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Chapter 2
Demand, Supply, & Market
Equilibrium
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1-1
Learning Objectives
❖ Identify demand functions and distinguish between a
change in demand and a change in quantity demanded
❖ Identify supply functions and distinguish between a
change in supply and a change in quantity supplied
❖ Explain why market equilibrium occurs at the price for
which quantity demanded equals quantity supplied
❖ Measure gains from market exchange using consumer
surplus, producer surplus, and social surplus
❖ Predict the impact on equilibrium price and quantity of
shifts in demand or supply
❖ Examine the impact of government imposed price
ceilings and price floors
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2-2
Demand
❖ Quantity demanded (Qd)
~ Amount of a good or service consumers are
willing & able to purchase during a given
period of time
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2-3
Demand
❖ Three types of demand relations:
❖ 1. General demand functions which show
how quantity is related to product price
and the other five factors that affect
demand.
❖ 2. Direct Demand functions which show
the relation between quantity demanded
and the price of the product with all other
factors held constant.
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2-4
Demand
❖ 3. Inverse demand functions which give
the maximum prices buyers are willing to
pay to obtain various amounts of the
product.
❖ Direct demand functions are derived from
general demand functions and inverse
demand curves are derived from direct
demand curves.
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2-5
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)
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2-6
Demand
❖ Isolating the individual effect of a single
variable requires that all other variables
that affect Quantity Demanded be held
constant. Therefore, whenever we speak
of the effect that a particular variable has
on quantity demanded, we mean the
individual effect holding all other variables
constant.
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
2-7
Demand
❖ Price: consumers are willing and able to
buy more of a good the lower the price of
the good and will buy less of a good the
higher the price of the good.
❖ Price and quantity demanded are
inversely related when all other factors
are held constant.
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2-8
Demand
❖ An increase in Income can cause the
amount of a good or service consumers
purchase either to increase or decrease.
❖ It depends on if the good or service is a
normal good or inferior Good.
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2-9
Demand
❖ Normal good
~ A good or service for which an increase
(decrease) in income causes consumers to
demand more (less) of the good, holding all other
variables in the general demand function constant
❖ Inferior good
~ A good or service for which an increase
(decrease) in income causes consumers to
demand less (more) of the good, all other factors
held constant
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2-10
Demand
❖ Goods and services may be related in
consumption in either of two ways:
❖ Substitutes or Complements
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2-11
Demand
❖ Substitutes
~ Two goods are substitutes if an increase
(decrease) in the price of one good causes
consumers to demand more (less) of the other
good, holding all other factors constant
❖ Complements
~ Two goods are complements if an increase
(decrease) in the price of one good causes
consumers to demand less (more) of the other
good, all other things held constant
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2-12
Demand
❖ A change in consumers tastes or
preferences can change demand for a
good or service. (Organic, Environmental,
health benefits).
❖ When all other variables are held constant
a movement in consumer tastes toward a
good or service will increase demand and
a movement in consumers tastes away
from a good will decrease demand for the
good.
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2-13
Demand
❖ If consumers expect the price to be higher
in the future period, demand will rise in
the current period.
❖ If consumers expect the price of good to
decline in the future, demand will fall in
the current period.
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2-14
Demand
❖ An increase in the number of consumers
in the market will increase the demand for
a good and a decrease in the number of
consumers will decrease the demand for
a good, all other factors held constant.
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2-15
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 the slope parameter shows how
variable is related to Qd
~ Positive sign indicates direct relationship
~ Negative sign indicates inverse relationship
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2-16
General Demand Function
❖ The intercept parameter “a” shows the value of
quantity demanded when all the other five
variables are all simultaneously equal to zero.
❖ The slope parameter “b” (of price) for example
measures the change in quantity demanded per
unit change in price.
❖ For example a price slope of -10 indicates that a
$1 increase in price causes quantity demanded
to decrease by 10 units.
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2-17
General Demand Function
❖ A demand function can be expressed as an
equation, a schedule or table (see Table 2.2), or
a graph (see Figure 2.1 for a showing of a
demand curve).
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2-18
General Demand Function
Variable
Relation to Qd
Sign of Slope Parameter
P
Inverse
b = Qd/P is negative
M
Direct for normal goods
Inverse for inferior goods
c = Qd/M is positive
c = Qd/M is negative
PR
Direct for substitutes
Inverse for complements
d = Qd/PR is positive
d = Qd/PR is negative
T
Direct
e = Qd/T is positive
PE
Direct
f = Qd/PE is positive
N
Direct
g = Qd/N is positive
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2-19
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 (examples to the contrary
have never been observed)
~ Qd increases when P falls, all else constant
~ Qd decreases when P rises, all else constant
~ Qd/P must be negative
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2-20
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 (demand price)
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2-21
A Demand Curve
(Figure 2.1)
Qd = 1,400 – 10P
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2-22
Graphing Demand Curves
❖ Change in quantity demanded
~ Occurs when 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 (to
the right if demand increase and to the left if
demand decreases).
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2-23
Shifts in Demand
(Figure 2.2)
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2-24
Supply
❖ Quantity supplied (Qs)
~ Amount of a good or service offered for
sale during a given period of time
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2-25
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)
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2-26
Determinants of Supply
❖ The quantity of good or service offered for
sale is determined not only by the price of
the good or service but also by the 1.
Price of the inputs used in production, 2.
the Price of goods that are related in
production, 3. the level of available
technology, 4 the expectations of
producers concerning the future price of
the good and 5. the number of firms or
amount of productive capacity in the
industry.
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2-27
Supply – all other things being
equal
❖ 1. The higher the price of the product the
greater the quantity firms will produce.
❖ The lower the price of the product the
smaller the quantity firms will produce.
❖ The Price and Quantity supplied are in
direct relationship.
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2-28
Supply – all other things being
equal
❖ 2. An increase in the price of one or more
of the inputs used to produce the product
will increase the cost of production.
❖ Therefore, an increase in the price of an
input causes a decrease in production,
while a decrease in the price of input
causes an increase in production. (Profits)
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2-29
Supply – all other things being
equal
❖ 3. Changes in the prices of goods that are
related in production may affect producers
in either one of two ways: Depending on
whether the Goods are Substitutes
(Wheat and Corn)or Complements ( Oil
and Natural Gas, Nickel and Copper, Beef
and leather hides, bacon and pork chops).
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2-30
General Supply Function
❖ Substitutes in production
~ Goods for which an increase in the price of one
good relative to the price of another good causes
producers to increase production of the now
higher-priced good and decrease production of
the other good
❖ Complements in production
~ Goods for which an increase in the price of one
good, relative to the price of another good,
causes producers to increase production of both
goods
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2-31
Supply – all other things being
equal
❖ 4.Tecnology is the state of knowledge
concerning how to combine resources to
produce goods and services.
❖ An improvement in technology results in
one or more of the inputs used in making
the good to be more productive.
❖ Can make more goods with same amount
of inputs or the same amount of goods
with fewer inputs.
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2-32
Supply – all other things being
equal
❖ 5. If a firm expects the price of a good
they produce to rise in the future they may
withhold some of the good in the market,
thereby reducing supply of the good in the
current period.
❖ 6. The number of firms in the industry
increases or if the productive capacity of
existing firms increases, more of the good
or service will be supplied at each price.
(And Conversely)
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2-33
General Supply Function – in
linear function form
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
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2-34
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
Pr
Inverse for substitutes
Direct for complements
m = Qs/Pr is negative
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
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2-35
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)
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2-36
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 given quantity for sale
(supply price)
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2-37
A Supply Curve
(Figure 2.3)
Qs = -400 + 20P
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2-38
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
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2-39
Shifts in Supply
(Figure 2.4)
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2-40
Shifts in Supply Curve
❖ A shift in supply only occurs when one of
the five determinants of supply changes in
value.
❖ An increase in supply causes a shift to the
right for the supply curve.
❖ A decrease in supply causes a shift to the
left for the supply curve.
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2-41
Supply and Demand Analysis
❖ The essential skill for doing demand and
supply analysis of real world markets is
the ability to identify correctly all of the
underlying demand and supply shifters
that are working to cause the market
prices and quantities to move higher or
lower.
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2-42
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
(equilibrium quantity) & producers can sell
all they want at the “market-clearing” or
“equilibrium” price.
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2-43
Market Equilibrium
(Figure 2.5)
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2-44
Market Equilibrium
❖ Excess supply (surplus)
~ Exists when quantity supplied exceeds
quantity demanded
❖ Excess demand (shortage)
~ Exists when quantity demanded exceeds
quantity supplied
~ There is no excess supply or demand at the
market equilibrium point.
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2-45
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
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2-46
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
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2-47
Measuring the Value of
Market Exchange (Figure 2.6)
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2-48
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
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2-49
Demand Shifts (Supply Constant)
(Figure 2.7)
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2-50
Demand Shifts & Supply
Constant
❖ When demand increases and supply is
constant, equilibrium price and quantity
both rise.
❖ When demand decreases and supply is
constant, equilibrium price and quantity
both fall.
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2-51
Supply Shifts (Demand Constant)
(Figure 2.8)
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2-52
Supply Shifts & Demand
Constant
❖ When supply increases and demand is
constant, equilibrium price falls and
equilibrium quantity rises.
❖ When supply decreases and demand is
constant, equilibrium price rises and
equilibrium quantity falls.
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2-53
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
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2-54
Simultaneous Shifts
❖ When demand and supply both shift
simultaneously, if the change in quantity
(price) can be predicted, the change price
(quantity) is indeterminate.
❖ The change in equilibrium quantity or
price is determined when the variable can
either rise of fall depending upon the
relative magnitudes by which demand and
supply shift.
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2-55
Simultaneous Shifts
❖ When both demand and supply increase,
a small increase in supply relative to
demand causes prices to rise, while a
large increase in supply relative to
demand causes a price to fall.
❖ When there is a simultaneous increase in
both demand and supply, equilibrium
output always increases. But the change
in equilibrium price is indeterminate.
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2-56
Simultaneous Shifts: (ï‚­D, ï‚­S)
P
S
S′
S′′
B
P′
P
P′′
•
A
•
•
C
D′
D
Q
Q′
Q′′
Q
Price may rise or fall; Quantity rises
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2-57
Simultaneous Shifts: (D, S)
P
S
S′
S′
A
•
P
P′
P′′
•
B
• C
D
D′
Q′ Q Q′′
Q
Price falls; Quantity may rise or fall
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
2-58
Simultaneous Shifts: (D, S)
P
S′′
S′
P′′
•
C
•
P′
S
B
A
•
P
D′
D
Q′′
Q Q′
Q
Price rises; Quantity may rise or fall
© 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
2-59
Simultaneous Shifts: (D, S)
P
S′′
S′
P′′
P
P′
• C
S
A
•
B
•
D
D′
Q′′
Q′
Q
Q
Price may rise or fall; Quantity falls
© 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
2-60
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
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
2-61
Ceiling & Floor Prices
❖ When the government sets a ceiling price
below the equilibrium price, a shortage or
excess demand results because
consumers wish to buy more units of the
good than producers are willing to sell at
the ceiling price.
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
2-62
Ceiling & Floor Prices
❖ If the government sets a floor price above
the equilibrium price, a surplus or excess
supply results because producers offer for
sale more units of the good than buyers
wish to consume at the floor price.
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
2-63
Ceiling & Floor Prices (Figure 2.12)
Px
Price (dollars)
Px
Sx
2
Sx
3
2
1
Dx
22
50 62
Quantity
Panel A – Ceiling price
Dx
Qx
32 50
84
Qx
Quantity
Panel B – Floor price
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
2-64
Summary
❖ 6 variables influence demand: good’s price, income,
prices of related goods, consumers’ tastes, expected
future price, and number of consumers
~ Law of demand states that quantity demanded increases
(decreases) when price falls (rises), all else constant
❖ 6 variables influence supply: good’s price, input
prices, prices of goods related in production,
producers’ expectation of future price, number of firms
❖ Equilibrium price and quantity determined by
intersection of supply and demand curves
❖ Consumer surplus arises because the equilibrium
price consumers pay is less than the value they place
on the units they purchase.
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
2-65
Summary
❖ Consumer surplus arises because the equilibrium
price consumers pay is less than the value they place
on units they purchase
~ Producer surplus arises because equilibrium price is greater
than the minimum price producers would be willing to accept
to produce.
~ Social surplus: sum of consumer surplus and producer surplus
❖ When both supply and demand shift simultaneously,
one can predict either the direction of change in price
or the direction of change in quantity, but not both
❖ A ceiling price (below equilibrium) results in a
shortage; a floor price (above equilibrium) results in a
surplus
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
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