Demand, Supply, and Market Equilibrium
Chapter 3: Demand, Supply, and Market Equilibrium
Markets
Definition: An interaction between buyers and sellers.
Types of Markets: Markets can be:
Local
National
International
Price Discovery: The price of a good or service is determined through the interactions of buyers and sellers within a market.
Demand
Definition: A schedule or curve illustrating the various amounts of a product that consumers are willing and able to purchase at each of a series of possible prices.
"Other Things Equal" (Ceteris Paribus): This assumption means that all other factors influencing demand (such as tastes, income, related goods' prices) are held constant when analyzing the relationship between price and quantity demanded.
Individual Demand: The demand of a single consumer.
Market Demand: The sum of all individual demands for a particular product or service.
Law of Demand
Statement: Other things equal, as the price of a product falls, the quantity demanded rises; and as the price rises, the quantity demanded falls.
This implies an inverse relationship between price and quantity demanded.
Reasons for the Law of Demand:
Common sense: Consumers typically buy more of a good when its price is lower and less when its price is higher.
Diminishing marginal utility: As a consumer consumes more units of a good, the satisfaction (utility) derived from each additional unit tends to decrease. Therefore, they are only willing to buy more if the price is lower.
Income effect: A lower price increases the purchasing power of a consumer's money income, enabling them to buy more of the product.
Substitution effect: A lower price makes the product relatively more attractive compared to its substitutes, leading consumers to switch from substitutes to the now cheaper product.
The Demand Curve
Representation: A graphical representation of the demand schedule, with price on the vertical axis and quantity demanded on the horizontal axis.
Shape: The demand curve slopes downward from left to right, reflecting the inverse relationship between price and quantity demanded.
Example: Individual Demand Schedule:
$P$ | $Qd$
--- | ---
5 | 10
4 | 20
3 | 35
2 | 55
1 | 80
Market Demand Calculation
Market demand is derived by horizontally summing the individual demand quantities at each price level.
Example: Market Demand for Lattes (Three Buyers):
Price per Latte | Joe Java ($Qd$) | Sarah Coffee ($Qd$) | Mike Cappuccino ($Qd$) | Total ($Qd$) per Week
--- | --- | --- | --- | ---
5 | 10 | 12 | 8 | 30
4 | 20 | 23 | 17 | 60
3 | 35 | 39 | 26 | 100
2 | 55 | 60 | 39 | 154
1 | 80 | 87 | 54 | 221
Graphically, if at Price 3: Joe demands 35, Sarah demands 39, Mike demands 26. The market demand at Price 3 is 35 + 39 + 26 = 100.
Determinants of Demand (Factors that Shift the Demand Curve)
Change in consumer tastes and preferences: Favorable change (e.g., product becomes popular) increases demand; unfavorable change (e.g., product loses popularity) decreases demand.
Change in the number of buyers: An increase in the number of buyers increases market demand; a decrease reduces it.
Change in income:
Normal goods: For most goods, an increase in income leads to an increase in demand (e.g., restaurant meals, new cars).
Inferior goods: For some goods, an increase in income leads to a decrease in demand (e.g., generic brands, bus travel as opposed to car ownership).
Change in prices of related goods:
Complements: Goods that are used together. If the price of a complement falls, the demand for the original good increases (e.g., lower price for coffee makers increases demand for coffee).
Substitutes: Goods that can be used in place of one another. If the price of a substitute falls, the demand for the original good decreases (e.g., lower price for tea decreases demand for coffee).
Change in consumers’ expectations:
Future prices: If consumers expect prices to rise in the future, current demand may increase (e.g., anticipating a sale leads to delayed purchases).
Future income: If consumers expect their income to increase, current demand for certain goods may increase (e.g., expecting a bonus leads to desire for new car).
Changes in Demand vs. Changes in Quantity Demanded
Change in demand: Represented by a shift of the entire demand curve (either to the right for an increase, or to the left for a decrease). This is caused by a change in one or more of the determinants of demand (factors other than price).
Change in quantity demanded: Represented by a movement from one point to another point along a fixed demand curve. This is caused solely by a change in the price of the good itself.
Supply
Definition: A schedule or curve illustrating the various amounts of a product that producers are willing and able to sell at each of a series of possible prices during a specific period.
Individual Supply: The supply of a single producer.
Market Supply: The sum of all individual supplies for a particular product or service.
Law of Supply
Statement: Other things equal, as the price of a product rises, the quantity supplied rises; and as the price falls, the quantity supplied falls.
This implies a direct relationship between price and quantity supplied.
Reasons for the Law of Supply:
Price as an incentive to producers: Higher prices make production more profitable, encouraging firms to produce and offer more for sale.
At some point, costs will rise: As producers increase output, they eventually face rising marginal costs of production. To cover these higher costs and maintain profitability, they need higher prices.
The Supply Curve
Representation: A graphical representation of the supply schedule, with price on the vertical axis and quantity supplied on the horizontal axis.
Shape: The supply curve slopes upward from left to right, reflecting the direct relationship between price and quantity supplied.
Example: Starbuck's Supply of Lattes Schedule:
Price per Latte | Quantity Supplied per Month
--- | ---
5 | 60
4 | 50
3 | 35
2 | 20
1 | 5
Determinants of Supply (Factors that Shift the Supply Curve)
A change in resource prices: Lower resource prices decrease production costs and increase supply; higher resource prices increase costs and decrease supply.
A change in technology: Technological advancements lower production costs and increase supply.
A change in the number of sellers: More sellers increase market supply; fewer sellers decrease supply.
A change in taxes and subsidies:
Taxes: Increase production costs and decrease supply.
Subsidies: Decrease production costs and increase supply.
A change in prices of other goods: If the price of another good that producers can make with the same resources changes, it can affect the supply of the original good (e.g., if corn prices rise, farmers might shift from soybeans to corn, decreasing soybean supply).
A change in producer expectations: Expectations about future prices can influence current supply decisions. If producers expect higher prices in the future, they might reduce current supply to sell more later.
Changes in Supply vs. Changes in Quantity Supplied
Change in supply: Represented by a shift of the entire supply curve (either to the right for an increase, or to the left for a decrease). This is caused by a change in one or more of the determinants of supply (factors other than price).
Change in quantity supplied: Represented by a movement from one point to another point along a fixed supply curve. This is caused solely by a change in the price of the good itself.
Market Equilibrium
Definition: The point where the demand curve and supply curve intersect. At this point, the quantity demanded equals the quantity supplied.
Equilibrium Price: The price at which quantity demanded equals quantity supplied.
Equilibrium Quantity: The quantity demanded and supplied at the equilibrium price.
Surplus: Occurs when the price is above the equilibrium price, leading to quantity supplied exceeding quantity demanded. This puts downward pressure on price.
Shortage: Occurs when the price is below the equilibrium price, leading to quantity demanded exceeding quantity supplied. This puts upward pressure on price.
Rationing Function of Prices: The ability of competitive market forces (demand and supply) to establish a price at which buying and selling decisions are consistent, thereby eliminating surpluses and shortages.
Efficient Allocation: Market equilibrium leads to:
Productive efficiency: Goods are produced in the least costly way (using the best technology and resource combinations).
Allocative efficiency: The particular mix of goods and services most highly valued by society is produced.
Market Equilibrium Schedule Example
$P$ | $Qd$ | $Qs$
--- | --- | ---
5 | 2,000 | 12,000 (Surplus of 10,000)
4 | 4,000 | 10,000 (Surplus of 6,000)
3 | 7,000 | 7,000 (Equilibrium)
2 | 11,000 | 4,000 (Shortage of 7,000)
1 | 16,000 | 1,000 (Shortage of 15,000)
Changes in Demand and Equilibrium
Increase in Demand (Demand Curve shifts right):
Equilibrium price ($P$) rises.
Equilibrium quantity ($Q$) rises.
Decrease in Demand (Demand Curve shifts left):
Equilibrium price ($P$) falls.
Equilibrium quantity ($Q$) falls.
Changes in Supply and Equilibrium
Increase in Supply (Supply Curve shifts right):
Equilibrium price ($P$) falls.
Equilibrium quantity ($Q$) rises.
Decrease in Supply (Supply Curve shifts left):
Equilibrium price ($P$) rises.
Equilibrium quantity ($Q$) falls.
Complex Cases: Simultaneous Changes in Demand and Supply
When both demand and supply change simultaneously, the impact on either equilibrium price or equilibrium quantity (or both) can be less certain.
Outcome depends on the relative magnitudes of the shifts.
Example: If demand increases and supply increases simultaneously:
Equilibrium quantity will definitely increase.
Equilibrium price's change is indeterminate (depends on which shift is larger).
Government-Set Prices
Governments may intervene in markets to set prices above or below equilibrium, leading to market inefficiencies.
Price Ceilings
Definition: A maximum legal price that can be charged for a product, set below the equilibrium price.
Consequences:
Shortage: Because the price is artificially low, quantity demanded exceeds quantity supplied (Qd > Qs).
Rationing problem: Since not everyone who wants the product at the ceiling price can get it, a non-price rationing mechanism (e.g., waiting lines, lotteries, favoritism) typically emerges.
Black markets: Illegal markets may develop where goods are sold at prices above the legal ceiling.
Example: Rent control in cities.
Illustrative Diagram (Gasoline Market):
If equilibrium price is 4.00 and a ceiling is set at 3.00, a shortage occurs where Qd > Qs at 3.00.
Price Floors
Definition: A minimum legal price that can be charged for a product, set above the equilibrium price.
Consequences:
Chronic surpluses: Because the price is artificially high, quantity supplied exceeds quantity demanded (Qs > Qd).
The government may have to buy the surplus or impose restrictions on production to maintain the floor.
Example: Minimum-wage laws (a price floor in the labor market).
Illustrative Diagram (Wheat Market):
If equilibrium price is 2.00 and a floor is set at 3.00, a surplus occurs where Qs > Qd at 3.00.