Supply and Demand: Market Forces and Equilibrium
The Market Forces of Supply and Demand
Introduction to Markets and Competition
Market: Defined as a group of buyers and sellers for a particular product.
Competitive Market: Characterized by many buyers and sellers, where each individual participant has a negligible effect on the market price.
Perfectly Competitive Market: A specific type of competitive market assumed for foundational analysis, featuring:
All goods offered are exactly the same (homogeneous).
Buyers and sellers are so numerous that no single entity can influence the market price; each acts as a "price taker."
Assumption: For the purpose of this chapter, markets are assumed to be perfectly competitive.
Demand
Quantity Demanded (Q_d): The amount of a good that buyers are willing and able to purchase at a specific price.
It is represented by a single point on the demand curve.
If the price increases, Q_d will decrease.
Law of Demand: States that, ceteris paribus (other things equal), the quantity demanded of a good falls when the price of that good rises.
Demand (Curve): Represents the sum of consumers' preferences for goods or services across specific price intervals, illustrating how consumers' willingness to purchase changes as a function of various prices.
The Demand Schedule
Demand Schedule: A table that systematically shows the relationship between different prices of a good and the corresponding quantities demanded.
Example: Helen's demand for lattes
Price of lattes () | Quantity of lattes demanded (Q_d)
--|--
0.00 | 16
1.00 | 14
2.00 | 12
3.00 | 10
4.00 | 8
5.00 | 6
6.00 | 4
Helen's preferences align with the Law of Demand, showing an inverse relationship between price and quantity demanded.
Market Demand versus Individual Demand
Market Quantity Demanded: The total sum of the quantities demanded by all buyers at each given price.
Example: Helen and Ken's combined demand for lattes (assuming they are the only buyers)
Price () | Helen's Qd | Ken's Qd | Market Q_d
--|--|--|--
0.00 | 16 | 8 | 24
1.00 | 14 | 7 | 21
2.00 | 12 | 6 | 18
3.00 | 10 | 5 | 15
4.00 | 8 | 4 | 12
5.00 | 6 | 3 | 9
6.00 | 4 | 2 | 6
Demand Curve Shifters (Non-Price Determinants of Demand)
The demand curve illustrates the relationship between price and quantity demanded, assuming all other factors are constant.
Changes in these "other things" (non-price determinants) cause the entire demand curve to shift.
Key determinants:
Number of Buyers (Population):
An increase in the number of buyers leads to an increase in the quantity demanded at every price, shifting the demand (D) curve to the right.
Example: If the number of buyers increases from $D1$ to $D2$, at any price like P = $3.00, demand might increase from 15 to 20.
Income:
Normal Good: Demand is positively related to income.
An increase in income causes an increase in quantity demanded at each price, shifting the D curve to the right.
Inferior Good: Demand is negatively related to income.
An increase in income causes a decrease in quantity demanded at each price, shifting the D curve to the left.
Example: Public transportation might be an inferior good for some; as income rises, they might opt for cars instead.
Prices of Related Goods:
Substitutes: Two goods are substitutes if an increase in the price of one leads to an increase in the demand for the other.
Example: Pizza and hamburgers. If the price of pizza increases, demand for hamburgers increases, shifting the hamburger D curve to the right.
Other examples: Coke and Pepsi, laptops and desktop computers, compact discs and music downloads.
Complements: Two goods are complements if an increase in the price of one leads to a fall in demand for the other.
Example: Computers and software. If computer prices rise, fewer computers are bought, leading to less software demand, shifting the software D curve to the left.
Other examples: College tuition and textbooks, bagels and cream cheese, eggs and bacon.
Consumer Preferences or Tastes:
Anything that shifts consumer tastes toward a good will increase its demand, shifting the D curve to the right.
Example: The Atkins diet's popularity in the 1990s increased demand for eggs, shifting the egg D curve to the right.
Consumer Expectations:
Expectations about future prices or income influence current buying decisions.
Examples:
If people expect incomes to rise, current demand for expensive restaurant meals might increase.
Concerns about future job security due to a bad economy might immediately reduce demand for new automobiles.
Summary: Variables Affecting Demand
Variable | A change in this variable…
---|---
Price | …causes a movement along the D curve
Number of buyers | …shifts the D curve
Income | …shifts the D curve
Price of related goods | …shifts the D curve
Tastes | …shifts the D curve
Expectations | …shifts the D curve
Special Cases of Goods
Giffen Good:
A rare type of inferior good where people consume more of it as its price rises, thus violating the Law of Demand.
This occurs when cheaper, close substitutes are unavailable.
The income effect (reduced purchasing power due to price rise forcing more consumption of the cheaper staple) dominates the substitution effect (consumers typically buy less of a good as its price rises and more of substitutes), leading to increased purchases even with higher prices.
Veblen Good (Luxury Good):
A commodity for which consumers' preference for buying them increases as a direct function of their price.
Higher prices confer greater status or perceived exclusivity, contrary to the Law of Demand.
Often also a positional good.
Examples: High-end wines, designer handbags, luxury cars. Decreasing their prices might reduce demand as they are no longer seen as exclusive or high-status.
Active Learning 1: Demand Curve for Music Downloads
Task: Draw a demand curve for music downloads and analyze its shifts.
Scenario A: The price of iPods falls.
Analysis: Music downloads and iPods are complements. A fall in the price of iPods makes them more attractive, leading to increased demand for music downloads. The demand (D) curve for music downloads shifts to the right (e.g., from D1 to D2, increasing quantity from Q1 to Q2 at price P_1).
Scenario B: The price of music downloads falls.
Analysis: This is a change in the good's own price. The D curve does not shift. Instead, there is a movement along the fixed D curve to a point with a lower price (e.g., from P1 to P2) and a higher quantity (e.g., from Q1 to Q2).
Scenario C: The price of compact discs falls.
Analysis: CDs and music downloads are substitutes. A fall in the price of CDs makes them more attractive, leading consumers to buy fewer music downloads. The demand (D) curve for music downloads shifts to the left (e.g., from D1 to D2, decreasing quantity from Q1 to Q2 at price P_1).
Supply
Quantity Supplied (Q_s): The amount of a good that sellers are willing and able to sell at a certain price.
Law of Supply: States that, ceteris paribus (other things equal), the quantity supplied of a good rises when the price of the good rises.
The Supply Schedule
Supply Schedule: A table that shows the relationship between the price of a good and the quantity supplied.
Example: Starbucks' supply of lattes
Price of lattes () | Quantity of lattes supplied (Q_s)
--|--
0.00 | 0
1.00 | 3
2.00 | 6
3.00 | 9
4.00 | 12
5.00 | 15
6.00 | 18
Starbucks' supply schedule obeys the Law of Supply, showing a positive relationship between price and quantity supplied.
Market Supply versus Individual Supply
Market Quantity Supplied: The total sum of the quantities supplied by all sellers at each given price.
Example: Starbucks and Jitters' combined supply for lattes (assuming they are the only sellers)
Price () | Starbucks Qs | Jitters Qs | Market Q_s
--|--|--|--
0.00 | 0 | 0 | 0
1.00 | 3 | 2 | 5
2.00 | 6 | 4 | 10
3.00 | 9 | 6 | 15
4.00 | 12 | 8 | 20
5.00 | 15 | 10 | 25
6.00 | 18 | 12 | 30
Supply Curve Shifters (Non-Price Determinants of Supply)
The supply curve shows how price affects quantity supplied, ceteris paribus.
Changes in these "other things" (non-price determinants) cause the entire supply curve to shift.
Key determinants:
Input Prices: Wages, prices of raw materials, etc.
A fall in input prices makes production more profitable at each output price, leading firms to supply a larger quantity at each price. The supply (S) curve shifts to the right.
An increase in input prices makes production less profitable, shifting the S curve to the left.
Example: If the price of milk (an input for lattes) falls, the quantity of lattes supplied will increase at each price, shifting the S curve to the right.
Technology: Determines how many inputs are required to produce a unit of output.
A cost-saving technological improvement has the same effect as a fall in input prices: it shifts the S curve to the right (increased supply).
Number of Sellers (Producers):
An increase in the number of sellers increases the quantity supplied at each price, shifting the S curve to the right.
Producer Expectations:
Sellers may adjust their current supply based on expectations of future prices (if the good is not perishable).
Example: If oilfield owners expect higher oil prices in the future due to Middle East events, they might reduce current supply to save inventory and sell later at a higher price. The S curve shifts left.
Summary: Variables Affecting Supply
Variable | A change in this variable…
---|---
Price | …causes a movement along the S curve
Input prices | …shifts the S curve
Technology | …shifts the S curve
Number of sellers | …shifts the S curve
Expectations | …shifts the S curve
Active Learning 2: Supply Curve for Tax Return Preparation Software
Task: Analyze shifts in the supply curve for tax return preparation software.
Scenario A: Retailers cut the price of the software.
Analysis: This is a change in the good's own price. The S curve does not shift. There is a movement down along the fixed S curve to a lower price (e.g., P2) and a lower quantity (e.g., Q2).
Scenario B: A technological advance allows the software to be produced at lower cost.
Analysis: This is a change in technology, similar to a fall in input prices. It makes production more profitable. The S curve shifts to the right (e.g., from S1 to S2), increasing quantity supplied from Q1 to Q2 at price P_1).
Scenario C: Professional tax return preparers raise the price of the services they provide.
Analysis: This affects the demand for tax preparation software (as services are a substitute), not the supply of the software itself. The S curve for the software does not shift.
Supply and Demand Together: Market Equilibrium
When the supply (S) and demand (D) curves are combined, their intersection determines the market equilibrium.
Equilibrium: The point where quantity supplied (Qs) equals quantity demanded (Qd).
Equilibrium Price (P): The price at which Qs = Qd (e.g., P = $3.00 in the latte market).
P () | Qd | Qs
--|--|--
0 | 24 | 0
1 | 21 | 5
2 | 18 | 10
3 | 15 | 15
4 | 12 | 20
5 | 9 | 25
6 | 6 | 30
Equilibrium Quantity (Q): The quantity supplied and quantity demanded at the equilibrium price (e.g., Q = 15 lattes at P = $3.00).
Market Adjustment Processes
Surplus: Occurs when quantity supplied is greater than quantity demanded (Qs > Qd).
Example: If P = $5.00, then Qd = 9 lattes and Qs = 25 lattes, resulting in a surplus of 16 lattes (25 - 9 = 16).
Market Response: Facing a surplus, sellers have unsold goods and try to increase sales by cutting the price.
Price cuts cause Qd to rise and Qs to fall.
This process reduces the surplus.
Prices continue to fall until the market reaches equilibrium.
Shortage: Occurs when quantity demanded is greater than quantity supplied (Qd > Qs).
Example: If P = $1.00, then Qd = 21 lattes and Qs = 5 lattes, resulting in a shortage of 16 lattes (21 - 5 = 16).
Market Response: Facing a shortage, sellers realize they can sell more at a higher price and raise the price.
Price increases cause Qd to fall and Qs to rise.
This process reduces the shortage.
Prices continue to rise until the market reaches equilibrium.
Analyzing Changes in Equilibrium: The Three-Step Method
To determine the effects of any event on market equilibrium (P and Q):
Decide whether the event shifts the S curve, the D curve, or both.
Decide the direction in which the curve(s) shift(s) (left for decrease, right for increase).
Use a supply-demand diagram to visualize how the shift changes the equilibrium price (P) and quantity (Q).
Example 1: A Change in Demand (Increase in Price of Gas affecting Hybrid Cars)
Event to be analyzed: Increase in price of gas.
Curve Shift: The D curve for hybrid cars shifts because gas prices affect demand for hybrids. The S curve does not shift because gas prices do not affect the cost of producing hybrids.
Direction of Shift: The D curve shifts to the right ($D1$ to $D2$) because high gas prices make hybrids more attractive relative to other cars.
Effect on Eq'm: The shift causes an increase in both the equilibrium price (from P1 to P2) and the equilibrium quantity (from Q1 to Q2) of hybrid cars.
Important Distinction: When the price (P) rises, producers supply a larger quantity of hybrids. This is a movement along the existing S curve, not a shift in the S curve itself.
Terms for Shift vs. Movement Along Curve
Change in supply: A shift in the S curve, occurring when a non-price determinant of supply changes (e.g., technology, input costs).
Change in the quantity supplied: A movement along a fixed S curve, occurring only when the price (P) changes.
Change in demand: A shift in the D curve, occurring when a non-price determinant of demand changes (e.g., income, number of buyers).
Change in the quantity demanded: A movement along a fixed D curve, occurring only when the price (P) changes.
Example 2: A Change in Supply (New Technology reduces cost of producing Hybrid Cars)
Event: New technology reduces the cost of producing hybrid cars.
Curve Shift: The S curve shifts because the event affects the cost of production. The D curve does not shift because production technology is not a factor affecting demand.
Direction of Shift: The S curve shifts to the right ($S1$ to $S2$) because reduced costs make production more profitable at any given price.
Effect on Eq'm: The shift causes the equilibrium price to fall (from P1 to P2) and the equilibrium quantity to rise (from Q1 to Q2).
Example 3: A Change in Both Supply and Demand (Price of Gas Rises AND New Technology Reduces Production Costs)
Events: Price of gas rises and new technology reduces production costs for hybrid cars.
Curve Shift: Both curves shift.
Direction of Shifts: The D curve shifts to the right (due to higher gas prices, increasing hybrid attractiveness). The S curve shifts to the right (due to new technology, reducing production costs).
Effect on Eq'm: The equilibrium quantity (Q) unambiguously rises. However, the effect on equilibrium price (P) is ambiguous:
If demand increases more than supply, P rises.
If supply increases more than demand, P$$ falls.
Active Learning 3: Changes in Supply and Demand for Music Downloads
Task: Use the three-step method to analyze effects on equilibrium price and quantity of music downloads.
Event A: A fall in the price of compact discs.
Curve Shift: D curve shifts (CDs are substitutes for music downloads).
Direction of Shift: D shifts left (consumers buy cheaper CDs instead).
Effect on Eq'm: Both equilibrium P and Q fall.
Event B: Sellers of music downloads negotiate a reduction in the royalties they must pay for each song they sell.
Curve Shift: S curve shifts (royalties are a cost of production for sellers).
Direction of Shift: S shifts right (lower costs make selling more profitable).
Effect on Eq'm: Equilibrium P falls, and Q rises.
Event C: Events A and B both occur (fall in price of CDs AND fall in cost of royalties).
Curve Shift: Both curves shift.
Direction of Shifts: D shifts left (from Event A). S shifts right (from Event B).
Effect on Eq'm: Equilibrium P unambiguously falls. The effect on equilibrium Q is ambiguous:
The fall in demand (left shift of D) reduces Q.
The increase in supply (right shift of S) increases Q.
The net effect on Q depends on the relative magnitudes of the shifts.
Conclusion: How Prices Allocate Resources
Core Principle: Markets are generally an effective way to organize economic activity (one of the Ten Principles of Economics).
Price Mechanism: In market economies, prices naturally adjust to balance supply and demand.
Signaling Role of Prices: These equilibrium prices serve as crucial signals that guide economic decisions for both buyers and sellers, thereby efficiently allocating scarce resources to their most valued uses.