The Market Forces

of Supply and Demand

Chapter 2
PRINCIPLES OF MICROECONOMICS

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Contents
 Demand
 Supply
 Equilibrium
 Elasticity
 Government Policies

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Markets
 A group of buyers and sellers of a particular good or
service
 Can be highly organized
 Can be less organized

Market: any institution,

mechanism, or arrangement
which facilitates exchange.

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 2.1 DEMAND

Buyers determine demand...

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Demand
 Demand shows the willingness to pay for a good (WTP)
 Quantity demanded (QD)
 Amount of a good
 Buyers are willing and able to purchase
 Law of Demand
 Other things equal, when the price (P) of the good rises,
quantity demanded (QD) of a good falls

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Demand
 Relationship between Price of a good (P) and Quantity
demanded (QD) can be shown:
 Demand schedule - a table:
 Demand curve - a graph:
 Downward sloping curve
 Demand function:
 QD= f (P)

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 Catherine’s demand schedule and demand curve
Price of
Ice-Cream
Cones
1. A decrease
$3.00 in price . . .
Price of Quantity of
Ice-cream cone Cones demanded 2.50
2. . . . increases quantity
$0.00 12 cones 2.00
of cones demanded.
0.50 10
1.00 8 1.50
1.50 6
2.00 4 1.00 Demand curve
2.50 2
3.00 0 0.50

0 1 2 3 4 5 6 7 8 9 10 11 12
Quantity of Ice-Cream Cones

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1.2 Individual Demand
and Market Demand
 Individual demand:
 Demand of one individual
 Market demand
 Sum of all individual demands for a good or service
 Market demand curve
 Sum - individual demand curves horizontally

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Market demand as the sum of individual demands
(demand schedule)

Price of ice-cream cone Catherine Nicholas Market

$0.00 12 + 7 = 19
0.50 10 6 16
1.00 8 5 13
1.50 6 4 10
2.00 4 3 7
2.50 2 2 4
3.00 0 1 1

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 Market demand as the sum of individual demands
Catherine’s Nicholas’s Market
demand + demand = demand
Price of Price of Price of
Ice Ice Ice
Cream Cream Cream
Cones Cones Cones
$3.00 DCatherine $3.00 $3.00
DNicholas
2.50 2.50 2.50

2.00 2.00 2.00

1.50 1.50 1.50

DMarket
1.00 1.00 1.00

0.50 0.50 0.50

0 1 2 3 4 5 6 7 8 9 10 11 12 0 1 2 3 4 5 6 7 0 2 4 6 8 10 12 14 16 18
Quantity of Ice-Cream Cones Quantity of Quantity of Ice-Cream Cones
Ice-Cream Cones
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1.3 Shifts in Demand
 Increase in demand
 Any change that increases the quantity demanded at every price
 Demand curve shifts right
 Decrease in demand
 Any change that decreases the quantity demanded at every price
 Demand curve shifts left
 Variables that can shift the demand curve
 Income
 Prices of related goods
 Tastes
 Expectations
 Number of buyers

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Shifts in the demand curve
Price of
Ice-Cream Increase in
Cones Demand

Decrease in
Demand
Demand
Demand
Demand curve, D1
curve, D2
curve, D3
0
Quantity of Ice-Cream Cones

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Changes in demand
 1. Income (I)
 Normal good: other things constant, an increase in income
makes increase in demand
 Necessary goods
 Luxury goods
 Inferior good: Other things constant, an increase in income
makes decrease in demand

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Changes in demand
 2. Prices of related goods (Py)
 Substitutes - two goods
 An increase in the price of one leads to an increase in the
demand for the other

 Complements – two goods

 An increase in the price of one leads to a decrease in the
demand for the other

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Changes in demand
 3. Tastes (T)
 Change in tastes – changes the demand
 4. Expectations - about the future (income, prices) (E)
 Affect current demand
 5. Number of buyers – increase (N)
 Market demand - increases

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 Quick Review

 List the determinants of

the demand for bread.
 Give an example of a
demand schedule.
 Give an example of
something that would
shift the demand curve.

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 2.2 SUPPLY

Sellers determine supply...

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Supply
 Supply shows the willingness to sell (WTS) of sellers for
a goods
 Quantity supplied
 Amount of a good that sellers are willing and able to sell
 Law of supply
 Other things equal, when the price (P) of the good rises
quantity supplied (Qs) of a good rises

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Supply
 Relationship between: P and QS can be shown as:
 Supply schedule - a table: shows the quantity supplied at
each price

Price of Quantity of
Ice-cream cone Cones supplied
$0.00 0 cones
0.50 0
1.00 1
1.50 2
2.00 3
2.50 4
3.00 5

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Supply
 Relationship between: P and QS can be shown as:
 Supply curve - a graph:
 Upward sloping curve
 Supply function: QS = g (P)

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Ben’s supply schedule and supply curve
Price of
Ice-Cream
Cones Supply curve
$3.00

2.50 1. An increase
in price . . .
2.00

1.50
2. . . . increases quantity
1.00 of cones supplied.

0.50

0 1 2 3 4 5 6 7 8 9 10 11 12
Quantity of Ice-Cream Cones

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2.2 Individual Supply and Market Supply
 Individual supply: Supply of one seller
 Market supply: Sum of the supplies of all sellers for a
good or service
 Market supply curve
 Sum - individual supply curves horizontally

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 Market supply as the sum of individual supplies
(supply schedule)

Price of ice-cream cone Ben Jerry Market

$0.00 0 + 0 = 0
0.50 0 0 0
1.00 1 0 1
1.50 2 2 4
2.00 3 4 7
2.50 4 6 10
3.00 5 8 13

At a price of $2.00, Ben supplies 3 ice-cream cones, and Jerry supplies 4 ice-
cream cones. The quantity supplied in the market at this price is 7 cones

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 Market supply as the sum of individual supplies
Ben’s Jerry’s Market
supply + supply = supply
Price of Price of Price of
Ice Ice Ice
Cream Cream Cream
Cones SBen Cones Cones
$3.00 $3.00 $3.00 SMarket
SJerry
2.50 2.50 2.50

2.00 2.00 2.00

1.50 1.50 1.50

1.00 1.00 1.00

0.50 0.50 0.50

0 1 2 3 4 5 6 7 8 9 10 11 12 0 1 2 3 4 5 6 7 0 2 4 6 8 10 12 14 16 18
Quantity of Ice-Cream Cones Quantity of Quantity of Ice-Cream Cones
Ice-Cream Cones
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2.3 Shifts in Supply
 Increase in supply
 Any change that increases the quantity supplied at every price
 Supply curve shifts right
 Decrease in supply
 Any change that decreases the quantity supplied at every price
 Supply curve shifts left
 Variables that can shift the supply curve
 1. Input Prices (Pi)
 Supply – negatively related to prices of inputs
 2. Technology (T)
 Advance in technology – increase in supply
 3. Expectations about future (E)
 Affect current supply
 4. Number of sellers (N) – increase
 Market supply - increase

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Shifts in the supply curve
Price of Supply Supply
Ice-Cream Supply
curve, S3 curve, S1 curve, S2
Cones
Decrease in
supply
Increase in
Supply
`

0
Quantity of Ice-Cream Cones

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 2.3 Market Equilibrium

Supply and Demand Together

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Equilibrium
 Equilibrium - a situation
 Market price has reached the level :
 Quantity supplied = quantity demanded
 Equilibrium price - PE:
 Balances quantity supplied and quantity demanded
 Equilibrium quantity - QE
 Quantity supplied and the quantity demanded at the equilibrium
price

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The equilibrium of supply and demand
Price of
Ice-Cream
Cones Supply
$3.00

2.50 Equilibrium
price Equilibrium
2.00

1.50

1.00
Equilibrium Demand
0.50 quantity

0 1 2 3 4 5 6 7 8 9 10 11 12
Quantity of Ice-Cream Cones

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Market Surplus and Shortage
 Surplus
 Quantity supplied > quantity demanded
 Excess supply
 Downward pressure on price
 Shortage
 Quantity demanded > quantity supplied
 Excess demand
 Upward pressure on price

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 Markets not in equilibrium
(a) Excess Supply (b) Excess demand
Price of Price of
Ice Ice
Cream Supply Supply
Surplus Cream
Cones Cones

$2.50

2.00 $2.00

1.50
Demand Demand
Quantity Quantity Quantity Quantity
demanded supplied supplied Shortage
demanded
0 4 7 10 0 4 7 10
Quantity of Ice-Cream Cones Quantity of Ice-Cream Cones

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Quiz
 Market of good A is shown as:

 What are the demand and supply functions?

 What is the equilibrium price and quantity?
 What are the market quantities at the prices of P1 = VND
8500 và P2= VND 11500

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Three steps to analyzing changes in
equilibrium
 Decide: the event shifts the supply curve, the demand
curve, or both curves
 Decide: curve shifts to right or to left
 Use supply-and-demand diagram
 Compare initial and new equilibrium
 How the shift affects equilibrium price and quantity

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 How an increase in demand affects the equilibrium
Price of
Ice-Cream Supply 1. Hot weather
Cones increases the demand
for ice cream . . .
…resulting in
higher price . . .
$2.50 New equilibrium

2.00
Initial equilibrium

D2
D1
3. …and a higher quantity sold.

0 7 10
Quantity of Ice-Cream Cones

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 How a decrease in supply affects the equilibrium
Price of
1. An increase in the
Ice-Cream price of sugar reduces
Cones the supply of ice cream . . . S2
…resulting in
higher price . . .
S1
$2.50
New equilibrium
2.00
Initial equilibrium
Demand

3. …and a smaller quantity sold.

0 4 7
Quantity of Ice-Cream Cones

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 A shift in both supply and demand
Price of (a) Price Rises, Quantity Rises Price of (b) Price Rises, Quantity Falls
Ice Ice
Cream New Cream Small S2
Cones Large equilibrium S2 S Cones increase S1
1 in demand
increase New
in demand equilibrium
P2 P2
Large
decrease
P1
Small D2 P1 in supply
decrease
in supply D2
Initial Initial
equilibrium equilibrium D1
D1

0 Q1 Q2 0 Q2 Q1
Quantity of Ice-Cream Cones Quantity of Ice-Cream Cones

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What happens to price and quantity when supply or demand shifts?
No change An increase A decrease
In Supply In Supply In supply

No change P same P down P up

In demand Q same Q up Q down

An increase P up P ambiguous P up
In demand Q up Q up Q ambiguous

A decrease P down P Down P ambiguous

In demand Q down Q ambiguous Q down

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Quiz
 True or False. Explain.
A and B are substitutes. The increasing price of A leads the
price of B decreased.

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Suppose we are analyzing the market for hot chocolate.
Graphically illustrate the impact each of the following would have
on demand or supply. Also show how equilibrium price and
quantity have changed.

 a. Winter starts and the weather turns sharply colder.

 b. The price of tea, a substitute for hot chocolate, falls.
 c. The price of cocoa beans decreases.
 d. The price of whipped cream falls.
 e. A better method of harvesting cocoa beans is introduced.
 f. The Surgeon General of the U.S. announces that hot chocolate cures
acne.
 g. Protesting farmers dump millions of gallons of milk, causing the price of
milk to rise.
 h. Consumer income falls because of a recession and hot chocolate is
considered a normal good.
 i. Producers expect the price of hot chocolate to increase next month.
 j. Currently, the price of hot chocolate is $0.50 per cup above equilibrium.

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 Quick review

 What are demand

determinants?
 What are supply
determinants?
 What is excess demand?
 What is excess supply?

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2.3 The Elasticity

Elasticity of Demand
Elasticity of Supply
The Price Elasticity of Demand
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 Definition: Measure of how much quantity demanded of a

good responds to 1% change in the price of that good
D
D %Q
E 
P
%P
 Edp < 0
Computing the price elasticity of
demand
 Use absolute value (drop the minus sign)
 Arc-elasticity of demand: Midpoint method
P
 Two points: (Q1, P1) and (Q2, P2)
A
PA

(Q2  Q1 )/[(Q 2  Q1 )/ 2 ]
D PB
B
E  P
(P2  P1 )/[(P2  P1 )/ 2 ] QA QB
Q
(Q2  Q1 )( P2  P1 )
 PA = 25, QA = 150
(P2  P1 )(Q2  Q1 )
PB = 12, QB = 320
What is the AB arc elasticity
of demand?
Computing the price elasticity of
demand

 Point-elasticity of demand
 One points (Q*, P*)

%Q dQ / Q dQ P
D P*
E  P     Q' ( p) 
%P dP / P dP Q Q*

 E.g. Demand curve Q = 50- 3P. What is the elasticity of demand at the
point of P = 5

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 Variety of demand curves
 (a) Demand is perfectly inelastic
 Elasticity = 0
 Demand curve: vertical
 (b) Demand is inelastic
 Elasticity < 1
 (c) Demand has unit elasticity
 Elasticity = 1
 (d) Demand is elastic
 Elasticity > 1
 (e) Demand is perfectly elastic
 Elasticity = infinity
 Demand curve – horizontal
 The flatter the demand curve, the greater the price elasticity of demand
Determinants of price elasticity of
demand
 Availability of close substitutes
 Goods with close substitutes: More elastic demand
 Necessities vs. luxuries
 Necessities – inelastic demand
 Luxuries – elastic demand
 Definition of the market
 Narrowly defined markets – more elastic demand
 Time horizon

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Elasticity of a linear demand curve (graph)
Price

$7 Elasticity
is larger
6 than 1
5
4 1. an
Elasticity
3 is smaller
than 1
2
Demand
1

0 2 4 6 8 10 12 14 Quantity

The slope of a linear demand curve is constant, but its elasticity is not.

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 (2)Income elasticity of demand ( ED ) I

 Measure of how much the quantity demanded of a good

responds to 1% change in consumers’ income

D %QD
E 
I
%I
 Normal goods: EDI >0
 Necessities: O< EDI <1
 Luxuries:EDI >1
 Inferior goods: EDI <0
(3)Cross-price elasticity of demand

 Measure of how much the quantity demanded of one good

X responds to 1% change in the price of another good Y

%QDx
E XY 
 Substitutes: Exy >0 %PY
 Complements: Exy <0
 Independents: Exy =0
(4) The Price Elasticity of Supply
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 Measure of how much the quantity supplied of a good

responds to 1% change in the price of that good
S
S %Q
E 
P
%P
 Depends on the flexibility of sellers to change the amount of
the good they produce
 Computing price elasticity of supply

Arc elasticity Point elasticity

(P1, Q1) A(P, Q)
(P2, Q2)

Q1  Q 0 S %QS
E 
P
Q1  Q 0 %P
( )
E PS  2 dQ P P
P1  P 2    Q`( P) 
P1  P 2 dP Q Q
( )
2

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Variety of supply curves
 Supply is perfectly inelastic
 Elasticity =0
 Supply curve – vertical
 Inelastic supply
 Elasticity < 1
 Supply curve – sloppy
 Unit elastic supply
 Elasticity =1
 Elastic supply
 Elasticity >1
 Supply curve – flat
 Supply is perfectly elastic
 Elasticity = infinity
 Supply curve – horizontal

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Determinant of price elasticity of supply

 Time period
 Supply is more elastic in long run
 Substitutions of inputs:
 Supply is more elastic when inputs have more substitutes

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Applications of Supply, Demand, &
Elasticity

 Why did OPEC fail to keep the price of oil high?

 1970s: OPEC reduced supply of oil
 Increase in prices 1973-1974 and 1971-1981
 Short-run: supply is inelastic
 Decrease in supply: large increase in price
 1982-1990 – price of oil decreased
 Long-run: supply is elastic
 Decrease in supply: small increase in price

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 8
A reduction in supply in the world market for oil
(a) The Oil Market in the Short Run (b) The Oil Market in the Long Run
Price 1. In the short run, when supply and Price
demand are inelastic, a shift in supply. . . 1. In the long run, when supply and
demand are elastic, a shift in supply. . .
S2
S1 S2 S1
P2

2. … leads to
1. an a P2 1. an
P1 large increase P1
in price

2. … leads to
Demand a Demand
small increase
in price
0 Quantity 0 Quantity

When the supply of oil falls, the response depends on the time horizon. In the short run,
supply and demand are relatively inelastic, as in panel (a). Thus, when the supply curve
shifts from S1 to S2, the price rises substantially. By contrast, in the long run, supply and
demand are relatively elastic, as in panel (b). In this case, the same size shift in the supply
curve (S1 to S2) causes a smaller increase in the price. 56
 2.4. Government Policies

In a “free”, unregulated market system, market forces establish equilibrium

prices and quantities.
While equilibrium conditions may be efficient it may be true that not everyone,
i.e. buyer or seller are satisfied.

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(1) Controls on Prices
 Enacted when policy-makers believe that the market price
is unfair to buyers and sellers.
 Result in government policies,
 price ceilings and floors.
 Tax policies
 Subsidies
a. Price ceiling
 Price ceiling: Legal maximum on the price at which a
good can be sold
 Examples:
 Not binding
 Above the equilibrium price
 Binding constraint
 Below the equilibrium price
 Shortage: Sellers must ration the scarce goods
 The rationing mechanisms – not desirable

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 A market with a price ceiling
(a) A price ceiling that is not binding (b) A price ceiling that is binding
Price of Price of
Ice Ice
Cream Supply Cream Supply
Cones Cones
Price ceiling
$4
Equilibrium
price
3 $3
Equilibrium
price Price ceiling
2
Demand
Demand
Shortage

Equilibrium Quantity Quantity

quantity supplied demanded

0 100 0 75 125
Quantity of Ice-Cream Cones Quantity of Ice-Cream Cones

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b. Price floor
 Price floor: Legal minimum on the price at which a good
can be sold
 Not binding
 Below the equilibrium price
 No effect
 Binding constraint
 Above the equilibrium price
 Surplus: Some seller are unable to sell what they want
 The rationing mechanisms – not desirable

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 A market with a price floor
(a) A price floor that is not binding (b) A price floor that is binding
Price of Price of
Ice Ice
Cream Supply Cream Surplus
Supply
Cone Cone
$4
Price floor
$3 3
Equilibrium Equilibrium
price price
Price floor
2

Demand Demand

Equilibrium Quantity Quantity

quantity demanded supplied

0 100 0 80 120
Quantity of Ice-Cream Cones Quantity of Ice-Cream Cones

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The minimum wage
 Market for labor
 Workers - supply of labor
 Firms – demand for labor
 If minimum wage – above equilibrium
 Unemployment
 Higher income - workers who have jobs
 Lower income - workers who cannot find jobs

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 How the minimum wage affects the labor market
(a) A free labor market (b) A Labor Market with a
Binding Minimum Wage
Wage Wage

Labor Labor
supply Labor surplus supply
(unemployment)

Minimum
wage
Equilibrium
wage
Labor Labor
demand demand

0 Equilibrium Quantity 0 Quantity Quantity Quantity

employment of Labor demanded supplied of Labor

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Quiz
Market of good B has demand and supply as:
P = 3Q – 12
P = 18 – 2Q
(P: $/unit, Q:kg)
1. What is the price and quantity of the free market?
2. If the Government controls the price by a price ceiling of
$4/kg and supplies shortage, what is the price and quantity on
the market?
3. Graphing out the result.
4. How much is the total surplus of this market according to a-
question?
5. How did the total surplus change in b- question?

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b. Taxes
 Taxes on sellers
 Immediate impact on sellers
 Shift in supply
 Supply curve shifts left
 Higher equilibrium price
 Lower equilibrium quantity
 The tax – reduces the size of the market
A tax on sellers
P A tax on sellers
Equilibrium with tax shifts the supply
S2 curve upward
Price S1 by the size of
buyers the tax
pay
Ptax
Price Tax
without Pe Equilibrium without tax
tax Ps
Price
sellers
receive
Demand, D1

0 Qtax Qe Q

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Taxes on sellers
 Taxes discourage market activity
 Smaller quantity sold
 Buyers and sellers share the burden of tax
 Buyers pay more: Worse off
 Sellers receive less
 Get the higher price but pay the tax
 Overall: effective price fall
 Worse off

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Quiz
 Market of good X has Demand and Supply as:
 P = 100 – Q and P = 25 + 2Q
 (P: $/unit; Q: 1000unit)

1. What is the equilibrium price and quantity of the market?

2. What are the price elasticities of demand and supply at the
equilibrium? (after chapter 3)
3. How much is the consumer surplus at the equilibrium?
4. If the government impose a tax of $5 per unit on the sellers of X,
what is the new market price and quantity?
5. How much is the tax revenue of the government?
6. How is the tax burden shared between sellers and buyers?
7. Graph out the results.

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