Chapter 3

Supply and Demand

Intertwined

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All

Learning Objectives
How do supply and demand determine
prices?
What is equilibrium?
What is surplus?
What is shortage?
What is the effect of a change in demand?
What is the effect of a change in supply?

3-2

When Supply and Demand Intersect

At $0.45:
Consumers want 12,000
apples.
Firms want to produce
12,000 apples.
Quantity demanded
= Quantity supplied.
Supply and demand
intersect.
= Equilibrium

$P
Quantity
demanded at
0.45

Supply

.45

Quantity
supplied at
0.45

Demand
12,000
Quantity of Apples
3-3

Surplus

At $0.70:
Consumers want 10,000
apples.
Firms want to produce
14,600 apples.
Quantity supplied
> quantity demanded
= Surplus.
Price will fall.

Quantity
demanded at
0.70

$P

Supply
.70

Quantity
supplied at
0.70

Demand
10,000

14,600

Quantity of Apples
3-4

Shortage

At $0.25:
Firms want to produce
9,000 apples.
Consumers want 15,000
apples.
Quantity supplied
< quantity demanded
= Shortage.
Price will rise.

$P

Quantity
supplied at
0.25

Supply
Quantity
demanded at
0.25

.25

Demand
9,000

15,000

Quantity of Apples
3-5

Equilibrium
A market at equilibrium is stable unless
disturbed by shift of supply or demand
curves.
A market not at equilibrium moves towards
equilibrium with change in price.

3-6

Equilibrium
Price

Demand
Price above
equilibrium
= Surplus.
Fall in price

Price below
equilibrium
= Shortage.
Rise in price

Equilibrium
price

Supply

Equilibrium

Equilibrium
quantity sold

Quantity

3-7

Do You Know?
When does a surplus arise?
When price is above equilibrium where
quantity supplied exceeds quantity
demanded.
When does a shortage arise?
When price is below equilibrium where
quantity demanded exceeds quantity
supplied.
3-8

Moving Towards New Equilibrium

An increase in supply:
A new equilibrium at a
lower price and a
higher quantity.

Price
Old
equilibrium

Old
Supply
New
Supply

New
equilibrium

Demand
Quantity

3-9

Moving Towards New Equilibrium

An increase in
demand:
A new equilibrium at a
lower price and a
higher quantity.

New
equilibrium

Price

Supply

Old
equilibrium

New
Demand
Old
Demand
Quantity

3-10

Moving Towards New Equilibrium

A decrease in supply:
A new equilibrium at a
higher price and a
lower quantity.

Price
New
equilibrium

New
Supply
Old
Supply

Old
equilibrium

Demand
Quantity

3-11

Moving Towards New Equilibrium

A decrease in
demand:
A new equilibrium at a
higher price and a
lower quantity.

Old
equilibrium

Price

Supply

New
equilibrium

Old
Demand
New
Demand
Quantity

3-12

Market Forces in a Fictional Tale

In anticipation of the blockade

Increase in demand for food and hence its price.
Smuggler transports food rather than luxury
goods.
After the blockade
With higher food prices, the smuggler is willing
to take the risk of shipping food.
After government control over food prices
No incentive for the smuggler to ship food.
3-13

Invisible Hand
Invisible hand of the market pushes
self-interested people to act for the
good of society.
It is not from the benevolence of the
butcher, the brewer or the baker, that
we expect our dinner, but from their
regard to their own interest.
3-14

Markets in Times of Crisis

Pets destroy wheat
crop.
Increase in demand
for a substitute, i.e.
fish.
Increase in price of
fish.
Fishermen catch
more fish.

New
equilibrium

Price

Supply

Old
equilibrium
$7

Demand
after

$4

Demand
before
600

800
Quantity of fish

3-15

Markets in Times of Crisis

War in the Middle
East reduces supply
of oil.
Price of oil rises.
Higher price causes
people to use less oil.
Market offers the best
solution among all the
alternatives.

$Price
New
equilibrium

Supply
after
Supply
before

150
Old
equilibrium

70

Demand
Quantity of oil

3-16

Markets in Times of Crisis

Hurricane damage affects the supply and
demand for bottled water.
Decrease in supply
Increase in demand
How will it affect new equilibrium price?
How will it affect new equilibrium quantity?
Only one can be determined, the other is
ambiguous.
3-17

Hurricane Damage
Increase in demand
> Decrease in supply.
Higher price
Higher quantity
Price
Demand
before

Increase in demand
< Decrease in supply.
Higher price
Lower quantity

Demand
after

Price
Supply
after
Supply
before

Quantity of bottled water

Demand Demand
before
after

Supply
after

Supply
before

Quantity of bottled water

3-18

Markets in Times of Crisis

Price gouging:
Increase in price as a result of market
reaction to increase in demand or
decrease in supply.
It provides incentive to firms to sell more.
It provides incentive to consumers to
conserve the good short in supply.
3-19

Diamonds vs. Water

Why do markets
place higher value on
diamonds than on
precious water?

Price

Water
demand

Diamond
demand

Water
Supply

Diamond
supply

Diamond
Equilibrium

Water is in much
greater supply than
diamonds.

Water
Equilibrium

Quantity

3-20

Diamonds vs. Water

A goods price is influenced by its marginal value
to consumers.
Marginal value = additional benefit received from
the last unit of the good consumed.
Consumers receive less marginal value from a
good the more they have of it.
At the equilibrium in market for water, so much
water is consumed that marginal value is very
low.
3-21

Market for Developable Land

Government passes
anti-development law:
Decrease in supply of
developable land.
Higher price and
lower quantity of
traded developable
land.

Price
New
Equilibrium

Supply
after
Supply
before

Old
Equilibrium

Demand
Quantity of developable land

3-22

Market for Newly Built Homes

Increase in price of
developable land
increases cost of
production.
Decrease in supply of
newly built homes.
Higher price and
lower quantity sold of
newly built homes.

Price
New
Equilibrium
after higher
land prices

New
Supply
Old
Supply

Old
Equilibrium
before higher
land prices

Demand
Quantity of newly built homes sold

3-23

Market for Previously Occupied Homes

Newly built and
previously occupied
homes are substitutes.
Higher price of newly built
homes:
Increase in demand for
previously occupied
homes
Higher price and higher
quantity sold of previously
occupied homes

Price

Old
Equilibrium
before higher
prices of new
homes

New
Equilibrium
before higher
prices of new
homes

Supply

New
Demand
Old Demand

Quantity sold of previously built homes

3-24

Do You Know?
Do markets move to new equilibrium
instantaneously?
No. It takes time. How long depends on the type
of market. It can be from a few seconds to a few
months.
What are some examples of forces that disturb
market equilibrium?
Any changes that effect demand or supply
disturb market equilibrium, e.g., change in input
prices, future expectations, change in price of
substitutes, innovations.
3-25

Do You Know?
What is Adam Smiths Invisible Hand?
Market forces guide self-interested people as if
by an invisible hand to act for the good of
society.
How does marginal value relate to the price of
water?
A goods price is influenced by its marginal value
to consumers. The marginal value of water is
very low since lots of water is consumed.
3-26

Summary
Equilibrium = When quantity demanded
meets quantity supplied.
Surplus = When quantity supplied
exceeds quantity demanded.
Shortage = When quantity demanded
exceeds quantity supplied.
A market not at equilibrium moves towards
equilibrium with change in price.
3-27

Summary
A goods price is determined by
intersection of demand and supply.
A change in demand or supply shifts the
market to a new equilibrium.
Market forces offer the best solution to any
changes in the society.

3-28

Coming Up
By how much does quantity
change when there is a change in
price?

3-29