Basics of Supply and Demand

Market Mechanism

Introduction What are supply and demand? How does a market mechanism

work? What are the effects of changes in

market equilibrium?

Supply and demand The Supply curve

The relationship between the quantity of a good that producers are willing to sell and the price of the good.

Measures quantity on the x-axis and price on the y-axis

(P)QQ SS

The Supply CurveS

The supply curve slopesupward demonstrating that

at higher prices firmswill increase output

The SupplyCurve Graphically

Quantity

Price($ per unit)

P1

Q1

P2

Q2

The Supply Curve Other Variables Affecting Supply

Costs of Production Labor Capital Raw Materials

Lower costs of production allow a firm to produce more at each price and vice versa

Change in Supply The cost of raw

materials falls Produced Q1 at

P1 and Q0 at P2 Now produce Q2

at P1 and Q1 at P2

Supply curve shifts right to S’

P S

Q

P1

P2

Q1Q0

S’

Q2

The Supply Curve Change in Quantity Supplied

Movement along the curve caused by a change in price

Change in Supply Shift of the curve caused by a change

in something other than price Change in costs of production

Supply and Demand The Demand Curve

The relationship between the quantity of a good that consumers are willing to buy and the price of the good.

Measures quantity on the x-axis and price on the y-axis

(P)QQ DD

The Demand Curve

D

The demand curve slopesdownward demonstrating that consumers are willing

to buy more at a lower priceas the product becomes

relatively cheaper.

Quantity

Price($ per unit)

P2

Q1

P1

Q2

The Demand Curve Other Variables Affecting Demand

Income Increases in income allow consumers to

purchase more at all prices Consumer Tastes Price of Related Goods

Substitutes Complements

DP

Q

D’

Q1

P2

Q0

P1

Q2

Change in Demand Income Increases

Purchased Q0, at P2 and Q1 at P1

Now purchased Q1 at P2 and Q2 at P1

Same for all prices

Demand Curve shifts right

The Demand Curve Changes in quantity demanded

Movements along the demand curve caused by a change in price.

Changes in demand A shift of the entire demand curve

caused by something other than price. Income Preferences

The Market Mechanism The market mechanism is the

tendency in a free market for price to change until the market clears

Markets clear when quantity demanded equals quantity supplied at the prevailing price

Market Clearing price – price at which markets clear

The Market Mechanism

D

S

The curves intersect atequilibrium, or market-

clearing, price. Quantity demanded

equals quantity supplied at P0

P0

Q0Quantity

Price($ per unit)

The Market Mechanism In equilibrium

There is no shortage or excess demand There is no surplus or excess supply Quantity supplied equals quantity

demanded Anyone who wishes to buy at the

current price can and all producers who wish to sell at that price can

Market Surplus The market price is above

equilibrium There is excess supply - surplus Downward pressure on price Quantity demanded increases and

quantity supplied decreases The market adjusts until new

equilibrium is reached

The Market Mechanism

D

S

P0

Q0

1. Price is above the market clearing price – P1

2. Qs > QD

3. Price falls to the market-clearing price

4. Market adjusts to equilibrium

P1

Surplus

Quantity

Price($ per unit)

QSQD

The Market Mechanism The market price is below

equilibrium: There is a excess demand - shortage Upward pressure on prices Quantity demanded decreases and

quantity supplied increases The market adjusts until the new

equilibrium is reached.

The Market Mechanism

D

S

QS QD

P2

Quantity

Price($ per unit)

1. Price is below the market clearing price – P2

2. QD > QS

3. Price rises to the market-clearing price

4. Market adjusts to equilibrium

Q3

P3

Shortage

The Market Mechanism Supply and demand interact to

determine the market-clearing price. When not in equilibrium, the market

will adjust to alleviate a shortage or surplus and return the market to equilibrium.

Markets must be competitive for the mechanism to be efficient.

Changes In Market Equilibrium Equilibrium prices are determined

by the relative level of supply and demand.

Changes in supply and/or demand will change in the equilibrium price and/or quantity in a free market.

S’

Changes In Market Equilibrium

Raw material prices fall S shifts to S’ Surplus at P1

between Q1, Q2 Price adjusts to

equilibrium at P3, Q3

P

Q

SD

P3

Q3Q1

P1

Q2

D’S

D

Q3

P3

Changes In Market Equilibrium

Income Increases Demand

increases to D1 Shortage at P1 of

Q1, Q2 Equilibrium at

P3, Q3

P

QQ1

P1

Q2

D’S’

Changes In Market Equilibrium

Income Increases & raw material prices fall Quantity

increases If the increase in

D is greater than the increase in S price also increases

P

Q

S

P2

Q2

D

P1

Q1

Shifts in Supply and Demand When supply and demand change

simultaneously, the impact on the equilibrium price and quantity is determined by:

1. The relative size and direction of the change

2. The shape of the supply and demand models

The Price of a College Education The real price of a college education

rose 55 percent from 1970 to 2002. Increases in costs of modern

classrooms and wages increased costs of production – decrease in supply

Due to a larger percentage of high school graduates attending college, demand increased

Market for a College Education

Q (millions enrolled))

P(annual cost

in 1970dollars)

D1970

S1970

S2002

D2002

$3,917

13.2

New equilibriumwas reached at $4,573 and a quantity of 12.3 million students

$2,530

8.6