Chapter 3: Where Prices Come From – The Interaction of Demand and Supply (Macroeconomics Study Notes)

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

Chapter Outline

• 3.1 The Demand Side of the Market

• 3.2 The Supply Side of the Market

• 3.3 Market Equilibrium: Putting Demand and Supply Together

• 3.4 The Effect of Demand and Supply Shifts on Equilibrium

Our Model of a Market

Perfectly Competitive Market

To analyze how prices are determined, economists use the model of a perfectly competitive market. This market is characterized by:

• Many buyers and sellers

• All firms selling identical products

• No barriers to entry for new firms

Although these assumptions are restrictive, the model is useful for analyzing many real-world markets.

3.1 The Demand Side of the Market

Market Demand

Market demand refers to the total demand by all consumers for a given good or service.

Demand Schedule and Demand Curve

• 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 Law of Demand

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

• Law of demand: Holding everything else constant, when the price of a product falls, the quantity demanded increases; when the price rises, the quantity demanded decreases.

What Explains the Law of Demand?

• Substitution effect: Consumers substitute toward the good whose price has fallen.

• Income effect: Lower prices increase consumers' purchasing power, allowing them to buy more.

Ceteris Paribus

When drawing the demand curve, economists assume ceteris paribus ("all else equal"), meaning all other variables are held constant except price and quantity demanded.

Shifting the Demand Curve

• A change in a non-price factor (e.g., income, tastes) shifts the entire demand curve.

• A shift to the right indicates an increase in demand; a shift to the left indicates a decrease in demand.

Variables That Shift Market Demand

• Income: Increases demand for normal goods, decreases demand for inferior goods.

• Prices of related goods: Substitutes and complements affect demand.

• Tastes: Changes in consumer preferences.

• Population and demographics: Changes in the number or characteristics of buyers.

• Expected future prices: Anticipation of future price changes affects current demand.

• Natural disasters and pandemics: Temporary disruptions can shift demand.

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 used for the same purpose (e.g., Big Mac and Whopper).

• Complements: Goods used together (e.g., water bottles and gym memberships).

Demographics and Tastes

• Demographic changes (e.g., aging population) can increase demand for specific goods.

• Changing tastes (e.g., fashion trends) can shift demand curves.

Expectations and External Events

• Expectations about future prices can increase or decrease current demand.

• Natural disasters and pandemics can temporarily shift demand for certain goods.

Change in Demand vs. Change in Quantity Demanded

• A change in price causes a movement along the demand curve (change in quantity demanded).

• A change in any other factor shifts the demand curve (change in demand).

3.2 The Supply Side of the Market

Market Supply

Market supply refers to the total amount of a product that firms are willing and able to sell at various prices.

Supply Schedule and Supply Curve

• 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 Law of Supply

• Quantity supplied: The amount of a good or service that a firm is willing and able to supply at a given price.

• Law of supply: Holding everything else constant, increases in price cause increases in quantity supplied; decreases in price cause decreases in quantity supplied.

Shifting the Supply Curve

• A change in a non-price factor (e.g., input prices, technology) shifts the entire supply curve.

• A shift to the right indicates an increase in supply; a shift to the left indicates a decrease in supply.

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.

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

• Expected future prices: Anticipation of higher future prices may decrease current supply.

• Natural disasters and pandemics: Disruptions decrease supply.

3.3 Market Equilibrium: Putting Demand and Supply Together

Market Equilibrium

Market equilibrium occurs when quantity demanded equals quantity supplied. In a perfectly competitive market, this is called competitive market equilibrium.

Surpluses and Shortages

• Surplus: Quantity supplied exceeds quantity demanded at a given price; price tends to fall.

• Shortage: Quantity demanded exceeds quantity supplied at a given price; price tends to rise.

Determination of Price

• Price is determined by the interaction of buyers and sellers.

• Neither group can dictate price in a competitive market.

3.4 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.

Effects of Shifts

• Increase in demand: Equilibrium price and quantity both rise.

• Increase in supply: Equilibrium quantity rises, equilibrium price falls.

• Both demand and supply increase: Equilibrium quantity rises; effect on price depends on relative magnitude of shifts.

Table: How Shifts in Demand and Supply Affect Equilibrium

Change	Demand Curve	Supply Curve	Equilibrium Price (P)	Equilibrium Quantity (Q)
Increase in Demand	Shifts right	No change	Rises	Rises
Decrease in Demand	Shifts left	No change	Falls	Falls
Increase in Supply	No change	Shifts right	Falls	Rises
Decrease in Supply	No change	Shifts left	Rises	Falls
Both Increase	Shifts right	Shifts right	Ambiguous	Rises

Shifts vs. Movements Along Curves

• A shift in supply or demand changes the equilibrium.

• A movement along the curve is caused by a change in price, not by a shift in the curve.

Key Equations

• Demand function: $Q_d = f(P, Y, P_r, T, N, E)$

• Supply function: $Q_s = f(P, P_i, T_e, P_r, N_f, E)$

• Equilibrium condition: $Q_d = Q_s$

Examples and Applications

• Reusable water bottles as status symbols: Changes in tastes can increase demand and affect market prices.

• Covid-19 pandemic: Shifted demand for certain goods and disrupted supply chains.

• Used car market: Supply shortages and increased demand led to higher prices.

Additional info: These notes expand on textbook slides and provide academic context, definitions, and examples for key macroeconomic concepts related to demand, supply, and market equilibrium.