CHAPTER 2

Supply, Demand and Equilibrium

 THE ROLE OF PRICE IN THE
MARKET
 Price is in essence the means of communication
in the market. By offering higher prices buyers
signal their desire to buy more of a good or a
resource to sellers. Sellers, on the other hand,
communicate the information about the cost of a
good or a resource to buyers through price.
 If too much of a good is produced => Price
 If not enough of a good is produced => Price
 SUPPLY

A General Definition:
Supply is the quantity of a good or resource
that sellers (or suppliers) are willing and able
to offer to the market for sale under a given
set of conditions over a specific period of time.
 DETERMINANTS OF SUPPLY

 Factors affecting supply of a good include

price, prices of inputs, technology, prices of
related goods, taxes, expectations, number
of firms, etc.
 SUPPLY AND PRICE:

A Narrower (More Specific) Definition

Supply (or a supply curve) is a schedule or
curve showing the quantities of a product a
firm (or firms) is (are) willing and able to
produce and offer to the market for sale at a
range of possible prices, ceteris paribus, over
a certain period of time.
 SUPPLY CURVE
The supply curve is a line or a curve showing the
relationship between price and quantity supplied;
it is a curve plotted in a two-dimensional space
with price measured along the vertical axis and the
quantity supplied measured along the horizontal
axis.
A supply curve shows the relationship between
price and quantity supplied only; all (other)
factors affecting supply are assumed to remain
unchanged along a supply curve.
 LAW OF SUPPLY

Other things remaining constant, as the

price of a good rises, the corresponding
quantity supplied increases, and as the price
falls the quantity supplied decreases; the
relationship between price and the quantity
supplied is positive.
SUPPLY
CURVE FOR
MILK
 THE REASONS BEHIND
THE LAW OF SUPPLY

 As more and more of a good is produced,

beyond some production level, the costs of
producing additional units begin to rise. In
order for a firm to produce more of that
good it has to charge (or be offered) higher
prices.
 INDIVIDUAL SUPPLY AND
MARKET SUPPLY
An individual supply curve reflects the
quantities of a good a producer (a firm) is
willing and able to produce and offer for sale
at a range of possible prices, ceteris paribus,
during a given period of time. A market
supply (curve) is the (horizontal) sum of
individual supply curves.
 SUPPLY AND QUANTITY SUPPLIED
A change in price (ceteris paribus) results in a change in
quantity supplied ( a movement along the curve), not a
change in supply.
A change in supply (or the supply curve) is caused by
changes in factors other than price. Such changes cause
shifts of the supply curve.
Changes in resource prices, technology, prices of related
goods (substitutes or accompanying products),
expectations, number of firms, etc. will result in changes
in (market) supply or shifts of the supply curve.
SHIFTS
BETWEEN
SUPPLY
CURVES
 DEMAND

Demand is the quantity of a good or

resource that buyers (or demanders) are
willing and able to buy under a given set of
conditions over a given period of time.
 DEMAND AND PRICE
Demand and Price, Ceteris Paribus:
A Narrower (More Specific) Definition
Demand is a schedule or a curve showing the
various amounts of a good or a service
consumers (buyers) are willing and able to
buy at various prices, ceteris paribus, over a
specified period of time
 DETERMINANTS OF DEMAND
1. Prices of related 5. Wealth
commodities 6. Expectations
2. Income of the regarding the
individual future
3. Tastes and 7. Climate and
preferences weather
4. Tastes of the 8. State of business
consumers
DEMAND
SCHEDULE
FOR MILK
 LAW OF DEMAND

Other things unchanged, as price rises, the

quantity demanded decreases, and as price
falls, the quantity demanded increases; the
relationship between price and the quantity
demanded is negative.
 The demand curve is a line or a
curve showing the relationship
between price and quantity
demanded; it is a curve plotted in a
two-dimensional space with price
measured along the vertical axis and
THE the quantity demanded measured
DEMAND along the horizontal axis.
CURVE A demand curve shows the
A graphical
relationship between price and
representation of quantity demanded only; all (other)
the demand factors affecting demand are
schedule assumed to remain unchanged along
a demand curve.
DEMAND
CURVE FOR
MILK
 THE REASONS BEHIND
THE LAW OF DEMAND

The price a consumer pays for a good is, in

fact, the opportunity cost of having it
The principle of diminishing marginal
utility
Income and substitution effects
 INDIVIDUAL DEMAND AND
MARKET DEMAND

An individual demand curve reflects the

quantities of a good a consumer is willing
and able to purchase at a range of possible
prices, ceteris paribus, during a given period
of time. A market demand (curve) is the
(horizontal) sum of individual demands.
 DEMAND (CURVE) VERSUS
QUANTITY DEMANDED

By “demand”or “demand curve” we mean a

range of quantities corresponding to various
prices reflected along a line or a curve. By
“quantity demanded” we mean a specific
quantity demanded corresponding to a
specific price.
 CHANGES IN DEMAND VERSUS
CHANGES IN QUANTITY DEMANDED
A change in price, ceteris paribus, results in a
change in quantity demanded; that is a
movement along the curve not a change in
demand.
A change in demand (curve) results from
changes in factors other than price. Such
changes cause shifts of the demand curve.
 FACTORS CAUSING CHANGES
(SHIFTS) IN DEMAND (CURVE)
Changes in income
Taste
Prices of related goods (substitutes or
complementary goods)
Expectations about future prices,
Number of buyers
Other non-self-price factors
MOVEMENT
ALONG A
DEMAND
CURVE VS.
SHIFT
BETWEEN
DEMAND
CURVES
 MARKET EQUILIBRIUM
Market equilibrium is a condition under
which the quantity supplied is equal to the
quantity demanded; when a market is in
equilibrium, there is no tendency for change.
The equilibrium price is the price at which
the quantity demanded is equal to the
quantity supplied.
 MARKET EQUILIBRIUM

Shortages occur when price is below the

equilibrium price; shortages cause the price
to rise.
Surpluses occur when price is above the
equilibrium price; surpluses cause the price
to fall.
DETERMINATION OF THE EQUILIBRIUM
PRICE AND QUANTITY OF MILK
Price Quantity Quantity Surplus or Price
per Quart Demanded Supplied Shortage? Direction

$1.50 45 90 Surplus Fall

1.40 50 80 Surplus Fall
1.30 55 70 Surplus Fall
1.20 60 60 Neither Unchanged
1.10 65 50 Shortage Rise
1.00 70 40 Shortage Rise
0.90 75 30 Shortage Rise

NOTE: Quantity is in billions of quarts per year.

Copyright  2000 by Harcourt, Inc. All rights reserved.
SUPPLY-DEMAND
EQUILIBRIUM
 CHANGES IN THE
MARKET EQUILIBRIUM

Changes (shifts) in the market supply

and/or the market demand result in changes
in the market equilibrium.
 PRICE ELASTICITY OF DEMAND
Price Elasticity of Demand
 degree of responsiveness of quantity demanded of a commodity
due to change in price, other things remaining the same.

"Elasticity of demand may be defined as the percentage change in

quantity demanded to the percentage change in price.“
- Alfred Marshall
"Elasticity of demand measures the responsiveness of demand to
changes in price.“
Kenneth Boulding
 PRICE ELASTICITY OF DEMAND
FORMULA

Price Elasticity of Demand

(PED) = Percentage Change in Quantity Demanded
Percentage Change in Price
or
= End Qd- Beginning Qd
Average Qd
End P- Beginning P
Average Qd
DETERMINANTS OF PRICE ELASTICITY
OF DEMAND
1. Availability of 5. Duration
substitute goods
2. Breadth of definition 6. Brand loyalty
of a good
3. Percentage of income 7. Who pays

4. Necessity
 FIVE TYPES OF
PRICE ELASTICITY OF DEMAND
1. Perfectly Elastic Demand 2. Perfectly Inelastic Demand

PED= ∞ PED= 0
 FIVE TYPES OF
PRICE ELASTICITY OF DEMAND
3. Relatively Elastic Demand 4. Relatively Inelastic Demand

PED > 1 PED < 1

5.Unitary Elastic
Demand
PED = 1
 PRICE ELASTICITY OF SUPPLY
• defined as the responsiveness of quantity supplied when the price of
the good changes. It is the ratio of the percentage change in quantity
supplied to the percentage change in price.
• always positive because the Law of Supply says that quantity
supplied increases with an increase in price. This means:
–If the supply is elastic, producers can increase output without a
rise in cost or a time delay
–If the supply is inelastic, firms find it hard to change production in
a given time period.
 PRICE ELASTICITY OF
SUPPLY FORMULA
Price Elasticity of Supply (PES) = Percentage
Change in Quantity Supply divided by the
Percentage Change in Price
 FIVE DETERMINANTS OF
PRICE ELASTICITY OF SUPPLY

1. Marginal Cost
2. Time
3. Number of Firms
4. The Mobility of Factors of Production
5. Capacity
 FIVE TYPES OF PRICE
ELASTICITY OF SUPPLY
1. Perfectly Inelastic Supply 2. Relatively Inelastic Supply
 FIVE TYPES OF
PRICE ELASTICITY OF SUPPLY
3. Unit Elastic Supply 4. Relatively Elastic Supply
FIVE TYPES
OF PRICE
ELASTICITY
SUPPLY
5. Perfectly Elastic
Supply