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 Determinants

Demand refers to the willingness and ability of consumers to purchase a good or service at various prices. The market demand is the total demand by all consumers for a given product.

• Market Demand: The sum of all individual demands for a 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 demand schedule, showing the relationship between price and quantity demanded.

Example: Demand Schedule for Water Bottles

Price (dollars per bottle)	Quantity (millions of bottles per week)
30	3
25	4
20	5

Law of Demand

The law of demand states that, ceteris paribus (all else equal), when the price of a product falls, the quantity demanded increases, and when the price rises, the quantity demanded decreases.

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

• Ceteris Paribus: The assumption that all other variables are held constant when analyzing the relationship between two variables.

Why Does the Law of Demand Hold?

• Substitution Effect: When the price of a good falls, it becomes relatively cheaper compared to other goods, leading consumers to substitute toward the cheaper good.

• 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 determinant of 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.

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

• Change in Demand: A shift of the entire demand curve due to factors other than the product's price.

Determinants of Demand (Factors that Shift the Demand Curve)

• Income:

  • 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).

• Prices of Related Goods:

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

  • Complements: Goods used together (e.g., water bottles and gym memberships). 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; if they expect prices to fall, current demand decreases.

• Natural Disasters and Pandemics: Events that disrupt normal economic activity can shift demand for certain goods (e.g., increased demand for home office equipment during a pandemic).

The Supply Side of the Market

Understanding Supply and Its Determinants

Supply refers to the willingness and ability of firms to produce and sell a good or service at various prices. The market supply is the total supply by all firms for a given product.

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

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

• 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

The law of supply states that, ceteris paribus, 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 determinant of 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.

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

• Change in Supply: A shift of the entire supply curve due to factors other than the product's price.

Determinants of Supply (Factors that Shift the Supply Curve)

• 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 a substitute rises, supply of the original good may decrease.

  • Complements in Production: If the price of a complement rises, supply of the original good may 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.

Market Equilibrium: Putting Demand and Supply Together

Market Equilibrium

Market equilibrium occurs where the quantity demanded equals the quantity supplied. The corresponding price is the equilibrium price, and the quantity is the equilibrium quantity.

• Equilibrium Price ($P^*$): The price at which quantity demanded equals quantity supplied.

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

Example:

• At a price of $20, consumers want to buy 5 million water bottles per week, and producers want to sell 5 million. Thus,$P^* = 20$,$Q^* = 5$ million.

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.

The Effect of Demand and Supply Shifts on Equilibrium

Predicting Changes in Price and Quantity

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

	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 may increase, decrease, or stay unchanged Q increases	P increases Q may increase, decrease, or stay unchanged
Demand Shifts Left	P decreases Q decreases	P may increase, decrease, or stay unchanged Q decreases	P decreases Q may increase, decrease, or stay unchanged

Example: Increase in Demand

• If incomes rise and reusable water bottles are a normal good, demand shifts right. Both equilibrium price and quantity rise.

Example: Increase in Supply

• If a new firm enters the market, supply shifts right. Equilibrium price falls, and equilibrium quantity rises.

Simultaneous Shifts

If both demand and supply shift, the effect on equilibrium price may be ambiguous, but the effect on equilibrium quantity can often be determined.

• If both demand and supply increase, equilibrium quantity rises, but the effect on price depends on the relative magnitude of the shifts.

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), not a shift of the curve. Only changes in non-price determinants shift the curves.

Key Terms and Formulas

• Law of Demand: $Q_d = f(P)$, where $Q_d$ decreases as $P$ increases.

• Law of Supply: $Q_s = f(P)$, where $Q_s$ increases as $P$ increases.

• Equilibrium Condition: $Q_d = Q_s$ at $P^*$.

Summary Table: Effects of Shifts in Demand and Supply

Change	Equilibrium Price	Equilibrium Quantity
Increase in Demand	Rises	Rises
Decrease in Demand	Falls	Falls
Increase in Supply	Falls	Rises
Decrease in Supply	Rises	Falls

Applications and Examples

• Reusable Water Bottles: Changes in consumer tastes, such as viewing water bottles as status symbols, can increase demand and raise both price and quantity.

• Used Cars (2020): Supply shortages for new cars and increased demand for used cars led to higher prices for used cars.

• Pandemics: Covid-19 reduced demand for in-person services but increased demand for home office equipment.