PART II

HOW MARKETS WORK

Chapter 4
The Market Forces of Supply and Demand
 What is a Market?
• The theory of supply and demand assumes that commodities
are traded by buyers and sellers dealing directly with each
other in markets

• Example: When I refer to the “market for coffee”, I simply mean the
buyers and sellers of coffee and the rules they obey when they trade

SUPPLY AND DEMAND 2

 Let’s get to the punch line
• In a market-based economy, the price of a commodity will be
high if the commodity is:
– Highly desired
– Costly to produce
– Sold under little or no competition

• Can you guess the circumstances in which the price of a commodity will
be low?

SUPPLY AND DEMAND 3

 Let’s get to the punch line
• In a market-based economy, the price of a commodity will be
high if the commodity is:
– Highly desired
– Costly to produce
– Sold under little or no competition

• The theory of supply and demand makes a very specific assumption

about the intensity of competition

SUPPLY AND DEMAND 4

PERFECT COMPETITION

SUPPLY AND DEMAND 5

 What is a competition?
• The theory of supply and demand assumes that commodities
are traded in perfectly competitive markets
• A perfectly competitive market is a market in which
– there are many buyers
– many sellers
– and all sellers sell the exact same product (homogeneity )
• As a result, each buyer and seller has a negligible impact on the
market price

SUPPLY AND DEMAND 6

 Are the markets for these commodities perfectly
competitive?
• Wheat
• White cotton T-shirts
• Automobiles
• Cable TV in your locality
• Electricity for home use in your locality

SUPPLY AND DEMAND 7

 What’s the opposite of perfect competition?
• Imperfect competition
– Monopoly (Chapter 15, one seller)
– Monopolistic Competition (Chapter 16, many sellers, differentiated
products)
– Oligopoly (Chapter 17, few sellers)

SUPPLY AND DEMAND 8

How should we describe the behavior of buyers?

DEMAND

SUPPLY AND DEMAND 9

 Demand
• Quantity demanded is the amount of a commodity that buyers
are willing and able to purchase
• Demand is a full description of how the quantity demanded
changes as the price of the commodity changes.
• Law of Demand: the claim that, other being equal (ceteris
paribus), the quantity demanded of a good falls when the price
of the good rises.

SUPPLY AND DEMAND 10

 Catherine’s Demand Schedule and Demand Curve
Price of
Ice-Cream Cone
$3.00

2.50

1. A decrease
2.00
in price ...

1.50
Because a lower price
increases the quantity 1.00
demanded,
the demand curve slopes
0.50
downward.

0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of
Ice-Cream Cones
2. ... increases quantity
of cones demanded.
SUPPLY AND DEMAND 11
Copyright © 2004 South-Western
Market Demand is the Sum of Individual Demands

SUPPLY AND DEMAND 12

 Law of Demand
• The law of demand states that
– the quantity demanded of a good falls when the price of the good
rises, and vice versa, provided all other factors that affect buyers’
decisions are unchanged

SUPPLY AND DEMAND 13

 Law of Demand
• The law of demand states that
– the quantity demanded of a good falls when the price of the good
rises, and vice versa, provided all other factors that affect buyers’
decisions are unchanged

SUPPLY AND DEMAND 14

 Law of Demand
• The law of demand states that
– the quantity demanded of a good falls when the price of the good
rises, and vice versa, provided all other factors that affect buyers’
decisions are unchanged

This a crucial phrase. It suggests that the quantity of ice cream

demanded may rise when the price of ice cream rises, provided there
is a simultaneous change in some other factor. Can you think of
examples where the price of ice cream rises, and yet the quantity of
ice cream demanded in your locality increases?

SUPPLY AND DEMAND 15

 “provided all other factors … are unchanged”
• The quantity demanded of a consumer good—such as ice cream—depends on
– The price of ice cream
– The prices of related goods
– Consumers’ incomes
– Consumers’ tastes
– Consumers’ expectations about future prices and incomes
– Number of buyers, etc.
• The Law of Demand says that the quantity demanded of a good is inversely related to
its price, provided all other factors are unchanged

SUPPLY AND DEMAND 16

 Why Might Demand Increase?
Quantity Demanded • How can we explain the
Price Situation A Situation B difference in Catherine’s
0.00 12 20 behavior in situations A
0.50 10 16 and B?
1.00 8 12 • Why does she consume
more in situation B at
1.50 6 8
every possible price?
2.00 4 6
2.50 2 4 Price

3.00 0 2
SUPPLY AND DEMAND Quantity Demanded 17
Shifts in the Market Demand Curve
• … are caused by changes in:
– Consumer income
– Prices of related goods
– Tastes
– Expectations, say, about future prices and prospects
– Number of buyers

SUPPLY AND DEMAND 18

 Shifts in the Demand Curve
Price of Any change that raises the quantity that
Ice-Cream buyers wish to purchase at any given
Cone price shifts the demand curve to the
right. Any changes that lowers the
quantity that buyers wish to purchase at
Increase any given price shift the demand curve to
in demand the left .

Decrease
in demand
Demand
curve, D 2
Demand
curve, D 1
Demand curve, D 3
0 Quantity of
SUPPLY AND DEMAND Ice-Cream Cones 19
 Shifts in the Demand Curve
• Consumer Income
– As income increases the demand for a normal good will increase (an
increase in income leads to an increase in demand)
– As income increases the demand for an inferior good will decrease ( an
increase in income leads to a decrease in demand)

• Example:
• Restaurant food is a normal good Price
• Demand shifts right when incomes rise
• Fast food is an inferior good
• Demand shifts left when incomes rise
Quantity Demanded
SUPPLY AND DEMAND 20
 Shifts in the Demand Curve
• Prices of Related Goods
– When a fall in the price of one good reduces the demand for another good, the
two goods are called substitutes
– When a fall in the price of one good increases the demand for another good,
the two goods are called complements

• Example:
• Pepsi and Coke are substitutes
• Pepsi’s demand shifts left when Coke’s price falls
Price
• Cars and gasoline are complements
• The demand for cars shifts right when the price of gas falls

Quantity Demanded
SUPPLY AND DEMAND 21
• Tastes: If you like ice cream, you but more of it.
• Expectations: If you expect to earn a higher income next
month, you may spent income buying ice cream.
• Number of buyers: number of buyers effect the price, it the we
have one more consumer in the market, the demand will
increase

22
23
 A change demand curve
Variable A change in this variable

Price of the good itself Represents a movement along

the demand curve

Income Shifts the demand curve

Price of related goods Shifts the demand curve

Tastes Shifts the demand curve

Expectations Shifts the demand curve

Numbers of Buyesr Shifts the demand curve

24
 Questions
1. A change in which of the following will NOT
shift the demand curve for hamburgers?
a. the price of hot dogs
b. the price of hamburgers
c. the price of hamburger buns
d. the income of hamburger consumers

SUPPLY AND DEMAND 25

How can we describe the behavior of sellers?

SUPPLY

SUPPLY AND DEMAND 26

 SUPPLY
• Quantity supplied is the amount of a good that sellers are
willing and able to sell
• Supply is a full description of how the quantity supplied of a
commodity responds to changes in its price

SUPPLY AND DEMAND 27

 Ben’s supply schedule and supply curve
Price of
Ice-Cream
Cones Supply curve
$3.00
Price of Quantity of 1. An increase
Ice-cream cone Cones supplied 2.50
in price . . .
$0.00 0 cones 2.00
0.50 0
1.00 1 1.50
1.50 2 2. . . . increases quantity
2.00 3 1.00 of cones supplied.
2.50 4
3.00 5 0.50

0 1 2 3 4 5 6 7 8 9 10 11 12
Quantity of Ice-Cream Cones

28
Market supply and individual supplies

Price of ice-cream cone Ben Jerry Market

$0.00 0 + 0 = 0
0.50 0 0 0
1.00 1 0 1
1.50 2 2 4
2.00 3 4 7
2.50 4 6 10
3.00 5 8 13

29
 Market supply and individual supplies
Ben’s Jerry’s Market
supply + supply = supply
Price of Price of Price of
Ice Ice Ice
Cream Cream Cream
Cones SBen Cones Cones
$3.00 $3.00 $3.00 SMarket
SJerry
2.50 2.50 2.50

2.00 2.00 2.00

1.50 1.50 1.50

1.00 1.00 1.00

0.50 0.50 0.50

0 1 2 3 4 5 6 7 8 9 10 11 12 0 1 2 3 4 5 6 7 0 2 4 6 8 10 12 14 16 18
Quantity of Ice-Cream Cones Quantity of Quantity of Ice-Cream Cones
Ice-Cream Cones
30
 Law of Supply
• The law of supply states that, the quantity supplied of a good
rises when the price of the good rises, and vice versa, as long
as all other factors that affect suppliers’ decisions are
unchanged

SUPPLY AND DEMAND 31

 Law of Supply
• The law of supply states that, the quantity supplied of a good
rises when the price of the good rises, and vice versa, as long
as all other factors that affect suppliers’ decisions are
unchanged

SUPPLY AND DEMAND 32

 Law of Supply
• The law of supply states that, the quantity supplied of a good
rises when the price of the good rises, and vice versa, as long
as all other factors that affect suppliers’ decisions are
unchanged

This a crucial phrase. It suggests that the quantity of ice cream

supplied may fall when the price of ice cream rises, provided there is a
simultaneous change in some other factor. Can you think of examples
where the price of ice cream rises, and yet the quantity of ice cream
sold in your locality decreases?

SUPPLY AND DEMAND 33

 Law of Supply—Explanation
• How can we make sense of the numbers in Ben’s
supply schedule?
• The best guess is that his costs must be something
like the cost schedule below.

A specific ice- It’s cost ($)

cream cone
1st 0.75
2nd 1.35 In this way, the Law of Supply
3rd 1.75 follows from the assumption of
Increasing Costs (or, Diminishing
4th 2.30 Returns)
5th 2.85
6th 3.10 SUPPLY AND DEMAND 34
 Shifts in the Supply Curve: What causes them?
Price of
Ice-Cream Supply curve, S 3
Supply
Cone
curve, S 1
Supply
Decrease curve, S 2
in supply

Increase
in supply

0 Quantity of
SUPPLY AND DEMAND Ice-Cream Cones 35
 Supply Shift
Ben’s Supply Schedule
• How could Ben’s supply have increased? Price ($) Quantity Supplied
Before After
0.00 0 0
0.50 0 1
Ice-cream cone It’s cost ($) 1.00 1 2
Before After 1.50 2 3
2.00 3 4
1st 0.75 0.45
2.50 4 5
2nd 1.35 0.85
3.00 5 6
3 rd
1.75 1.45
4th 2.30 1.95
5th 2.85 2.45
Anything that reduces
6 th
3.10 2.90
production costs, shifts
supply to the right.
SUPPLY AND DEMAND 36
 Shifts in the Supply Curve…
• … are caused by changes in
– Input prices
– Technology
– Number of sellers (short run)
• The market supply will shift right if
– Raw materials or labor becomes cheaper
– The technology becomes more efficient
– Number of sellers increases

SUPPLY AND DEMAND 37

EQUILIBRIUM

SUPPLY AND DEMAND 38

 Interaction of demand and supply
• We have seen what demand and supply are
• We have seen why demand and supply may shift
• Now it is time to say something about how buyers and sellers
collectively determine the market outcome
• To do this, we assume equilibrium

SUPPLY AND DEMAND 39

 Equilibrium
• The theory of supply and demand assumes that the price
automatically reaches a level at which the quantity demanded
equals the quantity supplied

SUPPLY AND DEMAND 40

SUPPLY AND DEMAND TOGETHER
Demand Supply
Schedule Schedule

At $2.00, the quantity demanded is

equal to the quantity supplied!
SUPPLY AND DEMAND 41
Equilibrium of supply and demand
Price of
Ice-Cream
Cones Supply
$3.00

2.50 Equilibrium
price Equilibrium
2.00

1.50
1.00
Equilibrium Demand
0.50 quantity

0 1 2 3 4 5 6 7 8 9 10 11 12
Quantity of Ice-Cream Cones

42
 Equilibrium
• Can we justify the assumption of equilibrium?

43
 When Markets are Not in Equilibrium

(a) Excess Supply

Price of
Ice-Cream Supply
Cone Surplus
$2.50

2.00

Demand

0 4 7 10 Quantity of
Quantity Quantity Ice-Cream
demanded supplied Cones
SUPPLY AND DEMAND 44
 Justifying Equilibrium

• Surplus
– When the price exceeds equilibrium price, the
quantity supplied exceeds the quantity demanded
• This is called excess supply or a surplus
• Suppliers will be forced to cut their prices, thereby
moving closer to equilibrium

SUPPLY AND DEMAND 45

 When Markets are Not in Equilibrium

(b) Excess Demand

Price of
Ice-Cream Supply
Cone

$2.00

1.50
Shortage

Demand

0 4 7 10 Quantity of
Quantity Quantity Ice-Cream
supplied demanded Cones
SUPPLY AND DEMAND 46
 When Markets are Not in Equilibrium

• Shortage
– When the price is less than the equilibrium price,
the quantity demanded exceeds the quantity
supplied
• This is called excess demand or a shortage
• Suppliers will raise the price, because too many buyers
are chasing too few goods, thereby moving closer to
equilibrium

SUPPLY AND DEMAND 47

 Equilibrium
• Law of supply and demand
– The price of a good adjusts to bring the quantity supplied and the quantity
demanded for that good into balance

SUPPLY AND DEMAND 48

 Let’s make some predictions
• We can use our understanding of the factors that shift the
demand and supply curves to predict the consequences of
– alternative policy proposals, and
– events outside our control that we need to be ready for

SUPPLY AND DEMAND 49

How an Increase in Demand Affects the Equilibrium
Price of
Ice-Cream 1. Hot weather increases
Cone the demand for ice cream . . .

Supply Can you now predict

the consequences of
$2.50 New equilibrium unusually cold
weather?
2.00 Can you use this
2. . . . resulting graph to predict the
Initial
in a higher effect on the market
equilibrium
price . . . for rice if there is an
D increase in the price
of wheat?
D

0 7 10 Quantity of
3. . . . and a higher Ice-Cream Cones
quantity sold. SUPPLY AND DEMAND 50
How a Decrease in Supply Affects the Equilibrium
Price of
Ice-Cream 1. An increase in the
Cone price of sugar reduces
the supply of ice cream. . .
S2
S1

Can you now predict

New the consequences of
equilibrium a decrease in the
$2.50
price of sugar?
2.00 Initial equilibrium Can you use this
graph to predict the
2. . . . resulting
effect on the market
in a higher
for rice if there is
price of ice
drought in our rice-
cream . . . Demand
growing areas?

0 4 7 Quantity of
3. . . . and a lower Ice-Cream Cones
quantity
SUPPLY AND DEMAND sold. 51
 A Shift in Both Supply and Demand
Event Effect on Price Effect on Quantity

Demand increases Up Up

Supply decreases Up Down

Both Up Ambiguous

SUPPLY AND DEMAND 52

A Shift in Both Supply and Demand

SUPPLY AND DEMAND 53

 Can you predict …
• The effect of a rise in the price of oil on the market for
– Hybrid cars
– Real estate
– Staple foods (corn, wheat, rice)
• The effect of the development of cheaper and better batteries
for electric cars on the market for
– traditional cars
– gas

SUPPLY AND DEMAND 54

 Question
• Suppose that the price of basketball tickets at your college is determined by market forces.
Price Quantity of demand Quantity of supply
4 10.000 8.000
8 8.000 8.000
12 6.000 8.000
16 4.000 8.000
20 2.000 8.000

1. Draw supply and demand curves. What is unusual about this supply curve?
2. What is the equilibrium price and quantity tickets?