CHAPTER 3

Demand, supply and the market

©McGraw-Hill Education, 2014

Key concepts in the study of markets

• Market: a set of arrangements by which buyers

and sellers are in contact to exchange goods or
services
• Demand: the quantity of a good buyers wish to
purchase at each conceivable price
• Supply: the quantity of a good sellers wish to sell
at each conceivable price
• Equilibrium price: price at which quantity
supplied = quantity demanded.

©McGraw-Hill Education, 2014

The supply curve shows the relation between price and
quantity demanded holding other things constant

S Other things include:

• Technology
Price

• Input costs
• Government regulations
•Business expectations

Quantity
©McGraw-Hill Education, 2014
 Market equilibrium

S Market equilibrium is at E0
Price

where quantity demanded

equals quantity supplied . The
P0 E0 equilibrium price is P0 and
quantity Q0

Q0
Quantity
©McGraw-Hill Education, 2014
 Behind the demand curve

•It is important to distinguish between movements (or

shifts) in the demand curve and movements along the
demand curve.

•Movements along the demand curve result from

changes in the price of the good itself.

©McGraw-Hill Education, 2014

Price Movements along the demand curve

• A movement along the demand

A curve from A to B occurs when
P0 price falls
B • Here all other determinants of
P1
demand remain constant.

Q0 Q1 Quantity

©McGraw-Hill Education, 2014

 Behind the demand curve
• Movements (or shifts) in the demand curves are
caused by
 Changes in the price of related goods –either
substitutes or complements
 Changes in consumer incomes
 Changes in tastes
 Expectations over future price changes.

©McGraw-Hill Education, 2014

 Income changes and demand

• The influence of changes in income on demand

depends on whether the good is

 a normal good or

 an inferior good.

©McGraw-Hill Education, 2014

 Movements of or shifts in the demand
curve
Price

• A movement (or shift) of the

demand curve from D0 to D1leads
to an increase in demand at each
P0 C and every price
A
P1 F • e.g., at P0 quantity demanded
B
increases from Q0 to Q2: at P1
quantity demanded increases from
Q1 to Q3
Q 0 Q1 Q 2 Q 3
Quantity

©McGraw-Hill Education, 2014

 A shift in demand
Price

If the price of a substitute

D0
D1 good decreases, then
less will be demanded at
each price.
P0 E0
P1 E1 The demand curve shifts
from D0D0 to D1D1.

If price stayed at P0 the

D0 resultant glut would put
D1 downward pressure on the price.
Q1 Q0 Demand would rise and supply
Quantity fall until equilibrium is restored
at E1.
©McGraw-Hill Education, 2014
 Behind the supply curve (1)

• It is important to distinguish between movements (or

shifts) in the supply curve and movements along the
supply curve.

• Movements along the supply curve result from

changes in the price of the good itself.

©McGraw-Hill Education, 2014

 Behind the supply curve (2)

• Movements (or shifts) in the supply curves are

caused by
 Changes in technology
 Changes in input costs
 Changes in government regulations
 Business expectations

©McGraw-Hill Education, 2014

 A shift in supply
S1
S0 Suppose safety
regulations are tightened,
Price

D
increasing producers’ costs
E2 The supply curve
P1 shifts to S1S1
P0 E0
If price stayed at P0, then there
would be excess demand and
upward pressure on price.
S0 D Demand would fall and supply
increase until market equilibrium
Q1 Q0 Quantity is restored.

©McGraw-Hill Education, 2014

 Consumer and producer surplus(1)

•The difference between what a consumer is willing

to pay for a good and the price actually paid is a
measure of the consumer’s surplus.
•Total consumer surplus in a market is the sum of all
the surpluses enjoyed by all consumers.

©McGraw-Hill Education, 2014

 Consumer and producer surplus (2)

•The difference between the price at which a firm

would be willing to supply a good and the price
actually received by the firm is a measure of its
producer surplus.
•Total producer surplus in a market is the sum of all
the surpluses enjoyed by all producers.

©McGraw-Hill Education, 2014

 Consumer and producer surplus (3)

For a single consumer, the consumer

surplus is the difference between the
maximum price that she is willing to
pay for a given amount of a good or
service and the price she actually
Price

Consumer
surplus pays.

The producer surplus for sellers is

the amount that sellers benefit by
P* selling at a market price that is higher
Producer
surplus than they would be willing to sell for.

Q* Quantity
©McGraw-Hill Education, 2014
Consumer and producer surplus and the
gains from trade

•The economic surplus in a market (sum of

consumer and producer surplus) is a measure of the
benefits firms and consumers derive from trade.
•It is maximized at the equilibrium price.
•Only at this price are all the benefits from exchange
exhausted.

©McGraw-Hill Education, 2014

 What, how and for whom
• The market:
– decides how much of a good should be produced
• by finding the price at which the quantity demanded
equals the quantity supplied
– tells us for whom the goods are produced
• those consumers willing to pay the equilibrium price
– determines what goods are being produced
• there may be goods for which no consumer is
prepared to pay a price at which firms would be
willing to supply

©McGraw-Hill Education, 2014

 Free markets and price controls: a market
in disequilibrium
Price

S • Suppose a disastrous harvest

moves the supply curve to SS.
P2 • The resulting market clearing or
P0 E equilibrium price is P0.
• Government may try to protect the
P1 A B
poor, setting a price ceiling at P1.
excess • The result is excess demand.
demand
S
RATIONING is needed to cope
QS Q0 QD Quantity with the resulting excess demand.

©McGraw-Hill Education, 2014

Free markets and price controls: a market
in disequilibrium

•Minimum wages are an example of a price floor and

can result in unemployment.
•Rent caps are an example of a price ceiling and can
result in shortages in rental markets.

©McGraw-Hill Education, 2014

 Exploring the mathematics of demand and
supply (1)
The demand equation:
QD =a - bP (1)

where QD denotes the quantity demanded, P the price while a and

b are two positive constants.

The supply equation:

QS =c + dP (2)

where QS s the quantity supplied, while c and d are two constants. We assume
that the constant d is positive.

©McGraw-Hill Education, 2014

Exploring the mathematics of demand and
supply (2)
Market equilibrium is where quantity demanded equals quantity supplied:
QD = QS

dP  bP  a  c
 P(b  d )  a  c
(a  c)
 P* 
(b  d )

P* is the equilibrium price that equates quantity

demanded and quantity supplied.

©McGraw-Hill Education, 2014

Uncovering demand and supply curves

• It is important to understand that demand and

supply curves are not physical objects that can be
seen or touched.

• Rather they are relationships revealed through the

appropriate use of statistical analyses undertaken
by skilled econometricians.

©McGraw-Hill Education, 2014

 Uncovering supply and demand

• We cannot plot ex ante demand curves and supply

curves
• So we use historical data and the supposition that
the observed values are equilibrium ones
• Since other things are often not constant, careful
use of statistical techniques is required to isolate
the parameters of a demand or supply curve.

©McGraw-Hill Education, 2014

 Concluding comments (1)
• Demand is the quantity that buyers wish to buy at
each price.
• Supply is the quantity of a good sellers wish to sell
at each price.
• The market clears, or is in equilibrium, when the
price equates the quantity supplied and the quantity
demanded, and there are no shortages or surpluses.
• An increase in the price of a substitute good (or
decrease in the price of a complementary good)
will raise the quantity demanded at each price.

©McGraw-Hill Education, 2014

 Concluding comments (2)

• The consumer surplus is measured by the area below the

market demand and above the equilibrium price.
• The producer surplus is measured by the area above the
market supply and below the equilibrium price.
• To be effective, a price ceiling must be imposed below the
free market equilibrium price.
• An effective price floor must be imposed above the free
market equilibrium price.

©McGraw-Hill Education, 2014