Lecture 2 Demand and Supply

Demand and Supply
March 12, 2022
(Ref: Perloff, Ch. 2,3,9) Demand and Supply March 12, 2022 1 / 59
Your first model
For commodities or services being exchanged in a market, in

equilibrium
quantity supplied = quantity demanded

by the producers by the consumers
Mostly, but not always, true.
Markets
Buyers ↓ Sellers
No market power Positive market power
Infinitely many N > Sellers > 1 One Differentiated
Infinitely many Competitive markets Oligopoly Monopoly Monopolistic Competition
N > Buyers > 1 Buyer oligopoly* Bilateral oligopoly Monopoly* Monopolistic Competition*
One Monopsony Monopsony* Bilateral monopoly Monopsony*
Differentiated Depends on the number of buyers
Markets
Buyers ↓ Sellers
Infinitely many Competitive markets
N > Buyers > 1
One
Differentiated
Markets
Buyers ↓ Sellers
Infinitely many Oligopoly
N > Buyers > 1
One
Differentiated
Markets
Buyers ↓ Sellers
Infinitely many Monopoly
N > Buyers > 1
One
Differentiated
Markets
Buyers ↓ Sellers
Infinitely many Monopolistic Competition
N > Buyers > 1
One
Differentiated
Perfectly competitive markets
Sellers and buyers engage in exchange in a market where:

Large number of buyers and sellers.
Homogeneous products.
Free entry and exit.
Perfect knowledge.
Absence of transportation costs.
Perfect mobility of factors of production.
Consequences:
Agents take prices as given.
Normal profits for all firms.
Demand
Consumers’ decision about how much to buy depends on

1 Price of the commodity.
2 Prices of related commodities.
3 Income.
4 Tastes.
5 Government actions. e.g. child labor
6 Networks. e.g. WhatsApp
7 Addiction. e.g. Sugary food.
Quantity demanded and Demand curve
Quantity demanded is the amount of a good that consumers are

willing to buy at a given price, holding constant the other factors
that influence purchases.
It might be different than quantity exchanged.
Demand curve/schedule is a functional relation that tells you the
quantity demanded at each possible price, holding constant the
other factors that influence purchases.
One is a number, the other is a function.
Demand curve/function
Demand curve
Quantity on the x-axis, price per unit on the y-axis.

Intercepts and slope have important interpretations.
Exercise: Using the two intercepts or an intercept and a slope to
deduce the linear demand function.
Proposition (Law of Demand)
Holding constant tastes, the prices of other goods, and other factors
that influence consumption, consumers demand more of a good the
lower its price.
Demand curve
Change in price ⇒ Movement along the demand curve.
Qd = a − bP
⇒ Qd1 = a − bP1
and
⇒ Qd2 = a − bP2
The parameters of the model, slope and intercept, remain the

same.1
1
A parameter is a measurable factor forming one of a set that defines a system or
sets the conditions of its operation.
Demand curve
Change in other factors ⇒ Moves the demand curve.

Qd = D(P, psubstitutes , pcomplement , Income)
Qd = 200 − 20P + 10psubstitutes − 5pcomplement + Income
Say, psubstitute = 10, pcomplement = 10, Income = 300
⇒ Qd = 550 − 20P
Now, say psubstitute = 20, all else remains the same.
⇒ Qd = 650 − 20P
Demand curve/function
Summing up demand curves
The total quantity demanded at a given price is the sum of the

quantity each consumer demands at that price.
Qd = Qd1 + Qd2
⇒ Qd = a1 − b1 P + a2 − b2 P
⇒ Qd = (a1 + a2 ) − (b1 + b2 )P
⇒ Qd = a − bP
Exercise
Suppose that the inverse demand function for movies is p = 120 − Q1

for college students and p = 120 − 2Q2 for other town residents. What
is the town’s total demand function (Q = Q1 + Q2 as a function of p)?
Use a diagram to illustrate your answer.
Supply
Sellers’ decision about how much to supply depends on

1 Price of the commodity.
2 Prices of inputs.
3 Technology.
4 Any other factors affecting costs and technology.
5 Usually, we assume firms do not have inherent tastes and
preferences.
Quantity supplied and Supply curve
Quantity supplied is the amount of a good that firms want to sell at

a given price, holding constant other factors that influence firms’
supply decisions.
It might be different than quantity exchanged.
Supply curve/schedule is a functional relation that tells you the
quantity supplied at each possible price, holding constant the
other factors that influence supply decisions.
One is a number, the other is a function.
Supply curve/function
c 1
Qs = c + dP ⇒ P = − + Qs
d d
Supply curve
Quantity on the x-axis, price per unit on the y-axis.

Intercepts and slope have important interpretations.
Exercise: Using the two points on the supply curve to deduce the
linear supply function.
Proposition (Law of Supply)

Holding constant all other factors that influence supply, sellers supply
more of a good the higher its price.
Supply curve
Change in price ⇒ Movement along the supply curve.
Qs = c + dP
⇒ Qs1 = c + dP1
and
⇒ Qs2 = c + dP2
The parameters of the model, slope and intercept, remain the

same.2
2
A parameter is a measurable factor forming one of a set that defines a system or
sets the conditions of its operation.
Supply curve
Change in other factors ⇒ Moves the supply curve.

Q = S(P, pinputs )
Q = 200 + 20P − 10pinputs
Say, pinputs = 10
⇒ Q = 100 + 20P
Now, say pinputs = 20, all else remains the same.
⇒ Q = 20P
Supply curve/function
Summing up supply curves
The total quantity supplied at a given price is the sum of the

quantity each seller supplies at that price.
Qs = Qs1 + Qs2
⇒ Qs = c1 + d1 P + c2 + d2 P
⇒ Qs = (c1 + c2 ) + (d1 + d2 )P
⇒ Qs = c + cP
Supply curves summation
2. Determine the foreign supply curve under quote Qf .

3. Determine the U.S. total supply curve with the quota.
5. How would the shape of the total supply curve change if the U.S.
domestic supply curve hit the vertical axis at a price above p
Market Equilibrium
An equilibrium is a situation in which no one wants to change his

or her behavior.
A market equilibrium is attained when
Quantity demanded = Quantity supplied
.
It consists of an equilibrium price and quantity.
Equilibrium (or market-clearing) price: The price at which buyers
want to buy as much as the sellers want to sell.
Equilibrium quantity: The quantity exchanged at that price.
Market Equilibrium
Surplus or excess supply drives the price down.

Shortage of excess demand drives the price up.
Market Equilibrium
The demand function for a good is Qd = a − bP and the supply

function is Qs = c + eP where a, b, c, and e are positive constants.
Solve for the equilibrium price and quantity in terms of these four
constants.
Changes in equilibrium
Shift in the demand curve causes movement of the along the

supply curve and vice-versa.
Both the direction and extent of the shift matter.
Figure: Market for eggs and market for education over the years
The demand function for roses is Qd = a − bP and the supply function

is Qs = c + eP + ft where a, b, c, e, and f are positive constants and t
is the average temperature in a month. Show how the equilibrium
quantity and price vary with temperature.
Q: Why do invaders/colonizers destroy libraries and universities?
A: Because they understand supply and demand.
Sarajevo cellist Vedran Smailović, who often played at funerals, plays at the National
and University Library of Bosnia and Herzegovina that was partially destroyed by the
Bosnian-Serb army in 1992.
Another application
Did the price of office space in Manhattan go up or down because of

the WTC attacks?
Destruction of millions of square feet of office space.
Terrorized people.
Another application
Figure: Office space in Manhattan before and after the attack
The terrorist hurt the confidence more than the physical

infrastructure.
Lower
(Ref: Perloff, Q
Ch. but
2,3,9) also lower P.Demand
So, did the consumer gain?
and Supply March 12, 2022 35 / 59
Consumer surplus, producer surplus, and
Dead-weight loss3
Consumer surplus is the monetary difference between what consumers are willing to pay
and what they end up paying. (remaining willingness to pay)
Producer surplus is the monetary difference between what seller get for the sales and the
minimum amount necessary for the seller to be willing to produce the good. (profits)
Dead-weight loss is the net reduction in welfare from a loss of surplus by one group that is
not offset by a gain to another group from an action that alters a market equilibrium.
[graphical and mathematical exposition]
3
Reference: Chapter 9
Consumer surplus, producer surplus, and
Dead-weight loss4
4
Reference: Chapter 9
Government intervention in a market
1. Quotas
Argument: Infant-industry, self-sufficiency.

Example: Immigration
2. Price ceiling
Argument: Pro-poor
Example: 1973 oil crisis, Authoritarian leaders imposing price controls,
A price ceiling can be non-binding.
2. Price floor
Argument: Standard of living, firms that do not provide minimum wages are siphoning
subsidies.
Example: Minimum wages, agricultural support price.
A price floor can also be non-binding.
Elasticities of Supply and Demand
So, interventions lead to inefficiencies. But who bears the brunt?

Elasticity: Percentage change in one variable resulting from a
1-percent increase in another.
∆Y
Y X ∆Y
Exy = (%∆Y )/(%∆X ) = ∆X
=
X
Y ∆X
High absolute value of elasticity means people are flexible.
Price elasticity of demand
(Own) Price elasticity of demand: Percentage change in quantity

demanded for a 1-percent change in price.
∆Qd
Qd P ∆Qd P dQd
Epd = (%∆Qd )/(%∆P) = ∆P
= = |p
P
Qd ∆P Qd dP
Since demand curve is usually negatively sloped, Epd is usually

< 0. But we often refer to the absolute value.
|Epd | → ∞: Demand is perfectly elastic. An increase in price will cause the demand to go
to zero. E.g.: perfect substitutes being sold at different prices.
|Epd | > 1: Demand is elastic. An increase in price will cause a big fall in demand. E.g.:
luxury good, goods with close substitutes.
|Epd | < 1: Demand is inelastic. An increase in price will not cause a big fall in demand.
E.g.: necessities with no close substitutes.
|Epd | = 1: Demand is unitary elastic. A one percent-increase in price will cause the
demand to fall by one percent.
|Epd | = 0: Demand is perfectly inelastic. An increase in price will have no impact on the
demand. E.g. medicines, Oxygen (, if it was priced).
What does it depend on?

On preferences, availability of substitutes,
time horizon, and storage capacity.

1970s Oil crisis: Gasoline demand was highly inelastic in the 1970s
then today.
Dodge charger to Toyota Prius
You can do without computers one more day but not forever.
How many paper towel rolls do you get? Do you shop for winter
wear after winters?
Income elasticity of demand
Income elasticity of demand: Percentage change in quantity

demanded for a 1-percent change in income.
∆Qd
Qd I ∆Qd I dQd
EId = (%∆Qd )/(%∆I) = ∆I
= = |I
I
Qd ∆I Qd dI
Remember, this is not movement along the demand curve.

Can be positive or negative (more on this in the next lecture.)
Cross-price elasticity of demand
Cross-price elasticity of demand: % change in quantity demanded

of commodity x for a 1 % change in price of commodity y.
∆Qdx
Qdx Py ∆Qdx Py dQdx
CEpd = (%∆Qdx )/(%∆Py ) = ∆Py
= = |p
Qdx ∆Py Qdx dPy
Py
The market for American muscle cars started shrinking slowly

after the oil crisis.
Depends on whether the commodities are substitutes or
complements (next lecture).
Price elasticity of supply
Price elasticity of supply: Percentage change in quantity supplied

for a 1-percent change in price.
∆Qs
Qs P ∆Qs P dQs
Eps = (%∆Qs )/(%∆P) = ∆P
= = |p
P
Qs ∆P Qs dP
Price elasticity of supply
|Eps | → ∞: Supply is perfectly elastic. An decrease in price will cause the supply to go to
zero. E.g.: perfect substitutes sold at their production costs.
|Eps | > 1: Supply is elastic. An decrease in price will cause a relatively large decrease in
supply.
|Eps | < 1: Supply is inelastic. An increase in price will not cause a big fall in demand. E.g.:
apartments for rent in Manhattan.
|Eps | = 1: Supply is unitary elastic. A one percent-increase in price will cause the demand
to fall by one percent.
|Eps | = 0: Supply is perfectly inelastic. A decrease in price will have no impact on the
supply. E.g. daily perishables.
Elasticities in action
The inelastic side of the market loses more surplus.
Taxes
Taxes are another form of government intervention but
government benefits from it.
Sales tax are levied on the sale/purchase of items.
Specific tax - a tax of a certain amount of money per unit sold.
Ad valorem tax - proportional tax (Not as common. Skip.)
Incidence of tax
|Pt∗ −Pc/p |
Tax incidence/burden = t
Again, the inflexible party suffers more.
Incidence of tax example
Inverse Demand Curve: P = 14.30 − 0.05Qd

Supply Curve: Qs = 88 + 40P
Specific tax: τ = $1.05
Calculate the new equilibrium and the incidence of tax on the
consumers and the producers.
Solution: ∆P = 70 cents, ∆Q = −14
Incidence of tax
In 2010, Americans smoked 315 billion cigarettes, or 15.75 billion packs of cigarettes. The
average retail price, including taxes, was about 5 dollars a pack. Statistical studies have shown
that the price elasticity of demand is -0.4, and the price elasticity of supply is 0.5.
1 Using this information, derive linear demand and supply curves for the cigarette market.
2 In 1998, Americans smoked 23.5 billion packs of cigarettes, and the retail price was about
$2.00 per pack. The decline in cigarette consumption from 1998 to 2010 was due in part to
greater public awareness of the health hazards from smoking, but was also due in part to
the increase in price. Suppose that the entire decline was due to the increase in price.
What could you deduce from that about the price elasticity of demand?
Recap
Scarcity of resources ⇒ Trade-offs.

When making decisions, self-interest maximizing individuals
respond to incentives.
Economists study these decisions and come up with ways to
influence those decisions to improve welfare.
Decisions generate demand and supply.
Recap
Demand and supply curves - movement along and shifts.

Buyers and sellers meet in the market and exchange at the
market price.
In competitive markets, all agents are price-takers.
In equilibrium, quantity demanded equals quantity supplied.
(exceptions)
Comparative statics.
Recap
Consumer surplus, producer surplus and dead-weight loss.

Government intervention often leads to net welfare-loss.
Elasticity.
Specific tax and its burden.
Home Assignment 1
Chapter 2: 3.4
Chapter 3: 2.13, 2.14, 3.1
Chapter 3: 4.16

Lecture 2 Demand and Supply

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Demand and Supply

March 12, 2022

For commodities or services being exchanged in a market, in

quantity supplied = quantity demanded

No market power Positive market power

Infinitely many N > Sellers > 1 One Differentiated

Infinitely many Competitive markets Oligopoly Monopoly Monopolistic Competition

One Monopsony Monopsony* Bilateral monopoly Monopsony*

Differentiated Depends on the number of buyers

No market power Positive market power

Infinitely many N > Sellers > 1 One Differentiated

Infinitely many Competitive markets

N > Buyers > 1

No market power Positive market power

Infinitely many N > Sellers > 1 One Differentiated

Infinitely many Oligopoly

N > Buyers > 1

No market power Positive market power

Infinitely many N > Sellers > 1 One Differentiated

Infinitely many Monopoly

N > Buyers > 1

No market power Positive market power

Infinitely many N > Sellers > 1 One Differentiated

Infinitely many Monopolistic Competition

N > Buyers > 1

Sellers and buyers engage in exchange in a market where:

Consumers’ decision about how much to buy depends on

Quantity demanded is the amount of a good that consumers are

Quantity on the x-axis, price per unit on the y-axis.

Change in price ⇒ Movement along the demand curve.

The parameters of the model, slope and intercept, remain the

Change in other factors ⇒ Moves the demand curve.

Qd = 200 − 20P + 10psubstitutes − 5pcomplement + Income

Say, psubstitute = 10, pcomplement = 10, Income = 300

Now, say psubstitute = 20, all else remains the same.

The total quantity demanded at a given price is the sum of the

Suppose that the inverse demand function for movies is p = 120 − Q1

Sellers’ decision about how much to supply depends on

Quantity supplied is the amount of a good that firms want to sell at

Quantity on the x-axis, price per unit on the y-axis.

Proposition (Law of Supply)

Change in price ⇒ Movement along the supply curve.

The parameters of the model, slope and intercept, remain the

Change in other factors ⇒ Moves the supply curve.

Q = 200 + 20P − 10pinputs

Now, say pinputs = 20, all else remains the same.

The total quantity supplied at a given price is the sum of the

2. Determine the foreign supply curve under quote Qf .

An equilibrium is a situation in which no one wants to change his

Quantity demanded = Quantity supplied

Surplus or excess supply drives the price down.

The demand function for a good is Qd = a − bP and the supply

Shift in the demand curve causes movement of the along the

Both the direction and extent of the shift matter.

The demand function for roses is Qd = a − bP and the supply function

Did the price of office space in Manhattan go up or down because of

Figure: Office space in Manhattan before and after the attack

The terrorist hurt the confidence more than the physical

[graphical and mathematical exposition]

Argument: Infant-industry, self-sufficiency.

So, interventions lead to inefficiencies. But who bears the brunt?

(Own) Price elasticity of demand: Percentage change in quantity

Since demand curve is usually negatively sloped, Epd is usually