BackDemand and Supply: Foundations of Market Economics
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Demand and Supply
What is a Market?
A market is an institution or mechanism that brings together buyers (demand) and sellers (supply) to facilitate the exchange of goods, services, resources, money, or capital. Prices are determined in the market by the interaction of demand and supply.
Types of markets:
Markets for goods and services
Markets for resources
Markets for money
Markets for capital
Demand
Definition of Demand
Demand is a schedule or curve that shows the various amounts of a product that consumers are willing and able to purchase at each of a series of possible prices during a specified period of time. The key assumption is that other things are equal (ceteris paribus).
Demand Schedule and Demand Curve
Demand schedule: A table showing the amount of a good or service buyers are willing and able to purchase at various prices over a specified period of time.
Demand curve: A curve showing the amount of a good buyers are willing and able to purchase at various prices over a specified period of time.
Law of Demand
The law of demand states that, other things equal, as price falls, the quantity demanded rises, and as price rises, the quantity demanded falls. This creates a negative (inverse) relationship between price and quantity demanded.
Explanations for the law of demand:
Price acts as an obstacle to buyers.
Law of diminishing marginal utility.
Income effect.
Substitution effect.
Price as an Obstacle to Buyers
Limited income prevents consumers from buying everything they want. Lower prices allow consumers to buy more.
Law of Diminishing Marginal Utility
As one consumes additional units of a good or service, the additional satisfaction (utility) from each extra unit decreases.
Example: The second "Big Mac" provides less satisfaction than the first.
Because additional units yield less utility, the price must be lower to make up for less utility.
Income Effect
A lower price increases the purchasing power of money income, enabling consumers to buy more at a lower price (or less at a higher price) without changing consumption of other goods.
Substitution Effect
A lower price makes a good relatively cheaper compared to other goods, encouraging consumers to substitute the lower-priced good for higher-priced alternatives.
The Demand Curve
The demand curve is downward sloping, reflecting the inverse relationship between price and quantity demanded.
Price (per bushel) | Quantity Demanded (bushels per week) |
|---|---|
$5 | 10 |
$4 | 20 |
$3 | 35 |
$2 | 55 |
$1 | 80 |
The Market Demand
Market demand is the sum of all individual demands for a product from all buyers in the market.
Price (per bushel) | First Buyer | Second Buyer | Third Buyer | Total Quantity Demanded per Week |
|---|---|---|---|---|
$5 | 10 | 12 | 8 | 30 |
$4 | 20 | 23 | 17 | 60 |
$3 | 35 | 39 | 26 | 100 |
$2 | 55 | 60 | 39 | 154 |
$1 | 80 | 87 | 54 | 221 |
Changes in Demand vs. Changes in Quantity Demanded
Change in quantity demanded: Caused only by a change in price (other things equal); represented by movement along the demand curve.
Change in demand: Caused by a change in one or more determinants of demand; represented by a shift of the demand curve.
Determinants of Demand
Change in consumer tastes and preferences
Change in the number of buyers
Change in income:
Normal goods: Demand increases as income increases.
Inferior goods: Demand decreases as income increases.
Change in prices of related goods:
Complementary goods: Goods used together; demand for one increases as the price of the other falls.
Substitute goods: Goods used in place of each other; demand for one increases as the price of the other rises.
Change in consumer expectations (future prices, future income)
Supply
Definition of Supply
Supply is a schedule or curve that shows the amounts of a product that producers are willing and able to make available for sale at each of a series of possible prices during a specified period of time.
Supply Schedule and Supply Curve
Supply schedule: A table showing the amount of a good or service producers are willing and able to sell at various prices over a specified period of time.
Supply curve: A curve showing the amount of a good producers are willing and able to sell at various prices over a specified period of time.
Law of Supply
The law of supply states that, other things equal, as the price rises, the quantity supplied rises, and as the price falls, the quantity supplied falls. This creates a positive (direct) relationship between price and quantity supplied.
Explanations for the law of supply:
Price acts as an incentive to producers.
At some point, costs will rise as output increases.
The Supply Curve
The supply curve is upward sloping, reflecting the direct relationship between price and quantity supplied.
Price (per bushel) | Quantity Supplied (bushels per week) |
|---|---|
$5 | 60 |
$4 | 50 |
$3 | 35 |
$2 | 20 |
$1 | 5 |
The Market Supply
Market supply is the sum of all individual supplies from all producers in the market.
Price (per bushel) | Quantity Supplied per Producer | Number of Producers | Total Quantity Supplied per Week |
|---|---|---|---|
$5 | 60 | 200 | 12,000 |
$4 | 50 | 200 | 10,000 |
$3 | 35 | 200 | 7,000 |
$2 | 20 | 200 | 4,000 |
$1 | 5 | 200 | 1,000 |
Changes in Supply vs. Changes in Quantity Supplied
Change in quantity supplied: Caused only by a change in price (other things equal); represented by movement along the supply curve.
Change in supply: Caused by a change in one or more determinants of supply; represented by a shift of the supply curve.
Determinants of Supply
Change in resource prices
Change in technology
Change in the number of sellers
Change in taxes and subsidies
Change in prices of other goods (substitutes and complements in production)
Change in producer expectations regarding future prices
Market Equilibrium
Definition and Graphical Representation
Market equilibrium occurs where the demand curve and supply curve intersect. The equilibrium price (market-clearing price) is the price at which quantity demanded equals quantity supplied. The equilibrium quantity is the quantity corresponding to the equilibrium price.
Above equilibrium: surplus (excess supply)
Below equilibrium: shortage (excess demand)
At equilibrium: markets are economically efficient
Efficiency in Market Equilibrium
Productive efficiency: Goods are produced in the least costly way, using the best technology and the right mix of resources.
Allocative efficiency: The right mix of goods is produced, representing the combination most highly valued by society.
Equilibrium Price and Quantity
At equilibrium, the market clears, and there is no persistent shortage or surplus.
Rationing Function of Prices
The competitive forces of demand and supply automatically establish a price at which selling and buying decisions are coordinated. Prices rise and fall to eliminate shortages and surpluses.
Changes in Supply and Demand and Their Effects on Equilibrium
Increase in supply: Equilibrium price falls, equilibrium quantity rises.
Decrease in supply: Equilibrium price rises, equilibrium quantity falls.
Increase in demand: Equilibrium price rises, equilibrium quantity rises.
Decrease in demand: Equilibrium price falls, equilibrium quantity falls.
Changes in both supply and demand: The effect on equilibrium price and quantity depends on the relative magnitude of the shifts.
Change in Supply | Change in Demand | Effect on Equilibrium Price | Effect on Equilibrium Quantity |
|---|---|---|---|
Increase | Decrease | Decrease | Indeterminate |
Decrease | Increase | Increase | Indeterminate |
Increase | Increase | Indeterminate | Increase |
Decrease | Decrease | Indeterminate | Decrease |
Government Set Prices: Price Ceilings and Price Floors
Price Ceilings
A price ceiling is a legally established maximum price for a good or service, set by the government. Price ceilings are typically set below the equilibrium price to make essential goods more affordable, but they create shortages and can lead to unofficial markets (black markets).
Price ceilings distort the efficient allocation of resources and income distribution.
Price Floors
A price floor is a legally established minimum price for a good or service, set by the government. Price floors are usually set above the equilibrium price to ensure sufficient income for suppliers (e.g., farmers). Price floors create persistent surpluses.
Example: If the equilibrium price of wheat is $2 per bushel and the government sets a price floor of $3 per bushel, there will be a surplus of wheat.
Summary Table: Price Ceilings vs. Price Floors
Policy | Set Above/Below Equilibrium? | Result |
|---|---|---|
Price Ceiling | Below | Shortage |
Price Floor | Above | Surplus |
Key Equations:
Demand function:
Supply function:
Equilibrium:
Additional info: These notes provide a comprehensive overview of the foundational concepts of demand, supply, market equilibrium, and government price controls, suitable for introductory microeconomics students.
