# Supply and Demand

## Demand

It defines the number of goods or services consumers are willing to purchase at each price. It describes the entire relationship between the price and the quantity demanded.

Figure 1. This graph illustrates the demand for rice in a hypothetical market. The horizontal axis represents the quantities or pounds of rice, and the vertical axis represents the price per pound. In this market, each price has an associated quantity of rice demanded. For example, when the price equals $8, the quantity demanded is 10 pounds of rice. Figure 2. This graph illustrates the movement along the demand curve when there is price change. ### Review of Key Concepts • The quantity demanded is the total number of items purchased at each price. • Law of demand: Other things remain the same, there is an inverse relationship between price and quantity. Hence: An increase in the price decreases the quantity demanded of that good or service. Similarly, a reduction in the price leads to a rise in the quantity demanded of that good or service The law of demand results from: • Substitution Effect: When the price of a good or service increases relative to other similar goods or services, then people look for substitutes for it. This leads to a decrease in the demand for goods or services. • Income Effect: When the price of a good or service increases and income remains the same, people cannot afford all the items they were used to buying. Then, the quantity demanded of that good or service decreases. Figure 3. This graph illustrates shifts in demand. Changes in demand for a good or service lead to a shift in the entire demand curve. ### Demand Curve: It shows the relationship between price and quantity demanded during a particular period. By convention, economist graph the quantity on the horizontal axis and the price on the vertical axis. Figure 1 shows the hypothetical quantities demanded each month at prices ranging from$2 to $8 per pound. Note that the curve shows that the higher the price, the lower the quantity demanded; therefore, demand curves are downward sloping. #### Movements along the demand curve: • A rise in the price, other things remaining equal, leads to a decrease in the quantity demanded and a movement up along the demand curve. The blue arrow in Figure 2 illustrates this movement. • Similarly, a fall in the price, other things remaining equal, leads to an increase in the quantity demanded and a movement down along the demand curve. The purple arrow in Figure 2 illustrates this movement. Change (Shifts) in the demand curve: Demand changes occur when something influences the consumer’s buying plans other than the price of the good or service. Hence, the quantity of goods or services changes at every possible price. This will lead to a new demand curve. The consumer buying plans could be affected by changes in income, the prices of related goods, preferences, population or number of consumers, and expectations about the future. The formers are usually referred to as the demand shifters. • The demand curve shifts to the right when the demand increases. Demand curve 2 in Figure 3 illustrates this shift. • The demand curve shifts to the left when the demand decreases. Demand curve 3 in Figure 3 illustrates this shift. ## Supply Figure 4. This graph illustrates the supply of rice in a hypothetical market. The horizontal axis represents the quantities or pounds of rice, and the vertical axis represents the price per pound. In this market, each price has an associated quantity of rice supplied. For example, when the price is equal to$8, the quantity supplied by the producers is 40 pounds of rice.

It’s defined as the number of goods and services a producer is willing to supply at each price. It describes the entire relationship between the price and quantity the producer supplies. Watch it!

Figure 5. This graph illustrates the movement along the supply curve when there is price change.

### Review of Key Concepts

• The quantity supplied is the total number of items sold at each price.
• Law of Supply: Other things remain the same, there is a positive relationship between price and quantity. Hence:

An increase in the price increases the quantity supplied of that good or service. Similarly, a reduction in the price leads to a fall in quantity supplied of that good or service.

The law of supply results from the marginal cost of production. Producers are willing to supply an item only if they can cover their marginal cost of production.

### Supply Curve:

Figure 6. This graph illustrates shifts in supply. Changes in the supply of a good or service lead to a shift in the entire supply curve.

The supply curve shows the relationship between price and quantity supplied during a particular period. By convention, economist graph the quantity on the horizontal axis and the price on the vertical axis. Figure 4 shows the hypothetical quantities supplied each month at prices ranging from $2 to$8 per pound. Note that the curve shows that the higher the price, the higher the quantity supplied. Therefore supply curves are upward sloping.

#### Movements along the supply curve:

• A rise in the price, other things remaining equal, leads to an increase in the quantity supplied and a movement up along the supply curve. The blue arrow in Figure 5 illustrates this movement.
• Similarly, a fall in the price, other things remaining equal, leads to a decrease in the quantity supplied and a movement down along the supply curve. The purple arrow in Figure 5 illustrates this movement.

#### Change (Shifts) in the supply curve:

A change in supply occurs when something influences the producer’s selling plans other than the price of the good. Hence, the quantity of goods or services changes at every possible price. This will lead to a new supply curve.

The producer selling plans could be affected by changes in the prices of factors of production, the prices of related goods, the number of suppliers, technology advancements, returns from alternative activities, natural events, and expectations about the future. The formers are usually referred to as the supply shifters.

• The supply curve shifts to the right when the supply increases. Supply curve 2 in Figure 6 illustrates this shift.
• The demand curve shifts to the left when the demand decreases. Supply curve 3 in Figure 6 illustrates this shift.

## Market Equilibrium

Figure 7. This graph combines demand and supply curves to describe the market equilibrium. The market equilibrium is found where these two graphs intersect. The equilibrium price is $5 per pound; at this price, consumers and suppliers are willing to trade$25 million pounds of rice.

The equilibrium in a market occurs when the price balances the willingness to purchase and sell from buyers and producers, respectively. One way to find the market equilibrium is by putting together the demand and supply curves. The objective is to identify the price at which the quantity the buyers are willing to purchase equals the amount the sellers are willing to offer for sale.

### Price Controls:

Under a free market, theoretically, the consumer and producer surpluses are maximized. However, the government usually intervenes to regulate prices through price controls:

• Price Ceilings: are defined as the maximum price suppliers are allowed to charge for a good or service. A classic example of this is rent control.
• Price Floors: are defined as the minimum price consumers are required to pay for a good or service. A classic example of this is the minimum wage.
Figure 16. Panel (a) illustrates the Deadweight Loss generated after introducing a price floor in this market. Notice that the quantities that are sold are lower than the equilibrium quantity. Panel (b) shows the consumer and producer surplus change due to price control.

Imagine that the government decides to intervene in the market to protect consumers from price increases due to an enormous harvest failure in the rice fields. Thus, the government decrees a price ceiling so that the maximum price a producer can charge per pound of rice is $3 when the equilibrium price is$5. This will produce a rice shortage of 20 million pounds of rice. Figure 15 illustrates this scenario.

Figure 17. Panel (a) illustrates a surplus generated by a price floor. Panel (b) shows the change in the consumer and producer surplus due to price control.

The shortage will create inefficiency in the market since the amount of rice transacted will be too low. Thus, there will be many consumers willing to buy rice who won’t’ be able to do it, and as a result, black markets are likely to appear.  In this scenario, the total surplus will decrease, and the amount of the fall is called Deadweight Loss (DWL). Figure 16 illustrates it.

Now, imagine an alternative scenario. The government would like to protect the producers from foreign cheaper rice. Thus, the government introduces a price floor so that the minimum price a pound of rice could be sold is $8 per pound. Similarly, this action will create inefficiencies in the market since it will create missing transactions among suppliers and lead to a surplus of 30 million pounds of rice in this market. Figure 17 illustrates this scenario. # Excise Taxes Excise taxes are taxes on sales of goods and services used by the government to raise revenue. These taxes affect demand and supply because they increase the price consumers pay and reduce the price received by suppliers. Thus, we are usually interested in understanding who bears the tax burden or the tax incidence. ### Tax on the Suppliers: A tax on suppliers has the same effect as increasing the cost of production. Economists usually model this as if the supply curve shifted upwards by the amount of the tax. Figure 18. Sales tax on suppliers Figure 19. Sales tax on consumers Figure 18 illustrates the effect of a tax on suppliers of$4 per pound of rice. The supply shifts down by $4, and the new equilibrium quantity is found where the demand and new supply meet. ### Tax on the Consumers: A tax on consumers has the same effect as decreasing their income. Economists usually model this as if the demand curve shifted downward by the amount of the tax. Figure 19 illustrates the effect of a tax on consumers of$4 per pound of rice. The demand shifts down by $4; the new equilibrium quantity is found where the supply and new demand meet. The anterior example illustrates that the tax incidence is the same regardless of whether the tax is on the sellers or the buyers. However, the tax division between consumers and suppliers will depend on the price elasticity of demand and supply. In the examples depicted in Figure 18 and Figure 19, consumers and suppliers paid the same amount in tax – i.e.,$2, because the price elasticity of demand and supply is the same for both curves. However:

• When the elasticity of demand is higher than the elasticity of supply the tax is paid mainly by the consumers.
• When the price elasticity of supply is higher than the price elasticity of demand the tax is mainly paid by suppliers.

### Efficiency

Figure 20. Deadweight Loss and Tax Revenue

Imposing a tax usually creates inefficiency or DWL. Figure 20 illustrates the DWL, consumer surplus, producer surplus, and tax revenue when an excise tax is imposed on the supplier.

# Marginal Benefit and Marginal Cost

The price found in free markets seems to coordinate individual actions in such a way that the outcome looks as if it were created by a benevolent invisible hand. However, even with a free market, the price sometimes isn’t right. To learn why the price isn’t always right, we must consider private and social costs and benefits.

 BENEFITS COST PRIVATE Received by the consumers or the producers in the rice market Paid by the consumers or producers in the rice market EXTERNAL Received by people other than consumers and producers—those outside the rice market. paid by people other than consumers and producers—those outside the rice market. SOCIAL Private + External Private + External

As a social planner, the government is interested in maximizing social surplus; thus, it needs to make sure it’s computing it correctly. To maximize social surplus, it needs to consider the private costs or benefits and the external ones. In particular, the government will pay close attention to Externalities.

An externality is a cost or benefit imposed onto a third party that isn’t directly related to the market where the externality is produced:

• External Cost: it’s a cost that an individual or a firm imposes on a third party and is not compensated. Externalities that impose external costs are called negative externalities; a classic example is air pollution.
• External Benefit: it’s a benefit that an individual or a firm grants to others without receiving any compensation. Externalities that confer an external benefit are called positive externalities, and vaccination is a classic example.

Externalities, then, produce social costs or benefits depending on whether they are negative or positive. So, the government will try to maximize:

Figure 20. Marginal Cost Curves

${\displaystyle Social\,Surplus=Consumer\;Surplus+Producer\;Surplus+Everyone\;Else\;Surplus}$

Figure 21. Marginal Benefit Curves

To maximize social surplus, we must define:

• Marginal Private Cost (MPC): it’s defined as the additional private cost of producing one additional unit of a good or service as borne by the producer.
• Marginal External Cost (MEC): it’s defined as the additional cost of producing one additional unit of a good or service as borne by a third party unrelated to the producer.
• Marginal Social Cost (MSC): it’s defined as the additional cost imposed on society, including the one producing it and everyone else impacted, by producing one additional unit of a good or service. It’s equivalent to:

${\displaystyle Marginal\,Social\,Cost\,(MSC)=Marginal\,Private\,Cost\,(MPC)+Marginal\,External\,Cost\,(MEC)}$

• Marginal Private Benefit (MPB): It’s defined as the additional benefit that a consumer of a good or service gets for consuming one additional unit of it.
• Marginal External Benefit (MEB): It’s defined as the additional gain that a third party gets from consuming one additional unit of a good or service.
• Marginal Social Benefit (MSB): It’s defined as the additional gain to society from consuming one additional unit of a good or service. It’s equivalent to:

${\displaystyle Marginal\,Social\,Benefit\,(MSB)=Marginal\,Private\,Benefit\,(MPB)+Marginal\,External\,Benefit\,(MEB)}$

Figure 22. Efficient Equilibrium