LESSON #00A

MARKET DEMAND AND SUPPLY

ECON628 MANAGERIAL ECONOMICS
WONG FOT CHYI
WONG FOT CHYI
 Lesson Outline
 Demand
➢ Factors that change quantity demanded and demand
➢ The demand function
✓ Direct Demand Function
✓ Inverse Demand Function
➢ Consumer Surplus
 Supply
➢ Factors that change quantity supplied and supply
➢ The supply function
✓ Direct Supply Function
✓ Inverse Supply Function
➢ Producer Surplus
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 Introduction
 Supply and demand are the two words economists use
most often. They are the forces that:
➢ make market economies work
➢ determine the quantity of each good produced and the price
at which it is sold.
 This lesson introduces the theory of supply and demand in
the product or output market:
➢ how buyers and sellers behave and how they interact with one
another
➢ how supply and demand determine prices in a market economy
and how prices, in turn, allocate the economy’s scarce resources.
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 Introduction
 Basic Decision-Making Units in a Simple Market Economy:
✓ Firms: Firms are the primary producing units in a market economy
that transforms resources (inputs) into products (outputs).

✓ Households: The consuming units in an economy, as well as the

suppliers of resources (inputs) to the production process.

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 Introduction
 Input and Output Markets in a Simple Market Economy:
Markets in which goods and
services are exchanged.

Markets in which the resources

used to produce goods and
services are exchanged.
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 Introduction
 Circular Flow of Economic Activity in A Simple Market Economy

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 Introduction
 The terms supply and demand refer to the behaviour of
people as they interact with one another in competitive
markets.
 A market is a group of buyers and sellers of a particular
product.
 A competitive market is one with many buyers and sellers,
each has a negligible effect on price.
 In a perfectly competitive market:
➢ All goods exactly the same
➢ Buyers & sellers so numerous that no one can affect market
price—each is a “price taker”
 In this lesson, we assume markets are perfectly competitive.
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 Demand Analysis

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 General Demand Function
 A household’s decision about what quantity Qd of a
particular output, or product, to demand depends on
a number of factors, including:
1. Price of good or service (P)
2. Incomes of the households or consumers (M)
3. Accumulated wealth of the households (W)
4. Prices of related goods & services (PR)
5. Preferences or taste patterns of consumers (T)
6. Expected future price of product (PE)
 General demand function
Qd = f(P, M, W, PR, T, PE)
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 General Demand Function
Qd = f(P, M, W, PR, T, PE)
Change in Current and Expected Future Prices of Product
 Current Price (P)
➢ Consumers are willing and able to buy more of a good the
lower the price of the good and will buy less of a good the
higher the price of the good.
➢ Price and quantity demanded are negatively (inversely) related
❖ Substitution and income effects
 Expected Future Price (PE)
➢ Consumers’ expectations about the future price of a product can
change their current purchasing decisions.
➢ If consumers expect the price to be higher in a future period,
demand will probably rise in the current period, and vice versa.
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 General Demand Function
Qd = f(P, M, W, PR, T, PE)
Change in Consumer’s Income (M) or Wealth (W)
 Income (M):

➢ The sum of a household’s wages, salaries, profits, interest

payments, rents, and other forms of earnings in a given
period of time. It is a flow measure.
 Wealth (W) or Net Worth: Flow Stock
➢ The total value of what a
household owns minus what
it owes at a point in time.
It is a stock measure.
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 General Demand Function
Qd = f(P, M, W, PR, T, PE)
Change in Consumer’s Income (M) or Wealth (W)
 Normal good

➢ A good or service for which an increase (decrease) in

income or wealth causes consumers to demand more
(less) of the good, holding all other variables in the
general demand function constant
 Inferior good
➢ A good or service for which an increase (decrease) in
income or wealth causes consumers to demand less
(more) of the good, all other factors held constant

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 General Demand Function
Qd = f(P, M, W, PR, T, PE)
Change in Prices of Related Goods (PR)
 Substitutes
➢ Two goods are substitutes if an increase (decrease) in
the price of one good causes consumers to demand
more (less) of the other good, holding all other factors
constant
 Complements
➢ Two goods are complements if an increase (decrease)
in the price of one good causes consumers to demand
less (more) of the other good, all other things held
constant
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 General Demand Function
Qd = f(P, M, W, PR, T, PE)
Change in Tastes (T) and Preferences
 Changes in preferences can and do manifest
themselves in market behaviour.
 Within the constraints of prices and incomes,
preference shapes the demand curve, but it is
difficult to generalize about tastes and preferences.

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 General Demand Function
Qd = f(P, M, W, PR, T, PE)
 One simple, but useful, representation of a demand
function is the linear demand function:

Qd = a + bP + cM + dW + ePR + fT + gPE
 b, c, d, e, f and g are slope parameters
➢ Measure effect on Qd of changing one of the factors
or variables while holding the others constant
 Sign of parameter shows how variable is related to Qd
➢ Positive sign indicates direct relationship
➢
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Negative sign indicates inverse relationship
 General Demand Function
Qd = a + bP + cM + dW + ePR + fT + gPE
Variable Relation to Qd Sign of Slope Parameter

P Inverse b = Qd /P is negative

Direct for normal goods c = Qd /M is positive
M
Inverse for inferior goods c = Qd /M is negative
Direct for normal goods d = Qd /W is positive
W Inverse for inferior goods d = Qd /W is negative
Direct for substitutes e = Qd /PR is positive
PR
Inverse for complements e = Qd /PR is negative

T Direct f = Qd /T is positive

PE Direct g = Qd /PE is positive

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 Direct Demand Function
 The direct demand function, or simply demand,
shows how quantity demanded, Qd , is related to
product price, P, when all other variables are held
constant:
ഥ W, 𝑷
𝑸𝒅 = 𝒇(𝑷, 𝑴, ഥ 𝑷
ഥ 𝑹 , T, ഥ𝑬)
𝑸𝒅 = 𝒇(𝑷)

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 Direct Demand Function
𝑸𝒅 = 𝒇(𝑷)
 The Law of Demand
➢ Qd increases when P falls, all else constant
➢ Qd decreases when P rises, all else constant
➢ Qd /P must be negative
 The negative relationship between price and quantity
demanded: Ceteris paribus, as price rises, quantity
demanded decreases; as price falls, quantity
demanded increases during a given period of time,
all other things remaining constant.
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 Direct Demand Function
 For example, consider the following 3-variable general demand
function, Qd = f(P, M, PR):

𝑸𝒅 = 𝟑𝟐𝟎𝟎 − 𝟏𝟎𝑷 + 𝟎. 𝟎𝟓𝑴 − 𝟐𝟒𝑷𝑹

 To derive a direct demand function, Qd = f(P), the variables M and

PR must be assigned specific (fixed) values.
 Suppose consumer income is $60,000 and the price of a related
good is $200. To find the direct demand function, the fixed values
of M and PR are substituted into the general demand function:
𝑸𝒅 = 𝟑𝟐𝟎𝟎 − 𝟏𝟎𝑷 + 𝟎. 𝟎𝟓(𝟔𝟎𝟎𝟎𝟎) − 𝟐𝟒(𝟐𝟎𝟎)
𝑸𝒅 = 𝟑𝟐𝟎𝟎 − 𝟏𝟎𝑷 + 𝟑𝟎𝟎𝟎 − 𝟒𝟖𝟎𝟎

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𝑸𝒅 = 𝟏𝟒𝟎𝟎 − 𝟏𝟎𝑷
 Inverse Demand Function
 Traditionally, price (P) is plotted on the vertical axis &
quantity demanded (Qd) is plotted on the horizontal axis
➢ The equation plotted is the inverse demand function,

P = f(Qd)

[NOTE: Strictly, if Qd = f(P), then P = f -1(Qd) = g(Qd), where g is the inverse function of f.
We use f to denote generically all functions.]

➢ E.g. using our earlier illustration, the inverse demand

function ban be derived as:
𝑸𝒅 = 𝟏𝟒𝟎𝟎 − 𝟏𝟎𝑷
𝑷 = 𝟏𝟒𝟎 − 𝟎. 𝟏𝑸𝒅
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 Graphing Demand Curves
 Demand schedule: Shows how much of a given
product a household would be willing to buy at
different prices for a given time period.
 Demand curve: A graph illustrating how much
of a given product a household would be willing
to buy at different prices.

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 Graphing Demand Curves
 A point on a demand curve
shows either: P

➢ Maximum amount of a good

that will be purchased for a
given price
➢ Maximum price consumers will
pay for a specific amount of
the good (demand price)
✓ demand price can thus be
interpreted as the economic
value of any specific unit of Q
a product.
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 Graphing Demand Curves
 A point on a demand curve
shows either: P

➢ Maximum amount of a good

that will be purchased for a
given price
➢ Maximum price consumers will
pay for a specific amount of
the good (demand price)
✓ demand price can thus be
interpreted as the economic
value of any specific unit of Q
a product.
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 Graphing Demand Curves
 Table shows Alex’s demand schedule and Figure shows Alex’s
demand curve for energy bars.

(bars per week)

WONG FOT CHYI Quantity demanded (bars per week)

 Graphing Demand Curves
 Figure shows an increase in Alex’s demand.
 Because an energy bar is a normal good, an increase in Alex’s
income increases his demand for energy bars.

(bars per (bars per

week) week)

WONG FOT CHYI Quantity demanded (bars per week)

Change in Quantity Demanded vs Change in Demand

 Change in quantity
demanded
➢ Occurs when price changes
➢ Movement along demand
curve
 Change in demand
➢ Occurs when one of the
other variables, or
determinants of demand,
changes
➢ Shifts in the demand curve
rightward or leftward

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 Market 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, ceteris
paribus or holding other variables constant.
 The sum of all the quantities of a good or service
demanded per period by ALL the households buying
in the market for that good or service.
➢ Horizontal sum of the demand curves of individual
buyers
➢ Size of market demand increases with the number
of consumers in market (N)
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 Market Demand
 For example, if Alex and Naomi are the only consumers in the
market for a product, the market demand curve is the horizontal
sum of the individual demand curves of Alex and Naomi:

Alex’s Demand Naomi’s Demand Market Demand

Price Price Price
$17 $17 $17

20
$12 $12 $12

60 50
$5 $5 $5

0 60 0 20 0 20 110
Quantity 50
Quantity Quantity

(a) (b) (c)

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 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.
 Consumer surplus = difference between the amount
consumers are willing to pay and the amount they
have to pay for a good.
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 Market Demand and Consumer Surplus
Consumer surplus
Price

$5
Total Consumer Value:
0.5($5 – $3)x2+(3 – 0)x(2 – 0) = $8
$4
Market Price
$3
$2

$1 Demand

0 1 2 3 4 5 Quantity
WONG FOT CHYI in liters
 Market Demand and Consumer Surplus
Consumer surplus
Price

$5

$4
Market Price Total Consumer Expenditure:
$3
$(3 – 0) x (2 – 0) = $6
$2

$1 Demand

0 1 2 3 4 5 Quantity
WONG FOT CHYI in liters
 Market Demand and Consumer Surplus
Consumer surplus
Price Consumer Surplus:
0.5($5 – $3)x(2 – 0) = $2

$5

$4
Market Price
$3
$2

$1 Demand

0 1 2 3 4 5 Quantity
WONG FOT CHYI in liters
 Supply Analysis

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 Supply
 Firms build factories, hire workers, and buy raw
materials because they believe they can produce and
sell the products they make for more than it costs to
produce them.
 Firms aim to maximize profit, i.e. the difference between
revenues and costs.
 Cost of production depends on a number of factors,
including the available technologies and the prices and
quantities of the inputs needed by the firm (labour, land,
capital, energy, and so on).

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 General Supply Function

 If the objective is to maximize profits, a firm’s decision to

supply quantity Qs depends on the following key factors:
➢ Price of good or service (P)

➢ Input prices (PI )

➢ Prices of goods related in production (Pr)

➢ Technological advances (T)

➢ Expected future price of product (Pe)

 General supply function

Qs = f(P, PI , Pr , T, Pe)

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 General Supply Function
Qs = f(P, PI , Pr , T, PE)
Change in Current and Expected Future Prices of Product
 Current Price (P)
➢ The higher (lower) the price of the product, the greater (smaller)
the quantity firms wish to produce and sell, all other things being
equal.
➢ Producers are motivated by higher prices to produce and sell
more, while lower prices tend to discourage production.
➢ Price and quantity supplied are, in general, directly or positively
related.
 Expected Future Price (PE)
➢ If firms expect the price of a good they produce to rise in the
future, they may withhold some of the good, thereby reducing
supply of the good in the current period.
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 General Supply Function
Qs = f(P, PI , Pr , T, PE)
Change in Prices of Inputs (PI)
 Inputs, e.g. labour and raw materials, are used to output
➢ Changes in prices of inputs affect the cost of

production
 If the cost rises (falls), the good becomes less (more)
profitable and producers will want to supply a smaller
(larger) quantity at each price.
 Hence, an increase (decrease) in the price of an input
causes a decrease (increase) in production.

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 General Supply Function
Qs = f(P, PI , Pr , T, PE)
Change in Prices of Goods Related in Production (Pr)
 Substitutes in production

➢ Goods for which an increase in the price of one good

relative to the price of another good causes producers to
increase production of the now higher-priced good and
decrease production of the other good
➢ E.g. corn and wheat

 Complements in production
➢ Goods for which an increase in the price of one good,
relative to the price of another good, causes producers to
increase production of both goods
➢ E.g. crude oil and natural gas; beef and leather hides
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 General Supply Function
Qs = f(P, PI , Pr , T, PE)
Change in Technology (T)
 Technology is the state of knowledge concerning how to
combine resources to produce goods and services.
 An improvement in technology generally results in one or
more of the inputs used in making the good to be more
productive.
 The cost of producing a given level of output falls when
firms use better technology, which would lower the costs
of production, increase profit, and increase the supply of
the good to the market, all other things remaining the
same.
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 General Supply Function
Qs = f(P, PI , Pr , T, PE)
 One simple, but useful, representation of a supply
function is the linear supply function:

Qs = h + kP + lPI + mPr + nT + rPe

 k, l, m, n, & r are slope parameters
➢ Measure effect on Qs of changing one of the
variables while holding the others constant
 Sign of parameter shows how variable is related to Qs
➢ Positive sign indicates direct relationship

➢ Negative sign indicates inverse relationship

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 General Supply Function
Qs = h + kP + lPI + mPr + nT + rPe
Variable Relation to Qs Sign of Slope Parameter

P Direct k = Qs /P is positive

PI Inverse l = Qs /PI is negative

Inverse for substitutes m = Qs /Pr is negative

Pr
Direct for complements m = Qs /Pr is positive

T Direct n = Qs /T is positive

Pe Inverse r = Qs /Pe is negative

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 Direct Supply Function
 The direct supply function, or simply supply, shows
how quantity supplied, Qs , is related to product
price, P, when all other variables are held
constant:
ഥ𝑰 , 𝑷
𝑸𝒔 = 𝒇(𝑷, 𝑷 ഥ 𝒓, 𝑻
ഥ, 𝑷
𝑻, ഥ 𝒆)
𝑸𝒔 = 𝒇(𝑷)

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 Direct Supply Function

𝑸𝒔 = 𝒇(𝑷)
 The Law of Supply
➢ Qs increases when P rises, all else constant
➢ Qs decreases when P falls, all else constant
➢ Qs /P must be positive
 The positive relationship between price and quantity
of a good supplied: An increase in market price,
ceteris paribus, will lead to an increase in quantity
supplied, and a decrease in market price will lead to
a decrease in quantity supplied.
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 Inverse Supply Function
 Traditionally, price (P) is plotted on the vertical
axis & quantity supplied (Qs) is plotted on the
horizontal axis
➢ The equation plotted is the inverse supply
function, P = f(Qs)

WONG FOT CHYI

 Graphing Supply Curves
 Supply schedule: Shows how much of a product
firms will sell at alternative prices.
 Supply curve: A graph illustrating how much of a
product a firm will sell at different prices.

WONG FOT CHYI

 Graphing Supply Curves
 A point on a direct supply
curve shows either: P

➢ Maximum amount of a good

that will be offered for sale at
a given price
➢ Minimum price necessary to
induce producers to voluntarily
offer a given quantity for sale
(supply price)

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 Graphing Supply Curves
 A point on a direct supply
curve shows either: P

➢ Maximum amount of a good

that will be offered for sale at
a given price
➢ Minimum price necessary to
induce producers to voluntarily
offer a given quantity for sale
(supply price)

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 Graphing Supply Curves
Table shows Clarence Brown’s supply schedule and Figure shows
Clarence Brown’s supply curve of energy bars.

(hundreds of bars per week)

A rise in the price, other things

remaining the same, brings an
increase in the quantity
supplied.
WONG FOT CHYI Quantity supplied (hundreds of bars per week)
 Graphing Supply Curves
 Figure shows an increase in supply.
 An advance in the technology increases Clarence Brown’s supply of
energy bars and shifts the supply curve rightward.

(hundreds (hundreds
of bars per of bars per
week) week)

Quantity supplied (hundreds of bars per week)

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Change in Quantity Supplied vs Change in Supply

 Change in quantity
supplied
➢ Occurs when price changes
➢ Movement along supply
curve
 Change in supply
➢ Occurs when one of the
other variables, or
determinants of supply,
changes
➢ Shifts in the supply curve
rightward or leftward
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 Market 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.
 Total supply in the marketplace is the sum of ALL the
amounts supplied by ALL the firms selling in the market.
➢ It is the sum of ALL the individual quantities supplied at each
price, or horizontal sum of the supply curves of individual
firms or producers
➢ Size of market supply increases with the number of firms
producing the product (F)

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 Market Supply
 For example, if there are only 2 firms, Firm A and Firm B, in the
market producing a product, the market supply curve is then the
horizontal sum of the individual supply curves of Firms A and B:

Firm A’s Supply Firm B’s Supply Market Supply

Price Price Price

60 80
$100 $100 $100

30
$60 $60 $60

$20 $20 $20

0 30 60 0 80 0 30 140
Quantity Quantity Quantity
(a) (b) (c)
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 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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 Market Supply and Producer Surplus
Producer Surplus:
Price Total Revenue Supply P = 50 + ⅓QS
= $350 x 900 = $315,000
Market Price
$350

$50

0 900 Quantity
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 Market Supply and Producer Surplus
Producer Surplus:
Price Supply P = 50 + ⅓QS

Market Price
$350

Min Payment Required

= 0.5($50 + $350) x 900
= $180,000
$50

0 900 Quantity
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 Market Supply and Producer Surplus
Producer Surplus:
Price Supply P = 50 + ⅓QS

Market Price
$350
Producer Surplus
= 0.5($350 – $50) x 900
= $135,000

$50

0 900 Quantity
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 End of Lesson

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