MODULE 3: ANALYSIS OF THE THEORY OF

DEMAND, SUPPLY, AND MARKETS

In this module, you will learn how consumers behave in the market by exploring the concept
of demand, how they to respond changes in price and in other factors other than the price. Similarly,
you will learn how producers behave in the market by exploring the concept of supply, how they
respond to changes in price and in non-price determinants to supply. You will discover the
relationship between price and quantity demanded and price and quantity supplied. Next, you will
learn how prices reach equilibrium. This considers how buyers and sellers behave and how they
interact with one another to determine prices in the market. Then, learn about horizontal and vertical
methods for reading the demand and supply curves, how demand and supply curves shift, and how
these changes affect equilibrium.

We extend the analysis of demand and supply by looking at how consumers and producers
respond to changes in price by examining the concept of elasticity. These concepts will be further
used to examine the effect of taxes on prices and quantities consumed and produced. Lastly, we also
extend demand and supply concepts to evaluate consumers and producers welfare using the concept
of consumer surplus and producer surplus.

At the end of this module, you should have achieved the following topic or unit learning
outcomes.

UNIT LEARNING OUTCOMES

Describe demand and supply concepts and how these forces determine and affect equilibrium
price and quantity.
Graphically illustrate the effect of change in demand and/or supply on market equilibrium.
Demonstrate how elasticities of demand and supply are calculated and interpreted.

TOPIC 1: DEMAND
DEFINITION

Demand is technically defined as a curve (or can be a schedule or an equation) which shows
the various amounts of a good that consumers (buyers) are willing and able to make available for sale
at each of a series of possible prices, during some specified period of time.

We note, first and foremost, that demand manifests consumers’ (buyers’) willingness and
ability to buy. This means that consumers are willing to buy because they have the desire to have the
product and at the same time they have the money (purchasing power) to buy the product. Second,
demand for a good is time-bounded. Demand happens at a given period of time, it can be in a day, a
month, a quarter of a year, in one year, and so on.

Demand for a good (or service) at a given time depends on many factors (price, technology,
competition, etc.). However, if other factors (also called non-price determinants) are held constant (or
not changing) at a given time, the quantity (amount) of a good that sellers are willing to sell becomes
a function of or depends on the price of the good. Based from this principle, a demand schedule (a
table that shows the quantity supplied at each price) can be illustrated.

We assume that the buyer has money worth P100 and only used to buy good X. If we assume
prices of good X, the amounts the buyer can buy can be determined.

Table 1: Demand Schedule

Price (Php) Quantity Demanded
100 1
50 2 LAW OF DEMAND
25 4
20 5 The amount of a good that buyers are willing
10 10 to sell at a given price is called the quantity demand
5 20 (Qd). There are many determinants of Qd, but price
4 25 (P) plays a special role in analyzing consumer’
2 50 (buyers’) behavior. As seen in the schedule, as the
1 100 price per unit of good X falls, quantity demanded (in
units) increases. This relationship between price and
quantity demanded is called the law of demand: Other things equal, when the price of a good rises,
the quantity demanded of the good falls, and when the price falls, the quantity demanded rises. The
curve showing the relationship between price and quantity demanded is the demand curve.

What explains the law of demand? (i.e., why is it that price and quantity demanded are
negatively related)? There are two basic reasons for this relationship:

1. Income effect and substitution effect

There are two views of income: nominal income and real income. Nominal ( or money) income
is the value or amount of income received. For example, an individual receives P10,000 this
month. Real income reflects the purchasing power of the nominal income, i.e., how much goods
and services that money income of P10,000 buy. The income effect tells us that as the P of a
good falls, the Qd rises because the purchasing power of the same nominal income the individual
has increases allowing more amounts to be purchased a P falls.

The substitution effect on the other hand, tells us that as the P of a good rises, Qd falls because
the consumer has this tendency to substituted other goods that are now relatively cheaper
compared to the good which increased in P.

2. Law of diminishing marginal utility

Diminishing – decreasing
Utility – satisfaction
Marginal – extra, added, additional
Marginal utility – the extra satisfaction derived from consuming extra unit of the same
good

The law of diminishing marginal utility states that all else equal, as the consumption (Qd) of a
good increases the marginal utility derived from each additional unit declines. What decreases as
additional unit of the same good is consumed is the extra (or added) satisfaction. As more units
of the same good is consumed, it means that the extra satisfaction we derived will eventually
diminish. Since the extra utility diminishes as more unit of the same good is consumed,
consumers tend to place a lower value (the price) on the good. Therefore, the only way to
increase Qd (or entice consumers to buy more units of the same despite diminished marginal
utility) is for P to fall.
DEMAND CURVE

Demand curves are downward sloping,

which reflects the inverse relationship
between price and quantity demanded.

Figure 1: Demand Curve

INDIVIDUAL DEMAND VS. MARKET DEMAND

Market demand is derived by summing up all the individual demands for a good. Market
supply is simply the horizontal summation (summation of all quantities demanded by all buyers
at each possible price) of all individual demand.

Figure 2: Market Demand

CHANGE IN DEMAND (SHIFTS IN THE DEMAND CURVE)

Because the market demand curve holds other things constant at a given period of time, a
change in demand or a shift in the demand curve is caused by a change in one or more of the non-
price determinants (or other factors) that affect the quantity demanded for a good. When a change in
demand occurs, it happens at a new time period and is compared to the demand at a previous time
period. Graphically:

PX D’

D
D” There are more
quantities supplied
at each possible
Increase in Demand price than in the
There are less previous time-
quantities period
demanded at each Decrease in Demand
possible price
than in the
previous time-
period

QdX
Figure 3: Shifts in Demand Curve

There are many variables that can shift the supply curve. Here are some of the most
important.

1. Tastes and Preferences

A favorable change in consumer tastes (preferences) for a product – a change that makes the
product more desirable – means that more of it will be demanded at each price. Demand will
increase; the demand curve will shift rightward. An unfavorable change in consumer preferences
will decrease demand, shifting the demand curve to the left. New products may affect consumer
tastes; for example. consumers’ concern over the health hazards of cholesterol and obesity have
increased the demand for broccoli, low-calorie beverages, and fresh fruit while decreasing the
demand for beef, fast foods, whole milk.

2. Number of Buyers
An increase in the number of buyers in a market is likely to increase product demand; a decrease
in the number of buyers will probably decrease demand. For example, a rising number of older
persons will increase the demand for medical care, and retirement communities. In contrast,
emigration (out-migration) from many small rural communities has reduced the population and
thus the demand for housing, home appliances, and auto repair in those towns.

3. Income
How changes in income affect demand is a more complex matter. For most products, a rise in
income causes an increase in demand. Products whose demand varies directly with money
income are called superior goods, or normal goods. Although most products are normal goods,
there are some exceptions. As incomes increase beyond some point, the demand for used
clothing, retread tires, and third-hand automobiles may decrease, because the higher incomes
enable consumers to buy new versions of those products. Goods whose demand varies inversely
with money income are called inferior goods.

4. Prices of Related Goods

A change in the price of a related good may either increase or decrease the demand for a product,
depending on whether the related good is a substitute or a complement:
  A substitute good is one that can be used in place of another good. Also, goods are
substitutes when the price of one good is positively related to the demand for the other good.
(For example, pork and chicken are substitutes; an increase in the price of pork will reduce its
quantity demanded, therefore those who will reduce its quantity demand for pork will shift to
chicken causing the demand for chicken to increase.
 A complementary good is one that is used together with another good. Also, two goods are
complements when the price of one good is inversely related to the demand for the other
good. For example, if the price of coffee increases, quantity demanded will decrease,
therefore who cuts down consumption of coffee will find themselves reducing consumption
of creamer causing the demand for creamer to decrease.

5. Consumer Expectations
Changes in consumer expectations may shift demand. A newly formed expectation of higher
future prices may cause consumers to buy now in order to “beat” the anticipated price rises, thus
in- creasing current demand. Similarly, a change in expectations concerning future income may
prompt consumers to change their current spending. For example, workers who become fearful
of losing their jobs may reduce their demand for, say, vacation travel.

Table 2: Factors Causing Demand Curve to Shift

Factors Affecting Demand
Demand Curve Shifts to the Right Demand Curve Shifts to the Left
(Increase in Demand) (Decrease in Demand)
Favorable change in tastes/preferences Unfavorable change in tastes/preferences
Increase in number of buyers Decrease in number of buyers
Increase in income for normal goods Decrease in income for normal goods
Decrease in income for inferior goods Increase in income for inferior goods
Increase in price of a substitute good Decrease in price of a substitute good
Decrease in price of a complement good Increase in price of a complement good
Expectation of an increase in price Expectation of an decrease in price

DEMAND FUNCTION

Demand function is the mathematical expression of law of demand. In other words, demand
function quantifies the relationship between quantity demanded and price of a product, while keeping
the other factors at constant. The law of demand expresses the nature of relationship between quantity
demanded and price of a product, while the demand function measures that relationship.

The demand function can be expressed in two ways: (1) as a quantity function: QD = f(P) or,
(2) as a price-function: P = f(QD). Note however, that even if a demand function can be expressed in
two ways, they still represent one demand curve.

We now quantify the law of demand by expressing the demand function in terms of a linear
equation: y = mx + b

where: b = vertical intercept

m = slope (inclination of the line)
= measures the rate of ∆ in y for a unit ∆ in x
∆ y y 2− y 1
m= =
∆ x x 2−x 1

Determining a linear equation can be done through algebraic solution and applying the
formulae:
 y 2− y 1
Using two-point form formula: y− y1 = ( x−x 1)
x2− x1

Point-slope formula: y− y1 =m( x−x 1)

Example: Given the data below, determine the demand function, interpret the slope and the vertical
intercept, and graph the demand curve.

Price (x) Quantity Demanded (y)

8 60
10 50
2. Demand function: Q-function

Q−60= ( 50−60
10−8 )
P−8 Q−50= ( −102 ) P−8
Q−60=−5 P+ 40 Q = –5P + 40 + 60 Q = –5P + 100

Demand function: P-function

10−8
P−8= ( 60−50 ) Q−60 P−8= (−102 )Q−60
P−8=−0.2Q+12 P = –0.2Q + 12 + 8 P = –0.2Q + 20

3. Interpretation

Interpreting the quantity function: Q = –5P + 100

Slope m = –5 (units): for every P1 change (increase or decrease) in price, quantity demanded
will change (increase or decrease) by 5 units
Vertical intercept b = 100 (units): if P = P0 (or if the good is given for free), the maximum
amount that consumers can consume of the good is 100 units.

Interpreting the price function: P = –0.2Q + 20

Slope m = P0.2: a unit change (increase or decrease) in quantity demanded will change
(increase or decrease) price by 20 centavos
Vertical intercept P20: No amount of the good will be consumed if the price is P20

4. Demand curve
 Figure 4: Demand Curve
TOPIC 2: SUPPLY
A market is not complete without the other side of it. We now turn to the other side of the
market and examine the behavior of sellers.

DEFINITION

We begin by defining the term supply. Supply is technically defined as a curve (or can be a
schedule or an equation) which shows the various amounts of a product that producers (sellers) are
willing and able to make available for sale at each of a series of possible prices, during some specified
period of time.

We note, first and foremost, that supply manifests producers’ (sellers’) willingness and ability
to produce or sell. This means that producers (sellers) are willing because they are profit-motivated,
aside from a good or service is demand-driven (there are willing consumers to pay for the good (or
service). Producers (sellers) are also able (capacity) to produce (sell) because they have the resources.

Supply for a good is time-bounded. Supply happens at a given period of time, it can be in a
day, a month, a quarter of a year, in one year, and so on. Just as demand for a good is realized on a
specific time-period, so is the supply for a good.

Supply for a good (or service) at a given time depends on many factors (price, technology,
competition, etc.). However, if other factors (also called non-price determinants) are held constant (or
not changing) at a given time, the quantity (amount) of a good that sellers are willing to sell becomes
a function of or depends on the price of the good. Based from this principle, a supply schedule (a table
that shows the quantity supplied at each price) can be illustrated:

Table 3: Supply of Rice, Benguet, 2006-2016

Year Price (average, Production (Metric
Quantity supplied
annual per kg) Tons)
 2006 P19.99 10,248.00
2007 20.81 10,921.00
2008 29.05 11,142.00
2009 29.69 11,244.00
2010 29.72 11,357.00
2011 29.92 11,363.50
2012 30.00 11,402.40
2013 30.80 11,569.15
2014 38.89 11,780.75
2015 39.64 11,793.60
2016 39.95 11,794.25
Source: PSA (Philippine Statistics Authority), Rice Statistics

LAW OF SUPPLY

The amount of a good that producers are willing to sell at a given price is called the quantity
supplied (QS). There are many determinants of QS, but price (P) plays a special role in analyzing
producers’ (suppliers’) behavior. As seen in the schedule, as the average price per kg of rice rises
overtime, production (quantity supplied, in metric tons) also increase. This relationship between price
and quantity supplied is called the law of supply: Other things equal, when the price of a good rises,
the quantity supplied of the good also rises, and when the price falls, the quantity supplied falls as
well. The curve showing the relationship between price and quantity supplied is the supply curve.

What explains the law of supply

(i.e., why is it that price and
quantity supplied are positively
related)? A high price is an
incentive to producers. They are
willing to produce or sell more
amounts of a good at higher price
as it means more economic
benefit (more profit). Similarly, a
low price is a disincentive to
sellers – a lower price means
lower profit.

Figure 5: Supply Curve

INDIVIDUAL SUPPLY VS. MARKET SUPPLY

Just as market demand is the sum of the demands of all buyers, market supply is the sum of
the supplies of all sellers. Market supply is horizontal summation (summation of all quantities
supplied by all sellers at each possible price) of all individual supply.
 Figure 6: Individual Supply and Market Supply

CHANGE IN SUPPLY (SHIFTS IN THE SUPPLY CURVE)

Because the market supply curve holds other things constant at a given period of time, a
change in supply or a shift in the supply curve is caused by a change in one or more of the non-price
determinants (or other factors) that affect the quantity supplied for a good. When a change in supply
occurs, it happens at a new time period and is compared to the supply at a previous time period.
Graphically:

PX S”
There are less Decrease in Supply S
quantities supplied S’
at each possible
price than in the
previous time-
period
There are more
Increase in Supply quantities supplied
at each possible
price than in the
previous time-
period.

QSX
Figure 7: Shifts in Supply Curve

There are many variables that can shift the supply curve. Here are some of the most
important.

1. Input prices. Firms use a number of different inputs to produce any kind of good or service (i.e.
output). When the prices of those inputs increase, the firms face higher production costs. As a
result, producing said good or service becomes less profitable and firms will reduce supply. That
 is the supply curve shifts to the left (i.e. inward). By contrast, a decrease in input prices reduces
production costs and therefore shifts the supply curve to the right (i.e. outward).

2. Technology. The use of advanced technology in the production process increases productivity,
which makes the production of goods or services more profitable. As a result, the supply curve
shifts right, i.e. supply increases. Please note that technology in the context of the production
process usually only causes an increase in supply, but not a decrease. The reason for this is
simple: new technology is only adopted if it increases productivity. Otherwise, sellers can just
stick with the technology they already have, which does not affect productivity (and thus supply).

3. Number of Sellers. The number of sellers in a market has a significant impact on supply. When
more firms enter a market to sell a specific good or service, supply increases. That is the supply
curve shifts to the right. Meanwhile, when firms exit the market, supply decreases, i.e. the supply
curve shifts to the left.

4. Producers’ Expectations. The seller’s expectations of the future have a significant impact on
supply. Or more specifically, their expectations of future prices and/or other factors that affect
supply. If they expect prices to increase in the near future, they will hold some of their output
back (i.e. reduce current supply) in order to increase supply in the future, when it becomes more
profitable.
5. Taxes and Subsidies. Part of a firm’s cost of production is tax. Business tax is not directly part
of producing a good or service, as it is not an input cost. However, as government mandates all
firms to pay the tax, it does add to total cost of production. Therefore, an increase in business
taxes collected by government will increase the total cost of production, firms supply less of a
good than a previous time period (where business taxes are still low), causing the supply curve to
shift to the left. On the other hand, subsidies are taxes on reverse (i.e., there are financial aids or
grants to firms by the government). With more subsidies coming from the government, firms can
lower down costs, then more will be supplied at the current time than in the previous time period.

6. Natural and Social Factors. There are always a number of natural and social factors that affect
supply. They can either affect how much output sellers can produce or how much they want to
produce. Whenever one of those factors causes supply to decrease, the supply curve shifts to the
left, whereas an increase in supply results in a shift to the right. As a rule of thumb, natural
factors generally affect how much sellers can produce, while social factors have a greater effect
on how much they want to produce.
Examples of natural factors that affect supply include natural disasters, pestilence, diseases, or
extreme weather conditions. Basically, anything that can have an effect on inputs or facilities that
are required in the production process. Meanwhile, examples of social factors include increased
demand for organic products, waste disposal requirements, minimum wage laws, other
government regulations (e.g., environmental compliance, quota). Note that not all of those factors
necessarily have an impact on the cost of production, but all of them affect production decisions.

Table 4: Factors Causing Supply Curve to Shift

Factors Affecting Supply
Supply Curve Shifts to the Right Supply Curve Shifts to the Left
(Increase in Supply) (Decrease in Supply)
Decrease in cost of inputs Increase in cost of inputs
Advanced and improved technology Complex and outdated technology
Increase in number of sellers Decrease in number of sellers
Expectation of fall of prices in future Expectation of rise of prices in future
Favorable taxation policy Unfavorable taxation policy
Favorable weather condition Unfavorable weather condition

SUPPLY FUNCTION
 Supply function is the mathematical expression of law of supply. In other words, supply
function quantifies the relationship between quantity supplied and price of a product, while keeping
the other factors at constant. The law of supply expresses the nature of relationship between quantity
supplied and price of a product, while the supply function measures that relationship.

The supply function can be expressed in two ways: (1) as a quantity function: QS = f(P) or, (2)
as a price-function: P = f(QS). Note however, that even if a supply function can be expressed in two
ways, they still represent one supply curve.

We now quantify the law of supply by expressing the supply function in terms of a linear
equation: y = mx + b

where: b = vertical intercept

m = slope (inclination of the line)
= measures the rate of ∆ in y for a unit ∆ in x
∆ y y 2− y 1
m= =
∆ x x 2−x 1

Determining a linear equation can be done by algebraic solution applying the following
formulae:

y 2− y 1
Using two-point form formula: y− y1 = ( x−x 1)
x2− x1

Or use point-slope formula: y− y1 =m( x−x 1)

Example: Consider the data below on price and quantity supplied. Determine the supply function.
Interpret the slope and intercept of the supply function. Graph the supply curve

Price (x) Quantity Supplied (y)

7 500
9 600
1. Supply function: Q-function

Q−500= ( 600−500
9−7 )
P−7 Q−500= ( 1002 ) P−7
Q−500=50 P−350 Q = 50P – 350 + 500 Q = 50P + 150

Supply function: P-function

9−7
P−7= ( 600−500 ) Q−500 P−7= ( 1002 )Q−500
P−7=0.02 Q−10 P = 0.02Q – 10 + 7 P = 0.02Q – 3

2. Interpretation:

Interpreting the quantity function: Q = 50P + 150

 Slope m = 50 (units): for every P1 change (increase or decrease) in price, quantity supplied
will change (increase or decrease) by 50 units
Vertical intercept b = 150 (units): if P = P0, the minimum amount to be given away for free
is 150 units

Interpreting the price function: P = 0.02Q – 3

Slope m = P0.02: a unit change (increase or decrease) in quantity supplied will change
(increase or decrease) price by 2 centavos
Vertical intercept –P3: if QS = 0 (no amount will be produced/sold in the market), minimum
loss is P3

3. Supply curve

Figure 8: Supply Curve

TOPIC 3: MARKET EQUILIBRIUM

In the previous topics, we discussed demand and supply, both for individual consumers and
firms and for markets. In this topic, we will combine both of these concepts to discuss equilibrium in
the market.

Equilibrium is an ideal state of rest or balance, once achieved it tends to persist. When one is
at the equilibrium then no force exists that will move one away from the equilibrium. When buyers
and sellers meet in the market to exchange goods and services, they carry with them their own self-
interest. A buyer wants a lower price as much as possible and a seller wants a higher price as much as
possible. These are conflicting interests and how are they reconciled? Or how does the market attain
equilibrium?

Once buyers and sellers “agree” on the price of a good or service in the market, equilibrium is
achieved. The price is called equilibrium price or market-clearing price. This price is now acceptable
to both buyers and sellers, and as long as no other factors will change to cause a change in this price,
this condition remains in the market.
 Putting together the demand and supply curves in the same graph, equilibrium occurs where
the demand and supply curves intersect. Formally, this occurs at the price where quantity demanded
(Qd) equals quantity supplied (Qs)

Figure 9: Equilibrium Price and Quantity

Although this is the equilibrium in the demand and supply model, it remains important to
understand why it is the equilibrium. That is, how does the equilibrium meet the characteristics
defined above that must exist for something to be a stable equilibrium? We must essentially show that
the equilibrium has three characteristics:

1. When the actual price exceeds the equilibrium price some force exists that moves the market
back to the equilibrium price. In the figure below, suppose that the actual price, at P2, in the
market exceeds the equilibrium price, PE. This means, first of all, that the quantity demanded
(QD) no longer equals the quantity supplied (QS).
 Figure 10: Disequilibrium: Surplus

Recall that QD is given by the demand curve at the given price. Likewise, QS is given by the
supply curve at the given price. Hence, when price equals P2, then QD will equal Q1 and QS will
equal Q2; quantity supplied is more than quantity demanded. This result is known as an excess
supply or a surplus.

When a surplus occurs that means that firms are unable to do what they desire in the market
given the price. Given a price of P2, firms produce and would like to sell a quantity of Q2, but can
only actually find buyers for a quantity of Q1. The difference between the two equals the actual
surplus. Notice, however, that consumers can do what they wish in the market given the price.

How do firms and consumers respond when faced with a surplus? Given that consumers can
already buy as much as they wish in the market given the price, they do not change their
behavior. Firms, on the other hand, cannot sell all of the output that they produce. Left with
unsold inventory, firms respond by attempting to sell that inventory. How do they induce
consumers to buy their production, rather than their competitors? The most basic way to do so is
by offering the product to consumers at a lower price. However, such price competition by firms
will continue as long as any surplus exists. As a result, the price will decrease until the surplus
dissipates. Thus, the force that causes the price to fall back to the equilibrium when a surplus
exists is price competition by that sector of the market that cannot do what it wishes at the market
price, in this case firms.

2. When the actual price is less than the equilibrium price some force exists that moves the market
back to the equilibrium price. In the graph below, suppose that the actual price, at P1 in the
market is less than the equilibrium price, PE. This means, first of all, that the quantity demanded
(QD) no longer equals the quantity supplied (Q S). When the price equals P1, then QD will equal Q2
 and QS will equal Q1; quantity demanded is more than quantity supplied. This result is known as
an excess demand or a shortage.

Figure 11: Disequilibrium: Shortage

When a shortage occurs, consumers are unable to do what they desire in the market, given the
price. Given that firms can already sell as much as they want at the price, firms will not change
their behavior at the given price. However, consumers cannot buy all of the good they want at the
current price. Faced with unmet demand, consumers respond by all of them attempting to buy the
limited quantity available for sale. How do consumers induce firms to sell their limited
production to them? Again, the most basic method, which is consistent with profit-maximization,
is for consumers to offer to pay higher prices. However, such price competition, this time by
consumers, will continue as long as the shortage exists. Thus, the price will continue to increase
until the shortage completely disappears.

Although it is price competition, just as when a surplus exists, that forces the market to move
back to the equilibrium, in this case it is by consumers and not firms.

3. When the actual price equals the equilibrium price no force exists that moves the market away
from the equilibrium price.
 Figure 12: Natural Tendency to Equilibrium

Thus, price competition only exists when one of the actors in the market is dissatisfied, when
they either cannot sell or buy all that they desire at the market price. But at the equilibrium price
and quantity of PE and QE in Figure 2:11, both firms’ and consumers’ desires are being met
exactly because quantity demanded equals quantity supplied. The fact that there exists neither a
surplus nor a shortage means that no price competition will form moving the market away from
the equilibrium.

Thus, as shown in Figure 2.12, both of the requirements for a stable equilibrium are met – when
not at the equilibrium some force, price competition, moves the market back to equilibrium and
when at the equilibrium the price competition does not form, keeping the market at the
equilibrium. Although the force in the demand and supply model moving the market to
equilibrium is price competition, students often have difficulty remembering which actor is
competing. To understand this point, just ask who it is that doesn’t get to do what they desire at
the current market price. That will be the party who changes their behavior and competes in an
attempt to reach a desirable outcome. Clearly, the party who has already attained his desires
given the situation in the market will not change her behavior in order to compete.

PREDICTIONS ABOUT EQUILIBRIUM AND QUANTITY

The main purpose of the demand and supply model is to be able to make predictions about the
impact of a given change in the market upon equilibrium price and quantity. These predictions depend
upon the following steps:

1. Identify exactly the impact upon the given market. (That is, which market is being
impacted and by what event?)
2. Does the change affect demand, supply, or both?
 3. In which direction is demand or supply affected?
4. What happens to equilibrium price and quantity as a result?

For example, if the price of wheat increases, what impact will this have upon the market for
bread? Wheat is an input into the production of bread. Hence, the supply of bread will be affected
because supply deals with production. Recall from our discussion of demand and supply in the
previous chapter that when input prices increase, the costs of production are in turn increased, which
decreases the supply of the good, in this case bread. What is the impact on equilibrium price and
quantity? The specific impact is discussed separately for each of eight different possible scenarios
below. These will focus on answering only the last of the four questions above – what happens to
equilibrium price and quantity for a given change in demand or supply. As a student, you should be
prepared to answer the other three questions as well.

A. Change in Either Demand or Supply

 Increase in Demand

An increase in demand occurs when the

demand curve shifts to the right, as
shown in the graph. The original D
curve equals D1 and coupled with the
Supply curve of S1, means that the
original equilibrium equals E1. Before
the demand shift, price and quantity
equal P1 and Q1, respectively.

Figure 13: Increase in Demand

However, when the demand increases (shifts right) at a price of P 1 the market is no longer
in equilibrium. Rather, a shortage or excess demand now exists. As discussed above, when a
shortage occurs price competition by consumers forces the price to rise to a new
equilibrium, E2, where the new equilibrium price and quantity equal P 2 and Q2
respectively. Notice that this process of price competition does cause us to move to the
equilibrium.

The end result is that both equilibrium price and quantity increase.

 Decrease in Demand

A decrease in demand occurs when the

demand curve shifts to the left as shown in
the graph. Again, the original demand curve
equals D1 and coupled with the Supply curve
of S1, means that the original equilibrium
equals E1. Thus, price and quantity equal P1
and Q1before the demand shift, respectively.

However, when the demand decreases to D2,

the market moves to a new equilibrium, E2
with equilibrium price and quantity both
decreasing to P2 and Q2, respectively.
  Increase in Supply

An increase in supply occurs when the

supply curve shifts to the right as shown in
the graph. The original demand and supply
curves equal D1 and S1, respectively. Thus,
the original equilibrium equals E1, with a
price and quantity equal to P1 and Q1
respectively.

However, when the supply increases to S 2,

the market moves to a new equilibrium, E 2,
with equilibrium price decreasing to P2 while
equilibrium quantity increases to Q2.

Figure 15: Increase in Supply

 Decrease in Supply

A decrease in supply happens when the

supply curve shifts to the left, shown in
graph. Again, the original demand and supply
curves equal D1 and S1, respectively. The
original equilibrium equals E1, with a price
and quantity equal to P1 and Q1 respectively.

When the supply decreases to S 2, market

forces move the market to the new
equilibrium, E2, with equilibrium price
increasing to P2 and equilibrium quantity
decreasing
The to types
above four Q2. of demand and supply shifts are the basic results of the demand and
supply model. They will serve as the basis for much that comes in the class. Let us now consider how
to use the graphs. Here is one example of a simple type of question that is relevant.
Figure 16: Decrease in Supply
Which of the following would be most likely to result in an increase in equilibrium price and
a decrease in equilibrium quantity in a market?

A. An increase in demand (supply is constant)

B. A decrease in demand (supply is constant)
C. An increase in supply (demand Is constant)
D. A decrease in supply (demand is constant)
 Answers A through D is illustrated by the next graphs, respectively. Carefully examine each
graph to find the one that shows the indicated move in equilibrium price and quantity. Clearly, choice
D is the correct answer, which is shown in Figures 2:13-2:16. The student should note how a change
in the stem of the question would change the correct answer. For example, if it asks about an increase
in both equilibrium price and quantity then the correct answer is choice A. Make sure you understand
all of the other possible questions based on this type.

In addition to the above type of question, students should be prepared to ask more difficult
questions; questions that rely upon them correctly working through all four of the steps discussed
above. Consider, for example, the following question:

Suppose that the price of gas increases. What impact, if any, will this change have upon the
market for cars?

A. The change will have no impact on the market for cars.

B. Equilibrium price and quantity of cars will increase.
C. Equilibrium price and quantity of cars will decrease.
D. Equilibrium price will increase while quantity will decrease.
E. Equilibrium price will decrease while quantity will increase.

In order to answer this question, you must decide which will be affected, demand or supply.
Be careful, it’s possible that neither will be affected, in which case the correct answer is A. Recall,
that cars and gasoline are complements in consumption. Since demand is related to consumption, it is
the demand curve that will be affected and not the supply curve. Likewise, since complementary
goods are those that are consumed together, when the price of gas increases, people will buy less gas
(law of demand). However, with lower use of gas also comes less demand for cars. As a result, the
demand for cars will fall. As shown by Figure 2.14, when the demand for a good falls, then the
equilibrium price and quantity of that good will also fall. Hence, choice C is the correct answer.

B. Change in Both Demand and Supply

It is possible for both demand and supply to be affected simultaneously in the real world. As a
result, it is useful to be able to make predictions about what will happen in a market when such a
result occurs. For example, suppose that some change occurs in the market for gasoline that
induces both consumers and firms to expect that the price of gas will rise in the future.

Recall that an expected higher price will induce consumers to buy more of the good now since it
is cheaper now than it is expected to be in the future. Hence, demand for gas now will increase.
Likewise, an expected higher future price will induce suppliers to sell less of the good now since
its relatively cheaper price is less attractive to profit maximizing firms than the future expected
higher price. Hence, supply for gas now will decrease.

What happens to equilibrium price and

quantity in this situation? A simultaneous
decrease in Supply combined with an
increase in Demand is illustrated in Figure
2.18. The original demand and supply curves
are D1 and S1, respectively. The new
demand and supply curves, after the effect of
the price expectations occur, are D2 and S2,
respectively.

Figure 17: Decrease in Supply, Increase in Demand

The graph illustrates that equilibrium price will increase but that quantity remains constant.

This result, however, is somewhat deceptive. Notice that, as discussed above, the result of a
decrease in Supply (Figure 2.16) is to increase price and decrease quantity while the result of an
increase in demand (Figure 2.13) is to increase both price and quantity. Clearly, because the
changes in both demand and supply curves cause price to increase, then price will increase.

However, each shift has an opposite impact on equilibrium quantity. The supply shift decreases
quantity, while the demand shift increases quantity. Figure 2.17 illustrates the result that occurs if
these two opposing impacts on quantity exactly cancel each other out. This only occurs when the
two shifts are of the same magnitude. However, it is just as possible that quantity could increase
(demand shift larger) or decrease (supply shift larger). Without information about the magnitude
of the two shifts we simply cannot determine what will happen to quantity.

This discussion highlights an important point about simultaneous shifts of both supply and
demand. In each of the four cases discussed below, either equilibrium price or quantity will be
indeterminate without information about the magnitude of the shifts. However, simply drawing a
graph as we did above with only a single shift of a single curve, leads one to misleading
conclusions without that information. This is because when drawing such a shift on a graph one
must make an assumption about the relative magnitudes of the two shifts. As a result, it is
actually more useful to not draw any additional graphs. Instead, simply look at the four graphs
that we’ve already discussed above and consider the impact of each shift separately.

 Increase in Both Demand and Supply

Change Impact on PE Impact on QE

Demand Increases Increases Increases
Supply Increases Decreases Increases
Total Impact Indeterminate Increases

 Increase in Demand, Decrease in Supply

Change Impact on PE Impact on QE

Demand Increases Increases Increases
Supply Decreases Increases Decreases
Total Impact Increases Indeterminate

 Decrease in Demand; Increase in Supply

Change Impact on PE Impact on QE

Demand Decreases Decreases Decreases
Supply Increases Decreases Increases
Total Impact Decreases Indeterminate

 Decrease in both Demand and Supply

Change Impact on PE Impact on QE

Demand Decreases Decreases Decreases
Supply Decreases Increases Decreases
Total Impact Indeterminate Indeterminate
 Notice that in the four cases, one has price increasing, one has price decreasing, one has quantity
increasing, and one has quantity decreasing. Students should be prepared to answer applied
questions where both demand and supply curves shift simultaneously. This would be similar to
the question asked above about the market for gasoline where expectations about future prices
affect both demand and supply simultaneously.

ALGEBRAIC SOLUTION TO MARKET EQUILIBRIUM

We will now combine the knowledge we gained about linear demand and linear supply
equations to figure out how to determine the equilibrium price and quantity in the market using the
demand and supply equations.

The equilibrium condition states that at a certain price (i.e., equilibrium price), QS = QD.
Following this condition, we just equate the determined demand and supply equations. For example:

Consider the market for shoes. The linear demand and supply functions are:
QD = 250 – 10P
QS = 50 + 10P

We now equate demand and supply equations based on equilibrium condition.

50 + 10P = 250 – 10P

Combining similar terms:

10P + 10P = 250 – 50 simplifying,
20P = 200 solve for P
20 P 200
=
20 20

P = 10 equilibrium price

Solve for equilibrium quantity by substituting the value of price on demand/supply equations:
At equilibrium price, QS = QD

QS = 50 + 10(10) QD = 250 – 10(10)

QS = 50 + 100 QD = 250 – 100

QS = 150 QD = 150

Therefore, equilibrium is established in the market if P =10 and Q = 150.

By tabular solution, we will arrive at the same values of equilibrium price and equilibrium.
Set up a demand and supply schedules.

Table 4: Market Equilibrium Schedule

P QS QD Gap (QS – QD)
0 50 250 –200
2.5 75 225 –150 Shortage
5 100 200 –100
7.5 125 175 –50
10 150 150 0
12.5 175 125 50
15 200 100 100
Surplus
 17.5 225 75 150
20 250 50 200
22.5 275 25 250
25 300 0 300

A gap means an existence of either a surplus (QS > QD) or a shortage (QD > QS). A negative
value of the gap means shortage and a positive value of gap means surplus. Only at equilibrium where
gap is equal to zero. The equilibrium condition can also be illustrated using a graphical presentation.

Figure 18: Market Equilibrium

TOPIC 4: APPLICATIONS

One of the main purposes of teaching the demand and supply model in a principles class is
that the model is extremely powerful in predicting how markets work. This sections gives two of the
many possible examples of how the model is useful in analyzing market outcomes. Considered below
is the impact of a particular type of governmental market intervention, known as price controls. Price
controls refer to the government attempting to control the market price through legal intervention in
the market. Two different types of price controls, price floors and price ceilings, are defined and
analyzed separately.

PRICE CEILINGS

 Definition

A price ceiling is a maximum legal price. The name is descriptive of the effect of a maximum
legal price. Similar to a ceiling, the market price can be below the ceiling, but not above it. There
are a number of examples of price ceilings. One example is rent controlled housing. A number of
 jurisdictions, usually urban areas, impose a price ceiling, often called rent controls, on housing in
an attempt to reduce the prices consumers pay for housing.

 What is an effective price ceiling?

An effective price ceiling is one that, when enforced, will cause the market to move away from
the equilibrium.

Which of all the possible ceiling prices are

effective and which ineffective? Graph 9
shows the normal, free-market equilibrium
where quantity demanded equals quantity
supplied, at a price of PE and a quantity of
QE. It also shows two other prices, one
higher than the equilibrium price (P2) and
one lower (P1).

Figure 19: Price Ceiling

Which of these two prices, or both, would be effective price ceilings? The answer to this question
depends upon a clear understanding of the definitions of both an effective price ceiling and a
price ceiling itself. Recall that a price ceiling is a maximum legal price. Hence, the actual market
price can be below but not above a ceiling price. An effective price is one that when enforced
will move the market away from the equilibrium. Put together, these two concepts mean that only
ceiling prices set below the equilibrium, such as P1 in Figure 2.19, will be effective.

Ceiling prices below the equilibrium price are effective while those above are ineffective because
the market in the absence of some intervening factor will always attempt to be at the equilibrium
price. However, a ceiling price set above the equilibrium, such as at P 2, still allows the market to
be at the equilibrium. On the other hand, at P 1, even though the market attempts to be at the
higher equilibrium price of PE, the enforced ceiling price will not allow this.

 Equilibrium

Now consider the impact of only effective price ceilings. That is, consider only the impact of
ceiling prices that are set below the equilibrium price. There are three possible outcomes, all of
which are discussed in more detail below. Either the market will (1) make no change and remain
at the original equilibrium or (2) the price of the good will decrease but a shortage of the good
will develop or (3) the price of the good will actually increase.

 Enforceable price ceilings?

Which of the above three outcomes occurs depends crucially upon whether or not the
government can actually enforce the ceiling price. This is not a trivial question, either. Clearly,
the actors in the market will have an incentive to attempt to avoid the regulation and return to the
equilibrium, just as happens when the market is not in equilibrium for other reasons. For
 example, one way to get around rent control laws for housing is to pay what is commonly known
as “key money.” That is a payment upfront to have the keys in an apartment changed when
changing renters. However, if the key money is substantial, then this is clearly an attempt to
avoid the price ceiling.

Thus, the analysis of the impact of the price ceiling depends crucially upon whether or not the
price ceiling can be enforced.

1. Price is Enforced
If the ceiling price equals P1 as shown by Graph 9, then the result is straightforward. At this
price in the graph, then a shortage occurs, with quantity demanded equaling Q 2 and quantity
supplied equaling Q1. While the price does fall to the ceiling price, some consumers are not
able to buy the good. That is true even of some consumers who previously were able to buy
the good at the equilibrium.

2. Ceiling Price is Not Enforced

There are actually two possible outcomes if the price ceiling cannot be enforced. In this
case, someone is being paid a price in excess of the ceiling price for the product. The
outcome depends crucially upon who gets that extra money.

a. If the extra money simply goes to the firm producing the good, then they respond as do
all firms when receiving a higher price. They increase their quantity supplied.
Likewise, consumers respond to the higher price by reducing their quantity demanded.
As a result, the market simply moves back to the original equilibrium. (Note: the
market might not go back all the way to the original equilibrium if the cost of avoiding
the price ceiling is substantial. In that case, the equilibrium quantity will be lower.)

b. If the extra money does not go to the firm producing the good but, instead ends up
going to some third party, then quite a different outcome results. Why might this even
be a possibility? This commonly occurs because it is easier for the government to
enforce the ceiling price upon the original producers but it cannot enforce the ceiling
price on people who buy and then resell the product. This is the classic formation of a
black market.

What happens in a black market? First, because the producing firms are not receiving a
higher price, they do not change their behavior. They continue to produce at the same
level, Q1, in Figure 2.19. Hence, the crucial question is how will consumers react to the
formation of the black market. Recall that they are generally now buying the product,
not from the firm at a price of P1 but from the black marketeers.

The black marketeers will attempt to resell the good at the highest price they can in the
market. How high will consumers be willing to pay in order to ensure that they receive
the limited quantity available? The relationship between quantity and price for
consumers is given by the demand curve. Hence, when the quantity available equals
Q1, then the price in the market will equal P 2. This is commonly known as the black
market price.

• Does the Price Ceiling Improve the Position of Consumers?

The normal justification for the imposition of price ceilings is to improve the welfare of
consumers in a market where prices are considered too high by some subjective standard. Thus, it
is crucial to ask as part of our analysis, how well do price ceilings achieve their stated goal?
 The results are actually not encouraging, as an examination of the results above clearly indicate.
Consider each of the three possible outcomes:

1. When the ceiling price is enforced, the price does fall in the market to whatever price is set
by the government. However, a shortage occurs in the market so that some consumers are
unable to buy at this lower price. Hence, some consumers will be better off, those who can
buy the good at the lower price. However, other consumers will be worse off, those who
cannot buy the good at all but would have at the higher price.

2. When the ceiling price is not enforced and the illegal higher price is paid to the firms
producing the good, the market does not change with the regulation. As a result, the price
ceiling does not advantage consumers. In fact, consumers may be worse off if avoiding
enforcement, as is likely, is costly to them. Furthermore, the government will be wasting
some resources in passing and attempting to enforce the regulation. Hence, there exists no
possibility of a consumer advantage and significant possibility of substantial costs.

3. When the ceiling price is not enforced and a black market forms, consumers actually end up
paying a higher price and also buy a lower quantity. For both reasons, they are worse off as
a result of the price ceiling.

PRICE FLOORS

 Definition

A price floor is a minimum legal price. The name is descriptive of the effect of a minimum legal
price. Similar to an actual floor, the market price can be above the floor, but not below it.
Examples of price floors include the national minimum wage in the U.S. and price floors
imposed for a number of agricultural products.

 What is an effective price floor?

An effective price floor is one that, when enforced, will cause the market to move away from the
equilibrium. Which of all the possible floor prices are effective and which ineffective? In Figure
2.20, the equilibrium in the absence of any price controls will be at P E and QE. The graph also
shows a price above (P2) and one below (P1) the equilibrium price.

Which of these two prices, or both, would be

effective price floors? Again, to understand this
point, one must clearly understand the definitions
of both a price floor and of an effective price floor.
Because a price floor is a minimum legal price, the
actual price can be above, but not below, a given
price floor. Likewise, because an effective price
floor is one that forces the market away from the
actual equilibrium only prices above the
equilibrium price, such as P2 in the graph, will be
effective. If the price floor were set below the
equilibrium price, at P1 in the graph, then the
market legally can and would still choose the
equilibrium price.

 Equilibrium
Figure 19: Price Ceiling
 Next consider only the impact of effective price floors, those that are set above the equilibrium
price. In the case of price floors, there are only two possible outcomes. Either the market will (1)
make no change and remain at the original equilibrium or (2) the price will increase but a surplus
of the good will also result.

 Enforceable Price Floors?

Which outcome will actually occur, similar to the analysis for price ceilings, depends crucially
upon whether or not the price floor can actually be enforced. Again, the actors in the market have
an incentive to avoid the floor and return to the equilibrium.

1. Floor Price is Not Enforced

If the floor price is not enforced, then there exists only one possible outcome. At the floor
price a surplus would exist so price competition by firms would force the price back to the
equilibrium, at a price of PE and a quantity of QE. Similar to the same situation for price
ceilings, there would potentially exist significant costs to the unenforceable floor price as
firms attempt to avoid the regulation.

2. Floor Price is Enforced

The situation that results is quite different if the floor price is enforced. In that case, at a
floor price of P2, then quantity demanded would only equal Q 1 while quantity supplied
would equal Q2. Hence, a surplus would occur with firms unable to sell all that they wish to
at the higher price.

 Supporting an effective price floor

Price floors are usually intended to advantage firms or, in the case of minimum wage laws,
individuals who supply labor. However, as we’ve seen above they do not necessarily work as
planned. Either they have no impact on the market, even though imposing substantial
enforcement costs, or they do increase the price while causing a surplus. In the latter case, only
those firms who can sell their product will be better off. Other firms will be worse off and may
even be forced out of business.

As a result, the government often enacts programs, known as price supports, in order to alleviate
these problems. These programs tend to involve some type of government subsidy.

1. Government subsidies
A government subsidy is when the government either pays for part of the higher price for
the good, or more commonly, buys up the extra surplus at the floor price. Such subsidies are
often called price supports because they are enacted in order to keep the price at the higher
level. For example, price support programs are common in agricultural industries where
products have price floors imposed.

What does the government do with the product that it buys up in the subsidy program?
Often, they will use the good as part of a welfare program to support poor people, perhaps
giving the good away to welfare recipients or other qualifying individuals.

• What is the effect if the price floor is not subsidized?

In this instance the surplus persists and eventually some firms will go out of business. But the
cycle will not stop there. The higher price of the good and resultant higher profits for surviving
firms will induce other firms to enter the industry, which will cause another surplus. As a result,
more firms will go out of business. This cycle could possibly continue indefinitely.
Another important point is to carefully examine the impact on other markets. Consider for
example the impact of minimum wage legislation. Suppose the minimum wage is increased,
Then the effect will be dependent upon which workers are considered. Higher skilled workers
have higher wages and, hence, are not affected by the change because the price floor is not
effective for them. It is only the lower skilled and wage workers who are affected directly. The
impact is as discussed above for these unskilled workers.

However, skilled workers are indirectly impacted by the minimum wage in the following
manner. As the wage increases for unskilled workers, they become less desirable to firms, who
reduce their employment. For skilled workers, especially those who are close substitutes for the
unskilled workers, employment increases as a result. That is, firms’ demand increases for those
skilled workers who are substitutable for the lower paid unskilled workers. As demand increases
(shifts right) this will increase both employment and wages, not for the lower skilled workers, but
for skilled workers. Thus, even though the minimum wage is unlikely to help unskilled workers,
ultimately causing unemployment for unskilled workers, it will advantage skilled workers. Of
course, the regulation is not originally intended (or is it?) to advantage skilled workers.