CHAPTER 2

Market Forces:
Demand and Supply

McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter Overview
Chapter Outline
• Demand
– Factors that change quantity demanded and demand
– The demand function
– Consumer surplus
• Supply
– Factors that change quantity supplied and supply
– The supply function
– Producer surplus
• Market equilibrium
• Price restrictions and market equilibrium
– Price ceilings
– Price floors
• Comparative statics
– Changes in demand
– Changes in supply
– Simultaneous shifts in supply and demand

2-2
 Demand
Demand
• Market demand curve
– Illustrates the relationship between the total
quantity and price per unit of a good all
consumers are willing and able to purchase,
holding other variables constant.
• Law of demand
– The quantity of a good consumers are willing and
able to purchase increases (decreases) as the
price falls (rises).

2-3
 Demand
Market Demand Curve
Price ($)
$40

$30

$20

$10
Demand

0 20 40 60 80 Quantity
(thousands per year)

2-4
 Demand
Changes in Quantity Demanded
• Changing only price leads to changes in
quantity demanded.
– This type of change is graphically represented by a
movement along a given demand curve, holding
other factors that impact demand constant.
• Changing factors other than price lead to
changes in demand.
– These types of changes are graphically
represented by a shift of the entire demand curve.

2-5
 Demand
Changes in Demand
Price

A Increase
in
demand

Decrease
in B
demand

D1
D2 D0

0 Quantity

2-6
 Demand
Demand Shifters
• Income
– Normal good
– Inferior good
• Prices of related goods
– Substitute goods
– Complement goods
• Advertising and consumer tastes
– Informative advertising
– Persuasive advertising
• Population
• Consumer expectations
• Other factors
2-7
 Demand
Advertising and the Demand for Clothing
Price of
high-style
clothing
Due to an
increase in
advertising
$50

$40

D2
D1
0 50,000 60,000 Quantity of
high-style
clothing
2-8
 Demand
The Demand Function
• The demand function for good X is a
mathematical representation describing how
many units will be purchased at different
prices for X, the price of a related good Y,
income and other factors that affect the
demand for good X.

2-9
 Demand
The Linear Demand Function
• One simple, but useful, representation of a
demand function is the linear demand function:
𝑑
𝑄𝑋 = 𝛼0 + 𝛼𝑋 𝑃𝑋 + 𝛼𝑌 𝑃𝑌 + 𝛼𝑀 𝑀 + 𝛼𝐻 𝐻
, where:
– 𝑄𝑋 𝑑 is the number of units of good X demanded;
– 𝑃𝑋 is the price of good X;
– 𝑃𝑌 is the price of a related good Y;
– 𝑀 is income;
– 𝐻 is the value of any other variable affecting demand.

2-10
 Demand
Understanding the Linear Demand Function
• The signs and magnitude of the 𝛼 coefficients
determine the impact of each variable on the
number of units of X demanded.
𝑄𝑋 𝑑 = 𝛼0 + 𝛼𝑋 𝑃𝑋 + 𝛼𝑌 𝑃𝑌 + 𝛼𝑀 𝑀
• For example:
– 𝛼𝑋 < 0 by the law of demand;
– 𝛼𝑌 > 0 if good Y is a substitute for good X;
– 𝛼𝑀 < 0 if good X is an inferior good.

2-11
 Demand
The Linear Demand Function in Action
• Suppose that an economic consultant for X Corp. recently
provided the firm’s marketing manager with this estimate of the
demand function for the firm’s product:
𝑄𝑋 𝑑 = 12,000 − 3𝑃𝑋 + 4𝑃𝑌 − 1𝑀 + 2𝐴𝑋

Question: How many of good X will consumers purchase when

𝑃𝑋 = $200 per unit, 𝑃𝑌 = $15 per unit, 𝑀 = $10,000 and 𝐴𝑋 =
2,000? Are goods X and Y substitutes or complements? Is good X a
normal or an inferior good?

Answer:
𝑄𝑋 𝑑 = 12,000 − 3 200 + 4 15 − 1 10,000 + 2 2000 =
5,460 units. Goods X and Y are substitutes. Good X is an inferior
good.

2-12
 Demand
Inverse Demand Function
• By setting 𝑃𝑌 = $15 and 𝑀 = $10,000 and 𝐴 =
2,000 the demand function is
𝑄𝑋 𝑑 = 12,000 − 3𝑃𝑋 + 4 15 − 1 10,000 + 2 2,000
the linear demand function simplifies to
𝑑
𝑄𝑋 = 6,060 − 3𝑃𝑋
Solving this for 𝑃𝑋 in terms of 𝑄𝑋 𝑑 results in
1 𝑑
𝑃𝑋 = 2,020 − 𝑄𝑋
3
, which is called the inverse demand function. This
function is used to construct a market demand
curve.

2-13
 Demand
Graphing the Inverse Demand Function in Action

Price

$2,020

1
𝑃𝑋 = 2,020 − 𝑄𝑋 𝑑
3

0 6,060 Quantity

2-14
 Demand
Consumer Surplus
• Marketing strategies – like value pricing and
price discrimination – rely on understanding
consumer value for products.
– Total consumer value is the sum of the maximum
amount a consumer is willing to pay at different
quantities.
– Total expenditure is the per-unit market price
times the number of units consumed.
– Consumer surplus is the extra value that
consumers derive from a good but do not pay
extra for.

2-15
 Demand
Market Demand and Consumer Surplus in Action

Consumer Surplus
Price per
liter
Consumer Surplus:
0.5($5 - $3)x(2-0) = $2
$5
Total Consumer Value:
0.5($5 - $3)x2+(3-0)(2-0) = $8
$4

$3 Expenditures:
$(3-0) x (2-0) = $6
$2

$1 Demand

0 1 2 3 4 5 Quantity
in liters

2-16
 Supply
Supply
• Market supply curve
– Summarizes the relationship between the total
quantity all producers are willing and able to
produce at alternative prices, holding other
factors affecting supply constant.
• Law of supply
– As the price of a good rises (falls), the quantity
supplied of the good rises (falls), holding other
factors affecting supply constant.

2-17
 Supply
Changes in Quantity Supplied
• Changing only price leads to changes in
quantity supplied.
– This type of change is graphically represented by a
movement along a given supply curve, holding
other factors that impact supply constant.
• Changing factors other than price lead to
changes in supply.
– These types of changes are graphically
represented by a shift of the entire supply curve.

2-18
 Supply
Change in Supply in Action
Price
S1 S0

B S2
Decrease
in supply

Increase
in supply
A

0 Quantity

2-19
 Supply
Supply Shifters
• Input prices
• Technology or government regulation
• Number of firms
– Entry
– Exit
• Substitutes in production
• Taxes
– Excise tax
– Ad valorem tax
• Producer expectations

2-20
 Supply
Change in Supply in Action
Excise tax
Price
of S0+t
gasoline
$1.20 S0
t = 20¢
t

$1.00 t = per unit tax of 20¢

0 Quantity of
gasoline per
week
2-21
 Supply
Change in Supply in Action
Price Ad valorem tax
of
backpacks
S1 = 1.20 x S0
$24

S0

$20
$12

$10

0 1,100 2,450 Quantity of

backpacks per
week
2-22
 Supply
The Supply Function
• The supply function for good X is a
mathematical representation describing how
many units will be produced at different prices
for X, prices of inputs W, prices of
technologically related goods, and other
factors that affect the supply for good X.

2-23
 Supply
The Linear Supply Function
• One simple, but useful, representation of a
supply function is the linear supply function:
𝑠
𝑄𝑋 = 𝛽0 + 𝛽𝑋 𝑃𝑋 + 𝛽𝑊 𝑊 + 𝛽𝑟 𝑃𝑟 + 𝛽𝐻 𝐻
, where:
– 𝑄𝑋 𝑠 is the number of units of good X produced;
– 𝑃𝑋 is the price of good X;
– 𝑊 is the price of an input;
– 𝑃𝑟 is price of technologically related goods;
– 𝐻 is the value of any other variable affecting
supply.

2-24
 Supply
Understanding the Linear Supply Function
• The signs and magnitude of the 𝛽 coefficients
determine the impact of each variable on the
number of units of X produced.
𝑄𝑋 𝑠 = 𝛽0 + 𝛽𝑋 𝑃𝑋 + 𝛽𝑊 𝑊 + 𝛽𝑟 𝑃𝑟
• For example:
– 𝛽𝑋 > 0 by the law of supply.
– 𝛽𝑊 < 0 increasing input price.
– 𝛽𝑟 > 0 technology lowers the cost of producing
good X.

2-25
 Supply
The Linear Supply Function in Action
• Your research department estimates that the
supply function for televisions sets is given by:
𝑄𝑋 𝑠 = 2,000 + 3𝑃𝑋 − 4𝑃𝑅 − 1𝑃𝑊

Question: How many televisions are produced

when 𝑃𝑋 = $400, 𝑃𝑅 = $100 per unit, and 𝑃𝑊 =
$2,000?

Answer:
𝑄𝑋 𝑠 = 2,000 + 3 400 − 4 100 − 1 2,000 =
800 television sets.
2-26
 Supply
Inverse Supply Function
• By setting 𝑃𝑊 = $2,000 and 𝑃𝑟 = $100 in
𝑠
𝑄𝑋 = 2,000 + 3𝑃𝑋 − 4 100 − 1 2,000
the linear supply function simplifies to
𝑄𝑋 𝑠 = 3𝑃𝑋 − 400
𝑠
Solving this for 𝑃𝑋 in terms of 𝑄𝑋 results in
400 1 𝑠
𝑃𝑋 = + 𝑄𝑋
3 3
, which is called the inverse supply function.
This function is used to construct a market
supply curve.

2-27
 Supply
Producer Surplus
• The amount producers receive in excess of the
amount necessary to induce them to produce
the good.

2-28
 Supply
Producer Surplus in Action

Price 400 1 𝑆
𝑃𝑋 = + 𝑄𝑋 Supply
3 3
$400
Producer surplus

$400
3
0 800 Quantity

2-29
 Market Equilibrium
Market Equilibrium
• Competitive market equilibrium
– Determined by the interactions of the market
demand and market supply for the good.
– A price and quantity such that there is no shortage
or surplus in the market.
– Forces that drive market demand and market
supply are balanced, and there is no pressure on
prices or quantities to change.

2-30
 Market Equilibrium
Market Equilibrium I

Price Supply
Surplus

𝑃𝐻

𝑃𝑒

𝑃𝐿

Shortage
Demand

0 𝑄0 𝑄𝑒 𝑄1 280 Quantity

2-31
 Market Equilibrium

Market Equilibrium II
• Consider a market with demand and supply
functions, respectively, as
𝑄𝑑 = 10 − 2𝑃 and 𝑄 𝑠 = 2 + 2𝑃
• A competitive market equilibrium exists at a
price, 𝑃𝑒 , such that 𝑄𝑑 𝑃𝑒 = 𝑄 𝑠 𝑃𝑒 . That is,
10 − 2𝑃 = 2 + 2𝑃
8 = 4𝑃
𝑃𝑒 = $2
𝑄𝑒 = 10 − 2 $2 = 10 and 𝑄𝑒 = 2 + 2($4) = 10
𝑄𝑒 = 10 units

2-32
 Price Restrictions and Market Equilibrium

Price Restrictions
• In a competitive market equilibrium, price and
quantity freely adjust to the forces of demand
and supply.
• Sometime government restricts how much
prices are permitted to rise or fall.
– Price ceiling
– Price floor

2-33
 Price Restrictions and Market Equilibrium

Price Ceiling in Action I

Price Supply

Lost social welfare

Nonpecuniary price

𝑃𝐹

𝑃𝑒

𝑃𝑐 Priceceiling

Shortage
Demand

0 𝑄𝑠 𝑄𝑒 𝑄𝑑 280 Quantity

2-34
 Price Restrictions and Market Equilibrium

Price Ceiling in Action II

• Consider a market with demand and supply
functions, respectively, as
𝑄𝑑 = 10 − 2𝑃 and 𝑄 𝑠 = 2 + 2𝑃
• Suppose a $1.50 price ceiling is imposed on the
market.
– 𝑄𝑑 = 10 − 2 $1.50 = 7 units.
– 𝑄 𝑠 = 2 + 2($1.50) = 5 units.
– Since 𝑄𝑑 > 𝑄 𝑠 a shortage of 7 − 5 = 2 units exists.
– Full economic price of 5𝑡ℎ unit is 5 = 10 − 2𝑃𝑓𝑢𝑙𝑙 , or
𝑃𝑓𝑢𝑙𝑙 = $2.50. Of this,
• $1.50 is the dollar price
• $1 is the nonpecuniary price
2-35
 Price Restrictions and Market Equilibrium

Price Floor in Action I

Price Supply

Surplus
𝑃𝑓 Pricefloor

𝑃𝑒 Cost of
purchasing
excess supply

Demand

0 𝑄𝑑 𝑄𝑒 𝑄𝑠 280 Quantity

2-36
 Price Restrictions and Market Equilibrium

Price Floor in Action II

• Consider a market with demand and supply
functions, respectively, as
𝑄 𝑑 = 10 − 2𝑃 and 𝑄 𝑠 = 2 + 2𝑃
• Suppose a $4 price floor is imposed on the
market.
– 𝑄 𝑑 = 10 − 2 $4 = 2 units
– 𝑄 𝑠 = 2 + 2($4) = 10 units
– Since 𝑄 𝑠 > 𝑄 𝑑 a surplus of 10 − 2 = 8 units
exists
– The cost to the government of purchasing the
surplus is $4 × 8 = $32.
2-37
 Comparative Statics

Comparative Statics
• Comparative static analysis
– The study of the movement from one equilibrium
to another.
• Competitive markets, operating free of price
restraints, will be analyzed when:
– Demand changes;
– Supply changes;
– Demand and supply simultaneously change.

2-38
 Comparative Statics

Changes in Demand
• Increase in demand only
– Increase equilibrium price
– Increase equilibrium quantity
• Decrease in demand only
– Decrease equilibrium price
– Decrease equilibrium quantity
• Example of change in demand
– Suppose that consumer incomes are projected to
increase 2.5% and the number of individuals over 25
years of age will reach an all time high by the end of
next year. What is the impact on the rental car
market?

2-39
 Comparative Statics

Change in Demand in Action

Demand for Rental Cars
Price Supply

$49

$45
Demand1

Demand0

0 100 104 108 Quantity

(thousands
rented per day)

2-40
 Comparative Statics

Changes in Supply
• Increase in supply only
– Decrease equilibrium price
– Increase equilibrium quantity
• Decrease in supply only
– Increase equilibrium price
– Decrease equilibrium quantity
• Example of change in demand
– Suppose that a bill before Congress would require
all employers to provide health care to their
workers. What is the impact on retail markets?

2-41
 Comparative Statics
Change in Supply in Action

Price Supply1

Supply0
1
𝑃

𝑃0

Demand

0 𝑄1 𝑄0 Quantity

2-42
 Comparative Statics
Simultaneous Shifts in Supply and Demand
• Suppose that simultaneously the following
events occur:
– an earthquake hit Kobe, Japan and decreased the
supply of fermented rice used to make sake wine.
– the stress caused by the earthquake led many to
increase their demand for sake, and other
alcoholic beverages.
• What is the combined impact on Japan’s sake
market?

2-43
 Comparative Statics
Simultaneous Shifts in Supply and Demand in Action

Japan’s Sake Market

Price
Supply2
C
𝑃2
Supply1

B Supply0
𝑃1

A
𝑃0
Demand1
Demand0

0 𝑄2 𝑄0 𝑄1 Quantity

2-44
 Conclusion
• Demand and supply analysis is useful for
– Clarifying the “big picture” (the general impact of
a current event on equilibrium prices and
quantities).
– Organizing an action plan (needed changes in
production, inventories, raw materials, human
resources, marketing plans, etc.).

2-45
 Demand
Market Demand Curve
Price
(Dollars per Barrel) International Oil Market

$140

$100

$60

$20 Demandoil

0 80 160 240 280 Quantity

(Millions of Barrels)

2-46
 Demand
Changes in Quantity Demanded
Price
(Dollars per Barrel) International Oil Market

$140

Increase in quantity demanded

$100
$90

Demandoil

0 80 100 280 Quantity

(Millions of Barrels)

2-47
 Demand
Change in Demand
International Oil Market
Price
(Dollars per Barrel)

$160

$140

$100
$90
Increase in demand

Demandoil2
Demandoil1

0 80 100 120 140 280 Quantity

(Millions of Barrels)

2-48
 Supply
Change in Quantity Supplied

International Oil Market

Price Supplyoil
(Dollars per Barrel)

$65
Increase in quantity supplied
$60

$20

0 80 90 Quantity
(Millions of Barrels)

2-49
 Supply
The Market Supply Curve

International Oil Market

Price Supplyoil
(Dollars per Barrel)

$140

$100

$60

$20

0 80 160 240 Quantity

(Millions of Barrels)

2-50
 Supply
Change in Supply in Action

International Oil Market

Price Supplyoil2 Supplyoil1
(Dollars per Barrel) Decrease in supply
$140

$100

$50

$20

0 100 160 180 240 Quantity

(Millions of Barrels)

2-51
 Market Equilibrium
Competitive Market Equilibrium I

International Oil Market

Price Supplyoil
(Dollars per Barrel) Surplus
$140 160 million barrels
Forces of demand and supply
$120 put downward
pressure on price.
Pe = $80 Competitive market equilibrium
Qd(Pe) = Qs(Pe)
Forces of demand and supply
$40 put upward pressure
Shortage on price.
$20 160 million barrels Demandoil

0 40 Qe = 120 200 280 Quantity

(Millions of Barrels)

2-52
 Price Restrictions and Market Equilibrium

Price Ceiling in Action I

International Oil Market

Price Supplyoil
(Dollars per Barrel)

$140 Lost social welfare

Nonpecuniary price

Pf = $120

Pe = $80 Competitive market equilibrium

Qd(Pe) = Qs(Pe)

Pc = $40 Priceceiling

Shortage
$20 160 million barrels Demandoil

0 40 Qe = 120 200 280 Quantity

(Millions of Barrels)

2-53
 Comparative Statics

Changes in Demand
• Increase in demand only
– Increase equilibrium price
– Increase equilibrium quantity
• Decrease in demand only
– Decrease equilibrium price
– Decrease equilibrium quantity
• Example of change in demand
– Suppose that worldwide demand for fuel-efficient
automobiles is projected to increase by 30% next year.
What is the impact on the international crude oil
market?

2-54
 Comparative Statics

Change in Demand in Action

International Oil Market
Price Supplyoil
(Dollars per Barrel)

$140

Pe1 = $80

Pe2 = $36

$20 Demandoil2 Demandoil1

0 Qe2 = 68 Qe1 = 120 280 Quantity

(Millions of Barrels)

2-55
 Comparative Statics

Changes in Supply
• Increase in supply only
– Decrease equilibrium price
– Increase equilibrium quantity
• Decrease in supply only
– Increase equilibrium price
– Decrease equilibrium quantity
• Example of change in demand
– Suppose that war breaks out in a major oil-
producing country in the Middle East. What is the
impact on the international crude oil market?

2-56
 Comparative Statics
Change in Supply in Action

International Oil Market

Price Supplyoil2 Supplyoil1
(Dollars per Barrel)

$140

Pe2 = $100
Pe1 = $80

$20 Demandoil

0 Qe2 = 80 Qe1 = 120 280 Quantity

(Millions of Barrels)

2-57
 Comparative Statics
Simultaneous Shifts in Supply and Demand
• Suppose that simultaneously the following
two events occur:
– worldwide demand for fuel-efficient automobiles
is projected to increase by 30% next year.
– war breaks out in a major oil-producing country in
the Middle East.
• What is the combined impact on the
international crude oil market?

2-58
 Comparative Statics
Simultaneous Shifts in Supply and Demand in Action

International Oil Market

Price Supplyoil2 Supplyoil1
(Dollars per Barrel)

$140

The equilibrium price increases

Pe1 = $80 or decreases depending on the
magnitude of the demand
Pe2 = $65 and supply changes.

$20 Demandoil2 Demandoil1

Qe2 = 10 Qe1 = 120 280 Quantity

(Millions of Barrels)

2-59