Where Prices Come From: The Interaction of Demand and Supply

3. Where Prices Come From: The Interaction of Demand and Supply

3.1 The Demand Side of the Market

• Variables influencing demand:

  • Begin by investigating how buyers behave, referring to this as market demand, the demand by all the consumers of a given good or service.

• Demand Schedule:

  • A table showing the relationship between the price of a product and the quantity of the product demanded.

• Demand Curve:

  • A curve that illustrates the relationship between the price of a product and the quantity of the product demanded.

• Quantity Demanded:

  • The amount of a good or service that a consumer is willing and able to purchase at a given price.

• Law of Demand:

  • States that, holding everything else constant (ceteris paribus), when the price of a product falls, the quantity demanded of the product will increase, and when the price of a product rises, the quantity demanded of the product will decrease.

  • Qd = f(P), where Qd is the quantity demanded and P is the price.

• Explanations for the Law of Demand:

  1. Substitution Effect:

     • When the price of a good falls, consumers substitute toward the good whose price has fallen, making it more or less expensive relative to other goods, holding constant the effect of the price change on consumer purchasing power.

  2. Income Effect:

     • Consumers have more purchasing power, which is like an increase in income.

     • The change in the quantity demanded of a good that results from the effect of a change in the good’s price on a consumer’s purchasing power, holding all other factors constant.

• Ceteris Paribus Condition:

  • The requirement that when analyzing the relationship between two variables—such as price and quantity demanded—other variables must be held constant.

• Shifting the Demand Curve:

  • A change in something other than price that affects demand causes the entire demand curve to shift.

  • A shift to the right is an increase in demand.

  • A shift to the left is a decrease in demand.

  • As the demand curve shifts, the quantity demanded will change, even if the price doesn’t change.

  • The quantity demanded changes at every possible price.

• Variables That Shift Market Demand:

  • Income:

    • An increase in income increases demand if the product is normal and decreases demand if the product is inferior.

    • Normal Good: A good for which the demand increases as income rises and decreases as income falls (e.g., new clothes, restaurant meals, vacations).

    • Inferior Good: A good for which the demand increases as income falls and decreases as income rises (e.g., second-hand clothes, instant noodles).

  • Prices of Related Goods:

    • An increase in the price of related goods increases demand if products are substitutes and decreases demand if products are complements.

    • Substitutes: Goods and services that can be used for the same purpose (e.g., Big Mac and Whopper, Ford F-150 and Dodge Ram, reusable water bottles and bottled spring water).

    • Complements: Goods and services that are used together (e.g., Big Mac and McDonald’s fries, left shoes and right shoes, reusable water bottles and gym memberships).

  • Tastes:

    • If consumers’ tastes change, they may buy more or less of the product.

    • Example: If influencers successfully advertise reusable water bottles, they affect consumers’ tastes, increasing demand for reusable water bottles.

  • Population and Demographics:

    • Demographics: The characteristics of a population with respect to age, race, and gender.

    • Increases in the number of people buying something will increase the amount demanded.

    • Example: An increase in the elderly population increases the demand for medical care.

  • Expected Future Prices:

    • Consumers decide which products to buy and also when to buy them.

    • Future products are substitutes for current products.

    • An expected increase in the price tomorrow increases demand today.

    • An expected decrease in the price tomorrow decreases demand today.

    • Example: If you found out the price of gasoline would go up tomorrow, you would increase your demand today.

  • Natural Disasters and Pandemics:

    • Temporary disruptions to economic activity can happen via natural disasters or pandemics.

    • Natural Disaster: A hurricane, flood, or similar act of nature that causes damage to stores, factories, or office buildings.

    • Pandemic: A situation in which a disease becomes sufficiently widespread as to significantly affect economic activity.

    • Example: The Covid-19 pandemic reduced the demand for goods that required people gathering (restaurants, concert tickets, etc.) but increased the demand for computing equipment to work from home.

• Change in Demand vs. Change in Quantity Demanded:

  • A change in the price of the product being examined causes a movement along the demand curve, which is a change in quantity demanded.

  • Any other change affecting demand causes the entire demand curve to shift, which is a change in demand.

3.2 The Supply Side of the Market

• Market Supply:

  • The decisions of firms about how much of a product to provide at various prices.

• Supply Schedule:

  • A table that shows the relationship between the price of a product and the quantity of the product supplied.

• Supply Curve:

  • A curve that shows the relationship between the price of a product and the quantity of the product supplied.

• Quantity Supplied:

  • The amount of a good or service that a firm is willing and able to supply at a given price.

• Law of Supply:

  • States that, holding everything else constant, increases in price cause increases in the quantity supplied, and decreases in price cause decreases in the quantity supplied.

  • Qs = f(P), where Qs is the quantity supplied and P is the price.

• Shifting the Supply Curve:

  • A change in something other than price that affects supply causes the entire supply curve to shift.

    • A shift to the right is an increase in supply.

    • A shift to the left is a decrease in supply.

  • As the supply curve shifts, the quantity supplied will change, even if the price doesn’t change.

  • The quantity supplied changes at every possible price.

• Variables That Shift Market Supply:

  • Prices of Inputs:

    • Inputs are anything used in the production of a good or service.

    • For a reusable water bottle, this includes plastic, labor, and transportation services.

    • An increase in the price of input decreases the profitability of selling the good, causing a decrease in supply.

    • A decrease in the price of an input increases the profitability of selling the good, causing an increase in supply.

  • Technological Change:

    • A firm may experience a positive or negative change in its ability to produce a given level of output with a given quantity of inputs.

    • Examples:

      • A new, more efficient way of producing water bottles would increase their supply.

      • Governmental restrictions on how much workers are allowed to work might decrease the supply of water bottles.

  • Prices of Related Goods in Production:

    • Many firms can produce and sell alternative products: substitutes in production.

    • Example: An Illinois farmer can plant either corn or soybeans. If the price of soybeans rises, that farmer will plant (supply) less corn.

    • Sometimes, two products are necessarily produced together: complements in production

    • Example: Cattle provide both beef and leather. An increase in the price of beef encourages more cattle farming, which increases the supply of leather.

  • Number of Firms and Expected Future Prices:

    • More firms in the market will result in more products available at a given price (greater supply).

    • If a firm anticipates that the price of its product will be higher in the future, it might decrease its supply today in order to increase it later.

    • Fewer firms \rightarrow supply decreases.

  • Natural Disasters and Pandemics:

    • Less of a good will be supplied due to disruptions in production

    • Example: During hurricanes and floods, some manufacturing plants will be damaged and forced to shut down. The result will be fewer units supplied.

• Change in Supply vs. Change in Quantity Supplied:

  • A change in the price of the product being examined causes a movement along the supply curve, which is a change in the quantity supplied.

  • Any other change affecting supply causes the entire supply curve to shift, which is a change in supply.

3.3 Market Equilibrium: Putting Demand and Supply Together

• Market Equilibrium:

  • A situation in which quantity demanded equals quantity supplied.

  • Recall that markets with many buyers and sellers are perfectly competitive markets; a market equilibrium in one of these markets is called a competitive market equilibrium.

• Competitive Market Equilibrium:

  • Occurs where quantity demanded equals quantity supplied in a market with many buyers and sellers.

• Surplus:

  • A situation in which the quantity supplied is greater than the quantity demanded.

  • Sellers will compete among themselves, driving the price down.

• Shortage:

  • A situation in which the quantity demanded is greater than the quantity supplied.

  • Sellers will realize they can increase the price and still sell as many water bottles, so the price will rise.

• Price Determination:

  • Price is determined by the interaction of buyers and sellers.

  • Neither group can dictate price in a competitive market (i.e., one with many buyers and sellers).

  • However, changes in supply and/or demand will affect the price and quantity traded.

3.4 The Effect of Demand and Supply Shifts on Equilibrium

• Predictions with Demand and Supply Graphs:

  • Predictions about price and quantity in our model require us to know demand and supply curves.

  • Typically, we know price and quantity but do not know the curves that generate them.

  • The power of the demand and supply model is in its ability to predict directional changes in price and quantity.

• Increase in Demand:

  • If reusable water bottles are a normal good, as income rises, demand shifts to the right.

    • Equilibrium price rises.

    • Equilibrium quantity rises.

• Increase in Supply:

  • When a new producer enters the market, more water bottles are supplied at any given price—an increase in supply.

    • Equilibrium price falls.

    • Equilibrium quantity rises.

• Simultaneous Shifts in Demand and Supply:

  • Over time, it is likely that both demand and supply will change.

  • For example, as new firms enter the market for water bottles and incomes increase, we expect:

    • The supply curve will shift to the right, and

    • The demand curve will shift to the right.

  • Equilibrium quantity will rise, but the effect on the equilibrium price is not clear.

    • If demand shifts more than supply: equilibrium price and quantity both rise.

    • If supply shifts more than demand: quantity rises, but equilibrium price falls.

    • Without knowing the relative size of the changes, the effect on the equilibrium price is ambiguous. It is possible, but unlikely, that the equilibrium price will remain unchanged.

• Shifts of a Curve vs. Movements Along a Curve:

  • Suppose an increase in supply occurs.

    • Equilibrium quantity will increase, and

    • Equilibrium price will decrease.

  • The decrease in price will cause a movement along the demand curve but not an increase in demand.

  • The demand curve already describes how much of the good consumers want to buy at any given price.

  • When the price change occurs, we just look at the demand curve to see what happens to how much consumers want to buy.