Market Demand and Supply: Where Prices Come From

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

Introduction to Market Analysis

This chapter explores how prices are determined in markets through the interaction of buyers and sellers. The focus is on the model of a perfectly competitive market and the foundational concepts of demand and supply.

Perfectly Competitive Market

Definition and Assumptions

• Perfectly competitive market: A market characterized by:

  • Many buyers and sellers

  • All firms selling identical (homogeneous) products

  • No barriers to entry for new firms

• Although these assumptions are restrictive, the model is useful for analyzing many real-world markets.

The Demand Side of the Market

Market Demand

• Market demand: 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 the price of a product and the quantity demanded.

Example: The demand schedule for water bottles might look like:

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

Quantity Demanded and the 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.

Why the Law of Demand Holds

• 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 Condition

• Ceteris paribus: Latin for "all else equal"; when analyzing the relationship between two variables, all other variables are held constant.

Shifts in the Demand Curve

What Causes Demand to Shift?

• A change in a non-price factor causes the entire demand curve to shift.

• Rightward shift: Increase in demand

• Leftward shift: Decrease in demand

Variables That Shift Market Demand

• Income: Demand for normal goods increases with income; demand for inferior goods decreases with income.

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

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

• Population and demographics: More buyers or changes in population characteristics can shift demand.

• Expected future prices: Expectations about future prices can affect current demand.

• Natural disasters and pandemics: Can temporarily disrupt demand for certain goods.

Types of 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).

Related Goods

• Substitutes: Goods used in place of each other (e.g., Big Mac and Whopper).

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

Demographics and Tastes

• Population characteristics (age, race, gender) influence demand for specific goods.

• Generational preferences (e.g., Millennials vs. Gen Z) can shift demand for products.

Expectations and External Events

• Expectations of future price increases can increase current demand.

• Natural disasters and pandemics can reduce or increase demand for certain goods (e.g., Covid-19 increased demand for home computing equipment).

Change in Demand vs. Change in Quantity Demanded

• Change in quantity demanded: Movement along the demand curve due to a price change.

• Change in demand: Shift of the entire demand curve due to a non-price factor.

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 the price of a product and the quantity supplied.

Quantity Supplied and the 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 the quantity supplied, and decreases in price cause decreases in the quantity supplied.

Shifts in the Supply Curve

What Causes Supply to Shift?

• A change in a non-price factor causes the entire supply curve to shift.

• Rightward shift: Increase in supply

• Leftward shift: 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: If firms expect higher future prices, they may decrease current supply.

• Natural disasters and pandemics: Can disrupt production and decrease supply.

Examples

• An increase in the price of plastic (input) decreases the supply of reusable water bottles.

• Technological improvements in production increase supply.

• If the price of soybeans rises, a farmer may plant less corn (substitutes in production).

• More firms entering the market increases supply.

• Hurricanes can damage factories, reducing supply.

Change in Supply vs. Change in Quantity Supplied

• Change in quantity supplied: Movement along the supply curve due to a price change.

• Change in supply: Shift of the entire supply curve due to a non-price factor.

Market Equilibrium

Definition and Determination

• Market equilibrium: The situation in which quantity demanded equals quantity supplied.

• Occurs in perfectly competitive markets; the equilibrium price is where the demand and supply curves intersect.

Surpluses and Shortages

• Surplus: Quantity supplied exceeds quantity demanded at a given price; leads to downward pressure on price.

• Shortage: Quantity demanded exceeds quantity supplied at a given price; leads to upward pressure on price.

Effects of Shifts in Demand and Supply on Equilibrium

• Changes in demand or supply shift the respective curves, affecting equilibrium price and quantity.

• Both demand and supply can shift simultaneously, with varying effects on price and quantity depending on the magnitude of each shift.

	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 ? Q increases	P increases Q ?
Demand Shifts Left	P decreases Q decreases	P ? Q decreases	P ? Q ?

Note: "?" indicates the direction depends on the relative magnitude of the shifts.

Movements Along vs. Shifts of Curves

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

• A change in a non-price factor causes a shift of the entire curve (change in demand or supply).

Key Equations

• Demand function (linear): $Q_d = a - bP$

• Supply function (linear): $Q_s = c + dP$

• Equilibrium: $Q_d = Q_s$

Summary

• Market prices and quantities are determined by the interaction of demand and supply.

• Shifts in demand or supply curves lead to changes in equilibrium price and quantity.

• Understanding the difference between movements along a curve and shifts of a curve is essential for analyzing market outcomes.