Chapter 2:

The Market Forces of

Supply and Demand
Content
2.1. Markets and Competition
2.2. Demand
2.3. Supply
2.4. Supply and Demand Together
2.5. Consumer Surplus, Producer Surplus, and Total Surplus
2.6. Price Controls of Government

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This chapter looks for the answers to these questions:

• What factors affect buyers’ demand for goods?

• What factors affect sellers’ supply of goods?
• How do supply and demand determine the price of a good
and the quantity sold?
• How do changes in the factors that affect demand or supply
affect the market price and quantity of a good?
• How do markets allocate resources?

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2.1. Markets and Competition
• A market is a group of buyers and sellers of a particular product.
• A competitive market is one with many buyers and sellers, each
has a negligible effect on price.
• In a perfectly competitive market:
– All goods exactly the same
– Buyers & sellers so numerous that no one can affect market
price – each is a “price taker”
• In this chapter, we assume markets are perfectly competitive.

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2.2. Demand
• The quantity demanded of any good is the amount of the good
that buyers are willing and able to purchase.
• Law of demand: the claim that the quantity demanded of a good
falls when the price of the good rises, other things equal

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The Demand Schedule Price Quantity
of of lattes
lattes demanded
• Demand schedule:
a table that shows the relationship $0.00 16
between the price of a good and the 1.00 14
quantity demanded 2.00 12
• Example: 3.00 10
Helen’s demand for lattes. 4.00 8
5.00 6
6.00 4

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 Helen’s Demand Schedule & Curve
Price of Price Quantity
Lattes of of lattes
lattes demanded
$6.00
$0.00 16
$5.00 1.00 14
$4.00 2.00 12
$3.00 3.00 10
4.00 8
$2.00
5.00 6
$1.00 6.00 4
$0.00
Quantity
0 5 10 15 of Lattes
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Market Demand versus Individual Demand
• The quantity demanded in the market is the sum of the
quantities demanded by all buyers at each price.
• Suppose Helen and Ken are the only two buyers in the Latte
market. (Qd = quantity demanded)
Price Helen’s Qd Ken’s Qd Market Qd
$0.00 16 + 8 = 24
1.00 14 + 7 = 21
2.00 12 + 6 = 18
3.00 10 + 5 = 15
4.00 8 + 4 = 12
5.00 6 + 3 = 9
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6.00 4 + 2 = 6 8
The Market Demand Curve for Lattes
Qd
P P
(Market)
$6.00
$0.00 24
$5.00 1.00 21
$4.00 2.00 18
3.00 15
$3.00
4.00 12
$2.00
5.00 9
$1.00 6.00 6
$0.00 Q
0 5 10 15 20 25

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Demand function
• Standard demand function:
𝑄 = 𝑓 𝑃 = 𝑎1 + 𝑎2 . 𝑃
• Inversed demand function:
𝑎1 1
𝑃 = 𝑓 𝑄 = − + .𝑄
𝑎2 𝑎2
1
< 0 : the slope of demand curve
𝑎2

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Demand Curve Shifters
• The demand curve shows how price affects quantity
demanded, other things being equal.
• These “other things” are non-price determinants of demand
(i.e., things that determine buyers’ demand for a good, other
than the good’s price).
• Changes in them shift the D curve.

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 Demand Curve Shifters # of Buyers

• Increase in # of buyers increases quantity demanded at

each price, shifts D curve to the right.

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Demand Curve Shifters Income

• An increase in income causes

increase in quantity demanded at
Normal good each price
• shifts D curve to the right

• An increase in income causes

decrease in quantity demanded at
Inferior good each price
• shifts D curves to the left

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Demand Curve Shifters Prices of Related Goods

Substitutes Complements

• An increase in the price • An increase in the price

of one causes an of one causes a fall in
increase in demand for demand for the other
the other • Ex: Car and gas
• Ex: Pepsi and Coca

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 Demand Curve Shifters Tastes
• Anything that causes a shift in tastes toward a good will
increase demand for that good and shift its D curve to the
right.

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Demand Curve Shifters Expectations
• Expectations affect consumers’ buying decisions.
• Examples:
– If people expect their incomes to rise, their demand for meals at
expensive restaurants may increase now.
– If the economy sours and people worry about their future job
security, demand for new autos may fall now.

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Summary: Variables That Influence Buyers
Variable A change in this variable
1. Price causes a movement along the D curve
2. # of buyers shifts the D curve
3. Income shifts the D curve
4. Price of related goods shifts the D curve
5. Tastes shifts the D curve
6. Expectations shifts the D curve

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 ACTIVE LEARNING 1
Demand Curve
Draw a demand curve for music downloads.
What happens to it in each of
the following scenarios? Why?
A. The price of iPods falls
B. The price of music downloads falls
C. The price of CDs falls

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 2.3. Supply
• The quantity supplied of any good is the amount that sellers are
willing and able to sell.
• Law of supply: the claim that the quantity supplied of a good
rises when the price of the good rises, other things equal

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 The Supply Schedule Price Quantity
of of lattes
• Supply schedule: lattes supplied
A table that shows the $0.00 0
relationship between the price of
1.00 3
a good and the quantity supplied.
2.00 6
• Example:
3.00 9
Starbucks’ supply of lattes.
4.00 12
5.00 15
6.00 18

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 Starbucks’ Supply Schedule & Curve
Price Quantity
P of of lattes
$6.00 lattes supplied
$0.00 0
$5.00
1.00 3
$4.00
2.00 6
$3.00 3.00 9
$2.00 4.00 12
5.00 15
$1.00
6.00 18
$0.00 Q
0 5 10 15
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 Market Supply versus Individual Supply
• The quantity supplied in the market is the sum of the quantities
supplied by all sellers at each price.
• Suppose Starbucks and Jitters are the only two sellers in this
market. (Qs = quantity supplied)
Price Starbucks Jitters Market Qs
$0.00 0 + 0 = 0
1.00 3 + 2 = 5
2.00 6 + 4 = 10
3.00 9 + 6 = 15
4.00 12 + 8 = 20
5.00 15 + 10 = 25
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6.00 18 + 12 = 30 25
 The Market Supply Curve
QS
P P
(Market)
$6.00 $0.00 0
$5.00 1.00 5
$4.00 2.00 10
3.00 15
$3.00
4.00 20
$2.00
5.00 25
$1.00 6.00 30
$0.00 Q
0 5 10 15 20 25 30 35
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 Supply function
• Standard supply function:
𝑄 = 𝑓 𝑃 = 𝑏1 + 𝑏2 . 𝑃
• Inversed supply function:
𝑏1 1
𝑃 = 𝑓 𝑄 = − + .𝑄
𝑏2 𝑏2
1
> 0 : the slope of supply curve
𝑏2

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 Supply Curve Shifters
• The supply curve shows how price affects quantity
supplied, other things being equal.
• These “other things” are non-price determinants of supply.
• Changes in them shift the S curve.

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 Supply Curve Shifters Input Prices
• Examples of input prices: wages, prices of raw materials.
• A fall in input prices makes production more profitable at each
output price, so firms supply a larger quantity at each price, and
the S curve shifts to the right.

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 Supply Curve Shifters Input Prices
P
$6.00 Suppose the price
$5.00
of milk falls.
At each price, the
$4.00 quantity of
$3.00 Lattes supplied
will increase
$2.00
(by 5 in this
$1.00 example).
$0.00 Q
0 5 10 15 20 25 30 35
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 Supply Curve Shifters Technology
• Technology determines how much inputs are required to produce
a unit of output.
• A cost-saving technological improvement has the same effect as
a fall in input prices, shifts S curve to the right.

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 Supply Curve Shifters # of Sellers
• An increase in the number of sellers increases the
quantity supplied at each price, shifts S curve to the right.

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 Supply Curve Shifters Expectations
Example:
– Events in the Middle East lead to expectations of higher oil prices.
– In response, owners of Texas oilfields reduce supply now, save some
inventory to sell later at the higher price.
– S curve shifts left.

In general, sellers may adjust supply* when their expectations of

future prices change.
(*If good not perishable)

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Summary: Variables that Influence Sellers

Variable A change in this variable

1. Price causes a movement along the S curve

2. Input Prices shifts the S curve

3. Technology shifts the S curve

4. # of Sellers shifts the S curve

5. Expectations shifts the S curve

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 ACTIVE LEARNING 2
Supply Curve
Draw a supply curve for tax return preparation
software. What happens to it in each of the
following scenarios?

A. Retailers cut the price of the software.

B. A technological advance allows the software to
be produced at lower cost.
C. Professional tax return preparers raise the price
of the services they provide.

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 2.4. Supply and Demand Together
P
$6.00 D S
Equilibrium:
$5.00 P has reached
$4.00 the level where
quantity supplied equals
$3.00
quantity demanded
$2.00
$1.00
$0.00 Q
0 5 10 15 20 25 30 35
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 Equilibrium price
the price that equates quantity supplied
with quantity demanded
P
$6.00 D S P QD QS
$5.00 $0 24 0
$4.00 1 21 5

$3.00
2 18 10
3 15 15
$2.00
4 12 20
$1.00 5 9 25
$0.00 Q 6 6 30
0 5 10 15 20 25 30 35
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 Equilibrium quantity
the quantity supplied and quantity demanded
at the equilibrium price
P
$6.00 D S P QD QS
$5.00 $0 24 0
$4.00 1 21 5

$3.00
2 18 10
3 15 15
$2.00
4 12 20
$1.00 5 9 25
$0.00 Q 6 6 30
0 5 10 15 20 25 30 35
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 Surplus (a.k.a. excess supply)

P
$6.00 D Surplus S
$5.00 when quantity supplied is
greater than quantity demanded
$4.00

$3.00
$2.00
$1.00
$0.00 Q
0 5 10 15 20 25 30 35
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 Surplus (a.k.a. excess supply)
Facing a surplus,
P sellers try to increase
$6.00 D Surplus S sales by cutting price.
$5.00
This causes
$4.00 QD to rise and QS to fall…
$3.00 …which reduces the
surplus.
$2.00
$1.00
Prices continue to fall
until market reaches
$0.00 Q equilibrium.
0 5 10 15 20 25 30 35
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 Shortage (a.k.a. excess demand)
P
$6.00 D S
$5.00
$4.00 when quantity demanded is
$3.00 greater than quantity
supplied
$2.00
$1.00
$0.00 Shortage Q
0 5 10 15 20 25 30 35
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 Shortage (a.k.a. excess demand)
P
$6.00 D S Facing a shortage,
sellers raise the price,
$5.00
causing QD to fall
$4.00 and QS to rise,
$3.00 …which reduces the
shortage.
$2.00
Prices continue to rise
$1.00 until market reaches
Shortage
$0.00 Q equilibrium.
0 5 10 15 20 25 30 35
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Exercise 1. Supply and demand data for concerts are shown below

Price $20 $24 $28 $32 $36 $40

Quantity
10 9 8 7 6 5
demanded
Quantity
1 3 5 7 9 11
supplied

(a) Plot the supply and demand curves to scale and establish the
equilibrium price and quantity.
(b) What is the excess supply or demand when price is $24?
When price is $36?

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Exercise 1 (cont.)
(c) Describe the market adjustments in price induced by these two prices.
(d) The functions underlying the example in the table are linear and can
be presented as P =18 + 2Q (supply) and P = 60 - 4Q (demand). Solve
the two equations for the equilibrium price and quantity values.

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Three Steps to Analyzing Changes in Eq’m

1. Decide whether event shifts S

curve, D curve, or both.

2. Decide in which direction curve

shifts.

3. Use supply-demand diagram to

see how the shift changes eq’m P
and Q.
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 EXAMPLE: The Market for Hybrid Cars
P
price of
S1
hybrid cars

P1

D1
Q
Q1
quantity of
hybrid cars
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 EXAMPLE 1: A Shift in Demand
EVENT TO BE
ANALYZED: P
STEP 2:
Increase in price of gas. S1
D shifts right
STEP 1: P2 because high gas price
D curve shifts makes hybrids more
because price of gas affects demand P1 attractive relative to other
for hybrids. cars.
S curve does not shift, because price of
gas does not affect cost of producing D2
D1
hybrids.
Q
Q1 Q2
STEP 3:
The shift causes an increase in price and
quantity of hybrid cars.
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 EXAMPLE 1: A Shift in Demand
P
Notice: S1
When P rises, producers
supply a larger quantity P2
of hybrids, even though
the S curve has not P1
shifted.

Always be careful to D1 D2
distinguish b/w a shift in a Q
curve and a movement Q1 Q2
along the curve.

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 Terms for Shift vs. Movement Along Curve
• Change in supply: a shift in the S curve occurs when a non-price
determinant of supply changes (like technology or costs)
• Change in the quantity supplied: a movement along a fixed S
curve when P changes
• Change in demand: a shift in the D curve occurs when a non-price
determinant of demand changes (like income or # of buyers)
• Change in the quantity demanded: a movement along a fixed D
curve occurs when P changes

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 EXAMPLE 2: A Shift in Supply
EVENT: New
technology reduces cost P
of producing hybrid cars. S1 S2 STEP 2:
STEP 1: S shifts right
S curve shifts because event reduces
because event affects cost of cost,
production. P1
makes production
D curve does not shift, because P2 more profitable at any
production technology is not given price.
one of the factors that affect D1
demand. Q
Q1 Q2
STEP 3:
The shift causes price to fall
and quantity to rise.
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 EXAMPLE 3: A Shift in Both Supply and Demand
EVENTS: P
price of gas rises AND S1 S2
new technology reduces
production costs
P2
STEP 1:
Both curves shift. P1
STEP 2:
Both shift to the right.
D1 D2
STEP 3:
Q rises, but effect Q
Q1 Q2
on P is ambiguous:
If demand increases more than
supply, P rises.
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 EXAMPLE 3: A Shift in Both Supply and Demand
P
EVENTS:
S1 S2
price of gas rises AND
new technology reduces production
costs
P1
STEP 3, cont. P2

But if supply increases more D1 D2

than demand, Q
P falls. Q1 Q2

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 ACTIVE LEARNING 3
Shifts in supply and demand
Use the three-step method to analyze the effects of
each event on the equilibrium price and quantity of
music downloads.
Event A: A fall in the price of CDs
Event B: Sellers of music downloads negotiate a
reduction in the royalties they must pay
for each song they sell.
Event C: Events A and B both occur.

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2.5. Consumer Surplus, Producer Surplus,
and Total Surplus P
S
Consumer surplus WTP
(CS): the amount a
buyer is willing to pay P
minus the amount the
buyer actually pays
C D
Producer surplus (PS):
Q
the amount a seller Q
is paid for a good
minus the seller’s cost TS = CS + PS
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2.6. Price Controls of Government

Price ceiling: a legal maximum on the

price of a good or service

Price floor: a legal minimum on the

price of a good or service

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 Price Ceilings
Example 1: The Market for Apartments

P S
A price ceiling
above the Price
$1000
eq’m price is ceiling
not binding – $800
has no effect
on the market
outcome.
D
Q
300
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 Price Ceilings
Example 1: The Market for Apartments
P S
The eq’m price ($800)
is above the ceiling
and therefore illegal. $800
The ceiling is a Price
binding constraint on $500 ceiling
the price, causes a shortage
shortage. D
Q
250 400

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 The effect of Price Ceilings
P

Before Pc After Pc ∆
A S
CS A+D A+B B-D
D
PS B+E+C C -B-E PE
B E
G 0 0 0
PC
TS A+B+C+D+E A+B+C -D-E C D
shortage

Q
Q1 QE Q2
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 Price Floor
Example 2: The Market for Unskilled Labor
W S
A price floor
below the
eq’m price is
not binding – $4
has no effect Price
on the market $3
floor
outcome.
D
L
500
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 Price Floor
Example 2: The Market for Unskilled Labor
labor
The eq’m wage ($4) is W surplus
below the floor and S
Price
therefore illegal. $5
floor
The floor is a binding
constraint on the wage, $4
causes a
surplus (i.e.,
unemployment).
D
L
400 550
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 The Minimum Wage
W unemployment
Min wage laws S
do not affect Min.
$5
highly skilled workers. wage

They do affect teen $4

workers.
Studies:
A 10% increase
in the min wage raises
D
teen unemployment L
by 1-3%. 400 550

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 ACTIVE LEARNING 1
Price controls
The market for
P
140 hotel rooms
S
130
Determine
120
effects of:
110
A. $90 price 100
ceiling 90
B. $90 price 80 D
floor 70
C. $120 price 60
floor 50
40
0 Q
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 Evaluating Price Controls
• Recall one of the Ten Principles from Chapter 1:
Markets are usually a good way to organize economic
activity.

• Prices are the signals that guide the allocation of society’s

resources. This allocation is altered when policymakers
restrict prices.
• Price controls often intended to help the poor, but often hurt
more than help.

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Exercise 2: Suppose we are analyzing the market for hot chocolate. What
will happen to the equilibrium price and quantity of hot chocolate if:
a. The price of tea, a substitute for hot chocolate, falls and a better
method of harvesting cocoa beans is introduced.
b. Winter starts and the weather turns sharply colder and the price of
cocoa beans increases.
c. The price of tea, a substitute for hot chocolate, increases and producers
expect the price of hot chocolate to increase next month.

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Exercise 3.

Consider the market for apple juice. In this market, the supply curve is given by
𝑄𝑆 = 10𝑃𝐽 − 5𝑃𝐴 and the demand curve is given by 𝑄𝐷 = 100 − 15𝑃𝐽 + 10𝑃𝑇 ,
where J denotes apple juice, A denotes apples, and T denotes tea.

a. Assume that 𝑃𝐴 is fixed at $1 and 𝑃𝑇 = 5. Calculate the equilibrium price and

quantity in the apple juice market.

b. Suppose that a poor harvest season raises the price of apples to 𝑃𝐴 = 2. Find the
new equilibrium price and quantity of apple juice. Draw a graph to illustrate your
answer.

c. Suppose 𝑃𝐴 = 1 but the price of tea drops to 𝑃𝑇 = 3. Find the new equilibrium price
and quantity of apple juice.

d. Suppose 𝑃𝐴 = 1, 𝑃𝑇 = 5, and there is a price ceiling on apple juice of 5. What is

the excess demand for apple juice as a result? Draw a graph to illustrate your
answer.
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Exercise 4.
The demand of Vietnam’s rice for both domestic and export is given by: Q
= 3550 – 266P, where domestic demand is: Qd = 1000 – 46P.
Vietnam’s rice supply is: Q = 1800 + 240P (Q: ton; P: million dong/ton)
a. Find the equilibrium price and quantity.
b. What happens with price of Vietnam’s rice if demand for export
decreases 40%?

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Exercise 5.
Suppose the demand curve for a product is given by Q = 300 - 2P + 4I,
where I is average income measured in thousands of dollars. The supply
curve is Q = 3P - 50.
a. If I = 25, find the market-clearing price and quantity for the product.
b. If I = 50, find the market-clearing price and quantity for the product.
c. Draw a graph to illustrate your answers.

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Exercise 6.
Suppose the demand curve and supply curve for a product are as follow:
𝑄𝑆 = 20𝑃 − 5 𝑄𝐷 = −10𝑃 + 250
a. Calculate the equilibrium price and quantity.
b. Calculate the consumer surplus, producer surplus and total surplus at
equilibrium.
c. What happens if the government set price ceiling 𝑃𝑐 = 8.
d. Calculate the deadweight loss caused by price ceiling.

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