Supply and Demand

Chapter 02 Summary
 1. Demand
2. Supply
3. Market Equilibrium
4. Shocking the Equilibrium: Comparative
Statics
Important 5. Elasticities
Topics 6. Effects of a Sales Tax
7. Quantity Supplied need not equal Quantity
Demanded
8. When to use the SUPPLY AND DEMAND
model
 • Law of Demand
• Demand Curve slopes Downward
• higher the price, the less quantity is demanded,
assuming other factors remain constant.
• A change in price causes a movement along
the demand curve,
Demand • While a change in factors other than price
causes a shift in the demand curve.
• To derive a Total demand curve, we
horizontally sum the demand curves of
individuals, types of consumers, or countries
by adding the quantities demanded by each
individual at a given price.
Supply

• Affected by multiple factors

• price, costs, government regulations, and other factors.
• The market supply slopes upwards.
• Change in price causes movement along the supply curve.
• The total supply curve is the horizontal sum of the supply curves
for individual firms.
Market Equilibrium

• The equilibrium price and quantity in a market are determined by the

intersection of the demand and supply curves.
• Market forces, which include actions by both consumers and firms, work
together to drive the price and quantity towards the equilibrium levels.
• Initial price and quantity are too low, Market forces will push upwards.
• Initial price and quantity are too high, Market forces will push
downwards.
• Ultimately, the market will settle at the equilibrium price and quantity
where supply and demand are balanced.
Shocking the Equilibrium: Comparative Statics

• A change in an underlying factor other than price, such

as the price of substitutes or complements, income, or
the price of inputs, will cause a shift in the supply or
demand curve, which in turn alters the equilibrium.
• Comparative statics is the method economists use to
analyze how variables controlled by consumers and
firms, such as price and quantity, react to changes in
environmental variables.
Elasticities

• An elasticity is the percentage change in a variable in response to a given

percentage change in another variable, holding all other relevant variables
constant.
• The price elasticity of demand, ε, is the percentage change in the quantity
demanded in response to a given percentage change in price: A 1% increase in
price causes the quantity demanded to fall by ε %. Because demand curves slope
downward according to the Law of Demand, the elasticity of demand is always
negative.
• The price elasticity of supply, η , is the percentage change in the quantity
supplied in response to a given percentage change in price.
continued

• Given estimated elasticities, we can forecast the comparative

statics effects of a change in taxes or other variables that
affect the equilibrium.
Effects of a Sales Tax

• Ad valorem taxes and specific taxes are the two common types of sales taxes.
• Both types of sales taxes typically raise the equilibrium price and lower the
equilibrium quantity.
• Consumers do not bear the full burden of the tax as both usually raise the price
consumers pay and lower the price suppliers receive.
• The effects on quantity, price, and the incidence of the tax depend on the demand
and supply elasticity.
• In competitive markets, the impact of a tax on equilibrium quantities, prices, and
the incidence of the tax is unaffected by whether the tax is collected from
consumers or producers.
Quantity Supplied need not equal Quantity Demanded

• the quantity supplied equals the quantity demanded in a competitive market if the
government does not intervene.
• Government policies such as price floors or ceilings can disrupt the natural balance of
supply and demand.
• Price floors create excess supply, as the minimum price set by the government is above
the equilibrium price.
• Price ceilings create excess demand, as the maximum price set by the government is
below the equilibrium price.
When to use the • The supply-and-demand model is a useful
tool for analyzing markets.
SUPPLY AND • The model is only applicable in competitive
DEMAND markets.
model • Competitive markets are characterized by
many buyers and sellers.
• Firms in competitive markets sell identical
goods.
• Participants in competitive markets have full
information.
• Transaction costs are low in competitive
markets.
• Firms can easily enter and exit competitive
markets.