Supply, Demand and Market Equilibrium

Yujing Xu
University of Hong
Kong

Special Thanks to Dr. Ka-fu Wong

1
Example: Gains from Trade
o John is willing to pay $10 for an apple.
o Mary can produce an apple at the cost of $4.

o If they trade, together they can gain $6 (=10-4)

o Trade results in gains. The question is how to split the

gain, i.e., how is the price determined.

2
Prices are Determined in Markets

The market for any

good or service consists
of all (actual or
potential) buyers or
sellers of that good or
service. Shau Kei Wan Market
Sai Kung Pier Market
Supply (sellers) and
demand (buyers) jointly
determine the market price.

3
Buyer’s decision
o Should I purchase an additional unit of the good?
o Yes, only if the marginal benefit is higher than the
marginal cost (price + …) .

4
Demand for lobsters
o Suppose each of us can buy only one lobster at most. The
decision is YES/NO, based on benefit-cost analysis.
o Announce a price, count the number of people who would buy at
this price.
o Suppose Vi denotes person i’s willingness to pay.

Vi ≥ P Buy

Vi < P Not Buy

5
Demand for lobsters
• Repeat with many other prices, for each price, count the number
of people who would buy at this new price.
• ….

• Obtain a table of price and total quantity people would like to buy.
P Q
Person V ($) 0 7
1 1 1 7 This table of data can be
2 2 2 6 represented or
3 3 3 5
summarized in a graph or
4 4 4 4
5 3
in a mathematical
5 5
6 6 6 2 function.
7 7 7 1
8 0

6
The demand for lobsters
• The demand curve is the set of all price-quantity pairs
for which buyers are satisfied. ("Satisfied" means being
able to buy the amount they want to at a given price.)
• It always downward slopping
Price ($/lobster) D A graph (sometimes equations)
10 summarizes the information of a
data table.
8
Such graphs or equations are
6 supposedly nonlinear but are often
assumed linear to simplify
4 discussions.
2 D
0 Quantity
1 2 3 4 5 (1000s of lobsters/day)
7
Horizontal interpretation of the demand
curve
• If buyers face a price of $4/lobster, together they will
wish to purchase 4000 lobsters a day.

Horizontally: How much buyers are

Price ($/lobster) D willing and able to purchase at a
10 certain price.
8
6

4
2 D
0 Quantity
1 2 3 4 5 (1000s of lobsters/day)
8
Vertical interpretation of the demand curve
• If buyers are currently buying 4000 lobsters a day, the
demand curve tells us that the “marginal” buyer would
be willing to pay at most $4 for one additional lobster.
Price ($/lobster) D
Vertically: The highest price buyers
10
are willing to pay for a certain
8 quantity. Or equivalently, the
6 marginal benefit of the marginal
buyer for a certain quantity.
4
2 D
Quantity
0
1 2 3 4 5 (1000s of lobsters/day)
9
Why are demand curves downward sloping
1. Buyers/ consumers have different values of the good.
– When price is high, goods are only bought by those who are willing to pay a
high price.
– When the price is low, goods are also bought by those who are willing to
pay a lower price.
– That is buyers are willing to buy more if the price is lowered but the price
are getting higher then they will buy fewer
– The horizontal interpretation then implies a downward sloping demand
curve.

2. For a given consumer

– As the good becomes more expensive, people switch to substitutes and buy
less
Adding together individual consumers’ demand curves, the demand curve of
the whole market is also downward sloping.

10
Market demand
Given two individual demand curves, how do we
obtain the market demand curve?

11
Market demand
Fixed a price, add the quantity demanded.

12
Market demand
Fixed a price, add the quantity demanded.
Repeat with other prices.

Demand (Market)

13
Seller’s decision
o Should I sell an additional unit of the good?
o Yes, only if the marginal benefit (price + …) is higher than the
marginal cost.

14
Supply of lobsters
o Suppose each of us can sell only one lobster at most. The
decision is YES/NO, based on benefit-cost analysis.
o Announce a price, count the number of people who would sell at
this price.
o Suppose Ci denotes producer i’s cost of production.

Ci ≤ P Sell / Supply

Ci > P Not Sell / Not Supply

15
Supply of lobsters
• Repeat with many other prices, for each price, count the number of
people who would sell at this new price.
• ….

• Obtain a table of price and total quantity people who would like to sell.
P Q
Person C ($) 0 0
1 1 1 1 This table of data can be
2 2 2 2 represented or
3 3 3 3
summarized in a graph or
4 4 4 4
5 5
in a mathematical
5 5
6 6 6 6 function.
7 7 7 7
8 7

16
The supply of lobsters
The supply curve is the set of price-quantity pairs for which sellers are satisfied.
("Satisfied" means being able to sell the amount they want to at any given price.)
Note the curve is not necessary to be linear

Price ($/lobster) A graph (sometimes equations)

10 S summarizes the information of a
data table.
8
6
4
2
S Quantity
(1000s of lobsters/day)
0
1 2 3 4 5 6
17
Horizontal interpretation of the supply curve
• If sellers face a price of $4/lobster, they will wish to sell
2000 lobsters a day.

Price ($/lobster)
10 S
Horizontally: How much
8
suppliers are willing and able
6 to sell at a certain price.
4
2 S Quantity
(1000s of lobsters/day)
0
1 2 3 4 5 6
18
Vertical interpretation of the supply curve
• If sellers are currently selling 2000 lobsters a day, the
marginal cost of a lobster is $4.
Price ($/lobster)
Vertically: The minimum price
10 S
for which suppliers are willing
8 to sell a certain quantity. Or
6 equivalently, the marginal cost
of the marginal seller for a
4
certain quantity.
2 S Quantity
(1000s of lobsters/day)
0
1 2 3 4 5 6

19
Why is the supply curve upward sloping?
o The cost of producing a good is not equal across all suppliers.
o At a low price, a good is produced and sold only by the lowest cost
suppliers.
o At a high price, a good is also produced and sold by higher cost suppliers.
o (They are more willing to sell more if the price is higher in order to
maximize their profit)
o The horizontal interpretation then implies an upward sloping supply
curve.

o For an individual supplier,

o the additional cost to produce an additional unit of output (marginal
costs) increases with the total amount of output.
Adding together individual suppliers’ curve, the supply curve of the whole
market is upward sloping.

20
Market Supply
Given two individual supply curves, how do we
obtain the market supply curve?

21
Market Supply
Fixed a price, add the quantity supplied.

22
 Fixed a price, add the quantity supplied.
Market Supply Repeat with other prices. As the price
increases, more seller is going to sell their
goods. Thus, the higher the price the curve
become flatter(The slope must be decreasing)

23
Market Equilibrium
o Equilibrium:
o the condition of a system in which all competing influences
are balanced, such that the system has no tendency to
deviate from the current condition.

o When Qs = Qd at a certain price, the market is in equilibrium,

o the amount consumers would purchase at this price is
matched exactly by the amount producers wish to sell.
o When both consumers and producers are satisfied, the
current condition (characterized by P and Q) will has no
tendency to change.

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Market Equilibrium Quantity and Price
• Equilibrium occurs at the price-quantity pair for which
both buyers and sellers are satisfied.

Price ($/lobster)
D S
10 At the market equilibrium
8 price of $6 per lobster,
buyers and sellers are each
6 able to buy or sell as many
lobsters as they wish to.
4
2 D
S
0 Quantity
1 2 3 4 5 (1000s of lobsters/day)
25
Market equilibrium
The equilibrium price and quantity is a result of interaction
of supply and demand. The equilibrium is jointly
determined by
o Supply or cost of production.
o Demand or willingness to pay.

26
Excess supply
A situation in which price exceeds its equilibrium value is called
one of excess supply, or surplus.
Excess supply (P=8) = Qs(P=8) – Qd(P=8)
excess
Price ($/lobster) supply
D S
10
At $8, there is an excess
8 supply of 2000 lobsters in
6 this market.
4
2
S D
0 Quantity
1 2 3 4 5 (1000s of lobsters/day)
27
 From disequilibrium to equilibrium

Price ($/lobster) At prices above

D S
10 equilibrium, sellers are not
selling as much as they
8 want to. The impulse of a
dissatisfied seller is to
6
reduce his price.
4
2
S D
0 Quantity
1 2 3 4 5 (1000s of lobsters/day)

28
 Excess Demand
A situation in which price lies below its equilibrium value is
referred to as one of excess demand.
Excess demand (P=4) = Qd(P=4) – Qs(P=4)
Price ($/lobster)
D S
10
At a price of $4 in this
8 excess lobster market, there is an
demand excess demand of 2000
6
lobsters.
4
2 D
S
0 Quantity
1 2 3 4 5 (1000s of lobsters/day)
29
 From disequilibrium to equilibrium

Price ($/lobster)
D S At prices below the
10 equilibrium value, buyers
cannot obtain the
8 quantities they wish to
6 purchase.  Some buyers
adjust by offering slightly
4 higher prices.
2
S D
0 Quantity
1 2 3 4 5 (1000s of lobsters/day)

30
Zero excess supply and demand
Equilibrium occurs at the price-quantity pair for which both
buyers and sellers are satisfied.

Price ($/lobster)
D S
10
At the market
8 equilibrium price of $6,
6 both excess demand and
excess supply are exactly
4 zero.
2 D
S
0 Quantity
1 2 3 4 5 (1000s of lobsters/day)
31
The Trading Locus
When price differs from the equilibrium price and the market price is not allowed to adjust, actual
trading/transaction in the marketplace will be constrained (controlled) by
– the behavior of buyers if the price lies above equilibrium,
– the behavior of sellers if the price lies below equilibrium.
– Since if the price is too high , buyers may not willing to buy so trade is bounded by buyer
– If the price is too low, not much sellers are willing to sell the goods so the trade is constrained by
sellers

Price ($/lobster) Quantity traded(P=4)=min[Qd(P=4),Qs(P=4)].

D S
10 Trading locus
8
6

4
2
S D
0 Quantity
1 2 3 4 5 (1000s of lobsters/day)
32
Economic Surplus of Exchange
o John is willing to pay $10 for an apple.
o Mary can produce an apple at the cost of $4.

o If they trade, together they can gain

o Sum of their gains no matter the selling price:
o $6 (=10-4)

o This gain from exchange is also called the total economic surplus
from the exchange. If this trade is not allowed to happen, they lose
the gain from trade of $6.

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Economic Surplus of Exchange
o John is willing to pay $10 for an apple.
o Mary can produce an apple at the cost of $4.

o If the price they traded is $6, they will trade voluntary

o John gains (saves) $4 (=10-6)
o Mary gains $2 (=6-4)

o John’s gain is called consumer surplus -- economic surplus obtained

by a consumer or a buyer.
o Mary’s gain is called producer surplus -- economic surplus obtained by
a producer or a seller.

Total Economic Surplus = Consumer Surplus + Producer Surplus

6 4 2

34
Economic Surplus of Exchange
o John is willing to pay $4 for an apple.
o Mary can produce an apple at the cost of $10.

o If they are forced to trade, together they can gain

o -$6 (=4-10)

o This gain from exchange is negative. If this trade is

allowed not to happen, they can jointly avoid the
negative gain from trade of -$6.

35
 Economic Surplus of Exchange
o John is willing to pay $4 for an apple.
o Mary can produce an apple at the cost of $10.

o If the price they traded is $6,

o John gains -$2 (=4-6)
o Mary gains -$4 (=6-10)

o John will obtain a negative consumer surplus. Will he trade if given the
choice?
o Mary will obtain a negative producer surplus. Will she trade if given the
choice?
Forced! Total Economic Surplus = Consumer Surplus + Producer Surplus
-6 -2 -4
Choice! Total Economic Surplus = Consumer Surplus + Producer Surplus
0 0 0
36
Total Economic Surplus at Market
Equilibrium
Total Economic surplus of q units
= Economic surplus of 1st unit
+ Economic surplus of 2nd unit
+…
+ Economic surplus of q-th unit

37
Total Economic Surplus at Market
Equilibrium
Demand: Pd = 13 - Qd
Supply: Ps = 1 + Qs

Equilibrium: Pd = Ps ; Qd = Qs
Denote the equilibrium (P,Q) as:
P* = Pd = Ps ; Q* = Qd = Qs

13 – Q* = 1 + Q*
2Q* = 12
Q* = 6
P* = 7

Hence, equilibrium:
P* = Pd = Ps = 7 ;
Q* = Qd = Qs = 6

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Total Economic Surplus at Market
Equilibrium
Approximate Economic Surplus from the 1st unit

39
Total Economic Surplus at Market
Equilibrium
Approximate Economic Surplus from the 6 units

40
Total Economic Surplus at Market
Equilibrium
Total Economic surplus of q units
= Economic surplus of 1st 0.5 unit
+ Economic surplus of 2nd 0.5 unit
+…
+ Economic surplus of q-th 0.5 unit
+…
+ Economic surplus of 2q-th 0.5 unit

41
Total Economic Surplus at Market
Equilibrium
Approximate Economic Surplus from the 12 0.5 units

42
Total Economic Surplus at Market
Equilibrium
Approximate Economic Surplus from the 24 0.25 units

43
Total Economic Surplus at Market
Equilibrium
Approximate Economic Surplus from the 60 0.1 units

Accumulating the econ

surplus

44
Total Economic Surplus at Market
Equilibrium
Approximate Economic Surplus from the 6 units but with very small increments.

Total Economic surplus = (13-1) x 6 x 0.5 = 36= Area under the graph
45
Total Economic Surplus at Market
Equilibrium
Approximate Consumer Surplus from the 6 units but with very small increments.

Consumer surplus

Total Consumer surplus = (13-7) x 6 x 0.5 = 18= Its area

46
Total Economic Surplus at Market
Equilibrium
Approximate Economic Surplus from the 6 units but with very small increments.

Producer surplus

Total Producer surplus = (7-1) x 6 x 0.5 = 18= Its area

47
Social optimality of market equilibrium
o Marginal benefit to the buyers will be the same as the marginal
benefit to the society if 
o all the benefits of consumption go to buyers. 

o Marginal cost to the sellers will be the same as the marginal cost to
the society if 
o all the costs of production are borne by the sellers. No other cost
to the society.

o Thus, the total economic surplus from the market equilibrium can
be used to measure the welfare to the society if
o all the costs of production are borne by the sellers and
o all the benefits of consumption goes to buyers.

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Social optimality of market equilibrium
marginal benefit is equal to marginal cost at
equilibrium point and econ surplus is
maximized
Imagine you are the central
planner deciding how many
units to produce and how to
allocate the goods in order
to maximize the total
economic surplus to the
society.
We should expand as long as
the marginal benefit is higher
than or equal to the marginal
cost.
This socially optimal point
coincides with that of the
market equilibrium!!
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Social optimality of market equilibrium
Check social optimality:

o If we reduce the quantity a little,

does the total economic surplus to
the society increase or decrease?

o If we increase the quantity a

little, does the total economic
surplus to the society increase or
decrease?

50
Social optimality of market equilibrium

Check social optimality:

o If we reduce the quantity a

little, the total economic surplus
to the society will decrease.
o At Q=4, there are buyers who
value buying the good more
than sellers’ MC of producing.
Note there is excess buyers
than sellers.
o There are unexploited gains
from trade up until 6 units.

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Social optimality of market equilibrium

Check social optimality:

o If we increase the quantity a

little, the total economic
surplus to the society will
decrease.
o At Q=9, there are buyers who
value buying the good less
than sellers’ MC of producing.
Note there is excess sellers
than buyers.
o There are wasteful trades
beyond 6 units.

52
A mathematical note
Q: Must the supply and demand curves linear?
A: No. The equation or curve describing demand is a summary
of data. Similarly for supply. They need not be linear. Linear
functions are assumed mainly for illustration purpose and
simplification of calculation.

Q: Are we expected to solve the equilibrium from equations?

A: Yes. Similarly for total economic surplus, consumer surplus
and producer surplus.

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