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 behavior of buyers in a market and the factors that influence their purchasing decisions. Market demand is 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 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.

$Q_d = f(P)$

Explaining the Law of Demand

Two main effects explain why the law of demand holds:

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

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

Ceteris Paribus Condition

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

Shifting the Demand Curve

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

• Shift to the right: Increase in demand

• Shift to the left: Decrease in demand

A shift means quantity demanded changes at every possible price.

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 the number or characteristics of buyers.

• Expected future prices: Anticipation of 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 in place of each other (e.g., Big Mac and Whopper).

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

Effects of Changes in Related Goods

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

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

Changes in Tastes

Consumer preferences can shift demand. For example, influencer marketing can increase demand for reusable water bottles.

Population and Demographics

Demographic changes, such as an aging population, can increase demand for certain goods (e.g., medical care).

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 like hurricanes or pandemics can temporarily disrupt demand for certain goods and services.

Change in Demand vs. Change in Quantity Demanded

• Change in price: Movement along the demand curve (change in quantity demanded).

• Change in other factors: Shift of the entire demand curve (change in demand).

The Supply Side of the Market

Understanding Supply and Its Influencing Variables

Supply refers to the behavior of sellers and the factors influencing their decisions to provide goods and services. Market supply is the total supply by all firms for a given good or service.

• 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 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 quantity supplied; decreases in price cause decreases in quantity supplied.

$Q_s = f(P)$

Shifting the Supply Curve

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

• Shift to the right: Increase in supply

• Shift to the left: Decrease in supply

A shift means quantity supplied changes at every possible price.

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.

Change in Supply vs. Change in Quantity Supplied

• Change in price: Movement along the supply curve (change in quantity supplied).

• Change in other factors: Shift of the entire supply curve (change in supply).

Market Equilibrium: Putting Demand and Supply Together

Understanding Market Equilibrium

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

• Equilibrium price: The price at which buyers and sellers agree to trade.

• Equilibrium quantity: The quantity traded at the equilibrium price.

$Q_d = Q_s$

Surpluses and Shortages

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

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

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 and/or supply curves change equilibrium price and quantity. The model predicts the direction of these changes.

Examples of Shifts

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

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

Table: How Shifts in Demand and Supply Affect Equilibrium Price and Quantity

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

Shifts Over Time

Both demand and supply can shift over time due to changes in market conditions, technology, population, and preferences. The equilibrium quantity will rise, but the effect on equilibrium price depends on the relative magnitude of the shifts.

Application Example: Sticker Shock in the Market for Used Cars

In 2020, prices for used cars rose sharply due to supply shortages for new cars and increased demand for used cars. Rental car companies reduced their fleets, removing a major source of used cars. Both effects increased prices.

Shifts of a Curve vs. Movements Along a Curve

• Shift: Change in a non-price factor (e.g., technology, input prices) moves the entire curve.

• Movement along: Change in price moves along the existing curve.

For example, an increase in supply decreases equilibrium price and increases equilibrium quantity, but the decrease in price causes a movement along the demand curve, not a shift in demand.

Additional info: These notes summarize the foundational concepts of demand, supply, market equilibrium, and the effects of shifts in demand and supply, suitable for introductory macroeconomics students.