1

CHAPTER 2
Basic Demand and Supply Analysis
Chapter Outline List of Examples
2.1 Market Anal ysis 2-1 Equilibri um Price by Auction
2.2 Market Demand 2-2 Changes in Demand and Supply and Coffee
2.3 Market Supply Prices
2.4 When Is a Market in Equilibrium? 2-3 The Economics of U.S. Fann Support
2.5 Adjustment to Changes in Demand and Supply: Programs
Comparative Static Analysis 2--4 Working Through the Market with an
2.6 Domestic Demand and Supply, Imports, and Prices Excise Tax
2.7 titerfering With Versus Working Through the At the Frontier: Nonclearing Markets Theory
Market
Appendix: The Algebra of Demand, Supply,
and Equilibrium

After Studying This Chapter, You Should Be Able to:

• Know the meaning of demand and the law of demand
• Describe how the market demand and supply of a commodity determine its price
• Explain how changes in demand and supply affect the equilibrium price and quantity of a commodity
• Understand how imports affect product prices
• Describe the meaning of "working through the market" as opposed to "interfering with the market"

ave you ever stopped to think about how the price of a commodity (say, the price

H of your favorite music compact disc) is determined and why it often changes over
time? In this chapter we seek to answer these questions by providing an overview
of how markets functio n. We begin by defining the concept of a market. Next we discuss
the meaning of demand and a change in demand. After reviewi ng supply, we examine
how the interaction of the forces of market demand and supply determine the equilibrium
price and quantity of a commodity. Then we examine how the equilibrium price and quan-
tity of a commodity are affected by changes in d~mand and suppl y and by imports.
Finally, we examine the effect of modi fications and interferences in the operation of mar-
kets. So widespread is the applicability of the market model, that one could safely start

23
24 PART ONE Introduction to Microeconomics
7
answering any question of microeconomics by saying that it depends on demand a d
ply. Note, however, the "At the Frontier" discussion of noncleapng market theori~ su~

MARKET ANALYSIS
Most of microeconomic analysis is devoted to the study of how individual markets --------
ate. A market is an institutional arrangement under which buyers and sellersoper.
exchange some quantity of a good or service at a mutually agreeable price. Markets can
vide the framework for the analysis of the forces of demand and supply that, toge!:
determine c?mmodity and re,source_prices. ~s explained in-Chapt~r 1, prices play fur,
central role in microec_onomic analysis: · e
A market can, but need not, be a specific place or location where buyers and sellers actu.
ally come face tofacefor the purpose of transacting their business. For example, the New YorK
Stock Exchange is located in a building at-11 Wall Street in New York City. On the other han~
the market for college professors has no specific location; rather, it refers to all the fonnal and
infonnal infonnation networks on teaching opportunities throughout the nation. There is a
market for each good, service, or resource bought and sold in the ~conomy. Some of these
markets are local; some are regional, and others are national or.international in character.
. , Throughout this chapter, we assume that mark~ts are· perfectly competitive. A
perfectly competitive market is one in wpich there are so many buyeFs and sellers of a
product that each of them cannot affect the price of the product, all units of the product are
homogeneous or identical, resources are mobile, and knowledge of the market is perfect
For the purpose of the present chapter, this definition of a perfectly competitive marke1
suffices. A more detailed definition and analysis of this and other types of markets is given
in Chapter 9 and in Part Three of the text.

MARKET DEMAND
The concept of demand is one of the most crucial in microeconomic theory and in all of
economics. In this section, we review the concepts of 'the market demand schedule an!
the market demand curve, and examine the meaning of a change in demand.

Demand Schedule and Demand-curve

A market demand schedule is a table showing the quantity of a commodity that con·
sumers are willing and able to purchase over a given period of time at each price of.~:
commodity, while holding constant a:11 other relevant economic variables on whl~
t
demand depends (the ceteris paribus assumption). Among the variables held conS ant .
nd
consumers' incomes, their tastes, the prices of related commooities (substitutes a colll
plements), and the number of consumers in the market. 0•

For example, Table 2. provides a hypothetical daily demand schedule for harnb:~
ers in a large market (say, New York City, Chicago, or Los Angeles). At the price of$ rice
per hamburger, the quantity demanded is 2 million hamburgers per day. At the lower~ (X),
of $1.50, _the quantity d~m~~e? is 4 million hamburgers per day. At the price oflo,·tlte
the quantity demanded 1s 6 rmlhon hamburgers, and at the prices of $0.75 and $O.
quantity demanded is 7 and 8 million hamburgers, respectively.
 CHAPTER 2 Basic Demand and Supply Analysis 25

TABLE 2.1 ,~Market Dem_antl Sch~ ule-

for Hamburgers _" _.· : :_ · :: .
Price per Quantity Demanded per Day
Hamburger (million hamburgers)
$2.00 2
1.50 4
1.00 6
0.75 7
0.50 8

At lower prices, greater quantities of hamburgers are demanded. Each additional

hamburger consumed per day provides declining marginal or extra benefit, and so con-
sumers would only purchase greater quantities at lower prices. This is practically always
true for all commodities. Lower commodity prices will also bring more consumers into
the market. The inverse price-quantity relationship (indicating that a greater quantity of
the commodity is demanded at lower prices and a smaller quantity at higher prices) is
called the law of demand.
By plotting on a graph the various price-quantity combinations given by the market
demand schedule, we obtain the market demand curve for the commodity. The price per
unit of the commodity is usually measured along the vertical axis, while the quantity
demanded of the commodity per unit of time is measured along the horizontal axis. For
example, Figure 2.1 shows the market demand curve for hamburgers corresponding to the
market demand schedule of Table 2.1. The demand curve has a negative slope; that is, it
slopes downward to the right. This negative slope is a reflection of the law of demand or
inverse price-quantity relationship.
The various points-on the demand curve represent alternative price-quantity combi-
nations. For example, at the price of $2.00 per hamburger, the quantity demanded is 2 mil-
lion hamburgers (point B in Figure 2.1 ). If the price is $1.50, the quantity demanded is 4
million hamburgers (point C), and so on. A demand curve also shows the maximum price
consumers are willing to pay to purchase each quantity of a commodity per unit of time.
For example, the demand curve of Figure 2.1 shows that the demand price (i.e., the maxi-
mum price that consumers are willing to pay) for 2 million hamburgers is $2.00 per ham-
burger (point B); for 4 million hamburgers, the demand price is $1 .50, and so on. Finally,
a particular demand curve refers to a specific period of time. The demand curve of Figure
2.1 is for one day. The demand curve for hamburgers for a month is correspondingly
higher. 1

Changes in Demand
A demand curve can shift so that more or less of the commodity would be demanded at
any commodity price. The entire demand curve for a commodity would shift with a
change in (1) consumers' incomes, (2) consumers' tastes, (3) the price of related com-
modities, (4) the number of consumers in the market, or in any other variable held con-
stant in drawing a market demand curve. For example, with a rise in consumer income

1 The demand curve can, but need not, be a straight line.

26 PART ONE' Introduction to Microeconomics

..., P($)
·a::l
i...
Q.)
2.00
0-

eo 1.50
::l
,D
1.00
;::: 0.75
0
v 0.50
FIGURE 2.1 Market Demand Curve for Hamburgers Market u
·i::
demand curve D shows that at lower hamburger prices, greater i:i... D
quantities are demanded. This is reflected in the negative·slope of the 0 2 4 6 7 8
Q
demand curve and is referred to as the "law of demand'.' Million hamburgers per day

the demand curve for most commodities (normal goods) shifts.to the right, because con.
sumers can then afford to purchase ~ore ·of each.commodity at each price. The same is
true if consumers' tastes cha~ge (or if the _qualit~ of the .product improves) so that they
demand more of the commodity at eaeh pnce, or 1f the number of consumers in the mar-
ket increases.
A demand curve also shifts to the right if the price of a substitute commodity rises
or if·the.price of a complementary commodity falls. For example, if the price of hot dogs
(a substitute.,for hamburgers) .rises, people will switch some of their purchases away
from hot dogs and demand m0i:e hamburgers at each and every price of hamburgers (a
rightward shift in the demand for-harnburgers) .. Similarly, if the price of the bun _(a com-
plement of hamburgers) falls; , the demano for hamburgers· also shifts to the right (since
the price of a hamburger.with the. bun is then l0wer).
On the other hand, the demand curve for a commodity usually shifts to the left (so
· that less of it is demanded-at each.price) with a decline in -consumer income, a decrease in
the price of- substitute ·commodities, or a decrease in the number of consumers in the
market. T,he demand curve also shifts to the left if the price of complementary commodi-
ties rises or if consumer tastes change so that •they demand less of the commodity al
each price. · . · ·
Figure 2.2 shows D, die original demand curve for hamburgers (from Figure 2.1) an~
D', a \_ligher demand .curve.for hamburgers. With D', consumers demand more ha,mburg·
ers at each price. For example, at ·the price of $1.00, consumers demand 12 million haID·
burgers per day (point E') as compared with 6 milli0n demanded (point E) on curve D. 'fhe
shift from D to D' leads consumers to demand 6 million additional-hamburgers per day al
each price. . ..
A shift in demand is referred to as a change in demand and must be clearly diSt!OI
guished from a change in the quantity demanded, which refers instead to a moveill:e
along a given demand curve as a result of a change· in the commodity price. Thus, D
shift in demand from D to D~.is an increase in demand, while the movement along i;
say, from point E to point F, is a change in the quantity demanded. The chang~
5
demand is caused by the change in the economic variables that are held con lafl jn
drawing a given demand curve .(the ceteris paribus assumption), whereas a chang;f8
h · · result
t e quantity demanded is a movement along a given demand curve as a IJicP
change in the price of the commodity (with all the other economic variables on w
demand depends remaining constant).
 CHAPTER 2 Basic Demand and Supply Analysis 27

P($)
...
·g 2.50
...
0
'1.
2.00
•O
e.o
,E 1.50
§
,.c:: 1.00
'o0 0.75
u
FIGURE 2.2 Change in Demand for Hamburgers ·c: 0.50
Consumers demand more hamburgers at each price when i:i... D'
the demand curve shifts to the right from Dto D'. Thus, at
4 6 7 8 10 12 13 14 Q
P = $1.00, consumers purchase 12 million hamburgers with 0 2
D' instead of only 6 million with D. Million ~amburgers per day

MARKET SUPPLY
We have examined the market demand, now it is time to turn to the supply side.

Supply Schedule and Supply Curve

A market supply ~~~!le is a_table_showip.g _the quantity, supplied of a commodity at
each price for giveri period of time.·it ·assm:pes that techn~logy, resource prices, and, for
agricultural commodities, weather condiµoris; _are held constant (the ceteris paribus
assumption). Table 2.2 gives a hypothetical oaily supply schedule for hamburgers.
Starting at the bottom, the table shows that at the ·price of $0.50 per hamburger, the quan-
.tity supplied is 2 million hamburgers per day. At the higher price of $0.75 per hamburger,
the quantity supplied is 4 million hamburgers ~r day. At the price of $1.00, the quantity
supplied is 6 million hambtirgers per day, and so on. Higher hamburger prices allow pro-
ducers to bid resources away from other uses and supply greater quantities of hamburgers.
The various price-quantity combinati~ns (!fa supply,se:hed:ule can be plotted on a graph
to obtain the market supply curve for the commodity. F~r example, Figure 2.3 shows
- the market ·supply curve for hamburgers corresponding to·the market supply schedule of
Table 2.2. -The positive slope of the supp!Y curve (i.e.,-its upward-to-the-right inclination)
reflects the 'fact that higher prices must be paid to producers to-cover rising marginal, or
extra,' costs and thus induce them to supply greater'quantities of the commodity.
As with the demand curve, the various points on the supply curve represent alternative
price-quantity combinations. For·example, at the price of $0.50 per hamburger, the quan-
tity supplied is 2 million hamburgers per day (point R in Figure 2.3). If instead the price is
$0.75, the quantity supplied is 4 million hamburgers '(point N), and so on. A supply curve
also shows the minimum price that producers must receive to cover their rising marginal
costs and supply each quantity of the commodity. For example, the supply curve of Figure
2.3 shows that the supply price (i.e., the minimum price that suppliers must receive) in order
to supply 2 million hamburgers per day is $0.50 (point R); for 4 million hamburgers, the
supply price is $0.75 (point N), and so on. A particular supply curve is drawn for a specific
j g_ PART ONE Introduction to -Microeconomics

TABLE 2.2

Quantity Supplied per Day

Price per
(million hamburgers)
Hamburger
14
$2.00_,·
10
1.50
6
- 1.00
4
0.75 2 :;. -·~·
0.50

; ~, , :, _I'

, ..., P($)
·a::l ,., s ·, -'·••
' 2.00
0..

1.50
I-<

E
1.00
t:-
0
-0.75
~: , i tl 0..50
·c
p...
o.25

0 2 \ 6. .-J:JJ:~ I? ,,; - . :} ,i{4:;_:_ ~, 1) 2, ".

Million hamburgers per day '
FIGURE 2.3 ,,. Market SuppJicurve +or·H~mburge~s : t Market' t
. . - . . -. ; """~ , ,1:,:-\ .. ,1:«.,~
1 ..
.. r . supply curve 5 shows that higher hamburger PfJ~es inauce 1 .•·, .,
producers to supply g'reater quantities.
,f I 1 '' • •
- · ··· ' f ,
'·" '
• ,._, / (; , ' I°; \ J f•

r:,

:::::i:m:~:;,:co~S~n~~~y
· period._ of time. The supply curve ofJigure 2.3 i~ for' qne day. The supply curve of ham·

• i f I l 'II• .,. \. ,.
l~er : r.f ~e~ ~Ut.

• ..- • •
2

f
: I
A~--improvement i~ t~chn_ology, a redu~ti~n in ithe pri<;e qf re.~purces used in the produ~-
.tion of the commodity, and, for agricultur~ C(?mm9dities, mQr~ favorable weather con&·
tions (i.e., ,a change in the c,eteri~ paribu~_assyIV,pt~on) would,s~use the entire supply c~'.
f
of the commodity to shift to the right. P~odu_cers would then supply more of the coIJllll
I, ., ,

ity at each_ price. Foi exal)lpie, Figure 2.4 shows that at the priCC of$ 1.00, prod•~~
.. I
ply 12 IDillion hamburgers pyr day, (point f) with S' as., qpposed to only 6
hamburger~ w,ith S. . ; : . ,; " 1 • _ : , • • • ust~
The,~h~ft t~ the ngl:\t from S to S' 1s ~~ferreq ~Q a~ an increase m su~p~y. This ;Illove·
t
clearly d1stmgmshed
·
from an incr.ease
,
in the
·
quantity supplied,
·
which 1s mS ead01nt
. g10
,ment on a given supply curve in the upward direction (as,.for example, from P 0010
. tJ . F .' ' (frOIll $l
pom , m igu~~ .7.4) resulting froµi an· ip.crease i,n the c,ommodity price ·

It;.,,

2 As iri ,the case of demand, the supply curve c·an; but need not, be a straight-line.
 CHAPTER 2 Basic Demand and Supply Analysis 29

:;: , P($)
i::
;:l
•
s (
-
· 2.00·
0..
~- S'
1 .50
...;:l
..0 - ){' ~r
-~ 1.00
..c: 0.75
. 4-<
0
0.50
u
·c:: 0.25 I
'
0 2 4 6 8 10 12 14 16 Q
Million hamburgers per day _·

FIGURE 2.4 Change in the Supply of Hamburgers -When the

supply curve shifts to the right from S to S', producers supply more
hamburgers at each price. Thus, at P = $1.00, producers supply
12 miliion hamburgers with 5' instead of only 6 million with"S: ··
V ,·

$1.50}. OQ the other band, a de.crease.it): s_upply refers to a leftward shift in the supply curve
and must be clearly , distinguished-_ from a decrease in the quantity supplied of the
,commodity (which is amovement;do_wn a supply curve.and results from a decline in the
,. commodity price) . .

, WHEN Is A MARKET ·1N EQUILIBRiut1'? 3 . _

'I • , , I ,

We now examine how the interacti_on of the f?rces of d~~and :and supply determines the
equilibrium price and qu;mti~y of a commodi~y _in a.perfectly competitive market, ~~~
ket is in equilibrium ~ ~en no b~ ~!J~~~.!~.ti.°2!1!,ve_!,?~!11-geJ!i~~~tx..9,1
t h ~ a t-he orsli'tbuys.or sells at the given price. The equilibrium price of a
~ mmodity IS tfie pnce a r w f i l ~ de;;ii'cferb! the coiii'iiioclltyegtialstiiee
quanfity suppfiedand the~~ c~~-, lhe p;;~_ss)ry~hi7h°.equilibri~~i;
the imiTlreq)ia'ce'c:an Se"snown with a ta~le and ill~strated graphically.
Table 2..3 brings togepier the market d.~rp.and. and .sUpJ?lY ,schedules for hamburgers
from Tables 2.1 and _2.~. .From Table 2.3, ~e ~ee that only at P = $1.00 is the quantity
supplied of hamburgers equal to the quantity demanded and ~e market clears. Thus, P =
$1.00 is the equilibrium price and Q = 6 million hamburgers per day is the equilibrium
quantity. .
At prices above the equilibrium price, the quantity supplied exceeds the quantity
demanded and there is '_a surplus q~ the commodity, which drives the price down. For
~xample, at P = $2.00, the quantity supplied (QS) is 14 million hamburgers, the quantity
demanded (QD) is .z million hamburgers, so there is a surplus of 12 million hamburgers
per day (see the first line _of Table 2.3). Sellers must reduce prices to get rid of their
unwanted inventory accumulations of hamburgers. At lower prices, producers supply

3An algebraic analysis of how·equilibrium is' detennined for this case is given in the appendix to this chapter.
A more general analysis is provided in section A1.11 of the Mathematical Appendix at the end of the book.
30 PART ONE Introduction to Microeconomics

Quantity Supplied Quantity Demanded Surplus(+)

Price per pe(Day (million · per Day (million or Pressure
Hamburger
$2.00
hamburger:s)
14
s hamburgers) J:>
2
Shortage (
12
on Pnce

-----
tDownward
Downward
4 6
1.50 10

_I( r.O[::;i
0.75
r6. J
a
4
:::: 1371
7 -3
0 EquiUSJ
tUpward
8 -6 Upward
0.50 2

small~r quantities and ~onsumers demand larger quantities Ul'l;til the equilibrium price of
$1.00 IS reached, at which the quantity supplied of 6 million hamburgers per day equals th
. d e
quantity emanded and the market clears.
On the other ?and, at prices below th~ equilib?um price, the quantity supplied falls I
short of the quantity demanded and there IS a shortage of the commodity, which drives
the price up. For example,· ·at~P == $0.50;. QS- = 2' nm.hon hamburgers while QD = 8
milli?n hamburgers, so·that t~ere is a shortage o~ 6 millio_n•hamburgers per day (see the I
last hne of Table 2.3). The pnce of hamburgers IS then brd up by consumers who want
more hamburgers than are available at the low price of $0.50. As the price of ham·
burgers is bid up, .proqucers supply_gre_ater quantities. \3/hile consumers demand smaller
quantities .until the equilibrium price of P = $ l .00 is reached, at which QS ·= QD = 6
million hamburgers per day and the market clears. Thus, bidding drives price and quan·
tity to their equilibriuiri level. .
The 'determination of the equilibrium price can also be shown graphically by bring-
ing together ·on the 'same graph the market demand curve of Figure 2.1 and the market
supply curve of Figure 2.3. In Figure 2.5 the intersection of the market demand curve and .
the market supply cu!'Ve of hamburgers :at point E defines· the·equilibrium price of $1.00
per hamburger and'the equilibrium quantity of 6 million hamburgers per day.
At 'higher prices, there is an excess supply .or surplus of the commodity (the top
shaded area in Figure 2.5). Suppliers then lower prices to sell their excess supplies. ~e
surplus i·s eliminated .only when suppliers have.lowered their price to the equilibnUIII the
level. Ort the other hand, at below equilibrium prices, the excess demand or shortage (
bottom shaded area in the figure) drives the price up to the equilibrium level. This occ~
because consumers are unable to purchase all of the co'mmodity they want at beloW·
equilibrium prices and they bid up the price. The shortage i'. eliminated only when
somers have bid up the price to the"equilibrium level, that IS, only at P =$1.00, Q
QD.=6 million hamburgers per day, _and the market is in equilibrium (clears)- So, bO
demand and suppfr play a role in determining price. _ . . . Th tis,
· Equilibrium is the condition' which, once achieved, tends to persist m ume. a(be
as long as buyers 'and sellers do not change their behavior and D and S do not change,
equilibrium point remains the same. . ·bdoJ!l
At a particular point, in time
. ' the
. observed
. price may or ·may not be the equtli .•, ,,i
. e to.,8.l"
price. However, we know that market forces generally push the market pnc
 CHAPTER 2 Basic Demand and Supply Analysis 31

P($)
s

e; ., •· ·Excess ·supply. ·. ·
; 1.50 or,surphl.§. , ,
.B
..c: 1.00
4-<
0

-~ 0.75
Excess 1d~mand ·•
0.50 •
: j

· or shortage
• 1
0.25

6 7 8 10 12 14 Q
0 2 4
Mtllion hamburgers per day
FIGURE 2.5 Demand, Supply, and Equilibrium The intersection of D and 5 at point f
defines the equilibrium pHce of $100 per hamburger and the equilibrium quantity
of 6 million hamburgers per day. At P larger than ·$100, ·the resulting surplus will drive P
down toward equilibrium At P smaller than $HYO, the resulting shortage will drive P up
toward equilibrium

equilibrium. This may occur very rapidly or very slowly. Before the market price reaches
a particular equilibrium price, demand and supply may change (shift), defining a new
equilibrium price. For now we will assume that, in the absence of price controls, the mar-
ket price is the equilibrium price. Example 2-1 shows how the market-clearing, or equi-
librium~ price is actually approximate_d in the real wor:ld by auction or similar
· mechanisms.

t~'.~t:-· ;i~)J\r:t-::~:>Q~;~~r·.~~-~:~f;f~1(~(;-t~~:~!f~t}::~~:':;ti~~:.:·:;~:-. -
L'""~r:t.P~~~~-_1. .. .- :_:•-:·:' .~">\.' : ;· ,t:'?r; ,', ~~.{; ~·:.· .f'~!~·,,
~ - -i • :;·
11
JL ,1n , v;, JJ'~ ;.,Jf'., . ' ,: / ; ·,,~r~ --~ "'--

!' E,- ·1·b···•·.''.'.··•" •. ~·-.,. ·b·.·.··~ct.·;on.·,3., ... -. . ·...... '.., \ ··• ,.. ,,._. ·--,; :
1, qµ11 ~nu_,p_r,:Q~~-t· .J . ., : , ,•,iiit '1.i ,

. On~ ;a; :~uilibrium prices·are a~Mi~~teit~h~tl 'irt~th~ ·~~f-~odd '.;;r,i~

auctiJJ-:ci;~:,
the'..centunes, auc.tions-bave· b~en. used to ap1-1rox;inJ.aty the..m~ket~clearihg, 6qijilib or:
. . ." . rium,cprice ·?f everythini fromftlips to fine•artina goverfilnent bondi _How.-~~)i~c~-i1
}fP'f! ( •;, ,,::,f<noh's} 1work? ·Suppose.;that ·a ~ ~eller1,~fi'; a:-product OJ.! ~service-faces -a;-grol!p of'potefitiaL ~fi
J
/, • J

'• , ':'l ;!;",''Cfi/'f(}•~~ _-tl'l£buyer~.'. 'Flie selleti-ldlb'.~S what hiS{o1fi~el\,mirtimu~·acceptable (reserv.ation),pri~~, ~ d

t;.'' '1eacb"l boyer.,knows ·more or 'Iess1 ·m ~um pJ;ice;Jie.ot she willing to pay·for"Uie the is I
• • ' .., . p·;y ' 1Wi'; '· I\ ·good·:ot:isef'vice'. l,'fhe seJler and'@ei b~yers, ' however, :do ·not reveal' 'information j this
'11.'. ,..- ' unless and.'untilit, is in<their interesttoJ
1{ do so. ; ·' , · , ·: - ' . "·.A
will
, ; ' :-_. · ' -

·- t:1 ;,·· ~·The'actual•inl'trket;'.or,equ1librium, ptit:e-for µie good:or,s~rvice settle between J

,: '·' 1 ','If' JfJ~,1 / ,r; 1;Jil1:tfie prite 1that'theibGyer whcHS1\Villing,to paJ' the most for the good or·service (call him ·1
J "\ t I 1 l t ,'f ,., : 1t'J/i;,t,_.,11,;,, ... ·• Ln,.,J'J:l1.:.}f.t·,ik!j·.t;4l:J..lk _,,1-tft, ia...J.te·•·- J._ __ i;J/1.a ..... ..,_ _.,, ·- !l-...... ....~.,,.L,,,. -.J