Chapter 4 Notes: The Market Forces of Supply and Demand (Mankiw 9th ed.)
Markets and Competition
Supply and demand – The words economists use most often; the forces that make market economies work; refer to the behavior of people as they interact with one another in competitive markets.
Market – A group of buyers and sellers of a particular good or service.
Buyers as a group determine the demand for the product.
Sellers as a group determine the supply of the product.
Markets take many forms:
Highly organized markets (e.g., many agricultural commodities).
Less organized markets (e.g., a market for ice cream in a particular town).
Competitive market – Market with many buyers and many sellers; Each has a negligible impact on market price; Price and quantity are determined by the collective interaction of all buyers and sellers.
Perfectly competitive market – Goods offered for sale are all exactly the same; Buyers and sellers are so numerous that no single participant has influence over the market price; Price takers; Buyers can buy all they want; Sellers can sell all they want.
Monopoly – The only seller in the market; Sets the price; Other markets lie between perfect competition and monopoly.
Demand
Quantity demanded – Amount of a good that buyers are willing and able to purchase.
Law of demand – Other things equal: when the price of a good rises, the quantity demanded falls; when the price falls, the quantity demanded rises.
Demand – Relationship between the price of a good and quantity demanded.
Demand schedule: a table.
Demand curve: a graph; Price on the vertical axis; Quantity on the horizontal axis.
Individual demand – An individual’s demand for a product.
Market demand – Sum of all individual demands for a good or service.
Market demand curve – Sum of the individual demand curves horizontally.
Total quantity demanded varies as the price of the good varies, holding other things constant.
Shifts in the demand curve – Increase in demand: curve shifts right; Decrease in demand: curve shifts left.
Figure references:
Figure 3: Shifts in the Demand Curve – Any change that raises the quantity that buyers wish to purchase at any given price shifts the demand curve to the right. Any change that lowers the quantity that buyers wish to purchase at any given price shifts the demand curve to the left.
Variables that can shift the demand curve – Income, Prices of related goods, Tastes, Expectations, Number of buyers.
Income effects:
Normal good: other things constant; an increase in income leads to an increase in demand.
Inferior good: other things constant; an increase in income leads to a decrease in demand.
Prices of related goods – Substitutes: an increase in the price of one leads to an increase in the demand for the other. – Complements: an increase in the price of one leads to a decrease in the demand for the other.
Tastes – Changes in tastes affect demand.
Expectations about the future – If you expect an increase in income, current demand increases; If you expect higher prices, current demand increases.
Number of buyers – Market demand increases with more buyers.
Table 1: Variables That Influence Buyers:
Change in the price of the good itself represents a movement along the demand curve.
Other variables (Income; Prices of related goods; Tastes; Expectations; Number of buyers) shift the demand curve.
Two Ways to Reduce the Quantity of Smoking Demanded (Part 1–3):
Shift the demand curve for cigarettes and other tobacco products.
Increase the price of cigarettes via public policy or taxation; try public service announcements; mandatory health warnings on packages; prohibition of advertising.
If successful, the demand curve shifts to the left (lower quantity demanded at each price).
Quantitative effects of price changes on smoking (illustrative elasticity):
Manufacturer tax / price increase: 10% price rise → approximately 4% decrease in smoking overall.
Teenagers: 10% price rise → approximately 12% decrease in smoking.
Interpretations: The implied price elasticities are approximately
Figure 4: Shifts in the Demand Curve versus Movements along the Demand Curve – (a) and (b) illustrate the distinction between shifts in the entire curve and movements along it.
Supply
Quantity supplied – Amount of a good sellers are willing and able to sell.
Law of supply – Other things equal: when the price rises, the quantity supplied rises; when the price falls, the quantity supplied falls.
Supply – Relationship between the price of a good and the quantity supplied.
Supply schedule: a table.
Supply curve: a graph; Price on the vertical axis; Quantity on the horizontal axis.
Individual supply – A seller’s individual supply.
Market supply – Sum of the supplies of all sellers for a good or service; obtained by horizontally summing individual supply curves.
Shifts in supply – Increase in supply shifts the curve to the right; Decrease in supply shifts it to the left.
Figure references:
Figure 5: Ben’s Supply Schedule and Supply Curve.
Exhibit 7: Shifts in the Supply Curve.
Variables that can shift the supply curve – Input prices, Technology, Expectations about future, Number of sellers.
Input prices – Supply is negatively related to prices of inputs; Higher input prices decrease supply.
Technology – Advances reduce firms’ costs, increasing supply.
Expectations about future – If higher prices are expected in the future, current supply decreases; If lower prices are expected, current supply may increase (interpretive).
Number of sellers – More sellers increase market supply.
Table 2: Variables That Influence Sellers:
Change in price of the good itself represents a movement along the supply curve.
Other variables (Input prices; Technology; Expectations; Number of sellers) shift the supply curve.
Equilibrium and Market Clearing
Equilibrium – A balance of forces; Market price where quantity supplied equals quantity demanded; Intersection of supply and demand curves.
Equilibrium price – The market-clearing price; Equilibrium quantity – Quantity supplied and demanded at the equilibrium price.
Surplus – Quantity supplied exceeds quantity demanded; Excess supply; Exerts downward pressure on price; Movements along the curves reflect changes in quantity demanded and/or quantity supplied.
Shortage – Quantity demanded exceeds quantity supplied; Excess demand; Exerts upward pressure on price; Movements along the curves reflect changes in quantity demanded and/or quantity supplied.
In most markets, surpluses and shortages are temporary; prices adjust to restore equilibrium.
Three steps to analyzing changes in equilibrium:
1) Decide whether the event shifts the supply curve, the demand curve, or both.
2) Decide whether the curve shifts to the right or to the left.
3) Use the supply-and-demand diagram to compare the initial and the new equilibrium and determine effects on the equilibrium price and quantity.Change in equilibrium due to a shift in demand (illustrative):
Hot weather increases demand for ice cream; Demand curve shifts right; Equilibrium price rises; Equilibrium quantity rises.
Figure 10: How an Increase in Demand Affects the Equilibrium.
Shifts vs movements along curves (summary):
Shift in the supply curve = change in supply; movement along a fixed supply curve = change in the quantity supplied.
Change in demand = shift of the demand curve; movement along a fixed demand curve = change in the quantity demanded.
Change in market equilibrium due to a shift in supply:
Hurricane destroys part of the sugarcane crop; higher price of sugar; Supply curve shifts left; Equilibrium price rises; Equilibrium quantity falls.
Figure 11: How a Decrease in Supply Affects the Equilibrium.
Shifts in both supply and demand (simultaneous events):
Hurricane (supply shift left) and heat wave (demand shift right) may cause a higher price; effects on quantity depend on relative magnitudes:
If demand increases substantially while supply falls only a little: equilibrium quantity may rise.
If supply falls substantially while demand rises only slightly: equilibrium quantity may fall.
Figure 12: A Shift in Both Supply and Demand.
Table 4: What Happens to Price and Quantity When Supply or Demand Shifts? – Conceptual guide to effects of shifts on price/quantity.
Law of supply and demand – The price of any good adjusts to bring the quantity supplied and the quantity demanded for that good into balance in most markets; surpluses and shortages are temporary.
Three-part framework for analyzing changes in equilibrium (reiterated):
Decide which curve shifts; determine direction (left/right); compare initial vs new equilibrium to infer changes in price and quantity.
How Prices Allocate Resources
Prices, via supply and demand together, determine the prices of the economy’s many goods and services.
Prices serve as signals that guide the allocation of resources and act as a mechanism for rationing scarce resources; they determine who produces each good and how much is produced.
Example expository phrase: “Two dollars” “—and seventy-five cents.”
ASK THE EXPERTS: Price Gouging – Connecticut Senate Bill 60 proposal during severe weather emergencies to forbid pricing above what is deemed unconscionably excessive; illustrates policy debates about price signals and allocations during emergencies.
Two final points:
Prices allocate resources by coordinating decisions of buyers and sellers.
They reflect scarcity and preferences, helping the economy adjust to changes over time.