Demand Curve

A demand curve depicts how the quantity demanded of a good changes as the price of that good

Price per shirt

changes, holding everything else constant.

Normally, as the price of a good increases, the quantity demanded of that good falls; this is known
as a normal good. This can be shown as movements along the demand curve. This is known as the
Law of Demand. $25

$20
Price
$15

$10

$5
P0

1 2 3 4 5 6 7 8 9 10
P1
D Quantity of Shirts demanded

Shifts in the Demand Curve and Non-price Determinants of Demand

Q0 Q1 Quantity demanded
A change in any determinant of demand for a good, other than the price, will produce a shift in the
demand curve. A shift to the right represents an increase in the demand for that good at each given price.
A “demand curve” is a graphic representation of the relationship between the quantity
This can be seen as the shift from D0 to D1 in Figure (a). A shift to the left represents a decrease in the
of a good demanded and the price of the good (other factors remaining constant). For
demand for that good at each given price. This is seen as a shift from D0 to D2 in Figure (b).
example, let the following schedule represent Smith's demand for shirts on October 1st:

Figure: Shifts in the Demand Curve

Price $25 $22 $20 $18 $15 $12 $11 $9 $6

Quantity 0 1 2 3 4 5 6 7 8
demanded

This information can be represented in graphic form as a demand curve or schedule as follows (it is
customary to designate the vertical axis to measure price and the horizontal axis to measure quantity):
 Price Price
S

Price
D1

D0
D0

D2

Quantity
supplied

D0 D1 Quantity D2 D0 Quantity
demanded demanded
(a) (b)

There are a number of factors that can produce a shift in the demand curve:
1. Consumer Income – at any given price of a good, as Y (income) increases, the
quantity demanded of a good normally increases.
2. Number of Population – at any given price of a good, as number of population
grows, quantity demanded of a good normally increases.
A Supply Curve depicts how the quantity supplied of some good changes during a specific period
of time, as the price of that good changes, c e t e r i s p a r i b u s .
Law of Supply – Normally, as the price of a good rises, the quantity supplied rises. This can be
shown by the movement along the supply curve.
A supply curve is a graphic representation of the relationship between the (hypothetical) price of a
good and the quantity supplied. Let the table below represent Jones' supply schedule of watermelons on
July 4th:

$2
3. Consumer Preferences – at any given price of a good, if consumer tastes shift in Price $1 $3 $3.50 $4.50 $5 $5.50 $6 $7 $8
favor of that particular good, there will be an increase in the demand for that good.
Quantity 0 1 2 3 4 5 6 7 8 9
4. Price and Availability of Related Goods – a decrease in the price of demanded
complementary goods (such as tennis rackets and tennis balls) shifts the demand of our original good
to the right. The opposite happens when the price of the complement increases. Decrease in the price of
the goods which are substitutes (as margarine is for butter) shifts the demand curve to the left. The
opposite happens when the price of the substitutes increases.

Supply Curve
 Shifts in the Supply Curve and Non-price Determinants of Supply

A change in any determinant of supply for a good, other than the price of that good, will produce a
shift of the supply curve. A shift to the right represents an increase in the supply for that good at each
given price. This can be seen in Figure (a) as a shift from S0 to S1 . A shift to the left represents a
decrease in the supply for that good at each given price. This can be seen as a shift from S0 to S2 in the
Figure (b).

There are a number of factors that can produce a shift in the supply curve, as opposed to
movements along the supply curve which are caused by changes in the price of the good in question:

Quantity supplied
Quantity supplied
(a) (b)

1. Size of the Industry – At any given price of a good, an increase in the size of the industry
producing that good will shift the supply curve to the right, thus, increasing its supply.

2. Technological Progress – At any given price of a good, any technological progress in the
production of that good will increase the supply for the good.

3. Prices of Inputs – At any given price of a good, if the prices of inputs, which are used in the
production of this good, decrease, the supply curve of this good will shift to the right (an
increase in supply).

4. Price of Related Outputs – At any given price of a good, as the prices of the related outputs
increase, the supply of the good in question will also increase.

Q e Qe' Quantity Q e '' Q e

Quantity
(a) (b)
 a) AS D ↑ (increases) and S is fixed, Eq (equilibrium) P (price) ↑
and Eq Q (quantity) ↑.
b) AS D ↓ and S is fixed, Eq P ↓ and Eq Q ↓ .
Qe Qe' Quantity Q e' Q e
Quantity
(c) (d)
c) AS S ↑ and D is fixed, Eq P ↓ and Eq Q ↑.
d) AS S ↓ and D is fixed, Eq P ↑and Eq Q ↓ .
Shortage – Occurs when quantity demanded exceeds quantity supplied. That is, consumers
demand more than producers are willing to supply.
Surplus – Occurs when quantity supplied exceeds quantity demanded. That is, producers are
willing to supply more than consumers are willing to buy.
Equilibrium Point – Occurs where the demand curve intersects the supply curve. At this point,
price and quantity have no incentive to change.
Dynamics – Consider the path by which economy goes from one equilibrium point to another.
Marshallian and Walrasian Stable Equilibrium
In our simple supply and demand diagram, any movement away from equilibrium will bring about
correcting market forces which will cause a movement back to equilibrium. This is called a stable
equilibrium. For example, if prices rise to P2, as in the graph, the quantity supplied will be greater than
the quantity demanded. Thus, we will have a surplus supply on the market. Suppliers will want to lower
their price to get rid of this surplus and prices will fall back to Pe. If for some reason prices fell to P1 ,
demand would exceed supply and a supply shortage would occur. Consumers would bid prices back up
to Pe . In the example, we moved price away from equilibrium and noted the correcting forces to get price
back to equilibrium price. This stable equilibrium is called a Walrasian equilibrium: that is, price is the
adjusting mechanism to get back to equilibrium.
P D Surplus S
P2
Pe
P1
Shortage
Q1 Qe Q2 Quantity
However, instead of looking at the price, suppose quantity were to move to Q2. At Q2, the supply
price would be greater than the demand price; therefore, less trade would take place and the quantity will
fall back to Qe. The opposite scenario will happen if the quantity happens to be at Q1 . When we move
quantity away from equilibrium quantity and note its return, we are observing Marshallian equilibrium:
that is, we look at quantity as the adjusting mechanism to get back to equilibrium.
Price Ceilings and Price Floors
When market forces are permitted to interact freely, quantity demanded will equal
quantity supplied (point E in Figure 1). A price ceiling occurs when prices are set below the
equilibrium price by the government or some other non-market force. This price ceiling
induces shortages, Q D – Q s .
Figure 1. Price Ceiling
 ∆Q / Q ∆Q P
ε= = ×
Price ∆P / P ∆P Q
S
D
E
Arc Elasticity (used in practice) measures larger changes, and makes allowance by taking %Δ in
relative to average between two points in consideration:
Pe 1 
∆Q /  ( Q1 + Q2 ) 
ε= 2  = ∆Q / ( Q1 + Q2 )
1  ∆P / ( P1 + P2 )
Pc ∆P /  ( P1 + P2 ) 
Shortage
2 

QS QD Quantity
The Geometric Computation of Elasticity

Horizontal Axis Formula

Figure 2. Price Floor

Price
D S A
P
Surplus

PF
D E

Pe

O C B
Quantity demanded
QD QS Quantity

The support price for a good, a price floor, occurs when the government or some other non-
market force pushes the price for that good higher than its equilibrium price. A price floor induces a supply
Price elasticity of demand at point E on demand curve AB is:
surplus, Q s – Q D . This is depicted in Figure 2.

Point vs.Arc Elasticity  ∆Q P  CB CE  CB

ε = × = × =
Point Elasticity (ideal, preferred in principle) measures minute changes, so that asymmetries  ∆P Q  CE OC  OC
between %Δ in different directions is insignificant:
 Vertical Axis Formula (using the same diagram)
P P P
 ∆Q P   DE OD  OD Perfectly elastic
ε = × = × = demand ε = ∞
 ∆P Q   DA DE  DA Unitary
Elastic
elastic
demand
demand
Five Categories of ratio (ε) the Demand price elasticity
ε=1 ε>1
Elasticity ratio Effects on Expenditures:
1. | ε | = 0 perfectly inelastic ↑ p, QD → ↑ expenditure
QD QD Q
2. | ε | < 1 inelastic ↑ p > ↓QD → ↑ expenditure

3. | ε | = 1 unitary elastic ↑ p =↓QD → expenditure

Determinants of the Demand Price Elasticity
4. | ε | > 1 elastic ↑ p < ↓QD → ↓expenditure

Elastic = Inelastic =
5. | ε | = ∞ perfectly elastic A very small ΔP causes the QD to become 0 or ∞ ,
depending on the direction of the price change. luxuries necessities
many substitutes few substitutes
large part of budget small part of budget
longer time period shorter time period
P P large number of product uses small number of product uses
Total Revenue Test – determines ε
Perfectly
Inelastic
inelastic
demand total revenue = price × quantity = f(ε)
demand
ε=0 ε <1
inelastic D ↓ P → ↓ TR

elastic D ↓ P → ↑ TR

QD QD
unitary elastic D ↓ P → TR

Thus, looking at total revenue is an easy way to determine the characteristics of elasticity.

Linear Constant Slope Case:

Figure: Constant Slope Demand Case

 Substitutes = εgood A, good B > 0
Price
Complements = εgood A, good B < 0

ε>1 Income Elasticity of Demand (ε)

ε=1 The income elasticity of demand is the responsiveness of quantity demanded of an item to
changes in income.

ε<1
%∆ QD ∆QD ∆ Y
ε= = /
%∆ Y ∆ QD Y
D
Categories of ε

MR Quantity 1. ε > 0 superior/normal goods ↑Y → ↑ expenditure

2. ε < 0 inferior/poor man’s goods ↑Y → ↓ expenditure

Note: Along a straight line demand curve, slope is constant, but elasticity changes because slope
3. ε > 1 luxuries ↑Y → ↑ expenditure > ↑Y
is an absolute measure and elasticity is a relative measure.

4. 0 < ε < 1 necessities ↑Y → ↑ expenditure < ↑Y

∆TR
MR (marginal revenue) = rate of change of TR; MR =
∆Q Elasticity of Supply

% ∆QS ∆QS ∆P
ε= = /
%∆P QS P
Categories of ε :
ε = 1 at the exact midpoint of the demand curve. 1. ε = 0 perfectly inelastic
2. ε < 1 inelastic
When MR = 0, TR is max = 1 and ε is unitary elastic. 3. ε = 1 unitary elastic
4. ε > 1 elastic
5. ε = ∞ perfectly elastic, the “constant cost” case
When MR < 0, ε is inelastic.

Linear/Constant Slope Supply Case

When MR > 0, ε is elastic.
Linear supply curve = ε > 1 if cuts P axis
ε = 1 if passes through origin
Cross Elasticity of Demand (εA, B) ε < 1 if cuts Q axis

The cross elasticity of demand is the relation between the percent change in QD of one
good and the percent change in price of another good.

∆Q A ∆PB
εgood A, good B = /
QA PB
 P ε=0 ε<1
ε=1
ε>1

ε=∞

Q
Marshall’s Three Time Periods:

S
D’ D’ S D’
D 2 D S
D
2

D’ D’ D’
1 1
D D D

Immediate run Short run Long run

Note: Effects of D over time: elasticity of supply increases in the long run because there is more
time for adjustments to the changes in prices. The immediate run implies a fixed supply.