Chapter 2
Demand, Supply and Equilibrium
Demand: Definition, Law
The quantity of a good or a service that is
purchased by a consumer or the consumer
desires to purchase at a certain price is
demand.
Law of Demand: All other things remaining
unchanged, a rise in price leads to a fall in
quantity demanded and a fall in price leads to a
rise in quantity demanded. Such inverse
relationship between price and quantity
demanded is known as the law of demand.
Demand Curve
Because of the inverse relationship between
price and quantity demanded, demand
curve slopes downward to the right.
Assume a linear demand function
Q = 100-2P
Q=100-2P
Demand Curve
Price Price Quantity
0 100
50 D
10 80
40 C 20 60
30 40
30
40 20
20 B 50 0
10
A
O Quantity
20 40 60 80 100
Figure- 2.1
Q=100-2P
Demand Curve
Price Price Quantity
0 100
50 D
10 80
40 C 20 60
30 40
30
40 20
20 B 50 0
10
A
O Quantity
20 40 60 80 100
Figure- 2.1
Graph the demand function
.
Q 60 P2
Determinants of Demand
Demand for a good or a service depends on
a variety of factors. Own price, other
goods’ prices and income are considered
as the prime determinants of demand.
Own Price: All other things remaining
unchanged a fall in own price of a good or
a service leads to a rise in its quantity of
demand. This inverse relation between
price and quantity demanded gives rise to
negatively sloping demand curve.
Change in Quantity Demanded
Impact of own price
Price
P A
1
P B
2
O Quantity
Q Q
1 2
Figure- 2.2
Price of Other goods
• Two types of goods may be in place-
substitutes and complementary
Substitutes: The goods that can be
alternatively used are substitutes. Bus and
train services are substitutes.
Complementary: The goods that are jointly
used are called complementary goods.
Car and fuel are complementaries.
Impact of Substitutes
• If X and Y are substitutes, a consumer will
increase consumption of good X in the
event of an increase in price of Y.
Impact of Substitute’s Price
Demand for four-
stroke Demand for
Price of Y Rickshaw
Price of X
N
Change in demand Change in quantity
demanded
P G
y2
C P F
P E y1
0
D D
1 2
M
O Q Q Quantity of Y
O X X Quantity of X y2 y1
1 2
Figure- 2.3
Impact of Price of Complementary goods
• If X and Z are complementary goods then
increase in price of Z will cause a fall in
demand for X. For example, fuel is
complementarily used with car. Use of car
turns out expensive if fuel price increases.
In the result, demand for car falls following
an increase in price of fuel.
Impact of Complement’s Price
Demand for Car
Demand for Fuel
Price of X Price of Z
S
Change in demand Change in quantity
demanded
P M
z2
T N P H
P z1
0
D D
2 1
R
O X X Quantity of X O Q Q Quantity of Z
2 1 z2 z1
Figure- 2.4
Impact of Income
Three types of goods are defined in terms of
income.
1.Normal good
2.Inferior good
3.Income neutral good
.
• In case of normal good, increase in
income leads to increase in demand and
vice versa.
• Increase in income, on the other hand,
causes decrease in demand for the inferior
goods.
• Demand for income neutral good remains
unaltered with increase or decrease in
income.
Impact of Increase in Income on Demand for Normal Good
Rent per kilometer
P C
1 E
D D
1 2
O X X Demand for Taxicab
1 2
Figure- 2.5
Impact of Increase in Income
Price of X Price of Y
Normal Good Inferior Good
T P R H
P N y1
0
D D
1 2
D D
2 1
O X X Quantity of X O Q Q Quantity of Y
1 2 y2 y1
Figure- 2.5
Supply
Definition: The quantity of a good or a service
that is sold or ready for sale at a certain price
is called supply.
Law of Supply: Other things remaining
unchanged a rise in price causes a rise in
quantity of supply and vice versa, which is
known as the law of supply. Because of
direct relationship between price and quantity
of supply, supply curve slopes upward.
Supply Curve
Draw the supply curve Qs 5P
Supply Curve
Price Price Quantity
Qs 5P
0 0
5
Supply Curve 1 5
4 D 2 10
3 15
3 C 4 20
2 5 25
B
1 A
O Quantity
5 10 15 20 25
Figure- 2.7
CW
• Draw a supply curve assuming the
function below:
Qs = -2+4P
Determinants of Supply
• Among other factors, price of the good,
prices of factors of production, technology,
weather largely influence supply. Impact of
own price is observed through the change
in quantity of supply along the supply
curve. This change is called change in
quantity supplied. Own price remaining
unchanged, if factor price changes then
supply changes through the shifting of
supply curve- which is called change in
supply.
Own Price
Price
P B
2
A
P
1
Q Q
O 1 2 Quantity
Change in Supply (Fall in Factor Price)
Price
S S
1 2
E F
P
0
O Quantity
Q Q
1 2
Figure- 2.8
Change in Supply (Rise in Factor Price)
Price
S S
2 1
H G
P
0
O Quantity
Q Q
2 1
Figure- 2.8
Change in Supply (Technological Progress)
Price
S S
1 2
E F
P
0
O Quantity
Q Q
1 2
Figure- 2.8
Change in Supply (Unfavourable Weather)
Price
S S
2 1
H G
P
0
O Quantity
Q Q
2 1
Figure- 2.8
Market Equilibrium
Equality between quantity demanded and
quantity supplied is defined as equilibrium.
If quantity demanded exceeds quantity
supplied, excess demand will prevail that
pushes price up. Excess supply,
measured as the quantity of supply over
demand, in contrast, drives price down.
Market Equilibrium
Price
5
4 Qs 5P
3
E
2
Q 20 5P
1 d
O Quantity
5 10 15 20 25
Figure- 2.10
Equilibrium
Price
Excess Supply
SS
P Supply Curve
2 C F
P E
0
B
P
1 A
Demand Curve
Excess Demand
DD
O Quantity
Q
0
Figure- 2.9
CW
• Solve for equilibrium price and quantity
using typical demand and supply functions
below.
• Qd=98-2P and Qs=-2+3P
CW
• Solve for equilibrium price and quantity using
typical demand and supply functions below.
• Qd=98-2P and Qs=-2+3P
Equilibrium condition is Qd=Qs
98-2P = -2+3P
-2P-3P = -2-98
-5P = -100
P=20
Equilibrium price and quantity
• When P = 20, Qd= 98-(2X20) = 58
• When P = 20, Qs= -2+(3X20) = 58
Qd= Qs= 58
Equilibrium price P 20
Q58
Equilibrium quantity
Exercise
Assume a demand function Qd 20 P2 and
supply function Qs 25P, compute
equilibrium price and quantity.
Quadratic Formula
If aP2+bP+c=0
P b b2 4ac
2a
Movement in Equilibrium
Factors influencing demand or supply will
cause a corresponding change in
equilibrium.
Consider the following cases-
Increase/Decrease in demand
Increase/Decrease in supply
Increase/Decrease in both demand and
supply
Impact of increase in demand
Price
S
1
P F
2
E Increase in
P demand
1
D
D 2
1
O Quantity
Q Q
1 2
Impact of increase in supply
Price
S
1 S
2
G
P Increase in
1 supply
P H
2
D
1
O Quantity
Q Q
1 2
Impact of increase in both demand and supply
(case I)
Price S
1
S
M 2
P
2 L S
P
1 T
D
2
D
1
O Quantity
Q Q
1 2
Impact of increase in both demand and supply
(case II)
Price S
1
S
2
N R
P
1
D
D 2
1
O Quantity
Q Q
1 2
Impact of increase in both demand and supply
(case III)
Price S
1
S
2
P W X
1 Z
P T
2
D
D 2
1
O Q
Q 2 Quantity
1
CW
• Consider the following cases
- Decrease in demand
- Decrease in supply
- Decrease in both demand and supply
