Supply and Demand: Foundations of Market Analysis

Supply and Demand

Introduction to Supply and Demand

The supply and demand model is a fundamental framework in microeconomics for understanding how prices and quantities are determined in competitive markets. This chapter covers the determinants of demand and supply, the concept of market equilibrium, the effects of shocks and government interventions, and the aggregation of individual behaviors into market outcomes.

Demand

Determinants of Demand

Demand for a good is influenced by several factors, each of which can shift the demand curve:

• Price of the good: The most direct determinant; as price changes, quantity demanded changes (movement along the curve).

• Tastes: Consumer preferences can increase or decrease demand.

• Information: Knowledge about the good (e.g., health effects) can shift demand.

• Prices of other goods: Includes complements (goods used together) and substitutes (goods used in place of each other).

• Income: Higher income generally increases demand for normal goods and decreases it for inferior goods.

• Government rules and regulations: Taxes, subsidies, and regulations can affect demand.

• Other factors: Such as expectations about future prices or demographic changes.

The Demand Curve

The demand curve shows the quantity of a good that consumers are willing to buy at each possible price, holding other factors constant. The law of demand states that, all else equal, consumers demand more of a good when its price is lower.

• Quantity demanded: The amount consumers are willing to buy at a specific price.

• Movement along the curve: Caused by a change in the good's own price.

• Shift of the curve: Caused by changes in other determinants (e.g., income, tastes).

The Demand Function

The demand function expresses quantity demanded as a function of price and other variables:

$Q = D(p, p_b, p_c, Y)$ where $Q$ is quantity demanded, $p$ is the price of the good, $p_b$ is the price of beef, $p_c$ is the price of chicken, and $Y$ is consumer income.

Example (linear demand function for pork):

$Q = 171 - 20p + 20p_b + 3p_c + 2Y$

Given $p_b = 4$, $p_c = 3.33$, $Y = 12.5$: $Q = 286 - 20p$

Inverse Demand Function

The inverse demand function expresses price as a function of quantity:

$Q = 286 - 20p$ $20p = 286 - Q$ $p = 14.30 - 0.05Q$

Summing Demand Curves

The market demand curve is the horizontal sum of individual demand curves:

$Q = Q_1 + Q_2 = D_1(p) + D_2(p)$

Supply

Determinants of Supply

Supply for a good is determined by:

• Price of the good: Higher prices generally increase quantity supplied.

• Costs: Input prices and technology affect production costs and supply.

• Government rules and regulations: Taxes, subsidies, and regulations can shift supply.

The Supply Curve

The supply curve shows the quantity of a good that firms are willing to sell at each price, holding other factors constant. Movement along the curve is due to price changes; shifts are due to changes in costs or regulations.

The Supply Function

The supply function expresses quantity supplied as a function of price and input costs:

$Q = S(p, p_h)$ where $p_h$ is the price of hogs (input).

Example (linear supply function for pork):

$Q = 178 + 40p - 60p_h$

Given $p_h = 1.50$: $Q = 88 + 40p$

Summing Supply Curves

The market supply curve is the horizontal sum of individual supply curves (domestic and foreign):

Market Equilibrium

Definition and Determination

Market equilibrium occurs where quantity demanded equals quantity supplied. The equilibrium price is where consumers can buy as much as they want and sellers can sell as much as they want.

• Excess demand: Quantity demanded exceeds quantity supplied at a given price.

• Excess supply: Quantity supplied exceeds quantity demanded at a given price.

Mathematical Solution for Equilibrium

Set $Q_d = Q_s$ and solve for $p$ and $Q$:

Example: $Q_d = 286 - 20p$ $Q_s = 88 + 40p$ Set equal: $286 - 20p = 88 + 40p$ $60p = 198$ $p^* = 3.30$ $Q^* = 286 - 20(3.3) = 220$

General Equilibrium Solution

For general linear functions:

Demand: $Q = a - bp$ Supply: $Q = c + ep$ Equilibrium: $a - bp = c + ep$ $p^* = \frac{a - c}{b + e}$ $Q^* = \frac{ae + bc}{b + e}$

Shocking the Equilibrium

Shifts in Demand or Supply

Equilibrium changes only if a shock occurs that shifts the demand or supply curve. Shocks include changes in tastes, income, input prices, or government policy.

Government Interventions

Types and Effects

Government policies can shift supply or demand, or cause the quantity demanded to differ from quantity supplied:

• Licensing laws, quotas: Shift supply curves.

• Price ceilings, price floors: Cause market imbalances (excess demand or supply).

Quotas and Price Controls

Quotas limit the quantity that can be imported or sold, shifting the supply curve and raising prices if binding. Price ceilings (maximum prices) and price floors (minimum prices) prevent the market from reaching equilibrium, creating shortages or surpluses.

Perfectly Competitive Markets

Characteristics

In perfectly competitive markets:

• All participants are price takers.

• Firms sell identical products.

• Full information is available to all.

• Trading costs are low.

Summary Table: Key Concepts in Supply and Demand

Concept	Definition	Example
Demand Curve	Shows quantity demanded at each price	Q = 286 - 20p
Supply Curve	Shows quantity supplied at each price	Q = 88 + 40p
Equilibrium	Where Qd = Qs	p* = 3.30, Q* = 220
Excess Demand	Qd > Qs at a price	Shortage
Excess Supply	Qs > Qd at a price	Surplus
Quota	Limit on quantity supplied	Import quota on sugar
Price Ceiling	Maximum legal price	Rent control
Price Floor	Minimum legal price	Minimum wage