CHAPTER TWO

THEORY OF
DEMAMD AND
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SUPPLY 1
Chapter outline

Defn of Demand, law of demand and

elasticity of demand
Defn of Supply, law of supply and elasticity
of supply
Market equilibrium
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 Introduction
Supply and demand is an economic model are
 Designed to explain how prices are
determined in certain types of markets
What you will learn in this chapter?
Law of demand and supply
 How the model of supply and demand works
and how to use it
 Strengths and limitations of model
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 Markets
 Specific location(STUATION) where buying
and selling takes place, such as
 Supermarket or a flea market
 In economics, a market is not a place;
rather
 A group of buyers and sellers with the potential
to trade with each other
 Economists think of the economy as a
collection of individual markets
 First step in an economic analysis is to define
and characterize the market or collection of
markets to analyze
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 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

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 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”

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 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
or sellers .Each is a small part of the market, and the
product is standardized
 Imperfectly competitive markets have just a few large
buyers or sellers or else the product of each seller is
unique in some way

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 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

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 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

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 Continued…

 A desire becomes an effective desire or

demand only when it is backed by the
following three factors:
 Ability to pay for the good desired,
 Willingness to pay the price of the good
desired, and
 Availability of the good itself.

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 The Law of Demand
 States that when 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
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 The Demand Schedule and The
Demand Curve
 Demand schedule
 A list (price- quantity combination) showing the
quantity of a good that consumers would choose to
purchase at different prices, with all other variables
held constant
 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

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 The Demand Curve
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
B demanded (point B).
2.00

40,000 60,000 Number of Bottles

per Month
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 Shifts vs. Movements Along The
Demand Curve
 A change in the price of a good causes a movement
along the demand curve
 In Figure 1
 A fall (rise) in price would cause a movement to the
right (left) along the demand curve
 A change in income causes a shift in the demand
curve itself
 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

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Other Properties of Demand
Curves
 Demand curves intersect the quantity (X)-axis, as a result of time
limitations and diminishing marginal utility.
 Demand curves intersect the (Y)-axis, as a result of limited incomes and
wealth.

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 A Shift of The Demand Curve
Price per
Bottle An increase in income
shifts the demand curve for
maple syrup from D1 to D2.

At each price, more bottles

are demanded after the
shift

B C
$2.00

D1 D2

60,000 80,000 Number of Bottles

per Month
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 Dangerous Curves: “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 demanded
 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
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Income: Factors That Shift The Demand
Curve (Non own price determinants)

 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
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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
 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
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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
 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

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 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

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 Movements Along and Shifts of The
Demand Curve
Price
Price increase moves us
leftward along demand
curve
P2
Price decrease moves
us rightward along
demand curve
P1

P3

Q2 Q1 Q3 Quantity
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 Movements Along and Shifts of The
Demand Curve
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

Quantity
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 Movements Along and Shifts of The
Demand Curve
Price
Entire demand curve shifts
leftward when:
• income or wealth ↓
• price of substitute ↓
• price of complement ↑
• population ↓
• expected price ↓
• tastes shift away from good

D1
D2

Quantity
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 Market demand and individual
demand
 Market Demand:
 Is derived by horizontally adding the
quantity demanded for the product by
all buyers at each price.

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 From Household Demand to
Market Demand
 Assuming there are only two households in the
market, market demand is derived as follows:

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 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
 A particular price for the good
 All other constraints on firms

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 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
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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, (so
again P-Q combination but??)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
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 The Supply Curve
Price per When the price is $2.00
Bottle per bottle, 40,000 bottles
S
are supplied (point F).

$4.00 G

At $4.00 per bottle,

2.00 F quantity supplied is
60,000 bottles (point G).

40,000 60,000 Number of Bottles

per Month
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 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
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 A Shift of The Supply Curve
Price per A decrease in transportation costs
Bottle 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 Number of Bottles

per Month
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 Factors That Shift the Supply
Curve(non own price determinants)
 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

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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)

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 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
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 Changes in Supply and in Quantity
Supplied

Price Price increase moves S

us rightward along
supply curve

P2

P1
Price decrease
moves us leftward
P3 along supply curve

Q3 Q1 Q2 Quantity
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 Changes in Supply and in Quantity
Supplied
Price Entire supply curve shifts S1
rightward when: S2
• price of input ↓
• price of alternate good ↓
• number of firms ↑
• expected price ↓
• technological advance
• favorable weather

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37
 Changes in Supply and in Quantity
Supplied
Price
Entire supply curve shifts S2
leftward when: S1
• price of input ↑
• price of alternate good ↑
• number of firms ↓
• expected price ↑
• unfavorable weather

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38
 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

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 Market Equilibrium
Price per 2. causes the price 3. shrinking the
Bottle to rise . . . excess demand . . .

E
4. until price reaches its
$3.00 equilibrium value of $3.00
.
H
1.00 J
Excess Demand
D
25,000 50,000 75,000 Number of Bottles
1. At a price of $1.00 per
per Month
bottle an excess demand
of 03/07/25
50,000 bottles . . . 40
 Excess Demand: Putting Supply
and Demand Together
 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

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 Excess Supply and Price
Adjustment
1. At a price of $5.00 per
Price per bottle an excess supply
Bottle of 30,000 bottles . . .

Excess Supply at $5.00 S 3. shrinking the

excess supply . . .
$5.00 L
K
2. causes the
price to drop, E
3.00 4. until price reaches its
equilibrium value of
$3.00.

D
35,000 50,000 65,000 Number of Bottles
per Month
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Excess Supply: Putting Supply and
Demand Together
 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

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 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

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 Eqiulibrium change
4. Equilibrium 3. to a new
Price per price equilibrium.
Bottle increases
2. moves us along
S the supply
curve . . .
$4.00 F'
1. An increase in
3.00 E demand . . .

D2

D1

50,000 60,000 Number of Bottles of

5. and equilibrium quantity Maple Syrup per Period
increases too.
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 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

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 A Shift of Supply and A New
Equilibrium
Price per
Bottle S2 S1

$5.00 E'

3.00 E

35,000 50,000 Number of Bottles

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 Changes in the Market for Handheld
PCs
Price per 3. moved the market to
Handheld a new equilibrium.
PC
2. and a decrease
in demand . . .
4. Price
decreased . . . S2002
S2003
A
$500 1. An increase in
B supply . . .
$400

5. and quantity D2002

decreased as well.
D2003
2.45 3.33 Millions of Handheld PCs
per Quarter
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 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

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 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
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The Concept of
Elasticity
 Elasticity is a measure of responsiveness of a
dependent variable to changes in an independent
variable.
 Accordingly, we have the concepts of elasticity of
demand and elasticity of supply.
 Elasticity of demand refers to the degree of
responsiveness of quantity demanded of a good to
a change in its price, or change in income, or
change in prices of related goods

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 Elasticity of Demand
 Three kinds of demand elasticity: price elasticity,
income elasticity(type of good), and cross
elasticity of demand(the relation between the
goods) .
 Price elasticity of demand ( elastic, inelastic,
unitary)
 Is the percentage change in quantity demanded
to a percentage change in price
 Point and arc price elasticity of demand

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 PRICE ELASTICITY OF DEMAND (point elasticity )

Commonly Expressed as…

P The percentage change in quantity

The percentage change in price

%Q d
P2 % P
P1

D
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Q2Q1 Q 53
03/07/25 54
 PRICE ELASTICITY OF DEMAND
Refinement –

The Midpoint Formula(arc elasticiy)

Change in Change in
quantity price
Ed =
Sum of
 Sum of
Quantities/2 prices/2

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03/07/25 56
DEMAND Ed = % change in Qd
% change in P
E xy = %  Qd of X
CROSS
% Price of Y
INCOME Ei = % Qd
% Income

Es = % change in Qs
Supply % change in P
03/07/25 57
 EXERCISE
Distinguish BETWEEN following terms
1. Normal goods and inferior goods
2. Complementary goods and substitute goods
3. Market demand and individual demand
4. Individual supply and market supply
5. Excess demand and excess supply

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