Chapter 4 Notes: Demand, Supply, and Equilibrium

4.1 Markets

A market is a group of economic agents who are trading a good or service plus the rules and arrangements for trading.
Examples include agricultural and industrial goods (wheat, soybeans, iron, coal) and services; markets can be physical locations (e.g., Holland's Aalsmeer Flower Auction) or dispersed (gas stations on every corner).
Prices act as a selection device, encouraging trade between sellers who can produce at low cost and buyers who place high value on the good.
The chapter focuses on markets in which exchanges occur voluntarily at flexible prices determined by market forces (as opposed to government-set prices).
The gasoline market is used as an example: the price is set so that the quantity of gasoline that drivers want to buy equals the quantity that gas stations are willing to sell.
In a perfectly competitive market, two conditions hold: (1) sellers all sell an identical good or service, (2) no individual buyer or seller is powerful enough to affect the market price. In such markets, all participants are price-takers.
Mention of “price-takers” highlights that buyers and sellers accept the market price and cannot bargain for a better price.
Real-world markets are rarely perfectly competitive, but many close enough to serve as useful approximations (e.g., many nearby gas stations keep prices close to the market price; isolated stations are the exception).
Three core questions drive the analysis:
- How do buyers behave?
- How do sellers behave?
- How do the behaviors of buyers and sellers jointly determine the market price and quantity traded?
The chapter analyzes a competitive market and uses the demand curve and the supply curve to explore these questions.

4.2 How Do Buyers Behave?

Buyers are assumed to be price-takers: they treat the market price as a take-it-or-leave-it offer and do not haggle.
At a given price, the amount of the good buyers are willing to purchase is called the quantity demanded (Q_d).
Example intuition: as gas prices rise, many buyers reduce purchases (e.g., switch to biking, carpool, public transit), especially in the long run.
Chloe’s example (demand schedule): shows how quantity demanded changes with price, holding all else fixed (income, rents, tolls, etc.).
A demand schedule is a table of Q_d at different prices; a demand curve graphically plots price (y-axis) vs. quantity demanded (x-axis) with the common convention: quantity demanded on the x-axis and price on the y-axis.
Observations from Chloe’s schedule:
- Price of $6 → Q_d = 50 gallons/year
- Price of $1 → Q_d = 300 gallons/year
Key property of demand curves: the price and quantity demanded are negatively related (the Law of Demand).
Willingness to Pay (WTP): the height of the demand curve at a given quantity is the maximum price a buyer is willing to pay for the next marginal unit.
- Example: willing to pay $4 for the 150th gallon (i.e., with 149 gallons already available, WTP for the next gallon is $4).
- Example: with 199 gallons already used, WTP for the next gallon drops to $3.
Diminishing marginal benefit: as a consumer obtains more of a good, the extra units provide less additional benefit, so willingness to pay for an extra unit falls as quantity on hand increases.
- Donuts illustration: first donut is worth more than the fourth donut; generally, more of the same good yields lower WTP for an additional unit.
From individuals to aggregates:
- Although most individual demand curves slope downward, they differ across individuals (income, tends, preferences, etc.).
- The aggregate market demand curve is the sum of all individual demand curves: $D^{\text{market}}(P) = \sumi Di(P)$
- The market demand curve plots the relationship between total quantity demanded and market price, holding all else equal.
Building the market demand curve (two buyers example): the market demand is the sum of the two individual demand curves; the concept extends to all buyers.
Important nuance: a demand curve shifts only when the quantity demanded changes at a given price. A shift occurs due to non-price factors; a change in the good’s own price causes movement along the demand curve, not a shift.
Shifting the demand curve: five major factors:
- Tastes and preferences
- Income and wealth
- Availability and prices of related goods
- Number and scale of buyers
- Buyers’ beliefs about the future
Changes in Tastes and Preferences:
- Example: concern about climate change reduces demand for oil products (gasoline) as hybrid/electric vehicles become more popular; demand curve shifts left (decrease in quantity demanded at each price).
- A taste shift in the opposite direction shifts the curve right (increase).
Changes in Income and Wealth:
- For a normal good, higher income shifts the demand curve right (more bought at each price); lower income shifts it left.
- Inferior goods (e.g., canned Spam in some contexts) see demand shift left as income rises.
Changes in Availability and Prices of Related Goods:
- Substitutes: if the price of a substitute rises, demand for the good increases (rightward shift).
- Complements: if the price of a complement falls, demand for the good increases (rightward shift).
- Example for substitutes: higher price of public transportation → more driving → gasoline demand shifts right.
- Example for complements: cheaper ski trips increase transportation demand and gasoline demand (rightward shift).
Changes in Number and Scale of Buyers:
- More buyers → demand curve shifts right; fewer buyers → shifts left.
- Scale matters: a policy in a small town has much less impact on global gasoline demand than a policy in a large city like Tokyo.
Summary: Shifts in the demand curve occur due to changes in tastes, income/wealth, related goods, number/scale of buyers, and future beliefs. Movements along the demand curve occur only due to changes in the price of the good itself.

4.3 How Do Sellers Behave?

To complete the market picture, we study sellers and how they respond to prices.
Quantity supplied (Q_s): the amount of the good that sellers are willing to offer for sale at a given price.
Supply curve is typically plotted with price on the vertical axis and quantity supplied on the horizontal axis (the book uses red to denote supply curves).
Supply schedules (Exhibit 4.6) show the quantity supplied at different prices; a rise in the price of the good generally increases the quantity supplied.
The key relation: the price and quantity supplied are positively related (the Law of Supply).
Willingness to Accept (WTA): the minimum price at which a seller is willing to sell an extra unit; for an optimizing firm, WTA equals marginal cost (MC) of production.
- Example: if the price is $50, the firm would be willing to supply the 1 billionth barrel if that price covers its marginal cost (the firm is willing to accept $50 for the marginal barrel at that level of output).
- The supply curve height reflects the firm’s marginal cost; accepting less than MC for the marginal unit would imply a loss on that unit.

4.4 From Individual to Market Supply

Just as the market demand curve is the sum of all individual demand curves, the market supply curve is the sum of all individual supply curves: $Q^{\text{S,market}}(P) = \sumi Qi^{\text{S}}(P)$
Plot the market supply curve by summing quantities supplied at each price; this yields the total quantity supplied at each price in the market, holding all else equal.
Shifting the supply curve: four major factors shift the supply curve (holding price constant):
- Prices of inputs used to produce the good
- Technology used to produce the good
- Number and scale of sellers
- Sellers’ beliefs about the future
Changes in Prices of Inputs Used to Produce the Good:
- If the input price rises (e.g., steel for oil platforms), producing oil becomes more expensive; firms supply less at each price, shifting the supply curve left.
- Conversely, lower input prices shift the curve right.
Changes in Technology Used to Produce the Good:
- Technological advances (e.g., fracking) increase production efficiency and shift the supply curve to the right (more supply at each price).
Changes in the Number and Scale of Sellers:
- An increase in the number of suppliers shifts the supply curve to the right; a decrease shifts it to the left.
- Example: Libyan civil conflict reduced Libyan oil production (roughly 550 million barrels/year) causing a leftward shift in the world supply curve.
Changes in Sellers’ Beliefs about the Future:
- Expectations about future prices influence current supply; for natural gas, summer storage to meet winter demand illustrates forward-looking behavior that can shift supply across seasons (e.g., leftward shift in summer, rightward shift in winter to maximize annual revenue).
Summary: Shifts in the supply curve occur due to changes in input prices, technology, number/scale of sellers, and future expectations. Movements along the supply curve occur only due to a change in the price of the good itself.

4.5 Supply and Demand in Equilibrium

The interaction of buyers and sellers determines the market price and the traded quantity.
In a perfectly competitive market, the market converges to the price where quantity supplied equals quantity demanded.
Visualizing this on a single graph: the demand curve (blue) and the supply curve (red) intersect at the competitive equilibrium.
Example: In the oil market, the competitive equilibrium occurs at $P^{*} = 50$ and $Q^{*} = 35\text{ billion barrels/year}$ ; at this point, quantity supplied equals quantity demanded.
When the market price is above the competitive equilibrium price, there is excess supply: the quantity supplied exceeds the quantity demanded.
- Example: at $P = 70$ , Qs = 38 and Qd = 29 (excess supply).
When the market price is below the competitive equilibrium price, there is excess demand: the quantity demanded exceeds the quantity supplied.
- Example: at a price that yields Qd = 44 and Qs = 30 (excess demand).
In short:
- Equilibrium price: the price that clears the market (Qd = Qs).
- Equilibrium quantity: the corresponding traded quantity.
- When prices are not free to fluctuate, markets fail to equate Qd and Qs, leading to inefficiencies.

Summary of Key Concepts

Market: a group of economic agents trading a good or service under agreed-upon rules.
Perfectly competitive market: (i) identical goods, (ii) no single actor can affect price; all participants are price-takers.
Market price: the price at which the market clears; buyers and sellers accept this price.
Demand curve: relationship between price and quantity demanded, holding all else equal; typically downward-sloping (Law of Demand).
Demand schedule: table of Q_d at different prices; demand curve is its graphical representation.
Law of Demand: as price falls, quantity demanded rises (holding all else equal).
Willingness to Pay (WTP): the maximum price a buyer is willing to pay for a given marginal unit; equals the height of the demand curve at that quantity; exhibits diminishing marginal benefit.
Aggregation: market demand is the sum of individual demand curves: $D^{\text{market}}(P) = \sumi Di(P)$
Demand shifts vs movements along the curve:
- Shifts occur due to changes in tastes, income/wealth, prices of related goods, number/scale of buyers, and future beliefs.
- Movements along the demand curve occur due to changes in the good’s own price.
Supply curve: relationship between price and quantity supplied, holding all else equal; typically upward-sloping (Law of Supply).
Willingness to Accept (WTA): minimum price at which a seller is willing to sell an extra unit; for optimizing firms, WTA equals marginal cost (MC).
Aggregation of supply: market supply is the sum of individual supplies: $Q^{\text{S,market}}(P) = \sumi Qi^{\text{S}}(P)$
Supply shifts vs movements along the curve:
- Shifts occur due to changes in input prices, technology, number/scale of sellers, and future beliefs.
Equilibrium in a competitive market: the crossing point of the demand and supply curves; at equilibrium, $Qd(P^) = Qs(P^)$ ; the price is the competitive equilibrium price $P^$ and the quantity is the competitive equilibrium quantity $Q^$ .
If prices are not free to fluctuate, markets may fail to clear, resulting in excess supply or excess demand.

Key Terms

Market: A group of economic agents who are trading a good or service plus the rules and arrangements for trading.
Market price: The price at which the market clears; buyers and sellers accept this price.
Perfectly competitive market: A market where (i) sellers all sell an identical good or service, and (ii) no individual buyer or seller is powerful enough to affect the market price; all participants are price-takers.
Price-taker: An individual buyer or seller who accepts the market price and cannot bargain for a better price.
Quantity demanded: The amount of the good buyers are willing to purchase at a given price.
Demand schedule: A table showing the quantity demanded at different prices, holding all else fixed.
Holding all else equal: A concept used to analyze the relationship between two variables by assuming all other relevant factors remain constant.
Demand curve: A graphical representation plotting price (y-axis) versus quantity demanded (x-axis), showing the relationship between price and quantity demanded, holding all else equal.
Negatively related: The relationship between price and quantity demanded, where as one increases, the other decreases (typically for demand curves).
Law of Demand: As the price of a good falls, the quantity demanded rises (and vice versa), holding all else equal.
Willingness to pay (WTP): The maximum price a buyer is willing to pay for the next marginal unit of a good; equals the height of the demand curve at that quantity.
Diminishing marginal benefit: As a consumer obtains more of a good, the extra units provide less additional benefit, so willingness to pay for an extra unit falls as quantity on hand increases.
Aggregation: The process of summing individual demand or supply curves to derive the total market demand or supply curve.
Market demand curve: The sum of all individual demand curves, plotting the relationship between total quantity demanded and market price, holding all else equal.
Demand curve shifts: Occur when the quantity demanded changes at a given price due to non-price factors (e.g., changes in tastes, income, related goods, number of buyers, or future beliefs).
Movement along the demand curve: Occurs only due to a change in the good’s own price, illustrating how quantity demanded changes as price changes, holding all other factors constant.
Normal good: A good for which higher income shifts the demand curve right (more bought at each price); lower income shifts it left.
Inferior good: A good for which demand shifts left as income rises (and vice versa).
Substitutes: Goods that can be used in place of one another; if the price of a substitute rises, demand for the good increases.
Complements: Goods that are typically consumed together; if the price of a complement falls, demand for the good increases.
Quantity supplied: The amount of the good that sellers are willing to offer for sale at a given price.
Supply schedule: A table showing the quantity supplied at different prices.
Supply curve: A graphical representation plotting price (y-axis) versus quantity supplied (x-axis), showing the relationship between price and quantity supplied, holding all else equal.
Positively related: The relationship between price and quantity supplied, where as one increases, the other also increases (typically for supply curves).
Law of Supply: As the price of a good rises, the quantity supplied increases (and vice versa), holding all else equal.
Willingness to accept (WTA): The minimum price at which a seller is willing to sell an extra unit; for an optimizing firm, WTA equals the marginal cost of production.
Market supply curve: The sum of all individual supply curves, plotting the relationship between total quantity supplied and market price, holding all else equal.
Input: Resources used in the production of a good or service.
Supply curve shifts: Occur when the quantity supplied changes at a given price due to non-price factors (e.g., changes in input prices, technology, number of sellers, or future beliefs).
Movement along the supply curve: Occurs only due to a change in the good’s own price, illustrating how quantity supplied changes as price changes, holding all other factors constant.
Competitive equilibrium: The point where the demand curve and the supply curve intersect, where quantity supplied equals quantity demanded ( $Qd(P^) = Qs(P^)$ ).
Competitive equilibrium price ( $P^*$ ): The price that clears the market, where quantity demanded equals quantity supplied.
Competitive equilibrium quantity ( $Q^*$ ): The corresponding quantity traded at the competitive equilibrium price.
Excess supply: A situation where the quantity supplied exceeds the quantity demanded at a given price (i.e., the market price is above the equilibrium price).
Excess demand: A situation where the quantity demanded exceeds the quantity supplied at a given price (i.e., the market price is below the equilibrium price).

Questions for Review

What is meant by holding all else equal? How is this concept used when discussing movements along the demand curve? How is this concept used when discussing movements along the supply curve?
- "Holding all else equal" is a concept used to analyze the relationship between two variables by assuming all other relevant factors remain constant. When discussing movements along the demand curve, it means that only the good's own price changes, while factors like income and tastes are held constant. Similarly, for the supply curve, a movement along it occurs only due to a change in the good's own price, with input prices and technology remaining unchanged. This allows economists to isolate the impact of price on quantity.
What is meant by diminishing marginal benefits? Are you likely to experience diminishing marginal benefits for goods that you like a lot? Are there exceptions to the general rule of diminishing marginal benefits? (Hint: Think about a flashlight that requires two batteries.) Explain your answer.
- Diminishing marginal benefits means that as a consumer obtains more of a good, each additional unit provides less extra benefit, causing willingness to pay for an extra unit to fall. Even for goods you like a lot, you are likely to experience diminishing marginal benefits, as the satisfaction derived from consuming successive units typically decreases. An exception could be a flashlight requiring two batteries, where the first battery provides no benefit alone, but the second battery, enabling the flashlight to work, provides a significant, non-diminishing benefit in conjunction with the first. Some goods might have increasing marginal benefits for initial units if they are part of a set required for functionality.
How is the market demand schedule derived from individual demand schedules? How does the market demand curve differ from an individual demand curve?
- The market demand schedule is derived by summing the quantity demanded by all individual buyers at each specific price from their individual demand schedules. The market demand curve is then a graphical representation of this aggregate quantity demanded at different prices. It differs from an individual demand curve by representing the total quantity demanded by all consumers in the market, rather than just one person's demand, while still typically exhibiting the Law of Demand.
Explain how the following factors will shift the demand curve for Gillette shaving cream.
a. The price of a competitor's shaving cream increases.
- The price of a competitor's shaving cream increases: This factor will shift the demand curve for Gillette shaving cream to the right. Since a competitor's product is a substitute, its higher price makes Gillette's product relatively more attractive, increasing the quantity demanded at each price for Gillette.
b. With an increase in unemployment, the average level of income in the economy falls.
- With an increase in unemployment, the average level of income in the economy falls: Assuming Gillette shaving cream is a normal good, a fall in average income will shift its demand curve to the left. Consumers will demand less at each price due to reduced purchasing power.
  c. Shaving gels and foams, marketed as being better than shaving creams, are introduced in the market.
- Shaving gels and foams, marketed as being better than shaving creams, are introduced in the market: The introduction of seemingly superior products (substitutes) will likely shift the demand curve for Gillette shaving cream to the left. This represents a change in consumer tastes and preferences, drawing demand away from shaving cream. It also introduces new competition, reducing demand for the existing product.
What does it mean to say that we are running out of "cheap oil"? What does this imply for the future supply curve for oil? What does this imply for the price of oil in the future?
- "Running out of cheap oil" means that easily accessible and low-cost oil reserves are becoming depleted, forcing producers to extract oil from more expensive and harder-to-reach sources. This implies that the future supply curve for oil will shift to the left, as the marginal cost of production increases, meaning firms will supply less oil at any given price. Consequently, this will imply a higher equilibrium price for oil in the future, as the cost of bringing it to market rises.
What does the Law of Supply state? What is the key feature of a typical supply curve?
- The Law of Supply states that as the price of a good rises, the quantity supplied increases, and conversely, as the price falls, the quantity supplied decreases, holding all else equal. The key feature of a typical supply curve is that it is upward-sloping. This positive relationship between price and quantity supplied reflects sellers' willingness to offer more for sale when they can receive a higher price, which covers their marginal costs.
What is the difference between willingness to accept and willingness to pay? For a trade to take place, does the willingness to accept have to be lower, higher, or equal to the willingness to pay?
- Willingness to accept (WTA) is the minimum price at which a seller is willing to sell an extra unit of a good, often equaling the marginal cost of production for an optimizing firm. Willingness to pay (WTP) is the maximum price a buyer is willing to pay for the next marginal unit. For a trade to take place, the willingness to accept of the seller must be lower than or equal to the willingness to pay of the buyer. If WTA is higher than WTP, a mutually beneficial trade price cannot be found.
Explain how the following factors will shift the supply curve for beer, which is made from hops.
a. New irrigation technology increases the output per acre of hops farms.
- New irrigation technology increases the output per acre of hops farms: This technological advance will increase the efficiency of hops production, reducing the cost per unit. Consequently, the supply curve for beer (made from hops) will shift to the right, meaning more beer can be supplied at each price.
  
  b. The government raises the minimum wage, which increases the wage paid to workers on hops farms.
- The government raises the minimum wage, which increases the wage paid to workers on hops farms: An increase in minimum wage raises the price of labor, which is an input cost for hops farms. Higher input prices make production more expensive, leading firms to supply less beer at each given price. Therefore, the supply curve for beer will shift to the left.
How do the following affect the equilibrium price in a market?
a. A leftward shift in the demand curve
- A leftward shift in the demand curve: This indicates a decrease in demand. With a leftward shift in the demand curve, the equilibrium price in the market will decrease, and the equilibrium quantity will also decrease. Buyers are willing to purchase less at every price.
  
  b. A rightward shift in the supply curve
- A rightward shift in the supply curve: This indicates an increase in supply. With a rightward shift in the supply curve, the equilibrium price in the market will decrease, and the equilibrium quantity will increase. Sellers are willing to offer more at every price.
  
  c. A large rightward shift in the demand curve and a small rightward shift in the supply curve
- A large rightward shift in the demand curve and a small rightward shift in the supply curve: A large increase in demand (rightward shift) combined with only a small increase in supply (rightward shift) will lead to a significant increase in the equilibrium price. The equilibrium quantity will also increase, but the price effect will be pronounced due to the demand shift outweighing the supply shift.
  
  d. A large leftward shift in the supply curve and a small leftward shift in the demand curve
- A large leftward shift in the supply curve and a small leftward shift in the demand curve: A large decrease in supply (leftward shift) combined with only a small decrease in demand (leftward shift) will lead to a significant increase in the equilibrium price. The equilibrium quantity will decrease, with the supply shift being the dominant factor driving the price up.
Why was a fixed price of $50 not the best way of allocating used laptops? Suggest other possible ways of distributing the laptops that would be more efficient.
- A fixed price of $50 may not have been the best way of allocating used laptops because it does not account for the varying valuations different consumers might place on the laptops based on their personal needs and circumstances. Alternative methods for distributing the laptops that could be more efficient include:
  - Auction System: Allowing buyers to bid on laptops could help determine their market value and ensure that those who value them the most end up with the laptops.
  - Tiered Pricing: Implementing a pricing system that reflects the condition and specifications of each laptop could help match the price more closely to consumer willingness to pay.
  - Lottery System: A random draw could ensure equal access opportunities for all interested buyers, reducing potential inequities in distribution.
  - Targeted Distribution: Prioritizing certain groups (e.g., students or low-income individuals) could help ensure that the laptops reach those who need them the most.