1. Chapter 3:
Demand
and Supply

2. Objectives After studying this chapter, you will be able to:
Describe a competitive market and think about a price as an opportunity cost
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 a 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 requires 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 Columbia 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:

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 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 Website 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.)

7. Demand Substitution effect Income 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

8. 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.

9. Demand
Figure 3.1 on the following slide 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.

10. The Demand Curve e d c b a 3.00 2.50 Price (dollars per disc) 2.00
Figure 3.1
3.00
Demand
for CD-Rs e
2.50 d
2.00
Price (dollars per disc) c
1.50 b
1.00 a
Instructor Notes:
1) The demand curve shows the relationship between quantity demanded and price, everything else remaining the same.
2) The demand curve slopes downward: As price decreases, the quantity demanded increases.
3) The demand curve can be read in two ways. For a given price, it tells us the quantity that people plan to buy. For example, at a price of $3 a tape, the quantity demanded is 4 million tapes a week.
4) For a given quantity, the demand curve tells us the maximum price that consumers are willing and able to pay for the last tape available. For example, the maximum price that consumers will pay for the 6 millionth tape is $2.
0.50
Quantity (millions of discs per week) 17

11. Demand Price Quantity (dollars per disc) (millions of discs per week)B C D E
Instructor Notes:
1) The table shows a demand schedule listing the quantity of tapes demanded at each price if all other influences on buyers’ plans remain the same.
2) At a price of $1 a tape, 9 million tapes a week are demanded; at a price of $3 a tape, 4 million tapes a week are demanded. 14

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 changes, other than the price of the good, 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 Six main factors bring changes in demand. They are:
Prices of related goods
Income
Expected future prices
Expected future income
Population
Preferences

15. Prices of related goods
Demand
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 a substitute for CD-Rs rises, or when the price of a complement for CD-Rs falls, the demand for CD-Rs increases.

16. An Increase in Demand Price Quantity Price Quantity
Original demand schedule New demand schedule
CD burner $ CD burner $100
Price Quantity Price Quantity
(dollars (millions of discs (dollars (millions of discs
per disc) per week) per disc) per week))
A A'
B B'
C C'
D D'
E E'
Instructor Notes:
1) A change in any influence on buyers’ plans other than price itself results in a new demand schedule and a shift of the demand curve.
2) A change in the price of a Walkman changes the demand for tapes.
3) At a price of $3 a tape (row c of the table), 4 million tapes a week are demanded when the Walkman costs $200 and 8 million tapes a week are demanded when the Walkman costs only $50.
4) A fall in the price of a Walkman increases the demand for tapes because the Walkman is a complement of tapes. 24

17. An Increase in Demand and a Shift in the Demand Curve
Figure 3.2
0.50
1.00
1.50
2.00
2.50
3.00 E' D' C' B' A'
Demand for CD-Rs
(CD burner $100) E D
Price (dollar per disc) C B
Instructor Notes:
When demand increases, the demand curve shifts rightward, as shown by the shift arrow and the resulting red curve.
Demand for CD-Rs
(CD burner $200) A
Quantity (millions of discs per week) 26

18. Demand Expected future prices Income
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.

19. Demand Population Preferences
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.

20. A Change in the Quantity Demanded Versus a Change in Demand
Figure 3.3
Price
Decrease in
quantity
demanded D1
Increase in
demand D2
Decrease in
demand
Increase in
quantity
demanded D0 D0
Quantity 36

21. A Change in the Quantity Demanded Versus a Change in 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.
When one of the other factors that influence buying plans changes, there is a change in demand and a shift of the demand curve.

22. 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.

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.
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 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.
A supply schedule lists the quantities supplied at each price when all the other influences on producers’ planned sales remain the same.

25. The Supply Curve e d Supply curve c b a 3.00 Supply of CD-Rs 2.50
Figure 3.4
0.50
1.00
1.50
2.00
2.50
3.00
Supply of CD-Rs e
Price (dollar per disc) d
Supply curve c b
Instructor Notes:
1) The supply curve shows the relationship between the quantity supplied and price, everything else remaining the same.
2) The supply curve usually slopes upward: As the price of a good increases, so does the quantity supplied.
3) A supply curve can be read in two ways. For a given price, it tells us the quantity that producers plan to sell.
4) And for a given quantity, it tells us the minimum price that producers are willing to accept for that quantity. a
Quantity (millions of discs per week) 46

26. (dollars per disc) (millions of discs per week)
A Supply Schedule
Price Quantity
(dollars per disc) (millions of discs per week) A B C D E
Instructor Notes:
The table shows the supply schedule of tapes. For example, at $2 a tape, 3 million tapes a week are supplied; at $5 a tape, 6 million tapes a week are supplied. 43

27. 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.
An increase in supply causes the supply to shift rightward.
A decrease in supply causes the supply curve to shift leftward. 47

28. A Change in Supply Five main factors that bring changes to supply:
Prices of the factors of production
Price of related goods produced
Substitutes in Production
Complements in Production
Expected future prices
The number of suppliers
Technology 48

29. The Supply of CD-Rs Changes in supply
The supply of CD-Rs decreases if:
The price of a factor of production used to produce discs rises
The price of a substitute in production rises
The price of a complement in production falls
The price of a CD-R is expected to rise in the future
The number of CD-R producers decreases
A less efficient technology is used to produce CD-Rs. 55

30. The Supply of CD-Rs Changes in supply
The supply of CD-Rs increases if:
The price of a factor of production used to produce the good falls
The price of a substitute in production falls
The price of a complement in production rises
The price of a CD-R is expected to fall in the future
The number of firms supplying CD-Rs increases
More efficient technologies technology is used to produce CD-Rs. 56

31. Price Quantity Price Quantity
An Increase in Supply
Original supply schedule New supply schedule
Old technology New technology
Price Quantity Price Quantity
(dollars (millions of tapes (dollars (millions of tapes
per tape) per week) per tape) per week)
A A'
B B'
C C'
D D'
E E'
Instructor Notes:
1) A change in any influence on sellers’ plans other than the price of the good itself results in a new supply schedule and a shift of the supply curve.
2) For example, if Sonny and 3M invent a new, cost-saving technology for producing tapes, the supply of tapes changes.
3) At a price of $3 a tape, 4 million tapes a week are supplied when producers use the old technology (row c of the table) and 8 million tapes a week are supplied when producers use the new technology. 51

32. An Increase in Supply and a Shift in the Supply Curve
Supply of CD-Rs
(old technology)
0.50
1.00
1.50
2.00
2.50
3.00
Supply of CD-Rs
(new technology) a' b' c' d' e' e d
Price (dollar per disc) c b
Instructor Notes:
An advance in technology increases the supply of tapes and shifts the supply curve rightward, as shown by the shift arrow and the resulting red curve. a
Figure 3.5
Quantity (millions of discs per week) 53

33. Supply A change in the quantity supplied versus a change in 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.
When one of the other factors that influence selling plans changes, there is a change in supply and a shift of the supply curve.

34. A Change in the Quantity Supplied Versus a Change in Supply
Figure 3.6
Increase in
quantity
supplied S1
supply
Decrease in S0 S0 S2
Increase in
supply
Price
Decrease in
quantity
supplied
Quantity 62

35. 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—

36. Market Equilibrium Price as a regulator
If the price is too low, quantity demanded exceeds quantity supplied.
If the price is too high, quantity supplied exceeds quantity demanded.

37. Market Equilibrium Quantity Quantity Shortage(–) 0.50 9 0 –9
Price demanded supplied or surplus(+)
(dollars
per disc) (millions of discs per week) –9 –3
Instructor Notes:
1) If the price is $2 a tape, 6 million tapes a week are demanded and 3 million are supplied.
2) There is a shortage of 3 million tapes a week, and the price rises.
3) If the price is $4 a tape, 3 million tapes a week are demanded and 5 million are supplied.
4) There is a surplus of 2 million tapes a week, and the price falls.
5) If the price is $3 a tape, 4 million tapes a week are demanded and 4 million are supplied.
6) There is neither a shortage nor a surplus.
7) Neither buyers nor sellers have any incentive to change price.
8) The price at which the quantity demanded equals the quantity supplied is the equilibrium price. 51

38. Market Equilibrium 3.00 Supply of CD-Rs 2.50 Price (dollar per disc)
Surplus of
2 million discs
at $2 a disc
Figure 3.7
0.50
1.00
1.50
2.00
2.50
3.00
Supply of CD-Rs
Demand
for CD-Rs
Price (dollar per disc)
Equilibrium
Shortage of 3 million discs at $2 a disc
Instructor Notes:
1) If the price is $2 a tape, 6 million tapes a week are demanded and 3 million are supplied.
2) There is a shortage of 3 million tapes a week, and the price rises.
3) If the price is $4 a tape, 3 million tapes a week are demanded and 5 million are supplied.
4) There is a surplus of 2 million tapes a week, and the price falls.
5) If the price is $3 a tape, 4 million tapes a week are demanded and 4 million are supplied.
6) There is neither a shortage nor a surplus.
7) Neither buyers nor sellers have any incentive to change price.
8) The price at which the quantity demanded equals the quantity supplied is the equilibrium price.
Quantity (millions of discs per week) 46

39. 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.

40. Predicting Changes in Price and Quantity
A change in demand
When demand increases, both the price and the quantity increase.
An increase in demand shifts the demand curve rightward and creates a shortage at the original price.
The price rises and the quantity supplied increases.
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.

41. The Effect of a Change in Demand
Quantity demanded Quantity supplied
Price (millions of discs per week) millions of discs per week
(dollars/tape) CD burner $300 CD Burner $100 51

42. The Effects of a Change in Demand
Supply of CD-Rs
0.50
1.00
1.50
2.00
2.50
3.00
Figure 3.8
Demand for CD-Rs
(CD burner $100)
Price (dollar per disc)
Demand for tapes
(CD burner $300)
Quantity (millions of discs per week) 52

43. Predicting Changes in Price and Quantity
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. The Effects of a Change in Supply
Price Quantity demanded Quantity supplied
dollars/disc (millions of discs per week) (millions of tapes/week)
Old New
technology technology 51

45. The Effects of a Change in Supply
Supply of CD-Rs
(old technology)
Supply of CD-Rs
(new technology)
0.50
1.00
1.50
2.00
2.50
3.00
Price (dollar per disc)
Instructor Notes:
1) As the price falls to $2, the quantity demanded increases--shown by the blue arrow on the demand curve--to the new equilibrium quantity of 6 million tapes a week.
2) Following an increase in supply, the quantity demanded increases but demand does not change--the demand curve does not shift.
Demand for CD-Rs
Figure 3.9
Quantity (millions of disc per week) 52

46. Predicting Changes in Price and Quantity
The effects of an increase 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.
An increase in both demand and supply increases the equilibrium quantity but has an uncertain effect on the equilibrium price.

47. The Effects of an Increase in Both Demand and Supply51

48. The Effects of an Increase in Both Demand and Supply
Supply of CD-Rs
(new technology)
Supply of CD-Rs
(old technology)
0.50
1.00
1.50
2.00
2.50
3.00
Demand for tapes
(CD burner $50)
Price (dollar per disc)
Instructor Notes:
1) The new supply curve intersects the new demand curve at $3 a tape, the same price as before, but the quantity increases to 8 million tapes a week.
2) These increases in demand and supply increase the quantity but leave the price unchanged.
Demand for tapes
(CD burner $300)
Figure 3.10
Quantity (millions of discs per week) 52

49. Predicting Changes in Price and Quantity
The effects of a decrease in demand and an increase in supply
An increase in supply and a decrease in demand lowers the equilibrium price, but has an uncertain effect on the equilibrium quantity.

50. The Effects of a Decrease in Demand and an Increase in Supply51

51. The Effects of a Decrease in Demand and an Increase in Supply
Supply of CD-Rs
(old technology)
Figure 3.11
0.50
1.00
1.50
2.00
2.50
3.00
Supply of CD-Rs
(new technology)
Demand for CD-Rs
(MP3 download free
Demand for CD-Rs
(MP3 download $10)
Price (dollar per disc)
Instructor Notes:
1) The new supply curve intersects the new demand curve at $2, a lower price, but in this case the quantity remain constant at 6 million tapes a week.
2) This decrease in demand and increase in supply lowers the price but leaves the quantity unchanged.
Quantity (millions of tapes per week) 52

52. END
CHAPTER 3