Supply and Demand

McGraw-Hill/Irwin Copyright 2015 by McGraw-Hill Education (Asia). All rights reserved.

 Learning Objectives
1. Describe how the demand and supply curves
summarize the behavior of buyers and sellers in
the marketplace.
2. Discuss how the supply and demand curves
interact to determine equilibrium price and
quantity.
3. Illustrate how shifts in supply and demand
curves cause prices and quantities to change
4. Explain and apply the Efficiency Principle and
the Equilibrium Principle (also called The
No-Cash-on-the-Table Principle).
What, How, and For Whom?
Every society answers three basic questions
WHAT Which goods will be produced?
How much of each?

HOW Which technology?

Which resources are used?

FOR How are outputs distributed?

WHOM Need?
Income?
 Central Planning versus the
Market
Central Planning The Market
Decisions by Buyers and sellers
individuals or small signal wants and costs
groups Resources and goods are
Agrarian societies allocated accordingly
Government programs Interaction of supply and
Sets prices and goals for the demand answer the three
group basic questions
Individual influence is
limited

Mixed economies use both the market and central planning

 Buyers and Sellers in the
Market
The market for any good consists of all the
buyers and sellers of the good
Together, they determine outcome
Buyers and sellers have different motivations
Buyers want to benefit from the good
Sellers want to make a profit
Market price balances two forces
Value buyers derive from the good
Cost to produce one more unit of the good
 Demand
A demand curve
illustrates the quantity Demand for Donuts

buyers would purchase P

at each possible price

Demand curves have a $4

negative slope
$2
Consumers buy less at D
higher prices Q
8 16
Consumers buy more at (000s of pieces/day)
lower prices
 Demand Slopes Downward
Buyers buy more at lower prices and buy less at
higher prices
What happens when price goes up?
The substitution effect: Buyers switch to
substitutes when price goes up
The income effect: Buyers' overall purchasing
power goes down
 Demand Slopes Downward
Buyers value goods differently
The buyers reservation price is the highest price
an individual is willing to pay for a good
Demand reflects the entire market, not one
consumer
Lower prices bring more buyers into the market
Lower prices cause existing buyers to buy more
Interpreting the Demand Curve

Horizontal
Demand for Donuts
P
interpretation of
demand:
$4
Given price, how much
will buyers buy?
$2
At a price of $4, the
D quantity demanded is
Q 8,000 slices/day.
8 16
(000s of pieces/day)
Interpreting the Demand Curve

Demand for Donuts

Vertical interpretation of
P demand:
Given the quantity to
be sold, what price is
$4
the marginal consumer
willing to pay?
$2
D If 8,000 slices are sold
8 16
Q the marginal consumer
(000s of pieces/day) is willing to pay $4 per
slice.
 The Supply Curve
The supply curve illustrates the
quantity of a good that sellers are
willing to offer at each price
Supply of Donuts
If the price is more than opportunity P
cost, offer more S
Opportunity cost differs among $4
sellers due to
Technology Different costs $2
such as rent
Q
Skills Expectations 8 16
(000s of pieces/day)
The Increasing Opportunity Cost
Principle explains the upward sloping
supply curve
Low-Hanging Fruit Principle
Interpreting the Supply Curve

Supply of Donuts Horizontal

P interpretation of
S supply:
$4 Given price, how much
will suppliers offer?
$2 At a price of $2,
suppliers are willing to
Q
8 16 sell 8,000 pieces/day.
(000s of pieces/day)
Interpreting the Supply Curve
Vertical interpretation of
Supply of Donuts supply:
P Given the quantity to be
sold, what is the
S
opportunity cost of the
$4 marginal seller?
If 8,000 pieces are sold,
$2 the marginal cost of
producing the 8,000th piece
Q is $2.
8 16
The sellers reservation
(000s of pieces/day)
price is the lowest price the
seller would be willing to sell
for
Equal to marginal cost
 Market Equilibrium
A system is in equilibrium when there is no
tendency for it to change
The equilibrium price is the price at which the
supply and demand curves intersect
The equilibrium quantity is the quantity at
which the supply and demand curves intersect
The market equilibrium occurs when all buyers
and sellers are satisfied with their respective
quantities at the market price
At the equilibrium price, quantity supplied equals
quantity demanded
 Market Equilibrium
Quantity supplied
Market for Donuts
equals quantity
P
demanded AND S
Price is on supply
and demand curves $3
No tendency to
D
change P or Q Q
12
Buyers are on their (000s of pieces/day)
demand curve
Sellers are on their
supply curve
 Excess Supply and Excess
Demand
Excess Supply Excess Demand
At $4, 16,000 pieces supplied At $2, 8,000 pieces supplied
and 8,000 slices demanded 16,000 slices demanded

Market for Donuts Market for Donuts

P P
Surplus
S S

$4
Shortage
$2
D D
Q Q
8 16 8 16
(000s of pieces/day) (000s of pieces/day)
 Incentive Principle: Excess
Supply at $4
Suppliers have an incentive
to decrease the price in order Market for Donuts
to sell more P
Lower prices decrease the S
surplus $4
As price decreases: $3.50
$3 Equilibrium
the quantity offered for sale
decreases along the supply D
curve Q
8 12 16
the quantity demanded (000s of pieces/day)
increases along the
demand curve
 Incentive Principle: Excess
Demand at $2
Demanders have an
Market for Donuts incentive to increase the
P price in order to buy more
S
Higher prices decrease the
shortage
$3
As price increases
$2.50 Equilibrium the quantity offered for
$2 sale increases along the
D supply curve
Q
8 12 16 As price increases, the
(000s of pieces/day)
quantity demanded
decreases along the
demand curve.
Rent Controls Are Price Ceilings
A price ceiling is a
maximum allowable price,
Market for New York City Apartments
set by law
P
Rent controls set a maximum
price that can be charged for S
a given apartment
If the controlled price is $1,600
below equilibrium, then:
$800
Quantity demanded D
increases 1 2 3
Q
Quantity supplied (millions of apartments/day)
decreases
A shortage results
 Movement along the Demand
Curve
When price goes up,
quantity demanded Demand for Canned Tuna
goes down P

When price goes down,

buyers move to a new,
higher quantity $2
demanded $1
D
A change in quantity Q
8 10
demanded results from
(000s of cans/day)
a change in the price of
a good.
 Shift in Demand
If buyers are willing to
buy more at each price, Demand for Canned Tuna
then demand has P
increased
Move the entire demand
curve to the right $2
Change in demand D'
If buyers are willing to D
Q
8 10
buy less at each price,
(000s of cans/day)
then demand has
decreased
 Movement Along the Supply
Curve
When price goes up,
quantity supplied goes Supply of Donuts
P
up S
When price goes up,
$4
sellers move to a new,
higher quantity
supplied $2

A change in quantity Q
supplied results from a 8 16

change in the price of a (000s of pieces/day)

good.
 Shift in Supply
Supply increases when Supply decreases when
sellers are willing to offer sellers are willing to offer
more for sale at each less for sale at each
possible price possible price
Moves the entire supply Moves the entire supply
curve to the right curve to the left
Supply of Donuts Supply of Tuna
P P
S S*
S'
S
$2
$2

8 9 Q 8 9 Q

(000s of pieces/day) (000s of cans/day)

 Tennis Market
If rent for tennis court decreases, demand for tennis
balls increases
Tennis courts and tennis balls are complements

Tennis Court Rentals Tennis Ball Sales

P P

S
$10
$1.40
$1.00
$7 D'
D
D
Q Q
4 11 40 58
(00s rentals/day) (millions of balls/day)
 Causes of Shifts in Demand
Price of complementary goods
Tennis courts and tennis balls
Price of substitute goods
Internet and overnight delivery are substitutes
Income: normal or inferior goods?
Preferences
Dinosaur toys after Jurassic Park movie
Number of buyers in the market
Expectations about the future
Price changes never cause a shift in demand
Apartments Near Washington
Subway
If government wages rise,
Convenient Apartments demand for apartments
P D D' S near subway stations
increases
P' Demand increases
Price increases
Quantity increases
P
Demand for a normal
good increases when
Q income increases
Q Q'
Demand for an inferior good
(units/month)
increases when income
decreases
 Causes of Shifts in Supply
A change in the price of an input
Steel for bicycles, skill workers wages
A change in technology
Desktop publishing and term papers
Internet distribution of products (e-commerce)
Weather (agricultural commodities and outdoor
entertainment)
Number of sellers in the market
Expectation of future price changes
Price changes never cause a shift in supply
 Shifts in Supply: Bicycles
Costs of production affect the supply of a
product
Cost of steel for bicycles increases
Supply decreases
Supply of Bicycles
With no change in demand, P
the price of bicycles S'
S
$80
increases to $80 and quantity
$60
decreases to 800
D

600 800 1,000 Q

(bicycles/month)
 Shift in Supply: Handmade
Carpets
Cost of labor used to produce handmade
carpets decreases
The Market for Handmade Carpets
Supply increases
Demand is constant P
S
S'
The price of handmade $120
$90
carpets decreases to
D
$90,000 per carpet
Q
Quantity increases to 50 40 50
(carpets/month)
 Supply and Demand Shifts:
Four Rules
An increase in demand will lead to an increase in
both equilibrium price and quantity

P
S
P'

P
D'
D
Q Q' Q
 Supply and Demand Shifts:
Four Rules
An decrease in demand will lead to a decrease
in both equilibrium price and quantity

P
S
P

P'
D
D'
Q' Q Q
 Supply and Demand Shifts:
Four Rules
An increase in supply will lead to a decrease in the
equilibrium price and an increase in the equilibrium
quantity.
P S
S'
P
P'

D
Q Q' Q
 Supply and Demand Shifts:
Four Rules
An decrease in supply will lead to an increase in
the equilibrium price and a decrease in the
equilibrium quantity.

P S'
S
P'
P

D
Q' Q Q
 Supply and Demand Both
Change: Tortilla Chips
Oils used for frying are harmful AND the price of
harvesting equipment decreases

S
S'
P
Price ($/bag)

P'

D
D'

Q' Q
Millions of bags per month
Changes in Supply and Demand

Supply

Demand Increases Decreases

P Depends P Increases
Increases
Q Increases Q Depends

P Decreases P Depends
Decreases
Q Depends Q Decreases
 Efficiency and Equilibrium
Markets communicate information effectively
Value buyers place on the product
Opportunity cost of producing the product
Markets maximize the difference between
benefits and costs
Market outcomes are the best provided that
The market is in equilibrium AND
No costs or benefits are shared with the public
 Cash on the Table
Buyer's surplus: buyer's reservation price
minus the market price
Seller's surplus: market price minus the seller's
reservation price
Total surplus = buyer's surplus + seller's
surplus
Total surplus is buyer's reservation price seller's
reservation price
No cash on the table when surplus is
maximized
No opportunity to gain from additional sales or
purchases
 Efficiency Principle
The socially optimal quantity maximizes total surplus
for the economy from producing and selling a good
Economic efficiency -- all goods are produced at
their socially optimal level
Efficiency Principle: Efficiency is an important social
goal because when the economic pie grows larger,
everyone can have a larger slice.
Equilibrium price and quantity are efficient if:
Sellers pay all the costs of production
Buyers receive all the benefits of their purchase
Efficiency: marginal cost equals marginal benefit
Production is efficient if total surplus is maximized
 Smart for One, Dumb for All
Producers sometimes shift costs to others
Pollution is like getting free waste disposal services
Total marginal cost = seller's marginal cost plus
marginal cost of pollution
When costs are shifted, supply is greater than
socially optimal
Buyers may create benefits for others
Marginal benefit is less than the full social benefit
Vaccinations, my neighbor's landscaping
The demand for these goods is less than socially
optimal
 Equilibrium Principle
Equilibrium Principle: a market in equilibrium
leaves no unexploited opportunities for
individuals
BUT it may not exploit all gains achievable through
collective action
Only when the seller pays the full cost of production
and the buyer captures the full benefit of the good
is the market outcome socially optimal
Regulation, taxes and fines, or subsidies can move
the market to the optimal level.
 Supply and Demand

Demand
Changes Equilibrium
Price and
Quantity
Supply
Changes
Changes Efficiency Principle

Equilibrium Principle