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Topic 5. Elements of the

market mechanism:
1. Demand and the law of demand
demand, supply, elasticity 2. Supply and the law of supply
of demand and supply. 3. Market equilibrium
4. Price elasticity of demand
5. Cross price elasticity of demand
6. Income elasticity of demand
7. Price elasticity of supply

Demand is … It is worth noting that this definition incorporates three

• Demand refers to the quantities that people are or
would be willing to buy at different prices during a
given time period, assuming that other factors
affecting these quantities remain the same
important concepts:
1. It involves three parameters – price, quantity and
time.
2. It refers to quantities in the plural, therefore a
whole relationship, not a single quantity.
3. It involves the ceteris paribus (other things being
equal) assumption, which is a very common one in
making statements in economics.

Equations
There are three methods of demand
The general form of the demand function:
representation:
• Qd = f(P; A ; Y ; Ps; Pc; F; S, CE…)
•Equations,
Where:
P represents price of the product,
A represents advertising expenditure,
•Tables , Y represents average income of the market,
Ps represents the price of a substitute product,
Pc represents the price of a complements product
•Graphs F represents fashion,
S represents seasons
CE represents consumer expectations

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Consumer's Demand Schedule for Coffee

Equations
Quantity Demanded
• Price in the most important factor, that's why the
Price (per pound) (pounds per year)
general form of the demand function in terms of
price and quantity demanded is: $5 5

4 10
Qd = f(P) 3 15

2 20

1 25

Consumer's Demand
Demand curve
Curve for Coffee
$5
• An individual demand curve for a particular good
Individual
illustrates the same information as the individual 4 demand curve
Price of Coffee (per pound)

demand schedule.
• It reveals the relationship between the price and 3
the quantity demanded, showing that when the
price is higher, the quantity demanded is lower. 2

0 5 10 15 20 25 30
Quantity of Coffee Demanded (pounds per year)

Market Demand Creating a Market Demand Curve

• Economists usually speak of the demand curve in

terms of large groups of people.
• The horizontal summing of the demand curves of Homer Marge Rest of Springfield Market Demand

many individuals is called the market demand curve 5

4
5

4
5

4
5

for a product.
Price of Coffee

Price of Coffee
Price of Coffee
Price of Coffee

3 3 3 3
+ + =
DHOMER DM
• It reflects the fact that the total quantity purchased
2 2 2 DS 2
DMARGE
1 1 1 1

in the market at a price is the sum of the quantities 0 5 10 15 20 25 0 5 10 15 20 25 0 2,970 4,960 0 3,000 5,000

purchased by each demander. Quantity of Coffee Quantity of Coffee Quantity of Coffee Quantity of Coffee

The market demand curve shows the

amounts that all the buyers in the market
would be willing to buy at various prices.

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Change in quantity demanded

A Market Demand Curve
and change in demand

Price of Coffee (per pound)

• Change in quantity demanded. Changes in the
5
price of a good lead to a change in the quantity
Market
4 demand
demanded of that good. This corresponds to a
curve movement along a given demand curve.
3
• Change in demand. Changes in variables other than
2 the price of a good, such as income or the price of
another good, lead to a change in demand. This
1 corresponds to a shift of the entire demand curve.
0 2 4 6 8 10 12
Quantity of Coffee Demanded
(thousands of pounds per year)

Change in quantity demanded

Shifts in the Demand Curve P
D1
D2

D3
• An increase in demand is represented by a A
C
rightward shift in the demand curve. Pa

• A decrease in demand is represented by a leftward B

shift in the demand curve. Pb

Change in demand
Q
Qa Qb Qc

Shifts in the Demand Curve Shifts in the Demand Curve

• A major variable that shifts the demand curve is the
price of closely related goods.
• Two goods are called substitutes if an increase in the
price of one causes a decrease in the demand for the
other good.
• The opposite also applies: Two goods are called substitutes if a
decrease in the price of one causes an increase in the demand
for the other good.

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• Substitutes Goods for which an increase (decrease) in

the price of one good leads to an increase (decrease)
in the demand for the other good.
Shifts in the Demand Curve
• Because personal tastes differ, what are substitutes
for one person may not be so for another person.
• Further, some substitutes are better than others.
• For example, butter and margarine.

Shifts in the Demand Curve Shifts in the Demand Curve

• Two goods are complements if an increase in the
price of one good causes a decrease in the demand
for the other good.
• The opposite is also true: Two goods are
complements if a decrease in the price of one good
causes an increase in the demand for the other
good.

• Complements Goods for which an increase (decrease)

in the price of one good leads to a decrease (increase)
in the demand for the other good.
Shifts in the Demand Curve
• Generally the consumption of goods and services is
positively related to the income available to
consumers.
• As individuals receive more income, they tend to
increase their purchases of most goods and
services.

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Shifts in the Demand Curve Possible Demand Shifters

Income increases (normal good)
• Other things equal, an increase in income usually
leads to an increase in demand for goods
(rightward shift).
• A decrease in income usually leads to a decrease in

Price
the demand for goods (leftward shift).
• Such goods are called normal goods.
• For example, CDs and movie tickets.

D0 D1
0
Quantity

Shifts in the Demand Curve Possible Demand Shifters

Increase in the number of buyers in the market
• The demand for a good or service will vary with the
size of the potential consumer population.
• An increase in the potential consumer population
will increase (shift right) the demand for a good or
Price

service.

D0 D1
0
Quantity

Possible Demand Shifters

Tastes change in favor of the good
• Changes in fashions, seasons, advertising, etc. can
change tastes or preferences.
• An increase in tastes or preferences for a good or
service will increase (shift right) the demand for a
Price

good or service.

Shifts in the
Demand Curve
D0 D1
0
Quantity

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The law of demand
• The law of demand states that other factors being
constant (cetris peribus), price and quantity
demand of any good and service are inversely
related to each other.
• When the price of a product increases, the demand
for the same product will fall.
• Veblen goods are a member of a group of
commodities whose demand is proportional to their
price. The Veblen effect is named after economist
Thorstein Veblen, who first identified the concepts of
conspicuous consumption and status-seeking in 1899
2. Supply
Supply is the amount of something that firms, or
other economic agents are willing to provide to
the marketplace
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Exceptions to the law of demand
• Giffen goods area products that people consume
more of as the price rises.
• The goods in question must be an inferior good.
(Potatoes during the Irish Great Famine (“Potato
Paradox”), Anthony Bopp (1983) proposed that
kerosene, a low-quality fuel used in home heating,
was a Giffen good. Schmuel Baruch and Yakar Kanai
(2001) suggested that shochu, a Japanese distilled
beverage, might be a Giffen good too.)
• Expectation of change in the price of commodity.
If an increase in the price of a commodity causes
households to expect the price of a commodity to
increase further, they may start purchasing a
greater amount of the commodity even at the
presently increased price
Determinants of supply
• Qs = f (P, Px, Py, Pz, T, Tx, Pa, Pb, Pc, Exp, N …)
where:
• P - Price of the good
• Px, Py, Pz - Resource Prices
• T - Technology
• Tx - Taxes and subsidies
• Pa, Pb, Pc - Price of Other Goods
• Exp - Expectations
• N - Number of Sellers
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Equations The law of supply

• Price in the most important factor, that's why the
general form of the supply function in terms of
price and quantity supplied is:
Qs = f(P)
• The law of supply states that, other things equal,
the quantity supplied will vary directly with the
price of the good.
• According to the law of supply,
• the higher the price of the good, the greater the
quantity supplied,
• and the lower the price of the good, the smaller the
quantity supplied.

The law of supply The law of supply

• The quantity supplied is positively related to the
price.
• Firms supplying goods and services want to increase
their profits, and the higher the price per unit, the
greater the profitability generated by supplying more of
that good or service.
• Also, if costs are rising for producers as they produce
more units, they must receive a higher price to
compensate them for their higher costs.

Supply Individual supply (by one firm)

• The quantity supplied is positively related to the • The individual supply curve is upward sloping.
price. • At higher prices, it will be more attractive to
• Firms supplying goods and services want to increase production.
increase their profits, and the higher the price
• Existing firms will produce more at higher prices
per unit, the greater the profitability generated
than at lower price in a particular time interval,
by supplying more of that good or service.
other things equal.
• Also, if costs are rising for producers as they
produce more units, they must receive a higher
price to compensate them for their higher costs.

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An Individual Supply Curve Market Supply

$5

Price of Coffee (per pound)

• The market supply curve for a product is the
4 horizontal summation of the supply curves for
individual firms.
3 John’s
supply • It reflects the fact that the total quantity sold in the
2
curve market at a price is the sum of the quantities sold
by each supplier.
1

0 20 40 60 80 100 120
Quantity of Coffee Supplied
(pounds per year)

changes in quantity supplied vs.

Exhibit 2: A Market Supply Curve
change in supply
Price of Coffee (per pound)

Quantity Supplied $5
(pounds per year)
• Changes in the price of a good lead to changes in
Other Market 4
Price John +
Producers
=
Supply
quantity supplied, which are shown as movements
$5 80 + 7,920 = 8,000 3 Market along a given supply curve.
4 70 + 6,930 = 7,000 Supply
3 50 + 4,950 = 5,000
2 Curve • Changes in supply occur for other reasons
2 30 + 2,970 = 3,000
1 10 + 990 = 1,000 • A change in any other factor that can affect supplier
1 behavior results in a shift of the entire supply
curve.
0 2 4 6 8 10 12
Quantity of Coffee Supplied
(thousands of pounds per year)

Change in Supply versus

Non-price factors of supply
Change in Quantity Supplied
S0 S1
• These factors include:
A B • supplier input prices
P1
B C Change in • expectations
Price of Cotton

quantity supplied • number of suppliers

B C • technology: regulations, taxes, subsidies
A Change in
P0
supply

0 QA QB QC
Quantity of Cotton

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Supply Supply Shifts

• An increase in supply shifts the supply curve to the
S2
right. S0
• A decrease in supply shifts the supply curve to the Decrease
Increase S1
left. in in
Supply Supply

Price
0
Quantity

Change in Supply Change in Supply

• Higher input prices increase the cost of production,
reducing the per-unit profit potential at existing
prices.
• Lower input prices decrease the cost of production,
which increases the per-unit profit potential at
existing prices.
• If producers expect a higher price in the future,
they will supply less now.
• They would prefer to wait and sell when their
goods will be more valuable.
• If producers expect a lower price for their products
in the future, they will supply more today.
• Otherwise, if they wait to sell, then their goods will
be worth less.

Change in Supply Change in Supply

• The market supply curve is the horizontal
summation of the individual supply curves.
• So an increase in the number of suppliers will
increase market supply.
• A decrease in the number of suppliers will decrease
market supply.
• Technological progress can lower the cost of
production and increase supply.
• Supply may also change because of changes in the
legal and regulatory environment in which firms
operate.
• For example, safety and pollution regulations, minimum
wages, taxes, etc.

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Possible Supply Shifters Possible Supply Shifters

S0 S1
S1 S0 S0 S1 S1 S0

Price
Price

Price

Price
S0 S1

0 Quantity
0 Quantity 0 Quantity 0 Quantity
Supplier’s input price

Price
Supplier’s input price (fuel) falls Producer expects Taxes rise
(wages) increases now that the price will
be lower later
0 Quantity
Number of suppliers
increases

Market Equilibrium Price and A Hypothetical Market Supply and

Quantity Demand Schedule for Coffee
$6
• A Hypothetical Market Supply and Demand Supply
5
Schedule for Coffee
4

3
Price of Coffee
(per pound)

1
Demand
0 2 4 6 8 10 12 14
Quantity Demanded and Supplied of Coffee
(thousands of pounds/year)

Market Equilibrium Price and

Market Equilibrium
• At the equilibrium price, both buyers and sellers
are able to carry out their purchase and sales plans.
• At the equilibrium market price, the amount that
buyers are willing and able to buy is exactly equal
to the amount that sellers are willing and able to
produce
Quantity
• . However, at any other price, either suppliers or
demanders would be unable to trade as much as
they would like.
• If the price is set above or below the equilibrium
price, there will be shortages or surpluses.
• However, market forces will move the price back to
the equilibrium level.

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A Hypothetical Market Supply and Market Equilibrium Price and

Demand Schedule for Coffee Quantity
$6
Supply • At a price greater than the equilibrium price, a
5 Surplus
QS>QD surplus, or excess quantity supplied, would exist.
4 • Sellers would be willing to sell more than
3 demanders would be willing to buy.
Price of Coffee

• Frustrated suppliers would cut their price and

(per pound)

2 Shortage
QD>QS cut back on production, and consumers would
1 buy more.
Demand
• This would eliminate the unsold surplus and
0 2 4 6 8 10 12 14 return the market to equilibrium.
Quantity Demanded and Supplied of Coffee
(thousands of pounds/year)

Market Equilibrium Price and Changes in Equilibrium

Quantity
• At a price less than the equilibrium price, a
shortage, or excess quantity demanded, would
exist.
• Buyers would be willing to buy more than sellers
would be willing to sell.
• Frustrated buyers would compete for the
existing supply, raising the price, and producers
would increase the quantity supplied.
• The quantity demanded would decrease,
eliminating the shortage, and returning the
market to equilibrium.
Price and Quantity
• Demand curves shift when any of the other factors
that affect buyers’ behavior change (but not the
good’s price).
• Supply curves shift when any of the other factors
that affect sellers’ behavior change (but not the
good’s price).
• These changes (shifts) in the demand and supply
curves will lead to changes in the equilibrium price
and equilibrium quantity.

Higher Icecream Prices Changes in Equilibrium

in the Summer Price and Quantity
S
• An increase in demand results in a greater
equilibrium price and a greater equilibrium
P1 quantity.
Price of IceCream

• Conversely, a decrease in demand results in a lower

equilibrium price and a lower equilibrium quantity.
P0
Shortage
DSUMMER
DWINTER
0 Q0 Q1
Quantity of IceCream

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Changes in Equilibrium
A Change in Demand
Supply
Price and Quantity
Price of Aspen Hotel Rooms

• A decrease in supply results in a higher equilibrium

price and a lower equilibrium quantity.
PFEB
• Conversely, an increase in supply results in a lower
equilibrium price and a higher equilibrium quantity.
PMAY
Shortage
DMAY
DFEB

0
QMAY QFEB QD
Quantity of Aspen Hotel Rooms

Changes in Equilibrium
The Market for Strawberries
Price and Quantity
SWINTER
• Very often, supply and demand will both shift in
SSUMMER the same time period.
Price of Strawberries

Surplus
P0
• That is, supply and demand will shift
simultaneously.
P1

Demand

0 Q0 Q1 QS
Quantity of Strawberries

Changes in Equilibrium
Shifts in Supply and Demand
Price and Quantity a. A Little Increase in Supply and a Big Decrease in Demand

• The change in quantity will depend on the relative S0

changes in supply and demand. E0 S1
• If the decrease in demand is greater than the P0
increase in supply, the equilibrium quantity will
decrease. E1
• If the increase in supply is greater than the P1
decrease in demand, the equilibrium quantity will
increase.
Price

D0
D1
0 Q1 Q0
Quantity

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Shifts in Supply and Demand Price Controls

b. A Big Increase in Supply and a Little Decrease in Demand

S0 • While nonequilibrium prices can crop up in the

S1
private sector, reflecting uncertainty, they seldom
E0 last for long.
P0
• Governments, however, often impose
nonequilibrium prices for significant time periods.
E1 • Price controls involve the use of the power of the
P1 state to establish prices different from the
equilibrium prices that would otherwise prevail.
D0
Price

D1
0 Q0 Q1
Quantity

The Unemployment Effects of a

Price Control Minimum Wage
Unemployed SLABOR
Supply
(labor surplus)

W MIN
Wage (price of labor)

P*
WE
Price

Control
PRC
Price
Shortage Demand DLABOR
0 QS Q* QD 0 QD QE QS
Quantity Quantity of Labor

Consumer Surplus Consumer Surplus

P
• The difference between the maximum price consumers are
willing to pay for a product and the actual price.
S
• The surplus, measurable in dollar terms, reflects the extra
utility gained from paying a lower price than what is
required to obtain the good.
Consumer Surplus is • Consumer surplus can be measured by calculating the
the area under the demand difference between the maximum willingness to pay and the
Market
curve and above the market actual price for each consumer, and then summing those
Price
price.
differences.
• Or consumer surplus is shown graphically as the area under
D
the demand curve and above the equilibrium price.
Q • Consumer surplus and price are inversely related – all else
equal, a higher price reduces consumer surplus.

77 78

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Producer Surplus Producer Surplus

P
• The difference between the actual price producers receive
S and the minimum acceptable price.
• Producer surplus can be measured by calculating the
difference between the minimum acceptable price and the
Producer surplus is actual price for each unit sold, and then summing those
Market the area under the market differences.
Price price and above the price
necessary for supply. • Producer surplus is shown graphically as the area above the
supply curve and below the equilibrium price.
D
• Producer surplus and price are directly related – all else
Q equal, a higher price increases producer surplus.

79 80

Maximum benefit to society occurs when price and

quantity are at the equilibrium point.
P

Consumer surplus and

Market Producer surplus are
Price maximized.

Equilibrium quantity Q

81

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