Supply and Demand 2

Chapter Outline

2.1 Markets and Models

2.2 Demand
2.3 Supply
2.4 Market Equilibrium

2.5 Elasticity
2.6 Conclusion

2-­‐1  

Introduction 2
In this chapter, we introduce the supply and
demand model. We will:
• Describe the basics of supply and demand
• Use equations and graphs to represent supply
and demand
• Analyze markets for goods and services using
the supply and demand model

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2.1 Markets and Models 2
What is a market?
A market is characterized by a specific
• Product or service being bought and sold
• Location
• Point in time
Markets facilitate exchange, including economic resources
and final goods and services

2-­‐3  

2.1 Markets and Models 2

What are the supply and demand for a good?
• Supply: The combined amount of a good that all producers in a
market are willing to sell
• Demand: The combined amount of a good that all consumers are
willing to buy

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2.2 Demand 2
What factors influence the demand for a good or
service?
• Price
• Number of consumers
• Consumer wealth
• Consumer tastes
• Prices of other, related goods
• Compliments and substitutes

2-­‐5  

2.2 Demand 2
Many factors influence demand for goods and
services… is there one factor that stands out?
• Focus on how the price of a good influences the quantity
demanded by consumers
• Demand curve – describes relationship between quantity
demanded and price, holding all other factors constant

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 2.2 Demand 2
Consider the market for oranges. We want to map out the quantity (in
pounds) demanded by local consumers at various prices ($/pound)
Price  of  oranges  (dollars/
pound)
At $6, consumers demand no oranges;
this is known as the demand choke price
6
As the price drops, consumers demand a
5 greater quantity of oranges
4 We draw a demand curve that connects
all the observed price-quantity
3
combinations
2
REMEMBER TO ALWAYS LABEL
1 GRAPHS!

0 400 800 1,200 1,600 2,000 2,400 Quantity  of  oranges  

(pounds)
2-­‐7  

2.2 Demand 2
1.  Derivation of Demand Curve from Demand Schedule

Price  of  Oranges  (per  pound)   Pounds  of  Oranges  

$1   2000  
$2   1600  
$3   1200  
$4   800  
$5   400  
$6   0  
$7   0  

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2.2 Demand 2
2. Determine Slope of the Demand Curve using any two points

Rise ΔinY 2−3 −1

Slope = = = = = −0.0025
Run ΔinX 1600 −1200 400
Price  of  Oranges  (per  pound)   Pounds  of  Oranges  
$1   2000  
$2   1600  
$3   1200  
$4   800  
$5   400  
$6   0  
$7   0  
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2.2 Demand 2
3. Now, use the slope and one point (X =2,Y=1600) to solve for
the one unknown in the demand equation – the intercept term:

Y = mX + b
Y = −0.0025X + b
Y + 0.0025X = b
2 + 0.0025(1600) = b
2+4 = b
6=b

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2.2 Demand 2
4. Combine the slope and intercept terms to give us the Inverse
Demand Curve.

Y = mX + b
Y = −0.0025X + 6
Pr ice = −0.0025QD + 6
Pr ice = 6 − 0.0025QD

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2.2 Demand 2
5. Solve for Quantity Demanded and get the Demand Curve

Pr ice = 6 − 0.0025QD
Pr ice − 6 = −0.0025QD
Pr ice − 6
= QD
−0.0025
−400 Pr ice + 2400 = QD
QD = 2400 − 400 Pr ice

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2.2 Demand 2
QD  =  2,400  –  400P
where QD is the quantity of oranges demanded (in pounds)
and P is the price of oranges ($/pound)
It is common in economics to plot price on the vertical axis.
Solving for price as a function of quantity demanded yields
the inverse demand curve
P  =  6  –  0.0025QD

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2.2 Demand 2
What about the other factors that influence demand?
• The demand curve is graphed in two dimensions; all other
factors are assumed constant
• If another factor changes, the demand curve will shift

Change in demand – a shift of the entire demand curve

caused by a change in a non-price factor that affects
demand.

Change in quantity demanded – a movement along the

demand curve in response to a price change, with
everything else held constant
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 2.2 Demand 2
Figure 2.2 Shifts in the Demand Curve

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Application 2
Mad Cow disease and beef
Bovine spongiform encephalopathy (Mad Cow Disease),
is a potentially fatal disease contracted through the
consumption of infected beef products
Schlenker and Villas-Boas (2009) investigate the impact Image: FreeDigitalPhotos.net

of the announcement of the first confirmed case of MCD

in the US (December 23, 2003) on daily beef sales for a
national supermarket chain
The authors find a significant drop in the quantity of beef
purchased following the announcement: approximately
21% less beef was purchased in the following 35 days
How do we represent this “shock” using demand curves?

Citation: Wolfram Schlenker and Sofia B. Vilas-Boas. 2009. Consumer and Market Responses to Mad Cow Disease.
Image: FreeDigitalPhotos.net
American Journal of Agricultural Economics 91(4):1140−1152.

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Application 2
Prior to discovery, consumers demand five millions pounds of beef
Price  of  beef  ($/
pound) per day at $3 per pound (numbers are examples)
Post-discovery, health concerns cause demand to shift inward,
reducing quantity demanded at $3 by one million pounds per day

3
Demand  curve  after  
announcement  of  MCD

Demand  curve  prior  to  

announcement  of  MCD

0 4 5 Quantity  of  beef  per  day  

(millions  of  pounds)

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2.2 Demand 2
Why do we treat price differently?
1.  Price is usually the most important factor influencing demand
2.  Prices in most markets can change easily and often
3.  Price is the one factor of demand most likely to measurably
impact the supply of a good, and therefore ties together the
two sides of the model
1.  What would happen if we used number of consumers on
Y-axis?
Now to the supply side of the model

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 2.3 Supply 2
What factors influence the supply of a good or
service?
• Price
• Number of sellers
• Production costs (related to production
technology)
• Sellers’ outside options

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2.3 Supply 2
We can describe the relationship between the quantity of oranges
supplied (in pounds) and the price ($/pound) with a supply curve
Price  of  oranges  
(dollars/pound)
At prices below $2 per pound, suppliers find it
unprofitable to sell any oranges; this is known as
6 the supply choke price
5 As the price increases beyond $2, suppliers will
provide oranges to the market
4
Just as with demand, we connect the observed
3
price-quantity combinations using a supply curve
2

0 400 800 1,200 1,600 Quantity  of  oranges  

(pounds)
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2.3 Supply 2
We can also describe the supply curve mathematically
The supply curve on the previous slide is given as
QS  =  400P  –  800
where QS is the quantity of oranges supplied (in pounds) and
P is the price of oranges ($/pound)
Since we plot price on the vertical axis, the inverse supply
curve is given as
P  =  2  +  0.0025QS

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2.3 Supply 2
When a factor affecting supply other than price
changes, the result is a shift in the supply curve
Change in supply – a shift of the entire supply curve
caused by a change in a non-price factor that affects supply

Change in quantity supplied – a movement along the

supply curve in response to a price change, with everything
else held constant

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 2.3 Supply 2
Figure 2.5 Shifts in the Supply Curve

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Application 2
Solar panels and polysilicon
Solar energy is often touted as a key ingredient in the
future of energy, but has historically been cost-prohibitive
Recently, prices for solar modules have fallen rapidly,
pushing the cost of solar power closer to “grid parity”
• Grid parity means solar can compete with other sources of
energy on a cost basis

One of the key reasons has to do with the cost of

production—the price of polysilicon, a semiconductor that
is the basis for most solar systems, dropped more than
90% between 2008 and 2011
How can we describe this phenomenon using supply Image: FreeDigitalPhotos.net

curves?
Citation: Roca, M and B. Sills. November 10, 2011. “Solar Glut Worsens as Supply Surge Cuts Prices 93%: Commodities.”
Bloomberg News, www.bloomberg.com

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 Application 2
Price  of   In 2008, the cost of solar
solar  
capacity  
installation averaged $3 per watt;
($/watt) Supply  curve  in  2008
producers were willing to supply
10 megawatts (MW) (numbers
are examples)
As suppliers of polysilicon expand
3
capacity, the cost of this key input
drops, shifting the supply of solar
energy out
Supply  curve  in  2011 Producers are willing to supply 30
MW in 2011 at a price of $3 per
watt
0 10 30
New  solar  
capacity  
(megawatts)
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2.4 Market Equilibrium 2

Combining the descriptions of market supply and market
demand completes the model
• Remember, supply and demand curves relate the price of a
good to the quantity demanded or supplied
The point at which these two curves cross is called the
market equilibrium
• Market equilibrium – occurs when the price of a good results in
the quantity demanded equal to the quantity supplied
• Equilibrium price – the only price at which the quantity
demanded equals the quantity supplied

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 2.4 Market Equilibrium 2
The market equilibrium can be identified mathematically. For the
orange example:
QD  =  2,400  –  400P          ,            QS  =  400P  –  800
At equilibrium, Qe  =  QD  =  QS (Qe is equilibrium quantity); we solve
for equilibrium price, Pe, by setting supply equal to demand
2,400  –  400Pe  =  Qe  =  400Pe  –  800
Combining terms containing Pe yields
 800Pe  =  3200  ,  Pe  =  4  
To find Qe, substitute Pe  =  4  into either equation, yielding Qe  =  800  

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2.4 Market Equilibrium 2

Graphically, equilibrium can be found by plotting supply and
demand together
Price  of  oranges  (dollars/ Demand and supply intersect at price
pound)
S of $4.00 per pound of oranges,
resulting in 800 pounds of oranges
6
being sold
5
This is the only price that can “clear”
4 the market
• Higher prices: quantity supplied exceeds
3
quantity demanded
2
• Lower prices: quantity demanded
exceeds quantity supplied
1
D
0 400 800 1,200 1,600 2,000 2,400 Quantity  of  oranges  
(pounds)
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 2.4 Market Equilibrium 2
How do markets move toward equilibrium? First, if P  >  Pe,
quantity supplied will exceed quantity demanded
•  Excess supply is referred to as surplus
•  To sell their products, producers must lower prices
•  As prices fall, quantity demanded increases and quantity
supplied decreases until the market reaches equilibrium at a
lower price

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2.4 Market Equilibrium 2

Describing a surplus graphically

Price  of  oranges  (dollars/ At a price of $5, 1,200 pounds are

pound)
S supplied, but only 400 are demanded
Surplus
6 There is a surplus of 800 pounds
To reach equilibrium, prices must fall,
5
leading to a decrease in the quantity
4 supplied, and an increase in the quantity
demanded
3

1
D
0 400 800 1,200 1,600 2,000 2,400 Quantity  of  oranges  
(pounds)
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 2.4 Market Equilibrium 2
Likewise, if  P  <  Pe, quantity demanded will exceed quantity
supplied
•  Excess demand is referred to as shortage
•  The shortage will induce buyers to bid up the price
•  As prices rise, quantity demanded will fall and quantity
supplied will rise until the market reaches equilibrium at a
higher price

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2.4 Market Equilibrium 2

Describing a shortage graphically

Price  of  oranges  (dollars/ At a price of $3, 400 pounds are supplied,
pound)
S but 1,200 pounds are demanded

6 There is a shortage of 800 pounds

5 To reach equilibrium, prices must rise,

leading to a decrease in the quantity
4 demanded, and an increase in the quantity
3
supplied

2
Shortage
1
D
0 400 800 1,200 1,600 2,000 2,400 Quantity  of  oranges  
(pounds)
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 2.4 Market Equilibrium 2
In January, 2012, the FDA announced it had detected low
levels of carbendazim, a potentially dangerous fungicide, in
samples of orange juice
How will this announcement affect the market for oranges?
• Supply side – the levels detected were not sufficient to induce
action by FDA; assume no impact on supply
• Demand side – bad press can have negative impacts on
demand for food products… what should happen?

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2.4 Market Equilibrium 2

We can describe this graphically

Price  of  oranges   Prior to the FDA’s discovery, 800 pounds of

(dollars/pound) oranges are sold at $4 per pound
S

6 After the announcement, demand shifts from D1

to D2
5
The new equilibrium occurs when 400 pounds
4 are sold at a price of $3 per pound

3 There has been a decrease in demand and a

decrease in the quantity of oranges
2 supplied in response to a falling price
1
D2 D1
0 400 800 1,200 1,600 2,000 2,400 Quantity  of  oranges  
(pounds)
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2.4 Market Equilibrium 2
Summary of the effect of a shift in supply or demand on
market equilibrium

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2.4 Market Equilibrium 2

What determines the magnitude of the change in equilibrium
price and quantity?
Two important parameters
• Size of the shift
• Slope of the curves
• If demand shifts, the slope of the supply curve determines size of
changes to equilibrium price and quantity, and vice versa
• The size of the change in price is inversely related to the size of
the change in quantity

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2.4 Market Equilibrium 2
Figure 2.11 Size of Equilibrium Price and Quantity Changes, and the
Slopes of the Supply and Demand Curves

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2.4 Market Equilibrium 2

Sometimes, supply and demand shift simultaneously
Hurricane Katrina and the New Orleans housing market
• Katrina destroyed many homes… what happens to supply?
• The hurricane displaced thousands of residents, many have not
returned… what happens to demand?
• How will these shifts affect the housing market equilibrium in
New Orleans?

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 2.4 Market Equilibrium 2
Hurricane Katrina and the New Orleans housing market

Price S2 S1   The hurricane shifts supply and demand

inward. The result is a large drop in quantity,
and a small drop in price

ΔP   However, without specific information on

ΔP   shifts and slopes of supply and demand, we
cannot know for sure what happens to price
Example: Consider smaller demand shift;
quantity still falls, but price has risen
D2   D2   D1   slightly!

0 Quantity
ΔQ  
ΔQ  

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