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 concept of market demand aggregates the demand of all consumers for a particular product.

• 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.

• Quantity Demanded: The specific amount a consumer is willing and able to buy at a given price.

• Law of Demand: Holding all else constant, as the price of a product falls, the quantity demanded increases; as the price rises, the quantity demanded decreases.

Example: If the price of reusable water bottles drops from $30 to $20, the quantity demanded increases from 3 million to 5 million bottles per week.

Explaining the Law of Demand: Substitution and Income Effects

• Substitution Effect: When the price of a good falls, consumers substitute it for other goods, increasing its quantity demanded.

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

Example: If reusable water bottles become cheaper, consumers may buy them instead of bottled spring water (substitution effect) and may also buy more overall due to increased purchasing power (income effect).

Ceteris Paribus and Shifts in Demand

The ceteris paribus condition means 'all else equal.' When analyzing demand, other variables are held constant to isolate the effect of price changes.

• 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 factors other than price.

Variables That Shift Market Demand

• Income: Demand increases for normal goods as income rises, decreases for inferior goods.

• Prices of Related Goods: Substitutes (demand increases if the price of a substitute rises); Complements (demand decreases if the price of a complement rises).

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

• Population and Demographics: More buyers increase demand; demographic changes affect demand for specific goods.

• Expectations about Future Prices: Expected future price increases raise current demand; expected decreases lower current demand.

• Natural Disasters and Pandemics: Temporary disruptions can shift demand for certain goods.

Variable	Effect on Demand	Example
Income (Normal Good)	Increases	New clothes, vacations
Income (Inferior Good)	Decreases	Second-hand clothes, instant noodles
Price of Substitute	Increases	Reusable water bottles vs. bottled spring water
Price of Complement	Decreases	Reusable water bottles and gym memberships
Tastes	Increases/Decreases	Influencer trends for water bottles
Population	Increases	Aging population increases demand for medical care
Expectations	Increases/Decreases	Anticipated gasoline price changes
Disasters/Pandemics	Increases/Decreases	COVID-19 increased demand for home computing

The Supply Side of the Market

Understanding Supply and Its Influencing Variables

Supply refers to the willingness and ability of firms to offer goods or services for sale at various prices. Market supply aggregates the supply decisions of all firms in the market.

• 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 specific amount a firm is willing and able to sell at a given price.

• Law of Supply: Holding all else constant, as the price of a product rises, the quantity supplied increases; as the price falls, the quantity supplied decreases.

Shifts 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 factors other than 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 in production (e.g., corn vs. soybeans); complements in production (e.g., beef and leather).

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

• Expected Future Prices: Anticipated higher future prices may decrease current supply.

• Natural Disasters and Pandemics: Disruptions decrease supply.

Variable	Effect on Supply	Example
Input Prices	Decrease/Increase	Plastic cost for water bottles
Technological Change	Increase/Decrease	Efficient production methods
Related Goods	Decrease/Increase	Corn vs. soybeans; beef and leather
Number of Firms	Increase/Decrease	Entry/exit of water bottle producers
Expected Prices	Decrease/Increase	Oil producers holding supply for future
Disasters/Pandemics	Decrease	Floods damaging factories

Market Equilibrium: Putting Demand and Supply Together

Defining 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, and the market clears.

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

Example: If the equilibrium price for reusable water bottles is $20, both buyers and sellers agree to trade 5 million bottles per week.

Surpluses and Shortages

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

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

Example: At $25, there is a surplus of 2 million bottles; at $10, there is a shortage of 4 million bottles.

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 by how much.

Demand Curve	Supply Curve Unchanged	Supply Curve Shifts Right	Supply Curve Shifts Left
Unchanged	P unchanged, Q unchanged	P decreases, Q increases	P increases, Q decreases
Shifts Right	P increases, Q increases	P unchanged, Q increases	P increases, Q unchanged
Shifts Left	P decreases, Q decreases	P decreases, Q unchanged	P unchanged, Q decreases

Example: If incomes rise and reusable water bottles are a normal good, demand shifts right, raising both equilibrium price and quantity. If a new firm enters the market, supply shifts right, lowering price and increasing quantity.

Simultaneous Shifts in Demand and Supply

When both demand and supply shift, the effect on equilibrium price may be ambiguous, but equilibrium quantity will rise if both curves shift right.

• If demand increases more than supply, both price and quantity rise.

• If supply increases more than demand, quantity rises but price falls.

• If shifts are equal, price may remain unchanged.

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. Shifts are caused by changes in other variables.

Key Terms and Concepts

• Perfectly Competitive Market: Many buyers and sellers, identical products, free entry/exit.

• Normal Good: Demand increases as income rises.

• Inferior Good: Demand increases as income falls.

• Substitute: Goods used in place of each other.

• Complement: Goods used together.

• Equilibrium: Where quantity demanded equals quantity supplied.

• Surplus: Excess supply.

• Shortage: Excess demand.

Key Equations

• Law of Demand: $Q_d = f(P)$, where $Q_d$ is quantity demanded and $P$ is price.

• Law of Supply: $Q_s = f(P)$, where $Q_s$ is quantity supplied and $P$ is price.

• Market Equilibrium: $Q_d = Q_s$ at equilibrium price $P^*$.

Additional info: These notes expand on the textbook slides by providing definitions, examples, and tables for clarity and exam preparation.