Demand and Supply
Price Determination
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In a market economy, the economic questions, “What to
produce, how to produce, and for whom to produce”, are
answered by the price system.
“What to produce?”: Goods and services are produced
because a person can earn a profit, and price is a factor in
profit.
“How to produce?”: Costs are the chief determinant in
production decisions, so the price of resources influences
this question.
“For whom to produce?”: In a market economy, the
person who buys the good, receives the good. Prices
determine who buys it and who doesn’t.
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Prices can be:
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Prices for goods and services
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Example: gas, tuition, movie tickets, stock, etc.
Wages: the price of labor
Interest rates: the price to use money
Rent: the price for using land
Prices for ingredients (crude oil, iron ore)
How are prices determined?
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In a market economy, prices are determined
through the interaction of demand and supply!
A market is a real or artificial meeting place
where buyers and sellers come together and
decide the price of the good or service.
Examples are: a grocery store, an art auction,
EBAY, the stock exchange, applying for a bank
loan, a job interview, or buying goods at a mall.
Demand
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Demand: The desire, willingness, and ability to
want a good or service at different price levels.
The Law of Demand:
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As prices increase, the quantity demanded decreases.
 If P ↑  QD
As prices decrease, the quantity demanded increases.
 If P   QD
Demand is an inverse relationship because of 2
effects.
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Income Effect: increase in Price, you feel less wealthy
Substitution Effect: increase in Price, you buy other goods in
substitute
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Demand can be shown 2 ways: A Demand Schedule and a
Demand Curve
A table of buyers’ intentions is a Demand Schedule
Example:
Price of
DVDs
$6.00
$8.00
$10.00
$12.00
$14.00
$16.00
$18.00
$20.00
$22.00
Quantity Demanded of
DVDs
10 million
9 million
8 million
7 million
6 million
5 million
4 million
3 million
2 million
Supply
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Supply: The willingness and ability to provide
goods and services at different price levels.
Law of Supply:
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As prices increase, the quantity supplied increases.
 If P   QS 
As prices decrease, the quantity supplied decreases.
 If P   QS 
Direct relationship because when prices increase
there is more profit potential, but when prices
decrease, a seller cannot cover costs.
There are 2 methods of showing supply: Supply
Schedule and a Supply Curve
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Supply Schedule: A table of sellers intentions.
Example:
Price of
DVDs
$6.00
$8.00
$10.00
$12.00
$14.00
$16.00
$18.00
$20.00
$22.00
Quantity Supplied of
DVDs
2 million
3 million
4 million
5 million
6 million
7 million
8 million
9 million
10 million
Equilibrium
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When the demand curve and supply curve
intersect, this is called equilibrium.
Equilibrium is defined as a place where the
exact quantity demanded at a price is equal
to the exact quantity supplied at a price.
In other words Qd = Qs, not D = S
Equilibrium
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There is a natural tendency for a market to be in
equilibrium. This is called the “Invisible Hand”
by Adam Smith (father of Economics).
Markets are self-correcting
If the price charged is higher than the equilibrium
price, then Qd < Qs and a surplus will occur.
If the price charged is less than the equilibrium
price, then Qd > Qs and a shortage occurs.
Price of
DVDs
$6.00
$8.00
$10.00
$12.00
$14.00
$16.00
$18.00
$20.00
$22.00
Quantity Demanded of
DVDs
10 million
9 million
8 million
7 million
6 million
5 million
4 million
3 million
2 million
Quantity Supplied of
DVDs
2 million
3 million
4 million
5 million
6 million
7 million
8 million
9 million
10 million
Self- Correcting Mechanism
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Surplus is eliminated by lowering the price.
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As prices decrease, the Qd increases (Law of
Demand).
As prices decrease, the Qs decreases (Law of
Supply).
Shortage is eliminated by increasing the price.
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As price increases, the Qd decreases (Law of
Demand).
As price increases, Qs increases (Law of Supply).
What causes prices to change?
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The entire demand and/or supply curve must
shift.
A shift in a demand or supply curve means that
there is an increase or decrease in the Qd or Qs at
every price
Example of an D:
Price
$2
$4
$6
Qd1
10
8
6
Qd2
12
10
8
Increases in Demand
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1.
2.
3.
4.
5.
6.
Caused by the following:
 Tastes & Preferences
 Income
 Price of a substitute
good
 Price of a
complementary good
 Population
 in Expectation of
future prices
Changes in Price Caused by
Changes in Supply
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Example of S
Price
$2
$4
$6
QS1
6
8
10
QS2
8
10
12
Increases in Supply
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1.
2.
3.
4.
5.
6.
7.
8.
Caused by:
 in Costs of production
 Taxes
 Government Rules
 Technology
 Price of resource
ingredients
Supply Shocks
(unexpected events)
 Number of Sellers
 Expectations of future
prices sellers face
What if the price is too high?
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Government can establish
a price ceiling
Price Ceiling is the legal
maximum price a seller
may charge for a good or
service
Sometimes referred to as
price caps or price
freezes
Price ceilings always
create a shortage of the
good or service in
question
Price Ceilings continued
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Ceilings usually promote the economic goals
of stable prices and economic equity, but
hurt the goals of economic freedom, and
economic growth.
Examples of price ceilings are salary caps in
sports, rent controls in large cities, price
freezes on prescription medicines, and
tuition caps on university costs, and revenue
caps on school districts.
What if the price is too low?
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Government can establish
a price floor
Price Floor is the legal
minimum price a seller
may receive for a good or
service. (Sometimes
referred to as price
supports)
Price floor is always
placed above what the
equilibrium price is.
Price floors always create
a surplus of the good or
service in question
Price Floors continued
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Floors usually promote the economic
goals of economic equity and equitable
distribution of income, but hurt the
goals of economic freedom, and
economic growth
Examples of price floors are milk, rice,
wheat, and sugar supports, and the
minimum wage.
Advantages of a price system
compared to rationing
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Prices are neutral: Prices do not favor a
consumer or producer.
Prices are flexible: Prices can absorb unexpected
shocks to the economy.
Prices allow for freedom of choice when
shopping.
Prices have no administration cost.
Prices are efficient: Easy way to change
consumer and producer behavior.
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Without a price system, we would rely on rationing
which has a problem with fairness, high costs, and
reduced incentives.