RET PA HC
3
Demand, Supply,
and Market Equilibrium
Prepared by: Fernando Quijano
and Yvonn Quijano
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
Firms and Households:
The Basic Decision-Making Units
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• A firm is an organization that
transforms resources (inputs) into
products (outputs). Firms are the
primary producing units in a market
economy.
• An entrepreneur is a person who
organizes, manages, and assumes the
risks of a firm, taking a new idea or a
new product and turning it into a
successful business.
• Households are the consuming units in
an economy.Principles of Economics, 7/e
© 2004 Prentice Hall Business Publishing
Karl Case, Ray Fair
2 of
Input Markets and Output Markets:
The Circular Flow
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• The circular flow of
economic activity
shows how firms
and households
interact in input and
output markets.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
3 of
Input Markets and Output Markets:
The Circular Flow
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• Product or output
markets are the markets
in which goods and
services are exchanged.
• Input markets are the
markets in which
resources—labor,
capital, and land—used
to produce products, are
exchanged.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
4 of
Input Markets and Output Markets:
The Circular Flow
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• Goods and services flow
clockwise. Firms provide
goods and services;
households supply labor
services.
© 2004 Prentice Hall Business Publishing
• Payments (usually money)
flow in the opposite
direction (counterclockwise)
as the flow of labor
services, goods, and
services.
Principles of Economics, 7/e
Karl Case, Ray Fair
5 of
Input Markets and Output Markets:
The Circular Flow
• Input or factor markets are the
markets in which the resources used
to produce products are exchanged.
They include:
• The labor market, in which
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households supply work for wages
to firms that demand labor.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
6 of
Input Markets and Output Markets:
The Circular Flow
• Input or factor markets are the
markets in which the resources used
to produce products are exchanged.
They include:
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• The capital market, in which
households supply their savings,
for interest or for claims to future
profits, to firms that demand funds
to buy capital goods.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
7 of
Input Markets and Output Markets:
The Circular Flow
• Input or factor markets are the
markets in which the resources used
to produce products are exchanged.
They include:
• The land market, in which
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households supply land or other
real property in exchange for rent.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
8 of
Input Markets and Output Markets:
The Circular Flow
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• Inputs into the production
process are also called
factors of production.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
9 of
Demand in Product/Output Markets
• A household’s decision about the
quantity of a particular output to
demand depends on:
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• The price of the product in
question.
• The income available to the
household.
© 2004 Prentice Hall Business Publishing
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Principles of Economics, 7/e
Karl Case, Ray Fair
Demand in Product/Output Markets
• A household’s decision about the
quantity of a particular output to
demand depends on:
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• The household’s amount of
accumulated wealth.
• The prices of other products
(substitutes and complements)
available to the household.
© 2004 Prentice Hall Business Publishing
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Principles of Economics, 7/e
Karl Case, Ray Fair
Demand in Product/Output Markets
• A household’s decision about the
quantity of a particular output to
demand depends on:
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• The household’s tastes and
preferences.
• The household’s expectations
about future income, wealth, and
prices.
© 2004 Prentice Hall Business Publishing
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Principles of Economics, 7/e
Karl Case, Ray Fair
Demand in Product/Output Markets
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• Quantity demanded is the
amount (number of units) of a
product that a household would
buy in a given time period if it
could buy all it wanted at the
current market price.
© 2004 Prentice Hall Business Publishing
13
Principles of Economics, 7/e
Karl Case, Ray Fair
Changes in Quantity Demanded
Versus Changes in Demand
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• The most important
relationship in individual
markets is that between
market price and quantity
demanded.
© 2004 Prentice Hall Business Publishing
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Principles of Economics, 7/e
Karl Case, Ray Fair
Changes in Quantity Demanded
Versus Changes in Demand
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• We use the ceteris paribus or “all
else equal” device, to examine the
relationship between the quantity
demanded of a good per period of
time and the price of that good, while
holding income, wealth, other prices,
tastes, and expectations constant.
© 2004 Prentice Hall Business Publishing
15
Principles of Economics, 7/e
Karl Case, Ray Fair
Changes in Quantity Demanded
Versus Changes in Demand
• Changes in price affect the
quantity demanded per period.
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• Changes in income, wealth,
other prices, tastes, or
expectations affect demand.
© 2004 Prentice Hall Business Publishing
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Principles of Economics, 7/e
Karl Case, Ray Fair
Price and Quantity Demanded:
The Law of Demand
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ANNA'S DEMAND
SCHEDULE FOR
TELEPHONE CALLS
PRICE
(PER CALL)
$
0
0.50
3.50
7.00
10.00
15.00
QUANTITY
DEMANDED
(CALLS PER
MONTH)
30
25
7
3
1
0
© 2004 Prentice Hall Business Publishing
• A demand schedule
is a table showing
how much of a given
product a household
would be willing to
buy at different prices.
• Demand curves are
usually derived from
demand schedules.
17
Principles of Economics, 7/e
Karl Case, Ray Fair
Price and Quantity Demanded:
The Law of Demand
ANNA'S DEMAND
SCHEDULE FOR
TELEPHONE CALLS
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PRICE
(PER
CALL)
$
0
0.50
3.50
7.00
10.00
15.00
© 2004 Prentice Hall Business Publishing
QUANTITY
DEMANDED
(CALLS PER
MONTH)
30
25
7
3
1
0
• The demand curve is
a graph illustrating
how much of a given
product a household
would be willing to buy
at different prices.
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Principles of Economics, 7/e
Karl Case, Ray Fair
Price and Quantity Demanded:
The Law of Demand
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• The law of demand
states that there is a
negative, or inverse,
relationship between
price and the quantity
of a good demanded
and its price.
© 2004 Prentice Hall Business Publishing
• This means that
demand curves slope
downward.
19
Principles of Economics, 7/e
Karl Case, Ray Fair
Other Determinants
of Household Demand
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• Income is the sum of all households
wages, salaries, profits, interest
payments, rents, and other forms of
earnings in a given period of time. It
is a flow measure.
• Wealth, or net worth, is the total
value of what a household owns
minus what it owes. It is a stock
measure.
© 2004 Prentice Hall Business Publishing
20
Principles of Economics, 7/e
Karl Case, Ray Fair
Other Determinants
of Household Demand
• Normal Goods are goods for which
demand goes up when income is
higher and for which demand goes
down when income is lower.
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• Inferior Goods are goods for which
demand falls when income rises.
© 2004 Prentice Hall Business Publishing
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Principles of Economics, 7/e
Karl Case, Ray Fair
Other Determinants
of Household Demand
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• Substitutes are goods that
can serve as replacements for
one another; when the price of
one increases, demand for the
other goes up.
• Perfect substitutes are
identical products.
© 2004 Prentice Hall Business Publishing
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Principles of Economics, 7/e
Karl Case, Ray Fair
Other Determinants
of Household Demand
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• Complements are goods that
“go together”; a decrease in
the price of one results in an
increase in demand for the
other, and vice versa.
© 2004 Prentice Hall Business Publishing
23
Principles of Economics, 7/e
Karl Case, Ray Fair
Shift of Demand Versus
Movement Along a Demand Curve
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• A change in demand is not
the same as a change in
quantity demanded.
© 2004 Prentice Hall Business Publishing
• A higher price causes lower
quantity demanded and a
move along the demand
curve DA.
• Changes in determinants of
demand, other than price,
cause a change in demand,
or a shift of the entire
demand curve, from DA to D
24B.
Principles of Economics, 7/e
Karl Case, Ray Fair
A Change in Demand Versus
a Change in Quantity Demanded
To summarize:
Change in price of a good or service
leads to
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Change in quantity demanded
(Movement along the curve).
Change in income, preferences, or
prices of other goods or services
leads to
Change in demand
(Shift of curve).
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
25
Karl Case, Ray Fair
The Impact of a Change in Income
:3 RET PA H C
• Higher income
decreases the demand
for an inferior good
© 2004 Prentice Hall Business Publishing
• Higher income
increases the demand
for a normal good
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Principles of Economics, 7/e
Karl Case, Ray Fair
The Impact of a Change
in the Price of Related Goods
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• Demand for
complement
good
(ketchup)
shifts left
• Price of hamburger rises
• Quantity of hamburger
demanded per month falls
© 2004 Prentice Hall Business Publishing
• Demand for
substitute
good
(chicken)
shifts right
Principles of Economics, 7/e
27
Karl Case, Ray Fair
From Household
Demand to Market Demand
:3 RET PA H C
• Demand for a good or service can be
defined for an individual
household, or for a group of
households that make up a market.
• Market demand is the sum of all the
quantities of a good or service
demanded per period by all the
households buying in the market for
that good or service.
© 2004 Prentice Hall Business Publishing
28
Principles of Economics, 7/e
Karl Case, Ray Fair
From Household
Demand to Market Demand
:3 RET PA H C
• Assuming there are only two households in the
market, market demand is derived as follows:
© 2004 Prentice Hall Business Publishing
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Principles of Economics, 7/e
Karl Case, Ray Fair
Supply in Product/Output Markets
• Supply decisions depend
on profit potential.
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• Profit is the difference
between revenues and
costs.
© 2004 Prentice Hall Business Publishing
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Principles of Economics, 7/e
Karl Case, Ray Fair
Supply in Product/Output Markets
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CLARENCE BROWN'S
SUPPLY SCHEDULE
FOR SOYBEANS
PRICE
(PER
BUSHEL)
$
2
1.75
2.25
3.00
4.00
5.00
QUANTITY
SUPPLIED
(THOUSANDS
OF BUSHELS
PER YEAR)
0
10
20
30
45
45
© 2004 Prentice Hall Business Publishing
• Quantity supplied
represents the number of
units of a product that a
firm would be willing and
able to offer for sale at a
particular price during a
given time period.
• A supply schedule is a
table showing how much
of a product firms will
supply at different prices.
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Principles of Economics, 7/e
Karl Case, Ray Fair
Price and Quantity Supplied:
The Law of Supply
:3 RET PA H C
CLARENCE BROWN'S
SUPPLY SCHEDULE
FOR SOYBEANS
PRICE
(PER
BUSHEL)
$
2
1.75
2.25
3.00
4.00
5.00
QUANTITY
SUPPLIED
(THOUSANDS
OF BUSHELS
PER YEAR)
0
10
20
30
45
45
© 2004 Prentice Hall Business Publishing
Price of soybeans per bushel ($)
• A supply curve is a graph illustrating how
much of a product a firm will supply per
period of time at different prices.
6
5
4
3
2
1
0
0
10
20
30
40
Thousands of bushels of soybeans
produced per year
Principles of Economics, 7/e
Karl Case, Ray Fair
50
32
Price of soybeans per bushel ($)
Price and Quantity Supplied:
The Law of Supply
• The law of supply
states that there is a
positive relationship
between price and
quantity of a good
supplied.
6
5
4
3
2
1
0
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0
10
20
30
40
Thousands of bushels of soybeans
produced per year
© 2004 Prentice Hall Business Publishing
50
• This means that
supply curves typically
have a positive slope.
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Principles of Economics, 7/e
Karl Case, Ray Fair
Other Determinants of Supply
• The price of the good or service.
• The cost of producing the good,
which in turn depends on:
• The price of required inputs
(labor, capital, and land),
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• The technologies that can be
used to produce the product,
• The prices of related products.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
34
Shift of Supply Versus
Movement Along a Supply Curve
:3 RET PA H C
• A higher price causes
higher quantity
supplied, and a
move along the
demand curve.
© 2004 Prentice Hall Business Publishing
• A change in determinants
of supply other than price
causes an increase in
supply, or a shift of the
entire supply curve, from
SA to SB.
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Principles of Economics, 7/e
Karl Case, Ray Fair
Shift of Supply Curve for Soybeans
Following Development of a New Seed Strain
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• In this example, since the
factor affecting supply is not
the price of soybeans but a
technological change in
soybean production, there is
a shift of the supply curve
rather than a movement
along the supply curve.
• The technological advance means that
more output can be supplied for at any
given price level.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
36
Shift of Supply Versus
Movement Along a Supply Curve
To summarize:
Change in price of a good or service
leads to
:3 RET PA H C
Change in quantity supplied
(Movement along the curve).
Change in costs, input prices, technology, or prices of
related goods and services
leads to
Change in supply
(Shift of curve).
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
37
Karl Case, Ray Fair
From Individual
Supply to Market Supply
:3 RET PA H C
• The supply of a good or service can
be defined for an individual firm, or
for a group of firms that make up a
market or an industry.
• Market supply is the sum of all the
quantities of a good or service
supplied per period by all the firms
selling in the market for that good or
service.
© 2004 Prentice Hall Business Publishing
38
Principles of Economics, 7/e
Karl Case, Ray Fair
From Individual
Supply to Market Supply
:3 RET PA H C
• As with market demand, market
supply is the horizontal summation
of individual firms’ supply curves.
© 2004 Prentice Hall Business Publishing
39
Principles of Economics, 7/e
Karl Case, Ray Fair
Market Equilibrium
:3 RET PA H C
• Market equilibrium is
the condition that exists
when quantity supplied
and quantity demanded
are equal.
• At equilibrium, there is no
tendency for the market
price to change.
© 2004 Prentice Hall Business Publishing
40
Principles of Economics, 7/e
Karl Case, Ray Fair
Market Equilibrium
:3 RET PA H C
• Only in equilibrium is
quantity supplied
equal to quantity
demanded.
© 2004 Prentice Hall Business Publishing
• At any price level
other than P0, such as
P1, quantity supplied
does not equal
quantity demanded.
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Principles of Economics, 7/e
Karl Case, Ray Fair
Excess Demand
:3 RET PA H C
• Excess demand, or
shortage, is the condition
that exists when quantity
demanded exceeds
quantity supplied at the
current price.
© 2004 Prentice Hall Business Publishing
• When quantity demanded
exceeds quantity supplied,
price tends to rise until
equilibrium is restored.
42
Principles of Economics, 7/e
Karl Case, Ray Fair
Excess Supply
:3 RET PA H C
• Excess supply, or surplus,
is the condition that exists
when quantity supplied
exceeds quantity demanded
at the current price.
© 2004 Prentice Hall Business Publishing
• When quantity supplied
exceeds quantity demanded,
price tends to fall until
equilibrium is restored.
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Principles of Economics, 7/e
Karl Case, Ray Fair
:3 RET PA H C
Changes in Equilibrium
• Higher demand leads to
higher equilibrium price and
higher equilibrium quantity.
© 2004 Prentice Hall Business Publishing
• Higher supply leads to
lower equilibrium price and
higher equilibrium quantity.
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Principles of Economics, 7/e
Karl Case, Ray Fair
:3 RET PA H C
Changes in Equilibrium
• Lower demand leads to
lower price and lower
quantity exchanged.
© 2004 Prentice Hall Business Publishing
• Lower supply leads to
higher price and lower
quantity exchanged.
Principles of Economics, 7/e
Karl Case, Ray Fair
45
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Relative Magnitudes of Change
• The relative magnitudes of change in supply and demand
determine the outcome of market equilibrium.
46
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
:3 RET PA H C
Relative Magnitudes of Change
• When supply and demand both increase, quantity
will increase, but price may go up or down.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
47
Review Terms and Concepts
:3 RET PA H C
capital market
income
perfect substitutes
complements, complementary goods
inferior goods
product or output markets
demand curve
input or factor markets
profit
demand schedule
labor market
quantity demanded
entrepreneur
land market
quantity supplied
equilibrium
law of demand
shift of a demand curve
excess demand or shortage
law of supply
substitutes
excess supply or surplus
market demand
supply curve
factors of production
market supply
supply schedule
firm
movement along a
demand curve
wealth or net worth
households
© 2004 Prentice Hall Business Publishing
48
normal goods
Principles of Economics, 7/e
Karl Case, Ray Fair