Demand, Supply and Market Equilibrium
Chapter 3: Demand, Supply and Market Equilibrium
Learning Objectives
LO3.1 Characterize and give examples of markets.
LO3.2 Describe demand and explain how it can change.
LO3.3 Describe supply and explain how it can change.
LO3.4 Explain how supply and demand interact to determine market equilibrium.
LO3.5 Explain how changes in supply and demand affect equilibrium prices and quantities.
LO3.6 Define government-set prices and explain how they can cause surpluses and shortages.
Introduction to the Supply and Demand Model
The supply and demand model is considered one of the most significant contributions of economics.
This model is essential for understanding market functions and aids in the production and consumption of goods and services.
It serves as the primary tool for explaining and analyzing economic decision-making processes.
The chapter discusses the mechanics of the model and its role in determining market prices and quantities.
3.1: Markets
Buyers and Sellers: Interaction between buyers and sellers defines the market.
Types of Markets: Local, national, and international.
Price Determination: The price is established through voluntary trade based on buyer-seller interactions.
Competitive Markets: Characterized by a large number of buyers and sellers, each acting independently.
3.2: Demand
Definition: A demand schedule or demand curve represents the various amounts of a product that consumers are willing and able to purchase at different prices during specified time periods.
Demand Schedule: A table that displays the quantity demanded at different prices.
Demand Curve: A graph plotting the quantity demanded against price.
Market Demand vs. Individual Demand: Individual buyer demand contributes to total market demand.
Law of Demand
Inverse Relationship: Describes that as price decreases, the quantity demanded increases, and vice versa.
Ceteris Paribus: The other-things-equal assumption indicates that factors affecting demand (like prices of substitutes) must remain constant to accurately evaluate demand for a product.
Rationale: The inverse relationship in demand is supported by common sense, diminishing marginal utility, and the income and substitution effects:
Income Effect: A lower price increases a consumer’s real income, allowing more purchases.
Substitution Effect: A lower price makes a product more attractive compared to alternatives.
Demand Curve Details
Graphical Representation: The demand curve demonstrates the inverse relationship between price and quantity demanded.
Axes: Quantity demanded is on the horizontal axis, and price is on the vertical axis.
Marginal Benefit Curve: The demand curve reflects the maximum price consumers are willing to pay for each additional unit.
Determinants of Demand
Changes that Shift Demand:
Change in consumer tastes and preferences.
Change in the number of buyers.
Change in income (Normal goods vs. Inferior goods).
Change in prices of related goods (Substitutes vs. Complements).
Change in consumer expectations regarding future prices and income.
Changes in Demand and Quantity Demanded
Shifts in Demand Curve: Shift to the right indicates an increase, while a shift to the left indicates a decrease.
Movement along the Curve: Changes in quantity demanded occur due to price changes, showcased as movement along the existing demand curve.
3.3: Supply
Definition: A supply schedule or curve shows the various amounts that producers are willing and able to sell at different prices during a specified period.
Individual Supply: Supply from a single producer.
Market Supply: The total supply from all producers in a market.
Law of Supply
Direct Relationship: States that as prices rise, the quantity supplied increases; as prices fall, the quantity supplied decreases.
Producer Incentives: Higher prices encourage producers due to potential increased revenue and cost coverage due to rising marginal costs.
Market Supply
Aggregated Supply: The market supply is calculated by summing the quantities each producer supplies at various price levels.
Determinants of Supply
Shifts in Supply Curve:
Change in factor prices.
Change in technology.
Change in taxes and subsidies.
Change in prices of other goods.
Change in producer expectations.
Change in the number of sellers.
Changes in Supply and Quantity Supplied
Whole Curve Shift: A change in supply shifts the entire curve in response to changes in determinants.
Movement Along the Curve: Changes in quantity supplied occur due to price alterations, moving along the supply curve.
3.4: Market Equilibrium
Definition: Market equilibrium occurs where the quantity demanded equals the quantity supplied, leading to price stability.
Equilibrium Price and Quantity: Identified at the intersection of the supply and demand curves.
Example: At a price of $3 per litre, the equilibrium quantity for gasoline is 7,000 litres, demonstrating balanced market conditions with no shortages or surpluses.
Price Adjustment Mechanisms
Shortages and Surpluses: Prices below equilibrium create shortages, prompting price increases until equilibrium is restored. Conversely, prices above equilibrium create surpluses, leading to price reductions.
Rationing Function: Prices serve to ration goods efficiently. At equilibrium, transactions occur efficiently as only buyers and sellers who agree at the equilibrium price participate.
Efficiency in Markets
Productive Efficiency: Induced by competition, producers must minimize costs and optimize resource use.
Allocative Efficiency: Resources are allocated to produce goods and services most valued by society, reflecting collective preferences in competitive markets.
3.5: Changes in Demand and Supply
Effects of Demand Changes:
If demand increases while supply is constant, equilibrium price rises, and equilibrium quantity increases.
If demand decreases while supply is constant, equilibrium price falls, and equilibrium quantity decreases.
Effects of Supply Changes:
If supply increases while demand is constant, equilibrium price falls, and equilibrium quantity rises.
If supply decreases while demand is constant, equilibrium price rises, and equilibrium quantity falls.
Complex Cases
Combined Changes: When both supply and demand change, the outcome for price and quantity can be complex and context-specific. Each curve shift must be considered individually to determine the net effect on equilibrium.
Table of Changes Effects
Change in Supply | Change in Demand | Effect on Equilibrium Price | Effect on Equilibrium Quantity |
|---|---|---|---|
Increase | Decrease | Decrease | Indeterminate |
Decrease | Increase | Increase | Indeterminate |
Increase | Increase | Indeterminate | Increase |
Decrease | Decrease | Indeterminate | Decrease |
3.6: Government-Set Prices
Market Price Adjustments: Most prices adjust to equilibrium levels, but government interventions may impose price controls to ensure fairness.
Price Ceilings: Set maximum legal prices, often below equilibrium. This leads to shortages, compelling governments to find fair distribution methods.
Examples: Rent controls that seek to maintain affordability but lead to reduced supply.
Price Floors: Set minimum legal prices, usually above equilibrium, resulting in surpluses as supply exceeds demand.
Examples: Agricultural price supports and minimum wage laws.
Consequences of Price Controls
Price Ceilings: Can create black markets and encourage consumers to engage in illegal trading. Rent controls can decrease the quality of housing and supply.
Price Floors: Cause overproduction, reducing the market's allocative efficiency, leading to higher prices and potential environmental harm.
Summary of Chapter 3
Markets connect buyers and sellers at various levels, with interactions determining prices and quantities based on demand and supply.
Demand reflects consumer willingness to pay and varies with price; supply reflects producer willingness and varies with price.
Equilibrium is achieved where supply meets demand, leading to efficient resource allocation, while government price controls can disrupt market equilibrium.