Week 3 Notes: Demand and Supply (Chapter 3) – Key Concepts and Determinants

Administrative reminders

• Week 3 ongoing: continuing chapter 3 (Demand and Supply). No new course slices this week; study guides for Exam 1 are available (two documents). The first interim exam is scheduled for September 2.
• Exam logistics: Next Tuesday is exam day (online). No in-person lecture that day; you’ll complete the exam online on your own.
• LockDown Browser: A proctoring app you must install on your computer to take future exams. If you haven’t used it before, use the practice test in quizzes to verify that the lockdown browser, webcam, and screen recording work properly. If issues arise, contact IT before the real exam.
• Homework: Homework 3 due before the end of this weekend.
• Office hours and email: Questions can be sent by email or discussed during office hours.

I. Review: What is demand?

• Demand is the relationship between the price of a good and the quantity that buyers are willing and able to purchase over a period of time. The relevant quantity is the quantity demanded $Q_d$, defined as the amount of a good that consumers are willing and able to buy at a given price.
• Key point: When the price changes, the quantity demanded changes accordingly. This is an inverse (negative) relationship between price $P$ and quantity demanded $Q_d$.
• Explanations for why this inverse relationship exists (three classic explanations):
  • Income effect: changes in purchasing power as price changes affect how much you can buy.
  • Substitution effect: as prices change, consumers substitute cheaper goods for more expensive ones.
  • Law of diminishing marginal utility: the additional satisfaction from each extra unit tends to fall, so consumers buy less as price rises.
• In short: The law of demand states that, all else equal, when price falls, quantity demanded rises; when price rises, quantity demanded falls.

II. The Demand Curve: shape and interpretation

• A demand curve graphically displays the negative relationship between price and quantity demanded.
• Axes convention (the traditional one):
  • Horizontal axis: quantity demanded $Q_d$.
  • Vertical axis: price $P$.
• Example: gasoline market (buyers’ side)
  • Given price levels and quantity demanded:
  • At $P = 2.00$, $Q_d = 460$ million gallons.
  • At $P = 1.80$, $Q_d = 500$ million gallons.
  • The remaining three price–quantity points continue in the same way (the transcript notes five combinations and then connects them).
  • Plot the points and connect to obtain the demand curve; it is typically not linear but downward-sloping.
• Important distinction from the budget constraint: a downward-sloping demand curve indicates a negative relationship between price and quantity demanded, not a trade-off/production possibility issue.
• The curve can be drawn as a smooth curve or a straight line; the key feature is that it slopes downward.

III. Changes along the demand curve vs changes of the demand curve

• Movement along the same demand curve (change in quantity demanded):
  • Caused by a change in price only; the other determinants remain the same.
  • This is a movement along the curve, not a shift of the curve.
• Shift of the demand curve (change in demand):
  • The entire demand curve shifts to a new position, indicating a change in demand at every price level.
  • Two directions:
  • Rightward shift: increase in demand (at every price, a higher quantity is demanded).
  • Leftward shift: decrease in demand (at every price, a lower quantity is demanded).
• Distinguishing principle: A shift occurs due to non-price determinants; a movement along the curve occurs due to the price change of the good itself.
• The instructor used a movie clip (hula hoops) as a practical exercise to identify when a change is a shift in demand versus a movement along the curve.

IV. Non-price determinants of demand (factors that shift the demand curve)

• When non-price factors change, the entire demand curve shifts. The determinants discussed include:
  • Income: affects normal vs. inferior goods.
  • Normal goods: higher income leads to higher demand (positive income elasticity).
  • Inferior goods: higher income leads to lower demand.
  • Prices of related goods (substitutes and complements):
  • Substitutes: goods that can replace each other (e.g., Pepsi and Coca-Cola).
    • If the price of a substitute rises, the demand for the other substitute rises (shift to the right for that good).
  • Complements: goods that are often consumed together (e.g., popcorn and movie tickets).
    • If the price of a complement changes, the demand for the related good moves in the opposite direction (e.g., higher popcorn price reduces demand for movie tickets).
  • Tastes and preferences: more interest or preference for a product increases demand.
  • Expectations about future prices or income: if price is expected to rise, current demand may increase to buy now; if income is expected to rise, behavior today may change.
  • Number of buyers: more buyers increases overall market demand.
  • Government policies: taxes and subsidies.
  • Taxes: reduce demand (shift left).
  • Subsidies: increase demand (shift right).
  • Other examples and scenarios discussed include:
  • Substitutes and complements in more depth with everyday examples (Pepsi vs Coca-Cola; popcorn and movie tickets).
  • Expectations about future prices (gas price expected to rise prompts immediate buying).
  • Income effects and the distinction between normal and inferior goods across various categories (e.g., travel, fashion, etc.).

V. Detailed look at substitutes and complements

• Complements:
  • If the price of a complement rises, the demand for the related good falls (shifts left); if the price of a complement falls, demand for the related good rises (shifts right).
  • Example framing noted: two goods that are commonly consumed together (popcorn and movie tickets).
• Substitutes:
  • If the price of one substitute rises, consumers shift demand toward the other substitute (shift right for the other good).
  • Example: Pepsi vs Coca-Cola. If Pepsi becomes more expensive, demand for Coca-Cola increases.
• The key mechanism: the type of relationship (complements vs substitutes) determines the direction of the demand shift when the price of the related good changes.

VI. Determinants of demand: a quick synthesis

• Summary of determinants to remember:
  • Income (normal vs inferior goods)
  • Tastes and preferences
  • Prices of related goods (substitutes and complements)
  • Expectations about future prices or income
  • Number of buyers
  • Government policy (taxes and subsidies)
  • Prices of related goods (as they affect substitutes and complements)
• The practical takeaway: when analyzing a market, identify the non-price factor at work to predict whether demand will shift left or right at all price levels.

VII. The demand curve in relation to the broader market framework

• Demand studies how consumers respond to price changes, holding other factors constant (ceteris paribus).
• Supply studies how producers respond to price changes, with its own ceteris paribus condition (to be discussed next class).
• The instructor signaled that future classes will bring demand and supply together to analyze market outcomes (equilibrium, shifts, and welfare).

VIII. The basics of supply (preview)

• Supply is the relationship between market price and the quantity producers are willing and able to sell, all else equal.
• The key idea: price acts as an incentive for producers. Higher prices typically lead to higher quantities supplied because they raise potential profit.
• The law of supply: the quantity supplied increases with price; the relationship is positive: rac{\partial Q_s}{\partial P} > 0.
• Consideration of costs: larger production (e.g., a bigger farm) generally entails higher average costs, which may require higher prices to cover rising costs and ensure profits.
• The two-sided nature of the relationship: increasing price can increase quantity supplied, and increasing quantity supplied can also influence price dynamics in the broader market.

IX. Looking ahead: where this fits in the course

• The next session will bring together the demand and supply analyses to discuss equilibrium, shifts, and real-world implications.
• The instructor emphasizes applying the concepts to real-world scenarios, markets, and policy questions rather than just memorizing definitions.

X. Quick reminders of practical aspects (from the lecture)

• Exam logistics: online format, lockdown browser requirements, and the practice test to ensure readiness.
• Use of office hours and email for questions.
• Homework 3 due by the weekend.

Quick reference: key formulas and relationships

• Demand responsiveness (inverse relationship):
  • Qualitative: rac{ ext{d}Q_d}{ ext{d}P} < 0
• Supply responsiveness (positive relationship):
  • Qualitative: rac{ ext{d}Q_s}{ ext{d}P} > 0
• Income effects and goods classifications:
  • Normal goods: rac{ ext{d}Q_d}{ ext{d}I} > 0
  • Inferior goods: rac{ ext{d}Q_d}{ ext{d}I} < 0
• Substitutes and complements (illustrative direction when related good’s price changes):
  • Substitutes: if price of substitute rises, demand for the other good moves right (increase in demand) for that good.
  • Complements: if price of a complement rises, demand for the related good moves left (decrease in demand).