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

Where Prices Come From: The Interaction of Demand and Supply

Introduction to Market Analysis

Understanding how prices are determined in a market is a central topic in microeconomics. This chapter explores the interaction between buyers and sellers, focusing on the concepts of demand and supply in perfectly competitive markets.

• Perfectly Competitive Market: A market with many buyers and sellers, identical products, and no barriers to entry for new firms.

• Application: Examples include markets for athletic shoes, reusable water bottles, and other standardized goods.

The Demand Side of the Market

Market Demand

Market demand refers to the total demand by all consumers for a given good or service. It is the foundation for understanding how buyers behave in response to price changes.

• Market Demand: The sum of individual demands for a product from all consumers in the market.

Demand Schedule and Demand Curve

The demand schedule and demand curve illustrate the relationship between the price of a product and the quantity demanded.

• Demand Schedule: A table showing the relationship between price and quantity demanded.

• Demand Curve: A graphical representation of the demand schedule, typically downward sloping.

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

Quantity Demanded and the Law of Demand

The law of demand states that, holding everything else constant, as the price of a product falls, the quantity demanded increases, and as the price rises, the quantity demanded decreases.

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

• Law of Demand: $\text{If } P \downarrow, Q_d \uparrow; \text{ if } P \uparrow, Q_d \downarrow$

Why Does the Law of Demand Hold?

Two main effects explain the law of demand: the substitution effect and the income effect.

• Substitution Effect: Consumers switch to goods that become relatively cheaper.

• Income Effect: Lower prices increase consumers' purchasing power, allowing them to buy more.

Ceteris Paribus Condition

When analyzing demand, economists use the ceteris paribus assumption, meaning all other variables are held constant except price and quantity demanded.

• Ceteris Paribus: "All else equal" condition for isolating the effect of price changes.

Shifts in the Demand Curve

Factors other than price can shift the entire demand curve. A rightward shift indicates an increase in demand, while a leftward shift indicates a decrease.

• Increase in Demand: Demand curve shifts right.

• Decrease in Demand: Demand curve shifts left.

Variables That Shift Market Demand

• Income: Increases demand for normal goods, decreases 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: Anticipation of future price changes.

• Natural Disasters and Pandemics: Temporary disruptions to demand.

Normal and Inferior Goods

• Normal Good: Demand increases as income rises (e.g., new clothes, vacations).

• Inferior Good: Demand increases as income falls (e.g., second-hand clothes, instant noodles).

Substitutes and Complements

• Substitutes: Goods that can replace each other (e.g., Big Mac and Whopper).

• Complements: Goods used together (e.g., left and right shoes).

Examples of Demand Shifts

• Increase in income: More demand for normal goods, less for inferior goods.

• Increase in price of a substitute: More demand for the related good.

• Increase in price of a complement: Less demand for the related good.

• Change in tastes: Influencer marketing increases demand for reusable water bottles.

• Demographic changes: Aging population increases demand for medical care.

• Expectations: Anticipated price increases boost current demand.

• Pandemics: Covid-19 increased demand for home computing, decreased for restaurants.

Change in Demand vs. Change in Quantity Demanded

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

• Change in Demand: Shift of the entire demand curve due to other factors.

The Supply Side of the Market

Market Supply

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

• Market Supply: The sum of individual firms' supply in the market.

Supply Schedule and Supply Curve

• Supply Schedule: A table showing the relationship between price and quantity supplied.

• Supply Curve: A graphical representation, typically upward sloping.

Quantity Supplied and the Law of Supply

• Quantity Supplied: The amount a firm is willing and able to sell at a given price.

• Law of Supply: $\text{If } P \uparrow, Q_s \uparrow; \text{ if } P \downarrow, Q_s \downarrow$

Shifts in the Supply Curve

• Increase in Supply: Supply curve shifts right.

• Decrease in Supply: Supply curve shifts left.

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.

Examples of Supply Shifts

• Input prices: Higher plastic prices reduce supply of water bottles.

• Technological change: Efficient production methods increase supply.

• Related goods: Higher price of soybeans leads farmers to plant less corn.

• Number of firms: Entry of new firms increases supply.

• Expected prices: Oil producers may reduce current supply if future prices are expected to rise.

• Natural disasters: Hurricanes reduce supply by damaging factories.

Change in Supply vs. Change in Quantity Supplied

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

• Change in Supply: Shift of the entire supply curve due to other factors.

Market Equilibrium

Equilibrium Price and Quantity

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

• Equilibrium Price ($P^*$): The price at which $Q_d = Q_s$.

• Equilibrium Quantity ($Q^*$): The quantity traded at equilibrium price.

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 Demand and Supply

Neither buyers nor sellers alone can dictate price in a competitive market. Changes in demand or supply affect both equilibrium price and quantity.

Effects of Shifts in Demand and Supply on Equilibrium

Directional changes in equilibrium price and quantity can be predicted by analyzing shifts in demand and supply curves.

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

Shifts Over Time

Over time, both demand and supply may shift due to changes in market conditions, technology, and demographics. The effect on equilibrium price is ambiguous without knowing the relative magnitude of each shift, but equilibrium quantity will rise if both curves shift right.

Application: Sticker Shock in the Used Car Market

In 2020, prices for used cars rose due to supply shortages for new cars and increased demand for used cars. Rental companies reduced their fleets, removing a major source of used cars, leading to higher prices.

Movements Along vs. Shifts of Curves

• Movement Along Curve: Caused by price changes; affects quantity demanded or supplied.

• Shift of Curve: Caused by changes in other factors; affects demand or supply itself.

Summary: The interaction of demand and supply determines market prices and quantities. Understanding the factors that shift these curves is essential for predicting market outcomes.