Principles of Macroeconomics - Chapter 4: The Market Forces of Supply and Demand
Chapter 4: The Market Forces of Supply and Demand
Chapter Objectives
Understand factors affecting buyers' demand for goods.
Understand factors affecting sellers' supply of goods.
Explain how supply and demand determine the price and quantity sold of a good.
Analyze how changes in demand or supply factors affect market price and quantity.
Distinguish between movements along and shifts of demand and supply curves.
Address real-world phenomena like price fluctuations in oil and gasoline and explain their underlying market mechanics.
4-1 Markets and Competition
Market: 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: A market characterized by many buyers and many sellers, where each participant has a negligible impact on the market price. Price and quantity sold are collectively determined by the interaction of all buyers and sellers.
Perfectly Competitive Market: A theoretical market structure with specific characteristics:
Goods offered for sale are exactly the same (homogeneous).
Buyers and sellers are numerous.
No single buyer or seller can influence the market price; they are price takers.
At the market price, buyers can purchase all they want, and sellers can sell all they want.
Other Markets:
Monopoly: A market with only one seller, who has the power to set the price.
Many markets exist on a spectrum between perfect competition and monopoly.
4-2 Demand
Demand (as an economic concept) requires three conditions:
A buyer wants the good.
A buyer can afford the good.
A buyer has made a definite plan to buy the good.
Wants are unlimited desires; demand reflects a decision to satisfy specific wants.
Quantity Demanded: The amount of a good that buyers are willing and able to purchase during a particular time period, at a particular price.
Law of Demand: States that, other things equal (ceteris paribus), when the price of a good rises, the quantity demanded of the good falls; and when the price falls, the quantity demanded rises.
Individual Demand: An individual's specific demand for a product.
Demand Schedule: A table illustrating the relationship between the price of a good and the quantity demanded. For example, Sam's demand for lattes shows that as price decreases, quantity demanded increases (e.g., at 0.00, demand is 16 lattes; at 6.00, demand is 4 lattes).
Demand Curve: A graphical representation of the relationship between the price of a good and the quantity demanded. It typically slopes downward.
Important Distinction: Quantity demanded refers to a specific point on the demand curve at a given price, while demand refers to the entire relationship shown by the curve.
Market Demand: The sum of all individual demands for a particular good or service.
Market Demand Curve: Derived by horizontally summing the individual demand curves. It shows how the total quantity demanded varies with price, assuming all other factors affecting consumer purchases remain constant.
Example: If Sam's demand for lattes at 1.00 is 14 and Dean's is 7, the market demand at 1.00 is 14+7=21 lattes.
Movement Along the Demand Curve: Caused exclusively by a change in the price of the good itself.
A rise in price causes a decrease in quantity demanded and an upward movement along the demand curve.
A fall in price causes an increase in quantity demanded and a downward movement along the demand curve.
Demand Curve Shifters (Non-Price Determinants of Demand): Factors that cause the entire demand curve to shift either rightward (increase in demand) or leftward (decrease in demand).
Number of Buyers (Population):
Increase in buyers $\rightarrow$ Increase in quantity demanded at each price $\rightarrow$ Demand curve shifts right.
Decrease in buyers $\rightarrow$ Decrease in quantity demanded at each price $\rightarrow$ Demand curve shifts left.
Income:
Normal good: A good for which an increase in income leads to an increase in demand (e.g., air travel).
Inferior good: A good for which an increase in income leads to a decrease in demand (e.g., long-distance bus trips).
Prices of Related Goods:
Substitutes: Pairs of goods used in place of each other. An increase in the price of one leads to an increase in demand for the other (e.g., if pizza price rises, demand for hamburgers shifts right).
Complements: Pairs of goods used together. An increase in the price of one leads to a decrease in demand for the other (e.g., if computer price rises, demand for software shifts left).
Tastes/Preferences: Anything that causes a shift in tastes toward a good will increase its demand and shift its D curve to the right (e.g., Atkins diet popularizes eggs, increasing egg demand).
Expectations About the Future:
Expectation of increased future income $\rightarrow$ Increase in current demand.
Expectation of higher future prices $\rightarrow$ Increase in current demand.
Example: If people expect incomes to rise, current demand for expensive restaurant meals may increase.
Shifts in the Demand Curve vs. Movements along the Demand Curve:
A shift in the demand curve (change in demand) occurs when a non-price determinant changes, altering the quantity demanded at every price.
A movement along the demand curve (change in quantity demanded) occurs only when the price of the good itself changes, altering the specific quantity consumers are willing and able to buy at that new price point.
Active Learning Examples for Demand:
Fall in the price of iPods (complements): Shifts demand for music downloads to the right.
Fall in the price of music downloads: Causes a movement down along the demand curve (higher quantity demanded at a lower price).
Fall in the price of music CDs (substitutes): Shifts demand for music downloads to the left.
4-3 Supply
Law of Supply: States that, other things equal, when the price of a good rises, the quantity supplied of the good rises; and when the price falls, the quantity supplied falls.
Quantity Supplied: The amount of a good that sellers are willing and able to sell during a given time period at a particular price.
Individual Supply: A single seller's supply for a product.
Supply Schedule: A table showing the relationship between the price of a good and the quantity supplied. For example, Starbucks' supply for lattes shows that as price increases, quantity supplied increases (e.g., at 0.00, supply is 0 lattes; at 6.00, supply is 18 lattes).
Supply Curve: A graph of the relationship between the price of a good and the quantity supplied. It typically slopes upward.
Market Supply: The sum of the supplies of all sellers for a particular good or service.
Market Supply Curve: Derived by horizontally summing individual supply curves. It shows how total quantity supplied varies with price, holding all other factors influencing producers' decisions constant.
Example: If Starbucks' supply for lattes at 3.00 is 9 and Peet's is 6, the market supply at 3.00 is 9+6=15 lattes.
Movement Along the Supply Curve: Caused exclusively by a change in the price of the good itself.
A rise in price causes an increase in quantity supplied and an upward movement along the supply curve.
A fall in price causes a decrease in quantity supplied and a downward movement along the supply curve.
Supply Curve Shifters (Non-Price Determinants of Supply): Factors that cause the entire supply curve to shift either rightward (increase in supply) or leftward (decrease in supply).
Input Prices (Price of Factors of Production):
Supply is negatively related to input prices (e.g., wages, raw materials).
A fall in input prices makes production more profitable $\rightarrow$ Firms supply a larger quantity at each price $\rightarrow$ Supply curve shifts right.
Technology: Advances in technology increase supply by making production more efficient or reducing costs. A cost-saving technological improvement shifts the supply curve to the right.
Number of Suppliers: An increase in the number of sellers $\rightarrow$ Increases the quantity supplied at each price $\rightarrow$ Supply curve shifts right.
Expectations About Future Prices: Sellers may adjust current supply based on expectations.
Expectation of higher future prices $\rightarrow$ Reduce current supply (if the good is not perishable) to sell later at a higher price $\rightarrow$ Supply curve shifts left.
Active Learning Examples for Supply:
Fall in the price of tax return software: Causes a movement down along the supply curve (lower quantity supplied at a lower price).
Fall in cost of producing software (technological advance): Shifts supply curve to the right.
Professional tax preparers raise their prices: This affects demand for tax software (as a substitute), not the supply of tax software.
4-4 Supply and Demand Together
Equilibrium: The point where the quantity of a good that buyers are willing and able to buy exactly balances the quantity that sellers are willing and able to sell.
Equilibrium Price: The price at which quantity demanded equals quantity supplied. This is where the supply and demand curves intersect.
Equilibrium Quantity: The quantity supplied and demanded at the equilibrium price.
Example: For lattes, if at 3.00, quantity demanded is 15 and quantity supplied is 15, then 3.00 is the equilibrium price and 15 is the equilibrium quantity.
Markets Not in Equilibrium:
Surplus (Excess Supply): Occurs when quantity supplied is greater than quantity demanded at a given price (price is above equilibrium).
Sellers respond by cutting prices to increase sales.
Falling prices cause quantity demanded to rise and quantity supplied to fall (movements along the curves).
Prices continue to fall until the market reaches equilibrium.
Example: If price is 5.00, QD = 9 and QS = 25, resulting in a surplus of 16 lattes.
Shortage (Excess Demand): Occurs when quantity demanded is greater than quantity supplied at a given price (price is below equilibrium).
Sellers can raise prices without losing sales.
Rising prices cause quantity demanded to fall and quantity supplied to rise (movements along the curves).
Prices continue to rise until the market reaches equilibrium.
Example: If price is 1.00, QD = 21 and QS = 5, resulting in a shortage of 16 lattes.
Law of Supply and Demand: The claim that the price of any good adjusts to bring the quantity supplied and the quantity demanded of that good into balance. In well-functioning markets, surpluses and shortages are temporary as prices quickly move towards equilibrium.
Three Steps to Analyzing Changes in Equilibrium:
Decide which curve(s) shift: Determine whether the event affects the supply curve, the demand curve, or both.
Decide direction of shift: Determine whether the curve(s) shift to the right (increase) or to the left (decrease).
Use supply-and-demand diagram: Compare the initial and new equilibrium to determine the effects on equilibrium price and quantity.
Shifts in Curves versus Movements along Them:
Change in supply refers to a shift in the entire supply curve (due to a non-price determinant).
Change in the quantity supplied refers to a movement along a fixed supply curve (due to a change in price).
Change in demand refers to a shift in the entire demand curve (due to a non-price determinant).
Change in the quantity demanded refers to a movement along a fixed demand curve (due to a change in price).
Examples of Changes in Equilibrium:
Increase in Demand (e.g., hot summer for ice cream, or increased gas price for hybrid cars):
D curve shifts right.
Equilibrium price and quantity both rise.
Decrease in Supply (e.g., increased sugar price for ice cream, or new technology reducing hybrid car costs):
S curve shifts left.
Equilibrium price rises, and equilibrium quantity falls.
Shift in Both Supply and Demand (e.g., increased gas price AND new technology for hybrid cars):
Both D and S curves shift right.
Equilibrium quantity rises.
Effect on equilibrium price is ambiguous; it depends on the relative magnitudes of the demand and supply shifts. Price could rise, fall, or stay the same.
Summary Table: What Happens to Price and Quantity When Supply or Demand Shifts?
No Change in Supply, No Change in Demand $\rightarrow$ P same, Q same
No Change in Supply, Increase in Demand $\rightarrow$ P up, Q up
No Change in Supply, Decrease in Demand $\rightarrow$ P down, Q down
Increase in Supply, No Change in Demand $\rightarrow$ P down, Q up
Increase in Supply, Increase in Demand $\rightarrow$ P ambiguous, Q up
Increase in Supply, Decrease in Demand $\rightarrow$ P down, Q ambiguous
Decrease in Supply, No Change in Demand $\rightarrow$ P up, Q down
Decrease in Supply, Increase in Demand $\rightarrow$ P up, Q ambiguous
Decrease in Supply, Decrease in Demand $\rightarrow$ P ambiguous, Q down
4-5 Conclusion: How Prices Allocate Resources
In market economies, prices serve as crucial signals that guide economic decisions and allocate scarce resources efficiently.
For every good, the price adjusts to ensure that the quantity supplied and the quantity demanded are in balance.
The equilibrium price determines how much buyers choose to consume and how much sellers choose to produce, thereby coordinating economic activity.
Ask the Experts: Price Gouging: An assertion that laws preventing high prices for essential goods in short supply during a crisis (price gouging laws) would raise social welfare. This opinion implies a debate around market efficiency vs. equity/fairness in emergency situations.
Think-Pair-Share Activity: Typhoon and Apple Crop:
Impact on roommate who drinks pineapple smoothies: Even if not consuming apples directly, the typhoon will affect the availability and price of apples, impacting markets for substitutes (other fruits) and complements (e.g., apple pie ingredients). For instance, if pineapple juice is a substitute for apple juice, its demand might increase, leading to higher prices. Alternatively, if apples are inputs to other goods, those goods' prices may change.
Other markets impacted: Markets for apple juice, apple pie, other fruits (substitutes), labor in apple orchards, transportation of produce, etc., will be affected through price and quantity changes as supply of apples dramatically decreases.
Self-Assessment:
Role of prices in market economies: Prices coordinate the decisions of buyers and sellers, allocating resources to their most valued uses by signaling scarcity and demand.
Prices that do not adjust (e.g., national park entrance fees): These are examples of prices that may be government-regulated or fixed, not adjusting freely to market forces. This can lead to non-price rationing, such as queues or limited availability, if demand outstrips the fixed supply at the given price.