Chapter 6: Demand, Supply, Market Equilibrium, and Welfare Analysis

Law of demand

Law of demand

Holding all else equal, when the price of a good rises, consumers decrease their quantity demanded for that good

All else equal

To predict how a change in one variable affects a second, we hold all other variables constant. This is also referred to as the “ceteris paribus” assumption

Absolute (or money) prices

The price of a good measured in units of currency

Relative prices

The number of units of any other good Y that must be sacrificed to acquire the first good X. Only relative prices matter

Substitution effect

The change in quantity demanded resulting from a change in the price of one good relative to the price of other goods

Income effect

The change in quantity demanded that results from a change in the consumer’s purchasing power (or real income)

Demand schedule

A table showing quantity demanded for a good at various prices

Demand curve

A graphical depiction of the demand schedule. The demand curve is downward sloping, reflecting the law of demand

Determinants of demand

The external factors that shift demand to the left or right

Normal goods

A good for which higher income increases demand

Inferior goods

A good for which higher income decreases demand

Substitute goods

Two goods are consumer substitutes if they provide essentially the same utility to the consumer

Complementary goods

Two goods are consumer complements if they provide more utility when consumed together than when consumed separately. Cars and gasoline are complementary goods

Law of supply

Holding all else equal, when the price of a good rises, suppliers increase their quantity supplied for that good

Supply schedule

A table showing quantity supplied for a good at various prices

Supply curve

A graphical depiction of the supply schedule. The supply curve is upward sloping, reflecting the law of supply

Determinants of supply

One of the external factors that influences supply. When these variables change, the entire supply curve shifts to the left or right

Market equilibrium

Exists at the only price where the quantity supplied equals the quantity demanded. Or, it is the only quantity where the highest price consumers are willing to pay is exactly the lowest price producers are willing to accept

Shortage

Also known as excess demand, a shortage exists at a market price when the quantity demanded exceeds the quantity supplied. The price rises to eliminate a shortage

Disequilibrium

Any price where quantity demanded is not equal to quantity supplied

Surplus

Also known as excess supply, a surplus exists at a market price when the quantity supplied exceeds the quantity demanded. The price falls to eliminate a surplus

Total welfare

The sum of consumer surplus and producer surplus. The free market equilibrium provides maximum combined gain to society. This is also called total surplus.

Consumer surplus

The difference between your willingness to pay and the price you actually pay. It is the area below the demand curve and above the price

Producer surplus

The difference between the price received and the marginal cost of producing the good. It is the area above the supply curve and under the price.