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 graphical representation of the relationship between price and 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: Consumers substitute toward the good whose price has fallen.

• Income effect: Consumers have more purchasing power, which is like an increase in income.

Substitution effect: The change in quantity demanded due to a change in price, making the good more or less expensive relative to other goods.

Income effect: The change in quantity demanded resulting from the effect of a price change on consumer purchasing power.

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 something other than price that affects demand causes the entire demand curve to shift.

• A shift to the right (D1 to D2) is an increase in demand.

• A shift to the left (D1 to D3) is a decrease in demand.

As the demand curve shifts, the quantity demanded changes at every possible price, even if the price does not change.

Variables That Shift Market Demand

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

• Prices of related goods: Increases demand for substitutes, decreases demand for complements.

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

• Population and demographics: More buyers increase demand.

• 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 McDonald's fries).

Effects of Changes in Related Goods

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

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

Changes in Tastes

If consumer tastes change, they may buy more or less of a product. For example, successful advertising for reusable water bottles increases demand for them.

Changes in Population/Demographics

Demographics refer to characteristics such as age, race, and gender. An increase in the number of buyers increases demand (e.g., more elderly people increases demand for medical care).

Changes in Expectations About Future Prices

• Expected increase in future prices increases current demand.

• Expected decrease in future prices decreases current demand.

Natural Disasters and Pandemics

• Natural disaster: Events like hurricanes or floods disrupt economic activity.

• Pandemic: Widespread disease significantly affects economic activity.

Example: The Covid-19 pandemic reduced demand for goods requiring gatherings but increased demand for home computing equipment.

Change in Demand vs. Change in Quantity Demanded

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

• Any other change affecting demand causes the entire demand curve to shift (change in demand).

3.2 The Supply Side of the Market

Market Supply

Market supply refers to the decisions of firms about how much of a product to provide 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 graphical representation of the relationship between price and 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 something other than price that affects supply causes the entire supply curve to shift.

• A shift to the right (S1 to S2) is an increase in supply.

• A shift to the left (S1 to S3) is a decrease in supply.

As the supply curve shifts, the quantity supplied changes at every possible price, even if the price does not change.

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 decisions.

• Number of firms in the market: 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.

Change in Prices of Inputs

• Inputs: Anything used in production (e.g., plastic, labor, transportation).

• Increase in input price decreases supply; decrease in input price increases supply.

Technological Change

• Positive technological change increases supply (e.g., more efficient production).

• Negative change or restrictions decrease supply.

Prices of Related Goods in Production

• Firms may switch production between substitutes (e.g., corn vs. soybeans).

• Complements in production (e.g., beef and leather) can affect supply of both goods.

Number of Firms and Expected Future Prices

• More firms increase supply; fewer firms decrease supply.

• Anticipated higher future prices may decrease current supply as firms wait to sell later.

Natural Disasters and Pandemics

• Disruptions (e.g., hurricanes, floods) reduce supply due to damaged production facilities.

Change in Supply vs. Change in Quantity Supplied

• A change in the price of the product causes a movement along the supply curve (change in quantity supplied).

• Any other change affecting supply causes the entire supply curve to shift (change in 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, and the price does not change unless there is a shift in demand or supply.

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 Buyers and Sellers

• Price is determined by the interaction of buyers and sellers.

• Neither group can dictate price in a competitive market.

• Changes in supply or demand affect price and quantity traded.

3.4 The Effect of Demand and Supply Shifts on Equilibrium

Predicting Changes in Price and Quantity

To predict changes in price and quantity, economists use demand and supply curves. The model is powerful for predicting directional changes, even if the exact magnitude is unknown.

Effects of Shifts in Demand and Supply

• An increase in demand raises equilibrium price and quantity.

• An increase in supply lowers equilibrium price and raises equilibrium quantity.

• The relative size of shifts determines the final effect on price and quantity.

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 of a Curve vs. Movements Along a Curve

• A shift in supply or demand changes equilibrium quantity and price.

• A movement along the demand or supply curve is caused by a change in the price of the good itself, not by a shift in the curve.

Key Equations

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

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

Where: $Q_d$ = quantity demanded $Q_s$ = quantity supplied $P$ = price of the good $I$ = income $P_r$ = price of related goods $T$ = tastes $N$ = number of buyers $E$ = expectations $P_i$ = price of inputs $T_e$ = technology $N_f$ = number of firms

Example Applications

• Reusable water bottles as status symbols: Changes in tastes can shift demand curves, affecting prices and quantities.

• Millennials and Gen Z: Demographic changes can shift demand for certain products.

• Covid-19 pandemic: Natural disasters and pandemics can shift both demand and supply curves.

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