Microeconomics: Lecture 2

The Basics of Supply and Demand

Introduction
Introduce a simple model of supply and
demand Later on we discuss building blocks of demand (consumer theory) and supply (theory of the firm) Allows us to study the market mechanism Use framework to analyze the effects of changes in market equilibrium
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Roadmap

Introducing demand and supply Equilibrium in a free market Market mechanism Excess supply/demand Change in equilibrium prices & quantities Price controls: min/max price

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Supply and Demand

1. Help us understand and predict how real-world economic conditions affect market price and production
2. Analyze the impact of government price controls, minimum wages, price supports, and production incentives on the economy 3. Determine how taxes, subsidies, tariffs and import quotas affect consumers and producers
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Supply and Demand

The Supply Curve

The relationship between the quantity of
a good that producers are willing to sell and the price of the good

Measures quantity on the x-axis and price

on the y-axis

Q S Q S (P)
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The Supply Curve

The supply curve slopes upward, demonstrating that at higher prices firms will increase output or new firms enter.

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The Supply Curve

Other Variables Affecting Supply

Costs of Production
Labor Capital Raw Materials

Lower costs of production allows a

firm to produce more at each price
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Change in Supply

The cost of raw materials falls (oil price, wages of lawyers)

Produced Q1 at P1 and Q0
at P2

Now produce Q2 at P1
and Q1 at P2

Supply curve shifts right

to S
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The Supply Curve

Change in Quantity Supplied:

Movement along the curve caused by a change in price

Change in Supply: Shift of the curve

caused by a change in something other than the price of the good Change in costs of production
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Supply and Demand

The Demand Curve

The relationship between the quantity of
a good that consumers are willing to buy and the price of the good.

Measures quantity on the x-axis and price

on the y-axis:

QD QD(P)
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The Demand Curve

The demand curve slopes downward, demonstrating that consumers are willing to buy more at a lower price as the product becomes relatively cheaper.

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The Demand Curve

Other Variables Affecting Demand

Income
Increases in income allow consumers to
purchase more at all prices

Consumer Tastes Price of Related Goods

Substitutes (subway and bicycle) Complements (cake mix and frosting)
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Change in Demand
Income Increases
Purchased Q0, at
P2 and Q1 at P1

Now purchased
Q1 at P2 and Q2 at P1

Same for all

prices

Demand curve
shifts right
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The Demand Curve

Changes in quantity demanded

Movements along the demand curve
caused by a change in price

Changes in demand
A shift of the entire demand curve caused
by something other than price

Income Preferences
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The Market Mechanism

The market mechanism is the tendency in a
free market for price to change until the market clears

Markets clear when quantity demanded

equals quantity supplied at the prevailing price

Market clearing price price at which

markets clear
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The Market Mechanism

The curves intersect at equilibrium, or marketclearing, price. Quantity demanded equals quantity supplied at P0

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The Market Mechanism

In equilibrium
There is no shortage or excess demand There is no surplus or excess supply Quantity supplied equals quantity demanded Anyone who wants to buy at the current price
can and all producers who want to sell at that price can

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Excess Supply

The market price is above equilibrium

There is excess supply surplus Downward pressure on price Quantity demanded increases and quantity
supplied decreases

The market adjusts until new equilibrium is

reached
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1.

2. 3.

4.

At P1, price is above the market clearing price Qs > QD Price falls to the marketclearing price Market adjusts to equilibrium

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Excess Demand
The market price is below equilibrium:
There is excess demand shortage Upward pressure on prices Quantity demanded decreases and quantity
supplied increases The market adjusts until the new equilibrium is reached

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1.

2. 3.

4.

At P2, price is below the market clearing price QD > QS Price rises to the marketclearing price Market adjusts to equilibrium

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The Market Mechanism

Supply and demand interact to determine
the market-clearing price

When not in equilibrium, the market will

adjust to alleviate a shortage or surplus and return the market to equilibrium

Markets must be (perfectly) competitive for

the mechanism to be efficient (detailed assumptions will follow later in course)
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Changes in Market Equilibrium

Equilibrium prices are determined by the
relative level of supply and demand

Changes in supply and/or demand will cause

change in the equilibrium price and/or quantity in a free market

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Changes in Market Equilibrium

Raw material
prices fall

S shifts to S Surplus at P1
between Q1 and Q2 Price adjusts to equilibrium at P3, Q3
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Changes in Market Equilibrium

Income Increases
Demand increases
to D

Shortage at P1 of
Q1 to Q2

Equilibrium at P3
and Q3
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Changes in Market Equilibrium

Income increases
and raw material prices fall

Quantity increases If the increase in

D is greater than the increase in S price also increases
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Shifts in Supply and Demand

When supply and demand change simultaneously, the impact on the equilibrium price and quantity is determined by:

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Introducing Intuition of Price-sensitivity (Elasticity)

P

D1

D2

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Introducing Intuition of Price-sensitivity (ctd.)

S S

D1 D2

Q
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Elasticities

Price elasticity of demand: sensitivity

of quantity demanded with respect to a change in price (inelastic elastic)

Price elasticity of supply: sensitivity of

quantity supplied with respect to a change in price (inelastic elastic)
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Comment: Different types of goods

Depending on type, impact of income

increase will generate different outcome on demand schedule
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Effects of Price Controls

Markets are rarely free of government
intervention Imposed taxes and granted subsidies Price controls Price controls usually hold the price above or below the equilibrium price Excess demand shortage (rent controls) Excess supply surplus (minimum wage)
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Summary
Demand and supply schedule provides simple
framework to analyze market outcomes

Set of underlying assumptions will be

formally introduced in following chapters

Demand: Aggregate over individual

consumers choice (CH 3-4)

Supply: Aggregate over individual firms

production (CH 6-8)
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Required Reading
Pindyck and Rubinfeld, Microeconomics, 8th
edition, Chapter 2, pp. 21-32 (we briefly mentioned price elasticity of demand and supply today. We will return to those concepts later in the course. If you want to read more about them now, you can look at pp. 33-48)

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