Chapter 2: Demand, Supply,
and Market Equilibrium
McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
Demand
• Quantity demanded (Qd)
• Amount of a good or service consumers are
willing & able to purchase during a given
period of time
2-2
Definitions
• Demand function
• Quantity demand as a function of the independent
variables that influence the quantity demanded
• Direct demand
• The direct relationship between the quantity demanded
and price (other independent variables held constant)
• Inverse demand
• The direct relationship between price and quantity
demanded
• Demand curve
• A graphical presentation of inverse demand
2-3
General Demand Function
• Six variables that influence Qd
• Price of good or service (P)
• Incomes of consumers (M)
• Prices of related goods & services (PR)
• Taste patterns of consumers (T)
• Expected future price of product (Pe)
• Number of consumers in market (N)
• General demand function
Qd = f(P, M, PR, T, Pe , N)
2-4
General Demand Function
Qd = a + bP + cM + dPR + eT + fPe + gN
• b, c, d, e, f, & g are slope parameters
• Measure effect on Qd of changing one of the
variables while holding the others constant
• Sign of parameter shows how variable is
related to Qd
• Positive sign indicates direct relationship
• Negative sign indicates inverse relationship
2-5
General Demand Function
Variable Relation to Qd Sign of Slope Parameter
P Inverse b = Qd/P is negative
Direct for normal goods Qd/M
c= is positive
M Qd/M
Inverse for inferior goods c = is negative
PR Direct for substitutes d = Qd/PR is positive
Inverse for complements d = Q /P is negative
d R
T Direct e = Qd/T is positive
Pe Direct f = Qd/Pe is positive
N Direct g = Qd/N is positive
2-6
Direct Demand Function
• The direct demand function, or simply
demand, shows how quantity demanded,
Qd , is related to product price, P, when all
other variables are held constant
• Qd = f(P)
• Law of Demand
• Qd increases when P falls, all else constant
• Qd decreases when P rises, all else constant
• Qd/P must be negative
2-7
Direct Demand Function
Demand for Pork
Qd f ( p, pb, pc, Y )
Qd 171 20 p 20 pb 3 pc 2 y
Qd / pb 20, q / pc 3, q / y 2
pb 4, pc 3, y 13
Qd 286 20 p
2-8
Inverse Demand Function
• Traditionally, price (P) is plotted on the
vertical axis & quantity demanded (Qd) is
plotted on the horizontal axis
• The equation plotted is the inverse demand
function, P = f(Qd)
2-9
Inverse Demand Function
• How much consumers are willing to pay as
a function of quantity
Q 286 20 p
p 14.30 0.05Q
p / Q .05
2-10
Graphing Demand Curves
• A point on a direct demand curve shows
either:
• Maximum amount of a good that will be
purchased for a given price
• Maximum price consumers will pay for a
specific amount of the good
2-11
Direct Demand Function
Q D ( p, M , PR )
Qd 3,200 10 p .05M 24 PR
M 60,000, PR 200
Qd 1,400 10 P
Qd / M .05
Inverse demand function
P 140-1/ 10Qd
2-12
Demand Schedule
2-13
A Demand Curve (Figure 2.1)
2-14
Graphing Demand Curves
• Change in quantity demanded
• Occurs when only price changes
• Movement along demand curve
• Change in demand
• Occurs when one of the other variables, or
determinants of demand, changes
• Demand curve shifts rightward or leftward
2-15
Three Demand Shifts
2-16
2-17
Shifts in Demand (Figure 2.2)
2-18
Supply
• Quantity supplied (Qs)
• Amount of a good or service offered for
sale during a given period of time
2-19
Supply
• Six variables that influence Qs
• Price of good or service (P)
• Input prices (PI )
• Prices of goods related in production (Pr)
• Technological advances (T)
• Expected future price of product (Pe)
• Number of firms producing product (F)
• General supply function
• Qs = f(P, PI, Pr, T, Pe, F)
2-20
General Supply Function
Qs = h + kP + lPI + mPr + nT + rPe + sF
• k, l, m, n, r, & s are slope parameters
• Measure effect on Qs of changing one of the
variables while holding the others constant
• Sign of parameter shows how variable is
related to Qs
• Positive sign indicates direct relationship
• Negative sign indicates inverse relationship
2-21
General Supply Function
Variable Relation to Qs Sign of Slope Parameter
P Direct k = Qs/P is positive
PI Inverse l = Qs/PI is negative
Inverse for substitutes m = Qs/Pr is negative
Pr Direct for complements m = Qs/Pr is positive
T Direct n = Qs/T is positive
Pe Inverse r = Qs/Pe is negative
F Direct s = Qs/F is positive
2-22
Direct Supply Function
• The direct supply function, or simply
supply, shows how quantity supplied, Qs ,
is related to product price, P, when all
other variables are held constant
• Qs = f(P)
2-23
Direct Supply Function
Supply of pork
Q S ( p, ph )
Q 178 40 p 60 ph
ph $1.50
Q 88 40 p
2-24
Inverse Supply Function
• Traditionally, price (P) is plotted on the
vertical axis & quantity supplied (Qs) is
plotted on the horizontal axis
• The equation plotted is the inverse supply
function, P = f(Qs)
2-25
Inverse Supply Function
Qs 88 40 p
p 2.2 .025Qs
2-26
Graphing Supply Curves
• A point on a direct supply curve shows
either:
• Maximum amount of a good that will be
offered for sale at a given price
• Minimum price necessary to induce producers
to voluntarily offer a particular quantity for sale
2-27
Direct Supply Function
Qs S ( P, PI , F )
Qs 100 20 P 10 PI 20 F
PI 100, F 25
Qs 400 20 P
Inverse Supply
P 20 1 / 20Qs
2-28
A Supply Curve (Figure 2.3)
2-29
Graphing Supply Curves
• Change in quantity supplied
• Occurs when price changes
• Movement along supply curve
• Change in supply
• Occurs when one of the other variables, or
determinants of supply, changes
• Supply curve shifts rightward or leftward
2-30
Three Supply Functions
Qs 100 20 P 10 PI 20 F
Qs / PI 10
2-31
Shifts in Supply (Figure 2.4)
2-32
Market Equilibrium
• Equilibrium price & quantity are
determined by the intersection of
demand & supply curves
• At the point of intersection, Qd = Qs
• Consumers can purchase all they want &
producers can sell all they want at the
“market-clearing” or “equilibrium” price
2-33
Market Equilibrium
Qd 1,400 10 P
Qs 400 20 P
Qd Qs
1,400 10 P 400 20 P
Pe $60
Qe 800
2-34
Market Equilibrium (Figure 2.5)
2-35
Market Equilibrium
• Excess demand (shortage)
• Exists when quantity demanded exceeds
quantity supplied
• Excess supply (surplus)
• Exists when quantity supplied exceeds
quantity demanded
2-36
Ceiling & Floor Prices
• Ceiling price
• Maximum price government permits sellers to
charge for a good
• When ceiling price is below equilibrium, a
shortage occurs
• Floor price
• Minimum price government permits sellers to
charge for a good
• When floor price is above equilibrium, a
surplus occurs
2-37
Ceiling & Floor Prices (Figure 2.12)
Px Px
Price (dollars)
Sx Sx
3
2 2
1
Dx Dx
Qx Qx
22 50 62 32 50 84
Quantity Quantity
Panel A – Ceiling price Panel B – Floor price
2-38
Market Equilibrium
Qd 1,400 10 P
Qs 400 20 P
Qd Qs
1,400 10 P 400 20 P
Pe $60
Qe 800
2-39
$50 Price Ceiling
Qd 1,400 10 P
Qd 1,400 10(50)
Qd 900
Qs 400 20 P
Qs 400 20(50)
Qs 600
Excess demand Qd Qs 300
A price ceiling is only effective when it is
set below the equilibrium price
2-40
Marginal Valuation
Qd 1,400 10 P
Qs 600
600 1,400 10 P
P 80
Highest black market price
2-41
$80 Price Floor
Qd 1,400 10 P
Qd 1,400 10(80)
Qd 600
Qs 400 20 P
Qs 400 20(80)
Qs 1,200
Excess supply Qs Qd 600
2-42
500 Unit Quota
Qd 1,400 10 P
Qe 800
Qs 500
Qd Qs
500 1,400 10 P
PQuota 90
2-43
The amount exchanged
• Above equilibrium price the amount
exchanged is determined by the demand
curve
• Below equilibrium price the amount
exchanged is determined by the supply
curve
2-44
Value of Market Exchange
• Typically, consumers value the goods
they purchase by an amount that
exceeds the purchase price of the goods
• Economic value
• Maximum amount any buyer in the market
is willing to pay for the unit, which is
measured by the demand price for the unit
of the good
2-45
Measuring the Value of
Market Exchange
• Consumer surplus
• Difference between the economic value of a
good (its demand price) & the market price the
consumer must pay
• Producer surplus
• For each unit supplied, difference between
market price & the minimum price producers
would accept to supply the unit (its supply
price)
• Social surplus
• Sum of consumer & producer surplus
• Area below demand & above supply over the
relevant range of output 2-46
Measuring the Value of
Market Exchange (Figure 2.6)
2-47
Changes in Market Equilibrium
• Qualitative forecast
• Predicts only the direction in which an
economic variable will move
• Quantitative forecast
• Predicts both the direction and the
magnitude of the change in an economic
variable
2-48
Demand Shifts (Supply Constant)
(Figure 2.7)
2-49
Supply Shifts (Demand Constant)
(Figure 2.8)
2-50
Simultaneous Shifts
• When demand & supply shift
simultaneously
• Can predict either the direction in which
price changes or the direction in which
quantity changes, but not both
• The change in equilibrium price or quantity
is said to be indeterminate when the
direction of change depends on the relative
magnitudes by which demand & supply
shift
2-51
Simultaneous Shifts: (D, S)
P
S
S′
S′′
B
P′ A •
P •
P′′ •C
D′
Q
Q Q′ Q′′
Price may rise or fall; Quantity rises
2-52
Simultaneous Shifts: (D, S)
P
S
S′
S′
A
P •
B
P′ •
P′′ •C D
D′
Q
Q′ Q Q′′
Price falls; Quantity may rise or fall
2-53
Simultaneous Shifts: (D, S)
P
S′′
S′
S
P′′ • C
B
P′ •
A
P •
D′
Q
Q′′ Q Q′
Price rises; Quantity may rise or fall
2-54
Simultaneous Shifts: (D, S)
P
S′′
S′
S
P′′ •C A
P •
P′ • B
D
D′
Q
Q′′ Q′ Q
Price may rise or fall; Quantity falls
2-55