Where Prices Come From: The Interaction of Demand and Supply

Vocabulary and Key Concepts

This section introduces foundational terms and concepts essential for understanding how prices are determined in a market economy through the interaction of demand and supply.

• Perfectly Competitive Market: A market with many buyers and sellers, where all firms sell identical products and there are no barriers to new firms entering the market.

• Demand Schedule: A table that shows the relationship between the price of a product and the quantity of the product demanded.

• Demand Curve: A graphical representation showing the relationship between the price of a product and the quantity demanded.

• Quantity Demanded: The amount of a good or service that a consumer is willing and able to purchase at a given price.

• Substitution Effect: The change in quantity demanded of a good that results from a change in its price, making the good more or less expensive relative to other goods, holding purchasing power constant.

• Income Effect: The change in quantity demanded of a good resulting from a change in the good's price on the consumer's purchasing power.

• Normal Good: A good for which demand increases as income rises and decreases as income falls.

• Inferior Good: A good for which demand increases as income falls and decreases as income rises.

• Substitutes: Goods that can be used for the same purpose; an increase in the price of one leads to an increase in demand for the other.

• Complements: Goods that are used together; an increase in the price of one leads to a decrease in demand for the other.

Law of Demand

The Law of Demand states that, holding all else constant, when the price of a product increases, the quantity demanded decreases, and when the price decreases, the quantity demanded increases.

• Explanation:

  1. Consumers substitute toward the good whose price has fallen (substitution effect).

  2. Consumers have more purchasing power, which is similar to an increase in income (income effect).

• Mathematical Representation:

  •   (Quantity demanded is a function of price)

  • Typically,   (The slope of the demand curve is negative)

• Example: If the price of coffee decreases, consumers may buy more coffee both because it is cheaper than tea (substitution effect) and because their real income allows them to buy more (income effect).

Variables That Shift Market Demand

Several factors, other than the price of the product itself, can cause the entire demand curve to shift. A shift to the right indicates an increase in demand, while a shift to the left indicates a decrease.

• Changes in Income:

  • For normal goods, higher income increases demand.

  • For inferior goods, higher income decreases demand.

• Changes in Prices of Related Goods:

  • Substitutes: An increase in the price of one good increases demand for its substitute.

  • Complements: An increase in the price of one good decreases demand for its complement.

• Changes in Tastes: If a good becomes more popular, demand increases.

• Changes in Population and Demographics: An increase in the number of buyers increases demand.

• Changes in Expected Future Prices: If consumers expect prices to rise in the future, current demand increases.

• Natural Disasters and Pandemics: These can shift demand for certain goods up or down depending on the situation.

Change in Demand vs. Change in Quantity Demanded

It is important to distinguish between a movement along the demand curve and a shift of the demand curve.

• Change in Quantity Demanded: Caused by a change in the price of the product being examined; represented by a movement along the demand curve.

• Change in Demand: Caused by any other factor (income, tastes, prices of related goods, etc.); represented by a shift of the entire demand curve.

• Example: If the price of ice cream falls, the quantity demanded increases (movement along the curve). If consumer income rises and ice cream is a normal good, the demand curve shifts to the right (increase in demand).

Summary Table: Factors Affecting Demand

Additional info: The supply side and market equilibrium are also crucial in determining prices, but are not covered in this excerpt. For a complete understanding, study the interaction of both demand and supply curves.