CHAPTER
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
C H A P T E R 3: Demand, Supply, and Market Equilibrium
Firms and Households:
The Basic Decision-Making Units
• 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.
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Karl Case, Ray Fair
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
Input Markets and Output Markets:
The Circular Flow
• The circular flow of
economic activity
shows how firms
and households
interact in input and
output markets.
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Karl Case, Ray Fair
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
Input Markets and Output Markets:
The Circular Flow
• 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.
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Karl Case, Ray Fair
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
Input Markets and Output Markets:
The Circular Flow
© 2004 Prentice Hall Business Publishing
• Goods and services flow
clockwise. Firms provide
goods and services;
households supply labor
services.
• Payments (usually money)
flow in the opposite
direction (counterclockwise)
as the flow of labor
services, goods, and
services.
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
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
households supply work for wages
to firms that demand labor.
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Principles of Economics, 7/e
Karl Case, Ray Fair
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
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 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.
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Principles of Economics, 7/e
Karl Case, Ray Fair
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
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
households supply land or other
real property in exchange for rent.
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Principles of Economics, 7/e
Karl Case, Ray Fair
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
Input Markets and Output Markets:
The Circular Flow
• Inputs into the production
process are also called
factors of production.
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Karl Case, Ray Fair
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
Demand in Product/Output Markets
• A household’s decision about the
quantity of a particular output to
demand depends on:
• The price of the product in
question.
• The income available to the
household.
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Principles of Economics, 7/e
Karl Case, Ray Fair
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
Demand in Product/Output Markets
• A household’s decision about the
quantity of a particular output to
demand depends on:
• The household’s amount of
accumulated wealth.
• The prices of other products
(substitutes and complements)
available to the household.
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Karl Case, Ray Fair
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
Demand in Product/Output Markets
• A household’s decision about the
quantity of a particular output to
demand depends on:
• The household’s tastes and
preferences.
• The household’s expectations
about future income, wealth, and
prices.
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Karl Case, Ray Fair
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
Demand in Product/Output Markets
• 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.
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Principles of Economics, 7/e
Karl Case, Ray Fair
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
Changes in Quantity Demanded Versus
Changes in Demand
• The most important
relationship in individual
markets is that between
market price and quantity
demanded.
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Karl Case, Ray Fair
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
Changes in Quantity Demanded Versus
Changes in Demand
• 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.
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Principles of Economics, 7/e
Karl Case, Ray Fair
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
Changes in Quantity Demanded Versus
Changes in Demand
• Changes in price affect the
quantity demanded per period.
• Changes in income, wealth,
other prices, tastes, or
expectations affect demand.
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Karl Case, Ray Fair
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
Price and Quantity Demanded:
The Law of Demand
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.
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
Price and Quantity Demanded:
The Law of Demand
ANNA'S DEMAND
SCHEDULE FOR
TELEPHONE CALLS
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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C H A P T E R 3: Demand, Supply, and Market Equilibrium
Price and Quantity Demanded:
The Law of Demand
© 2004 Prentice Hall Business Publishing
• 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.
• This means that
demand curves slope
downward.
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
Other Determinants
of Household Demand
• 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.
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Karl Case, Ray Fair
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
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.
• Inferior Goods are goods for which
demand falls when income rises.
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Karl Case, Ray Fair
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
Other Determinants
of Household Demand
• 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.
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Principles of Economics, 7/e
Karl Case, Ray Fair
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
Other Determinants
of Household Demand
• 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.
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Principles of Economics, 7/e
Karl Case, Ray Fair
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
Shift of Demand Versus
Movement Along a Demand Curve
© 2004 Prentice Hall Business Publishing
• A change in demand is not
the same as a change in
quantity demanded.
• 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 DB.
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
A Change in Demand Versus
a Change in Quantity Demanded
To summarize:
Change in price of a good or service
leads to
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).
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Karl Case, Ray Fair
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
The Impact of a Change in Income
• 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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C H A P T E R 3: Demand, Supply, and Market Equilibrium
The Impact of a Change
in the Price of Related Goods
• 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
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
From Household
Demand to Market Demand
• 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.
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Principles of Economics, 7/e
Karl Case, Ray Fair
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
From Household
Demand to Market Demand
• Assuming there are only two households in the
market, market demand is derived as follows:
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Principles of Economics, 7/e
Karl Case, Ray Fair
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
Supply in Product/Output Markets
• Supply decisions depend
on profit potential.
• Profit is the difference
between revenues and
costs.
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Principles of Economics, 7/e
Karl Case, Ray Fair
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
Supply in Product/Output Markets
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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• A supply curve is a graph illustrating how
much of a product a firm will supply per
period of time at different prices.
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 ($)
C H A P T E R 3: Demand, Supply, and Market Equilibrium
Price and Quantity Supplied:
The Law of Supply
6
5
4
3
2
1
0
0
10
20
30
40
50
Thousands of bushels of soybeans
produced per year
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Price of soybeans per bushel ($)
C H A P T E R 3: Demand, Supply, and Market Equilibrium
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
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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C H A P T E R 3: Demand, Supply, and Market Equilibrium
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),
• The technologies that can be
used to produce the product,
• The prices of related products.
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Karl Case, Ray Fair
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
Shift of Supply Versus
Movement Along a Supply Curve
© 2004 Prentice Hall Business Publishing
• A higher price causes
higher quantity
supplied, and a
move along the
demand curve.
• 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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C H A P T E R 3: Demand, Supply, and Market Equilibrium
Shift of Supply Curve for Soybeans
Following Development of a New Seed Strain
• 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.
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Principles of Economics, 7/e
Karl Case, Ray Fair
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
Shift of Supply Versus
Movement Along a Supply Curve
To summarize:
Change in price of a good or service
leads to
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).
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Principles of Economics, 7/e
Karl Case, Ray Fair
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
From Individual
Supply to Market Supply
• 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.
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Karl Case, Ray Fair
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
From Individual
Supply to Market Supply
• As with market demand, market
supply is the horizontal summation
of individual firms’ supply curves.
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Karl Case, Ray Fair
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
Market Equilibrium
• 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.
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Karl Case, Ray Fair
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
Market Equilibrium
© 2004 Prentice Hall Business Publishing
• Only in equilibrium is
quantity supplied
equal to quantity
demanded.
• At any price level
other than P0, such as
P1, quantity supplied
does not equal
quantity demanded.
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
© 2004 Prentice Hall Business Publishing
Excess Demand
• Excess demand, or
shortage, is the condition
that exists when quantity
demanded exceeds
quantity supplied at the
current price.
• When quantity demanded
exceeds quantity supplied,
price tends to rise until
equilibrium is restored.
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
© 2004 Prentice Hall Business Publishing
Excess Supply
• Excess supply, or surplus,
is the condition that exists
when quantity supplied
exceeds quantity demanded
at the current price.
• When quantity supplied
exceeds quantity demanded,
price tends to fall until
equilibrium is restored.
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
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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C H A P T E R 3: Demand, Supply, and Market Equilibrium
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.
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
Relative Magnitudes of Change
• The relative magnitudes of change in supply and demand
determine the outcome of market equilibrium.
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Karl Case, Ray Fair
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
Relative Magnitudes of Change
• When supply and demand both increase, quantity
will increase, but price may go up or down.
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Karl Case, Ray Fair
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C H A P T E R 3: Demand, Supply, and Market Equilibrium
Review Terms and Concepts
capital market
income
perfect substitutes
complements,
complementary goods
inferior goods
product or output markets
input or factor markets
profit
labor market
quantity demanded
land market
quantity supplied
law of demand
shift of a demand curve
law of supply
substitutes
market demand
supply curve
market supply
supply schedule
wealth or net worth
firm
movement along a
demand curve
households
normal goods
demand curve
demand schedule
entrepreneur
equilibrium
excess demand or shortage
excess supply or surplus
factors of production
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
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