1. 3
DEMAND AND SUPPLY
CHAPTER

2. Objectives After studying this chapter, you will be able to:
Explain the influences on demand
Explain the influences on supply
Explain how demand and supply determine prices and quantities bought and sold
Use demand and supply to make predictions about changes in prices and quantities

3. Slide, Rocket, Roller Coaster
Some prices slide, some rocket, and some roller coaster.
This chapter explains how prices are determined and how markets guide and coordinate choices.

4. Markets and Prices
A market is any arrangement that enables buyers and sellers to get information and do business with each other.
A competitive market is a market that has many buyers and many sellers so no single buyer or seller can influence the price.
The money price of a good is the amount of money needed to buy it.
The relative price of a good—the ratio of its money price to the money price of the next best alternative good—is its opportunity cost.
Before you jump into the demand-supply model, be sure that your students understand that a price in economics is relative price and that a relative price is an opportunity cost. Also spend some class time ensuring that they appreciate the key lessons of Chapter 2:
a) Prosperity comes from specialization and exchange.
b) Specialization and exchange require the social institutions of property rights and markets.
c) We must understand how markets work.
You might like to explain that the most competitive markets are explicitly organized as auctions. An interesting market to describe is that at Aalsmeer in Holland, which handles a large percentage of the world’s fresh cut flowers. Roses grown in Colombia are flown to Amsterdam, auctioned at Aalsmeer, and are in vases in New York, London, and Tokyo all in less than a day. If you have an Internet connection in your classroom, you can participate in a simulation of an auction of flowers. Here is the URL (which you can also click on at the Parkin Web site)

5. Demand If you demand something, then you: Want it, Can afford it, and
Have made a definite plan to buy it.
Wants are the unlimited desires or wishes people have for goods and services. Demand reflects a decision about which wants to satisfy.
The quantity demanded of a good or service is the amount that consumers plan to buy during a particular time period, and at a particular price.

6. Demand What Determines Buying Plans?
The amount of any particular good or service that consumers plan to buy is influenced by
1. The price of the good,
2. The prices of other goods,
3. Expected future prices,
4. Income,
5. Population, and
6. Preferences.

7. Demand The Law of Demand The law of demand states:
Other things remaining the same, the higher the price of a good, the smaller is the quantity demanded.
The law of demand results from
a substitution effect
an income effect
Estimating the demand for Coke (or bottled water) in the classroom.
Of the hundreds of classroom experiments that are available today, very few are worth the time they take to conduct. The classic demand-revealing experiment is one of the most productive and worthwhile ones.
Bring to class two bottles of ice-cold, ready-to-drink Coke, bottled water, or sports drink. (If your class is very large, bring six bottles).
Tell the students that you have these drinks and ask them to indicate if they would like one. Most hands will go up and you are now ready to make two points:
1. The students have just revealed a want but not a demand.
2. You don’t have enough bottles to satisfy their wants, so you need an allocation mechanism.
Ask the students to suggest some allocation mechanisms. You might get suggestions such as: give them to the oldest, the youngest, the tallest, the shortest, the first-to-the-front-of-the-class. For each one, point out the difficulty/inefficiency/inequity.
If no one suggests selling them to the highest bidder, tell the class that you are indeed going to do just that. Tell them that this auction is real. The winner will get the drink and will pay.
Now ask for a show of hands of those who have some cash and can afford to buy a drink. Explain that these indicate an ability to buy but not a definite plan to buy.
Continues on next (hidden) slide notes page.

8. Demand The Law of Demand The law of demand states:
Other things remaining the same, the higher the price of a good, the smaller is the quantity demanded.
The law of demand results from
a substitution effect
an income effect
Now begin the auction. Appoint a student to count hands (more than one for a big class) and appoint another student to keep a spreadsheet (see the Parkin Web site for a sample that you can download).
Begin at a low price, say 10¢ a bottle, and count the number willing to buy.
Raise the price in 10¢ increments and keep tally of the number who are willing to buy at each price.
When the number willing to buy equals the number of bottles you have for sale, do the transactions. (If you make a profit, and you might do so, tell the students that the profit, small though it is, will go the department fund for undergraduate activities—and deliver on that promise.)
Now use the data to make a demand curve for Coke (or other drink) in your classroom today.
Emphasize the law of demand.
Emphasize that every demand curve relates to a market for the good (as defined by geography or some other spatial dimension) and for a given time period.
Now that you have a demand curve, you can do some thought experiments that will shift it. Ask:
How would this demand curve have been different if the temperature in the classroom was 10 degrees higher/lower?
How would this demand curve have been different if half the class was sick and absent today?
How would this demand curve have been different if there was a Coke machine right in the classroom?
(Save your demand data for later. We’ll make some suggestions for its further use in Chapter 4.)

9. Demand
Substitution effect—when the relative price (opportunity cost) of a good or service rises, people seek substitutes for it, so the quantity demanded decreases.
Income effect—when the price of a good or service rises relative to income, people cannot afford all the things they previously bought, so the quantity demanded decreases.

10. Demand Demand Curve and Demand Schedule
The term demand refers to the entire relationship between the price of the good and quantity demanded of the good.
A demand curve shows the relationship between the quantity demanded of a good and its price when all other influences on consumers’ planned purchases remain the same.

11. Demand
Figure 3.1 shows a demand curve for recordable compact discs (CD-Rs).
A rise in the price, other things remaining the same, brings a decrease in the quantity demanded and a movement along the demand curve.

12. Demand A demand curve is also a willingness-and-ability-to-pay curve.
The smaller the quantity available, the higher is the price that someone is willing to pay for another unit.
Willingness to pay measures marginal benefit.

13. Demand A Change in Demand
When any factor that influences buying plans other than the price of the good changes, there is a change in demand for that good. The quantity of the good that people plan to buy changes at each and every price, so there is a new demand curve.
When demand increases, the quantity that people plan to buy increases at each and every price so the demand curve shifts rightward.
When demand decreases, the quantity that people plan to buy decreases at each and every price so the demand curve shifts leftward.

14. Demand
Table 3.1 (page 62) summarizes the factors that change demand. They are:
Prices of related goods
A substitute is a good that can be used in place of another good.
A complement is a good that is used in conjunction with another good.
When the price of substitute for CD-Rs rises or when the price of a complement for CD-Rs falls, the demand for CD-Rs increases.

15. Demand
Figure 3.2 shows the shift in the demand curve for CD-Rs when the price of CD burner falls.
Because a CD burner is a complement of a CD-R, the demand for CD-Rs increases.

16. Demand Expected future prices
If the price of a good is expected to rise in the future, current demand increases and the demand curve shifts rightward.
Income
When income increases, consumers buy more of most goods and the demand curve shifts rightward. A normal good is one for which demand increases as income increases. An inferior good is a good for which demand decreases as income increases.

17. Demand
Population
The larger the population, the greater is the demand for all goods.
Preferences
People with the same income have different demands if they have different preferences.

18. Demand A Change in the Quantity Demanded Versus a Change in Demand
Figure 3.3 illustrates the distinction between a change in demand and a change in the quantity demanded.

19. Demand
When the price of the good changes and everything else remains the same, there is a change in the quantity demanded and a movement along the demand curve.

20. Demand
When one of the other factors that influence buying plans changes, there is a change in demand and a shift of the demand curve.

21. Supply If a firm supplies a good or service, then the firm:
Has the resources and the technology to produce it,
Can profit from producing it, and
Has made a definite plan to produce and sell it.
Resources and technology determine what it is possible to produce. Supply reflects a decision about which technologically feasible items to produce.
The quantity supplied of a good or service is the amount that producers plan to sell during a given time period at a particular price.

22. Supply What Determines Selling Plans?
The amount of any particular good or service that a firm plans to supply is influenced by
1. The price of the good,
2. The prices of resources needed to produce it,
3. The prices of related goods produced,
4. Expected future prices,
5. The number of suppliers, and
6. Available technology.

23. Supply The Law of Supply The law of supply states:
Other things remaining the same, the higher the price of a good, the greater is the quantity supplied.
The law of supply results from the general tendency for the marginal cost of producing a good or service to increase as the quantity produced increases (Chapter 2, page 35).
Producers are willing to supply only if they at least cover their marginal cost of production.
Estimating the supply of Coke (or bottled water) in the classroom.
(It is best to do this next classroom activity on a different day from the demand experiment.)
Tell the students that you would like a Coke (or other drink) that is available from a machine somewhere near the classroom and you want someone to get it for you. You are going to continue teaching while the student is out of the room and you will be giving hints about what is on the next test.
Ask the students to raise their hands if they are willing to fetch one can of Coke if you pay $5.00. Write down the number.
Lower the price you’ve willing to pay in $1 increments until the number of students willing to fetch you the drink begins to decrease. Keep track of the numbers.
Lower the price you’re willing to pay in 25¢ increments until you get close to having only one student willing to fetch you the drink. Keep track of the numbers.
Lower the price in smaller increments if necessary until just one student is willing to fetch you a drink.
Continues on next (hidden) slide notes page.

24. Supply The Law of Supply The law of supply states:
Other things remaining the same, the higher the price of a good, the greater is the quantity supplied.
The law of supply results from the general tendency for the marginal cost of producing a good or service to increase as the quantity produced increases (Chapter 2, page 35).
Producers are willing to supply only if they at least cover their marginal cost of production.
Now use the data to make a supply curve for Coke (or other drink) in your classroom today.
Emphasize the law of supply.
Emphasize that every supply curve relates to a market for the good (as defined by geography or some other spatial dimension) and for a given time period.
Now that you have a supply curve, you can do some thought experiments that will shift it. Ask:
How would this supply curve have been different if the coke machine was a mile away?
How would this supply curve have been different if half the class was sick and absent today?
How would this supply curve have been different if there was a Coke machine right in the classroom?
How would this supply curve have been different if the temperature in the classroom was 10 degrees higher/lower?

25. Supply Supply Curve and Supply Schedule
The term supply refers to the entire relationship between the quantity supplied and the price of a good.
The supply curve shows the relationship between the quantity supplied of a good and its price when all other influences on producers’ planned sales remain the same.

26. Supply
Figure 3.4 shows a supply curve of recordable compact discs (CD-Rs).
A rise in the price, other things remaining the same, brings an increase in the quantity supplied and a movement along the supply curve.

27. Supply A supply curve is also a minimum-supply-price curve.
The greater the quantity produced, the higher is the price that a firm must be offered to be willing to produce that quantity.

28. Supply A Change in Supply
When any factor that influences selling plans other than the price of the good changes, there is a change in supply of that good. The quantity of the good that producers plan to sell changes at each and every price, so there is a new supply curve.
When supply increases, the quantity that producers plan to sell increases at each and every price so the supply curve shifts rightward.
When supply decreases, the quantity that producers plan to sell decreases at each and every price so the supply curve shifts leftward.

29. Supply
Table 3.2 (page 67) summarizes the factors that change supply. They are:
Prices of productive resources
If the price of resource used to produce a good rises, the minimum price that a supplier is willing to accept for producing each quantity of that good rises. So a rise in the price of productive resources decreases supply and shifts the supply curve leftward.

30. Supply Prices of related goods produced
A substitute in production for a good is another good that can be produced using the same resources. Goods are complements in production if they must be produced together.
The supply of a good increases and its supply curve shifts rightward if the price of a substitute in production falls or if the price of a complement in production rises.

31. Supply Expected future prices
If the price of a good is expected to fall in the future, current supply increases and the supply curve shifts rightward.
The number of suppliers
The larger the number of suppliers of a good, the greater is the supply of the good. An increase in the number of suppliers shifts the supply curve rightward.

32. Supply
Technology
Advances in technology create new products and lower the cost of producing existing products, so they increase supply and shift the supply curve rightward.

33. Supply
Figure 3.5 shows how an advance in the technology for producing recordable CDs increases the supply of CD-Rs and shifts the supply curve for CD-Rs rightward.

34. Supply A Change in the Quantity Supplied Versus a Change in Supply
Figure 3.6 illustrates the distinction between a change in supply and a change in the quantity supplied.

35. Supply
When the price of the good changes and other influences on selling plans remain the same, there is a change in the quantity supplied and a movement along the supply curve.

36. Supply
When one of the other factors that influence selling plans changes, there is a change in supply and a shift of the supply curve.

37. Market Equilibrium
Equilibrium is a situation in which opposing forces balance each other. Equilibrium in a market occurs when the price balances the plans of buyers and sellers.
The equilibrium price is the price at which the quantity demanded equals the quantity supplied.
The equilibrium quantity is the quantity bought and sold at the equilibrium price.
Price regulates buying and selling plans.
Price adjusts when plans don’t match.
The magic of market equilibrium and the forces that bring it about and keep the market there need to be demonstrated with the basic diagram, with intuition, and, if you’ve got the time, with hard evidence in the form of further class activity.
You might want to begin with the demand curve experiment and explain that in that market, the supply was fixed (vertical supply curve) at the quantity of bottles that you brought to class. The equilibrium occurred where the market demand curve (demand by the students) intersected your supply curve.
Then you might use the supply curve experiment and explain that in that market, demand was fixed (vertical demand curve) at the quantity that you had decided to buy. The equilibrium occurred where the market supply curve (supply by the students) intersected your demand curve.
Point out that the trades you made in your little economy made buyers and sellers better off.
If you want to devote a class to equilibrium and the gains from trade in a market, you might want to run a double oral auction. There are lots of descriptions of these and one of the best is at Marcelo Clerici-Arias’s Web site at Stanford University—

38. Market Equilibrium Price as a Regulator
Figure 3.7 illustrates the equilibrium price and equilibrium quantity in the market for CD-Rs.
If the price of a disc is $2, the quantity supplied exceeds the quantity demanded and there is a surplus of discs.

39. Market Equilibrium
If the price of a disc is $1, the quantity demanded exceeds the quantity supplied and there is a shortage of discs.
If the price of a disc is $1.50, the quantity demanded equals the quantity supplied and there is neither a shortage nor a surplus of discs.

40. Market Equilibrium Price Adjustments
At prices above the equilibrium, a surplus forces the price down.
At prices below the equilibrium, a shortage forces the price up.
At the equilibrium price, buying plans and selling plans agree and the price doesn’t change.

41. Market Equilibrium
Because the price rises if it is below equilibrium, falls if it is above equilibrium, and remains constant if it is at the equilibrium, the price is pulled toward the equilibrium and remains there until some event changes the equilibrium.

42. Predicting Changes in Price and Quantity
A Change in Demand
Figure 3.8 shows the effect of a change in demand.
An increase in demand shifts the demand curve rightward and creates a shortage at the original price.
The whole chapter builds up to this section, which now brings all the elements of demand, supply, and equilibrium together to make predictions.
Students are remarkably ready to guess the consequences of some event that changes either demand or supply or both. They must be encouraged to work out the answer and draw the diagram.
Explain that the way to answer any question that seeks a prediction about the effects of some events on a market has five steps. Walk them through the steps and have one or two students work some examples in front of the class. The five steps are:
1. Draw a demand-supply diagram and label the axes with the price and quantity of the good or service in question.
2. Think about the events that you are told occur and decide whether they change demand, supply, both demand and supply, or neither demand nor supply.
3. Do the events that change demand or supply bring an increase or a decrease?
4. Draw the new demand curve and supply curve on the diagram. Be sure to shift the curves in the correct direction—leftward for decrease and rightward for increase. (Lots of students want to move the curves upward for increase and downward for decrease—works O. K. for demand but exactly wrong for supply. Emphasize the left-right shift.)
5. Find the new equilibrium and compare it with the original one.
It is critical at this stage to return to the distinction between a change in demand (supply) and a change in the quantity demanded (supplied). You can now use these distinctions to describe the effects of events that change market outcomes.
At this point, the students know enough for it to be worthwhile emphasizing the magic of the market’s ability to coordinate plans and reallocate resources.
The price rises and the quantity supplied increases.

43. Predicting Changes in Price and Quantity
A Change in Supply
Figure 3.9 shows the effect of a change in supply.
An increase in supply shifts the supply curve rightward and creates a surplus at the original price.
The price falls and the quantity demanded increases.

44. Predicting Changes in Price and Quantity
A Change in Both Demand and Supply
A change in both demand and supply changes the equilibrium price and the equilibrium quantity, but we need to know the relative magnitudes of the changes to predict some of the consequences.

45. Predicting Changes in Price and Quantity
Figure 3.10 shows the effects of a change in both demand and supply in the same direction. An increase in both demand and supply increases the equilibrium quantity but has an uncertain effect on the equilibrium price.

46. Predicting Changes in Price and Quantity
Figure 3.11 shows the effects of a change in both demand and supply when they change in opposite directions. An increase in supply and a decrease in demand lowers the equilibrium price but has an uncertain effect on the equilibrium quantity.

47. 3
DEMAND AND SUPPLY
CHAPTER
THE END