BackMicroeconomics Chapter 3: Demand, Supply, and Price Determination
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Chapter Outline and Learning Objectives
Overview
This chapter introduces the fundamental concepts of demand, supply, and price determination in microeconomics. Students will learn to identify the factors affecting demand and supply, distinguish between shifts and movements along curves, and understand how market equilibrium is established and affected by changes in demand and supply.
Demand: Factors determining quantity demanded; shifts vs. movements along the demand curve.
Supply: Factors determining quantity supplied; shifts vs. movements along the supply curve.
Price Determination: Forces driving market price to equilibrium and the effects of changes in demand and supply.
Demand
Quantity Demanded
The concept of quantity demanded refers to the total amount of a product that consumers desire to purchase in a given time period. It is important to distinguish between the quantity demanded (desired purchases) and the quantity bought (actual purchases).
Quantity demanded is a flow variable, measured over a period of time, as opposed to a stock variable, which is measured at a point in time.
Actual purchases may differ from quantity demanded due to market constraints.
Quantity Demanded and Price
The basic hypothesis in microeconomics is that, ceteris paribus (all other things being equal), the price of a product and the quantity demanded are negatively related.
As price decreases, quantity demanded increases, and vice versa.
This relationship is due to the availability of substitute products and the ability to satisfy desires more cheaply at lower prices.
Example: If the price of apples falls, consumers may buy more apples because they can satisfy their desire for fruit at a lower cost.
Demand Schedules and Demand Curves
A demand schedule is a table showing the quantity demanded at various prices. A demand curve is a graphical representation of the demand schedule, typically downward sloping.
Reference Point | Price ($ per bushel) | Quantity Demanded (thousands of bushels per year) |
|---|---|---|
U | 20 | 110 |
V | 40 | 85 |
W | 60 | 65 |
X | 80 | 50 |
Y | 100 | 40 |
The demand curve plots price on the vertical axis and quantity demanded on the horizontal axis, showing the inverse relationship.
Shifts in the Demand Curve
A shift in the demand curve occurs when a relevant variable other than the product's price changes. This results in a new demand curve.
Rightward shift: Indicates an increase in demand.
Leftward shift: Indicates a decrease in demand.
Factors causing shifts:
Consumer income (normal or inferior goods)
Prices of other goods (substitutes or complements)
Consumer tastes/preferences
Number of consumers
Significant changes in weather
Example: An increase in consumer income may shift the demand curve for apples to the right, increasing quantity demanded at every price.
Price ($ per bushel) | Quantity Demanded (Income = $50,000) | Quantity Demanded (Income = $60,000) |
|---|---|---|
20 | 110 | 140 |
40 | 85 | 110 |
60 | 65 | 90 |
80 | 50 | 70 |
100 | 40 | 55 |
Additional info: The table above illustrates how an increase in income shifts the demand curve to the right.
Movements Along vs. Shifts of the Demand Curve
Movement along the curve: Caused by a change in the product's own price; quantity demanded changes but the demand curve itself does not shift.
Shift of the curve: Caused by changes in other factors (income, tastes, etc.); the entire demand curve moves to a new position.
Supply
Quantity Supplied
The quantity supplied is the total amount of a product that firms desire to sell in a given time period. It is a flow variable, representing the amount firms are willing to sell, not necessarily the amount actually sold.
Quantity supplied is measured over a period of time.
It reflects firms' willingness to sell at various prices.
Quantity Supplied and Price
The basic hypothesis is that, ceteris paribus, the price of a product and the quantity supplied are positively related.
As price increases, quantity supplied increases, and vice versa.
Higher prices make production and sale more profitable for producers.
Example: If the price of apples rises, farmers are more willing to supply apples to the market.
Supply Schedules and Supply Curves
A supply schedule is a table showing the quantity supplied at various prices. A supply curve is a graphical representation, typically upward sloping.
Price ($ per bushel) | Quantity Supplied (thousands of bushels per year) |
|---|---|
20 | 30 |
40 | 50 |
60 | 70 |
80 | 90 |
100 | 110 |
Additional info: The supply curve plots price on the vertical axis and quantity supplied on the horizontal axis, showing the direct relationship.
Shifts in the Supply Curve
A shift in the supply curve occurs when a relevant variable other than the product's price changes.
Rightward shift: Indicates an increase in supply.
Leftward shift: Indicates a decrease in supply.
Factors causing shifts:
Prices of inputs
Technology
Government taxes or subsidies
Prices of other products
Number of suppliers
Significant changes in weather
Example: Improved technology may shift the supply curve for apples to the right, increasing quantity supplied at every price.
Movements Along vs. Shifts of the Supply Curve
Movement along the curve: Caused by a change in the product's own price; quantity supplied changes but the supply curve itself does not shift.
Shift of the curve: Caused by changes in other factors (input prices, technology, etc.); the entire supply curve moves to a new position.
Market Equilibrium and Price Determination
The Concept of a Market
A market is any situation in which buyers and sellers negotiate the transaction of a good or service. Markets vary in the degree of competition among buyers and sellers.
In a perfectly competitive market, all participants are price takers.
Market Equilibrium
Market equilibrium occurs at the price where quantity demanded equals quantity supplied. This is known as the equilibrium price.
At equilibrium, the market "clears"—there is no excess supply or demand.
Any price above equilibrium leads to excess supply (surplus), causing downward pressure on price.
Any price below equilibrium leads to excess demand (shortage), causing upward pressure on price.
Example: If the equilibrium price of apples is $60 and the equilibrium quantity is 65,000 bushels, the market will clear at this point.
Equation:
where is quantity demanded and is quantity supplied at equilibrium price.
Changes in Market Equilibrium
Shifts in demand or supply curves lead to changes in equilibrium price and quantity.
Increase in demand: Raises both equilibrium price and quantity.
Decrease in demand: Lowers both equilibrium price and quantity.
Increase in supply: Lowers equilibrium price but raises equilibrium quantity.
Decrease in supply: Raises equilibrium price but lowers equilibrium quantity.
Relative Prices and Inflation
Absolute vs. Relative Prices
The absolute price of a product is the amount of money needed to acquire one unit. The relative price is the price of one good in terms of another.
Demand and supply curves are typically drawn in terms of relative prices.
Example: If apples cost $2 per pound and oranges cost $1 per pound, the relative price of apples to oranges is 2:1.
Limitations of the Demand and Supply Model
Applicability of the Model
The demand and supply model is useful for explaining changes in many markets, but it has limitations and cannot be applied to all products.
Three conditions must be met for the model to describe market price determination:
Many consumers, each small relative to the market size.
Many producers, each small relative to the market size.
Producers must sell homogeneous versions of the product.
Example: The model works well for apples but not for differentiated products like iPhones.
Applying Economic Concepts: Real-World Example
Demand and Supply Shocks: COVID-19 Pandemic
The COVID-19 pandemic caused significant shifts in demand and supply for various goods and services due to lockdowns and restrictions. Governments responded by borrowing and increasing spending, often issuing bonds to finance relief efforts.
Demand for some goods decreased (e.g., travel), while for others it increased (e.g., medical supplies).
Supply was affected by restrictions and disruptions in certain industries.
Additional info: This example illustrates how external shocks can shift demand and supply curves, affecting market equilibrium.
