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Chapter 2
The Basics of
Supply and
Demand
Topics to Be Discussed

Supply and Demand

The Market Mechanism

Changes in Market Equilibrium

Elasticities of Supply and Demand

Short-Run Versus Long-Run Elasticities
Chapter 2: The Basics of Supply and Demand
Slide 2
Supply and Demand

The Supply Curve

The supply curve shows how much of a good
producers are willing to sell at a given price,
holding constant other factors that might
affect quantity supplied
Chapter 2: The Basics of Supply and Demand
Slide 3
Supply and Demand

The Supply Curve

This price-quantity relationship can be shown
by the equation:
Qs  QS (P )
Chapter 2: The Basics of Supply and Demand
Slide 4
Supply and Demand
The Supply
Curve Graphically
Price
($ per unit)
Vertical axis measures
price (P) received
per unit in dollars
Horizontal axis measures
quantity (Q) supplied in
number of units per
time period
Quantity
Chapter 2: The Basics of Supply and Demand
Slide 5
Supply and Demand
Price
($ per unit)
S
The Supply
Curve Graphically
P2
The supply curve slopes
upward demonstrating that
at higher prices firms
will increase output
P1
Q1
Q2
Chapter 2: The Basics of Supply and Demand
Quantity
Slide 6
Supply and Demand

Non-price Determining Variables of
Supply

Costs of Production

Labor

Capital

Raw Materials

Technology

Government regulations
Chapter 2: The Basics of Supply and Demand
Slide 7
Supply and Demand
Change in Supply

The cost of raw
materials falls

At P1, produce Q2

At P2, produce Q1

Supply curve shifts right
to S’

P
S’
S
P1
P2
More produced at any
price on S’ than on S
Q0
Chapter 2: The Basics of Supply and Demand
Q1
Q2
Slide 8
Q
Supply and Demand

The Demand Curve

The demand curve shows how much of a
good consumers are willing to buy as the
price per unit changes holding non-price
factors constant.

This price-quantity relationship can be shown
by the equation:
QD  QD(P)
Chapter 2: The Basics of Supply and Demand
Slide 9
Supply and Demand
Price
($ per unit)
Vertical axis measures
price (P) paid
per unit in dollars
Horizontal axis measures
quantity (Q) demanded in
number of units per
time period
Quantity
Chapter 2: The Basics of Supply and Demand
Slide 10
Supply and Demand
Price
($ per unit)
The demand curve slopes
downward demonstrating
that consumers are willing
to buy more at a lower price
as the product becomes
relatively cheaper and the
consumer’s real income
increases.
D
Quantity
Chapter 2: The Basics of Supply and Demand
Slide 11
Supply and Demand

Non-price Determining Variables of
Demand

Income

Consumer Tastes

Price of Related Goods

Substitutes

Complements
Chapter 2: The Basics of Supply and Demand
Slide 12
Supply and Demand
Change in Demand

Income Increases
P
D’
D
P2

At P1, demand Q2

At P2, demand Q1

Demand Curve shifts right P1

More purchased at any
price on D’ than on D
Q0
Chapter 2: The Basics of Supply and Demand
Q1
Q2
Slide 13
Q
The Market Mechanism
Price
($ per unit)
S
The curves intersect at
equilibrium, or marketclearing, price. At P0 the
quantity supplied is equal
to the quantity demanded
at Q0 .
P0
D
Q0
Chapter 2: The Basics of Supply and Demand
Quantity
Slide 14
The Market Mechanism

Characteristics of the equilibrium or
market clearing price:
 QD
= QS
 No
shortage
 No
excess supply
 No
pressure on the price to change
Chapter 2: The Basics of Supply and Demand
Slide 15
The Market Mechanism
Price
($ per unit)
S
Surplus
P1
If price is above equilibrium:
1) Price is above the
market clearing price
2) Qs > Qd
3) Price falls to the
market-clearing price
P0
D
Q0
Chapter 2: The Basics of Supply and Demand
Quantity
Slide 16
The Market Mechanism
A Surplus

The market price is above equilibrium

There is excess supply

Producers lower prices

Quantity demanded increases and quantity
supplied decreases

The market continues to adjust until the
equilibrium price is reached.
Chapter 2: The Basics of Supply and Demand
Slide 17
The Market Mechanism
Price
($ per unit)
S
Surplus
P1
Assume the price is P1 , then:
1) Qs = Q2 > Qd = Q1
2) Excess supply is Q2Q1
3) Producers lower price.
4) Quantity supplied decreases
and quantity demanded
increases.
5) Equilibrium at P2Q3
P2
D
Q1
Q3
Q2 Quantity
Chapter 2: The Basics of Supply and Demand
Slide 18
The Market Mechanism
Price
($ per unit)
S
Assume the price is P2 , then:
1) Qd = Q2 > Qs = Q1
2) Shortage is Q1Q2.
3) Producers raise price.
4) Quantity supplied increases
and quantity demanded
decreases.
5) Equilibrium at P3, Q3
P3
P2
Shortage
Q1
Q3
D
Q2 Quantity
Chapter 2: The Basics of Supply and Demand
Slide 19
The Market Mechanism
Shortage

The market price is below equilibrium:

There is a shortage

Producers raise prices

Quantity demanded decreases and quantity
supplied increases

The market continues to adjust until the new
equilibrium price is reached.
Chapter 2: The Basics of Supply and Demand
Slide 20
The Market Mechanism

Market Mechanism Summary
1) Supply and demand interact to
determine the market-clearing price.
2) When not in equilibrium, the market will
adjust to alleviate a shortage or surplus
and return the market to equilibrium.
3) Markets must be competitive for the
mechanism to be efficient.
Chapter 2: The Basics of Supply and Demand
Slide 21
Changes In Market Equilibrium

Equilibrium prices are determined by the
relative level of supply and demand.

Supply and demand are determined by
particular values of supply and demand
determining variables.

Changes in any one or combination of
these variables can cause a change in
the equilibrium price and/or quantity.
Chapter 2: The Basics of Supply and Demand
Slide 22
Changes In Market Equilibrium

Raw material prices
fall

P
D
S
S’
S shifts to S’

Surplus @ P1 of
Q 1, Q 2

Equilibrium @ P3,
Q3
P1
P3
Q1 Q3 Q2
Chapter 2: The Basics of Supply and Demand
Slide 23
Q
Changes In Market Equilibrium

Income Increases
P

Demand shifts to D1

Shortage @ P1 of Q1, Q2 P3

Equilibrium @ P3, Q3
D
D’
S
P1
Q2 Q1 Q3
Chapter 2: The Basics of Supply and Demand
Slide 24
Q
Changes In Market Equilibrium

Income Increases &
raw material prices fall


The increase in D is
greater than the
increase in S
P
D
D’
S
S’
P2
P1
Equilibrium price and
quantity increase to P2,
Q2
Q1
Chapter 2: The Basics of Supply and Demand
Q2
Slide 25
Q
Shifts in Supply and Demand

When supply and demand change
simultaneously, the impact on the
equilibrium price and quantity is
determined by:
1) The relative size and direction of the
change
2) The shape of the supply and demand
curves
Chapter 2: The Basics of Supply and Demand
Slide 26
Elasticities of Supply and Demand

Generally, elasticity is a measure of the
sensitivity of one variable to another.

It tells us the percentage change in one
variable in response to a one percent
change in another variable.
Chapter 2: The Basics of Supply and Demand
Slide 27
Elasticities of Supply and Demand
Price Elasticity of Demand

Measures the sensitivity of quantity
demanded to price changes.

It measures the percentage change in the
quantity demanded for a good or service that
results from a one percent change in the
price.
Chapter 2: The Basics of Supply and Demand
Slide 28
Elasticities of Supply and Demand

The price elasticity of demand is:
EP  (%Q)/(% P)
Chapter 2: The Basics of Supply and Demand
Slide 29
Elasticities of Supply and Demand
Price Elasticity of Demand

So the price elasticity of demand is:
Q/Q P Q
EP 

P/P Q P
Chapter 2: The Basics of Supply and Demand
Slide 30
Elasticities of Supply and Demand

Interpreting Price Elasticity of Demand
Values
1) Because of the inverse relationship
between P and Q; EP is negative.
2) If EP (absolute value) > 1, the percent
change in quantity is greater than the percent
change in price. Demand is price elastic.
Chapter 2: The Basics of Supply and Demand
Slide 31
Elasticities of Supply and Demand

Interpreting Price Elasticity of Demand
Values
3) If EP (absolute value) < 1, the percent
change in quantity is less than the
percent change in price. We say the
demand is price inelastic.
Chapter 2: The Basics of Supply and Demand
Slide 32
Elasticities of Supply and Demand
Price Elasticity of Demand

The primary determinant of price elasticity
of demand is the availability of
substitutes.

Many substitutes, demand is price elastic

Few substitutes, demand is price inelastic
Chapter 2: The Basics of Supply and Demand
Slide 33
Price Elasticities of Demand
Price
EP  - 
The lower portion of
a downward sloping
demand curve is less elastic
than the upper portion.
4
Q = 8 - 2P
Ep = -1
2
Linear Demand Curve
Q = a - bP
Q = 8 - 2P
Ep = 0
4
Chapter 2: The Basics of Supply and Demand
8
Q
Slide 34
Price Elasticities of Demand
Price
Infinitely Elastic Demand
D
P*
EP  - 
Quantity
Chapter 2: The Basics of Supply and Demand
Slide 35
Price Elasticities of Demand
Completely Inelastic Demand
Price
EP  0
Q*
Chapter 2: The Basics of Supply and Demand
Quantity
Slide 36
Elasticities of Supply and Demand
Other Demand Elasticities

Income elasticity of demand measures
the percentage change in quantity
demanded resulting from a one percent
change in income.
Chapter 2: The Basics of Supply and Demand
Slide 37
Elasticities of Supply and Demand
Other Demand Elasticities

The income elasticity of demand is:
Q/Q
I Q
EI 

I/I
Q I
Chapter 2: The Basics of Supply and Demand
Slide 38
Income Elasticities of Demand

EI <0: inferior goods

EI >0: normal goods

EI <1: essential goods

EI >1: luxury goods
Chapter 2: The Basics of Supply and Demand
Slide 39
Elasticities of Supply and Demand
Other Demand Elasticities

Cross elasticity of demand measures the
percentage change in the quantity
demanded of one good that results from a
one percent change in the price of
another good.
Chapter 2: The Basics of Supply and Demand
Slide 40
Elasticities of Supply and Demand

The cross elasticity of demand is:
Qb/Qb Pm Qb
EQbPm 

Pm/Pm Qb Pm

The cross elasticity for substitutes is positive,
while that for complements is negative.
Chapter 2: The Basics of Supply and Demand
Slide 41
Elasticities of Supply and Demand
Elasticities of Supply

Price elasticity of supply measures the
percentage change in quantity supplied
resulting from a 1 percent change in price.

The elasticity is usually positive because
price and quantity supplied are directly
related.
Chapter 2: The Basics of Supply and Demand
Slide 42
Elasticities of Supply and Demand
Elasticities of Supply

We can refer to elasticity of supply with
respect to interest rates, wage rates, and the
cost of raw materials.
Chapter 2: The Basics of Supply and Demand
Slide 43
Short-Run Versus
Long-Run Elasticities
Demand

Most goods and services:


Short-run elasticity is less than long-run
elasticity. (e.g. gasoline)
Other Goods (durables):

Short-run elasticity is greater than long-run
elasticity (e.g. automobiles)
Chapter 2: The Basics of Supply and Demand
Slide 44
Gasoline: Short-Run and
Long-Run Demand Curves
Price
DSR
People tend to
drive smaller and
more fuel efficient
cars in the long-run
Gasoline
DLR
Quantity
Chapter 2: The Basics of Supply and Demand
Slide 45
Automobiles: Short-Run and
Long-Run Demand Curves
Price
DLR
People may put
off immediate
consumption, but
eventually older cars
must be replaced.
Automobiles
DSR
Quantity
Chapter 2: The Basics of Supply and Demand
Slide 46
Short-Run Versus
Long-Run Elasticities
Supply

Most goods and services:


Long-run price elasticity of supply is greater
than short-run price elasticity of supply.
Other Goods (durables, recyclables):

Long-run price elasticity of supply is less
than short-run price elasticity of supply
Chapter 2: The Basics of Supply and Demand
Slide 47
Short-Run Versus
Long-Run Elasticities
Primary Copper: Short-Run and
Long-Run Supply Curves
Price
SSR
SLR
Due to limited
capacity, firms
are limited by
output constraints
in the short-run.
In the long-run, they
can expand.
Quantity
Chapter 2: The Basics of Supply and Demand
Slide 48
Short-Run Versus
Long-Run Elasticities
Secondary Copper: Short-Run and
Long-Run Supply Curves
SLR
SSR
Price
Price increases
provide an incentive
to convert scrap
copper into new supply.
In the long-run, this
stock of scrap copper
begins to fall.
Quantity
Chapter 2: The Basics of Supply and Demand
Slide 49
Short-Run Versus
Long-Run Elasticities
Coffee
S’
S
Price
A freeze or drought
decreases the supply
of coffee
P1
P0
Short-Run
1) Supply is completely inelastic
2) Demand is relatively inelastic
3) Very large change in price
D
Q1
Q0
Chapter 2: The Basics of Supply and Demand
Quantity
Slide 50
Short-Run Versus
Long-Run Elasticities
Coffee
Price
S’
S
P2
P0
Intermediate-Run
1) Supply and demand are
more elastic
2) Price falls back to P2.
3) Quantity falls to Q2
D
Q2 Q 0
Chapter 2: The Basics of Supply and Demand
Quantity
Slide 51
Short-Run Versus
Long-Run Elasticities
Coffee
Price
Long-Run
1) Supply is extremely elastic.
2) Price falls back to P0.
3) Quantity increase to Q0.
S
P0
D
Q0
Chapter 2: The Basics of Supply and Demand
Quantity
Slide 52
Effects of Government Intervention -Price Controls

If the government decides that the
equilibrium price is too high, they may
establish a maximum allowable ceiling
price.
Chapter 2: The Basics of Supply and Demand
Slide 53
Effects of Price Controls
Price
S
If price is regulated to
be no higher than Pmax,
quantity supplied falls
to Q1 and quantity
demanded increases to
Q2. A shortage results
P0
Pmax
D
Excess demand
Q0
Chapter 2: The Basics of Supply and Demand
Quantity
Slide 54
Summary

Supply-demand analysis is a basic tool of
microeconomics.

The market mechanism is the tendency
for supply and demand to equilibrate, so
that there is neither excess demand nor
excess supply
Chapter 2: The Basics of Supply and Demand
Slide 55
Summary

Elasticities describe the responsiveness
of supply and demand to changes in
price, income, and other variables.

Elasticities pertain to a time frame.
Chapter 2: The Basics of Supply and Demand
Slide 56
End of Chapter 2