Chapter 2

The Basics of

Supply and Demand

Topics to Be Discussed

The Market Mechanism

Shifts in Supply and Demand

Short-Run Versus Long-Run

Understanding and Predicting the Effects of Changing Market Conditions

Introduction

Applications of Supply and Demand Analysis• Understanding and predicting how world

economic conditions affect market price

• Analyzing the impact of price controls

• Analyzing the impact of production incentives on price and output

• Analyzing the impact of taxation, subsidies, and import restrictions on prices and output

The Market Mechanism

Supply

• Measures how much producers are willing to sell for each price

• This price-quantity relationship can be shown by the equation:

)(PQQ SS

The Supply and Demand Model

Quantity

Price

($ per unit)

Vertical axis measures price (P) receivedper unit in dollars

Horizontal axis measures quantity (Q) supplied innumber of units per time period

The Supply and Demand Model

Quantity

S

The supply curve slopesupward demonstrating that

at higher prices firmswill increase output

Price

($ per unit)

The Market Mechanism

Demand

• Measures how much consumers are willing to buy for each price per unit.

• This price-quantity relationship can be shown by the equation:

)(PQQ DD

The Supply and Demand Model

Quantity

Vertical axis measures price (P) paidper unit in dollars

Horizontal axis measures quantity (Q) demanded innumber of units per time period

Price

($ per unit)

The Supply and Demand Model

Quantity

D

The demand curve slopesdownward demonstrating that consumers are willing

to buy more at a lower priceas the product becomes

relatively cheaper and the consumer’s real income

increases.

Price

($ per unit)

The Supply and Demand Model

Quantity

Price

($ per unit)

The Supply and Demand Model

Quantity

D

The curves intersect atequilibrium, or market-clearing, price. At P0 thequantity supplied is equalto the quantity demanded

at Q0 .

S

P0

Q0

Price

($ per unit)

The Market Mechanism

Characteristics of the equilibrium price:

• QD = QS

• No shortage

• No excess supply

• No pressure on the price to change

The Supply and Demand Model

Quantity

D

If price is above equilibrium:

1) Price is above the market clearing price2) Qs > Qd

3) Price falls to the market-clearing price

S

P0

Q0

P1

Surplus

Price

($ per unit)

Example:The Supply and Demand Model

Quantity

D

Assume the price is P1 , then:1) Qs : Q2 > Qd : Q1 2) Excess supply is Q1:Q2.3) Producers lower price.4) Quantity supplied decreases and quantity demanded increases.

S

Q1

P1

Surplus

Q2

Price

($ per unit)

Example:The Supply and Demand Model

Quantity

D

S

Q0

P0

Price

($ per unit)

The Supply and Demand Model

Quantity

Price

($ per unit

D

If price is below equilibrium:

1) Price is below the market clearing price2) Qd > Qs

3) Price rises to the market-clearing price

S

P0

Q0

P2

Shortage

Example:The Supply and Demand Model

Quantity

D

S

Q1 Q2

P2

Assume the price is P1 , then:1) Qd : Q2 > Qs : Q1

2) Shortage is Q1:Q2.3) Producers raise price.

4) Quantity supplied increases and quantity demanded decreases.

Price

($ per unit)

Shortage

Example:The Supply and Demand Model

Quantity

D

S

Q0

P0

Price

($ per unit)

Shifts in Supply and Demand

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.

Shifts in Supply and Demand

Non-price Determining Variables of Supply

• Costs of Production– Labor

– Capital

– Raw Materials

Shifts in Supply and Demand

Non-price Determining Variables of Demand

• Income

• Consumer Tastes

• Price of Related Goods

Example: The Price of Eggs

The real price of eggs fell 68% from 1970 to 1995.

Supply increased due to the increased mechanization of poultry farming and the reduced cost of production.

Demand decreased due to the increasing consumer concern over the health and cholesterol consequences of eating eggs.

Market for Eggs

Q (million dozens)

P(1970

dollars perdozen)

D1970

S1970

$0.61

5,300

Market for Eggs

Q (million dozens)

P(1970

dollars perdozen)

D1970

S1970

$0.61

5,300

D1995

Market for Eggs

Q (million dozens)

P(1970

dollars perdozen)

D1970

S1970

$0.61

5,300

D1995

S1995

$0.24

5,100

Prices fell untila new equilibrium

was reached at $0.24and a quantity

of 5,100 million dozen

Example: Upheaval in theWorld Oil Market

We can predict numerically the impact of a decrease in the supply of OPEC oil.

In 1995:

• P* = $18/barrel

• World demand and total supply = 23 bb/yr.

• OPEC supply = 10 bb/yr.

• Non-OPEC supply = 13 bb/yr

Example: Upheaval in theWorld Oil Market

Short-Run Impact of a stoppage Saudi Production equal to 3 bb/yr.

• Short-run Demand

D = 24.08 - 0.06P

• Short-run Competitive Supply

SC = 11.74 + 0.07P

Example: Upheaval in theWorld Oil Market

Short-Run Impact of a stoppage Saudi Production equal to 3 bb/yr.

• Short-run Total Supply--before supply reduction

ST = 21.74 + 0.07P

• Short-run Total Supply--after supply reduction

ST = 18.74 + 0.07P

Setting D=ST and solving for P,

P = (24.08-21.74)/ (.07+.06)=$18

Example: Upheaval in theWorld Oil Market

New Price After Reduction

24.08 - 0.06P = 18.74 + 0.07P

P = (24.08 – 18.74) = 41.08(0.06 + 0.07)

Quantity(billions barrels/yr)

Price($ per barrel)

5 D

0 5 15 20 25 30 3510

10

15

20

25

30

35

40

45

23

18

Impact of Saudi Production CutSTDSC

Short-RunEffect

Impact of Saudi Production Cut

Quantity(billions barrels/yr)

Price($ per barrel)

ST

5 D

0 5 15 20 25 30 3510

10

15

20

25

30

35

40

45

23

18

If Saudi Arabia wasto stop producing oil, supply curve shifts to the left by 3 bb/yr and equilibrium price rises

to $41/barrel.

D S’T

41

SC

Example: Upheaval in theWorld Oil Market

Long-Run Impact of a stoppage Saudi Production equal to 3 bb/yr..

• Long-run Demand

D = 32.18 - 0.51P

• Long-run Total Supply

S = 17.78 + 0.29P

Example: Upheaval in theWorld Oil Market

New Price is found setting long-run supply equal to long-run demand:

32.18 - 0.51P = 14.78 + 0.29P

P = (32.18 – 14.78) = 21.75(0.29 + 0.51)

Quantity(billions barrels/yr)

Price($ per barrel)

5 D

0 5 15 20 25 30 3510

10

15

20

25

30

35

40

45

23

18

Impact of Saudi Production Cut

STD SCLong-Run

Effect

Quantity(billions barrels/yr)

Price($ per barrel)

5 D

0 5 15 20 25 30 3510

10

15

20

25

30

35

40

45

23

18

Impact of Saudi Production Cut

STD SC

Due to the elasticityof the long-run

supply and demand curves, the long-run

effect of a cutin production is

much less.

S’T

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

Summary

The responsiveness of supply and demand to changes in price, income, and other variables pertains to a time frame, i.e., long run v. short run.

If we can estimate the supply and demand curves for a particular market, we can calculate the market clearing price.

Summary

Simple numerical analysis can often be done by fitting linear supply and demand curves to data on price and quantity.