CH – 3 Demand, Supply, and Market know whether the demand for a product is large

Equilibrium or small

MARKETS Law of Demand

Markets bring together buyers (“demanders”) “(Other things equal) Relative price and quantity
and sellers (“suppliers”), and they exist in many demanded are inversely proportional”
forms e.g. local music store, a farmer’s roadside
stand. Relative price: Price of a good relative to its
substitutes e.g. if the price of a good and its
Markets may be local or international, face-to- substitutes increase by $5, relative price
face or not. constant.

We will focus in this chap- ter on markets WHY THE INVERSE RELATIONSHIP BETWEEN
consisting of large numbers of inde- pendently PRICE AND QUANTITY DEMANDED?
acting buyers and sellers of standardized
products.  common sense. People ordinarily do
buy more of a product at a low price
 consumption is subject to diminishing
marginal utility. And because
successive units of a particular product
In such markets, price is “discovered” through
yield less and less marginal utility,
the interacting decisions of buyers and sellers.
consumers will buy additional units
only if the price of those units is
DEMAND progressively reduced.
 The income and substitution effects
Demand: A schedule or a curve that shows the combine to make consumers able and
various amounts of a product that consumers willing to buy more of a product at a
are willing and able to purchase at each of a low price than at a high price.
series of possible prices during a specified
period of time.
Income effect: A lower price increases the
purchasing power of a buyer’s money income,
Demand shows the quantities of a product that enabling the buyer to purchase more of the
will be purchased at various possible prices, product than before.
other things equal
Substitution effect: At a lower price buyers
have the incentive to substitute what is now a
less expensive product for similar products that
are now relatively more expensive

The Demand Curve

At $5 demand is 10, at $2 demand is 5.

The data does not tell us which of the five

possible prices will actually exist in the corn
market. That depends on the interaction
between demand and supply. Demand is simply
a statement of a buyer’s plans, or intentions,
with respect to the purchase of a product.

To be meaningful, the quantities demanded at

a) Individual demand curve
each price must relate to a specific period.
Unless a specific time period is stated, we do not b) Smooth curve
c) Its downward slope reflects the law of
demand—people buy more of a
 product, service, or resource as its price
falls.

Market Demand

At each price we sum horizontally the quantities

demanded from various individual demand
curves to obtain a market demand curve.

“Demand” is a schedule or a curve; therefore, a

“change in demand” means a change in the
schedule and a shift of the curve. But the
movement from point a to point b on curve D1
represents a change in quantity demanded:
Demand has not changed; it is the entire curve,
and it remains fixed in place.

Competition, of course, ordinarily entails many Change in demand:

more than three buyers of a product. To avoid
hundreds or thousands or millions of additions, a) Caused by change in one or more
we suppose that all the buyers in a market are determinants of demand
willing and able to buy the same amounts at b) Results in shift of demand curve
each of the possible prices. Then we just c) D1 to D2 / D1 to D3
multiply those amounts by the number of
buyers to obtain the market demand.
Change in quantity demanded:
price is the most important influence on the
amount of any product purchased. But other a) Caused by change in price
factors can and do affect purchases. These b) Results in movement on demand curve
c) a to b
factors, called determinants of demand

Change in Demand

Assumed to be constant when a demand curve is let’s see how changes in each determinant affect
drawn. demand.

The basic determinants of (market) demand are: Tastes: A favorable change—a change that
makes the product more desirable— in
consumer tastes will increase the demand
a) consumers’ tastes (preferences),
b) the number of buyers in the market
c) consumers’ incomes Number of Buyers: An increase in the number of
buyers in a market is likely to increase product
d) the prices of related goods
demand
e) consumer expectations.
Income:
A change in one or more of the determinants of
demand causes a change in demand. An increase
in demand is shown as a shift of the demand a) A rise in income causes an increase in
curve to the right, as from D1 to D2. A decrease demand of normal goods.
in demand is shown as a shift of the demand b) A rise in income causes an decrease in
curve to the left, as from D1 to D3. demand of inferior goods

Normal goods (Superior goods): Products

whose demand varies directly with money
income e.g. steaks, furniture.
Inferior goods: Goods whose demand varies Upward slope of the curve reflects the law of
inversely with money income e.g. used clothing, supply.
third-hand automobiles.
Market Supply
Prices of Related Goods:
We sum the quantities supplied by each
a) Increase in price of substitute increases producer at each price by “horizontally adding”
demand the supply curves of the individual producers.
b) Increase in price of a complimentary (Exactly like for demand curve).
good decreases demand
We suppose that all the producers in a market
Substitute good: One that can be used in place are willing to supply same amounts at each of
of another good e.g. Pepsi and coca cola the possible prices.

Complementary good: One that is used Determinants of Supply

together with another good e.g. Shoes and socks
We assume that price is the most significant
Unrelated Goods: A change in the price of one influence on the quantity supplied of any
has little or no effect on the demand for the product. But other factors called determinants
other e.g. butter and football. of supply can and do affect supply.

Consumer Expectations: A new consumer The basic determinants of (market) supply:

expectation that either prices or income will be
higher in the future increases demand. a) resource prices
b) technology
SUPPLY c) taxes and subsidies
d) prices of other goods
Supply is a schedule or curve showing the e) producer expectations
various amounts of a product that producers are f) the number of sellers in the market.
willing and able to make available for sale at
each of a series of possible prices during a Resource Prices: Increase in resource prices
specific period. decreases profits and hence, decreases supply
output at a particular product price.
Law of Supply
Technology: Improvements in technology
“(Other things equal) Price and quantity supplied (techniques of production) enable firms to
are directly proportional” produce units of output with fewer resources.
Because resources are costly, using fewer of
Production is subject to increasing marginal them lowers production costs and increases
cost e.g. the workers added to increase supply.
production may have to wait to gain access to
machines. As a result, each added worker Taxes and Subsidies: An increase in sales or
produces less added output. property taxes will increase production costs
and reduce supply. In contrast, subsidies lower
The Supply Curve the producers’ costs and increases supply.

Prices of Other Goods: Increase in profits from

other goods decreases supply e.g. Firms that
produce a particular product, say, soccer balls,
can sometimes use their plant and equipment to
produce alternative goods, say, basketballs and
volleyballs. The higher prices of these “other
goods” may entice soccer ball producers to
switch production to those other goods in order
to increase profits. This substitution in
production results in a decline in the supply of
soccer balls.
 Producer Expectations: e.g. Farmers anticipating
a higher wheat price in the future might
withhold some of their current wheat harvest
from the market, thereby causing a decrease in
the current supply of wheat. In contrast, in many
types of manufactur- ing industries, newly
formed expectations that price will increase may
induce firms to add another shift of workers or
to expand their production facilities, causing
current supply to increase.

Number of Sellers: The larger the number of

suppliers, the greater the market supply Competition among buyers and among sellers
drives the price to the equilibrium price; once
Changes in Quantity Supplied there, it remains unless it is subsequently
disturbed by changes in demand or supply
(shifts of the curves).

Surpluses drive prices down. Large surplus

would prompt competing sellers to lower the
price to encourage buyers to take the surplus off
their hands.

Shortages drive prices up. Many consumers who

want to buy a good at a certain price will not
obtain it. They will express a willingness to pay
more than that price to get the good.
Competition among these buyers will drive up
the price.
Change in supply:
Rationing Function of Prices
d) Caused by change in one or more
The ability of the competitive forces of supply
determinants of supply
and demand to establish a price at which selling
e) Results in shift of supply curve
and buying decisions are consistent
f) S1 to S2 / S1 to S3

Change in quantity supplied:

Whenever resources are particularly scarce,
d) Caused by change in price demand exceeds supply and prices are driven
e) Results in movement on supply curve up. The effect of such a price rise is to
f) a to b discourage demand, conserve resources, and
spread out their use over time.
MARKET EQUILIBRIUM
Efficient Allocation
Equilibrium Price and Quantity
Productive efficiency: The production of any
Equilibrium price (or market- clearing price): particular good in the least costly way.
It is the price where quantity demanded equals
quantity supplied in a competitive market (so
that neither buyers nor sellers can set the price.)

Graphically, the equilibrium price is indicated by

a) Achieved by using the best technology
and right mix of productive resources.
the intersection of the supply curve and the
b) Profitable for businesses
demand curve.
By expending the least-valued combination of
resources to produce products, society makes
available more-valued resources to produce quantity increases
other desired goods

Allocative efficiency: The particular mix of

goods and services most highly valued by
society (minimum-cost production assumed).

Competitive markets productive allocative and

productive efficiency.

Demand essentially reflects the marginal benefit

(MB) of the good (concept of diminishing
marginal utility on demand curves), based on Demand constant, supply decreases =
the utility received. Supply reflects the marginal Equilibrium price increases and equilibrium
cost (MC) of producing the good (concept of quantity decreases
increasing marginal cost on supply curves).

The market ensures that firms produce all units

of goods for which MB>MC and no units for
which MC>MB. At the intersection of the
demand and supply curves, MB equals MC and
allocative efficiency results

Changes in Supply, Demand, and Equilibrium

Supply constant, Demand increases =

Equilibrium price and equilibrium quantity Supply Increase; Demand Decrease :
increase.
a) Both changes decrease price, so the net
result is a price drop greater than that
resulting from either change alone
b) If the increase in supply is larger than
the decrease in demand, the
equilibrium quantity will increase. But
if the decrease in demand is greater
than the increase in supply, the
equilibrium quantity will decrease.

Supply Decrease; Demand Increase

Supply constant, Demand decreases =
Equilibrium price and equilibrium quantity
a) If the increase in supply is greater than
decrease
the increase in demand, the equilibrium
price will fall. If the opposite holds, the
equilibrium price will rise.
b) Both changes increase quantity, so the
net result is a quantity rise greater than
that resulting from either change alone

Supply Decrease; Demand Decrease

a) If the decrease in supply is greater than

the decrease in demand, equilibrium
Demand constant, supply increases = price will rise. If the reverse is true,
Equilibrium price decreases and equilibrium equilibrium price will fall.
b) Both changes decrease quantity, so the
net result is a quantity drop greater
 than that resulting from either change Their goals are to protect low-income families
alone from escalating rents caused by perceived
housing shortages and to make housing more
When a decrease in demand and a decrease in affordable to the poor.
supply, or an increase in demand and an
increase in supply, exactly cancel out, the net Price controls make it less attractive for
effect on equilibrium price will be zero; price landlords to offer housing on the rental market
will not change.
Owners may sell their rental units or convert
them to condo- miniums

Insurance companies, pension funds, and other

potential new investors in hous- ing will find it
more profitable to invest in office buildings,
shopping malls, or motels, where rents are not
controlled.
Price Ceilings
Result is that too few resources are allocated to
Price ceiling sets the maximum legal price a rental housing, causing housing shortages.
seller may charge for a product or service. A
price at or below the ceiling is legal; a price Price Floors
above it is not.
A price floor is a minimum price fixed by the
Price ceilings enable consumers to obtain some govern- ment. A price at or above the price floor
“essential” good or service that they could not is legal; a price below it is not
afford at the equilibrium price.
Invoked when society feels that the free
To impact the market, a price ceiling must be function- ing of the market system has not
below the equilibrium price. A ceiling price provided a sufficient income for certain groups
above equilibrium price will have no immediate of resource suppliers
effect on the market

Effects of price ceiling:

a) The rationing ability of the free market

Effects of price floor:
is rendered ineffective > Breeds the
question, “How should the resources be
distributed among consumers?” a) Disrupts the rationing ability of the free
market.
b) Shortage (Qd - Qs)
b) Surpluses (Qs - Qd)
c) Black Markets will arise where products
c) Society fails to achieve allocative
will be sold at prices above the legal
efficiency (society devotes too many of
price to make up for the shortage.
its scarce resources to production of the
surplus good and too few to producing
Rent Controls other, more valuable, goods and
services).
Maximum rents established by law
d) Consumers pay higher prices because of
the price floor.
e) Taxpayers pay higher taxes to finance
the government’s purchase of the
surplus
f) Because of surpluses, government
erects tariffs (taxes on imports). Other
countries to retaliate with their own
tariffs against manufacturing exports.,
so exports decrease.