Supply, Demand, and Market Equilibrium

C H A P T E R

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Prepared by: Fernando and Yvonn Quijano

© 2006 Prentice Hall Business Publishing Economics: Principles and Tools, 4/e O’Sullivan/ Sheffrin

Supply, Demand, andMarket Equilibrium

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© 2006 Prentice Hall Business Publishing Economics: Principles and Tools, 4/e O’Sullivan/ Sheffrin 2 of 42

Perfectly Competitive Market

• supply and demand—the most important tool of economic analysis—the simplest!

• The model of supply and demand explains how a perfectly competitive market operates.• A perfectly competitive market is a market

has a very large number of firms, each of which produces the same standardized product in amounts so small that no individual firm can affect the market price.

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The Demand Curve

• Here is a list of variables that affect the individual consumer’s decision, using the pizza market as an example:• The price of the product, for example,

the price of pizza• The consumer’s income• The price of substitute goods such as

pasta or satay

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The Demand Curve

• Here is a list of variables that affect the individual consumer’s decision, using the pizza market as an example:• The price of complementary goods such

as beer or lemonade• The consumer’s tastes and advertising

that may influence tastes• The consumer’s expectations about

future prices

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The Individual Demand Curve andthe Law of Demand

• The demand schedule is a table that shows the relationship between price and quantity demanded by an individual consumer, ceteris paribus (everything else held fixed).

Table 4.1 Al’s Demand Schedule for Pizza

Price Quantity of pizzas per month$2 13

4 106 78 4

10 1

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The Individual Demand Curveand the Law of Demand

• The individual demand curve is a graphical representation of the demand schedule.

• LAW OF DEMAND: The higher the price, the smaller the quantity demanded, ceteris paribus (everything else held fixed).

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The Individual Demand Curveand the Law of Demand

• Quantity demanded is the amount of a good an individual consumer or consumers as a group are willing to buy.

• A change in quantity demanded is a change in the amount of a good demanded resulting from a change in the price of the good.

• In this case, an increase in price causes a decrease in quantity demanded, and a movement upward along the individual’s demand curve.

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From Individual to Market Demand

• The market demand curve shows the relationship between price and quantity demanded by all consumers together, ceteris paribus (everything else held fixed).

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The Supply Curve

• Here are the variables that affect the decisions of sellers, using the market for pizza as an example:• The price of the product—in this case, the

price of pizza.• The cost of the inputs used to produce the

product, for example, wages paid to workers, the cost of dough and cheese, and the cost of the pizza oven.

• The state of production technology, such as the knowledge used in making pizza.

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The Supply Curve

• Here are the variables that affect the decisions of sellers, using the market for pizza as an example:• The number of producers—in this case, the

number of pizzerias.• Producer expectations about the future price

of pizza.• Taxes paid to the government or subsidies

received from the government.

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The Individual Supply Curveand the Law of Supply

• A firm’s supply schedule is a table that shows the relationship between price and quantity supplied, ceteris paribus (everything else held fixed).

Table 4.2 Nora’s Schedule for Pizza

Price Quantity of pizzas per month$4 100

6 2008 300

10 40012 500

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• The individual supply curve is a graphical representation of the supply schedule. Its positive slope reflects the law of supply.

• LAW OF SUPPLY: The higher the price, the larger the quantity supplied, ceteris paribus.

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• Quantity supplied is the amount of a good an individual firm or firms as a group are willing to sell.

• A change in quantity supplied is a change in the amount of a good supplied resulting from a change in the price of the good; represented graphically by a movement along the supply curve.


• In this case, an increase in price causes an increase in quantity supplied and a movement upward along the supply curve.

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Why is the Individual SupplyCurve Positively Sloped?

• To determine how much to produce, the individual firm chooses the quantity of output that satisfies the marginal principle.

Marginal PRINCIPLEIncrease the level of an activity if its marginal benefit exceeds its marginal cost; reduce the level of an activity if its marginal cost exceeds its marginal benefit. If possible, pick the level at which the activity’s marginal benefit equals its marginal cost.

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The Marginal Principle andthe Output Decision

• The marginal benefit of selling a pizza is the price received when the pizza is sold.

• Marginal cost is the cost of producing an additional pizza.

• The marginal cost of producing the first 299 pizzas is less than the $8 marginal benefit. The marginal principle is satisfied when 300 pizzas are produced.

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The Marginal Principle andthe Output Decision

• An increase in the price shifts the marginal benefit curve upward and increases the quantity at which the marginal principle is satisfied.

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From Individual Supplyto Market Supply

• The market supply curve shows the relationship between price and quantity supplied by all producers together, ceteris paribus (everything else held fixed).

• If there are 100 identical pizzerias, market supply equals 100 times the quantity supplied by a single firm at each price level.

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Market Equilibrium

• Market equilibrium is a situation in which the quantity of a product demanded equals the quantity supplied, so there is no pressure to change the price.

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Excess Demand Causesthe Price to Increase

• Excess demand is a situation in which, at the prevailing price, consumers are willing to buy more than producers are willing to sell.

• The market moves upward along the demand curve, decreasing quantity demanded, and upward along the supply curve, increasing quantity supplied.

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Excess Supply Causesthe Price to Drop

• Excess supply is a situation in which, at the prevailing price, producers are willing to sell more than consumers are willing to buy.

• The market moves downward along the demand curve, increasing quantity demanded, and downward along the supply curve, decreasing quantity supplied.

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Market Effects ofChanges in Demand

• A change in price causes a change in quantity demanded.

• A change in demand (caused by changes in something other than the price of the good) shifts the entire demand curve.

Change in Quantity Demanded versus Change in Demand

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Increases in Demand

• An increase in demand shifts the market demand curve to the right.

• At the initial price of $8, there is now excess quantity demanded.

• Equilibrium is restored at point n, with a higher equilibrium price and a larger equilibrium quantity.

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Causes of an Increase in Demand

• An increase in demand can occur for several reasons:• An increase in income (for a normal

good). A normal good is a good that consumers buy more of when their income increases. Most goods fall in this category.

• A decrease in income (for an inferior good). An inferior good is the opposite of a normal good. Consumers buy more of inferior goods when their income decreases.

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• An increase in demand can occur for several reasons:

• A decrease in the price of a complementary good. Two goods are complements when an increase in the price of one good decreases the demand for the other good.

• An increase in the price of a substitute good. When to goods are substitutes, an increase in the price of one good increases the demand for the other good.

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• An increase in demand can occur for several reasons:• An increase in population• A shift in consumer tastes• Favorable advertising• Expectations of higher future

prices

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Decreases in Demand

• A decrease in demand shifts the demand curve to the left.

• At the initial price of $8, there is now an excess supply.

• Equilibrium is restored at point n, with a lower equilibrium price ($6) and a smaller equilibrium quantity (20,000 pizzas).

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Decreases in Demand

• A decrease in demand can occur for several reasons:

• A decrease in income (for a normal good)

• A decrease in the price of a substitute good

• An increase in the price of a complementary good

• A decrease in population• A shift in consumer tastes• Favorable advertising• Expectations of lower future

prices

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Table 4.3 Changes in Demand Shift the Demand Curve (pg. 1)An increase in demand shifts the demand curve to the right when:

A decrease in demand shifts the demand curve to the left when:

The good is normal and income increases

The good is normal and income decreases

The good is inferior and income decreases

The good is inferior and income increases

The price of a substitute good increases

The price of a substitute good decreases

The price of a complementary good decreases

The price of a complementary good increases

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Table 4.3 Changes in Demand Shift the Demand Curve (pg. 2)An increase in demand shifts the demand curve to theright when:

A decrease in demand shifts the demand curve to the left when:

Population increases Population decreases

Consumer tastes shift in favor of the product

Consumer tastes shift away from the product

Consumers expect a higher price in the future

Consumers expect a lower price in the future

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Market Effects ofChanges in Supply

• A change in price causes a change in quantity supplied.

• A change in supply (caused by changes in something other than the price of the good) shifts the entire supply curve.

Change in Quantity Supplied versus Change in Supply

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Increases in Supply

• An increase in supply shifts the market supply curve to the right.

• At the initial price of $8, there is now excess supply.

• Equilibrium is restored at point n, with a lower equilibrium price and a larger equilibrium quantity.

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Causes of an Increase in Supply

• An increase in supply can occur for several reasons:• A decrease in input costs.• An increase in the number of

producers.• Expectations of lower future prices.• Product is subsidized.

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Decreases in Supply

• A decrease in supply shifts the supply curve to the left.

• At the initial price of $8, there is now an excess demand.

• Equilibrium is restored at point n, with a higher equilibrium price ($10) and a smaller equilibrium quantity (23,000 pizzas).

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Causes of a Decrease in Supply

• A decrease in supply can occur for several reasons:• An increase in input costs.• A decrease in the number of producers.• Expectations of higher future prices.• Taxes. If a tax per unit is imposed,

which will make the product less profitable, firms will produce less.

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Market Effects ofChanges in Supply

Table 4.4 Changes in Supply Shift the Supply CurveAn increase in supply shifts the supply curve to the right when:

A decrease in supply shifts the supply curve to the left when:

The cost of an input decreases The cost of an input increases

A technological advance decreases production cost

The number of firms increases The number of firms decreases

Producers expect a lower price in the future

Producers expect a higher price in the future

Product is subsidized Product is taxed

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Market Effects of Simultaneous Changes in Supply and Demand

• The equilibrium price will decrease and the equilibrium quantity will increase.

• Both the equilibrium price and the equilibrium quantity will increase.

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Using the Model to PredictChanges in Price and Quantity

• An increase in university enrollment will increase the demand for apartments, shifting the demand curve to the right. Both the equilibrium price and the equilibrium quantity will increase.

• A report of pesticide residue on apples decreases the demand for apples, shifting the demand curve to the left. Both the equilibrium price and the equilibrium quantity will decrease.

Predicting the Effects of Changes in Demand

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Using the Model to PredictChanges in Price and Quantity

• Technological innovation decreases production costs, shifting the supply curve to the right. The equilibrium price decreases, and the equilibrium quantity increases.

• Bad weather decreases the supply of coffee beans, shifting the supply curve to the left. The equilibrium price increases, and the equilibrium quantity decreases.

Predicting the Effects of Changes in Supply

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Explaining Changes inPrice or Quantity

• At the same time the quantity increased, the price decreased. Therefore, the increase in consumption resulted from an increase in supply, not an increase in demand.

• At the same time the price decreased, the quantity decreased. Therefore, the decrease in price was caused by a decrease in demand, not an increase in supply.

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The Market of Love

• How many are looking for true love?

Opportunities for Love

Value of Love

eros

phileo

agape

D

S

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Key Terms

perfectly competitive market

demand schedule

individual demand curve

quantity demanded

law of demand

change in quantity demanded

substitution effect

income effect

market demand curve

supply schedule

quantity supplied

change in quantity supplied

market supply curve

market equilibrium

excess demand

excess supply

change in demand

normal good

substitute good

complementary good

inferior good

change in supply

Documents

Supply, Demand, and Market Equilibrium