CHAPTER 3: SUPPLY AND DEMAND

 The goal of this chapter is to explain how supply and demand really work.
-What determines the price of a good or service?
-How does the price of a product affect its production and consumption?
-Why do prices and production levels often change?
Learning Objectives
03-01. Know the nature and determinants of market demand.
03-02. Know the nature and determinants of market supply.
03-03. Know how market prices are established.
03-04. Know what causes market prices to change.
03-05. Know how government price controls affect market outcomes.
>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.
>Market Participants
 All participants, for the most part, are trying to obtain the maximum return from the scarce resources they have.
Consumers: maximize the utility (satisfaction of unmet wants) they can get from available incomes.
Businesses: maximize profits by selling goods that satisfy while keeping costs low.
Government: maximize the general welfare of society.
 These motives explain most market activity.
>Specialization and Trade
 Most of us cannot produce everything we want to consume.
-Time, talent, and resource constraints.
 We should specialize and produce what we can at a lower opportunity cost than others.
 Produce more than we need for ourselves and ...
-… trade the excess for the goods we want to consume (which are produced by other specialists).
>The Circular Flow
There are two markets and four participants:
Consumers:
They are owners of factors of production (e.g., labor) who supply them to business firms in the factor market and earn
income.
They purchase goods and services in the product market.
>The Circular Flow
Business firms: they produce goods and services for the product market using the factors of production they bought from
their owners in the factor market.
Governments: they acquire resources in the factor market and provide services to both consumers and firms.
International participants: they supply imports and purchase exports in the product market and buy and sell resources in
the factor market.
>The Circular Flow of Economic Activity
 The circular flow of economic activity shows the connections between firms and households in input and output
markets.
>Input Markets and Output Markets
 Output, or product, 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.Payments flow in the opposite direction as the physical flow of
resources, goods, and services (counterclockwise).

>Input Markets
Input markets include:
 The labor market, in which households supply work for wages to firms that demand labor.
 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.
 The land market, in which households supply land or other real property in exchange for rent.
>Locating Markets
 A market exists wherever an exchange (transaction) takes place.
 Every market transaction involves an exchange of dollars for goods and service (in product markets) or resources (in
factor markets).
-In the circular flow, goods and services or resources flow one way, and dollars flow the opposite way.
>Supply and Demand
 Supply: the ability and willingness to sell specific quantities of a good at alternative prices in a given time period,
ceteris paribus.
 Demand: the ability and willingness to buy specific quantities of a good at alternative prices in a given time period,
ceteris paribus.
 Ceteris paribus: the assumption that nothing else is changing.
>The Law of Demand
 Law of demand: the quantity demanded of a good in a given time period increases as its price falls, ceteris paribus (and
vice versa).
 Inverse relationship between price (P) and quantity demanded (Qd).
 A downward-sloping curve on a market diagram.
>Individual Demand and Market Demand
 Each of us has a demand for a good or a service if we are willing and able to pay for it.
 The amount we buy depends on its price.
-If the price goes up, we buy less.
-If the price goes down, we buy more.
 Market demand is the collective summation of all buyers’ individual demands.
>From Household 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.
>Factors That Set Demand Behavior (Determinants of Demand)
 Tastes.  If any of these factors change, demand
 Income. behavior changes.
 Expectations.  A demand behavior change is shown by
 Other goods: shifting the demand curve.
-Substitutes. -Increase in demand: shift the curve right.
-Complements. -Decrease in demand: shift the curve left.
 Number of buyers.
>Determinants of Household Demand
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.
 The household’s amount of accumulated wealth.
 The prices of related products available to the household.
 The household’s tastes and preferences.
 The household’s expectations about future income, wealth, and prices.
>Changing Demand (Shifting the Demand Curve) >Income and Wealth
 Demand increases (shifts right) when Income is the sum of all households wages, salaries, profits,
-Taste for the good increases. interest payments, rents, and other forms of earnings in a given
-Income increases. period of time. It is a flow measure.
-Price of a substitute rises. Wealth, or net worth, is the total value of what a household
-Price of a complement falls. owns minus what it owes. It is a stock measure.
-Future prices are expected to rise.
-Number of buyers increases.
 Vice versa, and demand decreases (shifts left).
>Related Goods and Services
 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.
 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.
 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.
>Movements vs. Shifts
 Change in quantity demanded: movement along a demand curve in response to a change in price.
 Change in demand: a shift of the demand curve due to a change in one or more of the determinants of demand.
>Law of Supply
 Law of supply: the quantity of a good supplied in a given time period increases as its price increases, ceteris paribus,
and vice versa.
 Direct relationship between price (P) and quantity supplied (Qs).
 It is an upward-sloping curve on a market diagram.
>Factors that Set Supply Behavior (Determinants of Supply)
 Technology  If any of these factors change, supply behavior changes.
 Factor costs.  This type of change is shown by shifting the supply curve.
 Taxes and -Increase in supply: shift the curve right.
subsidies. -Decrease in supply: shift the curve left.
 Expectations.
 Other goods.
Number of sellers.
>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.
>Changing Supply (Shifting the Supply Curve)
 Supply increases (shifts right) when
-New technology lowers operating costs. -Future prices are expected to rise.
-Factor costs decrease. -Price of alternative goods fall.
-Taxes decrease or subsidies increase. -Number of sellers increases.
 Vice versa, and supply decreases (shifts left).
>Movements vs. Shifts
 Change in quantity supplied: movement along the supply curve due to a change in price.
 Change in supply: a shift in the supply curve due to one or more changes in the determinants of supply.
>Individual Supply and Market Supply
 Each producer is willing and able to produce a good or service if he or she can make a profit.
 The amount produced depends on its price.
-If the price goes up, more will be produced.
-If the price goes down, less will be produced.
 Market supply is the collective summation of all producers’ individual supplies.
>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.
>Putting a Market Together
 The interaction of buyers and sellers makes a market.
 Equilibrium: only one price and quantity combination
is compatible with the intentions of both buyers and sellers.
 Equilibrium is located where the demand curve and supply
curve intersect.
 >Equilibrium
 No shortage exists.
 No surplus exists.
 Qd = Qs = Qe.
 The price will not change until
there is a shift in demand or in supply.
>Market Equilibrium
 The operation of the market depends on the interaction between buyers and sellers.
 An 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.
>Equilibrium
 Markets reach equilibrium because buyers have a demand behavior (raise price, buy less, and vice versa) and sellers
have a supply behavior (raise price, supply more, and vice versa).
-No one is in charge!
-The market mechanism (Adam Smith’s “invisible hand”) leads the market to equilibrium.
 At equilibrium, quantity demanded (Qd) equals quantity supplied (Qs) at the equilibrium price (Pe).
-We say that the market mechanism signals the desired outcome at Pe.
>Resolving a Market Surplus
 Market surplus: the amount by which quantity
supplied (Qs) exceeds quantity demanded (Qd) at a
given price; excess supply.
 Price is too high.
 Qs > Qd, a surplus.
 Buyer and seller behaviors kick in.
 Price will fall to equilibrium price, Pe.
>Resolving a Market Shortage
 Market shortage: the amount by which quantity demanded (Qd)
exceeds quantity supplied (Qs) at a given price; excess demand.
 Price is too low.
 Qs < Qd, a shortage.
 Buyer and seller behaviors kick in.
 Price will rise to equilibrium price, Pe.
>What Causes the Price to Change?
 Price changes when equilibrium is upset.
… due to a shift in demand (a change in buyers’ behavior), or …
… due to a shift in supply (a change in sellers’ behavior).
 After the shift, a surplus or a shortage is created, and the market mechanism goes into effect to find the new equilibrium.
>Demand Increases
 Buyers’ behavior changes.
-Demand shifts right.
 Old equilibrium is upset.
 Creates a shortage.
-Price rises.
 A new equilibrium is established.
 Price rises from P1 to P2.
 Quantity rises from Q1 to Q2.
>Demand Decreases
 Buyers’ behavior changes.
-Demand shifts left.
 Old equilibrium is upset.
 Creates a surplus.
-Price falls.
 A new equilibrium is established.
 Price falls from P1 to P2.
 Quantity falls from Q1 to Q2
>Supply Increases
 Sellers’ behavior changes.
-Supply shifts right.
 Old equilibrium is upset.
 Creates a surplus.
-Price falls.
 A new equilibrium is established.
 Price falls from P1to P2.
 Quantity rises from Q1 to Q2.
>Supply Decreases
 Sellers’ behavior changes.
-Supply shifts left.
 Old equilibrium is upset.
 Creates a shortage.
-Price rises.
 A new equilibrium is established.
 Price rises from P1to P2.
 Quantity falls from Q1 to Q2.
>Summary: When Do Prices Change? >Market Outcomes
 Only when a market is in disequilibrium.  The market mechanism affects WHAT, HOW, and FOR WHOM to produce.
-Shortage? Price rises. WHAT? Markets determine which goods are desired and
-Surplus? Price falls. which are profitable.
 A shift in either demand or supply causes HOW? Profit-seeking producers will strive to produce goods in
the price to change, BUT…. the most efficient way.
 A price change does NOT cause FOR WHOM? To obtain a good, one must be both willing
-… the demand curve to shift or and able to purchase it.
-… the supply curve to shift.
>Price Controls
 Governments may impose an arbitrary maximum price (price ceiling) or a minimum price (price floor) on a market.
-The result is that the market cannot reach equilibrium.
>Price Ceilings & Floors
 A price ceiling is a legal maximum that can be charged for a good.
-Results in a shortage of a product
-Common examples include apartment rentals and credit cards interest rates.
 A price floor is a legal minimum that can be charged for a good.
-Results in a surplus of a product
-Common examples include soybeans, milk, minimum wage
>Price Ceiling
 Government imposes a maximum price less than Pe.
 This generates a shortage (Qd > Qs).
 The market mechanism cannot clear the market.
 A permanent shortage exists.

>Price Floor
 Government imposes a minimum price greater than Pe.
 This generates a surplus (Qs > Qd).
 The market mechanism cannot clear the market.
 A permanent surplus exists.