CHAPTER 2

THE BASICS
OF DEMAND
& SUPPLY
Supply and demand model
—  The
supply and demand model is a
model of how a competitive market
works.

—  Five key elements:

◦  Demand curve
◦  Supply curve
◦  Demand and supply curve shifts
◦  Market equilibrium
◦  Changes in the market equilibrium
Demand
1.  Key definitions
2.  The law of demand
3.  Illustrating demand
4.  Determinants of demand
5.  Distinguishing moving along demand
curve and demand shifting
 Demand
1.  Key Definitions
-  Demand illustrates the amounts of
commodity that buyers are willing and
can afford to buy at different prices in a
certain period of time given everything
else held constant
ü  Demand versus Need?
- Quantity demanded is the amount of
commodity that buyers are willing and can
afford to buy at a certain price during a period
of time given everything else held constant.
è Demand captures the whole relationship
between price and quantity demanded.
- Individual demand: the demand of a single
consumer.
- Market demand: the sum of the quantity
demanded for each individual buyer at each
price
DEMAND
2. The law of demand
Given everything else held constant, the
quantity demanded of a good will increase
when the price decrease, and vice versa.

Ceteris Paribus
P é QDê
P ê QDé
3. Illustrating demand
- Demand schedule
-  Demand curve
-  Demand function
Demand Schedule
—  A demand Demand Schedule for Cotton

schedule shows Price of cotton Quantity of cotton

demanded
(per pound)
how much of a (billions of pounds)

good or service $2.00 7.1

consumers will 1.75 7.5

want to buy at 1.50 8.1
different prices. 1.25 8.9

1.00 10.0

0.75 11.5

0.50 14.2
Demand Curve
Price of
cotton
(per pound) A demand curve is the graphical
representation of the demand
schedule.
$2.00
It shows how much of a good or
1.75
service consumers want to buy
1.50
at any given price.
1.25

1.00

0.75 As price rises, Demand

the quantity curve, D
0.50 demanded falls

0 7 9 11 13 15 17
Quantity of cotton
(billions of pounds)
-  Demand function is a mathematical
representation of the relationship between
quantity demanded and demand determinants.
QD = f( P, Py, I, T, E, N)
Where
QD : Quantity demanded
P : Price of the commodity
Py : Price of related commodities
I : Income
E : Expectations
N : Number of buyers
Demand function
Other things being equal, the demand
function can be simplified as follows:
Q = f (P)
If the relationship between quantity
demanded and price is linear:
Q = aP + b ( a<0)
 A change in quantity demanded vs. a
change in demand
—  When price changes, P
quantity demanded will
change sequentially.
P1 A
—  However demand, as
the relationship between P2 B
D
price and quantity
demanded, will not
change.
0 Q1 Q2 Q
—  Thus the demand curve
remains at the same
position.
What Causes a Demand Curve to
Shift?
Changes in the non-price factors (exogenous
factors): price of related goods, income,
expectation, taste, number of buyers è the
whole demand function changes
Movement along demand curve vs. demand
shift
—  Other factors are P
exogenous.
—  Leading to the shift
of demand curve
—  Eg: An increase in
price of substitute
D D’
results in the increase
of demand.
0 Q
A change in Demand
—  An increase in
population generate Demand Schedules for Cotton
an increase in Quantity of cotton
demand. Price of cotton
demanded
(billions of
(per pound)
—  This is represented pounds)
by the two demand in 2007 in 2010

schedules—one $2.00 7.1 8.5

showing demand in 1.75 7.5 9.0
2007, before the rise 1.50 8.1 9.7
in population, the 1.25 8.9 10.7
other showing 1.00 10.0 12.0
demand in 2010, 0.75 11.5 13.8
after the rise in 0.50 14.2 17.0
population.
An change in Demand
Price of
cotton
(per pound)
$2.00

Increase in 1.75 Demand curve

population à 1.50
in 2010

more cotton 1.25

clothing users 1.00

0.75
Demand curve in
0.50 2007 D D
1 2

0 7 9 11 13 15 17
Quantity of cotton
(billions of pounds)

A shift of the demand curve is a change in the quantity demanded at any

given price, represented by the change of the original demand curve to
a new position, denoted by a new demand curve.
Movement Along the Demand Curve
A movement along the demand curve is a change in
the quantity demanded of a good that is the result of a
Price of change in that good’s price.
cotton
(per
pound) A shift of the
demand curve…
$2.00

1.75

1.50
A C … is not the same thing
as a movement along the
1.25 demand curve
B
1.00

0.75

0.50 D D
1 2

0 7 8.1 9.7 10 13 15 17
Quantity of cotton
(billions of pounds)
Shifts of the Demand Curve
A “decrease in demand”
An “increase in
Price means a leftward
demand” meansshift
a of
the demand
rightward shiftcurve:
of the
atdemand
any given price,
curve:
Increase
in consumers
at any givendemand
price, a
demand
smaller quantity
consumers demandthana
larger before.
quantity than
(D1àD3)
before. (D1àD2)
Decrease
in demand

D D D
3 1 2

Quantity
DETERMINANTS CAUSING SHIFTS
DEMAND

Price of Substitute
—  Two commodities are substitute if we can
use either of them to achieve the same
purpose.
—  Impact of the price of substitutes on
demand

PY ↑⇒ QDY ↓⇒ QDX ↑
PY ↓⇒ QDY ↑⇒ QDX ↓
 DETERMINANTS OF DEMAND

Price of Complement
—  Two goods are complements if they are
necessarily consumed together to
guarantee their usefulness.
—  Impact

PY ↑⇒ QDY ↓⇒ QDX ↓
PY ↓⇒ QDY ↑⇒ QDX ↑
DETERMINANTS OF DEMAND
Income
—  Normal goods

I ↑⇒ QD ↑
I ↓⇒ QD ↓
—  Inferior goods
I ↑⇒ QD ↓
€ I ↓⇒ QD ↑
—  Ernst
Engel : At different income levels,
consumers have different perspectives toward
the same goods.
I  

I2   Inferior goods
I0  
I1  
Normal goods

0   Q2   Q1   Q0   Q  
 Determinants of demand
Tastes
—  Tastes are consumers’ preferences towards
goods.
—  Tastes depend on:
v Age
v Gender
v Convention and customs
v Time
 Determinants of Demand
Expectations
Expectations about future income or
prices will affect the demand for a good
today
—  Expectation of an increase in price =>
Current Demand Increases.
—  Expectation of an decrease in price =>
Current Demand Decreases.
—  Expectation of an increase in income è
Current demand increases.
DETERMINANTS OF DEMAND

4.5 Number of buyers

N ↑⇒ QD ↑
N ↓⇒ QD ↓
 Individual Demand Curve and the Market Demand Curve

The market demand curve is the horizontal sum of the

individual demand curves of all consumers in that market.
(a) (c)
(b)
Darla’s Market Demand Curve
Dino’s Individual
Individual
Demand Curve
Demand Curve
Price of blue Price of blue Price of blue
jeans (per jeans (per jeans (per
pair) pair) pair)

$30 $30 $30

D Market

1 1 1
DDarla D Dino

0 3 4 0 2 3 0 5 6 7
Quantity of blue jeans
Quantity of blue jeans Quantity of blue jeans
(pounds)
(pounds) (pounds)
Supply
1.  Key definitions
2.  The law of supply
3.  Illustrating supply
4.  Determinants of supply
Key definitions
—  Supply shows the amounts of commodity
that sellers are willing and able to sell at
different prices in a certain period of time
given everything else held constant.
—  Quantity supplied is the amount of
commodity that sellers are willing and
able to sell at a given price in a certain
period of time given everything else held
constant.
 THE LAW OF SUPPLY
—  CETERIS PARIBUS

P ↑⇒ Qs ↑

P ↓⇒ Qs ↓
€
Illustrating supply
—  Supply schedule
—  Supply curve
—  Supply function
Supply Schedule
—  A supply Supply Schedule for Cotton

schedule Quantity of
Price of cotton
shows how cotton supplied
much of a (per pound) (billions of
pounds)
good or
$2.00 11.6
service
1.75 11.5
would be
1.50 11.2
supplied at
1.25 10.7
different
1.00 10.0
prices.
0.75 9.1
0.50 8.0
Supply Curve
Price of cotton
(per pound)
A supply curve shows
graphically how much of a
Supply good or service people
curve, S
$2.00 are willing to sell at any
given price.
1.75 As price rises, the
quantity supplied
1.50
rises.
1.25

1.00

0.75

0.50

0 7 9 11 13 15 17
Quantity of cotton (billions of pounds)
Supply function
QS = g ( Px, Pi, G, Tec, E, N)
Where
v Pi : price of inputs
v G: Government policies
v Tec: Technology
v E: Expectations of sellers
v N: number of sellers
Supply function
—  Ceteris paribus
QS = g ( P)
If supply curve is linear:
QS = cP + d (c>0)
 Shifts of the Supply Curve
Any
Any “decrease
“increase in in
Pric
e
supply”
supply” means a
S
3
S
1
S
2
rightward
leftward shift
shiftofofthe
the
supply curve:
Increase
in supply
at
at any
any given
given price,
price,
there is ana decrease
increase in in
the quantity supplied.
(S1à
(S1à S S2)
3)

Decrease
in supply

Quantity
 Determinants causing shifts of
supply curve
Price of inputs (Pi)

$TC ↑
Pi ↑⇒ % ⇒ π ↓⇒ QS ↓
&TRconstan t

$TC ↓
Pi ↓⇒ % ⇒ π ↑⇒ QS ↑
€ &TRconstan t
Determinants causing shifts of supply curve

Government Policies
—  Tax
$TC ↑
Tax ↑⇒ % ⇒ π ↓⇒ QS ↓
&TRconst

—  Subsidy
€ $TCconst
Subsidy ↑⇒ % ⇒ π ↑⇒ Q S ↑
&TR ↑
 Determinants causing shifts of supply curve

St
—  The government P
imposes tax of $t/ P2
unit: Supply curve t S
shifts upward by a
distance of t P1

—  For the same quantity

supplied, producers
ask for a price which
0 Q1 Q
is $t higher than the
old price.
Determinants causing shifts of supply curve

—  Eg:
Q = 5 + 3P
Q( tons), P ( $/kg)
t = 0.5 $/ kg.
Derive the new supply function.
Determinants of supply

—  Supplyprior to tax

P = (Q – 5)/ 3
—  New supply function
Pt = P+ t
P t = (Q – 5)/ 3 + 0,5
P t = (Q – 3,5) /3
è Q = 3,5 + 3P
Determinants causing shifts of supply

Technology
Better technology
⇒  Higher productivity, reducing cost
⇒  Higher profit
⇒  Supply increases
Determinants of supply

Expectations of sellers
Expectation of a decrease in price è
Increase in current supply

Expectation of an increase in price è

Decrease in current supply
Determinants of supply

Number of sellers

Number of sellers increases è Increase in

supply

Number of sellers decreases è Decrease

in supply
Market equilibrium
— Equilibriumin a market: when the
quantity demanded of a good equals the
quantity supplied of that good

— The
price at which this takes place is the
equilibrium price (or market-clearing
price)
◦  The quantity of the good bought and sold at
that price is the equilibrium quantity.
Market Equilibrium
Price of
cotton
(per pound) Market equilibrium
$2.00
Supply occurs at point E,
where the supply
1.75
curve and the demand
1.50
curve intersect.
1.25

Equilibriu 1.00 E Equilibrium

m price
0.75

0.50 Demand

0 7 10 13 15 17

Quantity of cotton
Equilibrium (billions of pounds)
quantity
Price of cotton
Surplus
(per pound)
There is a surplus of a
Supply good when the quantity
$2.00
supplied exceeds the
1.75 Surplus quantity demanded.
1.50 Surpluses occur when
1.25 the price is above its
E
equilibrium level.
1.00

0.75

0.50 Demand

0 7 8.1 10 11.2 13 15 17
Quantity of cotton
Quantity Quantity (billions of pounds)
demanded supplied
Shortage
Price of
cotton (per There is a shortage of a
pound)
good when the quantity
Supply
$2.00 demanded exceeds the
1.75 quantity supplied.
1.50
Shortages occur when
the price is below its
1.25
equilibrium level.
1.00 E

0.75
Shortage
0.50 Demand

0 7 9.1 10 11.5 13 15 17
Quantity of cotton
(billions of pounds)
Quantity Quantity
supplied demanded
 Equilibrium and Shifts of the Demand Curve
Price of cotton

An increase
in demand… Supply

… leads to a movement
E
2
along the supply curve
P
2
due to a higher equilibrium
Price price and higher
rises E
1 equilibrium quantity.
P
1

D
2

D1

Q Q
1 2 Quantity of cotton

Quantity
rises
Equilibrium and Shifts of the Supply Curve
Price of
cotton

S S
2 1 A decrease in
supply…

E2
P
2
Price … leads to a movement
rises along the demand curve
P
1 E1 due to a higher
equilibrium price and
lower equilibrium
quantity.
Demand

Q Q
2 1 Quantity of cotton

Quantity
falls
Technology Shifts of the Supply Curve
An increase in supply S1 … leads to a movement along
Price …
the demand curve to a lower
equilibrium price and higher
S2 equilibrium quantity.

Technological innovation: In the early

E1 1970s, engineers learned how to put
P1 microscopic electronic components onto a
Price silicon chip; progress in the technique has
falls E2 allowed ever more components to be put
P2
on each chip.

Demand

Q1 Q2 Quantity
Quantity increases
Simultaneous Shifts of Supply and Demand
(a) One Possible Outcome: Price Rises, Quantity Rises

Small
Price of cotton
decrease in
supply S S
2 1

E
2
P The
Twoincrease
opposing in demand
forces
2
dominates the decrease
determining the
in supply.
equilibrium quantity.
E
1
P
1

D
2
D
1
Large increase in
demand
Q Q2 Quantity of cotton
1
Simultaneous Shifts of Supply and Demand
(b) Another Possible Outcome: Price Rises, Quantity Falls
Price of cotton
Large
decrease
S
in supply 2

S
1
Two
The opposinginforces
decrease supply
E
2
determining
dominates the
the increase
P equilibrium quantity.
in demand.
2

E
1 Small
P increase in
1
demand

D
2
D
1

Q Q Quantity of cotton
2 1
Simultaneous Shifts of Supply and Demand
We can make the following predictions about the outcome
when the supply and demand curves shift simultaneously:

Simultaneous
Shifts of
Supply Increases Supply Decreases
Supply and
Demand
Price: up
Demand Price: ambiguous
Increases Quantity:
Quantity: up
ambiguous
Price: down
Demand Price: ambiguous
Decreases Quantity:
Quantity: down
ambiguous
Why Governments Control Prices
— Themarket price moves to the level at which
the quantity supplied equals the quantity
demanded. But, this equilibrium price does
not necessarily please either buyers or sellers.

— Therefore,the government intervenes to

regulate prices by imposing price controls,
which are legal restrictions on how high or
low a market price may go.
Price controls

— Price
ceiling is the maximum price sellers are
allowed to charge for a good or service.

— Price
floor is the minimum price buyers are
required to pay for a good or service.
Price Ceilings
— Price ceilings are typically imposed during
crises—wars, harvest failures, natural disasters
—because these events often lead to sudden
price increases that hurt many people but
produce big gains for a lucky few.
— Examples:
◦  U.S. government–imposed ceilings on aluminum
and steel during World War II
◦  Rent control in New York City
◦  Interest rate ceiling
The Market for Apartments in the Absence of Government Controls

Monthly rent
(per apartment)

Quantity of apartments
S Monthly rent (millions)
$1,400 (per apartment) Quantity Quantity
1,300 demanded supplied
1,200 $1,400 1.6 2.4
1,100 1,300 1.7 2.3
E 1,200 1.8 2.2
1,000
1,100 1.9 2.1
900 1,000 2.0 2.0
800 900 2.1 1.9
700 800 2.2 1.8
700 2.3 1.7
600
D 600 2.4 1.6

0 1.6 1.7 1.8 1.9 2.0 2.1 2.2 2.3 2.4

Quantity of apartments (millions)

The Effects of a Price Ceiling
Monthly rent
(per apartment)

S
$1,400

1,200

E
1,000
Price
A B ceiling
800

Housing shortage of
400,000 apartments
600 D
caused by price
ceiling

0 1.6 1.8 2.0 2.2 2.4

Quantity of apartments (millions)
 The Market for Butter in the Absence of Government Controls

Price of butter Quantity of butter

(per pound) Price of butter (millions of pounds)
(per pound) Quantity Quantity
demanded supplied
$1.40 8.0 14.0
S
$1.40 $1.30 8.5 13.0
$1.20 9.0 12.0
1.30
$1.10 9.5 11.0
1.20 $1.00 10.0 10.0
$0.90 10.5 9.0
1.10
E $0.80 11.0 8.0
1.00 $0.70 11.5 7.0
0.90 $0.60 12.0 6.0

0.80

0.70

0.60
D

0 6 7 8 9 10 11 12 13 14
Quantity of butter (millions of pounds)
The Effects of a Price Floor
Price of butter
(per pound)

Butter surplus of 3 S
$1.40 million pounds caused
by price floor

1.20
A B
Price
E floor
1.00

0.80

0.60 D

0 6 8 9 10 12 14

Quantity of butter (millions of pounds)

SUMMARY
1. The supply and demand model illustrates
how a competitive market, one with many
buyers and sellers, none of whom can
influence the market price, works.

2. Thedemand schedule shows the quantity

demanded at each price and is represented
graphically by a demand curve.

The law of demand says that demand curves

slope downward; that is, a higher price for a
good or service leads people to demand a
smaller quantity, other things equal.
SUMMARY
3.  A movement along the demand curve
occurs when a price change leads to a
change in the quantity demanded.

When economists talk of increasing or

decreasing demand, they mean shifts of the
demand curve—a change in the quantity
demanded at any given price.

An increase in demand causes a rightward

shift of the demand curve. A decrease in
demand causes a leftward shift.
SUMMARY
4.  There are five main factors that shift the
demand curve:
• A change in the prices of related goods or
services, such as substitutes or
complements
• A change in income: when income rises,
the demand for normal goods increases and
the demand for inferior goods decreases.
• A change in tastes
• A change in expectations
• A change in the number of consumers
SUMMARY
5.  The market demand curve for a good or
service is the horizontal sum of the
individual demand curves of all consumers
in the market.

6.  The supply schedule shows the quantity

supplied at each price and is represented
graphically by a supply curve. Supply
curves usually slope upward.
SUMMARY
7.  A movement along the supply curve
occurs when a price change leads to a
change in the quantity supplied.

When economists talk of increasing or

decreasing supply, they mean shifts of the
supply curve—a change in the quantity
supplied at any given price.

An increase in supply causes a rightward

shift of the supply curve. A decrease in
supply causes a leftward shift.
SUMMARY
8.  There are five main factors that shift the
supply curve:
• A change in input prices
• A change in the prices of related goods
and services
• A change in technology
• A change in expectations
• A change in the number of producers

9.  The market supply curve for a good or

service is the horizontal sum of the
SUMMARY
10. The supply and demand model is based on
the principle that the price in a market moves
to its equilibrium price, or market-
clearing price, the price at which the
quantity demanded is equal to the quantity
supplied. This quantity is the equilibrium
quantity.

When the price is above its market-clearing

level, there is a surplus that pushes the price
down.
SUMMARY
11.  An
increase in demand increases both the
equilibrium price and the equilibrium
quantity; a decrease in demand has the
opposite effect.

An increase in supply reduces the

equilibrium price and increases the
equilibrium quantity; a decrease in supply
has the opposite effect.
SUMMARY
12. Shifts
of the demand curve and the supply
curve can happen simultaneously.

When they shift in opposite directions, the

change in equilibrium price is predictable but
the change in equilibrium quantity is not.

When they shift in the same direction, the

change in equilibrium quantity is predictable
but the change in equilibrium price is not.

In general, the curve that shifts the greater

KEY TERMS
—  Competitive market
—  Supply and demand model
—  Demand schedule
—  Quantity demanded
—  Demand curve
—  Law of demand
—  Shift of the demand curve
—  Movement along the
demand curve
—  Substitutes
—  Complements
—  Normal good
—  Inferior good
—  Individual demand curve
—  Quantity supplied
—  Supply schedule
—  Supply curve
—  Shift of the supply curve
—  Movement along the supply
curve
—  Input
—  Individual supply curve
—  Equilibrium price
—  Equilibrium quantity
—  Market-clearing price
—  Surplus
—  Shortage
—  Consider the market for good X:
—  P = 100 – 0.1Q
—  P = 10 + 0.1Q
—  (P: $/kg, Q: ton)
—  a. Determine the market equilibrium.
—  b. If the Government imposes a price ceiling of 42$/kg and
supplies the shortage amount, determine the price and
quantity.
—  c. If the Government doesn’t want to impose price ceiling
but still desires the same outcome as (b), should the Gov
impose tax or subsidize producers? Determine that subsidy
or tax.
—  A market demand curve
A.  is derived by a vertical summation of
individual demand curves.
B.  is derived by a horizontal summation of
individual demand curves.
C.  will shift in response to a change in the
price of the good.
D.  is always steeper than an individual
demand curve.
— If buyers today become more willing and able than before
to purchase larger quantities of Vanilla Coke at each price
of Vanilla Coke,
A. we will observe a movement downward along the demand
curve for Vanilla Coke.
b. we will observe a movement upward along the demand
curve for Vanilla Coke.
c. the demand curve for Vanilla Coke will shift to the right.
d. the demand curve for Vanilla Coke will shift to the left.
—  During the last decade, we observe that the
price of laptop has fallen sharply while the
quantity has increased. This fact can be
explained by which of the following events?
a.  The introduction of tablet
b.  Financial crisis
c.  Technological advance in laptop
production
d.  Higher income
—  What will happen if the price of Urban
Station coffee goes up?
a.  Demand curve for Urban shift rightward
b.  Demand curve for Urban shift leftward
c.  Demand curve for The coffee Inn shift
rightward
d.  Demand curve for The Coffee Inn shift
leftward
—  An increase in the price of oranges would
lead to
a.  an increased supply of oranges.
b.  a reduction in the prices of inputs used in
orange production.
c.  an increased demand for oranges.
d.  a movement up and to the right along the
supply curve for oranges
—  Another term for equilibrium price is
a.  dynamic price.
b.  market-clearing price.
c.  quantity-defining price.
d.  satisfactory price.
—  If
at the current price,there is a shortage
of a good,
a. sellers are producing more than buyers
wish to buy.
b. the market must be in equilibrium.
c. the price is below the equilibrium price.
d. quantity demanded equals quantity
supplied.
—  A weaker demand together with a stronger
supply would necessarily result in
a. a lower price.
b. a higher price.
c. an increase in equilibrium quantity.
d. a decrease in equilibrium quantity.