Chapter 3
Demand and Supply Theory
Market – an institution or mechanism that brings together buyers and sellers
of goods.
Demand – a schedule or a curve showing the various amounts of a product
that consumers are willing and able to purchase at each price.
Demand Schedule
Price
1.00
$2.00
$3.00
$4.00
Quantity
Demanded
40
30
20
10
Law of Demand states that there is an inverse relationship between
the price of a product and the quantity demanded if all else remains
equal.
Foundations of the law of demand:
1. Common sense
2. Diminishing marginal utility
a. Utility – satisfaction or enjoyment from an action or choice
b. The more you consume a product, the less enjoyment that you
receive from the product. Thus creating the inverse
relationship.
3. Income Effect – indicates that a lower price increases the purchasing
power of a buyer’s money income.
4. Substitution Effect – buyers have incentive to substitute the now
cheaper good for a similar but more expensive good.
a. Consumers tend to substitute cheap products for dear products.
Created by: Prof. M. Mari
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Demand Curve
Price
A
B
Demand curve
Quantity
50
75
Notice that as the price increases from $4 to $5, the quantity demanded
decreased to 50 units from 75 units. This is the inverse relationship between
price and quantity demanded.
As we move from point B to A, we call this a movement along the demand
curve.
Determinants of Demand – assumptions – other things equal




Tastes or preferences
Number of consumers in the market
Income
Price in relation to other goods
o Substitutes – two goods that are interchangeable
 If the price of one good increases then the quantity
demanded of the other good increases
o Complements – two goods that are consumed jointly
 If the price of one good increases then the quantity
demanded of the other complement decreases
 Expectation of future prices.
Created by: Prof. M. Mari
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Change in Demand - A change in one or more of the determinants of
demand will change the demand of a good.
Results in a SHIFT IN DEMAND.
1. Increase in demand
- At each and every price more of the good is sold
- Examples:
1. Income increases
2. Tastes increase
3. Price of related goods
a. Complements – the price of one complement
decreases
b. Substitutes – the price of a substitute
increases
4. Expected future prices increase
Demand Curve
Price
P1
A
P2
B
New demand curve
Demand curve
Quantity
Q1
Q2
At the original price of P1, the quantity of Q1 is sold. After an
increase in the demand of the good, at P1, the quantity of Q2 is
sold.
Created by: Prof. M. Mari
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2. Decrease in demand
- At each and every price less of the good is sold
- Examples:
1. Income decreases
2. Tastes decrease
3. Price of related goods
a. Complements – the price of one complement
increases
b. Substitutes – the price of a substitute
decreases
4. Expected future prices decrease
Demand Curve
Price
P1
P2
B
Demand curve
New Demand curve
Quantity
Q1
Q2
At the original price of P1, the quantity of Q2 is sold. After a
decrease in the demand of the good, at P1, the quantity of Q1 is
sold.
Change in the quantity demanded –
Caused by a change in price and only in the price of the good.
Results in a movement along the curve.
Created by: Prof. M. Mari
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Supply - shows the amounts of a product that a producer is willing and able
to produce and make available for sale at each price.
Price
$1.00
$2.00
$3.00
$4.00
Quantity
Supplied
100
200
300
400
Law of Supply – states that there is a direct relationship between the
price of a good and the quantity supplied as long as other things
remain constant.
As the price rises, the quantity supplied rises
As the price falls, the quantity supplied falls
Quantity
Q1
Q2
Determinants of Supply – other factors that affect supply
 Resource prices
 Technology
 Taxes and subsidies
 Price of other goods – substitution in production for more profitable
goods
 Price expectations
 Political and natural causes
Created by: Prof. M. Mari
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Change in one or more of these changes then there are a SHIFT IN
SUPPLY.
1. Increase in Supply – at each and every price more of the good is
available for sale.
 Resource prices will decrease
 Technology is better
 Taxes decrease or subsidies increase
 Price of other goods decrease
Price
Supply
New Supply
P1
Quantity
Q1
Q2
At price P1, the original supply curve has a quantity of Q1 but with an
increase in supply, quantity increases to Q2.
2. Decrease in Supply – at each and every price less of the good is
available for sale.
 Resource prices will increase
 Taxes increase
 Subsidies decrease
 Price of other goods increase
Price
Supply
New Supply
P1
Quantity
Created by: Prof. M. Mari
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Q1
Q2
Change in Quantity Supplied
A change in the price of a good and only the price of the good results in a
movement along the supply curve.
Market Equilibrium
The point where the market demands equals the market supply.
Supply
P1
PE
P2
Demand
QE
Surplus: At P1, the price leads to a quantity demanded which is less than
the quantity supplied. Producers are left with excess product to dispose of.
They lower the price of the product and continue to lower the price until the
Quantity demanded equals the Quantity supplied.
Shortage: At P2, the prices leads to a quantity demanded which is greater
than the quantity supplied. Consumers are left wanting a product that does
not exist on the shelves. They bid up the price to get their product. The
price continues to rise until the Quantity demanded equals the quantity
supplied.
Equilibrium - a price where the quantity supplied = the quantity
demanded. It is natural for the market to always move toward equilibrium.
Created by: Prof. M. Mari
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Capitalist Ideology – defined by
 Private property
 Freedom of enterprise and choice
o Private business are free to obtain economic resources to
organize those resources in the production of goods and
services of the firm’s own choosing and sell them in markets of
their choice.
o Choice – owners employ or dispose of their property and
money as they see fit.
o Consumer choice in a capitalist economy is perhaps the most
profound of these freedoms.
 Self interest as dominant
o Driving force of capitalism.
o Individuals maximize their utility
 Competition
o Freedom of choice exercised in promotion of one’s own
monetary returns is the basis for competition.
o Requires
 Large number of independent buyers and sellers
 Freedom of entry or exit
 Reliance on market system
o Market and prices are the coordinating mechanism of a
capitalist economy.
 A limited role for government
 Other characteristics
o Extensive use of technology and capital goods.
 Opportunity and motivation for such in competition
o Specialization
 Majority of consumers produce virtually none of the
goods and services they consume
 Majority of consumers consume little or nothing that they
produce
 Division of labor – human specialization enhances
society’s output by
 Making use of ability differences
 Allows learning by doing
 Saves time
o Use of money
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 Medium of exchange
Five fundamental questions of Competitive Market System
1. How much of a society’s resources should be used?
2. What is to be produced?
a. Economic costs are payments which must be made to secure and
retain the needed amounts of these resources
b. Normal profit – Total revenue – Total cost – Payments for
contribution of entrepreneur
c. Economic profit – above normal profit
i. Occurs in expanding industries
ii. New firms enter the industry at this sign
3. How is the quantity produced?
4. Who receives the quantity?
5. Can the system adapt to change?
Created by: Prof. M. Mari
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