Demand, Supply, and

Market Equilibrium

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 Markets and Competition

A market is a group of buyers and sellers of a

particular product.
A competitive market is one with many buyers and
sellers, each has a negligible effect on price.
In a perfectly competitive market:
All goods exactly the same
Buyers & sellers so numerous that no one can
affect market price – each is a “price taker”
In this session, we assume markets are perfectly
competitive.
The Circular Flow
Diagram

Diagrams like this one show the

circular flow of economic
activity, hence the name circular
flow diagram.
Here goods and services flow
clockwise: Labor services
supplied by households flow to
firms, and goods and services
produced by firms flow to
households.
Payment (usually money) flows
in the opposite
(counterclockwise) direction:
Payment for goods and services
flows from households to firms,
and payment for labor services
flows from firms to households.

Note: Color Guide—In Figure 3.1

households are depicted in blue
and firms are depicted in red.
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Demand in Product/Output Markets

A household’s decision about what quantity of a particular output,

or product, to demand depends on a number of factors, including:

 The price of the product in question (Px).

 The income available to the household (I).
The household’s amount of accumulated wealth (W).
 The prices of other products available to the household (Py).
 The household’s tastes and preferences (T).
 The household’s expectations about future income, wealth,
and prices (Ex).

We can express the demand function (determinants

of demand) above as follows:

DMx = f (Px, I /W, Py, T, # buyers, Ex)

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Demand in Product/Output Markets

Price and Quantity Demanded: The Law of Demand

TABLE 3.1 Anna’s Demand Schedule

for Telephone Calls
Price Quantity Demanded
(Per Call) (Calls Per Month)
$ 0 30
.50 25
3.50 7
7.00 3
10.00 1
15.00 0

 FIGURE 3.2 Anna’s Demand Curve

The relationship between price (P) and quantity
demanded (q) presented graphically is called a
demand curve. Demand curves have a negative
slope, indicating that lower prices cause quantity
demanded to increase. Note that Anna’s demand
curve is blue; demand in product markets is
determined by household choice.

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Demand in Product/Output Markets
Shift of Demand versus Movement Along a Demand Curve

 FIGURE 3.4 Shifts versus Movement Along a Demand Curve

a. When income increases, the demand for inferior goods shifts to the left
and the demand for normal goods shifts to the right.

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Demand in Product/Output Markets
Shift of Demand versus Movement Along a Demand Curve

 FIGURE 3.4 Shifts versus Movement Along a Demand Curve (continued)

b. If the price of hamburger rises, the quantity of hamburger demanded declines— his
is a movement along the demand curve.
The same price rise for hamburger would shift the demand for chicken (a substitute for
hamburger) to the right and the demand for ketchup (a complement to hamburger) to
the left.
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Demand in Product/Output Markets
From Household Demand To Market Demand

 FIGURE 3.5 Deriving Market Demand

from Individual Demand Curves
Total demand in the marketplace is simply the sum
of the demands of all the households shopping in a
particular market. It is the sum of all the individual
demand curves—that is, the sum of all the
individual quantities demanded at each price.

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Supply in Product/Output Markets

Price and Quantity Supplied: The Law of Supply

TABLE 3.3 Clarence Brown’s Supply

Schedule for Soybeans
Quantity Supplied
Price (Per Bushel) (Bushels Per Year)
$1.50 0
1.75 10,000
2.25 20,000
3.00 30,000
4.00 45,000
5.00 45,000

 FIGURE 3.6 Clarence Brown’s

Individual Supply Curve
A producer will supply more when
the price of output is higher. The
slope of a supply curve is positive.
Note that the supply curve is red:
Supply is determined by choices
made by firms.

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Supply in Product/Output Markets

Assuming that its objective is to maximize profits, a firm’s decision

about what quantity of output, or product, to supply depends on:
1. The price of the good or service (Px).
2. The cost of producing the product, which in turn depends on:
■ The price of required inputs (labor L, capital K, and land N)
(Pinputs –> PL, PK).
■ The technologies that can be used to produce the
product. (Tech)
3. Expectations (Ex)

We can denote the supply function (determinants of

supply) as follows:

SMx = g (Px, Pl, Pk, #sellers, Tech, Ex)

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Supply in Product/Output Markets

Shift of Supply versus Movement Along a Supply Curve

TABLE 3.4 Shift of Supply Schedule for Soybeans

Following Development of a New
Disease-Resistant Seed Strain
SCHEDULE D0 SCHEDULE D1
Quantity Supplied Quantity Supplied
Price (Bushels per Year (Bushels per Year
(per Bushel) Using Old Seed) Using New Seed)
$1.50 0 5,000
1.75 10,000 23,000
2.25 20,000 33,000
3.00 30,000 40,000
4.00 45,000 54,000
5.00 45,000 54,000

 FIGURE 3.7 Shift of the Supply Curve or Soybeans

Following Development of a New Seed Strain
When the price of a product changes, we move
along the supply curve for that product; the quantity
supplied rises or falls.
When any other factor affecting supply changes,
the supply curve shifts.

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Supply in Product/Output Markets
From Individual Supply to Market Supply

 FIGURE 3.8 Deriving Market Supply

from Individual Firm Supply Curves
Total supply in the marketplace is the sum of all
the amounts supplied by all the firms selling in
the market. It is the sum of all the individual
quantities supplied at each price.

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Market Equilibrium

Equilibrium The condition that

exists when quantity supplied
and quantity demanded are
equal. At equilibrium, there is
no tendency for price to
change.

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 Market Equilibrium

 FIGURE 3.9

Equilibrium Price: $2.50 per bushel

At Equilibrium: Qs = Qd

Equilibrium Quantity: 35,000 bushels

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 TWO BASIC MICROECONOMIC MODELS

(1) DMx = f (Px, I /W, Py, Taste, # buyers, Ex)

(2) SMx = g (Px, Plabor, Pcapital, #sellers, Tech, Ex)

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Market Equilibrium

Excess Demand
 FIGURE 3.9 Excess
Demand, or Shortage

At a price of $1.75 per

bushel, quantity demanded
exceeds quantity supplied.
When excess demand
exists, there is a tendency
for price to rise.
When quantity demanded
equals quantity supplied,
excess demand is
eliminated and the market is
in equilibrium. Here the
equilibrium price is $2.50
and the equilibrium quantity
is 35,000 bushels.

When quantity demanded exceeds quantity supplied, price tends

to rise. When the price in a market rises, quantity demanded falls
and quantity supplied rises until an equilibrium is reached at
which quantity demanded and quantity supplied are equal.
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Market Equilibrium

Excess Supply

 FIGURE 3.10 Excess

Supply, or Surplus

At a price of $3.00, quantity

supplied exceeds quantity
demanded by 20,000
bushels.
This excess supply will
cause the price to fall.

When quantity supplied exceeds quantity demanded at the

current price, the price tends to fall. When price falls, quantity
supplied is likely to decrease and quantity demanded is likely to
increase until an equilibrium price is reached where quantity
supplied and quantity demanded are equal.

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Market Equilibrium

Changes In Equilibrium

When supply and demand curves shift, the equilibrium

price and quantity change.

 FIGURE 3.11 The Coffee

Market: A Shift of Supply and
Subsequent Price Adjustment
Before the freeze, the coffee
market was in equilibrium at
a price of $1.20 per pound.
At that price, quantity
demanded equaled quantity
supplied.
The freeze shifted the
supply curve to the left (from
S0 to S1), increasing the
equilibrium price to $2.40.

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Market Equilibrium
Changes In Equilibrium

 FIGURE 3.12 Examples of

Supply and Demand Shifts
for Product X

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Elasticity
Basic idea:
Elasticity measures how much one variable responds to
changes in another variable.
One type of elasticity measures how much demand for
your websites will fall if you raise your price.

Definition:
Elasticity is a numerical measure of the
responsiveness of Qd or Qs to one of its
determinants.

Price elas of demandx

= % change in Qdx/ % change in Px
= (Qd2- Qd1)/ave Qd / (P2-P1)/ aveP
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 Price Elasticity of Demand

Price elasticity Percentage change in Qd

=
of demand Percentage change in P

Price elasticity of demand measures how much Qd responds to a change in P.

 Loosely speaking, it measures the price-

sensitivity of buyers’ demand.

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Calculating Percentage Changes

We use the midpoint method:

end value – start value

x 100%
midpoint
 The midpoint is the number halfway
between the start & end values, the
average of those values.
 It doesn’t matter which value you use as
the “start” and which as the “end” – you
get the same answer either way!

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Calculating Percentage Changes

Using the midpoint method, the % change

in P equals
P250 – P200
x = 22.2%
P225
100%
 The % change in Q equals
8 – 12
x = -40.0%
10 100%
 The price elasticity of demand equals
40/22.2 = -1.8

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ACTIVE LEARNING 1
Calculate an elasticity
Use the following
information to
calculate the
price elasticity
of demand
for hotel rooms:

if P = P70, Qd = 5000

if P = P90, Qd = 3000

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The Determinants of Price Elasticity:
A Summary

The price elasticity of demand depends on:

=> the extent to which close substitutes are

available
=> whether the good is a necessity or a luxury
=> how broadly or narrowly the good is defined
=> the time horizon – elasticity is higher in the
long run than the short run

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Examples:

1) Breakfast cereal vs. Sunscreen

2) “Blue Jeans” vs. “Clothing”

3) Insulin vs. Caribbean Cruises

4) Gasoline in the Short Run vs. Gasoline in the

Long Run

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Price Elasticity and Total Revenue

Continuing our scenario, if you raise your price

from P200 to P250, would your revenue rise or fall?
Revenue = P x Q
A price increase has two effects on revenue:
Higher P means more revenue on each unit
you sell.
But you sell fewer units (lower Q),
due to Law of Demand.
Which of these two effects is bigger?
It depends on the price elasticity of demand.

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Price Elasticity and Total Revenue

Price elasticity Percentage change in Q

=
of demand Percentage change in P

Revenue = P x Q
If demand is elastic, then

price elast. of demand > 1

% change in Q > % change in P
The fall in revenue from lower Q is greater
than the increase in revenue from higher P,
so revenue falls.

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Price Elasticity and Total Revenue Demand for
Elastic demand your websites
increased
(elasticity = 1.8) P revenue due lost
to higher P revenue
If P = P200,
due to
Q = 12 and lower Q
P250
revenue = P2400.
P200
If P = P250, D
Q = 8 and
revenue = P2000.
When D is elastic, Q
8 12
a price increase
causes revenue to fall.
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Price Elasticity and Total Revenue

Price elasticity Percentage change in Q

=
of demand Percentage change in P

Revenue = P x Q
If demand is inelastic, then
price elast. of demand < 1
% change in Q < % change in P
The fall in revenue from lower Q is smaller
than the increase in revenue from higher P,
so revenue rises.
In our example, suppose that Q only falls to 10
(instead of 8) when you raise your price to P250.
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Price Elasticity and Total Revenue
Demand for
Now, demand is your websites
inelastic: increased
elasticity = 0.82 P revenue due lost
If P = P200, to higher P revenue
Q = 12 and revenue = due to
lower Q
P2400. P250

If P = P250, P200
Q = 10 and
D
revenue = P2500.

When D is inelastic, Q
a price increase 10 12
causes revenue to rise.
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ACTIVE LEARNING 2
Elasticity and expenditure/revenue
A. Pharmacies raise the price of insulin by 10%. Does
total expenditure on insulin rise or fall?

B. As a result of a fare war, the price of a luxury cruise

falls 20%.
Does luxury cruise companies’ total revenue
rise or fall?

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APPLICATION: Does Drug Interdiction Increase or
Decrease Drug-Related Crime?
One side effect of illegal drug use is crime: Users
often turn to crime to finance their habit.
We examine two policies designed to reduce illegal
drug use and see what effects they have on drug-
related crime.
For simplicity, we assume the total peso value of
drug-related crime equals total expenditure
on drugs.
Demand for illegal drugs is inelastic, due to addiction
issues.

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Policy 1: Interdiction
Interdiction new value of
reduces the Price of drug-related
supply of S2
Drugs crime D
drugs. 1
S1
Since demand P2
for drugs is
inelastic,
initial value
P rises propor- P1
of drug-
tionally more
related
than Q falls.
crime

Result: an increase in Q2 Q1 Quantity

total spending on drugs, and of Drugs
in drug-related crime
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Policy 2: Education
new value of
Education Price of drug-related
reduces Drugs crime
the D2 D1
demand for S
drugs.
P and Q fall.
P1 initial
Result: value of
A decrease in P2 drug-
total spending related
on drugs, and crime
in drug- Q2 Q 1 Quantity
related crime. of Drugs

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 Price Elasticity of Supply

Price elasticity Percentage change in Qs

=
of supply Percentage change in P
Price elasticity of supply measures how much Qs responds to a change in P.

 Loosely speaking, it measures sellers’

price-sensitivity.
 Again, use the midpoint method to compute
the percentage changes.

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Price Elasticity of Supply

Price elasticity Percentage change in Qs

=
of supply Percentage change in P
P
Example: S
P
Price P2
rises
elasticity by 8% P1
of supply
equals
Q
16% Q1 Q2
= 2.0
8% Q
rises
by 16% 37
 The Determinants of Supply Elasticity
The more easily sellers can change the quantity they
produce, the greater the price elasticity of supply.
Example: Supply of beachfront property is harder to
vary and thus less elastic than
supply of new cars.
For many goods, price elasticity of supply
is greater in the long run than in the short run,
because firms can build new factories,
or new firms may be able to enter the market.

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ACTIVE LEARNING 3
Elasticity and changes in equilibrium
 The supply of beachfront property is
inelastic. The supply of new cars is elastic.
 Suppose population growth causes
demand for both goods to double
(at each price, Qd doubles).
 For which product will P change the most?
 For which product will Q change the most?

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 Other Elasticities Dx = f (Px, Income, Py,…)

Income elasticity of demand: measures the

response of Qd to a change in consumer income

Income elasticity Percent change in Qd

=
of demand Percent change in income

 Recall: An increase in income causes an

increase in demand for a normal good.
 Hence, for normal goods, income elasticity > 0.
 For inferior goods, income elasticity < 0.
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 Other Elasticities
Cross-price elasticity of demand:
measures the response of demand for one good
to changes in the price of another good

Cross-price elast. % change in Qd for good 1

=
of demand % change in price of good 2
 For substitutes, cross-price elasticity > 0
(e.g., an increase in price of beef causes an
increase in demand for chicken)
 For complements, cross-price elasticity < 0
(e.g., an increase in price of computers
causes decrease in demand for software)
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