ECU07101
MICROECONOMICS
Dr. MGALE, Y.J - IRDP
Email:
[email protected]2023 Website: www.irdp.ac.tz 1
Chapter 2
The Basics of Supply and
Demand
Introduction
What are supply and demand?
What is the market mechanism?
What are the effects of changes in
market equilibrium?
What are elasticities of supply and
demand?
©Mgale,2023 Chapter 2 3
Supply and Demand
Supply and demand analysis can:
1. Help us understand and predict how world
economic conditions affect market price and
production
2. Analyze the impact of government price
controls, minimum wages, price supports,
and production incentives on the economy
3. Determine how taxes, subsidies, tariffs and
import quotas affect consumers and
producers
©Mgale,2023 Chapter 2 4
Supply and Demand
Quantity supplied - the amount of a good
that sellers are willing and able to sell
The Supply Curve
The relationship between the quantity of a good
that producers are willing to sell and the price of
the good.
Measures quantity on the x-axis and price on
the y-axis
Q S Q S (P)
©Mgale,2023 Chapter 2 5
The Supply Curve
Price S
($ per unit)
The Supply
Curve Graphically
P2
The supply curve slopes
P1 upward demonstrating that
at higher prices firms
will increase output
Q1 Q2 Quantity
©Mgale,2023 Chapter 2 6
Change in Supply or Shifts in
Supply Curve
Other Variables Affecting Supply
Costs of Production
Labour, capital, raw materials
Lower costs of production allow a firm to produce
more at each price and vice versa
Input Prices - the supply of a good is negatively related
to the price of the inputs used to make the good.
Technology - By reducing firms’ costs, the advance in
technology raised the supply of outputs.
Expectations - The amount of output a firm supplies
today may depend on its expectations about the future
Number of Sellers
©Mgale,2023 Chapter 2 7
Change in Supply or Shifts in the
Supply Curve
The cost of raw materials
P
falls S S’
Produced Q1 at P1 and
Q0 at P2. Now produce Q2
at P1 and Q1 at P2. Supply
curve shifts right to S’
Any change that raises the
P1
quantity that sellers wish to
produce at any given price
shifts the supply curve to P2
the right.
Any change that lowers the
quantity that sellers wish to
produce at any given price
shifts the supply curve to
the left. Q0 Q1 Q2 Q
©Mgale,2023 Chapter 2 8
The Supply Curve
Change in Quantity Supplied
Movement along the curve caused by a change in price
Change in Supply
Shift of the curve caused by a change in something
other than price
Change in costs of production
©Mgale,2023 Chapter 2 9
Supply and Demand
Quantity demanded - the amount of a good
that buyers are willing and able to purchase
The Demand Curve
The relationship between the quantity of a good
that consumers are willing to buy and the price
of the good.
Measures quantity on the x-axis and price on
the y-axis
QD QD(P)
©Mgale,2023 Chapter 2 10
The Demand Curve
Price
($ per unit) The demand curve slopes
downward demonstrating
that consumers are willing
to buy more at a lower price
as the product becomes
relatively cheaper.
P2
P1
Q1 Q2 Quantity
©Mgale,2023 Chapter 2 11
Shifts in Demand Curve
Other Variables Affecting Demand
Income
Increases in income allow consumers to purchase
more at all prices
Consumer Tastes
Expectations
Number of buyers
Price of Related Goods
Substitutes - two goods for which an increase in the price of
one leads to an increase in the demand for the other
Complements - two goods for which an increase in the price
of one leads to a decrease in the demand for the other
©Mgale,2023 Chapter 2 12
Change in Demand
Income Increases D
P D’
Purchased Q0, at P2 and
Q1 at P1. Now purchased
Q1 at P2 and Q2 at P1. P2
Demand curve shifts right
Any change that raises the
quantity that buyers wish to P1
purchase at any given
price shifts the demand
curve to the right.
Any change that lowers the
quantity that buyers wish to
purchase at any given
price shifts the demand
Q0 Q1 Q2 Q
curve to the left.
©Mgale,2023 Chapter 2 13
The Demand Curve
Changes in quantity demanded
Movements along the demand curve caused by a
change in price.
Changes in demand
A shift of the entire demand curve caused by
something other than price.
Income, preferences etc.
©Mgale,2023 Chapter 2 14
The Market Mechanism
The market mechanism is the tendency
in a free market for price to change until
the market clears
Markets clear when quantity demanded
equals quantity supplied at the prevailing
price
Market Clearing price – price at which
markets clear
©Mgale,2023 Chapter 2 15
The Market Mechanism
Price S
($ per unit)
The curves intersect at
equilibrium, or market-
clearing, price.
Quantity demanded
P0 equals quantity
supplied at P0
Q0 Quantity
©Mgale,2023 Chapter 2 16
The Market Mechanism
In equilibrium
There is no shortage or excess demand
There is no surplus or excess supply
Quantity supplied equals quantity demanded
Anyone who wished to buy at the current
price can and all producers who wish to sell
at that price can
©Mgale,2023 Chapter 2 17
Market Surplus
The market price is above equilibrium
There is excess supply - surplus
Downward pressure on price
Quantity demanded increases and quantity
supplied decreases
The market adjusts until new equilibrium is
reached
©Mgale,2023 Chapter 2 18
The Market Mechanism
Price
($ per unit) S
1. Price is above
Surplus
the market
P1 clearing price –
P1
2. Qs > Q D
P0 3. Price falls to
the market-
clearing price
4. Market adjusts
to equilibrium
D
Q Q0 QS Quantity
D
©Mgale,2023 Chapter 2 19
The Market Mechanism
The market price is below equilibrium:
There is a excess demand - shortage
Upward pressure on prices
Quantity demanded decreases and quantity
supplied increases
The market adjusts until the new equilibrium
is reached.
©Mgale,2023 Chapter 2 20
The Market Mechanism
Price
($ per unit)
1. Price is below
the market
clearing price
– P2
2. QD > QS
3. Price rises to
P3 the market-
clearing price
4. Market adjusts
P2 to equilibrium
Shortage D
QS Q QD Quantity
3
©Mgale,2023 Chapter 2 21
The Market Mechanism
Supply and demand interact to determine
the market-clearing price.
When not in equilibrium, the market will
adjust to alleviate a shortage or surplus
and return the market to equilibrium.
Markets must be competitive for the
mechanism to be efficient.
©Mgale,2023 Chapter 2 22
Changes In Market Equilibrium
Equilibrium prices are determined by the
relative level of supply and demand.
Changes in supply and/or demand will
change in the equilibrium price and/or
quantity in a free market.
©Mgale,2023 Chapter 2 23
Changes In Market Equilibrium
P D
Raw material prices
S
fall S’
S shifts to S’
Surplus at P1
between Q1, Q2
Price adjusts to P1
equilibrium at P3, Q3 P3
Q1 Q3Q2 Q
©Mgale,2023 Chapter 2 24
Changes In Market Equilibrium
D D’
P
S
Income Increases
Demand increases to
D1
Shortage at P1 of Q1, P3
Q2 P1
Equilibrium at P3, Q3
Q1 Q3 Q Q
2
©Mgale,2023 Chapter 2 25
Changes In Market Equilibrium
P D
Income Increases & D’ S S’
raw material prices
fall
Quantity increases
If the increase in D is P2
greater than the P1
increase in S price
also increases
Q1 Q2 Q
©Mgale,2023 Chapter 2 26
Shifts in Supply and Demand
When supply and demand change
simultaneously, the impact on the
equilibrium price and quantity is
determined by:
1. The relative size and direction of the
change
2. The shape of the supply and demand
models
©Mgale,2023 Chapter 2 27
What Happens to Price and Quantity
When Supply or Demand Shifts?
As a quick quiz, make sure you can explain
at least a few of the entries in this table
using a supply-and-demand diagram.
©Mgale,2023 Chapter 2 28
Class work
Find out the equilibrium quantity from demand function Qd =
25-10P and supply function Qs=25P. What is the change in
price of demand function changes to Qd=30-10P, supply
function remaining the same?
From the demand function Qd=2000-30P and Supply function
Qs=20P. Find out (a) equilibrium price and quantity (b) gap
between demand and supply at P= 20 and P=50
The sales data of a book publishing company produces a
demand function as Q= 5000 – 50P. From this demand
function, find out (a) demand schedule and demand curve (b)
number of books sold at price 25 (c) price for selling 2500
copies (d) price for zero sales (e) sales at zero prices
©2005 Pearson Education, Inc. Chapter 2 29
Key takeaways
The demand curve shows how the quantity of a good
demanded depends on the price. According to the law of
demand, as the price of a good falls, the quantity
demanded rises. Therefore, the demand curve slopes
downward.
In addition to price, other determinants of how much
consumers want to buy include income, the prices of
substitutes and complements, tastes, expectations, and
the number of buyers. If one of these factors changes, the
demand curve shifts.
The supply curve shows how the quantity of a good
supplied depends on the price. According to the law of
supply, as the price of a good rises, the quantity supplied
rises. Therefore, the supply curve slopes upward.
©Mgale,2023. Chapter 2 30
Key takeaways …
In addition to price, other determinants of how much
producers want to sell include input prices, technology,
expectations, and the number of sellers. If one of these
factors changes, the supply curve shifts.
The intersection of the supply and demand curves
determines the market equilibrium. At the equilibrium price,
the quantity demanded equals the quantity supplied.
The behavior of buyers and sellers naturally drives markets
toward their equilibrium. When the market price is above
the equilibrium price, there is a surplus of the good, which
causes the market price to fall. When the market price is
below the equilibrium price, there is a shortage, which
causes the market price to rise.
©Mgale,2023. Chapter 2 31
Key takeaways …
To analyze how any event influences a market, we use the
supply-and-demand diagram to examine how the event
affects the equilibrium price and quantity. To do this, we
follow three steps.
First, we decide whether the event shifts the supply curve or the
demand curve (or both).
Second, we decide in which direction the curve shifts.
Third, we compare the new equilibrium with the initial equilibrium.
In market economies, prices are the signals that guide
economic decisions and thereby allocate scarce resources.
For every good in the economy, the price ensures that
supply and demand are in balance. The equilibrium price
then determines how much of the good buyers choose to
consume and how much sellers choose to produce.
©Mgale,2023. Chapter 2 32
Homework
What are the supply schedule and the supply curve,
and how are they related? Why does the supply curve
slope upward?
Does a change in producers’ technology lead to a
movement along the supply curve or to a shift in the
supply curve? Does a change in price lead to a
movement along the supply curve or to a shift in the
supply curve?
Define the equilibrium of a market. Describe the forces
that move a market toward its equilibrium.
Describe the role of prices in market economies.
©Mgale,2023. Chapter 2 33
Elasticities of Supply and Demand
Not only are we concerned with what direction
price and quantity will move when the market
changes, but we are concerned about how
much they change.
Elasticity gives a way to measure by how much
a variable will change with the change in
another variable.
Specifically, it gives the percentage change in
one variable resulting from a one percent
change in another.
©Mgale,2023 Chapter 2 34
Price Elasticity of Demand
Measures the sensitivity of quantity
demanded to price changes.
It measures the percentage change in the
quantity demanded of a good that results
from a one percent change in price.
% Q D
D
EP
% P
©Mgale,2023 Chapter 2 35
Price Elasticity of Demand
The percentage change in a variable is
the absolute change in the variable
divided by the original level of the
variable.
Therefore, elasticity can also be written
as:
Q Q P Q
E
D
P P Q P
P
©Mgale,2023 Chapter 2 36
Price Elasticity of Demand
Usually a negative number
As price increases, quantity decreases
As price decreases, quantity increases
When EP > 1, the good is price elastic
%Q > % P
When EP < 1, the good is price inelastic
%Q < % P
©Mgale,2023 Chapter 2 37
Price Elasticity of Demand
The primary determinant of price
elasticity of demand is the availability of
substitutes.
Many substitutes demand is price elastic
Can easily move to another good with price
increases
Few substitutes demand is price inelastic
©Mgale,2023 Chapter 2 38
Price Elasticity of Demand
Looking at a linear demand curve, as we
move along the curve Q/P will change
Price elasticity of demand must therefore
be measured at a particular point on the
demand curve
Elasticity will change along the demand
curve in a particular way
©Mgale,2023 Chapter 2 39
Price Elasticity of Demand
Given a linear demand curve
Elasticity depends on slope and on the
values of P and Q
The top portion of demand curve is elastic
Price is high and quantity small
The bottom portion of demand curve is
inelastic
Price is low and quantity high
©Mgale,2023 Chapter 2 40
Price Elasticity of Demand
Price EP = -
Demand Curve
4
Q = 8 – 2P
Elastic
2 Ep = -1
Inelastic
Ep = 0
4 8 Q
©Mgale,2023 Chapter 2 41
Price Elasticity of Demand
The steeper the demand curve becomes,
the more inelastic the good.
The flatter the demand curve becomes,
the more elastic the good
Two extreme cases of demand curves
Completely inelastic demand – vertical
Infinitely elastic demand - horizontal
©Mgale,2023 Chapter 2 42
Infinitely Elastic Demand
Price
EP =
P* D
Quantity
©Mgale,2023 Chapter 2 43
Completely Inelastic Demand
Price
D
EP = 0
Q* Quantity
©Mgale,2023 Chapter 2 44
Other Demand Elasticities
Income Elasticity of Demand
Measures how much quantity demanded
changes with a change in income.
Q/Q I Q
EI
I/I Q I
©Mgale,2023 Chapter 2 45
Other Demand Elasticities
Cross-Price Elasticity of Demand
Measures the percentage change in the
quantity demanded of one good that results
from a one percent change in the price of
another good.
Qb Qb Pm Qb
EQb Pm
Pm Pm Qb Pm
©Mgale,2023 Chapter 2 46
Other Demand Elasticities
Complements: Cars and Tires
Cross-price elasticity of demand is negative
Price of cars increases, quantity demanded of
tired decreases
Substitutes: Butter and Margarine
Cross-price elasticity of demand is positive
Price
of butter increases, quantity of margarine
demanded increases
©Mgale,2023 Chapter 2 47
Price Elasticity of Supply
Measures the sensitivity of quantity
supplied given a change in price
Measures the percentage change in quantity
supplied resulting from a 1 percent change in
price.
S
%ΔQ
S
EP
%ΔP
©Mgale,2023 Chapter 2 48
Elasticity: An Application
Supply: QS = 1900 + 24P
Demand: QD = 3550 – 266P
©Mgale,2023 Chapter 2 49
Elasticity: An Application
QD = QS
1800 + 240P = 3550 – 266P
506P = 1750
P = $3.46 per bushel
Q = 1800 + (240)(3.46) = 2630 million
bushels
©Mgale,2023 Chapter 2 50
Elasticity: An Application
We can find the elasticities of demand
and supply at these points
P ΔQD 3.46
D
EP ( 2.66 ) .035
Q ΔP 2,630
P ΔQS 3.46
S
EP (2.40 ) .032
Q ΔP 2,630
©Mgale,2023 Chapter 2 51
Elasticity: An Application
Assume the price of wheat is
$4.00/bushel due to decrease in supply
QD 3,550 (266)(4.00) 2,486
4.00
Q
D
P ( 266) 0.43
2,486
©Mgale,2023 Chapter 2 52
Short-Run Versus Long-Run
Elasticity
Price elasticity varies with the amount of
time consumers have to respond to a
price.
Short run demand and supply curves
often look very different from their long-
run counterparts.
©Mgale,2023 Chapter 2 53
Short-Run Versus Long-Run
Elasticity
Demand
In general, demand is much more price
elastic in the long run
Consumers take time to adjust consumption
habits
Demand might be linked to another good that
changes slowly
More substitutes are usually available in the
long run
©Mgale,2023 Chapter 2 54
Gasoline: Short-Run and Long-Run
Demand Curves
Price DSR •People cannot easily
adjust consumption in
short run.
•In the long run, people
tend to drive smaller and
more fuel efficient cars.
DLR
Quantity of Gas
©Mgale,2023 Chapter 2 55
Short-Run Versus Long-Run
Elasticity
Demand and Durability
For some durable goods, demand is more
elastic in the short run
If goods are durable, then when price
increases, consumers choose to hold on to
the good instead of replacing it
But in long run, older durable goods will have
to be replaced
©Mgale,2023 Chapter 2 56
Cars: Short-Run and Long-Run
Demand Curves
Price DLR
•Initially, people may put
off immediate car
purchase
•In long run, older cars
must be replaced.
DSR
Quantity of Cars
©Mgale,2023 Chapter 2 57
Short-Run Versus Long-Run
Elasticity
Income elasticity also varies with the
amount of time consumers have to
respond to an income change.
For most goods and services, income
elasticity is larger in the long run
When income changes, it takes time to
adjust spending
©Mgale,2023 Chapter 2 58
Short-Run Versus Long-Run
Elasticity
Income elasticity of durable goods
Income elasticity is less in the long-run than
in the short-run.
Increases in income mean consumers will want
to hold more cars.
Once older cars replaced, purchases will only to
be to replace old cars.
Less purchases from income increase in long
run than in short run
©Mgale,2023 Chapter 2 59
Short-Run Versus Long-Run
Elasticity
Most goods and services:
Long-run price elasticity of supply is greater
than short-run price elasticity of supply.
Other Goods (durables, recyclables):
Long-run price elasticity of supply is less
than short-run price elasticity of supply
©Mgale,2023 Chapter 2 60
Short-Run Versus Long-Run
Elasticity
SSR
Price
SLR
Due to limited
capacity, firms
are limited by
output constraints
in the short-run.
In the long-run, they
can expand.
Quantity Primary Copper
©Mgale,2023 Chapter 2 61
Short-Run Versus Long-Run
Elasticity
Price SLR SSR
Price increases
provide an incentive
to convert scrap
copper into new supply.
In the long-run, this
stock of scrap copper
begins to fall.
Quantity Secondary Copper
©Mgale,2023 Chapter 2 62
Effects of Price Controls
Markets are rarely free of government
intervention
Imposed taxes and granted subsidies
Price controls
Price controls usually hold the price
above or below the equilibrium price
Excess demand – shortage
Excess supply - surplus
©Mgale,2023 Chapter 2 63
Effects of Price Controls
Excess demand sometimes takes the
form of queues
Lines at gas stations during shortage
Sometimes get curtailments and supply
rationing
Natural gas shortage of the mid ’70’s
Producers typically lose, but some
consumers gain. Some consumers lose.
©Mgale,2023 Chapter 2 64
Key takeaways
The price elasticity of demand measures how much the
quantity demanded responds to changes in the price.
Demand tends to be more elastic if close substitutes are
available, if the good is a luxury rather than a necessity, if
the market is narrowly defined, or if buyers have
substantial time to react to a price change.
The price elasticity of demand is calculated as the
percentage change in quantity demanded divided by the
percentage change in price. If quantity demanded moves
proportionately less than the price, then the elasticity is
less than 1 and demand is said to be inelastic. If quantity
demanded moves proportionately more than the price,
then the elasticity is greater than 1 and demand is said to
be elastic.
©Mgale,2023. Chapter 2 65
Key takeaways
The income elasticity of demand measures how much the quantity
demanded responds to changes in consumers’ income. The cross-
price elasticity of demand measures how much the quantity
demanded of one good responds to changes in the price of another
good.
The price elasticity of supply measures how much the quantity
supplied responds to changes in the price. This elasticity often
depends on the time horizon under consideration. In most markets,
supply is more elastic in the long run than in the short run.
The price elasticity of supply is calculated as the percentage
change in quantity supplied divided by the percentage change in
price. If quantity supplied moves proportionately less than the price,
then the elasticity is less than 1 and supply is said to be inelastic. If
quantity supplied moves proportionately more than the price, then
the elasticity is greater than 1 and supply is said to be elastic
©Mgale,2023. Chapter 2 66
Home work
List and explain the four determinants of the price elasticity
of demand discussed in the chapter
What do we call a good with an income elasticity less than
zero?
How is the price elasticity of supply calculated? Explain
what it measures.
If a fixed quantity of a good is available, and no more can
be made, what is the price elasticity of supply?
A storm destroys half the soya bean crop. Is this event
more likely to hurt soya bean farmers if the demand for
soya beans is very elastic or very inelastic? Explain.
©Mgale,2023 Chapter 2 67
Home work
Suppose the price elasticity of demand for heating oil is 0.2 in the
short run and 0.7 in the long run. If the price of heating oil rises
from $1.80 to $2.20 per gallon, what happens to the quantity of
heating oil demanded in the short run? In the long run?.
Consider public policy aimed at smoking.
a. Studies indicate that the price elasticity of demand for
cigarettes is about 0.4. If a pack of cigarettes currently costs $5
and the government wants to reduce smoking by 20 percent, by
how much should it increase the price?
b. If the government permanently increases the price of
cigarettes, will the policy have a larger effect on smoking 1 year
from now or 5 years from now?
c. Studies also find that teenagers have a higher price elasticity
of demand than adults. Why might this be true?
©Mgale,2023 Chapter 2 68
