Chap 4: The Market Forces of Supply and Demand

1. Markets and Competition

Mankiw begins by explaining what a market is and the role competition plays in shaping market outcomes.

Key Points:

• Market: A group of buyers and sellers of a particular good or service. Markets can range from physical places (like farmers’ markets) to virtual markets (like online platforms).

• Competitive Market: A market where there are many buyers and sellers, none of whom can influence the market price. In competitive markets, prices are determined by the collective interaction of supply and demand.

  • Perfect Competition: A situation where goods offered are identical, and buyers and sellers are so numerous that no single buyer or seller has any influence over the market price.

2. Demand

Demand refers to the relationship between the price of a good and the quantity demanded by consumers. Mankiw explores how various factors influence demand, and how the demand curve captures this relationship.

The Demand Curve:

• Law of Demand: Other things being equal, when the price of a good rises, the quantity demanded of the good falls, and when the price falls, the quantity demanded rises.

  • Example: If the price of coffee increases, people will buy less coffee; if the price decreases, they will buy more.

• Demand Schedule: A table that shows the relationship between the price of a good and the quantity demanded.

• Demand Curve: A graph that shows the relationship between the price of a good and the quantity demanded. It slopes downward because of the law of demand.

Shifts in the Demand Curve:

• Increase in Demand: When more of a good is demanded at every price, the demand curve shifts to the right.

• Decrease in Demand: When less of a good is demanded at every price, the demand curve shifts to the left.

• Factors (determinants) that shift the Demand Curve:

  1. Income:

     • Normal Goods: Demand for these goods increases as income rises (e.g., luxury items).

     • Inferior Goods: Demand for these goods falls as income rises (e.g., generic brands).

  2. Prices of Related Goods:

     • Substitutes: If the price of one good rises, the demand for its substitute rises (e.g., if tea becomes expensive, demand for coffee increases).

     • Complements: If the price of one good rises, the demand for its complement falls (e.g., if the price of printers rises, the demand for ink cartridges decreases).

  3. Tastes/Preferences: A shift in consumer preferences can increase or decrease demand.

  4. Expectations of buyers: If consumers expect prices to rise in the future, they may increase current demand.

  5. Number of Buyers: More buyers increase demand, fewer buyers decrease it.

3. Supply

Supply refers to the relationship between the price of a good and the quantity that sellers are willing to sell. Mankiw explains how the supply curve reflects this relationship and what factors influence it.

The Supply Curve:

• Law of Supply: Other things being equal, when the price of a good rises, the quantity supplied of the good also rises, and when the price falls, the quantity supplied decreases.

  • Example: If the price of wheat increases, farmers will supply more wheat; if the price decreases, they will supply less.

• Supply Schedule: A table that shows the relationship between the price of a good and the quantity supplied.

• Supply Curve: A graph that shows the relationship between the price of a good and the quantity supplied. It slopes upward because of the law of supply.

Shifts in the Supply Curve:

• Increase in Supply: When more of a good is supplied at every price, the supply curve shifts to the right.

• Decrease in Supply: When less of a good is supplied at every price, the supply curve shifts to the left.

• Factors (determinants) that Shift the Supply Curve:

  1. Input Prices: If the cost of inputs (like labor or raw materials) rises, supply decreases (leftward shift); if input prices fall, supply increases (rightward shift).

  2. Technology: Improvements in technology make production more efficient (less input to create a unit of the output), leading to an increase in supply.

  3. Prices of substitutes in production: if it is more profitable to produce one good, the resources of its substitute will be decreased to make it

  4. Expectations of sellers: If producers expect higher prices in the future, they may reduce the current supply to sell more later at higher prices.

  5. Number of Sellers: More sellers increase supply; fewer sellers decrease it.

4. Supply and Demand Together: Market Equilibrium

Equilibrium occurs when the quantity supplied equals the quantity demanded. At this point, the market has found the price at which consumers are willing to buy and sellers are willing to sell.

Key Concepts:

• Equilibrium Price (also known as the market-clearing price): The price at which the quantity of the good demanded equals the quantity supplied.

  • Example: If a gallon of milk costs $3, and at that price, consumers want to buy 100 gallons, and sellers want to sell 100 gallons, then $3 is the equilibrium price.

• Equilibrium Quantity: The quantity of the good bought and sold at the equilibrium price.

• Surplus: When the price is above the equilibrium price, the quantity supplied exceeds the quantity demanded, leading to excess supply (or a surplus). Sellers will reduce prices to clear the surplus.

• Shortage: When the price is below the equilibrium price, the quantity demanded exceeds the quantity supplied, leading to excess demand (or a shortage). Sellers will raise prices until the shortage is eliminated.

5. Changes in Market Equilibrium

Market equilibrium can change if there is a shift in either the supply curve, the demand curve, or both. These shifts lead to new equilibrium prices and quantities.

Key Points:

• Shifts in Demand: When demand increases (demand curve shifts right), the equilibrium price and quantity both rise. When demand decreases (demand curve shifts left), the equilibrium price and quantity both fall.

  • Example: If a popular health study shows that drinking orange juice boosts health, demand for orange juice will increase, raising both the equilibrium price and quantity.

• Shifts in Supply: When supply increases (supply curve shifts right), the equilibrium price falls, and the equilibrium quantity rises. When supply decreases (supply curve shifts left), the equilibrium price rises, and the equilibrium quantity falls.

  • Example: If new technology makes it cheaper to produce electric cars, supply will increase, leading to a lower price and more cars being sold.

• Simultaneous Shifts in Supply and Demand: If both the supply and demand curves shift, the outcome for price and quantity depends on the magnitude of the shifts.

  • Example: If a new health trend boosts demand for kale (shifting demand to the right), while at the same time a drought decreases the supply of kale (shifting supply to the left), the price of kale will rise. The effect on the quantity will depend on which shift is larger.

6. Conclusion: How Prices Allocate Resources

Mankiw concludes the chapter by emphasizing that in a market economy, prices are the signals that guide the allocation of resources. The interactions of supply and demand determine the prices of goods and services, which in turn signal to producers what to make and to consumers what to buy.

Key Takeaways:

• Efficiency: Markets tend to allocate resources efficiently, where goods are produced by the suppliers who can do so at the lowest cost and are bought by consumers who value them the most.

• Role of Prices: Prices adjust to ensure that the quantity supplied equals the quantity demanded, effectively coordinating the economy's production and consumption activities.

Summary of Key Concepts:

• Demand Curve: Shows the relationship between price and quantity demanded (downward sloping).

• Supply Curve: Shows the relationship between price and quantity supplied (upward sloping).

• Market Equilibrium: The point where quantity demanded equals quantity supplied, determining the equilibrium price and quantity.

• Shifts in Demand and Supply: Factors like income, tastes, input prices, and technology can shift demand or supply curves, changing the equilibrium price and quantity.

• Surplus and Shortage: Surpluses occur when prices are too high, and shortages occur when prices are too low. Market forces push prices toward equilibrium.