1. Demand and Supply Analysis
CHAPTER 3
© 2003 South-Western/Thomson Learning

2. Demand
Demand indicates how much of a good consumers are both willing and able to buy at each possible price during a given time period, other things constant
Useful to think of demand as the planned rate of purchase per period at each possible price
Emphasis on individual being both willing and able to buy is critical to demand

3. Law of Demand
Says that quantity demanded varies inversely with price, other things constant
The higher the price, the smaller the quantity demanded
The lower the price, the larger the quantity demanded

4. Demand, Wants, and Needs
Consumer demand and wants are not the same thing
Wants ignore the importance of ability to buy as expressed by a person’s budget
Nor is demand the same as need
Need focuses on the willingness and again ignores the ability to purchase

5. Law of Demand What explains the law of demand?
Specifically, why is more demanded when the price is lower?
The explanation begins with unlimited wants confronting scarce resources
Many goods and services are capable of satisfying any particular want

6. Law of Demand
Clearly, some ways of satisfying your wants are more appealing than others
In a world without scarcity, everything would be free  person would always choose the most attractive alternative
However, scarcity is a reality  the degree of scarcity of one good relative to another helps determine each good’s relative price

7. Substitution Effect
Recall that the definition of demand includes the “other things constant” assumption
Among the “other things” are the prices of other goods
For example, when the price of pizza declines while other prices remain constant, pizza becomes relatively cheaper  consumers are more willing to purchase pizza when its relative price falls  they tend to substitute pizza for other goods

8. Substitution Effect Substitution Effect
When the price of a good falls, its relative price makes consumers more willing to purchase this good
Alternatively, when the price of a good increases, its relative price makes consumers less willing to purchase this good
Important to remember that it is the change in the relative price – the price of one good compared to the prices of other goods – that causes the substitution effect

9. Income Effect
Money income is simply the number of dollars received per period of time
Real income is person’s income measured in terms of the goods and services it can buy  purchasing power
When the price of a good decreases, a person’s real income increases  increased ability to buy a good  increase in quantity demanded
When the price of a good increases  real income declines  reduces the ability to buy a good  decline in quantity demanded

10. Exhibit 1: Demand Schedule & Demand Curve for Pizza
(a) Demand Schedule
Price per Quantity Demanded
Pizza per Week (millions)
a) $ b) c) d) e)
The price is for a 12 inch regular pizza and the time period is 1 week. The demand schedule lists possible prices, along with the quantity demanded at each price. The demand curve at the right shows each price / quantity combination listed in the demand schedule as a point on the demand curve.

11. Demand and Quantity Demanded
Demand for pizza is not a specific quantity, but rather the entire relation between price and quantity demanded, and is represented by the entire demand curve a
$15.00 t r a b u
12.00 q r e c p
9.00
An individual point on the demand curve shows the quantity demanded at a particular price e c i r
6.00 d P
For example, at a price of $12, the quantity demanded is 14 million pizzas per week e
3.00 D
The movement from say, b to c, is a change in quantity demanded and is shown as a movement along the demand curve and can only be caused by a change in price
Millions of pizzas per week

12. Individual Demand Market Demand
Individual demand refers to the demand of an individual consumer
Market demand is the sum of the individual demands of all consumers in the market
Important: Unless otherwise noted, we will be referring to market demand

13. Shifts of the Demand Curve
Demand curve focuses on the relationship between the price of a good and the quantity demanded when other factors that could affect demand remain unchanged
Money income of consumers
Prices of related goods
Consumer expectations
Number and composition of consumers in the market
Consumer tastes

14. Exhibit 2: Increase in the Market Demand
The original demand curve is given as D, and assumes a certain level of money income.
An increase in demand  rightward shift in the demand curve  consumers are willing and able to buy more at each price.
Price
$15
Suppose income now increases  some consumers will now be able to buy more pizza at each price  market demand increases from D to D'. b f 12 9
For example, at a price of $12, the amount of pizza demanded increases from 14 to 20 million per week as shown by the movement from b on demand curve D to point f on demand curve D'. 6 D' 3 D 32
Millions of pizzas per week
While not shown, a decrease in demand  leftward shift in the demand curve  means consumers are willing and able to buy less at each price.

15. Changes in Consumer Income
Goods can be classified into two broad categories depending on how the demand for the good responds to changes in money income
Normal goods: the demand increases when income increases and decreases when income decreases
Inferior goods: the demand decreases when income increases and increases when income decreases
As income increases, consumers tend to switch from consuming these goods to consuming normal goods

16. Changes in the Prices of Related Goods
The prices of other goods are another of the factors assumed constant along a given demand curve
Two general relationships
Two goods are substitutes if an increase in the price of one shifts the demand for the other rightward and, conversely, if a decrease in the price of one shifts the demand for the other good leftward
Two goods are complements if an increase in the price of one shifts the demand for the other leftward and a decrease in the price of one shifts the demand for the other rightward

17. Changes in Consumer Expectations
A change in consumer expectations with respect to future prices and future incomes is another of the factors which shifts demand
Changes in income expectations
If individuals expect income to increase in the future, current demand increases and vice versa
If individuals expect prices to increase in the future, current demand increases and decreases if future prices are expected to decrease

18. Number or Composition of Consumers
Because the market demand curve is the sum of the individual demand curves, a change in the number of consumers changes demand
Increase in the number of consumers  increase in market demand
Decrease in the number of consumers  decrease in market demand
Changes in the population that consumes pizza , for example, will change the demand for pizza

19. Changes in Consumer Tastes
Tastes are nothing more than a person’s likes and dislikes as a consumer
Difficult to say what determines tastes but clearly they are important
And whatever factors change taste will clearly change demand

20. Reminder
Important to remember the distinction between a movement along a given demand curve and a shift of the demand curve
A change in price, other things constant, causes a movement along a demand curve  changing quantity demanded
A change in one of the determinants of demand other than price causes a shift of a demand curve  changing demand

21. Supply
Supply indicates how much of a good producers are willing and able to offer for sale per period at each possible price, other things constant
Law of supply states that the quantity supplied is usually directly related to its price, other things constant
The lower the price, the smaller the quantity supplied
The higher the price, the greater the quantity supplied

22. Exhibit 3: Supply Schedule and Curve for Pizzas
Price per Quantity Supplied
Pizza per Week (millions) $
Price S
$15 12 9
Both the supply curve and the supply schedule show the quantities of pizza supplied per week at various prices by all the pizza makers in the market. 6 3
Price and quantity supplied are directly, or positively related. 12
Millions of pizzas per week
Producers offer more for sale at higher prices than at lower prices  the supply curve slopes upward.

23. Law of Supply
Two reasons producers tend to offer more for sale when the price rises
First, as the price increases, other things constant, a producer becomes more willing to supply the good
Prices act as signals to existing and potential suppliers about the rewards for producing various goods  higher prices attract resources from lower-valued uses

24. Law of Supply
Second, higher prices also increase the producer’s ability to supply the good
The law of increasing opportunity costs  the marginal cost of production increases as output increases
Since producers face a higher marginal cost of production, they must receive a higher price for that output in order to be able to increase the quantity supplied

25. Supply and Quantity Supplied
Supply refers to the relation between the price and quantity supplied as reflected by the supply schedule or the supply curve
Quantity supplied refers to a particular amount offered for sale at a particular price  particular point on a given supply curve

26. Individual Supply and Market Supply
Individual supply refers to the supply of an individual producer
Market supply is the sum of individual supplies of all producers in the market
Unless otherwise noted, we will be referring to market supply

27. Shifts of the Supply Curve
Assumed constant along a supply curve are the determinants of supply other than the price of the good
State of technology
Prices of relevant resources
Prices of alternative goods
Producer expectations
Number of producers in the market

28. Changes in Technology
If a more efficient technology is discovered, production costs fall  suppliers will be more willing and more able to supply the good  rightward shift of the supply curve
See Exhibit 4

29. Exhibit 4: An Increase in the Supply of Pizza
Suppose we begin with the initial supply curve as S. A new high-tech oven bakes pizza in half the time, and the impact of this is that the supply curve shifts from S to S'. S S'
$15.00 t r a g u
12.00 h q r e p
9.00 e c i r P
The result of the increase in supply is that more is supplied at each possible price. E.g., when the price is $12, the amount supplied increases from 24 million to 28 million pizzas, as shown by the movement from point g to point h.
6.00
3.00
Millions of pizzas per week

30. Changes in the Prices of Relevant Resources
Relevant resources are those employed in the production of the good in question
For example, if the price of mozzarella cheese falls, the cost of pizza production declines  supply increases  shifts to the right
Conversely, if the price of some relevant resource increases  supply decreases  shifts to the left

31. Prices of Alternative Goods
Nearly all resources have alternative uses
Alternative goods are those that use some of the same resources employed to produce the good under consideration
For example, as the price of bread increases, so does the opportunity cost of producing pizza  the supply of pizza declines
Conversely, a fall in the price of an alternative good makes pizza production more profitable  supply increases

32. Changes in Producer Expectations
Changes in producer expectations with respect to the future can change current supply
If pizza suppliers expect higher prices in the future, they may begin to expand today  current supply shifts rightward  increases
When a good can be easily stored, expecting future prices to be higher may reduce current supply
More generally, any change expected to affect future profitability could shift the supply curve

33. Changes in the Number of Producers
Since market supply sums the amounts supplied at each price by all producers, the market supply depends on the number of producers in the market
If that number increases, supply increases  shifts to the right
If the number of producers decreases, supply will decrease  shift to the left

34. Reminder
Remember the distinction between a movement along a supply curve and a shift of a supply curve
A change in price, other things constant, causes a movement along a supply curve, changing the quantity supplied
A change in one of the determinants of supply other than the price causes a shift of the supply curve  changing supply

35. Demand and Supply Create a Market
Demanders and suppliers have different views of price
Demanders pay the price
Suppliers receive it
Thus, a higher price is bad news for consumers but good news for producers
As the price rises, consumers reduce their quantity demanded along the demand curve and producers increase their quantity supplied along the supply curve

36. Markets
A market sorts out the conflicting price perspectives of individual participants – buyers and sellers
Market represents all the arrangements used to buy and sell a particular good or service
Markets reduce the transaction costs of exchange – the costs of time and information required for exchange
The coordination that occurs through markets occurs because of Adam Smith’s invisible hand

37. Exhibit 5b: The Market for Pizzas
Suppose the initial price is $12  producers supply 24 million pizzas per week as shown by the supply curve while consumers demand only 14 million  excess quantity supplied (or surplus) of 10 million pizzas per week S
Price
$15.00
Surplus
12.00
9.00 c
6.00
3.00 D 16 20 24
This surplus and suppliers’ desire to eliminate it put downward pressure on the price, as symbolized by the arrow pointing down in the graph
Millions of pizzas per week
As the price falls, producers reduce their quantity supplied and consumers increase their quantity demanded and the market moves towards equilibrium at point c

38. Exhibit 5b: The Market for Pizzas
Price
Alternatively, suppose the price is initially $6 per pizza. At this price consumers demand 26 million pizzas but producers supply only 16 million  an excess quantity demanded (or a shortage) of 10 million pizzas per week. S
$15.00
12.00 c
9.00
6.00
Shortage
3.00
Producers quickly notice that the quantity supplied has sold out and those customers still demanding pizzas are grumbling  pressures for higher prices as shown by the arrow D 16 20 26
Millions of pizzas per week
As prices increase, producers increase their quantity supplied and consumers reduce their quantity demanded until the equilibrium price of $9 at point c is reached

39. Summary
A surplus creates downward pressure on the price and a shortage creates upward pressure
So long as quantity supplied and quantity demanded differ, prices will tend to change
Note that a shortage or a surplus must always be defined at a particular price

40. Equilibrium
When the quantity that consumers are willing and able to pay equals the quantity that producers are willing and able to sell, the market reaches equilibrium  the independent plans of both buyers and sellers exactly match  market forces exert no pressure to change price or quantity
In our example, this occurs at point c  price = $9 per pizza and quantity is 20 million pizzas per week

41. Equilibrium
In one sense, the market is personal because each consumer and each producer makes a personal decision regarding how much to buy or sell at a given price
In another sense, the market is impersonal because it requires no conscious coordination among consumers or producers
Market forces synchronize the personal and independent decisions of many individual buyers and sellers

42. Changes in Equilibrium
Once a market reaches equilibrium, that price and quantity will prevail until one of the determinants of demand or supply changes
A change in any one of these determinants will usually change equilibrium price and quantity in a predictable way

43. Exhibit 6: Effects of an Increase in Demand
Price
The initial equilibrium price is given by D and S  $9 and 20 million pizzas per week. S D
Now suppose that one of the determinants of demand changes in a way that increases demand  demand shifts from D to D'.
$12 9
After demand increases to D', the amount demanded at the initial price of $9 is 30 million pizzas which exceeds the amount supplied of 20 million pizzas  shortage  upward pressure on price. D' 20 24 30
Millions of pizzas per week
As the price increases, the quantity demanded decreases along the new demand curve, D', and the quantity supplied increases along the existing supply curve S until the two quantities are again equal to each other at a price of $12 and a quantity of 24 million pizzas per week.

44. Shifts of the Demand Curve
Thus, given an upward-sloping demand curve, an increase in demand  a rightward shift of the demand curve increases both the equilibrium price and quantity
Alternatively, a decrease in demand  a leftward shift of the demand curve reduces both the equilibrium price and quantity

45. Exhibit 7: Effects of an Increase in Supply
Again, suppose that we begin with S and D as the initial supply and demand curves  the amount demanded at the initial price of $9.00 is 20 million pizzas. S S'
Price
Suppose supply now increases as shown by the shift from S to S'.
After supply increases, the amount supplied at the initial price of $9 increases from 20 to 30 million pizzas per week  a surplus  downward pressure on the price  the quantity supplied declines along the new supply curve and the quantity demanded increases along the existing demand curve until the new equilibrium is reached at $6 and the quantity is 26 million pizzas per week $9 6 D 20 26 30
Millions of Pizzas per Week

46. Shifts of the Supply Curve
An increase in supply  a rightward shift of the supply curve reduces the equilibrium price but increases equilibrium quantity
On the other hand, a decrease in supply  a leftward shift of the supply curve increases equilibrium price but decreases equilibrium quantity

47. Shifts of the Supply Curve
Given a downward-sloping demand curve, a rightward shift of the supply curve will decrease but increase quantity
A leftward shift will increase price but decrease quantity

48. Simultaneous Shifts in Demand and Supply
As long as only one curve shifts, we can say for sure what will happen to equilibrium price and quantity
If both curves shift, however, the outcome is less obvious
This possibility is shown in Exhibit 8

49. Exhibit 8: Indeterminate Effect of an
Increase in Both Supply and Demand
a) Shift in demand dominates
The initial supply and demand curves are shown as D and S  p and Q are the initial price and quantity. S S'
Suppose that supply and demand both increase  shift to the right. Further suppose that demand shifts more than supply as shown by D' and S'. p' p D'
In this instance, price and quantity both increase to p' and Q'. D Q Q'
Units per period
Conversely, if both demand and supply were to decrease – for example, from D‘ S‘ to D / S with the decline in demand dominating, the equilibrium quantity would decrease and price would decline.

50. Exhibit 8: Indeterminate Effect of an
Increase in Both Supply and Demand
b) Shift in supply dominates
Price S
Again, suppose both supply and demand increase but in this case, supply shifts by more than demand  price decreases from p to p"and quantity increases.
S" p
Alternatively, if both supply and demand decrease with the shift in supply dominating  price will increase and quantity will decrease.
p"
D" D Q
Q"
Units per period

51. Summary
If demand and supply shift in opposite directions, we can say what will happen to equilibrium price
It will increase if demand increases and supply decreases
It will decrease if demand decreases and supply increases
Without reference to the size of the shifts, we cannot say what will happen to equilibrium quantity
Exhibit 9 summarizes these results

52. Exhibit 9: Effects of Changes in Both
Supply and Demand
Change in Demand
Demand increases
Demand decreases
Equilibrium
Equilibrium
price change
price falls.
Supply
is indeterminate. y l
increases
Equilibrium p p
Equilibrium
quantity change u S
quantity increases.
is indeterminate. n i e g n
Equilibrium
Equilibrium price a h
price rises.
change is indeterminate. C
Supply
decreases
Equilibrium
Equilibrium
quantity change
quantity decreases.
is indeterminate.

53. Disequilibrium Prices
Markets do not always reach equilibrium quickly and during the time required for adjustment, the market is in disequilibrium
Disequilibrium is usually temporary as the market gropes for equilibrium
Sometimes, as a result of government intervention in markets, disequilibrium can last a long time

54. Exhibit 11a: Effects of a Price Floor
The federal government often regulates the prices of agricultural commodities in an attempt to ensure farmers a higher and more stable income than they would otherwise earn.
Price per gallon S
To achieve higher prices, the federal government sets a price floor  a minimum selling price that is above the equilibrium price
Surplus
$2.50
Suppose it places a $2.50 per gallon price floor for milk. At this price, farmers supply 24 million gallons per week, but consumers demand only 14 million gallons  a surplus of 10 million gallons
$1.90 D
This surplus milk will spoil if it sets on store shelves. As a result of this price support program, the government spends billions of dollars buying and storing surplus agricultural products.
Millions of gallons per month

55. Exhibit 11b: Effects of a Price Ceiling
Monthly rent
Sometimes public officials try to keep prices below the equilibrium levels by establishing a price ceiling, or a maximum selling price S
$1000
A common example is rent control in some cities. The market-clearing rent is $1,000 per month with 50,000 apartments being rented.
$600
Shortage
Now suppose the government decides to set a maximum rent of $600. At this ceiling price, 60,000 rental units are demanded, but only 40,000 are supplied (a shortage). D
Thousands of rental units per month

56. Summary
To have an impact, a price floor must be set above the equilibrium price and a price ceiling must be set below the equilibrium price
Effective price floors and ceilings distort markets in that they create a surplus and a shortage, respectively
In these situations, various nonprice allocation devices emerge to cope with the disequilibrium resulting from the intervention