Chapter 3

Supply and
Demand

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Overview
Market demand
Market supply
Market equilibrium
Comparative statics analysis
short-run analysis, long-run
analysis
Supply, demand, and price
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Learning objectives

define supply, demand, and equilibrium

price

identify non-price determinants of

supply and demand

distinguish between short-run rationing

function and long-run guiding function
of price

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Learning objectives

 illustrate how supply and demand can

be used to improve management
decisions

 use supply and demand diagrams to

determine price in the short and long
run

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Market demand

 Demand for a good or service is defined

as quantities that people are ready
(willing and able) to buy at various prices
within some given time period

Other factors besides price are held

constant

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Market demand
Market demand is the sum of all the
individual demands

Example: demand for pizza

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Market demand
The inverse
relationship
between price
and the
quantity
demanded of a
good or service
is called the
Law of
Demand

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Market demand
 Changes in price result in changes in the
quantity demanded
 This is shown as movement along the
demand curve

 Changes in non-price factors result in

changes in demand
 This is shown as a shift in the demand
curve

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Market demand
 Nonprice determinants of demand

 tastes and preferences

 income
 prices of related products
 future expectations
 number of buyers

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Market supply

 The supply of a good or service is defined

as quantities that people are ready to sell
at various prices within some given time
period

Other factors besides price held constant

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ublishing as Prentice Hall.
Market supply
 Changes in price result in changes in the
quantity supplied
 shown as movement along the supply
curve

 Changes in non-price determinants result

in changes in supply
 shown as a shift in the supply curve

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Market supply
 Nonprice determinants of supply

 costs and technology

 prices of other goods or services offered
by the seller
 future expectations
 number of sellers
 weather conditions

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Market equilibrium

 Equilibrium price: the price that equates

the quantity demanded with the quantity
supplied

 Equilibrium quantity: the amount that

people are willing to buy and sellers are
willing to offer at the equilibrium price
level

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Market equilibrium
 Shortage: a market situation in which the
quantity demanded exceeds the quantity
supplied
 shortage occurs at a price below the
equilibrium level

 Surplus: a market situation in which the

quantity supplied exceeds the quantity
demanded
 surplus occurs at a price above the
equilibrium level

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Market equilibrium

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Comparative statics analysis

 Comparative statics is a form of

sensitivity (or what-if) analysis

Commonly used method in economic

analysis

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Comparative statics analysis
 Process of comparative statics analysis:
 state all the assumptions needed to
construct the model
 begin by assuming that the model is in
equilibrium
 introduce a change in the model, so a
condition of disequilibrium is created
 find the new point of equilibrium
 compare the new equilibrium point with
the original one
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Comparative statics: example
Step 1
 assume all factors
except the price of
pizza are constant

 buyers’ demand and

sellers’ supply are
represented by lines
shown

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Comparative statics: example
Step 2
 begin the analysis in
equilibrium as shown
by Q1 and P1

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Comparative statics: example
Step 3
 assume that a new
study shows pizza to
be the most
nutritious of all fast
foods

 consumers increase
their demand for
pizza as a result

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Comparative statics: example
Step 4
 the shift in demand
results in a new
equilibrium price (P2)

 and a new equilibrium

quantity (Q2)

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Comparative statics: example
Step 5
 comparing the new
equilibrium point with
the original one, we
see that both
equilibrium price and
quantity have
increased

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Comparative statics analysis
 The short run is the period of time in
which:

 sellers already in the market respond to a

change in equilibrium price by adjusting
variable inputs

 buyers already in the market respond to

changes in equilibrium price by adjusting
the quantity demanded for the good or
service

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Comparative statics analysis
 Short run changes show the rationing
function of price

The rationing function of price is the

change in market price to eliminate the
imbalance between quantities supplied
and demanded is the change in market
price to eliminate the imbalance between
quantities supplied and demanded

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Short-run analysis
 an increase in demand
causes equilibrium
price and quantity to
rise

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Short-run analysis
 a decrease in demand
causes equilibrium
price and quantity to
fall

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Short-run analysis
 an increase in supply
causes equilibrium
price to fall and
equilibrium quantity to
rise

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Short-run analysis
 a decrease in supply
causes equilibrium
price to rise and
equilibrium quantity to
fall

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Long run analysis
 The long run is the period of time in
which:
 new sellers may enter a market
 existing sellers may exit from a market
 existing sellers may adjust fixed factors
of production
 buyers may react to a change in
equilibrium price by changing their
tastes and preferences
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Long run analysis
 Long run changes show the allocating
function of price

 The guiding or allocating function of

price is the movement of resources into or
out of markets in response to a change in
the equilibrium price

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Long-run analysis
 initial change: decrease in
demand from D1 to D2

 result: reduction in
equilibrium price and
quantity (to P2,Q2)

 follow-on adjustment:
 movement of resources
out of the market
 leftward shift in the
supply curve to S2

 equilibrium price and

quantity (to P3,Q3)

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Long-run analysis
 initial change: increase in
demand from D1 to D2

 result: increase in
equilibrium price and
quantity (to P2,Q2)

 follow-on adjustment:
 movement of resources
into the market
 rightward shift in the
supply curve to S2

 equilibrium price and

quantity (to P3,Q3)

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 Supply, demand, and price:
the managerial challenge
 in the extreme case, the forces of supply
and demand are the sole determinants of
the market price, not any single firm
 this type of market is ‘perfect
competition’

 in many cases, individual firms can exert

market power over price because of their:
 dominant size
 ability to differentiate their product
through advertising, brand name,
features, or services
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 Supply, demand, and price:
the managerial challenge

 Example: coffee

 ‘buy low, sell high’

 2000: overproduction led to price

falls
 2004: prices moved up again

 Starbucks effects

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 Supply, demand, and price:
the managerial challenge
 Example: air travel

 ‘buy high, sell low’

 industry deregulated in late 1970s

 tight competition

 post 9/11, a low-cost structure is

needed

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 Global application
 Example: the market for cobalt

 rare metal
 produced as a by-product
 strategic item
 prices rising

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