Introduction to Market Forces: Demand and Supply

1. CHAPTER 2
Market Forces: Demand and Supply

2. What will you learn in this module?
In this module, you will learn the supply and
demand function in the market and this will help
you to achieve the following module outcomes.
 What is the law of demand and law of supply?
 What are the important factors that cause demand and supply curve
to shift?
 What is the consumer surplus and producer surplus?
 Explain the difference between price floor and price ceilings?
 Distinguish excise taxes and ad valorem taxes, how these taxes
impact the market functions.
2-2

3. CHAPTER 2
Market Forces: Demand and Supply

4. LAW OF MARKET DEMAND

5. How to derive Market Demand?
• What is a “Market demand curve”?
• It shows the relationship between the quantity
and price per unit of a good that consumers are
willing and able to purchase, holding other
variables constant.
• Figure on the next slide shows the straight line
connecting those points called the market
demand curve interpolates the quantities
consumers would be willing and able to purchase
at the market prices.

6. Market Demand Curve
Quantity
(thousands per year)
Price ($)
Demand
$40
0
$30
$20
20 40
$10
60 80

7. A VIDEO ABOUT
"Market Demand Curve. How do we sum
individual demand curves? ”
And
"The Demand Curve"

8. What is the “Law of Demand”
• The Law of Demand states that the quantity
of a good consumers are willing and able to
purchase increases (decreases) as the price
falls (rises).
• The law of demand says that
• consumers will buy more when the price falls
and;
• consumers will buy less when the price falls.

9. Price changes lead to changes
Quantity Demanded
 Changing price leads to changes in
quantity demanded.
 As price increase from $10 to $20, quantity
decreases from 60 to 40
 This change is represented by a movement
along the demand curve, holding other factors
constant.
Quantity
(thousands per year)
Price ($)
Demand
$40
0
$30
$20
20 40
$10
60 80

10. A VIDEO ABOUT
“What is Law of Demand"

11. Other factors can also leads changes
in Quantity Demanded
• Changing factors other than price (such as advertising,
increase in income, increase of price of related goods)
also lead to changes in demand.
• These types of changes are graphically represented by a
shift of the entire demand curve either rightward or
leftward.
• This will be covered in the next section.

12. CHAPTER 2
Market Forces: Demand and Supply

13. WHY DEMAND CURVE
SHIFTS?

14. Changes in Demand
• Figure: Changes in Demand.
• The movement along a demand curve, such as the
movement from A to B is called a change in quantity
demanded.

15. Changes in Demand
Quantity0
Price
A
B
D0

16. Changes in Demand
• Figure: Changes in Demand.
• Whenever advertising, income or the price of related
goods changes, it leads to a change in demand; the
position of the entire demand curve shifts.
• A rightward shift in the demand curve is called an
increase in demand since more of the good is demanded
at each price.
• A leftward shift in the demand curve is called a decrease
in demand.

17. Changes in Demand
Quantity0
Price
D1
Increase
in
demand
A
B
D0D2
Decrease
in
demand

18. Why Demand Curve Shifts?
How Five Demand Shifters Affect Consumer Demand?
1. Consumer’s Income: Normal good, Inferior good
• Normal good: A good for which an increase (decrease) in
income leads to an increase (decrease) in the demand for
that good.
• Inferior good: A good for which an increase (decrease) in
income leads to a decrease (increase) in the demand for
that good.

19. Why Demand Curve Shifts?
2. Prices of related goods: Substitute goods, Complement
goods
• Substitutes: Goods for which an increase (decrease) in
the price of one good leads to an increase (decrease) in
the demand for the other good.
• Complements: Goods for which an increase (decrease)
in the price of one good leads to a decrease (increase) in
the demand for the other good.

20. Why Demand Curve Shifts?
3. Advertising and Consumer tastes
• Informative advertising: Advertising often provides
consumers with information about the existence or quality
of a product, which in turn induces more consumers to
buy the product.
• Persuasive advertising: Advertising can also influence
demand by altering the underlying tastes of consumers.

21. Why Demand Curve Shifts?
4. Population
The demand for a product is also influenced by changes in
the size and composition of the population.
5. Consumer Expectations
Changes in consumer expectations also can change the
position of the demand curve for a product. If consumers
expect future prices to be higher, they will substitute current
purchases for future purchases.

22. A VIDEO ABOUT
“Why Demand Curve Shifts"

23. Why Demand Curve Shifts?
Other Factors
Any variable that affects the willingness or ability of
consumers to purchase a particular good is a potential
demand shifter.
Take a look at the figure in the next slide. You may see how
advertising can influence demand by altering the underlying
tastes of consumers.

24. Effect of Advertising to Demand Curve
Figure: Advertising and the Demand for Clothing
• Advertising done by firms causes the demand curve for
clothing to shift from D1 to D2
• The old demand curve D1 shows that at Price (P) of $40
the Quantity Demanded (Q) is at 50,000.
• But, when the demand curve move from D1 to D2 due to
advertising, at Price (P) of $40 the Quantity Demanded
(Q) increases from 50,000 to 60,000

25. Advertising and the Demand for
Clothing
2-25
Quantity of
high-style
clothing
0
$50
$40
50,000
Price of
high-style
clothing
D2
60,000
Due to an
increase in
advertising
D1

26. CHAPTER 2
Market Forces: Demand and Supply

27. DEMAND FUNCTION

28. The Demand Function
• The demand function for good X is a mathematical
representation describing how many units will be
purchased at different prices for X, the price of a related
good Y, income and other factors that affect the demand
for good X.
2-28

29. The Linear Demand Function
• One simple, but useful, representation of a demand
function is the linear demand function:
, where:
• is the number of units of good X demanded;
• is the price of good X;
• is the price of a related good Y;
• is income;
• is the value of any other variable affecting demand.
2-29

30. Understanding the Linear Demand
Function
• The signs and magnitude of the 𝛼 coefficients determine
the impact of each variable on the number of units of X
demanded.
𝑄 𝑋
𝑑
= 𝛼0 + 𝛼 𝑋 𝑃𝑋 + 𝛼 𝑌 𝑃𝑌 + 𝛼 𝑀 𝑀
• For example:
• 𝛼 𝑋 < 0 by the law of demand;
• 𝛼 𝑌 > 0 if good Y is a substitute for good X;
• 𝛼 𝑀 < 0 if good X is an inferior good.
2-30

31. The Linear Demand Function in Action
• Suppose that an economic consultant for X Corp. recently provided
the firm’s marketing manager with this estimate of the demand
function for the firm’s product:
Question: How many of good X will consumers purchase when per
unit, per unit, and ? Are goods X and Y substitutes or complements? Is
good X a normal or an inferior good?
Answer:
units. Goods X and Y are substitutes. Good X is an inferior good.
2-31

32. What is Consumer Surplus?
• Total consumer value is the sum of the
maximum amount a consumer is willing to
pay for different quantities.
• Total expenditure is the per-unit market
price times the number of units consumed.
• Consumer surplus is the extra value that
consumers derive from a good but do not
pay extra for that good.
2-32

33. A VIDEO ABOUT
“Consumer Surplus and Producer
Surplus”

34. What is Consumer Surplus?
• By the law of demand, the amount a consumer is willing
to pay for an additional unit of a good falls as more of the
good is consumed.
• Given the demand curve in Figure: Consumer Surplus.
• You may refer to your textbook for more details on the
example provided in the graph.
2-34

35. Quantity
in liters
Price per
liter
Demand
$5
0
$3
$2
1 2
$1
4 5
Market Demand and Consumer Surplus
2-35
Total Consumer Value:
0.5($5 - $3)x2+(3-0)(2-0) = $8
Expenditures:
$(3-0) x (2-0) = $6
Consumer Surplus:
0.5($5 - $3)x(2-0) = $2
$4
3
Consumer Surplus

36. CHAPTER 2
Market Forces: Demand and Supply

37. LAW OF MARKET SUPPLY

38. Supply Side of the Market Forces
• We have looked at the Demand side of the Market Forces
now we will look at the Supply side of the Market Forces

39. What is Market Supply Curve?
•Market supply curve
•Summarises the relationship
between the total quantity that all
producers are willing and able to
produce at alternative prices,
holding other factors constant.

40. A VIDEO ABOUT
“The Supply Curve”

41. What is the “Law of Supply”
•Law of supply
•As the price of a good rises (falls),
the quantity supplied of the good
rises (falls), holding other factors
constant.

42. A VIDEO ABOUT
“Law of Supply”

43. Changes in Quantity Supplied
• Changing only price leads to changes in quantity
supplied.
• This type of change is graphically represented by a movement
along a given supply curve, holding other factors that impact supply
constant.
• Changing factors other than price lead to changes in
supply.
• These types of changes are graphically represented by a shift of
the entire supply curve.

44. CHAPTER 2
Market Forces: Demand and Supply

45. LAW OF MARKET SUPPLY

46. Changes in Supply
• Figure: Changes in Supply
• The movement along a supply curve, such as the
movement from A to B is called a change in quantity
supplied.

47. Change in Supply
2-47
Quantity
Price
0
A
B
S0

48. Changes in Supply
• Figure: Changes in Supply
• Whenever there changes in input price, technology,
government regulation, number of firms in the market,
substitutes in production, taxes or producer’s expectation,
it leads to a change in supply; the position of the entire
supply curve shifts.
• A rightward shift in the demand curve is called an
increase in supply since more of the good is produced at
each price.
• A leftward shift in the demand curve is called a decrease
in supply since less of the good is produced at each price.

49. Change in Supply
2-49
Quantity
Price
S2
0
Decrease
in supply
A
B
S0S1
Increase
in supply

50. Why Supply curve Shifts?
The Factors Influence the Supply Shifters
1. Input Prices
• In particular, as the price of an input rises, producers are
willing to produce less output at each given price.
2. Technology or Government Regulation
• Technological changes and changes in government
regulations also can affect the position of the supply
curve. Changes that make it possible to produce a given
output at a lower cost.

51. Why Supply curve Shifts?
3. Number of Firms
• If firms enter an industry, more output is available at each
given price. Similarly, as firms leave an industry, fewer
units are sold at each price.
• Entry
• Exit
4. Substitutes in Production
• Many firms have technologies that are readily adaptable
to several different products.

52. Why Supply curve Shifts?
5. Taxes
Excise tax: A tax on each unit of output sold, where the tax
revenue is collected from the supplier.
Ad valorem tax: It means "according to the value". Ad
valorem tax is a percentage tax; the sales tax is a well-
known example.
You may refer to the graph, Figure: Excise tax and Ad
Valorem Tax, to have a further understanding of these
taxes.

53. Why Supply curve Shifts?
Figure: Excise Tax – Tax on Each Unit
The figure shows the old price of gasoline per unit of $1.00
When an Excise Tax (t) of $0.20 is being charged per unit
of product, the new price of gasoline per unit of $1.20.
At the old price, the quantity of gasoline supplied per week
is S0.
With the new tax, the quantity of gasoline supplied per
week shift from S0 to S1

54. A per unit Excise Tax
2-54
Quantity of
gasoline per
week
Price
of
gasoline
0
t = per unit tax of 20¢
S0
S0+t
t = 20¢
$1.20
$1.00
t
Excise tax

55. Why Supply curve Shifts?
Figure: Ad Valorem Tax – Percentage Tax
The figure shows the old price of backpacks per unit of $10.00
When an Ad Valorem Tax (t) of 20% is being charged per unit of
product, the new price of backpacks per unit is $12.00.
As for the backpack with an old price of $20.00, the new an Ad Valorem
Tax (t) of 20% will cause this backpack to be priced at $24.00.
At the old price, the quantity of backpacks supplied per week is S0.
With the new tax, the quantity of backpacks supplied per week shift
from S0 to S1

56. An Ad Valorem Tax
2-56
Quantity of
backpacks per
week
Price
of
backpacks
0
S0
S1 = 1.20 x S0
$24
$10
Ad valorem tax
$12
1,100
$20
2,450

57. Why Supply curve Shifts?
• Once the 20 percent tax is implemented, the price
required to produce each unit goes up by 20 percent at
any output level. Therefore, the price will go up. An Ad
Valorem Tax will rotate the supply curve counterclockwise
and the new curve will shift farther away from the original
curve as the price increases. You may refer to the figure
below which explains why S1 is steeper than S0.
2-57

58. Why Supply curve Shifts?
6. Producer Expectations
• Producer Expectations about future prices also affect the
position of the supply curve.
• Selling a unit of output today and selling a unit of output
tomorrow are substitutes in production.

59. A VIDEO ABOUT
“The Supply Curve Shifts”

60. CHAPTER 2
Market Forces: Demand and Supply

61. THE SUPPLY FUNCTION

62. The Supply Function
• The supply function for good X is a mathematical
representation describing how many units will be
produced at different prices for X, prices of inputs W,
prices of technologically related goods, and other factors
that affect the supply for good X.
2-62

63. The Linear Supply Function
• One simple, but useful, representation of a supply
function is the linear supply function:
, where:
• is the number of units of good X produced;
• is the price of good X;
• is the price of an input;
• is price of technologically related goods;
• is the value of any other variable affecting supply.
2-63

64. Understanding the Linear Supply
Function
• The signs and magnitude of the 𝛽 coefficients determine
the impact of each variable on the number of units of X
produced.
𝑄 𝑋
𝑠
= 𝛽0 + 𝛽 𝑋 𝑃𝑋 + 𝛽 𝑊 𝑊 + 𝛽𝑟 𝑃𝑟
• For example:
• 𝛽 𝑋 > 0 by the law of supply.
• 𝛽 𝑊 < 0 increasing input price.
• 𝛽𝑟 > 0 technology lowers the cost of producing good X.
2-64

65. Producer Surplus
2-65
•Producer surplus is what the
producers receive in excess of the
amount necessary to produce the
good.

66. A VIDEO ABOUT
“Consumer Surplus and Producer
Surplus”

67. Producer Surplus
2-67
• Figure: Producer Surplus
• The gray area shows the producer surplus.
• At the price of $400, producer will and able to produce
quantity of 800.
• So, for quantity between 0 to 799, the producer willing to
produce at a price lower than $400 but it still receive $400
for it.
• This is producer surplus. It is the amount producers
receive in excess of the amount necessary to produce the
good.

68. Producer Surplus
Quantity
Price Supply
$400
0 800
𝑃𝑋 =
400
3
+
1
3
𝑄 𝑋
𝑆
$400
3
Producer surplus

69. CHAPTER 2
Market Forces: Demand and Supply

70. MARKET EQUILIBRIUM

71. Market Equilibrium
• The equilibrium price in a competitive market
is determined by the interactions of all buyers
and sellers in the market.
• The price of a good in a competitive market is
determined by the interaction of the market
supply and market demand for the good.
• When price and quantity is at an equilibrium,
there is no shortage or surplus in the market.
2-71

72. Market Equilibrium
• When the supply and demand curves
intersect, the market is in equilibrium. This is
where the quantity demanded and quantity
supplied are equal. The corresponding price is
the equilibrium price or market-clearing price,
the quantity is the equilibrium quantity.
2-72

73. What causes a market equilibrium?
• If only prices change, then the law of
supply and demand will cause both quantity
and price to revert back to the equilibrium.
However, if other determinants causes
changes in either demand or supply, then
the market equilibrium also changes,
because either the demand curve or the
supply curve or both shifts.
2-73

74. Market Equilibrium
•The figure depicts the market
supply and demand curves for
such a good.

75. A VIDEO ABOUT
“Market Equilibirium”

76. Market Equilibrium
2-76
Quantity
Price Supply
0
𝑃 𝐻
280
Demand
Surplus
Shortage
𝑃 𝑒
𝑃 𝐿
𝑄0 𝑄 𝑒
𝑄1

77. CHAPTER 2
Market Forces: Demand and Supply

78. PRICE RESTRICTIONS

79. Price Restrictions and Market
Equilibrium
•In this section, we examine the
impact of price ceilings and price
floors on market allocations.
•In a competitive market
equilibrium, price and quantity
freely adjust to the forces of
demand and supply.
2-79

80. A VIDEO ABOUT
“Price Ceilings and Price Floors”

81. Price System
• The price system uses price to determine who gets a
good and who does not. The price system allocates
goods to consumers who are willing and able to pay
the most for the goods.
• If the competitive equilibrium price of a shirt is $30,
consumers willing and able to pay for $30 will
purchase the good; consumers unwilling or unable to
pay that much will not buy the good.
2-81

82. Price Ceilings
• Suppose that the government views the equilibrium price
of Pe in Figure: Price Ceiling below as "too high" and
passes a law prohibiting firms from charging prices above
Pc. Such a price is called a price ceiling.
• A price ceiling is the maximum legal price that can be
charged in a market.
2-82

83. Price Ceilings
2-83
Quantity
Price Supply
0
𝑃 𝐹
𝑃 𝑐
𝑄 𝑠
𝑄 𝑒 𝑄 𝑑
280
Demand
Shortage
𝑃 𝑒
Priceceiling
Nonpecuniaryprice
Lost social welfare

84. Price Floors
• In contrast to the case of a price ceiling, sometimes
the equilibrium competitive price may be
considered too low for sellers. The best-known
price floor is the minimum legal price that can be
charged in a market.
• If the equilibrium price is above the price floor, the
price floor has no effect on the market. But if the
price floor is set above the competitive equilibrium
level, such as in Figure: Price Floor below, there is
an effect. Quantity supplied in Qs and quantity
demanded is Qd.
•
2-84

85. Price Floors
• In contrast to the case of a price ceiling, sometimes
the equilibrium competitive price may be
considered too low for sellers.
• The best-known price floor is the minimum legal
price that can be charged in a market.
• If the equilibrium price is above the price floor, the
price floor has no effect on the market. But if the
price floor is set above the competitive equilibrium
level, such as in Figure: Price Floor below, there
is an effect. Quantity supplied in Qs and quantity
demanded is Qd.
•
2-85

86. Price Floors
2-86
Quantity
Price Supply
0
𝑃 𝑓
𝑄 𝑑
𝑄 𝑒 𝑄 𝑠
280
Demand
Surplus
𝑃 𝑒
Pricefloor
Cost of
purchasing
excess supply

87. CHAPTER 2
Market Forces: Demand and Supply

88. COMPARATIVE STATIC
ANALYSIS
On Key Terms and Concepts
2-88

89. Comparative Static Analysis
• Comparative static analysis
• The study of the movement from one equilibrium to another.
• Competitive markets, no price restrictions, are analyzed
when:
• Changes in Demand;
• Changes in Supply;
• Demand and supply simultaneously change.
2-89

90. Changes in Demand
• Increase in demand only
• Increase equilibrium price and quantity
• Decrease in demand only
• Decrease equilibrium price and quantity
2-90

91. Change in Demand
2-91
Quantity
(thousands
rented per day)
Price Supply
0
$45
104
Demand for Rental Cars
Demand1
$49
Demand0
100 108

92. Changes in Supply
• Increase in supply only
• Decrease equilibrium price and quantity
• Decrease in supply only
• Increase equilibrium price and quantity

93. Change in Supply
2-93
Quantity
Price
Supply0
0 𝑄0
Demand
𝑃0
Supply1
𝑃1
𝑄1

94. Simultaneous Shifts in Supply and Demand
2-94
Quantity
Price
Supply0
𝑃0
0
Demand1
𝑃1
Supply1
Demand0
Japan’s Sake Market
𝑄0
𝑄1
Supply2
𝑃2
𝑄2
A
B
C

95. CHAPTER 2
Market Forces: Demand and Supply

96. RECAP
On Key Terms and Concepts
2-96

97. Key Concepts Chapter 2
• Law of Demand
• Law of Supply
• Determinants of Demand (demand shifters)
• Determinants of supply (supply shifters)
• Market Equilibrium (diagram)
• Price Ceiling and Price Floor (diagram)
• Excise Tax and Ad Valorem Tax (diagram)
• Equilibrium market demand and supply curve with tax
• Consumer surplus
• Producer surplus
2-97