Chapter 3: Where Prices Come From – The Interaction of Demand and Supply (Microeconomics Study Notes)

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

Chapter Outline

• 3.1 The Demand Side of the Market

• 3.2 The Supply Side of the Market

• 3.3 Market Equilibrium: Putting Demand and Supply Together

• 3.4 The Effect of Demand and Supply Shifts on Equilibrium

Our Model of a Market

Perfectly Competitive Market

To analyze how prices are determined, economists use the model of a perfectly competitive market. This market is characterized 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.

3.1 The Demand Side of the Market

Market Demand

Market demand refers to the total demand by all consumers for a given good or service.

Demand Schedule and Demand Curve

• Demand schedule: A table showing the relationship between the price of a product and the quantity demanded.

• Demand curve: A graph showing the relationship between the price of a product and the quantity demanded.

Quantity Demanded and Law of Demand

• 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.

What Explains the Law of Demand?

• 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.

Ceteris Paribus

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

Shifting the Demand Curve

• A change in a variable other than price (e.g., income, tastes) shifts the entire demand curve.

• A shift to the right indicates an increase in demand; a shift to the left indicates a decrease in demand.

Variables That Shift Market Demand

• Income: Increases demand for normal goods, decreases demand for inferior goods.

• Prices of related goods: Substitutes and complements affect demand.

• Tastes: Changes in consumer preferences.

• Population and demographics: Changes in the number and characteristics of buyers.

• Expected future prices: Expectations about future prices affect 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 for the same purpose (e.g., Big Mac and Whopper).

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

Demographics and Tastes

• Changes in population characteristics (age, race, gender) affect demand.

• Trends and advertising can shift consumer tastes, affecting demand.

Expectations and External Events

• Expectations about future prices can increase or decrease current demand.

• Natural disasters and pandemics can temporarily shift demand for certain goods.

Change in Demand vs. Change in Quantity Demanded

• A change in price causes a movement along the demand curve (change in quantity demanded).

• A change in any other factor shifts the demand curve (change in demand).

3.2 The Supply Side of the Market

Market Supply

Market supply refers to the total amount of a product that firms are willing and able to sell at various prices.

Supply Schedule and Supply Curve

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

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

Quantity Supplied and Law of Supply

• 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.

Shifting the Supply Curve

• A change in a variable other than price shifts the entire supply curve.

• A shift to the right indicates an increase in supply; a shift to the left indicates a decrease in supply.

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: Anticipated higher prices may decrease current supply.

• Natural disasters and pandemics: Disruptions decrease supply.

3.3 Market Equilibrium: Putting Demand and Supply Together

Market Equilibrium

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

• At equilibrium price, buyers and sellers trade the same quantity.

• No tendency for price to change unless demand or supply shifts.

Surpluses and Shortages

• Surplus: Quantity supplied exceeds quantity demanded; price falls.

• Shortage: Quantity demanded exceeds quantity supplied; price rises.

3.4 The Effect of Demand and Supply Shifts on Equilibrium

Predicting Changes in Price and Quantity

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	Rises	Rises
Decrease in Demand	Falls	Falls
Increase in Supply	Falls	Rises
Decrease in Supply	Rises	Falls
Both Demand and Supply Increase	Ambiguous	Rises
Both Demand and Supply Decrease	Ambiguous	Falls

Shifts vs. Movements Along Curves

• A shift in demand or supply changes the curve itself.

• A movement along the curve is caused by a change in price.

Key Equations

• Demand function: $Q_d = f(P, I, P_r, T, N, E)$

• Supply function: $Q_s = f(P, P_i, T_e, P_r, N_f, E)$

• Equilibrium condition: $Q_d = Q_s$

Examples and Applications

• Reusable water bottles as status symbols: Changes in tastes can shift demand curves.

• Millennials and Gen Z: Demographic changes affect market demand for products like reusable water bottles.

• Covid-19 pandemic: External shocks can shift both demand and supply for various goods.

Additional info: These notes expand on textbook slides by providing definitions, examples, and equations for key microeconomic concepts related to demand, supply, and market equilibrium.