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Chapter 3

Supply and Demand

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 3-1
Chapter Objectives
• Define and explain demand in a product
or service market
• Define and explain supply
• Determine the equilibrium point in the
market for a specific good, given data on
supply and demand at different price
levels

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 3-2
Chapter Objectives
• Understand what causes shifts in demand
and supply
• Understand how price ceilings cause
shortages
• Understand how price floors cause
surpluses

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 3-3
Demand
• The schedule of quantities of a
good or service that people are
willing and able to buy at
different prices
– Sometimes a schedule is also called
a table

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 3-4
Hypothetical Daily Demand for Coach Seats on Round-
trip Weekly Flights Between Denver and Chicago
Table 1
$500
Price QD 450
$500 1,000 400
450 3,000 350

400 7,000 300

350 12,000 250

300 19,000 200

150
250 30,000
D
100
200 45,000
50
150 57,000
10 20 30 40 50 60 70
100 67,000
Quantity (in thousands)

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 3-5
Hypothetical Daily Demand for Coach Seats on Round-
trip Weekly Flights Between Denver and Chicago
Table 1
$500
Price QD 450
$500 1,000 400
450 3,000 350

400 7,000 300

350 12,000 250

300 19,000 200

150
250 30,000
D
100
200 45,000
50
150 57,000
10 20 30 40 50 60 70
100 67,000
Quantity (in thousands)

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 3-6
Hypothetical Daily Demand for Coach Seats on Round-
trip Weekly Flights Between Denver and Chicago
Table 1
$500
Price QD 450
$500 1,000 400
450 3,000 350

400 7,000 300

350 12,000 250

300 19,000 200

150
250 30,000
D
100
200 45,000
50
150 57,000
10 20 30 40 50 60 70
100 67,000
Quantity (in thousands)

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 3-7
Hypothetical Daily Demand for Coach Seats on Round-
trip Weekly Flights Between Denver and Chicago
Table 1
$500
Price QD 450
$500 1,000 400
450 3,000 350

400 7,000 300

350 12,000 250

300 19,000 200

150
250 30,000
D
100
200 45,000
50
150 57,000
10 20 30 40 50 60 70
100 67,000
Quantity (in thousands)

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 3-8
Hypothetical Daily Demand for Coach Seats on Round-
trip Weekly Flights Between Denver and Chicago
Table 1
$500
Price QD 450
$500 1,000 400
450 3,000 350

400 7,000 300

350 12,000 250

300 19,000 200

150
250 30,000
D
100
200 45,000
50
150 57,000
10 20 30 40 50 60 70
100 67,000
Quantity (in thousands)

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 3-9
Hypothetical Daily Demand for Coach Seats on Round-
trip Weekly Flights Between Denver and Chicago
Table 1
$500
Price QD 450
$500 1,000 400
450 3,000 350

400 7,000 300

350 12,000 250

300 19,000 200

150
250 30,000
D
100
200 45,000
50
150 57,000
10 20 30 40 50 60 70
100 67,000
Quantity (in thousands)

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 3-10
Hypothetical Daily Demand for Coach Seats on Round-
trip Weekly Flights Between Denver and Chicago
Table 1
$500
Price QD 450
$500 1,000 400
450 3,000 350

400 7,000 300

350 12,000 250

300 19,000 200

150
250 30,000
D
100
200 45,000
50
150 57,000
10 20 30 40 50 60 70
100 67,000
Quantity (in thousands)

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 3-11
Hypothetical Daily Demand for Coach Seats on Round-
trip Weekly Flights Between Denver and Chicago
Table 1
$500
Price QD 450
$500 1,000 400
450 3,000 350

400 7,000 300

350 12,000 250

300 19,000 200

150
250 30,000
D
100
200 45,000
50
150 57,000
10 20 30 40 50 60 70
100 67,000
Quantity (in thousands)

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 3-12
Hypothetical Daily Demand for Coach Seats on Round-
trip Weekly Flights Between Denver and Chicago
Table 1
$500
Price QD 450
$500 1,000 400
450 3,000 350

400 7,000 300

350 12,000 250

300 19,000 200

150
250 30,000
D
100
200 45,000
50
150 57,000
10 20 30 40 50 60 70
100 67,000
Quantity (in thousands)

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 3-13
Hypothetical Daily Demand for Coach Seats on Round-
trip Weekly Flights Between Denver and Chicago
Table 1
$500
Price QD 450
$500 1,000 400
450 3,000 350

400 7,000 300

350 12,000 250

300 19,000 200

150
250 30,000
D
100
200 45,000
50
150 57,000
10 20 30 40 50 60 70
100 67,000
Quantity (in thousands)

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Table 1 is the Demand Figure 1 is the Graph of the
Schedule Demand Schedule

Table 1 Figure 1
$500
Price QD 450
$500 1,000 400
450 3,000 350

400 7,000 300

350 12,000 250

300 19,000 200

150
250 30,000
D
100
200 45,000 The line is the
50
150 57,000 Demand Curve
10 20 30 40 50 60 70
100 67,000
Quantity (in thousands)

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Price and Quantity Demanded Quantity Demanded is a point
are inversely related on the Demand Curve

Table 1 Figure 1
$500
Price QD 450
$500 1,000 400
450 3,000 350

400 7,000 300

350 12,000 250

300 19,000 200

150
250 30,000
D
100
200 45,000
50
150 57,000
10 20 30 40 50 60 70
100 67,000
Quantity (in thousands)

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 3-16
Remember, Demand is the Quantity Demanded is a point
entire schedule or the entire on the Demand Curve
curve
Table 1 Figure 1
$500
Price QD 450
$500 1,000 400
450 3,000 350

400 7,000 300

350 12,000 250

300 19,000 200

150
250 30,000
D
100
200 45,000
50
150 57,000
10 20 30 40 50 60 70
100 67,000
Quantity (in thousands)

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 3-17
Supply
• Is the “schedule” of quantities of a
good or service that people are
willing to sell at different prices

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 3-18
Supply is the entire schedule
or the entire curve

Price QS $500
S
$500 62,000
450
$450 59,000
400
$400 54,000
$350 48,000 350

$300 40,000 300


$250 30,000 250
$200 200
16,000 $150
150
7,000 $100
100
2,000
50

10 20 30 40 50 60 70
Quantity (in thousands)

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Quantity Supplied is a point on
the curve

Price QS $500
S
$500 62,000
450
$450 59,000
400
$400 54,000
$350 48,000 350

$300 40,000 300


$250 30,000 250
$200 200
16,000 $150
150
7,000 $100
100
2,000
50

10 20 30 40 50 60 70
Quantity (in thousands)

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 3-20
Demand and Supply Curves

S
Price QS QD $500

$500 62,000 1,000 450

$450 59,000 400

3,000 $400 54,000 350

7,000 $350 48,000 300

250
12,000 $300 40,000
200
19,000 $250 30,000
150
30,000 $200 16,000 D
100
45,000 $150 7,000
50
57,000 $100 2,000
67,000 10 20 30 40 50 60 70
Quantity (in thousands)

Equilibrium price We can find equilibrium price


is the price where and quantity by seeing where the
QD = QS supply and demand curves cross
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Demand and Supply Curves
Surpluses and Shortages
S
Price QS QD $500

$500 62,000 1,000 450 54,000-7,000 = 47,000


$450 59,000 400

3,000 $400 54,000 350

7,000 $350 48,000 300

250
12,000 $300 40,000
200
19,000 $250 30,000
150
30,000 $200 16,000 D
100
45,000 $150 7,000
50
57,000 $100 2,000
67,000 10 20 30 40 50 60 70
Quantity (in thousands)

Equilibrium price = EP MP > EP there is a surplus


Market price = MP

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Demand and Supply Curves
Surpluses and Shortages
S
Price QS QD $500

$500 62,000 1,000 450 54,000-7,000 = 47,000


$450 59,000 400

3,000 $400 54,000 350

7,000 $350 48,000 300

250
12,000 $300 40,000
200
19,000 $250 30,000
150
30,000 $200 16,000 D
100
45,000 $150 7,000
50
57,000 $100 2,000
67,000 10 20 30 40 50 60 70
Quantity (in thousands)

Equilibrium price = EP A surplus would force sellers to


Market price = MP lower their prices. Eventually,
prices would fall back to the
equilibrium price
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Demand and Supply Curves
Surpluses and Shortages
S
Price QS QD $500

$500 62,000 1,000 450

$450 59,000 400

3,000 $400 54,000 350

7,000 $350 48,000 300

250
12,000 $300 40,000
200
19,000 $250 30,000
150
30,000 $200 16,000 D
100 57,000-7,000 = 50,000
45,000 $150 7,000
50
57,000 $100 2,000
67,000 10 20 30 40 50 60 70
Quantity (in thousands)

Equilibrium price = EP
Market price = MP MP < EP here is a shortage

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Demand and Supply Curves
Surpluses and Shortages
S
Price QS QD $500

$500 62,000 1,000 450

$450 59,000 400

3,000 $400 54,000 350

7,000 $350 48,000 300

250
12,000 $300 40,000
200
19,000 $250 30,000
150
30,000 $200 16,000 D
100 57,000-7,000 = 50,000
45,000 $150 7,000
50
57,000 $100 2,000
67,000 10 20 30 40 50 60 70
Quantity (in thousands)

A shortage would allow sellers to raise


Equilibrium price = EP their prices. As prices increased people
Market price = MP would buy less. Eventually, prices
would move back to the equilibrium
price
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Demand and Supply Curves
Surpluses and Shortages
S
Price QS QD $500

$500 62,000 1,000 450

$450 59,000 400

3,000 $400 54,000 350

7,000 $350 48,000 300

250
12,000 $300 40,000
200
19,000 $250 30,000
150
30,000 $200 16,000 D
100
45,000 $150 7,000
50
57,000 $100 2,000
67,000 10 20 30 40 50 60 70
Quantity (in thousands)

We can see that the forces of demand


and supply work together to establish an
equilibrium price at which there are no
shortages or surpluses
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The schedule changes from QD1 to QD2

Table 4 $500
S

Price QD1 QD2 450


$500 1,000 12,000 400

450 3,000 15,000 350

300
400 7,000 21,000
250
350 12,000 30,000
200
300 19,000 40,000 150

250 30,000 55,000 D1


100
D2
200 45,000 63,000 50

150 57,000 75,000 10 20 30 40 50 60 70


Quantity (in thousands)
100 67,000 88,000

The demand curve shifts to the right from D1 to D2


This is an increase in demand
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The schedule changes from QD2 to QD1

Table 4 $500
S

Price QD1 QD2 450


$500 1,000 12,000 400

450 3,000 15,000 350

300
400 7,000 21,000
250
350 12,000 30,000
200
300 19,000 40,000 150

250 30,000 55,000 D1


100
D2
200 45,000 63,000 50

150 57,000 75,000 10 20 30 40 50 60 70


Quantity (in thousands)
100 67,000 88,000

The demand curve shifts to the left from D2 to D1


This is a decrease in demand
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Shifts in Supply and Demand

If the schedule changes the Price


Supply curve shifts 500 S S
450

400

350

300

250

200
Supply decreases . . . the 150
curve shifts to the left
100

50
D
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Shifts in Supply and Demand

If the schedule changes the Price


Supply curve shifts 500 S S
450

400

350

300

250

200

150
Supply increases . . . the 100
curve shifts to the right
50
D
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Shifts in Supply and Demand

If the Supply curve is S1 Price


what is the equilibrium price 500 S2 S1
and quantity? 450

400

350

300

250
The equilibrium price is 200
approximately 262 or 263
150

The equilibrium quantity is 100


approximately 35,000 50
D
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Shifts in Supply and Demand

If the Supply curve changes Price


to S2 what is the new 500 S2 S1
equilibrium price and 450
quantity?
400

350

300

250
The new equilibrium price 200
is approximately 325
150

The new equilibrium 100


quantity is approximately 50
26,000 D
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Shifts in Supply and Demand

Is a shift from S1 to S2 an Price


increase or decrease in 500 S2 S1
Supply? 450

400

350

300

250
A decrease 200

150

100

50
D
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Price Floors and Ceilings
The price can go no lower
than the floor.
25
S
20
The surplus is the amount
Surplus Price
by which the quantity 15
floor
supplied is greater than the
quantity demanded 10

5
D

A price floor creates a


10 20 30 40 50 60 70
permanent surplus
Quantity

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Price Floors and Ceilings
The price can go no higher
than the ceiling. S

40

The shortage is the amount 30


by which the quantity
demanded is greater than
20 Price ceiling
the quantity supplied Shortage

10
D

A price ceiling creates a


10 20 30 40 50 60 70 80
permanent shortage
Quantity

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Applications of Supply and
Demand
• Interest rates are set by
– Supply and demand
• Wage rates are set by
– Supply and demand
• Rents are determined by
– Supply and demand
• The prices of nearly all goods are determined by
– Supply and demand
• The prices of nearly all services are determined
by
– Supply and demand

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Hypothetical Demand for and Supply of Loanable Funds

S
20

18

16

14

12

10

2
D

100 200 300 400 500 600 700 800 9001,000 1,100
Quantity of loanable funds (in billions of dollars)

We can see that $600 billion is lent (or borrowed) at an interest rate
of 6 percent
What would happen if the supply of loanable funds increased?
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Hypothetical Demand for and Supply of Loanable Funds

S1
20 S2

18

16

14

12

10

2
D

200 400 600 800 1,000


Quantity of loanable funds (in billions of dollars)

The interest rate would decrease to 4 percent and the amount of


money borrowed would increase to $800 billion

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Hypothetical Demand for and Supply of Loanable Funds

S
20

18

16

14

12

10

6
D2
4

2
D1

200 400 600 800 1,000


Quantity of loanable funds (in billions of dollars)

If the demand for loanable funds rises to D2 the interest rate would
rise to 9 percent and the amount of money borrowed would rise to
$700 billion
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Last Word
• Government sometimes interferes with the free
operation of the markets by
– Imposing prices floors and price ceilings
– This creates the problems of shortages and
surpluses
• The government may also ensure the smooth operation
of the markets by protecting property rights,
guaranteeing enforcement of legal contracts, and
issuing a supply of money that buyers and sellers
readily accept
– Property rights are essential to a free and
prosperous nation
• While governmental interference with the market
system can have adverse affects, the government does
have a substantial supportive role to play in a market
economy.
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 3-40
Current Issue: High Gas Prices
• Hurricane Katrina
– Temporarily shut down off shore wells
– Briefly put 10% of our refineries out of commission
– Result – a sudden drop in oil supply
– The government took a “hands” off approach
– Gasoline prices rose sharply – duh?
– People could buy all they wanted at sharply
increased prices with no wait at the pumps

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The Alternative to High Gas Prices
In 1970 and 1979
• Middle east countries curtailed oil shipments to
the United States
• Resulted in reduced oil supply
• Government’s solution – restrict purchases and
hold down prices
• The result – long gas lines in many parts of the
country
• People paid less but waited much longer to
purchase gas at moderately higher prices
(sometimes one to two hours)

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 3-42
Summation
Gasoline Supply Decreases
• Short Run
– Prices Rise
– Many people cut back on their driving
• Long Run
– People buy more gas efficient cars
– Higher prices encourage greater exploration
for oil
– Higher prices encourage the development of
alternative energy sources

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Summation
Government Restricts Purchases and Holds
Down Price Increases
• Short Run
– Prices may rise moderately
– People cut back on their driving very little if
any
– Significant waits at the gas pumps occur
• Long Run
– People have little incentive to buy more gas
efficient cars
– Lower prices discourage greater exploration
for oil
– Higher prices discourage the development of
alternative energy sources
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 3-44
Closing Comments
• Most economists probably believe price ceilings do
more harm than good in the long run
• Most people probably think in the short run and want
government to do something about higher prices
• Government probably is inclined to get involved
• Corporate greed probably can and will influence
government actions
• The result . . . who knows? But past history indicates it
probably won’t be good for the consumer

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 3-45