1. Theory of Supply and Demand Hall and Lieberman, 3rd edition, Thomson South-Western, Chapter 3

2. Overview Market (who, what, how)
Supply and demand is an economic model
Designed to explain how prices are determined in certain types of markets
What you will learn in this chapter
How the model of supply and demand works and how to use it
The law of demand
The law of supply
The determination of market equilibrium
Factors shifting demand or supply curves

3. Markets
In economics, a market is not a place but rather a group of buyers and sellers with the potential to trade with each other
Market is defined not by its location but by its participants
First step in an economic analysis is to define and characterize the market or collection of markets to analyze
Economists think of the economy as a collection of individual markets

4. How Broadly Should We Define The Market
Defining the market often requires economists to group things together
Aggregation is the combining of a group of distinct things into a single whole
Markets can be defined broadly or narrowly, depending on our purpose
How broadly or narrowly markets are defined is one of the most important differences between Macroeconomics and Microeconomics

5. Defining Macroeconomic Markets
Goods and services are aggregated to the highest levels
Macro models lump all consumer goods into the single category “consumption goods”
Macro models will also analyze all capital goods as one market
Macroeconomists take an overall view of the economy without getting bogged down in details

6. Defining Microeconomic Markets
Markets are defined narrowly
Focus on models that define much more specific commodities
Always involves some aggregation
But stops it reaches the highest level of generality that macroeconomics investigates

7. Buyers and Sellers Buyers and sellers in a market can be
Households
Business firms
Government agencies
All three can be both buyers and sellers in the same market, but are not always
For purposes of simplification this text will usually follow these guidelines
In markets for consumer goods, we’ll view business firms as the only sellers, and households as only buyers
In most of our discussions, we’ll be leaving out the “middleman”

8. Competition in Markets
In imperfectly competitive markets, individual buyers or sellers can influence the price of the product
In perfectly competitive markets (or just competitive markets), each buyer and seller takes the market price as a given
What makes some markets imperfectly competitive and others perfectly competitive?
Perfectly competitive markets have many small buyers and sellers
Each is a small part of the market, and the product is standardized
Imperfectly competitive markets have just a few large buyers and sellers
Or else the product of each seller is unique in some way

9. Using Supply and Demand
Supply and demand model is designed to explain how prices are determined in perfectly competitive markets
Perfect competition is rare but many markets come reasonably close
Perfect competition is a matter of degree rather than an all or nothing characteristic
Supply and demand is one of the most versatile and widely used models in the economist’s tool kit
(example: laptop computers; orange juice)

10. Demand A household’s quantity demanded of a good
Specific amount household would choose to buy over some time period, given
A particular price that must be paid for the good
All other constraints on the household
Market quantity demanded (or quantity demanded) is the specific amount of a good that all buyers in the market would choose to buy over some time period, given
A particular price they must pay for the good
All other constraints on households

11. Quantity Demanded Implies a choice Is hypothetical Stresses price
How much households would like to buy when they take into account the opportunity cost of their decisions?
Is hypothetical
Makes no assumptions about availability of the good
How much would households want to buy, at a specific price, given real-world limits on their spending power?
Stresses price
Price of the good is one variable among many that influences quantity demanded
We’ll assume that all other influences on demand are held constant, so we can explore the relationship between price and quantity demanded

12. The Law of Demand
The price of a good rises and everything else remains the same, the quantity of the good demanded will fall
The words, “everything else remains the same” are important
In the real world many variables change simultaneously
However, in order to understand the economy we must first understand each variable separately
Thus we assume that, “everything else remains the same,” in order to understand how demand reacts to price
Consider an example from our real life: the price of laptop decreases, how is the total number of computer bought changed?

13. The Demand Schedule Demand schedule Demand V.S. Quantities demanded
A list showing the quantity of a good that consumers would choose to purchase at different prices, with all other variables held constant
Demand V.S. Quantities demanded
- demand is the entire relationship between price and quantity
- quantities demanded are specific amount of goods buyers want to buy

14. The Demand Curve
The market demand curve (or just demand curve) shows the relationship between the price of a good and the quantity demanded , holding constant all other variables that influence demand
Each point on the curve shows the total buyers would choose to buy at a specific price
Law of demand tells us that demand curves virtually always slope downward
Emphasize the “other things constant”
Emphasize the price influence
Exercise and example:
- Illustrate the example of maple syrup in the textbook – how to draw the graph? what is the relations? Is it the linear relation?

15. Figure 1: The Demand Curve
Number of Bottles per Month
Price per Bottle
When the price is $4.00 per bottle, 40,000 bottles are demanded (point A). A
$4.00
At $2.00 per bottle, 60,000 bottles are demanded (point B).
Maple syrup example
Horizontal axis;
Vertical axis
Points A and B, interpretation
Negative relations
Move along the curve – price change B
2.00 D
40,000
60,000

16. “Shifts” vs. “Movements Along” The Demand Curve
Move along the demand curve
From a change in the price of the good we analyze
In maple syrup example, Figure 1
A fall in price would cause a movement to the right along the demand curve (point A to B)
See figure 3(a)

17. Figure 3(a): Movements Along and Shifts of The Demand Curve
Quantity
Price
Price increase moves us leftward along demand curve P2
Price increase moves us rightward along demand curve P1 P3 Q2 Q1 Q3

18. “Shifts” vs. “Movements Along” The Demand Curve
Shift of demand curve
a change in other things than price of the good causes a shift in the demand curve itself, for example, income
In Figure 2
Demand curve has shifted to the right of the old curve (from Figure 1) as income has risen
A change in any variable that affects demand—except for the good’s price—causes the demand curve to shift

19. Figure 2: A Shift of The Demand Curve
Number of Bottles per Month
Price per Bottle
An increase in income shifts the demand curve for maple syrup from D1 to D2. D2 D1
At each price, more bottles are demanded after the shift B C
$2.00
60,000
80,000

20. “Change in Quantity Demanded” vs. “Change in Demand”
Language is important when discussing demand
“Quantity demanded” means
A particular amount that buyers would choose to buy at a specific price
It is a number represented by a single point on a demand curve
When a change in the price of a good moves us along a demand curve, it is a change in quantity demand
The term demand means
The entire relationship between price and quantity demanded—and represented by the entire demand curve
When something other than price changes, causing the entire demand curve to shift, it is a change in demand

21. Income: Factors That Shift The Demand Curve
An increase in income has effect of shifting demand for normal goods to the right
However, a rise in income shifts demand for inferior goods to the left
A rise in income will increase the demand for a normal good, and decrease the demand for an inferior good
Normal good and inferior good are defined by the relation between demand and income

22. Wealth: Factors That Shift The Demand Curve
Your wealth—at any point in time—is the total value of everything you own minus the total dollar amount you owe
- Example
An increase in wealth will
Increase demand (shift the curve rightward) for a normal good
Decrease demand (shift the curve leftward) for an inferior good

23. Prices of Related Goods: Factors that Shift the Demand Curve
Substitute—good that can be used in place of some other good and that fulfills more or less the same purpose
Example
A rise in the price of a substitute increases the demand for a good, shifting the demand curve to the right
Complement—used together with the good we are interested in
A rise in the price of a complement decreases the demand for a good, shifting the demand curve to the left

24. Other Factors That Shift the Demand Curve
Population
As the population increases in an area
Number of buyers will ordinarily increase
Demand for a good will increase
Expected Price
An expectation that price will rise (fall) in the future shifts the current demand curve rightward (leftward)
Tastes
Combination of all the personal factors that go into determining how a buyer feels about a good
When tastes change toward a good, demand increases, and the demand curve shifts to the right
When tastes change away from a good, demand decreases, and the demand curve shifts to the left

25. Small Summary -- Factors Affecting Demand
Income (depends on good’s nature: normal or inferior)
Wealth (depends on good’s nature)
Prices of substitutes (positively related)
Prices of complements (negatively related)
Population (positively related)
Expected price (positively related)
Tastes (positively related)

26. Figure 3(b): Movements Along and Shifts of The Demand Curve
Quantity
Price
Entire demand curve shifts rightward when:
income or wealth ↑
price of substitute ↑
price of complement ↓
population ↑
expected price ↑
tastes shift toward good D2 D1

27. Figure 3(c): Movements Along and Shifts of The Demand Curve
Quantity
Price
Entire demand curve shifts leftward when:
income or wealth ↓
price of substitute ↓
price of complement ↑
population ↓
expected price ↓
tastes shift toward good D1 D2

28. Supply
A firm’s quantity supplied of a good is the specific amount its managers would choose to sell over some time period, given
A particular price for the good
All other constraints on the firm
Market quantity supplied (or quantity supplied) is the specific amount of a good that all sellers in the market would choose to sell over some time period, given
All other constraints on firms

29. Quantity Supplied Implies a choice Is hypothetical Stresses price
Quantity that gives firms the highest possible profits when they take account of the constraints presented to them by the real world
Is hypothetical
Does not make assumptions about firms’ ability to sell the good
How much would firms’ managers want to sell, given the price of the good and all other constraints they must consider?
Stresses price
The price of the good is just one variable among many that influences quantity supplied
We’ll assume that all other influences on supply are held constant, so we can explore the relationship between price and quantity supplied

30. The Law of Supply
States that when the price of a good rises and everything else remains the same, the quantity of the good supplied will rise
The words, “everything else remains the same” are important
In the real world many variables change simultaneously
However, in order to understand the economy we must first understand each variable separately
We assume “everything else remains the same” in order to understand how supply reacts to price

31. The Supply Schedule and The Supply Curve
Supply schedule—shows quantities of a good or service firms would choose to produce and sell at different prices, with all other variables held constant
Supply curve—graphical depiction of a supply schedule
Shows quantity of a good or service supplied at various prices, with all other variables held constant

32. Figure 4: The Supply Curve
Number of Bottles per Month
Price per Bottle
When the price is $2.00 per bottle, 40,000 bottles are supplied (point F). S
$4.00 G
At $4.00 per bottle, quantity supplied is 60,000 bottles (point G).
2.00 F
40,000
60,000

33. Shifts vs. Movements Along the Supply Curve
A change in the price of a good causes a movement along the supply curve
In Figure 4
A rise (fall) in price would cause a rightward (leftward) movement along the supply curve
A drop in transportation costs will cause a shift in the supply curve itself
In Figure 5
Supply curve has shifted to the right of the old curve (from Figure 4) as transportation costs have dropped
A change in any variable that affects supply—except for the good’s price—causes the supply curve to shift

34. Figure 5: A Shift of The Supply Curve
Number of Bottles per Month
Price per Bottle
A decrease in transportation costs shifts the supply curve for maple syrup from S1 to S2. S1 S2
At each price, more bottles are supplied after the shift
$4.00 J G
60,000
80,000

35. Factors That Shift the Supply Curve
Input prices
A fall (rise) in the price of an input causes an increase (decrease) in supply, shifting the supply curve to the right (left)
Price of Related Goods
When the price of an alternate good rises (falls), the supply curve for the good in question shifts leftward (rightward)
Technology
Cost-saving technological advances increase the supply of a good, shifting the supply curve to the right

36. Factors That Shift the Supply Curve
Number of Firms
An increase (decrease) in the number of sellers—with no other changes—shifts the supply curve to the right (left)
Expected Price
An expectation of a future price increase (decrease) shifts the current supply curve to the left (right)

37. Factors That Shift the Supply Curve
Changes in weather
Favorable weather
Increases crop yields
Causes a rightward shift of the supply curve for that crop
Unfavorable weather
Destroys crops
Shrinks yields
Shifts the supply curve leftward
Other unfavorable natural events may effect all firms in an area
Causing a leftward shift in the supply curve

38. Figure 6(a): Changes in Supply and in Quantity Supplied
Price
Price increase moves us rightward along supply curve S P2 P1
Price increase moves us leftward along supply curve P3 Q3 Q1 Q2

39. Figure 6(b): Changes in Supply and in Quantity Supplied
Price
Entire supply curve shifts rightward when:
price of input ↓
price of alternate good ↓
number of firms ↑
expected price ↑
technological advance
favorable weather S1 S2

40. Figure 6(c): Changes in Supply and in Quantity Supplied
Price
Entire supply curve shifts rightward when:
price of input ↑
price of alternate good ↑
number of firms ↓
expected price ↑
unfavorable weather S2 S1

41. Summary: Factors That Shift The Supply Curve
The short list of shift-variables for supply that we have discussed is far from exhaustive
In some cases, even the threat of such events can cause serious effects on production
Basic principle is always the same
Anything that makes sellers want to sell more or less of a good at any given price will shift supply curve

42. Equilibrium: Putting Supply and Demand Together
When a market is in equilibrium
Both price of good and quantity bought and sold have settled into a state of rest
The equilibrium price and equilibrium quantity are values for price and quantity in the market but, once achieved, will remain constant
Unless and until supply curve or demand curve shifts
The equilibrium price and equilibrium quantity can be found on the vertical and horizontal axes, respectively
At point where supply and demand curves cross

43. Figure 7: Market Equilibrium
Number of Bottles per Month
Price per Bottle
2. causes the price to rise . . .
3. shrinking the excess demand . . . S E
4. until price reaches its equilibrium value of $3.00 .
$3.00 H J
1.00
Excess Demand D
25,000
50,000
75,000
1. At a price of $1.00 per bottle an excess demand of 50,000 bottles . . .

44. Excess Demand Excess demand
At a given price, the excess of quantity demanded over quantity supplied
Price of the good will rise as buyers compete with each other to get more of the good than is available

45. Figure 8: Excess Supply and Price Adjustment
1. At a price of $5.00 per bottle an excess supply of 30,000 bottles . . .
Number of Bottles per Month
Price per Bottle
Excess Supply at $5.00 S
3. shrinking the excess supply . . .
$5.00 K L
2. causes the price to drop, E
4. until price reaches its equilibrium value of $3.00.
3.00 D
35,000
50,000
65,000

46. Excess Supply Excess Supply
At a given price, the excess of quantity supplied over quantity demanded
Price of the good will fall as sellers compete with each other to sell more of the good than buyers want

47. Solve for Equilibrium Algebraically
Suppose that demand is given by the equation , where is quantity demanded, P is the price of the good. Supply is given by where is quantity supplied.
What is the equilibrium price and quantity?

48. Income Rises: What Happens When Things Change
Income rises, causing an increase in demand
Rightward shift in the demand curve causes rightward movement along the supply curve
Equilibrium price and equilibrium quantity both rise
Shift of one curve causes a movement along the other curve to new equilibrium point

49. Figure 9 Number of Bottles of Maple Syrup per Period Price per Bottle
3. to a new equilibrium.
4. Equilibrium price increases
2. moves us along the supply curve . . . S
$4.00 F'
1. An increase in demand . . .
3.00 E D2 D1
5. and equilibrium quantity increases too.
50,000
60,000

50. An Ice Storm Hits: What Happens When Things Change
An ice storm causes a decrease in supply
Weather is a shift variable for supply curve
Any change that shifts the supply curve leftward in a market will increase the equilibrium price
And decrease the equilibrium quantity in that market

51. Figure 10: A Shift of Supply and A New Equilibrium
Number of Bottles
Price per Bottle S2 S1
$5.00 E'
3.00 E D
35,000
50,000

52. Using Supply and Demand: The Invasion of Kuwait
Why did Iraq’s invasion of Kuwait cause the price of oil to rise?
Immediately after the invasion, United States led a worldwide embargo on oil from both Iraq and Kuwait
A significant decrease in the oil industry’s productive capacity caused a shift in the supply curve to the left
Price of oil increased

53. Figure 12: The Market For Oil
Barrels of Oil
Price per Barrel of Oil S2 S1 E' P2 P1 E D Q2 Q1

54. Using Supply and Demand: The Invasion of Kuwait
Why did the price of natural gas rise as well?
Oil is a substitute for natural gas
Rise in the price of a substitute increases demand for a good
Rise in price of oil caused demand curve for natural gas to shift to the right
Thus, the price of natural gas rose

55. Figure 13: The Market For Natural Gas
Cubic Feet of Natural Gas
Price per Cubic Foot of Natural
Gas S F' P4 F P3 D2 D1 Q3 Q4

56. Figure 11: Changes in the Market for Handheld PCs
Millions of Handheld PCs per Quarter
Price per Handheld PC
3. moved the market to a new equilibrium.
2. and a decrease in demand . . .
4. Price decreased . . .
S2002
S2003 A
$500
1. An increase in supply . . . B
$400
5. and quantity decreased as well.
D2002
D2003
2.45
3.33

57. Both Curves Shift
When just one curve shifts (and we know the direction of the shift) we can determine the direction that both equilibrium price and quantity will move
When both curves shift (and we know the direction of the shifts) we can determine the direction for either price or quantity—but not both
Direction of the other will depend on which curve shifts by more

58. The Three Step Process Key Step 1—Characterize the Market
Decide which market or markets best suit problem being analyzed and identify decision makers (buyers and sellers) who interact there
Key Step 2—Find the Equilibrium
Describe conditions necessary for equilibrium in the market, and a method for determining that equilibrium
Key Step 3—What Happens When Things Change
Explore how events or government polices change market equilibrium

59. Example: rental apartment
quantity demanded
quantity supplied
800 30 10
1000 25 14
1200 22 17
1400 19
1600 21
1800 15
Example: problem 4, chapter 3 in textbook.
Demand & Supply Diagram
Equilibrium P & Q
Why $1000 can not be equilibrium?
Effects from a tornado destroying some apartments.

60. Demand for two bedroom rental apartment

61. Summaries Through the study of the chapter, you will be able to
Characterize a market.
Use a demand schedule and a demand curve to demonstrate the law of demand.
Explain the difference between a change in demand (shift of the curve) and a change in quantity demanded (movement along the curve).
List the factors that will lead to a change in demand, and give examples of each.
Similar analysis for supply side.
Explain how equilibrium price and quantity are determined in a competitive market.
Explain what will happen in a competitive market after a shift in the supply curve, the demand curve, or both.
Describe the three steps economists take to answer almost any question about the economy.