CHAPTER 2

Market Forces: Demand and Supply

© 2017 by McGraw-Hill Education. All Rights Reserved. Authorized only for instructor use in the classroom. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 Learning Objectives
1. Explain the laws of demand and supply, and identify
factors that cause demand and supply to shift.
2. Calculate consumer surplus and producer surplus, and
describe what they mean.
3. Explain price determination in a competitive market,
and show how equilibrium changes in response to
changes in determinates of demand and supply.
4. Explain and illustrate how excise taxes, ad valorem
taxes, price floors, and price ceilings impact the
functioning of a market.
5. Apply supply and demand analysis as a qualitative
forecasting tool to see the “big picture” in competitive
markets.
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 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).
– Price and quantity demanded are inversely
related.
Copyright
© 2017© by2014 by the McGraw-Hill
McGraw-Hill Companies,
Education. All Inc. All rights reserved.
Rights Reserved. 2-3
 Demand
Market Demand Curve
Price ($)
$40

$30

$20

$10
Demand

0 20 40 60 80 Quantity
(thousands per year)

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 Demand

Shift in Quantity Demanded versus a

Shift in 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.

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 Demand

Changes in Demand
Price

A Increase
in
demand

Decrease
in B
demand

D1
D2 D0

0 Quantity

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 Demand

Demand Shifters
• 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
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 Demand
Advertising and the Demand for
Price of Clothing
high-style
clothing
Due to an
increase in
advertising
$50

$40

D2
D1
0 50,000 60,000 Quantity of
high-style
clothing
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 Demand
The Demand Function
• The demand function for good X is a
mathematical representation describing how
many units will be purchased at different
prices for X, the price of a related good Y,
income and other factors that affect the
demand for good X.

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 Demand
The Linear Demand Function
• One simple, but useful, representation of a
demand function is the linear demand function:
𝑑𝑑
𝑄𝑄𝑋𝑋 = 𝛼𝛼0 + 𝛼𝛼𝑋𝑋 𝑃𝑃𝑋𝑋 + 𝛼𝛼𝑌𝑌 𝑃𝑃𝑌𝑌 + 𝛼𝛼𝑀𝑀 𝑀𝑀 + 𝛼𝛼𝐻𝐻 𝐻𝐻
where:
– 𝑄𝑄𝑋𝑋 𝑑𝑑 is the number of units of good X demanded;
– 𝑃𝑃𝑋𝑋 is the price of good X;
– 𝑃𝑃𝑌𝑌 is the price of a related good Y;
– 𝑀𝑀 is income;
– 𝐻𝐻 is the value of any other variable affecting demand.

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 Demand

Understanding the Linear Demand

Function
• The signs and magnitude of the 𝛼𝛼 coefficients
determine the impact of each variable on the
number of units of X demanded.
𝑄𝑄𝑋𝑋 𝑑𝑑 = 𝛼𝛼0 + 𝛼𝛼𝑋𝑋 𝑃𝑃𝑋𝑋 + 𝛼𝛼𝑌𝑌 𝑃𝑃𝑌𝑌 + 𝛼𝛼𝑀𝑀 𝑀𝑀
• For example:
– 𝛼𝛼𝑋𝑋 < 0 by the law of demand;
– 𝛼𝛼𝑌𝑌 > 0 if good Y is a substitute for good X;
– 𝛼𝛼𝑀𝑀 < 0 if good X is an inferior good.

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 Demand

The Linear Demand Function in Action

• Suppose that an economic consultant for X Corp. recently
provided the firm’s marketing manager with this estimate of the
demand function for the firm’s product:
𝑄𝑄𝑋𝑋 𝑑𝑑 = 12,000 − 3𝑃𝑃𝑋𝑋 + 4𝑃𝑃𝑌𝑌 − 1𝑀𝑀 + 2𝐴𝐴𝑋𝑋

Question: How many of good X will consumers purchase when

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

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

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 Demand
Inverse Demand Function
• By setting 𝑃𝑃𝑌𝑌 = $15 and 𝑀𝑀 = $10,000 and 𝐴𝐴 =
2,000 the demand function is
𝑄𝑄𝑋𝑋 𝑑𝑑 = 12,000 − 3𝑃𝑃𝑋𝑋 + 4 15 − 1 10,000 + 2 2,000
the linear demand function simplifies to
𝑑𝑑
𝑄𝑄𝑋𝑋 = 6,060 − 3𝑃𝑃𝑋𝑋
Solving this for 𝑃𝑃𝑋𝑋 in terms of 𝑄𝑄𝑋𝑋 𝑑𝑑 results in
1 𝑑𝑑
𝑃𝑃𝑋𝑋 = 2,020 − 𝑄𝑄𝑋𝑋
3
which is called the inverse demand function. This
function is used to construct a market demand
curve.

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 Demand

Graphing the Inverse Demand

Function in Action
Price

$2,020

1
𝑃𝑃𝑋𝑋 = 2,020 − 𝑄𝑄𝑋𝑋 𝑑𝑑
3

0 6,060 Quantity

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 Demand

Consumer Surplus
• 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
extra for.

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 Demand
Market Demand and Consumer Surplus in Action

Consumer Surplus
Price per
liter
Consumer Surplus:
0.5($5 - $3)x(2-0) = $2
$5
Total Consumer Value:
0.5($5 - $3)x2+(3-0)(2-0) = $8
$4

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

$1 Demand

0 1 2 3 4 5 Quantity
in liters

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 Supply
Supply
• Market supply curve
– A curve indicating the total quantity of a good
that all producers in a competitive market would
produce at each price, holding input prices,
technology, and other variables 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.

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 Supply
Changes in Quantity Supplied versus
Changes in 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.
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 Supply
Changes in Supply
Price
S1 S0

B S2
Decrease
in supply

Increase
in supply
A

0 Quantity

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 Supply
Supply Shifters
• Input prices
• Technology or government regulation
• Number of firms
– Entry
– Exit
• Substitutes in production
• Taxes
– Excise tax: a tax on each unit of output sold, where
tax revenue is collected from the supplier
– Ad valorem tax: percentage tax
• Producer expectations

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 Supply
A Per Unit (Excise) Tax
Excise tax
Price
of S0+t
gasoline
$1.20 S0
t = 20¢
t

$1.00 t = per unit tax of 20¢

0 Quantity of
gasoline per
week
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 Supply
An Ad Valorem Tax
Price Ad valorem tax
of
backpacks
S1 = 1.20 x S0
$24

S0

$20
$12

$10

0 1,100 2,450 Quantity of

backpacks per
week
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 Supply
The Supply Function
• The supply function for good X is a
mathematical representation describing how
many units will be produced at alternative
prices for X, alternative input prices W, and
alternative values of other variables that
affect the supply for good X.

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 Supply
The Linear Supply Function
• One simple, but useful, representation of a
supply function is the linear supply function:

𝑠𝑠
𝑄𝑄𝑋𝑋 = 𝛽𝛽0 + 𝛽𝛽𝑋𝑋 𝑃𝑃𝑋𝑋 + 𝛽𝛽𝑊𝑊 𝑊𝑊 + 𝛽𝛽𝑟𝑟 𝑃𝑃𝑟𝑟 + 𝛽𝛽𝐻𝐻 𝐻𝐻

– 𝑄𝑄𝑋𝑋 𝑠𝑠 is the number of units of good X produced;

– 𝑃𝑃𝑋𝑋 is the price of good X;
– 𝑊𝑊 is the price of an input;
– 𝑃𝑃𝑟𝑟 is price of technologically related goods;
– 𝐻𝐻 is the value of any other variable affecting supply.

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 Understanding the Linear Supply
Supply

Function
• The signs and magnitude of the 𝛽𝛽 coefficients
determine the impact of each variable on the
number of units of X produced.
𝑄𝑄𝑋𝑋 𝑠𝑠 = 𝛽𝛽0 + 𝛽𝛽𝑋𝑋 𝑃𝑃𝑋𝑋 + 𝛽𝛽𝑊𝑊 𝑊𝑊 + 𝛽𝛽𝑟𝑟 𝑃𝑃𝑟𝑟
• For example:
– 𝛽𝛽𝑋𝑋 > 0 by the law of supply.
– 𝛽𝛽𝑊𝑊 < 0 increasing input price.
– 𝛽𝛽𝑟𝑟 > 0 technology lowers the cost of producing
good X.
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 Supply

The Linear Supply Function in Action

• Your research department estimates that the
supply function for televisions sets is given by:
𝑠𝑠
𝑄𝑄𝑋𝑋 = 2,000 + 3𝑃𝑃𝑋𝑋 − 4𝑃𝑃𝑅𝑅 − 1𝑃𝑃𝑊𝑊

Question: How many televisions are produced

when 𝑃𝑃𝑋𝑋 = $400, 𝑃𝑃𝑅𝑅 = $100 per unit, and 𝑃𝑃𝑊𝑊 =
$2,000?

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

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 Supply
Inverse Supply Function
• By setting 𝑃𝑃𝑊𝑊 = $2,000 and 𝑃𝑃𝑟𝑟 = $100 in
𝑠𝑠
𝑄𝑄𝑋𝑋 = 2,000 + 3𝑃𝑃𝑋𝑋 − 4 100 − 1 2,000
the linear supply function simplifies to
𝑄𝑄𝑋𝑋 𝑠𝑠 = 3𝑃𝑃𝑋𝑋 − 400
𝑠𝑠
Solving this for 𝑃𝑃𝑋𝑋 in terms of 𝑄𝑄𝑋𝑋 results in
400 1 𝑠𝑠
𝑃𝑃𝑋𝑋 = + 𝑄𝑄𝑋𝑋
3 3
which is called the inverse supply function.
This function is used to construct a market
supply curve.

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 Supply
Producer Surplus
• Producer surplus: the amount producers
receive in excess of the amount necessary to
induce them to produce the good.

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 Supply
Producer Surplus in Action

Price 400 1 𝑆𝑆
𝑃𝑃𝑋𝑋 = + 𝑄𝑄𝑋𝑋 Supply
3 3
$400
Producer surplus

$400
3
0 800 Quantity

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 Market Equilibrium
Market Equilibrium
• Competitive Market Equilibrium
– Determined by the intersection of the market
demand and market supply curves.
– 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.
– The equilibrium price is the price that equates
quantity demanded with quantity supplied

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 Market Equilibrium
Market Equilibrium

Price Supply
Surplus

𝑃𝑃𝐻𝐻

𝑃𝑃𝑒𝑒

𝑃𝑃𝐿𝐿

Shortage
Demand

0 𝑄𝑄0 𝑄𝑄𝑒𝑒 𝑄𝑄1 280 Quantity

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 Market Equilibrium

Market Equilibrium in Action

• Consider a market with demand and supply
functions, respectively, as
𝑄𝑄𝑑𝑑 = 10 − 2𝑃𝑃 and 𝑄𝑄 𝑠𝑠 = 2 + 2𝑃𝑃
• A competitive market equilibrium exists at a
price, 𝑃𝑃𝑒𝑒 , such that 𝑄𝑄𝑑𝑑 𝑃𝑃𝑒𝑒 = 𝑄𝑄 𝑠𝑠 𝑃𝑃𝑒𝑒 . That is,
10 − 2𝑃𝑃 = 2 + 2𝑃𝑃
8 = 4𝑃𝑃
𝑃𝑃𝑒𝑒 = $2
𝑄𝑄𝑒𝑒 = 10 − 2 $2 = 6 and 𝑄𝑄𝑒𝑒 = 2 + 2($2) =6
𝑄𝑄𝑒𝑒 = 6 units

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 Price Restrictions and Market Equilibrium

Price Restrictions and Market

Equilibrium
• In a competitive market equilibrium, price and
quantity freely adjust to the forces of demand
and supply.
• Sometime government restricts how much
prices are permitted to rise or fall.
– Price ceiling
– Price floor

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 Price Restrictions and Market Equilibrium

A Price Ceiling

Price Supply

Lost social welfare

Nonpecuniary price

𝑃𝑃𝐹𝐹

𝑃𝑃𝑒𝑒

𝑃𝑃𝑐𝑐 Priceceiling

Shortage
Demand

0 𝑄𝑄 𝑠𝑠 𝑄𝑄𝑒𝑒 𝑄𝑄𝑑𝑑 280 Quantity

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 Price Restrictions and Market Equilibrium

Price Ceiling in Action

• Consider a market with demand and supply
functions, respectively, as
𝑄𝑄𝑑𝑑 = 10 − 2𝑃𝑃 and 𝑄𝑄 𝑠𝑠 = 2 + 2𝑃𝑃
• Suppose a $1.50 price ceiling is imposed on the
market.
– 𝑄𝑄𝑑𝑑 = 10 − 2 $1.50 = 7 units.
– 𝑄𝑄 𝑠𝑠 = 2 + 2($1.50) = 5 units.
– Since 𝑄𝑄𝑑𝑑 > 𝑄𝑄 𝑠𝑠 a shortage of 7 − 5 = 2 units exists.
– Full economic price of 5𝑡𝑡𝑡 unit is 5 = 10 − 2𝑃𝑃𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 , or
𝑃𝑃𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 = $2.50. Of this,
• $1.50 is the dollar price
• $1 is the nonpecuniary price
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 Price Restrictions and Market Equilibrium

A Price Floor

Price Supply

Surplus
𝑃𝑃 𝑓𝑓 Pricefloor

𝑃𝑃𝑒𝑒 Cost of
purchasing
excess supply

Demand

0 𝑄𝑄𝑑𝑑 𝑄𝑄𝑒𝑒 𝑄𝑄 𝑠𝑠 280 Quantity

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 Price Restrictions and Market Equilibrium

Price Floor in Action

• Consider a market with demand and supply
functions, respectively, as
𝑄𝑄 𝑑𝑑 = 10 − 2𝑃𝑃 and 𝑄𝑄 𝑠𝑠 = 2 + 2𝑃𝑃
• Suppose a $3.50 price floor is imposed on the
market.
– 𝑄𝑄 𝑑𝑑 = 10 − 2 $3.50 = 3 units
– 𝑄𝑄 𝑠𝑠 = 2 + 2($3.50) = 9 units
– Since 𝑄𝑄 𝑠𝑠 > 𝑄𝑄 𝑑𝑑 a surplus of 9 − 3 = 6 units exists
– The cost to the government of purchasing the
surplus is $3.50 × 6 = $21.
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 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

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 Comparative Statics

Changes in Demand
• 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?

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 Comparative Statics

Effect of a Change in Demand for

Rental Cars
Price Supply

$49

$45
Demand1

Demand0

0 100 104 108 Quantity

(thousands
rented per day)

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 Comparative Statics

Changes in Supply
• 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?

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 Comparative Statics

Effect of a Change in Supply

Price Supply1

Supply0
1
𝑃𝑃

𝑃𝑃0

Demand

0 𝑄𝑄1 𝑄𝑄0 Quantity

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 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 Japan’s sake
market?
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 Comparative Statics

Simultaneous Shifts in Supply and

Demand in Action
Japan’s Sake Market
Price
Supply2
C
𝑃𝑃2
Supply1

B Supply0
𝑃𝑃1

A
𝑃𝑃0
Demand1
Demand0

0 𝑄𝑄2 𝑄𝑄0 𝑄𝑄1 Quantity

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