Chapter 2
Demand, Supply, and Market
Equilibrium
McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objectives
❖ Identify demand functions and distinguish between a
change in demand and a change in quantity demanded
❖ Identify supply functions and distinguish between a
change in supply and a change in quantity supplied
❖ Explain why market equilibrium occurs at the price for
which quantity demanded equals quantity supplied
❖ Measure gains from market exchange using consumer
surplus, producer surplus, and social surplus
❖ Predict the impact on equilibrium price and quantity of
shifts in demand or supply
❖ Examine the impact of government imposed price
ceilings and price floors 2-2
Demand
❖ Quantity demanded (Qd)
~ Amount of a good or service consumers are
willing & able to purchase during a given
period of time
2-3
General Demand Function
❖ Six variables that influence Qd
~ Price of good or service (P)
~ Incomes of consumers (M)
~ Prices of related goods & services (PR)
~ Taste patterns of consumers (T)
~ Expected future price of product (Pe)
~ Number of consumers in market (N)
❖ General demand function
Qd = f(P, M, PR, T, Pe , N)
2-4
General Demand Function
Qd = a + bP + cM + dPR + eT + fPe + gN
❖ b, c, d, e, f, & g are slope parameters
~ Measure effect on Qd of changing one of
the variables while holding the others
constant
❖ Sign of parameter shows how variable
is related to Qd
~ Positive sign indicates direct relationship
~ Negative sign indicates inverse relationship
2-5
General Demand Function
❖ Normal good
~ A good or service for which an increase
(decrease) in income causes consumers to
demand more (less) of the good, holding all
other variables in the general demand function
constant
❖ Inferior good
~ A good or service for which an increase
(decrease) in income causes consumers to
demand less (more) of the good, all other
factors held constant 2-6
General Demand Function
❖ Substitutes
~ Two goods are substitutes if an increase
(decrease) in the price of one good causes
consumers to demand more (less) of the other
good, holding all other factors constant
❖ Complements
~ Two goods are complements if an increase
(decrease) in the price of one good causes
consumers to demand less (more) of the other
good, all other things held constant
2-7
General Demand Function
Variable Relation to Qd Sign of Slope Parameter
P Inverse b = Qd/ P is negative
Direct for normal goods c = Qd/ M is positive
M
Inverse for inferior goods c = Qd/ M is negative
PR Direct for substitutes d = Qd/ PR is positive
Inverse for complements d = Qd/ PR is negative
T Direct e = Qd/ T is positive
Pe Direct f = Qd/ Pe is positive
N Direct g = Qd/ N is positive
2-8
Direct Demand Function
❖ The direct demand function, or simply
demand, shows how quantity demanded,
Qd , is related to product price, P, when all
other variables are held constant
~ Qd = f(P)
❖ Law of Demand
~ Qd increases when P falls, all else constant
~ Qd decreases when P rises, all else constant
~ Qd/ P must be negative
2-9
Inverse Demand Function
❖ Traditionally, price (P) is plotted on the
vertical axis & quantity demanded (Qd) is
plotted on the horizontal axis
~ The equation plotted is the inverse demand
function, P = f(Qd)
2-10
Graphing Demand Curves
❖ A point on a direct demand curve shows
either:
~ Maximum amount of a good that will be
purchased for a given price
~ Maximum price consumers will pay for a
specific amount of the good (demand price)
2-11
A Demand Curve (Figure 2.1)
Qd = 1,400 – 10P
2-12
Graphing Demand Curves
❖ Change in quantity demanded
~ Occurs when price changes
~ Movement along demand curve
❖ Change in demand
~ Occurs when one of the other variables, or
determinants of demand, changes
~ Demand curve shifts rightward or leftward
2-13
Shifts in Demand (Figure 2.2)
2-14
Supply
❖ Quantity supplied (Qs)
~ Amount of a good or service offered for
sale during a given period of time
2-15
Supply
❖ Six variables that influence Qs
~ Price of good or service (P)
~ Input prices (PI )
~ Prices of goods related in production (Pr)
~ Technological advances (T)
~ Expected future price of product (Pe)
~ Number of firms producing product (F)
❖ General supply function
Qs = f(P, PI, Pr, T, Pe, F)
2-16
General Supply Function
Qs = h + kP + lPI + mPr + nT + rPe + sF
❖ k, l, m, n, r, & s are slope parameters
~ Measure effect on Qs of changing one of the
variables while holding the others constant
❖ Sign of parameter shows how variable is
related to Qs
~ Positive sign indicates direct relationship
~ Negative sign indicates inverse relationship
2-17
General Supply Function
❖ Substitutes in production
~ Goods for which an increase in the price of one
good relative to the price of another good
causes producers to increase production of the
now higher-priced good and decrease
production of the other good
❖ Complements in production
~ Goods for which an increase in the price of one
good, relative to the price of another good,
causes producers to increase production of
both goods 2-18
General Supply Function
Variable Relation to Qs Sign of Slope Parameter
P Direct k = Qs/ P is positive
PI Inverse l = Qs/ PI is negative
Inverse for substitutes m = Qs/ Pr is negative
Pr m = Qs/ Pr is positive
Direct for complements
T Direct n = Qs/ T is positive
Pe Inverse r = Qs/ Pe is negative
F Direct s = Qs/ F is positive
2-19
Direct Supply Function
❖ The direct supply function, or simply
supply, shows how quantity supplied, Qs ,
is related to product price, P, when all
other variables are held constant
~ Qs = f(P)
2-20
Inverse Supply Function
❖ Traditionally, price (P) is plotted on the
vertical axis & quantity supplied (Qs) is
plotted on the horizontal axis
~ The equation plotted is the inverse supply
function, P = f(Qs)
2-21
Graphing Supply Curves
❖ A point on a direct supply curve shows
either:
~ Maximum amount of a good that will be
offered for sale at a given price
~ Minimum price necessary to induce producers
to voluntarily offer a given quantity for sale
(supply price)
2-22
A Supply Curve (Figure 2.3)
Qs = -400 + 20P
2-23
Graphing Supply Curves
❖ Change in quantity supplied
~ Occurs when price changes
~ Movement along supply curve
❖ Change in supply
~ Occurs when one of the other variables, or
determinants of supply, changes
~ Supply curve shifts rightward or leftward
2-24
Shifts in Supply (Figure 2.4)
2-25
Market Equilibrium
❖ Equilibrium price & quantity are
determined by the intersection of
demand & supply curves
~ At the point of intersection, Qd = Qs
~ Consumers can purchase all they want &
producers can sell all they want at the
“market-clearing” or “equilibrium” price
2-26
Market Equilibrium (Figure 2.5)
2-27
Market Equilibrium
❖ Excess supply (surplus)
~ Exists when quantity supplied exceeds
quantity demanded
❖ Excess demand (shortage)
~ Exists when quantity demanded exceeds
quantity supplied
2-28
Value of Market Exchange
❖ Typically, consumers value the goods
they purchase by an amount that
exceeds the purchase price of the
goods
❖ Economic value
~ Maximum amount any buyer in the market
is willing to pay for the unit, which is
measured by the demand price for the unit
of the good
2-29
Measuring the Value of
Market Exchange
❖ Consumer surplus
~ Difference between the economic value of a
good (its demand price) & the market price the
consumer must pay
❖ Producer surplus
~ For each unit supplied, difference between
market price & the minimum price producers
would accept to supply the unit (its supply
price)
❖ Social surplus
~ Sum of consumer & producer surplus
~ Area below demand & above supply over the
relevant range of output 2-30
Measuring the Value of
Market Exchange (Figure 2.6)
2-31
Changes in Market Equilibrium
❖ Qualitative forecast
~ Predicts only the direction in which an
economic variable will move
❖ Quantitative forecast
~ Predicts both the direction and the
magnitude of the change in an economic
variable
2-32
Demand Shifts (Supply Constant)
(Figure 2.7)
2-33
Supply Shifts (Demand Constant)
(Figure 2.8)
2-34
Simultaneous Shifts
❖ When demand & supply shift
simultaneously
~ Can predict either the direction in which
price changes or the direction in which
quantity changes, but not both
~ The change in equilibrium price or quantity
is said to be indeterminate when the
direction of change depends on the relative
magnitudes by which demand & supply
shift
2-35
Simultaneous Shifts: (D, S)
P
S
S′
S′′
B
P′ A •
P •
P′′ • C
D′
Q
Q Q′ Q′′
Price may rise or fall; Quantity rises
2-36
Simultaneous Shifts: (D, S)
P
S
S′
S′
A
P •
B
P′ •
P′′ • C
D
D′
Q
Q′ Q Q′′
Price falls; Quantity may rise or fall
2-37
Simultaneous Shifts: (D, S)
P
S′′
S′
S
P′′ • C
B
P′ •
A
P •
D′
Q
Q′′ Q Q′
Price rises; Quantity may rise or fall
2-38
Simultaneous Shifts: (D, S)
P
S′′
S′
S
P′′ • C A
P •
P′ • B
D
D′
Q
Q′′ Q′ Q
Price may rise or fall; Quantity falls
2-39
Ceiling & Floor Prices
❖ Ceiling price
~ Maximum price government permits sellers
to charge for a good
~ When ceiling price is below equilibrium, a
shortage occurs
❖ Floor price
~ Minimum price government permits sellers
to charge for a good
~ When floor price is above equilibrium, a
surplus occurs
2-40
Ceiling & Floor Prices (Figure 2.12)
Px Px
Price (dollars)
Sx Sx
3
2 2
1
Dx Dx
Qx Qx
22 50 62 32 50 84
Quantity Quantity
Panel A – Ceiling price Panel B – Floor price
2-41
Summary
❖ 6 variables influence demand: good’s price, income,
prices of related goods, consumers’ tastes, expected
future price, and number of consumers
~ Law of demand states that quantity demanded increases
(decreases) when price falls (rises), all else constant
❖ 6 variables influence supply: good’s price, input
prices, prices of goods related in production,
producers’ expectation of future price, number of firms
❖ Equilibrium price and quantity determined by
intersection of supply and demand curves
❖ Consumer surplus arises because the equilibrium
price consumers pay is less than the value they place
on the units they purchase.
2-42
Summary
❖ Consumer surplus arises because the equilibrium
price consumers pay is less than the value they place
on units they purchase
~ Producer surplus arises because equilibrium price is greater
than the minimum price producers would be willing to accept
to produce.
~ Social surplus: sum of consumer surplus and producer surplus
❖ When both supply and demand shift simultaneously,
one can predict either the direction of change in price
or the direction of change in quantity, but not both
❖ A ceiling price (below equilibrium) results in a
shortage; a floor price (above equilibrium) results in a
surplus 2-43
