Chapter 4: The Market Forces of Supply and Demand
CHAPTER 4: THE MARKET FORCES OF SUPPLY AND DEMAND
Overview and Themes
Understanding the key factors affecting supply and demand in markets is essential for grasping pricing mechanisms in an economy.
The following questions are critical:
What factors affect buyers’ demand for goods?
What factors affect sellers’ supply of goods?
How do buyers and sellers interact in the market?
How do supply and demand determine prices?
How do changes in demand or supply factors affect market price and quantity?
How do prices allocate scarce resources?
Markets and Competition
Market Definition: A market is defined as a group of buyers and sellers of a particular good or service.
Buyers determine the demand for the product.
Sellers determine the supply of the product.
Competitive Market Characteristics:
Involves many buyers and many sellers, where each participant has a negligible impact on market price.
A Perfectly Competitive Market exists when all goods are identical, leading to price-taking behavior where no individual can influence the price.
At the prevailing market price, buyers can purchase as much as they want, and sellers are willing to sell as much as they can.
Demand
Quantity Demanded: The quantity of a good that buyers are willing and able to purchase.
Law of Demand:
The quantity demanded of a good decreases as its price increases, holding all else equal.
Conversely, the quantity demanded increases as the price decreases, holding all else equal.
Demand Schedule and Demand Curve
Demand Schedule: A tabular representation showing the relationship between the price of a good and the quantity demanded.
Demand Curve: A graphical representation of the demand schedule, illustrating how price affects quantity demanded.
Example 1A: Sofia’s Demand for Muffins
Sofia's Demand Schedule:
Price of Muffins
Quantity Demanded
$0.00
16
$1.00
14
$2.00
12
$3.00
10
$4.00
8
$5.00
6
$6.00
4
Market Demand
Market Demand: The sum of all individual demands for a good or service.
Market Demand Curve: The aggregate of all individual demand curves summed horizontally to determine total quantity demanded at any price.
Example 1B: Market Demand with Two Buyers
Buyers: Sofia and Diego, with individual demands leading to a combined market demand at various price levels.
Example 1C: Market Demand Curve for Muffins
Market Demand Schedule:
Price
Quantity Supplied (Market)
$0.00
24
$1.00
21
$2.00
18
$3.00
15
$4.00
12
$5.00
9
$6.00
6
Shifts in the Demand Curve
Demand curve shifts occur because of changes in non-price determinants, such as:
Number of buyers
Income levels
Prices of related goods (substitutes and complements)
Tastes and preferences
Expectations about future prices
Changes in Number of Buyers
An increase in the number of buyers increases quantity demanded at each price, shifting the demand curve to the right.
A decrease in the number of buyers decreases quantity demanded, shifting the demand curve to the left.
Changes in Income
Normal Good: Demand increases as income increases, shifting the curve to the right.
Inferior Good: Demand decreases as income increases, shifting the curve to the left.
Changes in Prices of Related Goods
Substitutes: An increase in the price of one increases the demand for another (e.g., pizza and hamburgers).
Complements: An increase in the price of one decreases the demand for the other (e.g., smartphones and apps).
Changes in Tastes
Any shift in consumer preference toward a good increases its demand, shifting the demand curve to the right.
Example: Increased demand for video game consoles during COVID-19.
Expectations about the Future
If consumers expect future income increases or price increases, current demand increases.
Shift vs. Movement Along the Curve
A shift in demand occurs with changes in non-price determinants (e.g., income change).
A movement along a demand curve occurs with price changes.
Summary of Variables that Influence Buyers
Multiple factors influence buyers, including income, preferences, and the number of buyers in the market.
Supply
Quantity Supplied: The amount of a good sellers are willing to sell.
Law of Supply:
The quantity supplied rises when the price rises, holding other conditions constant.
The quantity supplied falls when the price falls, holding other conditions constant.
Supply Schedule and Supply Curve
Supply Schedule: A table that shows the relationship between the price of a good and the quantity supplied.
Supply Curve: A graph that visually represents this relationship.
Example 2A: Starbucks’ Supply of Muffins
Starbucks’ Supply Schedule:
Price of Muffins
Quantity Supplied
$0.00
0
$1.00
3
$2.00
6
$3.00
9
$4.00
12
$5.00
15
$6.00
18
Market Supply
Market Supply: The sum of all sellers' supply of a good.
Market Supply Curve: The horizontal sum of individual supply curves.
Shifts in the Supply Curve
Supply curve shifts are caused by changes in:
Input prices
Technology
Number of sellers
Expectations about the future
Changes in Input Prices
Decrease in input prices (e.g., lower wages, cheaper raw materials) results in a rightward shift in the supply curve, allowing for more quantity supplied at each price.
Example: Effect of falling flour prices on muffin supply.
Technology
Advances in technology can reduce production costs and shift the supply curve to the right, reflecting an increase in supply.
Number of Sellers
An increase in sellers raises the total quantity supplied at each price point, shifting the supply curve right.
A decrease results in the opposite effect, shifting the supply left.
Equilibrium
Equilibrium Price: The price level where quantity supplied equals quantity demanded.
When market forces reach equilibrium, the price stabilizes without upward or downward pressure.
Market Dynamics in Equilibrium
Shortage (excess demand): When quantity demanded exceeds quantity supplied, leading to shortages that push prices up until equilibrium is restored.
Surplus (excess supply): Occurs when quantity supplied exceeds quantity demanded, causing vendors to lower prices until equilibrium is found.
The Law of Supply and Demand
The law describes how prices adjust to balance out supply and demand in a market.
Analyzing Effects of Changes in Equilibrium
Identify if an event shifts the demand, supply, or both curves.
Determine the direction of the shift (left or right).
Use supply-and-demand diagrams to compare initial and new equilibria, analyzing the effects on equilibrium price and quantity.
Active Learning Scenarios
Various scenarios illustrate the impact of changes in prices of substitutes or related goods and the resulting shifts in supply and demand curves.
Mathematical Representation of Demand and Supply
Demand Equation: Q_d = 56 - 4P
Supply Equation: Q_s = -4 + 2P
Solving these equations will give market equilibrium prices and quantities, further exemplified through graphical representations.
Conclusion
Markets are effective at organizing economic activity, with prices serving as signals that guide decisions about the allocation of scarce resources.