Microeconomics Study Notes: Demand and Supply (Chapter 3)

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Chpt 3. Demand and Supply

Introduction

This chapter explores the fundamental concepts of demand and supply in microeconomics, focusing on how prices and quantities are determined in markets. Understanding these concepts is essential for predicting market outcomes and analyzing economic behavior.

3.1 Demand

Demand refers to the quantities of a specific good or service that individuals are willing to purchase at various prices, holding other factors constant (ceteris paribus).

Law of Demand: Quantity demanded is inversely related to price. As price increases, quantity demanded decreases, and vice versa.
Money Price: The absolute, nominal price observed in currency.
Relative Price: The price of one commodity in terms of another, calculated as the ratio of their money prices.
Demand Schedule: A table showing quantities demanded at different prices for a specific time period.
Demand Curve: A graphical representation of the demand schedule, downward sloping from left to right.

Example: If the price of external hard drives rises relative to cloud servers, even if both money prices fall, external hard drives become less competitive, affecting sales.

Market Demand

Market demand aggregates individual demand at each price level. The market demand curve is constructed by summing individual quantities demanded for all consumers.

3.2 Shifts in Demand

Movements along the demand curve are caused by changes in the good's own price. Shifts of the demand curve occur when other factors change.

Income: Normal goods see increased demand with higher income; inferior goods see decreased demand.
Tastes and Preferences: Favorable changes shift demand outward; unfavorable changes shift it inward.
Price of Related Goods: Complements are consumed together; a price increase in one decreases demand for the other. Substitutes satisfy similar wants; a price increase in one increases demand for the other.
Expectations: Anticipation of higher future prices or incomes increases current demand.
Market Size: More buyers increase market demand.

Example: If the government gives every student a digital device requiring wireless earbuds, demand for earbuds increases at every price.

Income Effects: Normal vs. Inferior Goods

Normal Good Example: Mac computers. Demand decreases during a recession as income falls.
Inferior Good Example: McDonald's meals. Demand increases during a recession as income falls.

Price of Related Goods

Complement Example: Trucks and gasoline. Lower gasoline prices increase demand for trucks.
Substitute Example: Surface Pro and MacBook. Lower MacBook prices decrease demand for Surface Pro.
Practice: Bacon (complement: eggs, substitute: breakfast sausage), Coffee (complement: cream, substitute: tea), Automobiles (complement: gasoline, substitute: public transportation).

3.3 Supply

Supply refers to the quantities of a specific good or service that firms are willing to sell at various prices, holding other factors constant.

Law of Supply: Quantity supplied is directly related to price. As price increases, quantity supplied increases.
Supply Schedule: A table showing quantities supplied at different prices for a specific time period.
Supply Curve: A graphical representation of the supply schedule, upward sloping from left to right.

Market Supply

Market supply aggregates individual supply at each price level. The market supply curve is constructed by summing individual quantities supplied for all producers.

3.4 Shifts in Supply

Movements along the supply curve are caused by changes in the good's own price. Shifts of the supply curve occur when other factors change.

Technology and Productivity: Improved technology shifts supply outward.
Prices of Inputs: Lower input prices reduce production costs and shift supply outward.
Price Expectations: Anticipation of higher future prices may cause producers to hold back supply.
Taxes and Subsidies: Taxes increase costs and shift supply inward; subsidies decrease costs and shift supply outward.
Number of Firms: More firms increase supply.

3.5 Equilibrium: Putting Demand and Supply Together

The intersection of demand and supply curves determines the market equilibrium price and quantity. At equilibrium, quantity demanded equals quantity supplied.

Shortage: Occurs when price is below equilibrium; quantity demanded exceeds quantity supplied. Prices rise as consumers compete.
Surplus: Occurs when price is above equilibrium; quantity supplied exceeds quantity demanded. Prices fall as suppliers compete.
Market Forces: Drive prices and quantities toward equilibrium.

Example: In the wireless earbud market, equilibrium price is $3/unit and equilibrium quantity is 6 million units.

Practice Problems

Price of lumber rises: Supply curve for bungalows shifts left (higher production cost).
Government caps bungalow prices: Movement along supply curve (lower quantity supplied).
New technology reduces building costs: Supply curve shifts right (lower production cost).
Government subsidies for bungalows: Supply curve shifts right (lower production cost).
Price of bungalows increases: Movement along supply curve (higher quantity supplied).

Appendix B: Calculating Equilibrium Price and Quantity Using Linear Equations

Linear equations model the relationship between price and quantity for demand and supply:

General form:
Demand equation:
Supply equation:
Equilibrium: Set and solve for (equilibrium price).
Insert equilibrium price into either equation to solve for (equilibrium quantity).

Example:

Set
Insert into :
Equilibrium quantity is 6 units.

Summary of Learning Objectives

Law of Demand: Higher price leads to lower quantity demanded; lower price leads to higher quantity demanded.
Changes in Demand vs. Quantity Demanded: Price changes cause movement along the curve; other factors cause shifts.
Law of Supply: Higher price leads to higher quantity supplied; lower price leads to lower quantity supplied.
Changes in Supply vs. Quantity Supplied: Price changes cause movement along the curve; other factors cause shifts.
Equilibrium: Intersection of demand and supply curves determines market price and quantity; surpluses and shortages are resolved by market forces.