The Basics of

Supply and
Demand

Dr. Chitrita Bhowmick

 Introduction
• The field of Economics is traditionally divided into two broad subfields-
• microeconomics Branch of economics that deals with the behavior of individual economic units—consumers, firms, workers, and investors—as well as the markets that these units comprise.
• macroeconomics Branch of economics that deals with aggregate economic variables, such as the level and growth rate of national output, interest rates, unemployment, and inflation.
 Theories and Models

• In economics, explanation and prediction are based on theories. Theories are developed to explain observed phenomena in terms of a set of basic rules and assumptions.

• A model is a mathematical representation, based on economic theory, of a firm, a market, or some other entity.
 Positive versus Normative Analysis

• positive analysis: Analysis describing relationships of

cause and effect.
• normative analysis: Analysis examining questions of what
ought to be.

• Positive: Minimum-wage laws cause unemployment

• Normative: The government should raise the minimum
wage.
 WHAT IS A MARKET?

• Market: Collection of buyers and sellers that, through their actual

or potential interactions, determine the price of a product or set of
products.
• market definition: Determination of the buyers, sellers, and range
of products that should be included in a particular market.

Market Definition—The Extent of a Market

• extent of a market Boundaries of a market, both geographical and
in terms of range of products produced and sold within it.
• Market definition is important for two reasons:

• A company must understand who its actual and potential competitors are for the various products that it sells or might sell in the future.

• Market definition can be important for public policy decisions.

The Basics of Supply and Demand

• Supply and demand are the forces that make market

economies work.
• Supply-demand analysis is a fundamental and powerful
tool that can be applied to a wide variety of interesting and
important problems. To name a few-

• Understanding and predicting how changing world economic

conditions affect market price and production
• Evaluating the impact of government price controls, minimum wages,
price supports, and production incentives
• Determining how taxes, subsidies, tariffs, and import quotas affect
consumers and producers
 SUPPLY AND DEMAND

The Supply Curve

● supply curve Relationship between the quantity of a good that

producers are willing to sell and the price of the good.

The Supply Curve

The supply curve, labeled S in

the figure, shows how the
quantity of a good offered for
sale changes as the price of
the good changes. The supply
curve is upward sloping: The
higher the price, the more firms
are able and willing to produce
and sell.

If production costs fall, firms

can produce the same quantity
at a lower price or a larger
quantity at the same price. The
supply curve then shifts to the
right (from S to S’).
 SUPPLY AND DEMAND

The Supply Curve

The supply curve is thus a relationship between the quantity
supplied and the price. We can write this relationship as an equation:

QS = QS(P)

Other Variables That Affect Supply

The quantity that producers are willing to sell depends not only on the price
they receive but also on their production costs, including wages, interest
charges, and the costs of raw materials.
When production costs decrease, output increases no matter what the market
price happens to be. The entire supply curve thus shifts to the right.
Economists often use the phrase change in supply to refer to shifts in the
supply curve, while reserving the phrase change in the quantity supplied to
apply to movements along the supply curve.
 SUPPLY AND DEMAND

The Demand Curve

● demand curve Relationship

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

We can write this relationship between quantity

demanded and price as an equation:

QD = QD(P)
 SUPPLY AND DEMAND

The Demand Curve

The Demand Curve

The demand curve, labeled D,

shows how the quantity of a good
demanded by consumers
depends on its price. The
demand curve is downward
sloping; holding other things
equal, consumers will want to
purchase more of a good as its
price goes down.
The quantity demanded may also
depend on other variables, such
as income, the weather, and the
prices of other goods. For most
products, the quantity demanded
increases when income rises.
A higher income level shifts the
demand curve to the right (from
D to D’).
 SUPPLY AND DEMAND

The Demand Curve

Shifting the Demand Curve

If the market price were held constant, we would expect to see an increase in
the quantity demanded as a result of consumers’ higher incomes. Because
this increase would occur no matter what the market price, the result would
be a shift to the right of the entire demand curve.

Shifting the Demand Curve

● substitutes Two goods for which an increase in the
price of one leads to an increase in the quantity
demanded of the other.

● complements Two goods for which an increase in

the price of one leads to a decrease in the quantity
demanded of the other.
 THE MARKET MECHANISM

Supply and Demand

The market clears at price P0

and quantity Q0.

At the higher price P1, a surplus

develops, so price falls.

At the lower price P2, there is a

shortage, so price is bid up.
 THE MARKET MECHANISM

Equilibrium

● equilibrium (or market clearing) price

Price that equates the quantity supplied

to the quantity demanded.

● market mechanism Tendency in a free

market for price to change until the market
clears.

● surplus Situation in which the quantity

supplied exceeds the quantity demanded.

● shortage Situation in which the quantity

demanded exceeds the quantity supplied.
 THE MARKET MECHANISM

When Can We Use the Supply-Demand Model?

We are assuming that at any given price, a given quantity will be produced
and sold.
This assumption makes sense only if a market is at least roughly competitive.
By this we mean that both sellers and buyers should have little market power
—i.e., little ability individually to affect the market price.
Suppose that supply were controlled by a single producer.
If the demand curve shifts in a particular way, it may be in the monopolist’s
interest to keep the quantity fixed but change the price, or to keep the price
fixed and change the quantity.
 CHANGES IN MARKET EQUILIBRIUM

New Equilibrium Following

Shift in Supply

When the supply curve

shifts to the right, the
market clears at a lower
price P3 and a larger
quantity Q3.
 CHANGES IN MARKET EQUILIBRIUM

New Equilibrium Following

Shift in Demand

When the demand curve

shifts to the right,
the market clears at a
higher price P3 and a
larger quantity Q3.
 CHANGES IN MARKET EQUILIBRIUM

New Equilibrium Following

Shifts in Supply and Demand

Supply and demand curves

shift over time as market
conditions change.
In this example, rightward
shifts of the supply and
demand curves lead to a
slightly higher price and a
much larger quantity.
In general, changes in price
and quantity depend on the
amount by which each
curve shifts and the shape
of each curve.
 CHANGES IN MARKET EQUILIBRIUM

Over the past two decades, the wages of skilled high-income workers
have grown substantially, while the wages of unskilled low-income
workers have fallen slightly.
From 1978 to 2005, people in the top 20 percent of the income
distribution experienced an increase in their average real pretax
household income of 50 percent, while those in the bottom 20 percent
saw their average real pretax income increase by only 6 percent.
While the supply of unskilled workers—people with limited educations
—has grown substantially, the demand for them has risen only slightly.
On the other hand, while the supply of skilled workers has grown
slowly, the demand has risen dramatically, pushing wages up.
 CHANGES IN MARKET EQUILIBRIUM

Supply and Demand for

New York City Office Space

Following 9/11 the

supply curve shifted to
the left, but the demand
curve also shifted to the
left, so that the average
rental price fell.
 ELASTICITIES OF SUPPLY AND DEMAND

● elasticity Percentage change in one variable resulting from a 1-

percent increase in another.

Price Elasticity of Demand

● price elasticity of demand Percentage change in quantity

demanded of a good resulting from a 1-percent increase in its
price.
 ELASTICITIES OF SUPPLY AND DEMAND

Linear Demand Curve

● linear demand curve Demand curve that is a straight line.

Linear Demand Curve

The price elasticity of demand

depends not only on the slope
of the demand curve but also
on the price and quantity.
The elasticity, therefore, varies
along the curve as price and
quantity change. Slope is
constant for this linear demand
curve.
Near the top, because price is
high and quantity is small, the
elasticity is large in magnitude.
The elasticity becomes smaller
as we move down the curve.
 ELASTICITIES OF SUPPLY AND DEMAND

Linear Demand Curve

(a) Infinitely Elastic Demand

For a horizontal demand curve,
ΔQ/ΔP is infinite. Because a tiny
change in price leads to an
enormous change in demand, the
elasticity of demand is infinite.
This happens in a highly competitive
market, where there are many close
substitutes. Example FMCG Market

● infinitely elastic demand Principle that consumers will buy as much

of a good as they can get at a single price, but for any higher price the
quantity demanded drops to zero, while for any lower price the quantity
demanded increases without limit.
 ELASTICITIES OF SUPPLY AND DEMAND

Linear Demand Curve

(b) Completely Inelastic Demand

For a vertical demand curve, ΔQ/ΔP is
zero. Because the quantity demanded is
the same no matter what the price, the
elasticity of demand is zero.
This happens when the good is essential,
the consumer will not change the quantity
demanded, even if the price changes.
Example – Medicines, LPG Cylinders

● completely inelastic demand Principle that consumers will buy a

fixed quantity of a good regardless of its price.
Further Analysis

The value of Ep can be positive, zero and negative.

Case 1: Ep is negative
Q and P can not be negative. So either ΔQ is negative or Δ P is negative. That
means, Q and P are moving in opposite directions. So if P increases, Q falls and
vice verse. Goods which exhibit such negative values of Ep are normal goods.
Normal goods have close substitutes in the market. So, if the price of one increases,
consumers shift to other substitute goods and the demand for the first good falls.
This is visible in highly competitive market. Example: Cell phone service providers
like Airtel, Vodafone. Airline market like Indigo, Spicejet.

Case 2: Ep is 0
Here ΔQ is 0, whatever be the value of Δ P. This means that price change does not
bring in any change in quantity demanded. Such goods are essential goods.
Example LPG Gas, Medicines etc.

Case 3: Ep is positive
Here, as P increases, Q also increases. These are luxury goods like expensive cars
– Mercedes or Audi. As price goes up, rich consumers demand the good, as that
signifies a style statement or life style. Example: De-Beers Diamonds.
 ELASTICITIES OF SUPPLY AND DEMAND

Other Demand Elasticities

● income elasticity of demand Percentage change in the quantity
demanded resulting from a 1-percent increase in income.

(2.2)

● cross-price elasticity of demand Percentage change in the

quantity demanded of one good resulting from a 1-percent increase in
the price of another.

(2.3)

Elasticities of Supply
● price elasticity of supply Percentage change in quantity supplied
resulting from a 1-percent increase in price.
 ELASTICITIES OF SUPPLY AND DEMAND

Point versus Arc Elasticities

● point elasticity of demand Price elasticity at a particular point on

the demand curve.

Arc Elasticity of Demand

● arc elasticity of demand Price elasticity calculated over a range of

prices.
 ELASTICITIES OF SUPPLY AND DEMAND

For a few decades, changes in the wheat market had

major implications for both American farmers and U.S.
agricultural policy.

To understand what happened, let’s examine the behavior of supply and

demand beginning in 2011.

By setting the quantity supplied equal to the quantity demanded, we can

determine the market-clearing price of wheat for 1981:
 ELASTICITIES OF SUPPLY AND DEMAND

Substituting into the supply curve equation, we get

We use the demand curve to find the price elasticity of demand:

Thus demand is inelastic.

We can likewise calculate the price elasticity of supply:

Because these supply and demand curves are linear, the price
elasticities will vary as we move along the curves.
 SHORT-RUN VERSUS LONG-RUN ELASTICITIES

Demand
Income Elasticities

Income elasticities also differ from the short run to the long run.
For most goods and services—foods, beverages, fuel, entertainment,
etc.— the income elasticity of demand is larger in the long run than in
the short run.
For a durable good, the opposite is true. The short-run income elasticity
of demand will be much larger than the long-run elasticity.
 SHORT-RUN VERSUS LONG-RUN ELASTICITIES

Demand

TABLE 2.1 Demand for Gasoline

Number of Years Allowed to Pass Following
a Price or Income Change
Elasticity 1 2 3 5
10
Price −0.2 −0.3 −0.4 −0.5 −0.8
Income 0.2 0.4 0.5 0.6 1.0

TABLE 2.2 Demand for Automobiles

Number of Years Allowed to Pass Following
a Price or Income Change
Elasticity 1 2 3 5
10
Price −1.2 −0.9 −0.8 −0.6
−0.4
Income 3.0 2.3 1.9 1.4 1.0
 UNDERSTANDING AND PREDICTING THE
EFFECTS OF CHANGING MARKET CONDITIONS

Fitting Linear Supply and Demand

Curves to Data

Linear supply and demand

curves provide a convenient
tool for analysis.
Given data for the equilibrium
price and quantity P* and Q*,
as well as estimates of the
elasticities of demand and
supply ED and ES, we can
calculate the parameters c and
d for the supply curve and a
and b for the demand curve.
(In the case drawn here, c < 0.)
The curves can then be used
to analyze the behavior of the
market quantitatively.
UNDERSTANDING AND PREDICTING THE
EFFECTS OF CHANGING MARKET CONDITIONS

Demand: Q = a − bP

Supply: Q = c + dP

Step 1:

E = (P/Q)(ΔQ/ΔP)

Demand: ED = −b(P*/Q*)

Supply: ES = d(P*/Q*)

Step 2:

a = Q* + bP*

Q = a − bP + fI
 UNDERSTANDING AND PREDICTING THE
EFFECTS OF CHANGING MARKET CONDITIONS

After reaching a level of about $1.00 per pound in 1980, the price
of copper fell sharply to about 60 cents per pound in 1986.
Worldwide recessions in 1980 and 1982 contributed to the decline
of copper prices.
Why did the price increase sharply in 2005–2007? First, the
demand for copper from China and other Asian countries began
increasing dramatically. Second, because prices had dropped so
much from 1996 through 2003, producers closed unprofitable
mines and cut production.
What would a decline in demand do to the price of copper? To find
out, we can use linear supply and demand curves.
 UNDERSTANDING AND PREDICTING THE
EFFECTS OF CHANGING MARKET CONDITIONS

Copper Prices, 1965–2007

Copper prices are shown in both nominal (no adjustment for inflation) and real
(inflation-adjusted) terms. In real terms, copper prices declined steeply from the
early 1970s through the mid-1980s as demand fell. In 1988–1990, copper prices
rose in response to supply disruptions caused by strikes in Peru and Canada but
later fell after the strikes ended. Prices declined during the 1996–2002 period but
then increased sharply during 2005–2007.
 UNDERSTANDING AND PREDICTING THE
EFFECTS OF CHANGING MARKET CONDITIONS

Copper Supply and Demand

The shift in the demand

curve corresponding to a
20-percent decline in
demand leads to a 10.5-
percent decline in price.
 UNDERSTANDING AND PREDICTING THE
EFFECTS OF CHANGING MARKET CONDITIONS

Since the early 1970s, the world oil market

has been buffeted by the OPEC cartel and
by political turmoil in the Persian Gulf.

Price of Crude Oil

The OPEC cartel and

political events caused
the price of oil to rise
sharply at times. It later
fell as supply and
demand adjusted.
 UNDERSTANDING AND PREDICTING THE
EFFECTS OF CHANGING MARKET CONDITIONS

Because this example is set in 2005–2007, all prices are measured in

2005 dollars. Here are some rough figures:
•2005–7 world price = $50 per barrel
•World demand and total supply = 34 billion barrels per year (bb/yr)
•OPEC supply = 14 bb/yr
•Competitive (non-OPEC) supply = 20 bb/yr
The following table gives price elasticity estimates for oil supply and
demand:

Short-Run Long-Run
World Demand: -0.05 -0.40

Competitive Supply: 0.10 0.40

 UNDERSTANDING AND PREDICTING THE
EFFECTS OF CHANGING MARKET CONDITIONS

Impact of Saudi Production Cut

The total supply is the sum of

competitive (non-OPEC)
supply and the 14 bb/yr of
OPEC supply.
Part (a) shows the short-run
supply and demand curves.
If Saudi Arabia stops
producing, the supply curve
will shift to the left by 3 bb/yr.
In the short-run, price will
increase sharply.
(a)
 UNDERSTANDING AND PREDICTING THE
EFFECTS OF CHANGING MARKET CONDITIONS

Impact of Saudi Production Cut

The total supply is the sum of

competitive (non-OPEC)
supply and the 14 bb/yr of
OPEC supply.
Part (b) shows long-run
curves.
In the long run, because
demand and competitive
supply are much more
elastic, the impact on price
will be much smaller.

(b)
 EFFECTS OF GOVERNMENT INTERVENTION—
PRICE CONTROLS

Effects of Price Controls

Without price controls, the

market clears at the equilibrium
price and quantity P0 and Q0.

If price is regulated to be no
higher than Pmax, the quantity
supplied falls to Q1, the
quantity demanded increases
to Q2, and a shortage
develops.
 EFFECTS OF GOVERNMENT INTERVENTION—
PRICE CONTROLS

Price of Natural Gas

 EFFECTS OF GOVERNMENT INTERVENTION—
PRICE CONTROLS

The (free-market) wholesale price of natural gas was $6.40 per mcf
(thousand cubic feet);
Production and consumption of gas were 23 Tcf (trillion cubic feet);
The average price of crude oil (which affects the supply and demand for
natural gas) was about $50 per barrel.
Supply: Q = 15.90 + 0.72PG + 0.05PO
Demand: Q = -10.35 - 0.18PG + 0.69PO
Substitute $3.00 for PG in both the supply and demand equations
(keeping the price of oil, PO, fixed at $50).

You should find that the supply equation gives a quantity supplied of
20.6 Tcf and the demand equation a quantity demanded of 23.6 Tcf.
Therefore, these price controls would create an excess demand of
23.6 − 20.6 = 3.0 Tcf.