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CHAPTER 2

Market Forces: Demand and Supply

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Learning Objectives
1. Explain the laws of demand and supply, and identify
factors that cause demand and supply to shift.
2. Calculate consumer surplus and producer surplus, and
describe what they mean.
3. Explain price determination in a competitive market, and
show how equilibrium changes in response to changes in
determinates of demand and supply.
4. Explain and illustrate how excise taxes, ad valorem taxes,
price floors, and price ceilings impact the functioning of a
market.
5. Apply supply and demand analysis as a qualitative
forecasting tool to see the “big picture” in competitive
markets.

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Demand
Demand

• Law of demand
– The quantity of a good consumers are willing and
able to purchase increases (decreases) as the price
falls (rises).

– Price and quantity demanded are inversely related.

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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.

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Demand
Market Demand Curve
Price ($)
$40

$30

$20

$10
Demand

0 20 40 60 80 Quantity
(thousands per year)

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Demand

Shift in Quantity Demanded versus a Shift


in Demand

• 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.

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Demand

Shift in Quantity Demanded versus a Shift


in Demand

• 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.

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Demand

Changes in Demand
Price

A Increase
in
demand

Decrease
in B
demand

D1
D2 D0

0 Quantity

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Demand

Demand Shifters

• Income
– Normal good
– Inferior good

• Prices of related goods


– Substitute goods
– Complement goods

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Demand

Demand Shifters

• Advertising and consumer tastes


– Informative advertising
– Persuasive advertising

• Population

• Consumer expectations

• Other factors

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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
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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.

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Demand
The Linear Demand Function

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Demand

Understanding the Linear Demand Function

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Demand

The Linear Demand Function in Action


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Demand
Inverse Demand Function

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Demand

Graphing the Inverse Demand Function in Action


Price

$2,020

0 6,060 Quantity

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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.

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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

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Supply
Supply
• Market supply curve
– A curve indicating the total quantity of a good that
all producers in a competitive market would
produce at each price, holding input prices,
technology, and other variables 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.

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Supply

Changes in Quantity Supplied versus Changes in Supply

• 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.

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Supply
Changes in Supply
Price
S1 S0

B S2
Decrease
in supply

Increase
in supply
A

0 Quantity

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Supply
Supply Shifters
• Input prices
• Technology or government regulation
• Number of firms
– Entry
– Exit
• Substitutes in production
• Taxes
– Excise tax: a tax on each unit of output sold, where tax
revenue is collected from the supplier
– Ad valorem tax: percentage tax
• Producer expectations

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Supply
A Per Unit (Excise) Tax
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
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Supply
An Ad Valorem Tax
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
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Supply
The Supply Function
• The supply function for good X is a
mathematical representation describing how
many units will be produced at alternative
prices for X, alternative input prices W, and
alternative values of other variables that affect
the supply for good X.

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Supply
The Linear Supply Function

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Supply
Understanding the Linear Supply
Function

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Supply

The Linear Supply Function in Action


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Supply
Inverse Supply Function

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Supply
Producer Surplus
• Producer surplus: the amount producers receive
in excess of the amount necessary to induce
them to produce the good.

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Supply
Producer Surplus in Action

Price Supply

$400
Producer surplus

0 800 Quantity

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Market Equilibrium
Market Equilibrium
• Competitive Market Equilibrium
– Determined by the intersection of the market
demand and market supply curves.
– 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.
– The equilibrium price is the price that equates
quantity demanded with quantity supplied

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Market Equilibrium
Market Equilibrium

Price Supply
Surplus

Shortage
Demand

0 280 Quantity

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Market Equilibrium

Market Equilibrium in Action


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Price Restrictions and Market Equilibrium

Price Restrictions and Market Equilibrium

• 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

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Price Restrictions and Market Equilibrium

A Price Ceiling

Price Supply

Lost social welfare


Nonpecuniary price

Priceceiling

Shortage
Demand

0 280 Quantity

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Price Restrictions and Market Equilibrium

Price Ceiling in Action


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Price Restrictions and Market Equilibrium

A Price Floor

Price Supply

Surplus

Pricefloor

Cost of
purchasing
excess supply

Demand

0 280 Quantity

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Price Restrictions and Market Equilibrium

Price Floor in Action


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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

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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?

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Comparative Statics

Effect of a Change in Demand for


Rental Cars
Price Supply

$49

$45
Demand1

Demand0

0 100 104 108 Quantity


(thousands
rented per day)

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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 supply
– Suppose that a bill before Congress would require
all employers to provide health care to their
workers. What is the impact on retail markets?

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Comparative Statics

Effect of a Change in Supply

Price Supply1

Supply0

Demand

0 Quantity

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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?
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Comparative Statics

Simultaneous Shifts in Supply and Demand in Action

Japan’s Sake Market


Price
Supply2
C
Supply1

B Supply0

A
Demand1
Demand0

0 Quantity

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