Chapter 3 Summary: Demand and Supply

Chapter 3: Where Prices Come From: The Interaction of Demand and Supply

3.1 The Demand Side of the Market

  • Variables Influencing Demand:

    • Price: The most important factor affecting demand.
    • Income:
      • Normal Good: Demand increases as income rises and decreases as income falls.
      • Inferior Good: Demand increases as income falls and decreases as income rises.
    • Prices of Related Goods:
      • Substitutes: Goods used for the same purpose. A decrease in the price of a substitute shifts demand to the left; an increase shifts demand to the right.
      • Complements: Goods used together. A decrease in the price of a complement shifts demand to the right; an increase shifts demand to the left.
    • Tastes: Subjective elements influencing consumer decisions. Increased taste shifts demand to the right; decreased taste shifts demand to the left.
    • Population and Demographics: Characteristics of a population (age, race, gender) that influence demand.
    • Expected Future Prices: Expectations of future price changes affect current demand.
    • Natural Disasters and Pandemics: Events that can significantly impact demand.

  • Perfectly Competitive Market:

    • Many buyers and sellers.
    • All firms sell identical products.
    • No barriers to new firms entering the market.

  • Demand Schedules and Demand Curves:

    • Demand Schedule: A table showing the relationship between price and quantity demanded.
    • Quantity Demanded: The amount a consumer is willing and able to purchase at a given price.
    • Demand Curve: A curve showing the relationship between price and quantity demanded.
    • Market Demand: The demand by all consumers of a given good or service.

  • Law of Demand:

    • Holding everything else constant, when the price of a product falls, the quantity demanded increases, and when the price rises, the quantity demanded decreases.

  • Explanations for the Law of Demand:

    • Substitution Effect: Change in quantity demanded due to a change in relative price, holding purchasing power constant.
    • Income Effect: Change in quantity demanded due to the effect of a change in price on consumer purchasing power, holding all other factors constant.

  • Ceteris Paribus Condition:

    • The requirement that when analyzing the relationship between two variables, other variables must be held constant.

  • Change in Demand vs. Change in Quantity Demanded:

    • Change in Demand: A shift in the entire demand curve due to a change in a variable other than price.
    • Change in Quantity Demanded: A movement along the demand curve due solely to a change in the product's price.

3.2 The Supply Side of the Market

  • Variables Influencing Supply:

    • Price: The most important factor affecting supply.
    • Prices of Inputs: If the price of an input rises, the supply curve shifts to the left. If the price of an input declines, the supply curve shifts to the right.
    • Technological Change: Positive or negative change in the ability of a firm to produce a given level of output with a given quantity of inputs.
    • Prices of Related Goods in Production:
      • Substitutes in Production: Alternative products a firm could produce. If the price of a substitute in production increases, the supply of the product will shift to the left.
      • Complements in Production: Goods produced together. An increase in the price of a product will cause the supply curve for its complement to shift to the right.
    • Number of Firms in the Market: Entry of firms shifts supply to the right; exit shifts supply to the left.
    • Expected Future Prices: Expectations of future price changes affect current supply.
    • Natural Disasters and Pandemics: Events that can significantly impact supply.

  • Quantity Supplied:

    • The amount of a good or service that a firm is willing and able to supply at a given price.

  • Supply Schedules and Supply Curves:

    • Supply Schedule: A table that shows the relationship between the price of a product and the quantity of the product supplied.
    • Supply Curve: A curve that shows the relationship between the price of a product and the quantity of the product supplied.

  • Law of Supply:

    • Holding everything else constant, increases in price cause increases in the quantity supplied, and decreases in price cause decreases in the quantity supplied.

  • Change in Supply vs. Change in Quantity Supplied:

    • Change in Supply: A shift in the entire supply curve due to a change in a variable other than price.
    • Change in Quantity Supplied: A movement along the supply curve due solely to a change in the product's price.

3.3 Market Equilibrium: Putting Demand and Supply Together

  • Market Equilibrium:

    • A situation in which quantity demanded equals quantity supplied.
    • Competitive Market Equilibrium: A market equilibrium with many buyers and sellers.

  • Surpluses and Shortages:

    • Surplus: Quantity supplied is greater than quantity demanded. Firms cut prices to increase sales.
    • Shortage: Quantity demanded is greater than quantity supplied. Firms raise prices due to excess demand.

  • Demand and Supply Both Count:

    • Neither consumers nor firms can dictate the equilibrium price alone.

3.4. The Effect of Demand and Supply Shifts on Equilibrium

  • Shifts in Demand:

    • Increase in demand (rightward shift) leads to higher equilibrium price and quantity.
    • Decrease in demand (leftward shift) leads to lower equilibrium price and quantity.

  • Shifts in Supply:

    • Increase in supply (rightward shift) leads to lower equilibrium price and higher equilibrium quantity.
    • Decrease in supply (leftward shift) leads to higher equilibrium price and lower equilibrium quantity.

  • Simultaneous Shifts in Demand and Supply:

    • The effect on equilibrium price and quantity depends on the relative magnitudes of the shifts.

  • Curve Shifts vs. Movements along Curves:

    • Price changes resulting from shifts in demand or supply do not cause further shifts in the curves themselves.