Where Prices Come From: The Interaction of Supply and Demand

Where Prices Come From: The Interaction of Supply and Demand

ECON 101 - Macroeconomics

Muhebullah Karimzada

Winter 2026

Chapter Outline

  • 3.1 The Demand Side of the Market
  • 3.2 The Supply Side of the Market
  • 3.3 Market Equilibrium: Putting Buyers and Sellers Together
  • 3.4 The Effect of Demand and Supply Shifts on Equilibrium

3.1 The Demand Side of the Market

Learning Objective Goal

  • Discuss the variables that influence demand.\n - Investigation of buyer behavior is central to understanding demand structure.
    • Market Demand: The total demand by all consumers for a given good or service.
    • Key Tools:
      • Demand Schedule: A table illustrating the relationship between product price and quantity demanded.
      • Demand Curve: A graphical representation showing the same relationship.

3.2 Demand Schedule and Demand Curve

Demand Schedule and Demand Curve

  • Demand Schedule:
    • Definition: A tabular representation that demonstrates the relationship between the price of a product and the quantity of the product that consumers are willing to purchase.
  • Demand Curve:
    • Definition: A graphical curve that illustrates the relationship between the price of a product and the quantity demanded, usually descending from left to right.

3.3 Ceteris Paribus

Ceteris Paribus Condition

  • Ceteris Paribus:
    • Definition: A Latin phrase meaning “all else equal.”
    • Description: When analyzing the relationship between two variables (e.g., price and quantity demanded), all other influencing factors must be held constant.

3.4 Quantity Demanded and the Law of Demand

Quantity Demanded

  • Quantity Demanded:
    • Definition: The specific amount of a good or service that consumers are willing and able to purchase at a defined price.

Law of Demand

  • Law of Demand:
    • Description:
      • Holding everything else constant, when the price of a product decreases, the quantity demanded increases.
      • Conversely, when the price of a product increases, the quantity demanded decreases.

3.5 Explanation of the Law of Demand

Explanation of Demand Changes

  • Key Effects: When the price of a good decreases, two primary effects occur:
    • Substitution Effect: Consumers shift their consumption towards the now cheaper good, substituting it for more expensive alternatives.
    • Income Effect: Consumers experience an increase in purchasing power, akin to having higher income, allowing them to afford more of the good.

3.6 Definitions of Substitution and Income Effects

Definitions

  • Substitution Effect:
    • Definition: The alteration in quantity demanded for a good following a price change, due to its new price relative to alternative goods, independent of the influence of price changes on consumer purchasing power.
  • Income Effect:
    • Definition: The alteration in quantity demanded for a good resulting from a price change affecting consumers' purchasing power, while keeping all other factors constant.

3.7 Everyday Example: Movie Tickets

Movie Ticket Price Influence

  • Scenario:
    • If movie ticket prices decline from $15 to $10:
      • Substitution Effect:
        • Movies become more attractive compared to other forms of entertainment (e.g., bowling or dining).
      • Income Effect:
        • Increased real income enables consumers to attend more movies each month.

3.8 Shifting the Demand Curve

Demand Curve Shifts

  • **Demand Shift:
    • Description:** A non-price change affecting demand results in a shift of the entire demand curve.
    • Movement Direction:
      • A rightward shift (D1 to D2) indicates an increase in demand.
      • A leftward shift (D1 to D3) indicates a decrease in demand.

3.9 Changes in Quantity Demanded vs. Demand Shift

Analysis

  • When demand shifts, quantity demanded changes at every price point even if prices remain constant.

3.10 Variables That Shift Market Demand

Influencing Factors:

  1. Income of Consumers
  2. Prices of Related Goods
  3. Tastes
  4. Population and Demographics
  5. Expectations

3.11 Changes in Consumer Income

Types of Goods

  • Normal Goods: Goods for which demand increases as income rises and decreases when income falls. Examples include new clothing, restaurant meals, and vacations.
  • Inferior Goods: Goods where demand increases as income falls and decreases when income rises, such as second-hand clothing and instant noodles.

3.12 Effect of Changes in Income

Income Effects

  • An increase in income leads to:
    • Normal Goods: Increase in demand (e.g., new clothes).
    • Inferior Goods: Decrease in demand (e.g., second-hand clothes).

3.13 Lobster as Normal vs. Inferior Good

Case Study: Lobster

  • In some regions, lobster is considered an inferior good; demand decreases with rising income.
  • In larger metropolitan areas, it is regarded as a normal good; demand increases with rising income.

Key Lesson

  • A good's classification as normal or inferior is context-specific and based on consumer behavior rather than intrinsic product characteristics.

3.14 Changes in Price of Related Goods

Related Goods Analysis

  • Substitutes: Goods that can fulfill similar needs. Examples: Big Mac vs. Whopper; Ford F-150 vs. Dodge Ram; jeans vs. khakis.
  • Complements: Goods that are used together. Examples: Big Mac vs. fries; hot dogs vs. buns.

3.15 Effects of Changes in Prices of Related Goods

Impact on Demand

  • Increase in the price of a Big Mac:
    • Demand for Whoppers (substitute): Increases.
    • Demand for McDonald's fries (complement): Decreases.

3.16 Changes in Tastes

Consumer Preferences

  • Consumers may increase or decrease their demand for products based on changing preferences. For instance, a rise in health consciousness might reduce demand for fast food.

3.17 Changes in Population and Demographics

Demographic Impact

  • Demographics Definition: Characteristics of a population, such as age, race, gender, etc.
  • Increase in population typically raises demand.

Example

  • A rise in the elderly population enhances the demand for medical care.

3.18 Changes in Future Price Expectations

Future Expectations

  • Consumers make purchasing decisions based not just on what to buy but also when to buy.
  • Understanding Future Expectations:
    • An anticipated price increase results in heightened demand today.
    • Conversely, an expected price decrease leads to reduced demand today.

Example

  • Awareness of a coming price hike in gasoline will likely spur increased current demand.

3.19 Graphing Demand and Supply Shifts

Change in Demand vs. Change in Quantity Demanded

  • A price change results in movement along the demand curve (change in quantity demanded).
  • Any other demand-affecting change shifts the entire demand curve (change in demand).

3.20 The Supply Side of the Market

Learning Objective Goal

  • Discuss the variables influencing supply.
    • Examine market supply or how businesses decide on product provision relative to price variations.

3.21 Supply Schedule and Supply Curve

Supply Representation

  • Supply Schedule:
    • Definition: A tabular illustration indicating the relationship between product price and quantity supplied.
  • Supply Curve:
    • Definition: A graphical depiction showing the correlation between product price and quantity supplied, typically ascending from left to right.

3.22 Quantity Supplied and the Law of Supply

Key Definitions

  • Quantity Supplied:
    • Definition: The exact amount of a good or service that a seller is willing to provide at a specified price.
  • Law of Supply:
    • Description:
      • Holding all else constant, when the price increases, the quantity supplied increases, and diminished prices lead to decreased quantity supplied.

3.23 Shifting the Supply Curve

Supply Curve Dynamics

  • A non-price-related change affecting supply triggers a shift in the entirety of the supply curve.
    • Shift to Right (S1 to S3): Indicates an increase in supply.
    • Shift to Left (S1 to S2): Indicates a decrease in supply.

3.24 Changes in Quantity Supplied vs. Supply Shift

Analysis

  • A shift in the supply curve results in a change in quantity supplied at each price, regardless of price changes.

3.25 Variables That Shift Market Supply

Influential Variables

  1. Prices of Inputs
  2. Technological Change
  3. Prices of Substitutes in Production
  4. Number of Firms in the Market
  5. Expected Future Prices

3.26 Changes in Prices of Inputs

Input Costs Impact

  • Inputs: Anything utilized in the creation of a product or service. Examples include rubber, plastic, and labor for athletic shoes.
  • Cost Changes:
    • Increased input prices diminish profitability, leading to decreased supply.
    • Decreased input prices enhance profitability, boosting supply.

3.27 Technological Change Impact

Technological Influence

  • Definition: A modification in a company's capability to produce a specified output level using a certain quantity of inputs.

Examples

  • Developing an efficient shoe production method increases supply.
  • Imposing government regulations on worker hours may reduce supply.

3.28 Prices of Substitute and Complement Goods in Production

Related Goods in Production

  • Firms often create interchangeable products, known as substitutes in production.
    • Example: A farmer may choose to plant either corn or soybeans; a price rise in soybeans can lead to decreased corn planting.
  • Complements in Production: Sometimes, products are produced in tandem.
    • Example: Cattle provide beef and leather; a rise in beef prices can encourage increased cattle farming, leading to a supply boost for leather.

3.29 Number of Firms and Market Supply

Market Dynamics

  • An increase in the number of firms enhances product availability, thereby augmenting supply at a given price.
  • Expected Future Prices: If firms foresee future price increases, they may hold back supply today with plans to increase it later.

3.30 Change in Supply vs. Change in Quantity Supplied

Differentiation

  • Movements along the supply curve are induced by price changes (change in quantity supplied).
  • Any other influencing factor results in a shift in the entire supply curve (change in supply).

3.31 Market Equilibrium

Learning Objective Goal

  • Illustration of market equilibrium using graphs.
  • Market Equilibrium: Condition wherein quantity demanded equals quantity supplied.
    • In perfectly competitive markets, this is termed competitive market equilibrium.

3.32 Equilibrium Example: Athletic Shoes

Example Scenario

  • In the athletic shoe market at a price of $100:
    • Consumers desire 10 million pairs per week.
    • Producers also aim to sell 10 million pairs per week.
  • Hence, the equilibrium price is $100 and the equilibrium quantity is 10 million pairs per week.

3.33 Surpluses and Shortages Analysis

Price Impact on Market Equilibrium

  • If Price is $125:
    • Demand drops to 9 million pairs, while supply increases to 11 million pairs, resulting in a surplus of 2 million pairs.
    • Prediction: Sellers will compete, lowering the price towards equilibrium.
  • If Price is $50:
    • Demand increases to 12 million pairs while supply falls to 8 million pairs, creating a shortage of 4 million pairs.
    • Prediction: Sellers will raise prices as demand surpasses supply, shifting towards equilibrium.

3.34 Price Determination in Competitive Markets

Equilibrium Interaction

  • Market prices result from buyer-seller interactions; neither can dictate price independently.
  • Changes in demand and/or supply will subsequently influence equilibrium price and quantities.

3.35 Predicting Changes in Prices and Quantities

Learning Objective Goal

  • Use demand and supply graphs for forecasting price and quantity changes upon shifts in supply and demand curves.

3.36 Effect of an Increase in Supply

Supply Increase Scenario

  • When a new shoemaker enters the market, supply increases:
    • Supply Curve Shifts Right (S1 to S2).
    • Outcome: Equilibrium price decreases while equilibrium quantity increases.

3.37 Effect of a Decrease in Demand

Demand Reduction Scenario

  • Even though specific price and quantity changes cannot be quantified without understanding curve shapes and positions, the predicted effects are a decrease in price and an increase in quantity.

3.38 Effect of an Increase in Demand

Demand Increase Scenario

  • When incomes rise and athletic shoes are deemed a normal good:
    • Demand shifts rightward.
    • Outcomes include rising equilibrium price and quantity.

3.39 Demand and Supply Shifts Impact Table

Shifts in Demand and Supply

Shift ConditionEquilibrium Price (P)Equilibrium Quantity (Q)
Increase in demand, supply unchangedRisesRises
Decrease in demand, supply unchangedFallsFalls
Increase in supply, demand unchangedFallsRises
Decrease in supply, demand unchangedRisesFalls
Increase in demand, decrease in supplyRises?
Decrease in demand, increase in supplyFalls?
Increase in demand, increase in supply?Rises
Decrease in demand, decrease in supply?Falls

Highlighted Row:

  • Focuses on the instance studied: an increase in supply which affects equilibrium.
  • “?” indicates the need for relative information on shifts for confirmation of impacts.

3.40 Shifts in Demand and Supply Over Time

Temporal Dynamics

  • Shifts in both demand and supply are expected over time; for instance:
    • New companies may increase supply, resulting in a rightward shift.
    • Rising incomes lead to demand increases, hence demand shifts rightward.

3.41 Case Studies: Demand vs. Supply Shifts

Demand Shift Impact

  • If demand increases more than supply:
    • Both equilibrium quantity and price rise.

Supply Shift Impact

  • Conversely, if supply shifts more significantly than demand:
    • Equilibrium quantity rises while price falls, with the price effect remaining ambiguous without precise shift sizes.

3.42 Movements vs. Shifts in Curves

Important Distinctions

  • An increase in supply prompts:
    • Rising equilibrium quantity & falling equilibrium price.
    • A significant point of error is in stating that price decreases lead to increased demand; this is inaccurate.
  • Price decreases instigate movements along the demand curve, not shifts.
    • The demand curve reflects consumer behavior at various price levels.

Summary

Key Takeaways

  • Demand: Follows the law of demand, depicted by substitution and income effects. Shifts occur due to changes in income, related goods’ prices, tastes, demographics, and expectations.
  • Supply: Follows the law of supply, with shifts influenced by input prices, technological advancements, related production goods’ prices, number of firms, and anticipated future prices.
  • Market Equilibrium: Achieved when quantity demanded equals quantity supplied; surpluses cause a price decline, while shortages provoke price increases. The demand and supply model effectively predicts a directional change in equilibrium price and quantity upon shifts.