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

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 analysis of demand helps explain how prices are determined in a market economy.

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

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

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

Key Terms and Concepts

• 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.

• Ceteris Paribus: The assumption that all other variables are held constant when analyzing the relationship between two variables (e.g., price and quantity demanded).

Why Does the Law of Demand Hold?

• Substitution Effect: When the price of a good falls, consumers substitute toward the cheaper good, increasing its quantity demanded.

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

Shifts in the Demand Curve

A change in a non-price factor causes the entire demand curve to shift:

• Rightward Shift: Increase in demand

• Leftward Shift: Decrease in demand

A change in price causes a movement along the demand curve, not a shift.

Variables That Shift Market Demand

• Income: Demand for normal goods increases as income rises; demand for inferior goods increases as income falls.

• Prices of Related Goods:

  • Substitutes: Goods used in place of each other (e.g., Coke and Pepsi). An increase in the price of one increases demand for the other.

  • Complements: Goods used together (e.g., printers and ink). An increase in the price of one decreases demand for the other.

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

• Population and Demographics: An increase in population or changes in demographic composition can increase demand for certain goods.

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

• Natural Disasters and Pandemics: Events that disrupt normal economic activity can shift demand for certain goods.

Examples

• If income rises, demand for new cars (a normal good) increases, while demand for used cars (an inferior good) may decrease.

• If the price of reusable water bottles rises, demand for bottled water (a substitute) increases, but demand for gym memberships (a complement) may decrease.

The Supply Side of the Market

Understanding Supply and Its Influencing Variables

Supply refers to the willingness and ability of firms to produce and sell a good or service at various prices. The analysis of supply helps explain how much of a good will be available at different prices.

• Market Supply: The total supply by all firms of a given good or service.

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

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

Key Terms and Concepts

• 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 the quantity supplied, and decreases in price cause decreases in the quantity supplied.

Shifts in the Supply Curve

A change in a non-price factor causes the entire supply curve to shift:

• Rightward Shift: Increase in supply

• Leftward Shift: Decrease in supply

A change in price causes a movement along the supply curve, not a shift.

Variables That Shift Market Supply

• Prices of Inputs: An increase in input prices decreases supply; a decrease increases supply.

• Technological Change: Improvements in technology increase supply; negative changes decrease supply.

• Prices of Related Goods in Production:

  • Substitutes in Production: If the price of one product rises, firms may switch to producing more of that product, reducing supply of the other.

  • Complements in Production: If the price of one product rises, supply of its complement may also increase.

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

• Expected Future Prices: If firms expect higher prices in the future, they may decrease current supply to sell more later.

• Natural Disasters and Pandemics: Disruptions can decrease supply by damaging production facilities.

Examples

• If the price of plastic (an input for water bottles) rises, the supply of water bottles decreases.

• Technological improvements in manufacturing increase the supply of goods.

Market Equilibrium: Putting Demand and Supply Together

Understanding Market Equilibrium

Market equilibrium occurs where the quantity demanded equals the quantity supplied. This intersection determines the equilibrium price and quantity in a competitive market.

• Equilibrium Price: The price at which quantity demanded equals quantity supplied.

• Equilibrium Quantity: The quantity bought and sold at the equilibrium price.

Surpluses and Shortages

• Surplus: Occurs when quantity supplied exceeds quantity demanded at a given price. This puts downward pressure on price.

• Shortage: Occurs when quantity demanded exceeds quantity supplied at a given price. This puts upward pressure on price.

Example

• At a price above equilibrium, a surplus develops, leading sellers to lower prices.

• At a price below equilibrium, a shortage develops, leading sellers to raise prices.

The Effect of Demand and Supply Shifts on Equilibrium

Predicting Changes in Price and Quantity

Shifts in demand and/or supply curves lead to changes in equilibrium price and quantity. The direction of these changes depends on which curve shifts and by how much.

• Increase in Demand: Raises both equilibrium price and quantity.

• Increase in Supply: Lowers equilibrium price but raises equilibrium quantity.

• Simultaneous Shifts: The effect on price or quantity may be ambiguous without more information.

Summary Table: Effects of Shifts in Demand and Supply

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

Movements Along vs. Shifts of Curves

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

• A change in a non-price factor causes the entire curve to shift (change in demand or supply).

Applications and Real-World Examples

• Reusable water bottles as a status symbol: Changes in tastes can shift demand.

• Used car market during 2020: Supply shortages and increased demand led to higher prices.

• Fracking and oil prices: Expectations about future prices can affect current supply decisions.

Key Equations

• General Demand Function: $Q_d = f(P, I, P_r, T, N, E)$ Where $Q_d$ = quantity demanded, $P$ = price, $I$ = income, $P_r$ = prices of related goods, $T$ = tastes, $N$ = number of buyers, $E$ = expectations.

• General Supply Function: $Q_s = f(P, P_i, T_e, P_r, N_f, E)$ Where $Q_s$ = quantity supplied, $P$ = price, $P_i$ = prices of inputs, $T_e$ = technology, $P_r$ = prices of related goods, $N_f$ = number of firms, $E$ = expectations.

Additional info: These notes are based on standard introductory macroeconomics textbook content and are suitable for exam preparation on the topic of market demand, supply, and equilibrium.