Demand, Supply, and Price: Microeconomic Foundations and Market Equilibrium

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Demand, Supply and Price

Introduction

This topic explores the fundamental question of how markets work by developing a simple model of demand and supply. By analyzing these forces, we can understand how market prices and quantities are determined, and how changes in external (exogenous) variables affect market outcomes.

Demand and supply are the core concepts for understanding market behavior.
We use models to analyze the effects of changes in one variable while holding others constant (ceteris paribus).

Economic Theory and Ceteris Paribus

Economic theory allows us to isolate the effect of a single variable by assuming all other factors remain unchanged. This approach is called ceteris paribus (Latin for "other things being equal").

Ceteris Paribus: Holding all other variables constant to analyze the impact of one change.
This method helps us understand the importance of each variable in economic models.

Demand

Determinants of Demand

Demand refers to the relationship between the price of a product and the quantity consumers wish to purchase. To analyze complex market problems, economists use robust theories to explain consumer demand, which are essential for studying taxation, market structure, and cartel behavior.

Quantity Demanded: The amount of a good or service that consumers want to purchase during a specific time period.
Quantity demanded is a desired quantity, not necessarily the amount actually purchased if supply is limited.
Measured as purchases per period (e.g., 1 million units per day).

Key Variables Influencing Quantity Demanded

Product's own price
Consumer's income
Prices of other products
Consumers’ preferences (or "tastes")
Population
Significant changes in weather

Law of Demand

The Law of Demand states that, ceteris paribus, the price of a product and the quantity demanded are negatively related. As price decreases, quantity demanded increases, and vice versa.

Consumers substitute away from more expensive products toward cheaper alternatives.
As price falls, the product becomes a more attractive option, increasing demand.

Representing Demand: Schedules and Curves

Demand Schedule: A table showing the relationship between quantity demanded and price, holding other factors constant.
Demand Curve: A graphical representation of the relationship between quantity demanded and price, ceteris paribus.

Price ($ per bushel)	Quantity Demanded (thousands of bushels per year)
20	110
40	85
60	65
80	50
100	40

Additional info: The demand curve is downward sloping, reflecting the law of demand.

Demand vs. Quantity Demanded

Demand: The entire relationship between quantity demanded and price for all possible prices.
Quantity Demanded: The specific amount desired at a particular price (a point on the demand curve).

Shifts in the Demand Curve

The demand curve assumes all factors except price are constant. Changes in other determinants cause the entire demand curve to shift.

An increase in average household income shifts the demand curve to the right (higher demand at every price).
A decrease in income or other factors can shift the curve to the left (lower demand at every price).

Common Factors Causing Demand Shifts

Consumers’ income
Prices of other goods
Consumers’ preferences
Population
Significant changes in weather

Normal and Inferior Goods

Normal Goods: Quantity demanded increases as income rises.
Inferior Goods: Quantity demanded decreases as income rises.
Example: As income increases, demand for taxis (normal good) rises, while demand for public transit (inferior good) falls.

Complements and Substitutes

Complements in Consumption: Goods consumed together (e.g., hamburgers and buns). An increase in the price of one reduces demand for both.
Substitutes in Consumption: Goods that can replace each other (e.g., hamburgers and hot dogs). An increase in the price of one increases demand for the other.

Supply

Determinants of Supply

Supply refers to the relationship between the price of a product and the quantity producers are willing to offer for sale. The supply model is essential for analyzing market outcomes and policy effects.

Quantity Supplied: The amount of a good or service producers are willing to sell during a specific time period.
Quantity supplied is a desired quantity, not necessarily the amount actually sold if demand is limited.

Law of Supply

The Law of Supply states that, ceteris paribus, the price of a product and the quantity supplied are positively related. As price increases, quantity supplied increases, and vice versa.

Higher prices make production more profitable, encouraging increased supply.

Representing Supply: Schedules and Curves

Supply Schedule: A table showing the relationship between quantity supplied and price, holding other factors constant.
Supply Curve: A graphical representation of the relationship between quantity supplied and price, ceteris paribus.

Factors Causing Supply Shifts

Price of inputs
Technology
Government taxes or subsidies
Prices of other products
Significant changes in weather
Number of suppliers

Examples of Supply Shifts

Technological innovation increases supply at every price (shift right).
Higher input prices decrease supply (shift left).
Government taxes decrease supply; subsidies increase supply.
More suppliers entering the market increases total supply.

Market Equilibrium

Determination of Price and Quantity

Market equilibrium occurs where the quantity demanded equals the quantity supplied. This intersection determines the market-clearing price and quantity.

Market: Any situation where buyers and sellers negotiate exchanges.
Equilibrium price: The price at which the market clears (no excess demand or supply).
Disequilibrium price: Any price where quantity demanded does not equal quantity supplied.

Excess Demand and Excess Supply

Excess Demand: Quantity demanded exceeds quantity supplied at a given price.
Excess Supply: Quantity supplied exceeds quantity demanded at a given price.

Shifts in Equilibrium

Changes in demand or supply shift the equilibrium price and quantity.

Increase in demand: Higher equilibrium price and quantity.
Decrease in demand: Lower equilibrium price and quantity.
Increase in supply: Lower equilibrium price, higher quantity.
Decrease in supply: Higher equilibrium price, lower quantity.

Endogenous vs. Exogenous Variables

Endogenous Variable: Explained within the theory (e.g., equilibrium price and quantity).
Exogenous Variable: Determined outside the theory (e.g., income, technology).
Comparative statics: Analyzing the effect of a change in a single exogenous variable on equilibrium.

Numerical Example

Suppose market demand and supply are given by:

Demand:
Supply:

To find equilibrium, set :

Substitute into either equation to find equilibrium quantity:

Summary

Quantity demanded and quantity supplied refer to desired amounts at specific prices.
Shifts in demand or supply curves result from changes in determinants other than price.
Market equilibrium is where quantity demanded equals quantity supplied.
Comparative statics allows prediction of market outcomes following changes in exogenous variables.