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

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Supply and Demand: Foundations of Market Prices

Introduction

Understanding how prices are determined in markets is a central topic in microeconomics. This chapter explores the interaction of demand and supply, the concept of market equilibrium, and how shifts in these curves affect prices and quantities traded.

Our Model of the Market

Perfectly Competitive Market

To analyze price formation, economists often use the model of a perfectly competitive market. This market is characterized by:

Many buyers and sellers
Identical products sold by all firms
No barriers to entry for new firms

While these assumptions are restrictive, the model provides useful insights for markets such as restaurants and retail stores.

3.1 - The Demand Side of the Market

Definition of Demand

Market demand is the total demand by all consumers for a given good or service. The demand curve shows the relationship between the price of a good and the quantity demanded, holding all other factors constant (ceteris paribus).

Demand Schedule and Demand Curve

The demand schedule is a table showing the quantity of a good consumers are willing to buy at different prices. The demand curve is a graphical representation of this relationship.

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

Willingness to Pay (WTP) refers to the maximum price a consumer is willing to pay for a good.

Law of Demand

As price increases, quantity demanded decreases.
As price decreases, quantity demanded increases.

This inverse relationship is known as the Law of Demand. It is driven by two effects:

Substitution Effect: Consumers switch to relatively cheaper goods when the price of a good rises.
Income Effect: A price increase reduces consumers' purchasing power, decreasing the quantity they can buy.

Change in Quantity Demanded vs. Change in Demand

Change in Quantity Demanded: Movement along the demand curve due to a change in price.
Change in Demand: Shift of the entire demand curve due to changes in non-price factors.

Variables That Shift Market Demand

Prices of Related Goods: Substitutes and complements affect demand.
Income: Demand for normal goods increases with income; demand for inferior goods decreases.
Tastes and Preferences: Changes in consumer preferences shift demand.
Population and Demographics: Larger or changing populations affect demand.
Expectations about Future Prices: Anticipated price changes can shift current demand.
Natural Disasters and Pandemics: Disruptions can increase or decrease demand for certain goods.

Example: If influencers promote reusable water bottles, consumer tastes shift, increasing demand for these products.

3.2 - The Supply Side of the Market

Definition of Supply

Market supply is the total amount of a good or service that firms are willing and able to sell at different prices. The supply curve shows the relationship between price and quantity supplied.

Supply Schedule and Supply Curve

The supply schedule is a table showing the quantity firms are willing to sell at different prices. The supply curve is its graphical representation.

As price increases, quantity supplied increases.
As price decreases, quantity supplied decreases.

This direct relationship is known as the Law of Supply.

Change in Quantity Supplied vs. Change in Supply

Change in Quantity Supplied: Movement along the supply curve due to a change in price.
Change in Supply: Shift of the entire supply curve due to changes in non-price factors.

Variables That Shift Market Supply

Prices of Inputs: Higher input prices decrease supply; lower input prices increase supply.
Technological Change: Advances increase supply by reducing production costs.
Prices of Related Goods in Production: Changes in profitability of related goods can shift supply.
Number of Firms: More firms increase market supply.
Expected Future Prices: Anticipated price changes can affect current supply.
Natural Disasters and Pandemics: Disruptions can decrease supply.
Government Regulations: Can restrict or encourage supply.

Example: If the price of plastic rises, the supply of reusable water bottles may decrease due to higher production costs.

3.3 - Market Equilibrium: Putting Demand and Supply Together

Definition of Market Equilibrium

Market equilibrium occurs when quantity demanded equals quantity supplied. The equilibrium price is where buyers and sellers agree to trade, and the equilibrium quantity is the amount traded at that price.

Surpluses and Shortages

Surplus: Quantity supplied exceeds quantity demanded at a given price. This leads to downward pressure on price.
Shortage: Quantity demanded exceeds quantity supplied at a given price. This leads to upward pressure on price.

Example: If the price of water bottles is set above equilibrium, a surplus results and sellers lower prices to clear excess inventory.

Effect of Demand and Supply Shifts on Equilibrium

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

Change	Equilibrium Price (P)	Equilibrium Quantity (Q)
Increase in Demand	Increases	Increases
Decrease in Demand	Decreases	Decreases
Increase in Supply	Decreases	Increases
Decrease in Supply	Increases	Decreases
Both Demand and Supply Increase	Indeterminate	Increases
Both Demand and Supply Decrease	Indeterminate	Decreases

Additional info: When both curves shift, the effect on equilibrium price is ambiguous unless the relative magnitude of shifts is known. The effect on equilibrium quantity is more predictable.

Rules for Curve Shifts

Price changes cause movements along curves, not shifts.
Non-price factors cause shifts of the entire curve.
Double shifts (both demand and supply) require analysis of relative changes to determine outcomes.

Key Formulas

Demand and Supply Functions

Demand Function:
Supply Function:

Where:

= Quantity Demanded
= Quantity Supplied
= Price of the good
= Income
= Price of substitutes
= Price of complements
= Tastes
= Number of buyers
= Expectations
= Price of inputs
Tech = Technology
= Price of related goods in production
= Number of firms
Reg = Government regulations

Summary Table: Shifts in Demand and Supply

Scenario	Equilibrium Price	Equilibrium Quantity
Demand increases, Supply unchanged	Increases	Increases
Demand decreases, Supply unchanged	Decreases	Decreases
Supply increases, Demand unchanged	Decreases	Increases
Supply decreases, Demand unchanged	Increases	Decreases
Both increase	Indeterminate	Increases
Both decrease	Indeterminate	Decreases

Conclusion

The interaction of demand and supply determines market prices and quantities. Understanding the factors that shift these curves is essential for predicting market outcomes and analyzing real-world economic events.