Chapter 2

Market Forces: Demand and

Supply
 Demand

Market demand curve

– Illustrates the relationship between the total quantity and price per unit of a good
all consumers are willing and able to purchase, holding other variables constant.
Law of demand
– The quantity of a good consumers are willing and able to purchase increases
(decreases) as the price falls (rises).
– Price and quantity demanded are inversely related.

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 Market Demand Curve (Figure 2-1)
Price ($)
$40

$30

$20

$10
Demand

0 20 40 60 80 Quantity
(thousands per year)

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 Shift in Quantity Demanded versus a Shift in Demand

Changing only price leads to changes in quantity demanded.

– This type of change is graphically represented by a movement along a given
demand curve, holding other factors that impact demand constant.

Changing factors other than price leads to changes in demand.

– These types of changes are graphically represented by a shift of the entire
demand curve.

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 Changes in Demand (Figure 2-2)
Price

A Increase
in
demand

Decrease
in B
demand

D1
D2 D0

0 Quantity

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 Demand Shifters
1. Income
• Normal good
• Inferior good
2. Prices of related goods
• Substitute goods
• Complement goods
3. Advertising and consumer tastes
• Informative advertising
• Persuasive advertising
4. Population
5. Consumer expectations
6. Other factors

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Advertising and the Demand for Clothing (Figure 2-3)
Price of
high-style
clothing
Due to an
increase in
advertising
$50

$40

D2
D1
0 50,000 60,000 Quantity of
high-style
clothing
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 The Demand Function

The demand function for good X is a mathematical representation

describing how many units will be purchased at different prices for X,
the price of a related good Y, income and other factors that affect the
demand for good X.

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 The Linear Demand Function

One simple, but useful, representation of a demand function is the linear

demand function:
𝑑
𝑄𝑋 = 𝛼0 + 𝛼𝑋 𝑃𝑋 + 𝛼𝑌 𝑃𝑌 + 𝛼𝑀 𝑀 + 𝛼𝐻 𝐻
where:
– 𝑄𝑋 𝑑 is the number of units of good X demanded;
– 𝑃𝑋 is the price of good X;
– 𝑃𝑌 is the price of a related good Y;
– 𝑀 is income;
– 𝐻 is the value of any other variable affecting demand.

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 Understanding the Linear Demand Function

The signs and magnitude of the 𝛼 coefficients determine the impact of

each variable on the number of units of X demanded.
𝑑
𝑄𝑋 = 𝛼0 + 𝛼𝑋 𝑃𝑋 + 𝛼𝑌 𝑃𝑌 + 𝛼𝑀 𝑀
For example:
– 𝛼𝑋 < 0 by the law of demand;
– 𝛼𝑌 > 0 if good Y is a substitute for good X;
– 𝛼𝑀 < 0 if good X is an inferior good.

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 The Linear Demand Function in Action
Suppose that an economic consultant for X Corp. recently provided the firm’s marketing
manager with this estimate of the demand function for the firm’s product:
𝑄𝑋 𝑑 = 12,000 − 3𝑃𝑋 + 4𝑃𝑌 − 1𝑀 + 2𝐴𝑋

Question: How many of good X will consumers purchase when 𝑃𝑋 = $200 per unit, 𝑃𝑌 =
$15 per unit, 𝑀 = $10,000 and 𝐴𝑋 = 2,000? Are goods X and Y substitutes or
complements? Is good X a normal or an inferior good?

Answer:
𝑄𝑋 𝑑 = 12,000 − 3 200 + 4 15 − 1 10,000 + 2 2,000 = 5,460 units. Goods X and
Y are substitutes. Good X is an inferior good.

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 Inverse Demand Function

By setting 𝑃𝑌 = $15 and 𝑀 = $10,000 and 𝐴 = 2,000 the demand function is

𝑄𝑋 𝑑 = 12,000 − 3𝑃𝑋 + 4 15 − 1 10,000 + 2 2,000
the linear demand function simplifies to
𝑄𝑋 𝑑 = 6,060 − 3𝑃𝑋
Solving this for 𝑃𝑋 in terms of 𝑄𝑋 𝑑 results in
1 𝑑
𝑃𝑋 = 2,020 − 𝑄𝑋
3
which is called the inverse demand function. This function is used to
construct a market demand curve.

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Graphing the Inverse Demand Function in Action (Figure 2-4)
Price

$2,020

1
𝑃𝑋 = 2,020 − 𝑄𝑋 𝑑
3

0 6,060 Quantity

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 Consumer Surplus

Marketing strategies – like value pricing and price discrimination – rely on

understanding consumer value for products.
– Total consumer value is the sum of the maximum amount a consumer is willing to
pay at different quantities.
– Total expenditure is the per-unit market price times the number of units
consumed.
– Consumer surplus is the extra value that consumers derive from a good but do
not pay extra for.

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Market Demand and Consumer Surplus in Action (Figure 2-5)

Consumer Surplus
Price per
liter
Consumer Surplus:
0.5($5 - $3)x(2-0) = $2
$5
Total Consumer Value:
0.5($5 - $3)x2+(3-0)(2-0) = $8
$4

$3 Expenditures:
$(3-0) x (2-0) = $6
$2

$1 Demand

0 1 2 3 4 5 Quantity
in liters

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 Supply

Market supply curve

– A curve indicating the total quantity of a good that all producers in a competitive
market would produce at each price, holding input prices, technology, and other
variables affecting supply constant.

Law of supply
– As the price of a good rises (falls), the quantity supplied of the good rises (falls),
holding other factors affecting supply constant.

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 Changes in Quantity Supplied
versus Changes in Supply
Changing only price leads to changes in quantity supplied.
– This type of change is graphically represented by a movement along a given
supply curve, holding other factors that impact supply constant.
Changing factors other than price leads to changes in supply.
– These types of changes are graphically represented by a shift of the entire supply
curve.

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 Changes in Supply (Figure 2-6)
Price
S1 S0

B S2
Decrease
in supply

Increase
in supply
A

0 Quantity

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 Supply Shifters

1. Input prices
2. Technology or government regulation
3. Number of firms
• Entry
• Exit
4. Substitutes in production
5. Taxes
• Excise tax: a tax on each unit of output sold, where tax revenue is collected from the
supplier
• Ad valorem tax: percentage tax
6. Producer expectations

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 A Per Unit (Excise) Tax (Figure 2-7)

Price
of S0+t
gasoline
$1.20 S0
t = 20¢
t

$1.00 t = per unit tax of 20¢

0 Quantity of
gasoline per
week
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 An Ad Valorem Tax (Figure 2-8)
Price Ad valorem tax
of
backpacks S1 = 1.20 x S0
$24

S0

$20
$12

$10

0 1,100 2,450 Quantity of

backpacks per
week
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 The Supply Function

The supply function for good X is a mathematical representation

describing how many units will be produced at alternative prices for X,
alternative input prices W, and alternative values of other variables that
affect the supply for good X.

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 The Linear Supply Function

One simple, but useful, representation of a supply function is the linear

supply function:

𝑄𝑋 𝑠 = 𝛽0 + 𝛽𝑋 𝑃𝑋 + 𝛽𝑊 𝑊 + 𝛽𝑟 𝑃𝑟 + 𝛽𝐻 𝐻

– 𝑄𝑋 𝑠 is the number of units of good X produced;

– 𝑃𝑋 is the price of good X;
– 𝑊 is the price of an input;
– 𝑃𝑟 is price of technologically related goods;
– 𝐻 is the value of any other variable affecting supply.

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 Understanding the Linear Supply Function

The signs and magnitude of the 𝛽 coefficients determine the impact of

each variable on the number of units of X produced.
𝑄𝑋 𝑠 = 𝛽0 + 𝛽𝑋 𝑃𝑋 + 𝛽𝑊 𝑊 + 𝛽𝑟 𝑃𝑟
For example:
– 𝛽𝑋 > 0 by the law of supply.
– 𝛽𝑊 < 0 increasing input price.
– 𝛽𝑟 > 0 technology lowers the cost of producing good X.

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 The Linear Supply Function in Action

Your research department estimates that the supply function for high
definition televisions (HDTVs)is given by:
𝑄𝑋 𝑠 = 2,000 + 3𝑃𝑋 − 4𝑃𝑡 − 1𝑃𝑊

Question: How many televisions are produced when 𝑃𝑋 = $400, 𝑃𝑡 =

$250 per unit, and 𝑃𝑊 = $1,400?

Answer:
𝑄𝑋 𝑠 = 2,000 + 3 400 − 4(250) − 1 1,400 = 800 HDTVs.

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 Inverse Supply Function

By setting 𝑃𝑊 = $2,000 and 𝑃𝑡 = $250 in

𝑄𝑋 𝑠 = 2,000 + 3𝑃𝑋 − 4 250 − 1 1,400
the linear supply function simplifies to
𝑄𝑋 𝑠 = 3𝑃𝑋 − 400
Solving this for 𝑃𝑋 in terms of 𝑄𝑋 𝑠 results in
400 1 𝑠
𝑃𝑋 = + 𝑄𝑋
3 3
which is called the inverse supply function. This function is used to
construct a market supply curve.

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 Producer Surplus

Producer surplus: the amount producers receive in excess of the amount

necessary to induce them to produce the good.

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Producer Surplus in Action (Figure 2-9)

Price 400 1 𝑆
𝑃𝑋 = + 𝑄𝑋 Supply
3 3
$400
Producer surplus

$400
3
0 800 Quantity

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 Market Equilibrium

Competitive Market Equilibrium

– Determined by the intersection of the market demand and market supply curves.
– A price and quantity such that there is no shortage or surplus in the market.
– Forces that drive market demand and market supply are balanced, and there is no
pressure on prices or quantities to change.
– The equilibrium price is the price that equates quantity demanded with quantity
supplied

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 Market Equilibrium (Figure 2-10)

Price Supply
Surplus

𝑃𝐻

𝑃𝑒

𝑃𝐿

Shortage
Demand

0 𝑄0 𝑄𝑒 𝑄1 280 Quantity

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 Market Equilibrium in Action

Consider a market with demand and supply functions, respectively, as

𝑄 𝑑 = 10 − 2𝑃 and 𝑄 𝑠 = 2 + 2𝑃

A competitive market equilibrium exists at a price, 𝑃𝑒 , such that 𝑄𝑑 𝑃𝑒 = 𝑄 𝑠 𝑃𝑒 .

That is,
10 − 2𝑃 = 2 + 2𝑃
8 = 4𝑃
𝑃𝑒 = $2

𝑄𝑒 = 10 − 2 $2 = 6 and 𝑄𝑒 = 2 + 2($2) =6
𝑄𝑒 = 6 units

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 Price Restrictions and Market Equilibrium

In a competitive market equilibrium, price and quantity freely adjust to

the forces of demand and supply.

At times, government restricts how much prices are permitted to rise or

fall.
– Price ceiling- the maximum legal price that can be charged in a market.
– Price floor- the minimum legal price that can be charged in a market.

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 A Price Ceiling (Figure 2-11)

Price Supply

Lost social welfare

Nonpecuniary price

𝑃𝐹

𝑃𝑒

𝑃𝑐 Priceceiling

Shortage
Demand

0 𝑄𝑠 𝑄𝑒 𝑄𝑑 280 Quantity

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 Price Ceiling in Action

Consider a market with demand and supply functions, respectively, as

𝑄 𝑑 = 10 − 2𝑃 and 𝑄 𝑠 = 2 + 2𝑃
Suppose a $1.50 price ceiling is imposed on the market.
– 𝑄𝑑 = 10 − 2 $1.50 = 7 units.
– 𝑄 𝑠 = 2 + 2($1.50) = 5 units.
– Since 𝑄𝑑 > 𝑄 𝑠 a shortage of 7 − 5 = 2 units exists.
– Full economic price of 5𝑡ℎ unit is 5 = 10 − 2𝑃𝑓𝑢𝑙𝑙 , or 𝑃𝑓𝑢𝑙𝑙 = $2.50. Of this,
• $1.50 is the dollar price
• $1 is the nonpecuniary price

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 A Price Floor (Figure 2-12)

Price Supply

Surplus
𝑃𝑓 Pricefloor

𝑃𝑒 Cost of
purchasing
excess supply

Demand

0 𝑄𝑑 𝑄𝑒 𝑄𝑠 280 Quantity

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 Price Floor in Action

Consider a market with demand and supply functions, respectively, as

𝑄 𝑑 = 10 − 2𝑃 and 𝑄 𝑠 = 2 + 2𝑃
Suppose a $3.50 price floor is imposed on the market.
– 𝑄𝑑 = 10 − 2 $3.50 = 3 units
– 𝑄 𝑠 = 2 + 2($3.50) = 9 units
– Since 𝑄 𝑠 > 𝑄𝑑 a surplus of 9 − 3 = 6 units exists
– The cost to the government of purchasing the surplus is $3.50 × 6 = $21.

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 Comparative Statics

Comparative static analysis

– The study of the movement from one equilibrium to another.

Competitive markets, operating free of price restraints, will be analyzed

when:
– Demand changes
– Supply changes
– Demand and supply simultaneously change

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 Changes in Demand

Increase in demand only

– Increase equilibrium price
– Increase equilibrium quantity
Decrease in demand only
– Decrease equilibrium price
– Decrease equilibrium quantity
Example of change in demand
– Suppose that consumer incomes are projected to increase 2.5% and the number
of individuals over 25 years of age will reach an all time high by the end of next
year. What is the impact on the rental car market?

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Effect of a Change in Demand for Rental Cars (Figure 2-13)

Price Supply

$49

$45
Demand1

Demand0

0 100 104 108 Quantity

(thousands
rented per day)

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 Changes in Supply

Increase in supply only

– Decrease equilibrium price
– Increase equilibrium quantity
Decrease in supply only
– Increase equilibrium price
– Decrease equilibrium quantity
Example of change in supply
– Suppose that a bill before Congress would require all employers to provide health
care to their workers. What is the impact on retail markets?

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Effect of a Change in Supply (Figure 2-14)

Price Supply1

Supply0
𝑃1

𝑃0

Demand

0 𝑄1 𝑄0 Quantity

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 Simultaneous Shifts in Supply and Demand

Suppose that simultaneously the following events occur:

– An earthquake hits Kobe, Japan and decreased the supply of fermented rice used
to make sake wine.
– The stress caused by the earthquake led many to increase their demand for sake,
and other alcoholic beverages.

What is the combined impact on Japan’s sake market?

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 Simultaneous Shifts in Supply and Demand in Action
(Figure 2-15)

Japan’s Sake Market

Price
Supply2
C
𝑃2
Supply1

B Supply0
𝑃1

A
𝑃0
Demand1
Demand0

0 𝑄2 𝑄0 𝑄1 Quantity

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