Supply, Demand, and the Market Process: Chapter 3 Study Notes

Supply, Demand, and the Market Process

Overview

This chapter introduces the fundamental concepts of supply and demand, the market equilibrium, and how shifts in supply and demand affect market outcomes. Understanding these principles is essential for analyzing how markets allocate resources and determine prices.

• 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

The Law of Demand

The law of demand states that, holding all else constant, as the price of a product falls, the quantity demanded increases; as the price rises, the quantity demanded decreases. This relationship results in a downward-sloping demand curve.

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

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

Equation:

$Q_d = f(P)$   (Quantity demanded is a function of price)

Deriving the Demand Curve

The demand curve shows the relationship between price and quantity demanded, holding other factors constant (ceteris paribus).

• As price increases, quantity demanded decreases.

• As price decreases, quantity demanded increases.

Demand vs. Quantity Demanded

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

• Change in Quantity Demanded: Movement along the demand curve due to a change in the price of the good.

• Change in Demand: A shift of the entire demand curve caused by factors other than the price of the good.

Shifters of Demand

Factors that shift the demand curve include:

• Change in Consumer Income:

  • Normal Goods: Demand increases as income rises.

  • Inferior Goods: Demand increases as income falls.

• Change in Population/Demographics: Changes in the size or composition of the population affect demand.

• Change in the Price of Related Goods:

  • Substitutes: Goods that can replace each other; an increase in the price of one increases demand for the other.

  • Complements: Goods used together; an increase in the price of one decreases demand for the other.

• Change in Expectations: Expectations about future prices or income can shift demand.

• Change in Consumer Tastes and Preferences: Changes in preferences can increase or decrease demand for specific goods.

The Supply Side of the Market

The Law of Supply

The law of supply states that, holding all else constant, increases in price cause increases in the quantity supplied, and decreases in price cause decreases in the quantity supplied. This relationship results in an upward-sloping supply curve.

Equation:

$Q_s = f(P)$   (Quantity supplied is a function of price)

Deriving the Supply Curve

• As price increases, quantity supplied increases.

• As price decreases, quantity supplied decreases.

Supply vs. Quantity Supplied

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

• Change in Quantity Supplied: Movement along the supply curve due to a change in the price of the good.

• Change in Supply: A shift of the entire supply curve caused by factors other than the price of the good.

Shifters of Supply

Factors that shift the supply curve include:

• Prices of Inputs: Higher input prices decrease supply; lower input prices increase supply.

• Change in Technology: Technological improvements increase supply.

• Prices of Related Goods in Production:

  • Substitutes in Production: Firms may switch production between alternative products.

  • Complements in Production: Some goods are produced together.

• Number of Firms in the Market: More firms increase supply.

• Expected Future Prices: Expectations about future prices can affect current supply decisions.

• Other Factors: Natural events, political disruptions, and changes in taxes can shift supply.

Market Equilibrium

Definition and Properties

Market equilibrium occurs when quantity demanded equals quantity supplied. At this point, the market is in balance, and there is no tendency for price to change.

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

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

Equation:

$Q_d = Q_s$

Surplus and Shortage

• Surplus (Excess Supply): Quantity supplied > quantity demanded; leads to downward pressure on price.

• Shortage (Excess Demand): Quantity demanded > quantity supplied; leads to upward pressure on price.

Economic Efficiency

A market is economically efficient when all potential gains from trade are realized. Transactions are efficient only if they create more benefit than cost.

Changes in Demand and Supply

Effects of Changes in Demand

• Increase in Demand: Both equilibrium price and quantity increase.

• Decrease in Demand: Both equilibrium price and quantity decrease.

Effects of Changes in Supply

• Increase in Supply: Equilibrium price decreases, equilibrium quantity increases.

• Decrease in Supply: Equilibrium price increases, equilibrium quantity decreases.

Simultaneous Changes

If both supply and demand change at the same time, the effect on equilibrium price and quantity depends on the relative magnitude and direction of the shifts.

Elasticity

Price Elasticity of Demand and Supply

Elasticity measures how sensitive quantity demanded or supplied is to changes in price.

• Elastic: Quantity changes significantly in response to price changes (flatter curves).

• Inelastic: Quantity changes little in response to price changes (steeper curves).

Equation:

$E_d = \frac{\% \text{ change in quantity demanded}}{\% \text{ change in price}}$

$E_s = \frac{\% \text{ change in quantity supplied}}{\% \text{ change in price}}$

Perfectly Competitive Markets

Characteristics

A perfectly competitive market is defined by:

• 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.

Invisible Hand Principle

Market Coordination

The invisible hand principle describes how individuals pursuing their own interests can promote the economic well-being of society, primarily through the price mechanism.

• Market prices communicate information

• Prices coordinate the actions of market participants

• Prices motivate economic players

Example: The story "I, Pencil" by Leonard Read illustrates how market prices guide the production and distribution of goods without central planning.

Summary Table: Shifters of Demand and Supply

Shifters of Demand	Shifters of Supply
Consumer income (normal/inferior goods)	Prices of inputs
Population/demographics	Technology
Prices of related goods (substitutes/complements)	Prices of related goods in production
Expectations (future prices/income)	Number of firms in the market
Consumer tastes and preferences	Expected future prices
Additional info: Government policy, advertising	Other factors: Natural events, taxes, regulations