CHAPTER 3
WHERE PRICES COME FROM:
THE INTERACTION OF DEMAND AND SUPPLY
The model of demand and supply is the most
powerful tool in economics and is used to
explain how prices are determined.
THE DEMAND SIDE OF THE MARKET

Demand schedule- A table showing the
relationship between the price of a product and
the quantity of the product demanded.

Demand curve- A curve that shows the
relationship between the price of a product and
the quantity of the product demanded.
THE LAW OF DEMAND
The rule that, holding everything else constant,
when the price of a product falls, the quantity
demanded of the product will increase, and
when the price of a product rises, the quantity
demanded of the product will decrease.
 The substitution effect and the income effect
support this law.

SUBSTITUTION EFFECT

The change in the quantity demanded of a
good that results from a change in price,
making the good more or less expensive
relative to other goods that are substitutes.
INCOME EFFECT

The change in the quantity demanded of a
good that results from the effect of a change in
the good’s price on consumers’ purchasing
power.
CETERIS PARIBUS (“ALL ELSE EQUAL”)

The requirement that when analyzing the
relationship between two variables—such as
price and quantity demanded—other variables
must be held constant.

Only move one element so that we can identify
the cause and effect
VARIABLES THAT SHIFT MARKET DEMAND
Income
 Price of related goods
 Tastes
 Populations and demographics
 Expected future prices

INCOME
The income that consumers have available to
spend affects their willingness and ability to
buy a good.
 A normal good is a good for which the demand
increases as income rises and decreases as
income falls.
 An inferior good is a good for which the demand
increases as income falls and decreases as
income rises.

PRICES OF RELATED GOODS

Substitutes- Goods and services that can be
used for the same purpose.

Complements- Goods and services that are
used together.
TASTES
Consumers can also be influenced by an
advertising campaign for a product.
 Trends, such as the popular low carbohydrate
diets caused a decline for some goods, such as
breads and an increase demand for goods
such as beef.

POPULATION AND DEMOGRAPHICS
Demographics are the characteristics of a
population with respect to age, race, and
gender.
 For example, as the number of senior citizens
increases, prune juice, denture paste, and the
demand for other products used by senior
citizens will increase.

EXPECTED FUTURE PRICES

If enough consumers believe that HD TVs will
be selling for lower prices in 3 months, the
demand for TVs will decrease now, as
consumers wait for the price to decrease.
A CHANGE IN DEMAND VERSUS A CHANGE IN
QUANTITY DEMANDED

A change in demand refers to a shift in the
demand curve which occurs when there is a
change in one of the variables, other than the
price of the product, that affects the
willingness of consumers to buy the products.

A change in quantity demanded refers to the
movement along the demand curve as a result
of a change in the product’s price.
WHICH IS WHICH?
THE SUPPLY SIDE OF THE MARKET

The most important variable that influences the
willingness and ability of firms to sell a good or
service is PRICE.

With higher marginal costs, firms will supply a
larger quantity only of the price is higher.
SUPPLY SCHEDULES AND SUPPLY CURVES
Supply schedule is a table that shows the
relationship between the price of a product and
the quantity of the product supplied.
 Supply curve is a curve that shows the
relationship between the price of a product and
the quantity of the product supplied.
 Law of supply is the rule that, holding
everything else constant, increases in price
cause increases in the quantity supplied, and
vice-versa.

VARIABLES THAT SHIFT SUPPLY
Prices of Inputs
 Technological Change
 Prices of Substitutes in Production
 Number of Firms in Market
 Expected Future Prices

PRICES OF INPUTS
Inputs are used in the production of the good
or service. Could make this less profitable.
 This is the factor most likely to shift the supply
curve.

TECHNOLOGICAL CHANGE

Technological change- A positive or negative
change in the ability of a firm to produce a
given level of output with a given quantity of
inputs.

Negative technological change is rare, but
could come from a natural disaster. This raises
a firms costs!
PRICES OF SUBSTITUTES IN PRODUCTION

These are the alternate products that the firm
can produce.
NUMBER OF FIRMS IN MARKET

When new firms enter the market, the supply
curve shifts to the right and when existing firms
exit, the supply curve shifts to the left.

For example, when the Zune was
first introduced, the market supply
curve for music players shifted to
the right.
EXPECTED FUTURE PRICES

If a firm expects the price of its product to be
higher in the future than the price today, it may
choose to decrease supply now and increase it
in the future.
A CHANGE IN SUPPLY VERSUS A CHANGE IN
QUANTITY SUPPLIED
A change in supply means a shift of the
supply curve. This will only shift when
there is a change in one of the variables,
other than the price of the product, that
affects the willingness of suppliers to sell
the product.
A change in quantity supplied refers to the
movement along the supply curve as a
result of a change in the product’s price.
WHICH IS WHICH?
MARKET EQUILIBRIUM: PUTTING DEMAND AND
SUPPLY TOGETHER

Market equilibrium- A situation in which
quantity demanded equals quantity supplied.
HOW MARKETS ELIMINATE SURPLUSES AND
SHORTAGES
Surplus- quantity supplied is greater than the
quantity demanded. Firms can increase their
sales by cutting the price, simultaneously
increasing the quantity demanded and
decreasing the quantity supplied.
 Shortage- quantity demanded is greater than
the quantity supplied. Firms can raise the price
without losing a sale because the demand for
the product is so high.

SURPLUS AND SHORTAGE
THE EFFECT OF DEMAND AND SUPPLY SHIFTS
ON EQUILIBRIUM

The equilibrium is constantly changing!
ENJOY!

http://www.youtube.com/watch?v=GjMMSTF14U