Chap 3,4 Vocabulary
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Law of Demand
Normal goods
Inferior goods
Substitute goods
Complementary
goods
Law of Supply
Demand Schedule
Demand Curve
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Substitution effect
Income effect
Determinants of
Demand
Shortage (or
excess demand)
Surplus (or excess
supply)
Market equilibrium
1
Chapters 3,4
Demand, Supply, and
Market Equilibrium; and
the Market System
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What a competitive market is and how it
is described by the supply and demand
model
What the demand curve and supply
curve are
The difference between movements along
a curve and shifts of a curve
How the supply and demand curves
determine a market’s equilibrium price
and equilibrium quantity
In the case of a shortage or surplus, how
price moves the market back to equilibrium
Supply and Demand
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The supply and demand model is
a model of how a competitive market
works.
Five key elements:
• Demand curve
• Supply curve
• Demand and supply curve shifts
• Market equilibrium
• Changes in the market equilibrium
Perfectly Competitive Market
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The model of supply and demand
explains how a perfectly
competitive market operates.
• A perfectly competitive
market is a market which has
a very large number of firms,
each of which produces the
same standardized product in
amounts so small that no
individual firm can affect the
market price.
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Price and Quantity
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Price – the amount of money paid for
an economic good/service
• Ex. A gallon of gasoline has a price of
$3.50
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Quantity – the amount of items
• Ex. If I fill my gas tank up with gas,
then the quantity purchased is 15
gallons
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LAW OF DEMAND: The higher the
price, the smaller the quantity
demanded, ceteris paribus
(everything else held fixed). Or if
the price is lower, we purchase a
higher quantity.
7
Demand Curve
Price of
coffee bean
(per gallon)
A demand curve is the graphical
representation of the demand
schedule; it shows how much of a
good or service consumers want to
buy at any given price.
$2.00
1.75
1.50
As price rises, the
quantity demanded
falls
1.25
1.00
0.75
Demand
curve, D
0.50
0
7
9
11
13
15
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Quantity of coffee beans
(billions of pounds)
Determinants of Demand (Why the
Demand Curve is downsloping)
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Law of Diminishing Marginal Utility
suggests that we receive less satisfaction
from additional units that we may
purchase, e.g. one Big Mac a very
satisfying, the 2nd perhaps not as
enjoyable.
The substitution effect is the change in
consumption resulting from a change in
the price of one good relative to the price
of other goods. For example, if the price
of Coke increases, we may purchase
more Pepsi.
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Determinants of Demand (contd.)
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The income effect describes the
change in consumption resulting
from an increase in the consumer’s
real income, or the income in terms
of the goods the money can buy. If
the price of gasoline decreases, we
now have more “income” to spend
on other goods.
Real income is the consumer’s income
measured in terms of the goods it can
buy.
10
The Individual Demand Schedule
Al’s Demand Schedule for
Pizza
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Price
Quantity of pizzas per
month
$2
13
4
10
6
7
8
4
10
1
The demand schedule is a table that shows
the relationship between price and quantity
demanded by an individual consumer, ceteris
paribus (everything else held fixed).
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From Individual to Market Demand
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The market demand curve shows
the relationship between price and
quantity demanded by all consumers
together, ceteris paribus (everything
else held fixed).
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The Individual Demand Curve
and the Market Demand Curve
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The individual
demand curve is a
graphical representation
of the demand schedule
for an individual.
The market demand
curve is a
representation of the
total individual demand
schedules.
LAW OF DEMAND:
The higher the price,
the smaller the quantity
demanded, ceteris
paribus (everything else
held fixed). Or if the
price is lower, we
purchase a higher
quantity.
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The Demand Curve
and the Law of Demand
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• In this case, an increase in
price causes a decrease in
quantity demanded, and a
movement upward along the
individual’s demand curve.
Quantity demanded is
the amount of a good
an individual consumer
or consumers as a
group are willing to
buy.
A change in quantity
demanded is a change
in the amount of a good
demanded resulting
from a change in the
price of the good.
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Market Effects of
Changes in Demand
Change in Quantity Demanded versus Change in Demand
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A change in price causes
a change in quantity
demanded. An increase
in price causes movement
from point b to point c.
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A change in demand
(caused by changes in
something other than
the price of the good)
shifts the entire demand 15
curve.
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Causes of an Increase in Demand (a
shift of the demand curve)
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An increase in demand can
occur for several reasons:
• 1. An change in income (for a normal
good). A normal good is a good that
consumers buy more of when their
income increases. Most goods fall in
this category. An example: steak
• 2. A change in income (for an inferior
good). An inferior good is the
opposite of a normal good. Consumers
buy more of inferior goods when their
income decreases. An example:
hamburger meat.
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Causes of an Increase in
Demand (Continued)
• 3. A change in the price of a substitute good.
When to goods are substitutes, an
increase in the price of one good increases
the demand for the other good. Example:
Coke and Pepsi.
• 4. A change in the price of a complementary
good. Two goods are complements when
an increase in the price of one good
decreases the demand for the other good.
Example: DVD player and DVD movies.
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Causes of an Increase in
Demand (Continued)
• 5. A change in population/number of
buyers. Example: lower drinking age to
18 or raise smoking age.
• 6. A shift in consumer tastes
• 7. good/bad advertising
• 8. Expectations of future price change
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Supply
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Producers willingness and ability to
sell a good/service
Law of Supply states that “holding all
else equal, when the price of a good
rises, suppliers increase the quantity
supplied for that good”. They can
increase their profits.
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The Supply Curve
and the Law of Supply
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The supply curve is a
graphical representation
of the supply schedule.
Its positive slope
reflects the law of
supply.
• LAW OF SUPPLY: The
higher the price, the larger
the quantity supplied,
ceteris paribus; and the
lower the price, the less
goods supplied.
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The Individual Supply Schedule
and the Law of Supply
Nora’s Supply Schedule for Pizza
Quantity of pizzas
Price
per month
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$4
100
6
200
8
300
10
400
12
500
A firm’s supply schedule is a table that
shows the relationship between price and
quantity supplied, ceteris paribus
(everything else held fixed).
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The Supply Curve for an Individual
Firm
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• In this case, an increase in
price causes an increase in
quantity supplied and a
movement upward along
the supply curve.
Quantity supplied is
the amount of a good
an individual firm or
firms as a group are
willing to sell.
A change in quantity
supplied is a change in
the amount of a good
supplied resulting from
a change in the price of
the good; represented
graphically by a
movement along the
supply curve.
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Market Effects of
Changes in Supply
Change in Quantity Supplied versus Change in Supply
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A change in price causes a
change in quantity
supplied. A price increase
from $6 to $8 increases
quantity supplied, point e to
point f.
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A change in supply (caused
by changes in something
other than the price of the
good) shifts the entire supply
curve. Shift from S1 to S2
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What Causes a change in Supply
• 1. A change in input (4 factors of
production) costs.
• 2. A change in the number of
producers.
• 3. Expectations of changes in future
prices.
• 4. Product is subsidized or taxed
• 5. Changes in technology
• 6. Price of other products or outputs
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Market Equilibrium
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Market
equilibrium is a
situation in which
the quantity of a
product demanded
equals the quantity
supplied, so there is
no pressure to
change the price.
The ability of the forces of supply and demand to establish a
price is called “the rationing function of prices”.
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The Competitive Market Response to a
shortage
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Excess demand (or
a shortage) is a
situation in which,
at the prevailing
price, consumers
are willing to buy
more than
producers are willing
to sell.
• To reach equilibrium, point e, the market moves
upward along the demand curve, decreasing quantity
demanded as price increases, and upward along the
supply curve, increasing quantity supplied.
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The Competitive Market Response to a
Surplus

Excess supply (or a
surplus) is a situation in
which, at the prevailing
price, producers are
willing to sell more than
consumers are willing
to buy.
• The market moves downward along the demand
curve, increasing quantity demanded, and downward
along the supply curve, decreasing quantity supplied.
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An Example of a Government set Price
Ceiling (can not charge higher)
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Price
Ceiling
At $6
If the government
sets a price for pizza
at $6, market forces
do not adjust to
equilibrium and a
shortage of 17,000
pizzas occurs. An
example of price
ceilings might be
rent controls in New
York City.
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A Real Shortage
Supply
Price of
diesel
Fuel per
liter
in Yuan
By creating a price
ceiling on the price
of diesel fuel, the
Chinese government
created a shortage.
E
.Price Ceiling
Shortage
0
7
9.1
10
Quantity
supplied
11.5
Demand
13
Quantity
demanded
15
17
Quantity of
diesel
Fuel supplied
An Example of the Government Setting
a Price Floor (cannot charge lower)
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Price
Floor
If the government sets
a price floor of$12 for
pizza, a surplus of
35,000 pizzas occurs
(15,000 demanded
and 50,000 produced).
Pizza producers cannot
be paid less than $12.
This price setting often
occurs with agricultural
products. Market
forces can not readjust
to the equilibrium
price.
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Using the Model to Predict
Changes in Price and Quantity
Predicting the Effects of Changes in Demand
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An increase in university
enrollment will increase the
demand for apartments, shifting
the demand curve to the right.
Both the equilibrium price and
the equilibrium quantity will
increase.
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A report of pesticide residue on
apples decreases the demand for
apples, shifting the demand curve
to the left. Both the equilibrium
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price and the equilibrium quantity
will decrease.
Using the Model to Predict
Changes in Price and Quantity
Predicting the Effects of Changes in Supply
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Technological innovation
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decreases production costs,
shifting the supply curve to the
right. The equilibrium price
decreases, and the equilibrium
quantity increases.
Bad weather decreases the
supply of coffee beans, shifting
the supply curve to the left. The
equilibrium price increases, and
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the equilibrium quantity
decreases.
Simultaneous changes in
Supply and Demand
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If both Supply and Demand shift
simultaneously, either the Price or
the Quantity will be indeterminate.
For example, if Demand and Supply
both increase, the Q will increase but
the P may increase, decrease, or be
unchanged.
Market Effects of Simultaneous
Changes in Supply and Demand
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Both the equilibrium
price and the
equilibrium quantity
will increase.
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The equilibrium price
will decrease and the
equilibrium quantity
will increase.
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Market Effects of Simultaneous
Changes in Supply and Demand
When both Supply and Demand simultaneously change,
either the Price or Quantity changes for certain; the other
variable change is uncertain, it may either increase or
decrease.
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Chapter 4 (pg 59-61, 68)
Characteristics of a Market
-
Private property
Freedom of enterprise/choice
Competition
Extensive use of capital goods
Specialization and the division of
labor
- Adam Smith’s “Invisible Hand”
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Conclusion
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Markets work best when supply and
demand determine the price of
goods/services or resources.
When forces other than supply and demand
determine the price of goods/services or
resources, surpluses and shortages result.
Over time, the forces of supply and demand
undermine artificial price controls
• Ex. Black markets, ticket scalping,
undocumented workers
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Review 1: Why Demand Curve is
Downsloping
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Income Effect – if goods are cheaper,
we have MORE money to buy more
goods.
Substitution effect – we can most
often substitute cheaper goods
Law of Diminishing Marginal Utility –
we get less satisfaction for additional
units purchased.
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Review 2
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What changes
Demand
• Income (normal
and inferior goods)
• Substitute prices
• Complementary
goods prices
• Change in number
of buyers
• Consumer tastes
• Expectations
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What changes
Supply
•
•
•
•
Input costs
Future expectations
Taxes/subsidies
Number of
producers
40
The Market Response to a shortage

Excess demand (or
a shortage) is a
situation in which,
at the prevailing
price, consumers
are willing to buy
more than
producers are willing
to sell.
• To reach equilibrium, point e, the market moves
upward along the demand curve, decreasing quantity
demanded, and upward along the supply curve,
increasing quantity supplied.
41
The Market Response to a
Surplus

Excess supply (or a
surplus) is a situation in
which, at the prevailing
price, producers are
willing to sell more than
consumers are willing
to buy.
• The market moves downward along the demand
curve, increasing quantity demanded, and downward
along the supply curve, decreasing quantity supplied.
42
Using the Model to Predict
Changes in Price and Quantity
Predicting the Effects of Changes in Demand

An increase in university
enrollment will increase the
demand for apartments, shifting
the demand curve to the right.
Both the equilibrium price and the
equilibrium quantity will increase.

A report of pesticide residue on
apples decreases the demand for
apples, shifting the demand curve to
the left. Both the equilibrium price
and the equilibrium quantity will 43
decrease.
Using the Model to Predict
Changes in Price and Quantity
Predicting the Effects of Changes in Supply

Technological innovation

decreases production costs,
shifting the supply curve to the
right. The equilibrium price
decreases, and the equilibrium
quantity increases.
Bad weather decreases the
supply of coffee beans, shifting
the supply curve to the left. The
equilibrium price increases, and
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the equilibrium quantity
decreases.
Predicting the Effects of simultaneous
Changes in Supply and Demand
D1
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D1
When supply and demand change simultaneously, one of the
changes in the variables, Price or Quantity, will be indeterminate.
In the above examples, Q increases in both, but in example 1, P
decreases and in example 2, P increases. So P would be
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indeterminate.