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Chapter 2: Demand, Supply, and Market Equilibrium
McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
2-2
Demand
• Quantity demanded (Qd)
• Amount of a good or service consumers are willing & able to purchase during a given period of time
2-3
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
2-4
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)
2-5
General Demand Function
• 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
Qd = a + bP + cM + dPR + eT + fPe + gN
2-6
Variable Relation to Qd Sign of Slope Parameter
General Demand Function
Inverse for complements
P
Pe
N
M
PR
Inverse
Direct
Direct
Direct
Direct for normal goods
Inverse for inferior goods
Direct for substitutes
b = Qd/P is negative
c = Qd/M is positive
c = Qd/M is negative
d = Qd/PR is positive
d = Qd/PR is negative
f = Qd/Pe is positive
g = Qd/N is positive
e = Qd/T is positiveT
2-7
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
2-8
Direct Demand Function
pQ
ypp
yqpqpQ
ypppQ
YpppfQ
d
c
cbd
cbd
cbd
b
20286
13,3,4
2/,3/,20/
232020171
),,( ,
Demand for Pork
2-9
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)
2-10
Inverse Demand Function
• How much consumers are willing to pay as a function of quantity
05./
05.030.14
20286
Qp
Qp
pQ
2-11
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
2-12
Direct Demand Function
d
d
d
R
Rd
R
Q/-P
MQ
PQ
PM
PMpQ
PMpDQ
101140
function demand Inverse
05./
10400,1
200,000,60
2405.10200,3
),,(
2-13
Demand Schedule
2-13
2-14
A Demand Curve (Figure 2.1)
2-15
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
2-16
Three Demand Shifts
2-17
2-18
Shifts in Demand (Figure 2.2)
2-19
Supply
• Quantity supplied (Qs)
• Amount of a good or service offered for sale during a given period of time
2-20
• 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)
Supply
2-21
General Supply Function
• 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
Qs = h + kP + lPI + mPr + nT + rPe + sF
2-22
Variable Relation to Qs Sign of Slope Parameter
General Supply Function
Direct for complements
P
Pe
F
PI
Pr
Direct
Direct
Direct
Inverse
Inverse
Inverse for substitutes
k = Qs/P is positive
l = Qs/PI is negative
m = Qs/Pr is negative
m = Qs/Pr is positive
r = Qs/Pe is negative
s = Qs/F is positive
n = Qs/T is positiveT
2-23
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)
2-24
Direct Supply Function
pQ
p
ppQ
ppSQ
h
h
h
4088
50.1$
6040178
),(
pork ofSupply
2-25
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)
2-26
Inverse Supply Function
s
s
Qp
pQ
025.2.2
4088
2-27
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
2-28
Direct Supply Function
s
s
I
Is
Is
QP
PQ
FP
FPPQ
FPPSQ
20/120
Supply Inverse
20400
25,100
201020100
),,(
2-29
A Supply Curve (Figure 2.3)
2-30
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
2-31
Three Supply Functions
10/
201020100
Is
Is
PQ
FPPQ
2-32
Shifts in Supply (Figure 2.4)
2-33
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
2-34
Market Equilibrium
800
60$
2040010400,1
20400
10400,1
e
e
sd
s
d
Q
P
PP
PQ
PQ
2-35
Market Equilibrium (Figure 2.5)
2-36
Market Equilibrium
• Excess demand (shortage)• Exists when quantity demanded exceeds
quantity supplied
• Excess supply (surplus)• Exists when quantity supplied exceeds
quantity demanded
2-37
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
2-38
Ceiling & Floor Prices (Figure 2.12)
Qx
Quantity
Qx
Px Px
Quantity
Pri
ce (
dolla
rs)
Sx
Dx
2
50
1
6222
3
32 84
Panel A – Ceiling price
Sx
Dx
2
50
Panel B – Floor price
2-39
Market Equilibrium
800
60$
2040010400,1
20400
10400,1
e
e
sd
s
d
Q
P
PP
PQ
PQ
2-40
$50 Price Ceiling
300demand Excess
600
)50(20400
20400
900
)50(10400,1
10400,1
sd
s
s
s
d
d
d
Q
Q
PQ
Q
Q
PQ
A price ceiling is only effective when it is set below the equilibrium price
2-41
Marginal Valuation
pricemarket black Highest
80
10400,1600
600
10400,1
P
P
Q
PQ
s
d
2-42
$80 Price Floor
600supply Excess
200,1
)80(20400
20400
600
)80(10400,1
10400,1
ds
s
s
s
d
d
d
Q
Q
PQ
Q
Q
PQ
2-43
500 Unit Quota
90
10400,1500
500
800
10400,1
Quota
sd
s
e
d
P
P
Q
Q
PQ
2-44
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
2-45
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
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
2-47
Measuring the Value of Market Exchange (Figure 2.6)
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
2-49
Demand Shifts (Supply Constant) (Figure 2.7)
2-50
Supply Shifts (Demand Constant) (Figure 2.8)
2-51
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
2-52
S′′
Simultaneous Shifts: (D, S)
S
D′
S′
D
Q
Price may rise or fall; Quantity rises
P
•A
Q
P
B•P′
Q′ Q′′
C•P′′
2-53
S′
Simultaneous Shifts: (D, S)
D
S
D′
S′
Q
Price falls; Quantity may rise or fall
P
•A
Q
P
B•P′
Q′ Q′′
C•P′′
2-54
Simultaneous Shifts: (D, S)
S′′
D
S
D′
S′
Q
Price rises; Quantity may rise or fall
P
•A
Q
P
B
•P′
Q′Q′′
C•P′′
2-55
Simultaneous Shifts: (D, S)
S′′
D
S
D′
S′
Q
Price may rise or fall; Quantity falls
P
•A
Q
PB•P′
Q′Q′′
C•P′′