Chapter 2
The Basics of Supply and Demand

Introduction
What are supply and demand?
What is the market mechanism?
What are the effects of changes in market equilibrium?
What are elasticities of supply and demand? ©2005 Pearson

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Topics to Be Discussed
How do short-run and long-run elasticities differ?
How do we understand and predict the effects of changing market conditions?
What are the effects of government intervention – price controls?

©2005 Pearson

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Supply and Demand
 Supply and demand analysis can:
1.

2.

3.

Help us understand and predict how real world economic conditions affect market price and production
Analyze the impact of government price controls, minimum wages, price supports, and production incentives on the economy
Determine how taxes, subsidies, tariffs and import quotas affect consumers and producers ©2005 Pearson

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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


Q S Q S(P)
©2005 Pearson

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The Supply Curve
S

Price
($ per unit)

The Supply Curve,
Graphically Depicted

P2
The supply curve slopes upward, demonstrating that at higher prices firms will increase output

P1

Q1

©2005 Pearson

Q2

Quantity

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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

©2005 Pearson

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Change in Supply
 The cost of raw materials falls

P



Produced Q1 at P1 and Q0 at P2



Now produce Q2 at P1 and Q1 at P2

P1



Supply curve shifts right to S’

P2

S

Q0

©2005 Pearson

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Q1

Q2

S’

Q

8

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 the price of the good
Change

©2005 Pearson

in costs of production

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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


Q D Q D(P)
©2005 Pearson

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The Demand Curve
Price
($ per unit)

The demand curve slopes downward, demonstrating that consumers are willing to buy more at a lower price as the product becomes relatively cheaper.

P2
P1
D
Q1

©2005 Pearson

Q2

Quantity

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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

©2005 Pearson

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Change in Demand
 Income Increases

P



Purchased Q0, at P2
P2
and Q1 at P1



Now purchased Q1 at
P2 and Q2 at P1



Same for all prices
Demand curve shifts right 

D

D’

P1

Q0

©2005 Pearson

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Q1

Q2

Q

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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

©2005 Pearson

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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
©2005 Pearson

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The Market Mechanism
S

Price
($ per unit)

The curves intersect at equilibrium, or marketclearing, price.
Quantity demanded equals quantity supplied at P0

P0

D

Q0

©2005 Pearson

Quantity

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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 wants to