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, which has:

• Many buyers and sellers

• All firms selling identical products

• No barriers to entry for new firms

While 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 is 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 graph showing the relationship between price and quantity demanded.

Example Table: Demand Schedule

Price (dollars per bottle)	Quantity (millions of bottles per week)
30	2
25	4
20	6
15	7

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, quantity demanded decreases.

What Explains the Law of Demand?

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

• Income effect: Consumers have more purchasing power when prices fall, increasing quantity demanded.

Ceteris Paribus

When drawing the demand curve, we assume ceteris paribus ("all else equal"), meaning other variables are held constant.

Shifting the Demand Curve

• A change in something other than price that affects demand shifts the entire demand curve.

• A shift to the right (D1 to D2) is an increase in demand.

• A shift to the left (D1 to D3) is a decrease in demand.

Variables That Shift Market Demand

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

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

• Tastes: Changes in consumer preferences.

• Population and demographics: Changes in population size or composition.

• Expected future prices: Anticipation of future price changes.

• Natural disasters and pandemics: Temporary disruptions to economic activity.

Table: Types of Goods

Type	Definition	Examples
Normal Good	Demand increases as income rises	New clothes, restaurant meals, vacations
Inferior Good	Demand increases as income falls	Second-hand clothes, instant noodles

Effects of Changes in Income

• Increase in income increases demand for normal goods (shift right).

• Increase in income decreases demand for inferior goods (shift left).

Changes in the Price of Related Goods

• Substitutes: Goods used for the same purpose (e.g., Big Mac and Whopper).

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

Effects of Changes in the Price of Related Goods

• Increase in price of a substitute increases demand for the other good.

• Increase in price of a complement decreases demand for the other good.

Changes in Tastes

• If consumer tastes change, demand may increase or decrease.

• Example: Influencer marketing increases demand for reusable water bottles.

Changes in Population/Demographics

• Demographics: Characteristics of a population (age, race, gender).

• Increase in population increases demand for goods.

• Example: Aging population increases demand for medical care.

Changes in Expectations About Future Prices

• Expected increase in future price increases current demand.

• Expected decrease in future price decreases current demand.

• Example: Anticipated rise in gasoline prices increases current demand.

Natural Disasters and Pandemics

• Temporary disruptions can decrease demand for some goods and increase for others.

• Example: COVID-19 reduced demand for restaurants, increased demand for home computing equipment.

Change in Demand vs. Change in Quantity Demanded

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

• Change in other factors shifts the demand curve (change in demand).

3.2 The Supply Side of the Market

Market Supply

Market supply refers to the decisions of firms about how much of a product to provide at various prices.

Supply Schedule and Supply Curve

• Supply schedule: Table showing relationship between price and quantity supplied.

• Supply curve: Graph showing relationship between price and quantity supplied.

Example Table: Supply Schedule

Price (dollars per bottle)	Quantity (millions of bottles per week)
30	7
25	5
20	4
15	2

Quantity Supplied and Law of Supply

• Quantity supplied: Amount 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 something other than price shifts the entire supply curve.

• Shift to the right (S1 to S2): Increase in supply.

• Shift to the left (S1 to S3): 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 in the market: More firms increase supply; fewer firms decrease supply.

• Expected future prices: Anticipated higher future prices may decrease current supply.

• Natural disasters and pandemics: Disruptions decrease supply.

Change in Prices of Inputs

• Inputs: Anything used in production (e.g., plastic, labor, transportation).

• Increase in input price decreases supply; decrease in input price increases supply.

Technological Change

• Positive change (e.g., more efficient production) increases supply.

• Negative change (e.g., government restrictions) decreases supply.

3.3 Market Equilibrium: Putting Demand and Supply Together

Market Equilibrium

• Market equilibrium: Quantity demanded equals quantity supplied.

• In a competitive market, equilibrium price and quantity are determined by the intersection of demand and supply curves.

Surpluses and Shortages

• Surplus: Quantity supplied exceeds quantity demanded; price falls.

• Shortage: Quantity demanded exceeds quantity supplied; price rises.

3.4 The Effect of Demand and Supply Shifts on Equilibrium

Predicting Changes in Price and Quantity

• Shifts in demand or supply curves change equilibrium price and quantity.

• Increase in demand raises both equilibrium price and quantity.

• Increase in supply lowers equilibrium price but raises equilibrium quantity.

Table: How Shifts in Demand and Supply Affect Equilibrium

Change	Equilibrium Price (P)	Equilibrium Quantity (Q)
Increase in Demand	Rises	Rises
Decrease in Demand	Falls	Falls
Increase in Supply	Falls	Rises
Decrease in Supply	Rises	Falls

Shifts of a Curve vs. Movements Along a Curve

• A shift in supply or demand changes the curve itself.

• A movement along the curve is caused by a change in price.

• Decrease in price causes movement along the demand curve, not a shift.

Examples and Applications

• Sticker shock in used cars: Supply shortages and increased demand led to higher prices.

• Millennials and Gen Z: Changing tastes affect market demand for products like reusable water bottles.

• Natural disasters and pandemics: COVID-19 shifted demand and supply in multiple markets.

Key Equations

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

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

• Market equilibrium: $Q_d = Q_s$

Where: $Q_d$ = Quantity demanded $Q_s$ = Quantity supplied $P$ = Price $I$ = Income $P_r$ = Price of related goods $T$ = Tastes $N$ = Population $E$ = Expectations $P_i$ = Price of inputs $T_e$ = Technological change $N_f$ = Number of firms

Additional info: These notes expand on the textbook slides by providing definitions, examples, and equations for key concepts in demand and supply analysis, suitable for exam preparation in a college-level macroeconomics course.