the
equilibrium price in a supply–demand diagram.) At this price, quantity demanded
exceeds quantity supplied. Buyers would be delighted to buy cheap gasoline, but many
sellers are going to close up shop. This is a shortage.
Consider a price above the equilibrium price. (That is, consider a price level above
the equilibrium price in a supply–demand diagram.) At this price, quantity supplied
exceeds quantity demanded. Sellers would be delighted to provide expensive gasoline,
but many buyers are going to cut back on purchases. This is a surplus.
But wait one second. This doesn't make any sense! How can we have a shortage in a
competitive market? With long lines of buyers going home empty-handed, sellers
would realize that they could charge higher prices, and still sell all their goods. In fact,
the higher price will also entice more sellers into the market. When the market price is
below the equilibrium price, the market price will rise!
On the other hand, how can we have a surplus in a competitive market? With sellers
nervously eyeing piles of unsold inventory, a clever merchant would realize that she
could charge slightly lower prices, undercut the market, and sell all her goods. Of
course, she is not the only seller to realize this; all of them will cut their prices. No seller
wants to be left with useless rotting inventory. When the market price is above the
equilibrium price, the market price will fall!
Putting two and two together, we see that market forces will always push the market
price toward the market-clearing price, and once it arrives there, there is no further
pressure to move. This is the law of supply and demand, and it is one of the most
powerful concepts in economics. Adam Smith called this equilibrium-seeking behavior
the Invisible Hand of the market.
Notes on Supply and Demand
1. We are accustomed to putting the independent variable on the horizontal axis, and
the dependent variable on the vertical axis. However, it's natural to think of price as
being the independent variable in these diagrams. For example, you might ask a
question like, "What quantity would the market demand at a price of $4000/ton?" But
we always put price on the vertical axis. Why? To make a long story short, there are
some historical reasons that economists started putting price on the vertical axis,
and now it's too late to change. Remember: price always goes on the vertical axis.
Period. (Okay, you really want the story? Here's why. It comes from the 1890 book Principles of
Economics by Alfred Marshall. "Marshallian demand" treats quantity as an independent variable.
"Walrasian demand" treats quantity as a dependent variable. Today, we more often think like Walras
(or we think of price and quantity as codependent), but we use Marshall's diagrams. Exact
explanations vary, but you can read more by Googling. For example, this blog gives some
background.)
2. When your TA encountered supply and demand curves, he found it useful to think of

them as boundaries of the areas in which sellers (and buyers) were willing and able to
sell (and buy) more at that price. These areas are the areas to the left of the supply
and demand curves, respectively. If this is intuitive to you, great. If not, forget it.
3. Notice that I drew the supply curve as a straight line, but the demand curve bowed
inward. There's a reason for that. If the demand curve intersected the quantity axis,
that would mean that even if the good were free, consumers would limit how much
they bought. We tend to think this isn't sensible. There's always going to be some
consumer who wants more. However, in this course, for simplicity, we'll often model
the demand curve as a straight line. We do that to make the math easier. However,
it's also not unreasonable, because you can think of the demand curve as being
straight over the range of analytically relevant prices. (In fact, for the calculus-minded
student, you can think of any linear functions we use as local linear
approximations of arbitrary curves.) This is why you'll often see supply and demand
curves drawn without touching any axes. Near the axes, things can get weird, and we
usually don't care about that area anyway.
4. We'll shortly be talking about shifts of supply and demand, which is when supply and
demand curves move or change shape. When the entire curve moves to the right, we
call this a rightward shift. When it moves to the left, we call it a leftward shift. But
sometimes we also use the terms inward and outward to describe shifts. For a
demand curve, it seems natural that the inward direction is leftward (or downward).
But what about a supply curve? It's not obvious whether an "inward"-shifting supply
curve is moving to the left (or upward), or to the right (and downward). The answer
is: inward always means leftward. "Inward" refers to the quantity moving to a lower
value at each price.
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6/4/2020 Supply–Demand Diagrams | Lecture 2: Applying Supply and Demand | 14.

100x Courseware | edX

Course  Week 1…  Lecture…  Supply…

Furthermore, we'll start by usually assuming that these markets are perfectly

Price Quantity demanded

$1/gal. 10.0M gal.

$2/gal. 5.0M gal.

$3/gal. 3.3M gal.

$4/gal. 2.5M gal.

$5/gal. 2.0M gal.

Let's plot this data to build a graphical intuition:

Let's show this in a supply schedule, with some additional ctitious datapoints:

$1/gal. 2.0M gal.

$2/gal. 4.0M gal.

$3/gal. 6.0M gal.

$4/gal. 8.0M gal.

$5/gal. 10.0M gal.

Let's plot this data to build a graphical intuition:

Equilibrium: Combining Supply and Demand

Notes on Supply and Demand

2. When your TA encountered supply and demand curves, he found it useful to think of

Supply–Demand Diagrams Hide Discussion

Show all posts by recent activity

 Question regarding something mentioned in the blog link

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