Chapter 2

Introducing

Supply and Demand

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

2-2

A Tale of a Desert…

When water is free of charge:• Miners consume lots of water. • Government is the only supplier of water.

When price of water is high:• Miners conserve and use less water.• Private sellers find new ways to sell more

water.

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Learning Objectives

• What is demand?

• What is law of demand?

• What factors change demand?

• What is supply?

• What is law of supply?

• What factors change supply?

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Demand

Demand

= How much consumers buy at various prices

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Quantity Demanded vs. Demand

• Quantity demanded

= The number of units consumers purchase at a specific price over a specific time period.

• Demand

= The entire relationship between price and quantity demanded over a specific time period.

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Price Quantity

Demanded

$.05 30,000

$.10 24,000

$.15 18,000

$.20 12,000

$.25 6,000

Demand for Apples

$P

.30

.25

.20

.15

.10

.05

.000 10 20 30 40

Quantity of Apples in thousand

D

Demand curve

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Law of Demand

• Consumers buy less of a good as its price increases and more of a good as its price decreases.

• As price increases, quantity demanded falls and as price decreases, quantity demanded rises.

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$P

.30

.25

.20

.15

.10

.05

.000 10 20 30 40

Quantity of Apples in thousand

D

Demand Curve

• Demand Curve

= A graph that shows demand relationship.

• Negative relationship between price and quantity demanded.

• Slope of demand curve is negative.

• Downward sloping demand curve.

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Market Demand

Market demand = the sum total of individual quantities demanded at each price.

Price Bill’s demand

Jane’s demand

Sophia’s demand

Market demand

$.05 20 10 5 35

$.10 16 8 4 28

$.15 12 4 3 19

$.25 8 1 1 10

$.30 5 0 0 5

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$P

30

25

20

15

10

5

00 10 20 30 40 50

Quantity of caps in thousand

Change in Quantity Demanded vs. Change in Demand

Ceteris paribus:• Change in price

causes change in quantity demanded.

• Movement along the same demand curve.

Lose 80%

D1

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$P

30

25

20

15

10

5

00 10 20 30 40 50

Quantity of caps in thousand

Change in Quantity Demanded vs. Change in Demand

Ceteris paribus:• Change in something

other than price causes change in demand.

• Shift of the entire demand curve.

• Increase in demand, demand curve shifts to the right.

• Decrease in demand, demand curve shifts to the left.

Lose 80%

Win world series

D1

D2

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$P

.73

00 10,000 25,000

Quantity demanded of Pepsi

• Substitutes compete with each other to satisfy similar needs.

• Increase in price of Coke with no change in price of Pepsi.

• Increase in price of a good causes increase in demand for its substitute.

• What will happen if price of Coke falls to $0.30 with no change in price of Pepsi?

Coke =$.50

Coke =$1.00

D1

D2

Behind Demand Curve: Substitutes

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$P

Quantity demanded of ketchup

• Complements used together to satisfy wants.

• Increase in price of hamburgers with no change in price of ketchup.

• Increase in price of a good causes decrease in demand for its complement.

• What will happen if price of burgers falls with no change in price of ketchup?

High price of burgers

Low price of burgers

D2

D1

Behind Demand Curve: Complements

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$P

Quantity demanded of sports car

• Normal goods

= Goods consumers buy more with higher income.

• When income increases, there is increase in demand for normal goods.

• Demand curve shifts to the right

Higher incomeLow

income

D1

D2

Behind Demand Curve: Income

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$P

Quantity demanded of pleather

• Inferior goods

= Goods consumers buy less of with higher income.

• When income increases, there is decrease in demand for inferior goods.

• Demand curve shifts to the left

Higher income

Low income

D2

D1

Demand for Inferior Goods

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Behind Demand Curve: Expectations

• What would you do if you heard that you might get a much better deal in the near future for the product you are planning to buy now?

• Osborne effect• Expectations about better deal (lower price, better

quality…) in the near future cause decrease in current demand.

= Leftward shift in the demand curve

• What would happen to demand for a product when its price is expected to increase in the near future?

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Behind Demand Curve: Other Things

Tastes and Fashions

• Demand increases for products considered to be fashionable.

Advertising

• Induces consumers to buy more, increasing the demand.

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Do You Know?

• What is the Law of Demand?As price increases, quantity demanded falls and as price decreases, quantity demanded rises.

• When do you move along a demand curve and when do you move to an entirely new demand curve?A change in price = movement along the curve.A change in a factor other than price = shift of the curve.

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Do You Know?

• How does an increase in the price of a good’s substitute affect the demand for the original good?

= Increase in demand for the original good.

• How does an increase in income affect the demand for an inferior good?

= Decrease in demand for the inferior good.

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Supply

Supply

= The quantity firms produce at various prices.

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Quantity Supplied vs. Supply

• Quantity supplied

= The number of units producers want to produce at a specific price over a specific time period.

• Supply

= The entire relationship between price and quantity supplied over a specific time period.

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Supply in Competitive Markets

Competitive markets:• Markets in which individual buyers and sellers

cannot set prices.• Firms’ primary motive is profit.• The higher the price, the greater the profit from

production.

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Law of Supply

• Firms produce less of a good as its price falls and more of a good as its price increases.

• As price increases, quantity supplied rises and as price decreases, quantity supplied falls.

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$P

.50

.25

0 0 15,000 50,000

Quantity supplied of Apples

Supply CurveSupply Curve

= A graph that shows supply relationship.

• Positive relationship between price and quantity supplied.

• Slope of supply curve is positive.

• Upward sloping supply curve .

S

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Market Supply

Market supply = the sum total of individual firms’ supply at each price.

Price Firm A’s

Supply

Firm B’s

Supply

Firm C’s

Supply

Market Supply

$.05 0 0 0 0

$.10 0 5 0 5

$.15 1 8 0 9

$.25 3 10 5 18

$.30 5 20 30 55

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$P

.50

.25

0 Quantity supplied of Apples

Change in Quantity Supplied vs. Change in Supply

Ceteris paribus:• Change in price causes

change in quantity supplied.

• Movement along the same supply curve.

• Change in something other than price causes change in supply.

• Shift of the entire supply curve.

Excellent weather

S2

Fair weather

S1

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$P

Quantity supplied

Behind Supply Curves: Costs

Ceteris paribus:• Increase in cost of

production decreases profits.

• Decrease in supply.• Supply curve shifts to

the left.

Low cost

S1

High cost

S2

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Behind Supply Curves: Expectations

• If firms expect prices to increase in the near future, they withhold goods to get better prices.

• Higher expected prices, decrease the current supply.

• How would you change your supply if you expect lower price in near future?

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$P

Quantity supplied

Behind Supply Curves: Input Prices

• Inputs = resources firms use to make goods.

• With increase in input prices or wages, firms use less inputs or workers.

• Decrease in supply.

Wage

=$5.15

S1

Wage =$6.15

S2

2-30

$P

Quantity supplied of Apples

Behind Supply Curves: Innovations

• Innovations and improved technology reduce cost of production.

• Increase in supply.

After

innovation

S2

Before innovation

S1

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Behind Supply Curves: Joint Production

• Two or more goods are jointly produced if the process that produces one necessarily produces others.

When price of bacon increases:• Quantity supplied of bacon increases.• Supply of ham and pork chops

also increases.

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Do You Know?

• What is the Law of Supply?

As price increases, quantity supplied rises and as price decreases, quantity supplied falls.

• What is the difference between a change in supply vs. a change in quantity supplied?

A change in price = change in quantity supplied.

A change in a factor other than price = change in supply.

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Do You Know?

• How do costs affect supply?

Increase in cost of production = decrease in supply.

• How can innovation affect supply?

Innovations and advanced technology = increase in supply.

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Summary

• Increase in the price causes decrease in quantity demanded and increase in quantity supplied.

Increase in demand caused by:• Increase in price of substitutes.• Fall in price of complements.• Increase in income for normal goods.• Decrease in income for inferior goods.• Expectations of future price increase.

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SummaryIncrease in supply caused by:

• Decrease in production costs.• Decrease in input prices.• Expectations of lower price in near future.• Innovations.• Increase in price of jointly produced good.• Demand curve is downward sloping.• Supply curve is upward sloping.• Increase causes shift to the right, decrease

causes shift to the left.

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Coming Up

How do demand and supply

determine the price in the market?