Unit 2: Supply, demand, and market equilibrium 

Fundamental Principles and Determinants of Market Demand

Executive Summary

The study of microeconomics is anchored in the law of demand, which establishes an inverse relationship between the price of a good and the quantity demanded, provided all other factors remain constant (ceteris paribus). A critical distinction must be maintained between a change in quantity demanded—a movement along an existing curve caused solely by a price change—and a change in demand, which involves a shift of the entire curve due to external determinants.

These determinants, often categorized by the mnemonic TONIE (Tastes, Other goods, Number of buyers, Income, Expectations), represent the variables that, when altered, redefine the buyer's relationship with the product. Understanding these shifts is essential for analyzing market equilibrium and consumer behavior. Key drivers of these behaviors include the substitution effect, the income effect, and the principle of decreasing marginal utility.

1. The Law of Demand and Its Representation

The law of demand states that as the price of a product increases, the quantity demanded decreases. Conversely, as the price decreases, the quantity demanded increases. This relationship is foundational to market mechanics and is expressed through two primary tools:

• Demand Schedule: A tabular format representing the data points of various price scenarios and their corresponding quantities demanded.

• Demand Curve: A graphical representation of the demand schedule. By convention, price (P) is plotted on the vertical axis and quantity (Q) on the horizontal axis. Nearly all demand curves share a downward slope from left to right, illustrating the negative relationship between price and quantity.

Movement vs. Shift

It is vital to distinguish between actions occurring on the curve and actions moving the curve itself:

• Movement Along the Curve: Caused strictly by a change in the price of the good in question. This is referred to as a "change in quantity demanded."

• Shift of the Curve: Caused by changes in external economic factors. A rightward shift represents an "increase in demand" (higher quantity demanded at every price), while a leftward shift represents a "decrease in demand" (lower quantity demanded at every price).

2. Determinants of Demand: The Factors of Shifting

The assumption of ceteris paribus ("other things being equal") is broken when one of the following determinants changes, causing the entire demand curve to shift.

Income (Normal vs. Inferior Goods)

The impact of income on demand depends on the nature of the good:

• Normal Goods: Products for which demand rises as consumer income increases (and falls as income decreases). Most goods, such as laptops or mid-sized sedans, fall into this category.

• Inferior Goods: Products for which demand falls as income increases. As consumers become wealthier, they "trade up" to higher-quality substitutes.

  • Example: The cheapest car on the market might see a demand decrease if the population's income rises, as buyers switch to safer or more prestigious models.

  • Example: Generic-brand groceries, used cars, and rental apartments are often considered inferior goods compared to name-brand items, new cars, and homeownership.

Price of Related Goods (Substitutes and Complements)

The demand for a product is intrinsically linked to the pricing of other goods:

• Substitutes: Goods that can be used in place of one another (e.g., tablets vs. laptops, or chicken vs. beef). If the price of a substitute increases, the demand for the original good shifts to the right.

• Complements: Goods typically consumed together (e.g., Kindles and ebooks, or golf clubs and golf balls). If the price of a complement increases, the demand for the original good shifts to the left because the total cost of the "experience" has risen.

Tastes and Preferences

Consumer desire is a primary driver of demand. Changes in preferences can be triggered by new information, trends, or health reports.

• Positive Shift: An author appearing on a popular talk show to praise a book increases preferences, shifting the demand curve right.

• Negative Shift: Reports of plagiarism or negative health impacts (e.g., a shift from beef to chicken due to health trends) shift the demand curve left.

Population and Composition (Number of Buyers)

The size and demographic makeup of a market dictate the total demand.

• Size: An increase in the total number of consumers generally increases demand for most goods (e.g., more people in a city increases demand for housing).

• Composition: A society with more children has a higher demand for daycare and tricycles; a society with a rising elderly population (projected to be 20% of the U.S. population by 2030) sees increased demand for nursing homes and hearing aids.

Expectations

Consumer behavior is influenced by what they believe will happen in the future.

• Future Prices: If consumers expect the price of a good (like coffee or ebook downloads) to rise in the future, current demand increases as people "stock up." Conversely, if they expect prices to drop (common in consumer electronics), current demand decreases as they wait for the sale.

• Future Income/Conditions: Expectations of an incoming hurricane can cause an immediate spike in demand for batteries and bottled water.

3. The Underlying Logic of the Downward Slope

Economists identify three specific reasons why consumers demand more of a good when its price falls:

4. Market Demand as a Summation

A market demand curve is not a single entity but the horizontal summation of all individual demand curves in a given market.

• Aggregation Process: For any given price, the quantities demanded by every individual actor (buyer 1, buyer 2, etc.) are added together.

• Example: If at $3.00, Buyer A wants 1 pound of apples and Buyer B wants 5 pounds, the market quantity demanded at $3.00 is 6 pounds.

• Scale: While simplified models use two buyers, real-world market demand curves represent the combined behavior of millions of individual actors.

5. Summary of Demand Determinants

The following table summarizes the factors that cause a shift in the demand curve:

The Law of Supply: Principles, Mechanics, and Determinants

Executive Summary

The Law of Supply is a fundamental economic principle describing the relationship between the price of a good or service and the quantity that producers are willing to provide to the market. It establishes that, ceteris paribus (all else being equal), a direct or positive relationship exists: as the price of a product increases, the quantity supplied increases; conversely, as the price decreases, the quantity supplied decreases. This behavior is driven by the profit-seeking motives of producers, who have greater incentives to allocate resources toward goods that command higher market prices. Understanding the distinction between a change in "quantity supplied" (a movement along the curve) and a change in "supply" (a shift of the entire curve) is critical for analyzing market dynamics and the impact of external factors such as production costs, technology, and government policy.

Fundamental Principles of Supply

The Law of Supply

The Law of Supply states that there is a positive relationship between price and quantity supplied. Because higher prices generally mean more potential profit for sellers, they are motivated to provide more of a good or service when its price rises.

• Price and Incentive: An increase in price encourages firms to expand operations, such as exploring new reserves, investing in infrastructure (pipelines, refineries), or extending operating hours.

• Upward Sloping Curve: Graphically, this relationship results in a supply curve that slopes upward from left to right.

The Ceteris Paribus Assumption

The laws of supply and demand only hold if "all other things are equal," a concept known by the Latin phrase ceteris paribus.

• Variable Isolation: A supply curve isolates the relationship between two variables: price (on the vertical axis) and quantity (on the horizontal axis).

• Fixed Factors: To observe how price alone affects supply, economists assume that no other relevant economic factors (such as the cost of inputs or technology) are changing. When these factors do change, the law of supply no longer describes a movement along a line but rather a shift of the entire relationship.

Measurement and Visualization Tools

Supply Schedules

A supply schedule is a table that summarizes the relationship between price and quantity supplied over a specific time period.

Example: Gasoline Supply Schedule | Price (per gallon) | Quantity Supplied (millions of gallons) | | :--- | :--- | | $1.00 | 500 | | $1.20 | 550 | | $1.40 | 600 | | $1.60 | 640 | | $1.80 | 680 | | $2.00 | 700 | | $2.20 | 720 |

The Supply Curve

The supply curve is the graphical representation of the supply schedule.

• Axes Convention: In an exception to standard mathematical rules, economics plots the independent variable (price) on the vertical axis and the dependent variable (quantity) on the horizontal axis.

• Shape: While the specific slope (steep, flat, or curved) varies by product, nearly all supply curves share the fundamental trait of sloping upward from left to right.

Mechanics of Change: Supply vs. Quantity Supplied

A critical distinction must be made between moving along a curve and shifting a curve. Confusion between these terms is a common misperception.

Change in Quantity Supplied

• Definition: A movement along a fixed supply curve.

• Cause: Exclusively caused by a change in the price of the good itself.

• Visual: Moving from one point to another on the same upward-sloping line.

Change in Supply

• Definition: A shift of the entire supply curve to the right (increase) or left (decrease).

• Cause: A change in one of the non-price determinants of supply.

• Visual: At every possible price point, a different quantity is now supplied.

  • Shift Right: Represents an increase in supply (more provided at every price).

  • Shift Left: Represents a decrease in supply (less provided at every price).

Determinants of Supply: Factors That Shift the Curve

When non-price factors change, the entire supply relationship is altered. The following table and descriptions outline the primary determinants.

1. Cost of Production (Input Prices)

The most significant factor shifting supply is the cost of inputs (labor, raw materials, fuel).

• Increase in Costs: If the price of steel rises, car manufacturing becomes more expensive. Producers profit less per unit and are motivated to supply fewer cars at any given price (Shift Left).

• Decrease in Costs: Lower property taxes or cheaper raw materials increase profitability, shifting the curve to the right.

2. Technology and Innovation

Technological improvements that reduce the cost of production shift the supply curve to the right.

• Example: The "Green Revolution" of the 1960s involved breeding improved seeds. This technological leap doubled harvests per acre, allowing for a much greater quantity of grain to be supplied at the same price points.

3. Government Policies: Taxes, Regulations, and Subsidies

Governments can treat various interventions as costs or incentives for producers.

• Taxes: Businesses treat taxes (e.g., alcohol excise taxes) as additional costs. Higher taxes decrease supply (Shift Left).

• Regulations: Requirements for a cleaner environment or safer workplace increase the cost of compliance, reducing supply.

• Subsidies: This is the opposite of a tax. A subsidy occurs when the government pays a firm or reduces its taxes for specific actions. This reduces production costs and increases supply (Shift Right).

4. Prices of Related Goods (Productive Substitutes)

Producers often have the flexibility to use their resources (land, labor) for different products.

• Substitution in Production: A farmer may grow grapes or blueberries. If the price of blueberries rises, the farmer will allocate more land to blueberries. Consequently, the supply of grapes will decrease, shifting the grape supply curve to the left, even if the price of grapes hasn't changed.

5. Future Price Expectations

How producers view future market conditions determines current supply.

• Expected Price Rise: If a producer of a storable good (like oil) expects prices to skyrocket in a year, they may "hoard" or withhold current supply to sell later at a higher price. This decreases current supply (Shift Left).

• Expected Price Fall: If prices are expected to drop (e.g., candy canes after the holidays), producers will increase current supply to sell as much as possible while prices remain high (Shift Right).

6. Natural Conditions and Number of Sellers

• Natural Conditions: For agricultural products, weather is a primary determinant. A drought (e.g., the 2014 Manchurian Plain drought) decreases supply, while exceptionally good weather shifts the curve to the right.

• Number of Sellers: In an aggregate market, more suppliers entering the market will increase the total quantity supplied at every price point, shifting the market supply curve to the right. Conversely, sellers leaving the market decreases supply.

Market Equilibrium Analysis: The Four-Step Framework and Dynamics of Supply and Demand

Executive Summary

Market equilibrium represents the point of balance where the quantity of a good or service supplied equals the quantity demanded. This state is achieved at a specific market-clearing price and quantity. When economic events disrupt this balance, markets transition through a period of disequilibrium—characterized by either a shortage or a surplus—before forces naturally drive them toward a new equilibrium.

To accurately predict how economic events impact the market, analysts utilize a systematic Four-Step Process. This framework distinguishes between shifts in the entire supply or demand curves (caused by external factors) and movements along existing curves (caused by price changes). While single shifts in either supply or demand produce predictable changes in price and quantity, simultaneous shifts in both curves lead to "indeterminate" outcomes where either the final price or quantity cannot be certain without knowing the magnitude of the shifts.

Core Principles of Market Equilibrium

1. Definitions of Equilibrium and Disequilibrium

• Equilibrium: Occurs when the plans of consumers and producers agree. Graphically, this is the intersection of the downward-sloping demand curve and the upward-sloping supply curve.

• Equilibrium Price (Market Clearing Price): The specific price at which quantity demanded exactly equals quantity supplied.

• Equilibrium Quantity: The specific amount of a good bought and sold at the equilibrium price.

• Disequilibrium: Any state where quantity supplied does not equal quantity demanded.

  • Surplus (Excess Supply): Occurs when the market price is above equilibrium; sellers lower prices to eliminate unsold inventory.

  • Shortage (Excess Demand): Occurs when the market price is below equilibrium; buyers bid up prices to obtain the scarce good.

2. The "Ceteris Paribus" Assumption

Economists use the Latin term ceteris paribus—meaning "other things equal"—to isolate the effects of a single event. When analyzing interconnected events, each must be examined individually while holding all other factors constant before combining the results to determine the net effect.

The Four-Step Analysis Process

To determine the impact of any economic event on price and quantity, the following framework is applied:

1. Step 1: Draw the Initial Model: Establish a baseline with correctly labeled axes (Price on the vertical, Quantity on the horizontal), a downward-sloping demand curve (D_0), an upward-sloping supply curve (S_0), and the initial equilibrium point (E_0).

2. Step 2: Identify the Affected Curve: Determine if the event influences demand factors (e.g., tastes, income, population, prices of related goods) or supply factors (e.g., input prices, technology, natural conditions, government policy).

3. Step 3: Determine the Direction of the Shift: Decide if the event causes an increase (shift to the right) or a decrease (shift to the left) and sketch the new curve (D_1 or S_1).

4. Step 4: Identify the New Equilibrium: Locate the new intersection (E_1) and compare the new equilibrium price and quantity to the original values.

Dynamics of Supply and Demand Shifts

Single Curve Shifts

The following table summarizes the predictable outcomes when only one curve shifts:

Simultaneous (Combined) Shifts

When both supply and demand shift at the same time, one variable (price or quantity) will have a clear direction, while the other will be indeterminate (uncertain) without knowing which shift was more significant.

Detailed Case Studies

1. Supply Shift: Excellent Weather for Salmon Fishing

• Event: Ideal climate conditions in 2000 stimulated salmon breeding and eased fishing operations.

• Analysis: This represents a change in natural conditions affecting supply.

• Outcome: The supply curve shifted to the right. The equilibrium price fell (from \$3.25 to \$2.50), and the equilibrium quantity increased (from 250,000 to 550,000 fish).

2. Demand Shift: Digital News and Traditional Print

• Event: Consumers shifted preferences from traditional news (print/radio) to digital sources.

• Analysis: This represents a change in tastes affecting demand for traditional news.

• Outcome: The demand curve for print news shifted to the left. This resulted in both a lower equilibrium price and a lower equilibrium quantity.

3. Combined Shift: The US Postal Service (USPS)

• Events: (A) Increased labor compensation for workers; (B) Increased consumer preference for digital communication (email/text).

• Analysis:

  • Higher labor costs = Increase in production costs = Supply shifts left.

  • Shift to digital = Change in tastes = Demand shifts left.

• Outcome: Both shifts decrease the equilibrium quantity. However, the effect on price is indeterminate because the supply shift pushes prices up while the demand shift pushes prices down.

Critical Distinctions and Common Pitfalls

Shift vs. Movement Along a Curve

A common analytical error is confusing a shift in a curve with a movement along a curve.

• Shift of a Curve: Caused by a change in an external economic factor (e.g., a new technology or change in income). It changes the quantity demanded or supplied at every price point.

• Movement Along a Curve: Caused only by a change in the price of the good itself.

  • A shift in supply causes a movement along the demand curve.

  • A shift in demand causes a movement along the supply curve.

  • Crucial Rule: A change in the price of a good never shifts the demand or supply curve for that specific good.

Timeline of Analysis

When performing these analyses, it is vital to maintain the correct order of cause and effect. An event (cause) leads to a curve shift, which then creates a disequilibrium (shortage or surplus), ultimately resulting in a price adjustment toward a new equilibrium (effect). Prices and quantities rarely "zoom" straight to equilibrium; they move in that general direction, often influenced by subsequent shifts before the first equilibrium is even reached.