Chapter 3: Where Prices Come From – The Interaction of Demand and Supply

Chapter Outline

• The Demand Side of the Market

• The Supply Side of the Market

• Market Equilibrium: Putting Demand and Supply Together

• The Effect of Demand and Supply Shifts on Equilibrium

The Demand Side of the Market

Understanding Demand and Its Influencing Variables

Demand refers to the willingness and ability of consumers to purchase a good or service at various prices. The concept of market demand aggregates the demand of all consumers for a particular product.

• Market Demand: The total demand by all consumers for a given good or service.

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

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

Quantity Demanded and the Law of Demand

The quantity demanded is the amount of a good or service that a consumer is willing and able to purchase at a given price. The law of demand states that, holding everything else constant, as the price of a product falls, the quantity demanded increases, and as the price rises, the quantity demanded decreases.

• Law of Demand: $\text{If } P \downarrow, Q_d \uparrow; \text{ if } P \uparrow, Q_d \downarrow$

Explaining the Law of Demand: Substitution and Income Effects

Two main effects explain the law of demand:

• Substitution Effect: Consumers substitute toward goods whose prices have fallen, making them relatively more attractive.

• Income Effect: A lower price increases consumers' purchasing power, allowing them to buy more.

Ceteris Paribus in Demand Analysis

When analyzing demand, economists use the ceteris paribus ("all else equal") condition to isolate the effect of price changes by holding other variables constant.

Shifts in the Demand Curve

A change in a non-price factor affecting demand causes the entire demand curve to shift. A shift to the right indicates an increase in demand; a shift to the left indicates a decrease.

• Increase in Demand: Demand curve shifts right.

• Decrease in Demand: Demand curve shifts left.

Variables That Shift Market Demand

• Income: Higher income increases demand for normal goods, decreases demand for inferior goods.

• Prices of Related Goods: Higher price of substitutes increases demand; higher price of complements decreases demand.

• Tastes: Changes in consumer preferences can increase or decrease demand.

• Population and Demographics: Larger or changing populations affect demand for specific goods.

• Expected Future Prices: Anticipated price changes can shift current demand.

• Natural Disasters and Pandemics: Temporary disruptions can alter demand patterns.

Normal and Inferior Goods

• Normal Good: Demand increases as income rises (e.g., new clothes, restaurant meals).

• Inferior Good: Demand increases as income falls (e.g., second-hand clothes, instant noodles).

Substitutes and Complements

• Substitutes: Goods that can replace each other (e.g., Big Mac and Whopper).

• Complements: Goods used together (e.g., Big Mac and McDonald's fries).

Change in Demand vs. Change in Quantity Demanded

• Change in Quantity Demanded: Movement along the demand curve due to a price change.

• Change in Demand: Shift of the entire demand curve due to non-price factors.

The Supply Side of the Market

Understanding Supply and Its Influencing Variables

Supply refers to the willingness and ability of firms to provide goods or services at various prices. The market supply aggregates the supply decisions of all firms.

• Supply Schedule: A table showing the relationship between the price of a product and the quantity supplied.

• Supply Curve: A graphical representation of the relationship between price and quantity supplied.

Quantity Supplied and the Law of Supply

The quantity supplied is the amount of a good or service that a firm is willing and able to sell at a given price. The law of supply states that, holding everything else constant, as the price of a product rises, the quantity supplied increases, and as the price falls, the quantity supplied decreases.

• Law of Supply: $\text{If } P \uparrow, Q_s \uparrow; \text{ if } P \downarrow, Q_s \downarrow$

Shifts in the Supply Curve

A change in a non-price factor affecting supply causes the entire supply curve to shift. A shift to the right indicates an increase in supply; a shift to the left indicates a decrease.

• Increase in Supply: Supply curve shifts right.

• Decrease in Supply: Supply curve shifts left.

Variables That Shift Market Supply

• Prices of Inputs: Higher input prices decrease supply; lower input prices increase supply.

• Technological Change: Improvements increase supply; restrictions decrease supply.

• Prices of Related Goods in Production: Substitutes and complements in production affect supply decisions.

• Number of Firms: More firms increase supply; fewer firms decrease supply.

• Expected Future Prices: Anticipated price changes can shift current supply.

• Natural Disasters and Pandemics: Disruptions can decrease supply.

Change in Supply vs. Change in Quantity Supplied

• Change in Quantity Supplied: Movement along the supply curve due to a price change.

• Change in Supply: Shift of the entire supply curve due to non-price factors.

Market Equilibrium: Putting Demand and Supply Together

Defining Market Equilibrium

Market equilibrium occurs when the quantity demanded equals the quantity supplied at a particular price. In perfectly competitive markets, this is called competitive market equilibrium.

• Equilibrium Price ($P^*$): The price at which $Q_d = Q_s$.

• Equilibrium Quantity ($Q^*$): The quantity traded at the equilibrium price.

Surpluses and Shortages

• Surplus: Occurs when quantity supplied exceeds quantity demanded at a given price; leads to downward pressure on price.

• Shortage: Occurs when quantity demanded exceeds quantity supplied at a given price; leads to upward pressure on price.

Interaction of Demand and Supply

Neither buyers nor sellers can dictate price in a competitive market. Price and quantity are determined by their interaction.

The Effect of Demand and Supply Shifts on Equilibrium

Predicting Changes in Price and Quantity

Shifts in demand or supply curves change the equilibrium price and quantity. The direction of change depends on which curve shifts and by how much.

	Supply Curve Unchanged	Supply Curve Shifts Right	Supply Curve Shifts Left
Demand Curve Unchanged	P unchanged Q unchanged	P decreases Q increases	P increases Q decreases
Demand Curve Shifts Right	P increases Q increases	P unchanged Q increases	P increases Q decreases
Demand Curve Shifts Left	P decreases Q decreases	P decreases Q decreases	P unchanged Q decreases

Shifts Over Time

Over time, both demand and supply may shift due to changes in population, income, technology, and market entry. The equilibrium quantity will rise, but the effect on equilibrium price depends on the relative magnitude of the shifts.

• If demand increases more than supply, both equilibrium price and quantity rise.

• If supply increases more than demand, equilibrium quantity rises but price falls.

• If shifts are equal, price may remain unchanged while quantity rises.

Movements Along vs. Shifts of Curves

• Movement Along Curve: Caused by a change in the good's own price.

• Shift of Curve: Caused by changes in non-price determinants (income, tastes, etc.).

Example Applications

• Reusable Water Bottles: Changes in consumer tastes and the entry of new firms affect both demand and supply, shifting curves and changing equilibrium price and quantity.

• Used Cars Market (2020): Supply shortages and increased demand led to higher prices.

Additional info: This summary expands on the brief points in the slides, providing definitions, examples, and context for each concept. All equations are presented in LaTeX format as required.