Course: Economics of EU Integration

Chapter 4 Mankiw G. pp. 61-85

Market Forces of Supply and Demand

Instructor: Giorgi Machavariani

Ten Principles of Economics

We will attempt to answer the following questions within this question:

• What factors affect buyers’ demand for goods?

• What factors affect sellers’ supply of goods?
• How do supply and demand determine the price of a good and the
quantity sold?
• How do changes in the factors that affect demand or supply affect the
market price and quantity of a good?
• How do markets allocate resources?
Introduction

• Market
- A group of buyers and sellers of a particular good or service

- Buyers as a group
• Determine the demand for the product

- Sellers as a group
• Determine the supply of the product
Markets and Competition

• Competitive market
- Many buyers and many sellers, each has a negligible impact on market price

• Perfectly competitive market

- All goods are exactly the same
- Buyers and sellers are so numerous that no one can affect the market price, “Price
takers”
Demand

• Quantity demanded
- Amount of a good that buyers are willing and able to purchase

• Law of demand
- Other things equal
- When the price of a good rises, the quantity demanded of the good falls
- When the price falls, the quantity demanded rises
Sam’s Demand Schedule
DEMAND SCHEDULE:
− A TABLE, SHOWS THE
RELATIONSHIP
BETWEEN THE PRICE OF
A GOOD AND THE
QUANTITY DEMANDED
− EXAMPLE: SAM’S
DEMAND FOR LATTES
− NOTICE THAT SAM’S
PREFERENCES OBEY THE
LAW OF DEMAND.
 PriSam’s Demand Schedule and Demand Curve
Price of
Lattes
$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00 Quantity of
0 5 10 15 Lattes
Demand

• Market demand

- Sum of all individual demands for a good or service

- Market demand curve: sum the individual demand curves horizontally

• To find the total quantity demanded at any price, we add the individual
quantities
Market Demand versus Individual Demand
• Suppose Sam and Dean are the only two buyers in the market for lattes.
(Qd = quantity demanded)
Price Sam’s Qd Dean’s Qd Market Qd
$0.00 16 + 8 = 24
1.00 14 + 7 = 21
2.00 12 + 6 = 18
3.00 10 + 5 = 15
4.00 8 + 4 = 12
5.00 6 + 3 = 9
6.00 4 + 2 = 6
 The Market Demand Curve for Lattes
P
$6.00

$5.00

$4.00

$3.00

$2.00

$1.00

$0.00
0 5 10 15 20 25 Q
Demand Curve Shifters
• The demand curve
- Shows how price affects quantity demanded, other things being equal

• These “other things” are non-price determinants of demand

- Things that determine buyers’ demand for a good, other than the good’s price

• Changes in them shift the D curve…

Demand Curve Shifters

• Number of buyers
- Increase in # of buyers

• Increases quantity demanded at each price

• Shifts D curve to the right

• Decrease in # of buyers
- Decreases quantity demanded at each price
- Shifts D curve to the left
 Demand Curve Shifters: # of Buyers
P
$6.00
• Suppose the number of
$5.00
buyers increases.
$4.00 •
$3.00 • Then, at each P, Qd will
$2.00 increase (by 5 in this
$1.00 example).
$0.00
Q
0 5 10 15 20 25 30
Demand Curve Shifters

• Income

- Normal good, other things constant

• An increase in income leads to an increase in demand: Shifts D curve to the right

- Inferior good, other things constant

• An increase in income leads to a decrease in demand: Shifts D curve to the left

Demand Curve Shifters
Prices of Related Goods, substitutes
- Two goods are substitutes if
• An increase in the price of one leads to an increase in the demand for the other

• Example: pizza and hamburgers

• An increase in the price of pizza increases demand for hamburgers, shifting
hamburger demand curve to the right

• Other examples:
• Coke and Pepsi, laptops and tablets, music CDs and music downloads
Demand Curve Shifters
• Prices of related goods, complements
- Two goods are complements if
• An increase in the price of one leads to a decrease in the demand for the other

- Example: computers and software

• If price of computers rises, people buy fewer computers, and therefore less
software; Software demand curve shifts left

- Other examples:
• College tuition and textbooks, bagels and cream cheese, eggs and bacon
Demand Curve Shifters

• Tastes
- Anything that causes a shift in tastes toward a good will increase
demand for that good and shift its D curve to the right

- Example:
• The Atkins diet became popular in the ’90s,
caused an increase in demand for eggs,
shifted the egg demand curve to the right
Demand Curve Shifters
• Expectations About the Future

- Expect an increase in income, increase in current demand

- Expect higher prices, increase in current demand

- Example:
• If people expect their incomes to rise, their D for meals at expensive restaurants
may increase now
Summary: Variables That Influence Buyers
Demand curve
• Draw a demand curve for music downloads
• What happens to it in each of the following scenarios?
• Why?

A. The price of iPods falls

B. The price of music
downloads falls
C. The price of music CDs falls
 A. The price of iPods falls
Price of
music MUSIC DOWNLOADS AND
down- IPODS ARE COMPLEMENTS.
loads
WHEN PRICE OF IPOD DROPS,
P1 LESS PEOPLE BUY IPODS AND
THEREFORE THEY WILL
DOWNLOAD MUSIC LESS
FREQUENTLY.
D1 D2
A FALL IN PRICE OF IPODS
Quantity of SHIFTS THE DEMAND CURVE
Q1
music downloads FOR MUSIC DOWNLOADS TO
THE RIGHT.
Active Learning 1 B. The price of music downloads falls

The D curve does not shift.

Price of
music
down- Move down along curve to a
loads point with lower P, higher Q.

P1

P2

D1

Q1 Q2 Quantity of
music downloads

22
Active Learning 1 C. The price of music CDs falls
Music CDs and music
downloads are substitutes.
Price of
music
When price of CDs falls, more
down-
loads people will buy them and
therefore they will download
less music
P1
A fall in the price of music CDs
shifts demand for music
downloads to the left.
D2 D1

Q2 Q1 Quantity of
music downloads

23
Supply
• Quantity supplied
- Amount of a good
- Sellers are willing and able to sell

• Law of supply
- Other things equal
- When the price of a good rises, the quantity supplied of the good rises
- When the price falls, the quantity supplied falls
Starbucks’ Supply Schedule
SUPPLY SCHEDULE: Price Quantity
of lattes of lattes supplied
− A TABLE, SHOWS THE
RELATIONSHIP $0.00 0
BETWEEN THE PRICE
1.00 3
OF A GOOD AND THE
QUANTITY SUPPLIED. 2.00 6
− EXAMPLE: STARBUCKS’ 3.00 9
SUPPLY OF LATTES
− NOTICE THAT 4.00 12
STARBUCKS’ SUPPLY 5.00 15
SCHEDULE OBEYS THE
6.00 18
LAW OF SUPPLY
Starbucks’ Supply Schedule and Supply Curve
P Quantity
Price
$6.00 of lattes
of lattes
supplied
$5.00
$0.00 0
$4.00
1.00 3
$3.00 2.00 6
$2.00 3.00 9
$1.00 4.00 12
$0.00 5.00 15
0 5 10 15 Q 6.00 18
Supply Curve Shifters

• The supply curve

- Shows how price affects quantity supplied, other things being equal

• These “other things”

- Are non-price determinants of supply such as technology, land, labor,
raw materials, capital, and so forth.
-

• Changes in them shift the S curve…

Supply Curve Shifters

Input prices

- Supply is negatively related to prices of inputs

- Examples of input prices: wages, prices of raw materials

- A fall in input prices makes production more profitable at each output price
Firms supply a larger quantity at each price
The S curve shifts to the right
Supply Curve Shifters: Input Prices
P •Suppose the price of
$6.00 milk falls.
• Cheap milk gives
$5.00
possibility to producers
$4.00 to supply more lattes
$3.00 (coffee)
•At each price, the
$2.00
quantity of lattes
$1.00 supplied will increase
$0.00 (by 5 in this example).
0 5 10 15 20 25 30 35
Q
29
Supply Curve Shifters
•Technology
• Determines how much inputs are required to produce a unit of output
- A cost-saving technological improvement has the same effect as a fall in input prices,
shifts S curve to the right

•Number of sellers
- An increase in the number of sellers
• Increases the quantity supplied at each price
• Shifts S curve to the right
Summary: Variables That Influence Sellers
Supply curve
Draw a supply curve for tax return preparation software. What happens to it
in each of the following scenarios?

A. Retailers cut the price of the software.

B. A technological advance allows the software to be produced at lower cost.
C. Professional tax return
preparers raise the price of
the services they provide.
Active Learning 2 A. Fall in price of tax return software

Price of S curve does not shift.

tax return
S1
software
Move down along the
P1
curve to a lower P and
lower Q.
P2

Q2 Q1 Quantity of tax
return software

33
 Active Learning 2 B. Fall in cost of producing software

Price of S curve shifts to the

tax return
S1
right:
software S2

at each price, Q
P1
increases.

Q1 Q2 Quantity of tax
return software

34
 Active Learning 2 C. Professional preparers raise
their price
Price of Trick question:
tax return
S1
software
This shifts the demand
curve for tax
preparation software,
not the supply curve.

Quantity of tax
return software

© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain 35
product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Supply and Demand Together
P
Equilibrium: D
$6.00 S
Price has
$5.00
reached the
level where $4.00

quantity $3.00
supplied equals $2.00
quantity $1.00
demanded
$0.00
Q
0 5 10 15 20 25 30 35

36
Supply and Demand Together
Equilibrium price: price where Q supplied = Q demanded
Equilibrium quantity: Q supplied and demanded at the
equilibrium price
P D S
$6.00
P QD QS
$5.00 $0 24 0
$4.00 1 21 5
2 18 10
$3.00
3 15 15
$2.00 4 12 20
$1.00 5 9 25
$0.00 6 6 30
Q
0 5 10 15 20 25 30 35
37
Markets Not in Equilibrium: Surplus
Surplus (excess supply):
quantity supplied is
P greater than quantity
D S
$6.00 Surplus demanded
$5.00
Example: if P = $5,
$4.00
then QD = 9 lattes
$3.00 and QS = 25 lattes
$2.00
resulting in a surplus of
$1.00 16 lattes
$0.00
Q
0 5 10 15 20 25 30 35
38
Markets Not in Equilibrium: Surplus
Facing a surplus,
sellers try to increase
P sales by cutting price.
D S
$6.00 Surplus
$5.00 This causes QD to rise
$4.00
and QS to fall…
$3.00

$2.00 …which reduces the

$1.00 surplus.
$0.00
Q
0 5 10 15 20 25 30 35
39
Markets Not in Equilibrium: Surplus
Facing a surplus,
sellers try to increase
P sales by cutting price.
D S
$6.00 Surplus
$5.00 This causes QD to rise
$4.00
and QS to fall…
$3.00
Prices continue to fall
$2.00 until market reaches
$1.00 equilibrium.
$0.00
Q
0 5 10 15 20 25 30 35
40
Markets Not in Equilibrium: Shortage
Shortage (excess
demand):
quantity demanded is
P D S
$6.00 greater than quantity
supplied
$5.00
$4.00 Example: if P = $1,
then QD = 21 lattes
$3.00
and QS = 5 lattes
$2.00
$1.00 resulting in a shortage of
16 lattes
$0.00 Shortage
Q
0 5 10 15 20 25 30 35
41
Markets Not in Equilibrium: Shortage
Facing a shortage,
sellers raise the price,
P D S causing QD to fall
$6.00

$5.00 and QS to rise,

$4.00
$3.00
…which reduces the
shortage.
$2.00
$1.00
Shortage
$0.00
Q
0 5 10 15 20 25 30 35
42
Markets Not in Equilibrium: Shortage
Facing a shortage,
sellers raise the price,
P D S causing QD to fall
$6.00

$5.00 and QS to rise,

$4.00
$3.00
…which reduces the
shortage.
$2.00 Prices continue to rise
$1.00 until market reaches
Shortage
$0.00
equilibrium.
Q
0 5 10 15 20 25 30 35
43
 Supply and Demand Together

Three steps to analyzing changes in equilibrium

1. Decide whether the event shifts the supply
curve, the demand curve, or, in some cases,
both curves
2. Decide whether the curve shifts to the right or
to the left
3. Use the supply-and-demand diagram
Compare the initial and the new equilibrium
Effects on equilibrium price and quantity

44
EXAMPLE: The Market for Hybrid Cars
P
price of
S1
hybrid cars

P1

D1
Q
Q1
quantity of
hybrid cars

45
EXAMPLE 1: A Shift in Demand
EVENT TO BE ANALYZED:
Increase in the price of gas.
P
STEP 1: D curve shifts
because price of gas affects demand S1
for hybrids. (S curve does not shift, P2
because price of gas does not affect
cost of producing hybrids)
STEP 2: D shifts right P1
because high gas price makes hybrids
more attractive relative to other cars.
STEP 3: The shift causes an increase D1 D2
in price and quantity of hybrid cars. Q
Q1 Q2

46
 Shift vs. Movement Along Curve

Change in supply:
A shift in the S curve
Occurs when a non-price determinant of supply changes (like
technology or costs)

Change in the quantity supplied:

A movement along a fixed S curve
Occurs when P changes

© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain 47
product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
 Shift vs. Movement Along Curve

Change in demand:
A shift in the D curve
Occurs when a non-price determinant of demand changes
(like income or # of buyers)

Change in the quantity demanded:

A movement along a fixed D curve
Occurs when P changes

48
EXAMPLE 2: A Shift in Supply
EVENT: New technology reduces cost
of producing hybrid cars. P
STEP 1: S curve shifts
S1 S2
because event affects cost of
production. (D curve does not shift,
because production technology is not
one of the factors that affect demand)
P1
STEP 2: S shifts right
because event reduces cost, makes P2
production more profitable at any given
price. D1
STEP 3: The shift causes price to fall Q
Q 1 Q2
and quantity to rise.

49
EXAMPLE 3: A Shift in Both Supply and Demand

EVENTS: Price of gas rises AND

new technology reduces P
production costs S1 S2

STEP 1: Both curves shift. P2

STEP 2: Both shift to the right.
P1

STEP 3: Q rises, but the effect

on P is ambiguous:
D1 D2

If demand increases more than Q

Q1 Q2
supply, P rises.

50
EXAMPLE 3: A Shift in Both Supply and Demand

EVENTS: Price of gas rises

AND new technology reduces P
production costs S1 S2

P1
P2
STEP 3: Q rises, but the
D1 D2
effect on P is ambiguous:
Q
Q1 Q2
But if supply increases more
than demand, P falls.
51
 Active Learning 3 Shifts in supply and demand

Use the three-step method to analyze the effects of

each event on the equilibrium price and quantity of
music downloads.
Event A: A fall in the price of music CDs
Event B: Sellers of music downloads
negotiate a reduction in the royalties they
must pay for each song they sell.
Event C: Events A and B both occur.

52
 Active Learning 3 A. A fall in the price of music CDs
The market for
STEPS: P music downloads
S1
1. D curve shifts
P1

2. D curve shifts left P2

3. P and Q both fall

D2 D1
Q
Q2 Q1

53
Active Learning 3 B. Fall in cost of royalties

STEPS: The market for

P music downloads
1. S curve shifts S1 S2
(Royalties are part of
P1
sellers’ costs)
P2
2. S curve shifts right

3. P falls, Q rises D1
Q
Q 1 Q2

54
 Active Learning 3 C. Fall in price of music CDs
and fall in cost of royalties
STEPS:
1. Both curves shift (see parts A & B)

2. D shifts left, S shifts right

3. P falls.
Effect on Q is ambiguous:
- the fall in demand reduces Q,
- the increase in supply increases Q.

55
 How Prices Allocate Resources

“Markets are usually a good way to organize economic activity”

In market economies
Prices adjust to balance supply and demand

These equilibrium prices

Are the signals that guide economic decisions and thereby allocate
scarce resources

56
Summary
• Economists use the model of supply and demand to analyze competitive
markets.
• Many buyers and sellers, all are price takers
• The demand curve shows how the quantity of a good demanded
depends on the price.
• Law of demand: as the price of a good falls, the quantity demanded rises;
the D curve slopes downward
• Other determinants of demand: income, prices of substitutes and
complements, tastes, expectations, and number of buyers.
• If one of these factors changes, the D curve shifts
Summary
• The supply curve shows how the quantity of a good supplied depends
on the price.
• Law of supply: as the price of a good rises, the quantity supplied rises; the S
curve slopes upward.
• Other determinants of supply: input prices, technology, expectations,
and number of sellers.
• If one of these factors changes, supply curve shifts.
• The intersection of the supply and demand curves determines the
market equilibrium.
• At the equilibrium price, quantity demanded = quantity supplied
Summary

• The behavior of buyers and sellers naturally drives markets toward

their equilibrium.

- When the market price is above the equilibrium price, there is a surplus
of the good, which causes the market price to fall.

- When the market price is below the equilibrium price, there is a

shortage, which causes the market price to rise.
Summary
• To analyze how any event influences a market, we use the supply-and-
demand diagram to examine how the event affects the equilibrium
price and quantity.
1. Decide whether the event shifts the supply curve or the demand curve
(or both).
2. Decide in which direction the curve shifts.
3. Compare the new equilibrium with the initial one.
• In market economies, prices are the signals that guide economic
decisions and thereby allocate scarce resources.