MACROECONOMICS: DEMAND AND SUPPLY
Demand and Supply: Core Concepts
Learning Objectives
Describe a competitive market and understand price as an opportunity cost.
Explain factors influencing demand.
Explain factors influencing supply.
Analyze how demand and supply determine prices and quantities in a market.
Apply the demand and supply model to predict changes in market prices and quantities.
Markets and Prices
Market: Any arrangement facilitating information exchange and business transactions between buyers and sellers.
Competitive Market: A market characterized by:
Many buyers.
Many sellers.
No single buyer or seller has the power to influence the price.
Money Price: The absolute amount of money required to purchase a good.
Relative Price: The ratio of a good's money price to the money price of the next best alternative good.
Represents the opportunity cost of buying that good.
Demand
Definition of Demand: For a person to demand something, they must:
Want it.
Be able to afford it.
Have a definite plan to buy it.
Wants: Unlimited desires or wishes for goods and services, which are distinct from demand.
Demand vs. Wants: Demand reflects a concrete decision about which wants to satisfy.
Quantity Demanded: The specific amount of a good or service consumers plan to buy during a particular time period at a given price.
The Law of Demand
Statement: Other things remaining the same (ceteris paribus):
The higher the price of a good, the smaller is the quantity demanded.
The lower the price of a good, the larger is the quantity demanded.
Reasons for the Law of Demand: Changes in price affect quantity demanded due to:
Substitution Effect: When the relative price (opportunity cost) of a good or service rises, consumers look for substitutes, leading to a decrease in its quantity demanded.
Income Effect: When the price of a good or service rises relative to a consumer's income, their real income (purchasing power) effectively decreases, meaning they cannot afford as much as before, leading to a decrease in its quantity demanded.
Demand Curve and Demand Schedule
Demand: Refers to the entire relationship between the price of a good and the quantity demanded.
Demand Curve: A graphical representation showing the relationship between the quantity demanded of a good and its price, assuming all other influences on planned purchases are constant.
Demand Schedule Example (Energy Bars):
Price of energy bar (dollars) | Quantity demanded (millions of bars per week)
0.50 | 22
1.00 | 15
1.50 | 10
2.00 | 7
2.50 | 5
Movement Along the Demand Curve: Caused by a change in the price of the good itself, with other factors constant.
A rise in price leads to a decrease in quantity demanded, illustrated as a movement up along the demand curve.
A fall in price leads to an increase in quantity demanded, illustrated as a movement down along the demand curve.
Willingness and Ability to Pay: A demand curve also represents a willingness-and-ability-to-pay curve.
The lower the quantity available, the higher the price someone is willing to pay for an additional unit.
Willingness to pay directly measures marginal benefit.
A Change in Demand (Shift of the Demand Curve)
Definition: Occurs when any influence on buying plans other than the price of the good changes.
Results in a new demand curve, meaning the quantity people plan to buy changes at every price.
Direction of Shift:
Increase in Demand: The demand curve shifts rightward.
Decrease in Demand: The demand curve shifts leftward.
Six Main Factors that Change Demand:
Prices of Related Goods:
Substitute: A good that can be used in place of another good.
If the price of a substitute for energy bars rises, the demand for energy bars increases (shifts right).
Complement: A good that is used in conjunction with another good.
If the price of a complement for energy bars falls, the demand for energy bars increases (shifts right).
Expected Future Prices:
If the price of a good is expected to rise in the future, current demand for that good increases (shifts right).
Income:
Normal Good: A good for which demand increases as income increases (shifts right).
Inferior Good: A good for which demand decreases as income increases (shifts left).
Expected Future Income and Credit:
If income is expected to increase in the future, or if credit becomes easier to obtain, current demand might increase.
Population:
A larger population leads to a greater demand for nearly all goods (shifts right).
Preferences:
Different preferences among individuals with the same income lead to different demands for goods.
Example: Increase in Income:
An increase in income causes the demand curve for energy bars to shift rightward.
Original demand schedule (original income):
Price | Quantity Demanded (millions)
0.50 | 22
1.00 | 15
1.50 | 10
2.00 | 7
2.50 | 5
New demand schedule (new higher income):
Price | Quantity Demanded (millions)
0.50 | 32
1.00 | 25
1.50 | 20
2.00 | 17
2.50 | 15
Supply
Definition of Supply: For a firm to supply a good or service, it must:
Have the resources and technology to produce it.
Be able to profit from producing it.
Have a definite plan to produce and sell it.
Technological Feasibility: Resources and technology determine what production is possible.
Supply Decision: Supply reflects a business decision about which technologically feasible items to produce.
Quantity Supplied: The specific amount of a good or service producers plan to sell during a particular time period at a given price.
The Law of Supply
Statement: Other things remaining the same (ceteris paribus):
The higher the price of a good, the greater is the quantity supplied.
The lower the price of a good, the smaller is the quantity supplied.
Reason for the Law of Supply: This law stems from the general tendency for the marginal cost of producing a good or service to increase as the quantity produced increases.
Producers are only willing to supply a good if they can at least cover their marginal cost of production.
Supply Curve and Supply Schedule
Supply: Refers to the entire relationship between the quantity supplied and the price of a good.
Supply Curve: A graphical representation showing the relationship between the quantity supplied of a good and its price, assuming all other influences on planned sales are constant.
Supply Schedule Example (Energy Bars):
Price of energy bar (dollars) | Quantity supplied (millions of bars per week)
0.50 | 0
1.00 | 6
1.50 | 10
2.00 | 13
2.50 | 15
Movement Along the Supply Curve: Caused by a change in the price of the good itself, with other factors constant.
A rise in price leads to an increase in quantity supplied, illustrated as a movement up along the supply curve.
A fall in price leads to a decrease in quantity supplied, illustrated as a movement down along the supply curve.
Minimum Supply Price: A supply curve also represents a minimum-supply-price curve.
As the quantity produced increases, marginal cost typically increases.
The lowest price at which a supplier is willing to sell an additional unit rises, and this lowest price corresponds to the marginal cost.
A Change in Supply (Shift of the Supply Curve)
Definition: Occurs when any influence on selling plans other than the price of the good changes.
Results in a new supply curve, meaning the quantity producers plan to sell changes at every price.
Direction of Shift:
Increase in Supply: The supply curve shifts rightward.
Decrease in Supply: The supply curve shifts leftward.
Six Main Factors that Change Supply:
Prices of Factors of Production:
If the price of an input (e.g., labor, raw materials) used to produce a good rises, the minimum acceptable price for production increases.
This decreases supply (shifts leftward).
Prices of Related Goods Produced:
Substitute in Production: Another good that can be produced using the same resources.
If the price of a substitute in production for energy bars falls, the supply of energy bars increases (shifts right).
Complement in Production: Goods that are produced together.
If the price of a complement in production rises, the supply of the good increases (shifts right).
Expected Future Prices:
If the price of a good is expected to rise in the future, producers might withhold current supply to sell later at a higher price.
This decreases current supply (shifts leftward).
The Number of Suppliers:
A larger number of suppliers in a market leads to a greater overall supply of the good (shifts rightward).
Technology:
Advances in technology typically lower production costs and can create new products.
This increases supply (shifts rightward).
State of Nature:
Includes all natural forces influencing production, such as weather.
A natural disaster (e.g., hurricane, drought) generally decreases supply (shifts leftward).
Example: Advance in Technology:
An advance in technology reduces production costs, increasing the supply of energy bars and shifting the supply curve rightward.
Original supply schedule (old technology):
Price | Quantity Supplied (millions)
0.50 | 0
1.00 | 6
1.50 | 10
2.00 | 13
2.50 | 15
New supply schedule (new technology):
Price | Quantity Supplied (millions)
0.50 | 7
1.00 | 15
1.50 | 20
2.00 | 25
2.50 | 27
Market Equilibrium
Equilibrium: A state where opposing forces balance each other, leading to no tendency for change.
Market Equilibrium: Occurs when the price effectively balances the buying plans of consumers and the selling plans of producers.
Equilibrium Price: The price at which the quantity demanded exactly equals the quantity supplied.
Equilibrium Quantity: The quantity of the good bought and sold at the equilibrium price.
The Role of Price as a Regulator:
When the price is above the equilibrium price, the quantity supplied exceeds the quantity demanded, creating a surplus.
Example: At a price of 2.00 per energy bar, quantity demanded is 7 million and quantity supplied is 13 million, resulting in a surplus of 6 million bars.
When the price is below the equilibrium price, the quantity demanded exceeds the quantity supplied, creating a shortage.
Example: At a price of 1.00 per energy bar, quantity demanded is 15 million and quantity supplied is 6 million, resulting in a shortage of 9 million bars.
At the equilibrium price, there is no shortage or surplus; plans align.
Example: At a price of 1.50 per energy bar, quantity demanded is 10 million and quantity supplied is 10 million, an equilibrium.
Price Adjustments:
Surplus: When a surplus exists (price > equilibrium), sellers will lower prices to clear excess inventory, forcing the market price down towards equilibrium.
Shortage: When a shortage exists (price < equilibrium), buyers will bid up prices to acquire the good, forcing the market price up towards equilibrium.
The price remains stable at equilibrium until an event changes either demand or supply.
Predicting Changes in Price and Quantity
Changes in Demand Only
An Increase in Demand:
The demand curve shifts rightward.
At the original price, a shortage emerges.
The market price rises.
The quantity supplied increases, represented by a movement up along the existing supply curve, leading to a higher equilibrium quantity.
A Decrease in Demand:
The demand curve shifts leftward.
At the original price, a surplus emerges.
The market price falls.
The quantity supplied decreases, represented by a movement down along the existing supply curve, leading to a lower equilibrium quantity.
Changes in Supply Only
An Increase in Supply:
The supply curve shifts rightward.
At the original price, a surplus emerges.
The market price falls.
The quantity demanded increases, represented by a movement down along the existing demand curve, leading to a higher equilibrium quantity.
A Decrease in Supply:
The supply curve shifts leftward.
At the original price, a shortage emerges.
The market price rises.
The quantity demanded decreases, represented by a movement up along the existing demand curve, leading to a lower equilibrium quantity.
Changes in Both Demand and Supply
Changes in the Same Direction:
Increase in Both Demand and Supply:
Equilibrium quantity increases.
Equilibrium price is uncertain because increased demand raises the price, while increased supply lowers it. The net effect depends on the relative magnitudes of the shifts.
Decrease in Both Demand and Supply:
Equilibrium quantity decreases.
Equilibrium price is uncertain because decreased demand lowers the price, while decreased supply raises it. The net effect depends on the relative magnitudes of the shifts.
Changes in Opposite Directions:
Decrease in Demand and Increase in Supply:
Equilibrium price lowers.
Equilibrium quantity is uncertain because decreased demand decreases the quantity, while increased supply increases it. The net effect depends on the relative magnitudes of the shifts.
Increase in Demand and Decrease in Supply:
Equilibrium price raises.
Equilibrium quantity is uncertain because increased demand increases the quantity, while decreased supply decreases it. The net effect depends on the relative magnitudes of the shifts.