1. Demand, Supply, and Market Equilibrium3
Demand, Supply, and Market Equilibrium
This chapter provides an introduction to demand and supply concepts. Both demand and supply are defined and illustrated; determinants of demand and supply are listed and explained. The concept of equilibrium and the effects of changes in demand and supply on equilibrium price and quantity are explained and illustrated. The chapter also includes brief discussions of efficiency (productive and allocative), and price controls (floors and ceilings).
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Any institution where buyers and sellers interact
Markets
Any institution where buyers and sellers interact
Price is determined in the interactions of buyers and sellers
In this chapter the focus is on markets that are competitive. This requires large numbers of buyers and sellers acting independently.
Local markets include such markets as the farmer’s market that brings together buyers and sellers of produce in the summer.
National markets include markets like the US real estate market and international markets like the New York Stock Exchange.
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3. Amount consumers are willing and able to purchase at a given price
Demand
Schedule or curve
Amount consumers are willing and able to purchase at a given price
Other things equal
Market demand
To be part of the demand for a good consumers have to be willing and able to purchase the good. When creating demand we are assuming that the only factor that causes consumers to buy more or less is the price of the good. It is assumed that all other factors that influence the amount that consumers will buy are constant. Market demand is created by summing the individuals’ demand curves.
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4. Law of Demand
Other things equal, as price falls, quantity demanded rises, and as price rises, quantity demanded falls.
Reasons:
Common sense
Law of diminishing marginal utility
Income effect and substitution effects
An inverse relationship exists between price and quantity demanded.
Prices act as obstacles for buyers and keeps them from being able to buy everything that they ever wanted. So, it makes sense that with a limited income consumers will buy more at lower prices.
Diminishing marginal utility: The decrease in added satisfaction that results as one consumes additional units of a good or service, i.e., the second “Big Mac” yields less extra satisfaction (or utility) than the first. Since additional units yield less utility, the price has to be lower to make up for less utility.
Income effect: A lower price increases the purchasing power of money income enabling the consumer to buy more at a lower price (or less at a higher price) without having to reduce consumption of other goods.
Substitution effect: A lower price gives an incentive to substitute the lower-priced good for the now relatively higher-priced goods.
The substitution and income effects occur whenever there is a change in price and further support the law of demand.
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5. Determinants of Demand
Factors other than price
Usually assumed to be constant
When a determinant changes, demand shifts
An inverse relationship exists between price and quantity demanded.
Prices act as obstacles for buyers and keeps them from being able to buy everything that they ever wanted. So, it makes sense that with a limited income consumers will buy more at lower prices.
Diminishing marginal utility: The decrease in added satisfaction that results as one consumes additional units of a good or service, i.e., the second “Big Mac” yields less extra satisfaction (or utility) than the first. Since additional units yield less utility, the price has to be lower to make up for less utility.
Income effect: A lower price increases the purchasing power of money income enabling the consumer to buy more at a lower price (or less at a higher price) without having to reduce consumption of other goods.
Substitution effect: A lower price gives an incentive to substitute the lower-priced good for the now relatively higher-priced goods.
The substitution and income effects occur whenever there is a change in price and further support the law of demand.
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6. Determinants of Demand
Change in buyer’s tastes
Change in number of buyers
Change in income
Normal Goods
Inferior Goods
When most consumers experience the same change in tastes for a particular good, the demand for the good will change. If there is a preferable change in tastes, demand will increase. On the other hand, if there is an unfavorable change in tastes, demand will fall.
If there are more buyers in the market for a good, demand will increase whereas when there are fewer buyers in the market for a good, demand will decrease.
Normal goods are goods that we buy more of as our incomes increase. Most of the goods that we buy are normal goods. We buy fewer normal goods when our income decreases.
Inferior goods are goods we buy more of as our income decreases. We buy fewer inferior goods as our income increases.
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7. Determinants of Demand
Change in prices of related goods
Complements
Substitutes
Chris Rock
Change in consumers’ expectations
Future prices
Future income
Future product availability
Complement goods are goods that we consume jointly. It isn’t beneficial to have one without its complement. When the price of one complement increases, the demand for the other complement decreases. When the price of one complement decreases, the demand for the other complement increases. Some examples: Cars and gasoline. Cars and tires. DVD players and DVDs.
Substitute goods are goods that we use in place of another. A perfect substitute is a good that we use in place of the other without any loss of satisfaction. If the price of one good increases, the demand for its substitute increases. If the price of one good decreases, the demand for the other substitute decreases. Some examples: Pepsi and Coke, beef and chicken.
If consumers expect the future price of a product to be higher, they increase their current demand for the product.
If consumers expect the future price of a product to be lower, they decrease their current demand for the product.
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8. Demand vs. Quantity Demanded
Change in demand
Refers to shift of entire demand curve to left or right
Cause: Change in determinants of demand
If resource prices (input prices) go up, supply decreases. If resource prices (input prices) go down, supply increases.
If technology increases, supply increases. If we adopt, or use, less efficient technology supply decreases.
If the number of sellers increase, supply increases. Economic profits in the market draw producers from less profitable markets into this market. If the number of sellers decrease, supply decreases. Economic losses in the market cause producers to leave market.
If taxes are increased on a specific product, supply decreases. If taxes are decreased, or eliminated on a specific product, supply increases. If subsidies are increased on a specific product, supply increases. If subsidies are decreased on a specific product, supply decreases.
If the price of another good that the producer could produce with the same resources rises, the supply decreases for the product the producers are currently producing.
If the price of another good that the producer could produce with the same resources falls, the supply increases for the product the producers are currently producing.
If producers expect that the price of the product they are producing will be higher in the future, they cut back on current supply and supply will decrease. If producers expect the price of the product they are producing will be lower in the future, they increase current supply to take advantage of the currently higher price.
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9. Demand vs. Quantity Demanded
Change in quantity demanded
Refers to movement from one point to another on fixed demand curve
Cause: Change in price of good under consideration
If resource prices (input prices) go up, supply decreases. If resource prices (input prices) go down, supply increases.
If technology increases, supply increases. If we adopt, or use, less efficient technology supply decreases.
If the number of sellers increase, supply increases. Economic profits in the market draw producers from less profitable markets into this market. If the number of sellers decrease, supply decreases. Economic losses in the market cause producers to leave market.
If taxes are increased on a specific product, supply decreases. If taxes are decreased, or eliminated on a specific product, supply increases. If subsidies are increased on a specific product, supply increases. If subsidies are decreased on a specific product, supply decreases.
If the price of another good that the producer could produce with the same resources rises, the supply decreases for the product the producers are currently producing.
If the price of another good that the producer could produce with the same resources falls, the supply increases for the product the producers are currently producing.
If producers expect that the price of the product they are producing will be higher in the future, they cut back on current supply and supply will decrease. If producers expect the price of the product they are producing will be lower in the future, they increase current supply to take advantage of the currently higher price.
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10. Amount producers are willing and able to sell at a given price
Supply
Schedule or curve
Amount producers are willing and able to sell at a given price
Other things equal
Market supply
To be part of the supply of a good producers have to be willing and able to produce the good. When creating supply we are assuming that the only factor that causes firms to produce more or less is the price of the good. It is assumed that all other factors that influence the amount that firms will produce are constant. Market supply is created by summing the individual firms’ supply curves.
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11. Higher prices act as an incentive to producers
Law of Supply
Other things equal, as price rises quantity supplied rises and as price falls quantity supplied falls.
Reason:
Higher prices act as an incentive to producers
At some point costs will rise
Producers are willing to produce and sell more of their product at a high price than at a low price. There is a direct relationship between price and quantity supplied.
Given product costs, a higher price means greater profits and thus an incentive to increase the quantity supplied.
Beyond some level of output producers usually encounter increasing costs per added unit of output.
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12. Determinants of Supply
Factors other than price
Usually assumed to be constant
When a determinant changes, supply shifts
An inverse relationship exists between price and quantity demanded.
Prices act as obstacles for buyers and keeps them from being able to buy everything that they ever wanted. So, it makes sense that with a limited income consumers will buy more at lower prices.
Diminishing marginal utility: The decrease in added satisfaction that results as one consumes additional units of a good or service, i.e., the second “Big Mac” yields less extra satisfaction (or utility) than the first. Since additional units yield less utility, the price has to be lower to make up for less utility.
Income effect: A lower price increases the purchasing power of money income enabling the consumer to buy more at a lower price (or less at a higher price) without having to reduce consumption of other goods.
Substitution effect: A lower price gives an incentive to substitute the lower-priced good for the now relatively higher-priced goods.
The substitution and income effects occur whenever there is a change in price and further support the law of demand.
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13. Determinants of Supply
A change in resource prices
A change in technology
A change in the number of sellers
A change in taxes and subsidies
A change in prices of other goods
A change in producer expectations
If resource prices (input prices) go up, supply decreases. If resource prices (input prices) go down, supply increases.
If technology increases, supply increases. If we adopt, or use, less efficient technology supply decreases.
If the number of sellers increase, supply increases. Economic profits in the market draw producers from less profitable markets into this market. If the number of sellers decrease, supply decreases. Economic losses in the market cause producers to leave market.
If taxes are increased on a specific product, supply decreases. If taxes are decreased, or eliminated on a specific product, supply increases. If subsidies are increased on a specific product, supply increases. If subsidies are decreased on a specific product, supply decreases.
If the price of another good that the producer could produce with the same resources rises, the supply decreases for the product the producers are currently producing.
If the price of another good that the producer could produce with the same resources falls, the supply increases for the product the producers are currently producing.
If producers expect that the price of the product they are producing will be higher in the future, they cut back on current supply and supply will decrease. If producers expect the price of the product they are producing will be lower in the future, they increase current supply to take advantage of the currently higher price.
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14. Supply vs. Quantity Supplied
Change in supply
Refers to shift of entire supply curve to left or right
Cause: Change in determinants of supply
If resource prices (input prices) go up, supply decreases. If resource prices (input prices) go down, supply increases.
If technology increases, supply increases. If we adopt, or use, less efficient technology supply decreases.
If the number of sellers increase, supply increases. Economic profits in the market draw producers from less profitable markets into this market. If the number of sellers decrease, supply decreases. Economic losses in the market cause producers to leave market.
If taxes are increased on a specific product, supply decreases. If taxes are decreased, or eliminated on a specific product, supply increases. If subsidies are increased on a specific product, supply increases. If subsidies are decreased on a specific product, supply decreases.
If the price of another good that the producer could produce with the same resources rises, the supply decreases for the product the producers are currently producing.
If the price of another good that the producer could produce with the same resources falls, the supply increases for the product the producers are currently producing.
If producers expect that the price of the product they are producing will be higher in the future, they cut back on current supply and supply will decrease. If producers expect the price of the product they are producing will be lower in the future, they increase current supply to take advantage of the currently higher price.
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15. Supply vs. Quantity Supplied
Change in quantity supplied
Refers to movement from one point to another on fixed supply curve
Cause: Change in price of good under consideration
If resource prices (input prices) go up, supply decreases. If resource prices (input prices) go down, supply increases.
If technology increases, supply increases. If we adopt, or use, less efficient technology supply decreases.
If the number of sellers increase, supply increases. Economic profits in the market draw producers from less profitable markets into this market. If the number of sellers decrease, supply decreases. Economic losses in the market cause producers to leave market.
If taxes are increased on a specific product, supply decreases. If taxes are decreased, or eliminated on a specific product, supply increases. If subsidies are increased on a specific product, supply increases. If subsidies are decreased on a specific product, supply decreases.
If the price of another good that the producer could produce with the same resources rises, the supply decreases for the product the producers are currently producing.
If the price of another good that the producer could produce with the same resources falls, the supply increases for the product the producers are currently producing.
If producers expect that the price of the product they are producing will be higher in the future, they cut back on current supply and supply will decrease. If producers expect the price of the product they are producing will be lower in the future, they increase current supply to take advantage of the currently higher price.
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16. Occurs when current price is too low
Market Shortage
Occurs when current price is too low
Quantity demanded exceeds quantity supplied at the current price
Current price will rise.
At prices below this equilibrium, note that there is an excess quantity demanded, or shortage.
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17. Occurs when current price is too high
Market Surplus
Occurs when current price is too high
Quantity supplied exceeds quantity demanded at the current price
Current price will fall
The equilibrium price is also known as the market clearing price. Graphically, note that the equilibrium price and quantity are where the supply and demand curves intersect. This is an IMPORTANT point to recognize and remember. Note that it is NOT correct to say supply equals demand!
Rationing function of prices is the ability of competitive forces of supply and demand to establish a price where buying and selling decisions are coordinated.
At prices above this equilibrium, note that there is an excess quantity supplied, or a surplus.
At prices below this equilibrium, note that there is an excess quantity demanded, or shortage.
At equilibrium the markets are efficient. Firms are producing in the least costly manner, achieving productive efficiency. Price is equal to marginal cost, achieving allocative efficiency.
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18. Price which equates quantity demanded and quantity supplied
Market Equilibrium
Price which equates quantity demanded and quantity supplied
No reason for price to change
Crisis
The equilibrium price is also known as the market clearing price. Graphically, note that the equilibrium price and quantity are where the supply and demand curves intersect. This is an IMPORTANT point to recognize and remember. Note that it is NOT correct to say supply equals demand!
Rationing function of prices is the ability of competitive forces of supply and demand to establish a price where buying and selling decisions are coordinated.
At prices above this equilibrium, note that there is an excess quantity supplied, or a surplus.
At prices below this equilibrium, note that there is an excess quantity demanded, or shortage.
At equilibrium the markets are efficient. Firms are producing in the least costly manner, achieving productive efficiency. Price is equal to marginal cost, achieving allocative efficiency.
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