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Supply and demand is an economic model of
price determination in a market.
It concludes that in a competitive market, the unit
price for a particular good will vary until it settles
at a point where the quantity demanded by
consumers (at current price) will equal the
quantity supplied by producers (at current price),
resulting in an economic equlibrium of price and
quantity.
Equilibrium in Market
The four basic laws of supply and demand are:
If demand increases and supply remains unchanged, then it
leads to higher equilibrium price and quantity.
If demand decreases and supply remains unchanged, then
it leads to lower equilibrium price and quantity.
If supply increases and demand remains unchanged, then it
leads to lower equilibrium price and higher quantity.
If supply decreases and demand remains unchanged, then
it leads to higher price and lower quantity.
Equilibrium in Market
Shortage
Let’s say that Loony’s uptown decides to sell their CDs
for $3 each.
More than likely there will be a lot more people wanting
to buy CDs than Loony’s has to sell.
Why? Because at such a low price, the quantity
demanded is quite high. But Loony’s does not want to
sell that many at such a low price.
This situation is called a shortage
Shortage - when Qd > Qs at current market price.
Amount of Shortage = Qd - Qs
Note - it is not correct to say Demand exceeds
Supply, but rather quantity demanded exceeds
quantity supplied.
Result of Shortage:
If you are the manager of
Loony’s and you find that
you are selling out of CDs
at $3, what do you want to
do?
Raise the price
Buyers can’t get all they
want. Therefore,
competition among
buyers drive prices up.
P will increase
Results of Shortage
P
Q
S
D
E
P*
Q*
P
sh
Q
s Q
d
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Let’s say that as the manager, you raised the prices of CDs
to $20.
At $20 you would love to sell a lot of CDs, but not a lot of
people are willing to pay $20 for a CD.
So the CDs keep piling up as they come in from your
supplier, but they don’t seem to be going out the door in
sales.
This situation is called a surplus
Surplus - when Q s
> Q
d
at current market price.
- Q
d
Note - not correct to say Supply exceeds Demand, but
rather that quantity supplied exceeds quantity
demanded.
Surplus
Result of Surplus:
As manager you have to
decide what do with all
these CDs that are piling up
and not selling. What do
you do?
Have a sale!
Firms have more than they
can sell. Therefore, firms
lower price to sell the
product.
As price decreases, Q d
increases and Q s
decreases
P will decrease
Results of Surplus
P
Q
S
D
E
P*
Q*
P
sur
Q
d
Q
s
Amount of Surplus
Note that if the price is below P* then
there will be a shortage causing
price to rise
If the price is above P* then there will
be a surplus causing price to fall
It’s as if P* is a magnet that keeps
drawing price to it (and
consequently quantity to Q*)
This magnet is sometimes called “The
Invisible Hand”
Equilibrium - where quantity
demanded equals quantity
supplied represented by the
intersection of the demand and
supply curves.
Equilibrium Price (P*) - price where
equilibrium occurs.
Equilibrium in the Market
Remember that Supply and Demand are drawn under the
ceteris paribus assumption.
Any factors which cause Supply and/or Demand to change
will affect equilibrium price and quantity.
Demand will change for any of the factors discussed
previously.
An outward (rightward) shift in demand increases both
equilibrium price and quantity
When consumers increase the quantity demanded at a given
price , it is referred to as an increase in demand.
Increased demand can be represented on the graph as the
curve being shifted to the right. At each price point, a
greater quantity is demanded, as from the initial curve D
to the new curve D2.
Increase in Demand
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If the quantity supplied
decreases ,
If the supply curve starts at S2,
and shifts leftward to S1,
The equilibrium price will
increase and the equilibrium
quantity will decrease as
consumers move along the
demand curve to the new
higher price and associated
lower quantity demanded.
Due to the change (shift) in
supply, the equilibrium
quantity and price have
changed.
Decrease in Supply
P
Q
S
1
D
P
1
Q
1
S
2
P
2
Q
2
E’
E
Supply will
change for any
of the factors
discussed
previously.
For instance,
let’s say that
the government
lowers taxes on
CDs
Changes in Supply
P
Q
S
D
E
P*
Q*
S’
P*’
Q*’
E’
To determine the impact of both supply and demand
changing:
First examine what happens to equilibrium price and
quantity when just demand shifts.
Second, examine what happens to equilibrium price and
quantity when just supply changes
Finally, add the two effects together.
General Results:
When supply and demand move in the same direction
- Equilibrium price is ambiguous
When supply and demand move in opposite directions
- Equilibrium quantity is ambiguous
Changes in Demand and Supply
Increase in Supply and Demand
P
Q
S
D
E
P*
Q*
D’
E’
P*’
Q*’
S’
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P
Q
S
D
E
P*
Q*
D’
E’
P*’=
Q*’
S’
Increase in Supply and Demand
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