Chapter 4

The Market Forces

of Supply and
Demand

1
This chapter looks at the demand and supply. These
are the forces that make economy works. Following
points are covered in the chapter:

•What factors affect buyers’ demand for goods?

•What factors affect sellers’ supply of goods?
•How do supply and demand determine the price of a
good and the quantity sold?
•How do changes in the factors that affect demand or
supply affect the market price and quantity of a
good?

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 Markets and Competition
 Demand and supply are studied in the context of
market.
 A market is a group of buyers and sellers of a
particular product.
 There are three types of markets:
 A perfectly competitive market is characterized
by:
• Homogeneous goods
• Buyers & sellers so numerous that no one can
affect market price – each is a “price taker”
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 Markets and Competition
• The other extreme is monopoly market : where there is a single
seller (for instance, indian railways- irctc)

• In between these two extremes, there is a market named

oligopoly : which is characterised by a few number of sellers.
Most of the industries in the real world are oligopoly markets.
(For instance, automobile market, network providers, cement
industry, and DTH providers etc.)

• In the real world, there are relatively few perfectly competitive

markets. However, we look at supply and demand in perfectly
competitive markets, for two reasons: First, it is simple and
therefore, easy to understand. Second, because some degree
of competition is present in most markets, many of the lessons
of supply and demand under perfect competition apply in more
complicated markets as well.

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 Demand
 Demand examines the behavior of buyers.
 The quantity demanded of any good is the
amount of the good that buyers are willing and
able to purchase.
 Law of demand: the claim that ,other things
equal, the quantity demanded of a good falls
when the price of the good rises

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 The Demand Schedule
Price Quantity
 Demand schedule:
The demand schedule is a table that of of lattes
shows the quantity demanded at each lattes demanded
price. The demand curve, which graphs $0.00 16
the demand schedule, illustrates how
the quantity demanded of the good 1.00 14
changes as its price varies. Because a 2.00 12
lower price increases the quantity
demanded, the demand curve slopes 3.00 10
downward. 4.00 8
5.00 6
Example: Catherine’s Demand
Schedule and Demand Curve 6.00 4

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 Demand Schedule & Curve
Price Price Quantity
of of lattes
lattes demanded
$0.00 16
1.00 14
2.00 12
3.00 10
4.00 8
5.00 6
6.00 4
Quantity
By convention, the price of ice cream is on the vertical axis, and the quantity of ice cream
demanded is on the horizontal axis. The downward-sloping line relating price and quantity
demanded is called the demand curve. 7
 Market Demand versus Individual Demand
 The quantity demanded in the market is the sum of the quantities
demanded by all buyers at each price. Thus, the market demand curve
is found by adding horizontally the individual demand curves.
 Suppose Helen and Ken are the only two buyers in the market.
(Qd = quantity demanded)

Price Helen’s Qd Ken’s Qd Market Qd

$0.00 16 + 8 = 24
1.00 14 + 7 = 21
2.00 12 + 6 = 18
3.00 10 + 5 = 15
4.00 8 + 4 = 12
5.00 6 + 3 = 9
6.00 4 + 2 = 6
 The Market Demand Curve

Qd
P P
(Market)
$0.00 24
1.00 21
2.00 18
3.00 15
4.00 12
5.00 9
6.00 6
Q

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 Demand Curve Shifters
 The demand curve shows how price affects
quantity demanded, other things being equal.
 These “other things” are non-price determinants
of demand (i.e., things that determine buyers’
demand for a good, other than the good’s price).

 Changes in them shift the D curve.

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Demand Curve Shifters: no. of buyers
 An increase in the number of buyers causes
an increase in quantity demanded at each price,
which shifts the market demand curve to the
right.

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Demand Curve Shifters: no. of buyers

P Suppose the number

of buyers increases.
Then, at each price,
quantity demanded
will increase

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Demand Curve Shifters: income

 Demand for a normal good (good for which,

other things equal, an increase in income leads
to an increase in demand) is positively related to
income.
• An increase in income causes increase
in quantity demanded at each price, shifting
the D curve to the right.

(Demand for an inferior good is negatively

related to income. An increase in income shifts
D curves for inferior goods to the left.)

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Demand Curve Shifters: prices of
related goods
 Substitutes are often pairs of goods that are used in
place of each other. For instance, tea and coffee,
hamburgers and hot dogs etc. An increase in the
price of one causes an increase in demand for the
other.
 Example: tea and coffee
An increase in the price of tea increases demand for
coffee, shifting coffee demand curve to the right.

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Demand Curve Shifters: prices of
related goods
 Complements are often pairs of goods that are
used together, such as fuel and automobiles,
computers and software, and pen and ink. An
increase in the price of one causes a fall in
demand for the other.
 Example: computers and software.
If price of computers rises, people buy fewer
computers, and therefore less software.
Software demand curve shifts left.

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Demand Curve Shifters: tastes

 Anything that causes a shift in tastes toward a

good will increase demand for that good
and shift its D curve to the right. (A reason why
many chips companies keep introducing the
different flavors)

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Demand Curve Shifters: expectations
 Expectations affect consumers’ buying
decisions.
 Example: an upcoming sale on flipkart will
induce buyers to buy in the future and reduce
the demand at present, shifting the demand
curve towards left.

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Summary: Variables That Affect Demand

Variable A change in this variable…

Price …causes a movement

along the D curve
No. of buyers …shifts the D curve
Income …shifts the D curve
Price of
related goods …shifts the D curve
Tastes …shifts the D curve
Expectations …shifts the D curve
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 Supply
 Supply examines the behavior of sellers.
 The quantity supplied of any good is the
amount that sellers are willing and able to sell.
 Law of supply: the claim that, other things
equal, the quantity supplied of a good rises
when the price of the good rises

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 The Supply Schedule
 Supply schedule: Price Quantity
The supply schedule is a table that of of lattes
shows the quantity supplied at each lattes supplied
price. This supply curve, which graphs
the supply schedule, illustrates how the $0.00 0
quantity supplied of the good changes 1.00 3
as its price varies. Because a higher
price increases the quantity supplied, 2.00 6
the supply curve slopes upward. 3.00 9
4.00 12
5.00 15
 Example: Ben’s Supply
6.00 18
Schedule and Supply
Curve
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 Ben’s Supply Schedule & Curve
Price Quantity
P of of lattes
lattes supplied
$0.00 0
1.00 3
2.00 6
3.00 9
4.00 12
5.00 15
6.00 18
Q

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 Market Supply versus Individual Supply
 The quantity supplied in the market is the sum of
the quantities supplied by all sellers at each price.
 Suppose Starbucks and Jitters are the only two
sellers in this market. (Qs = quantity supplied)
Price Starbucks Jitters Market Qs
$0.00 0 + 0 = 0
1.00 3 + 2 = 5
2.00 6 + 4 = 10
3.00 9 + 6 = 15
4.00 12 + 8 = 20
5.00 15 + 10 = 25
6.00 18 + 12 = 30
The Market Supply Curve
QS
P
(Market)
P
$0.00 0
1.00 5
2.00 10
3.00 15
4.00 20
5.00 25
6.00 30

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 Supply Curve Shifters
 The supply curve shows how price affects
quantity supplied, other things being equal.
 These “other things” are non-price determinants
of supply.
 Changes in them shift the S curve.

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Supply Curve Shifters: input prices
 Examples of input prices:
wages, prices of raw materials.
 A fall in input prices makes production
more profitable at each output price,
so firms supply a larger quantity at each price,
and the S curve shifts to the right.

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Supply Curve Shifters: input prices

P Suppose the
price of sugar
falls.
At each price,
the quantity of
ice cream
supplied
will increase.

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Supply Curve Shifters:
 Technology : A technological advancement
reducing the cost of production will raise the
supply, shifting the supply curve to the right.

 Number of sellers : An increase in the number

of sellers increases the quantity supplied at each
price, shifts the S curve to the right.

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Supply Curve Shifters: expectations

 Suppose a firm expects the price of the good it

sells to rise in the future.
 The firm may reduce supply now, to save some
of its inventory to sell later at the higher price.
 This would shift the S curve leftward.

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Summary: Variables That Affect Supply

Variable A change in this variable…

Price …causes a movement
along the S curve
Input prices …shifts the S curve
Technology …shifts the S curve
No. of sellers …shifts the S curve
Expectations …shifts the S curve

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 Supply and Demand Together

P
D S The Equilibrium of Supply
and Demand: The
equilibrium is found where
the supply and demand
curves intersect. At the
equilibrium price, the
quantity supplied equals
the quantity demanded.

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Equilibrium price:
The price that equates quantity supplied
with quantity demanded
P
D S P QD QS
$0 24 0
1 21 5
2 18 10
3 15 15
4 12 20
5 9 25
Q 6 6 30

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Equilibrium quantity:
The quantity supplied and quantity demanded
at the equilibrium price
P
D S P QD QS
$0 24 0
1 21 5
2 18 10
3 15 15
4 12 20
5 9 25
Q 6 6 30

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Surplus:
when quantity supplied is greater than
quantity demanded
P
D Surplus S Example:
If P = $5,
then
QD = 9
and
QS = 25
resulting in a surplus
of 16
Q

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Surplus:
when quantity supplied is greater than
quantity demanded
P
D Surplus S Facing a surplus,
sellers try to increase
sales by cutting the price.
This causes QD to rise
and QS to fall.

Prices continue to fall

until market reaches
equilibrium.
Q

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Shortage:
when quantity demanded is greater than
quantity supplied
P
D S Example:
If P = $1,
then
QD = 21
and
QS = 5
resulting in a
shortage of 16
Shortage Q

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Shortage:
when quantity demanded is greater than
quantity supplied
P In a shortage, too many buyers
D S are chasing too few goods.
Therefore, sellers respond to the
shortage
by raising the prices. It leads to
QS to rise, and QD to fall.

Prices continue to rise until

market reaches equilibrium.

Shortage
Q

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• Thus, regardless of whether the price starts off too high or too low,
the activities of the many buyers and sellers automatically push
the market price toward the equilibrium price. Once the market
reaches its equilibrium, all buyers and sellers are satisfied, and
there is no upward or downward pressure on the price.

• In most free markets, surpluses and shortages are only temporary

because prices eventually move toward their equilibrium levels.

• This phenomenon is so pervasive that it is called the law of supply

and demand: the claim that the price of any good adjusts to bring
the quantity supplied and the quantity demanded for that good into
balance.

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 Three Steps to Analyzing Changes in
Equilibrium

To determine the effects of any event,

1.
1. Decide
Decidewhether
whetherevent
eventshifts
shifts SScurve,
curve,
DDcurve,
curve,or
or both.
both.
2.
2. Decide
Decidein
inwhich
whichdirection
directioncurve
curveshifts.
shifts.
3.
3. Use
Usesupply-demand
supply-demanddiagram
diagramto tosee
see
how
howthe
theshift
shiftchanges
changes equilibrium
equilibrium PPand
and Q.
Q.

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EXAMPLE: A Change in Market
Equilibrium Due to a Shift in
Demand
Suppose that one summer the weather is very hot. How does this event affect the
market for ice cream?

1. The hot weather affects the demand curve by changing people’s taste for ice
cream. That is, the weather changes the amount of ice cream that people want to
buy at any given price. The supply curve is unchanged because the weather does
not directly affect the firms that sell ice cream.
2. Because hot weather makes people want to eat more ice cream, the demand
curve shifts to the right. This shift indicates that the quantity of ice cream
demanded is higher at every price.
3. At the old price, there is now an excess demand for ice cream, and this
shortage induces firms to raise the price. The increase in demand raises the
equilibrium price and the equilibrium quantity. In other words, the hot weather
increases the price of ice cream and the quantity of ice cream sold.

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EXAMPLE 1: A Change in Demand
EVENT TO BE
ANALYZED: P
S1
STEP 1: P2
D curve shifts
because
STEP 2: price of gas P1
affects demand for
D shifts right
hybrids.
because
STEP 3: high gas
S curve
price doeshybrids
makes not D1 D2
The shift
shift, causes
because an
price
more attractive Q
increase
of gas does in price
not Q1 Q2
relative to other cars.
and quantity
affect cost of of ice-
creams. hybrids.
producing
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EXAMPLE 1: A Change in Demand

Notice: P
When P rises,
S1
producers supply
a larger quantity P2
of ice-creams, even
though the S curve P1
has not shifted.
Always be careful
D1 D2
to distinguish b/w
a shift in a curve Q
Q1 Q2
and a movement
along the curve.
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Terms for Shift vs. Movement Along Curve
 Change in supply: a shift in the S curve
• occurs when a non-price determinant of supply
changes (like technology or costs)
 Change in the quantity supplied:
a movement along a fixed S curve
• occurs when P changes
 Change in demand: a shift in the D curve
• occurs when a non-price determinant of
demand changes (like income or no. of buyers)
 Change in the quantity demanded:
a movement along a fixed D curve
• occurs when P changes
EXAMPLE: A Change in Market
Equilibrium Due to a Shift in
Supply
Suppose that during another summer, a hurricane destroys part of the sugarcane
crop and drives up the price of sugar. How does this event affect the market for ice
cream?

1. The change in the price of sugar, an input for making ice cream, affects the
supply curve. By raising the costs of production, it reduces the amount of ice
cream that firms produce and sell at any given price. The demand curve does not
change because the higher cost of inputs does not directly affect the amount of ice
cream households wish to buy.

2. The supply curve shifts to the left because, at every price, the total amount that
firms are willing and able to sell is reduced.

3. At the old price, there is now an excess demand for ice cream, and this
shortage induces firms to raise the price. The decrease in supply raises the
equilibrium price and lowers the equilibrium quantity.

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EXAMPLE 2: A Change in Supply

P
S2
S1
STEP 1:
S curve shifts
because
STEP 2: event affects P1
cost of production.
S shifts left P2
D curve does
because eventnot
STEPbecause
shift, 3:
reduces cost, D1
The shift causes
production technology
makes production Q
price
is not to
onerise
of the Q1 Q 2
more profitable at
and quantity
factors to fall.
that affect
any given price.
demand.
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 EXAMPLE 3: A Change in Both Supply
and Demand
Now suppose that a heat wave and a P
hurricane occur during the same S2
summer. S1
STEP 1: P2
Both curves shift.
STEP 2:
Demand shifts to the P1
right. Supply shifts to the
left.
D1 D2
STEP 3: Q
QQ 2
P rises, but effect 1

on Q is ambiguous:
If demand curve shifts in a greater
45
proportion than supply, Q rises.
 EXAMPLE 3: A Change in Both Supply
and Demand
P
S2
S1
STEP 3:
If demand curve shifts in P2
a lesser proportion than
supply, Q falls. P1

D1 D2
Q
Q2 Q1

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EXAMPLE 3: A Change in Both Supply
and Demand
P
S2
S1

STEP 3: P2
If demand curve shifts in a
equal proportion P1
to supply, Q does not
change.
D1
D2 Q
Q1
=Q2

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