Chapter 3: Basic Elements of Supply and Demand

 Market: Is any arrangement that enables buyers and sellers to get information and do business with each other.
 Competitive Market: is a market that has many buyers and many sellers so no single buyer or seller can influence the
price.

 Money Price Vs Relative Price

- Money price of a good is the amount of money needed to buy it.
- The relative price of a good is the ratio of its money price to the money price of the next best alternative good, is
its opportunity cost.

 Demand
If you demand something, then
o You want it,
o You can afford it,
o You have made a definite plan to buy it.

 Wants: Are the unlimited desires or wishes people have for goods and services, Demand reflects a decision about which
wants to satisfy.

 Quantity Demanded of a good or service is the amount that consumers plan to buy during a particular time period, and at
a particular price.

 The Law Of Demand

The law of demand states:
o The higher the price of a good, the smaller is the quantity demanded.
o The lower the price of a good, the larger is the quantity demanded.

 Why does a change in the price change the quantity demanded?

- Substitution Effect: When the relative price (opportunity cost) of a good or service rises, people seek substitutes
for it, so the quantity demanded of the good or service decreases.

- Income Effect: When the price of a good or service rises relative to income, people cannot afford all the things
they previously bought, so the quantity demanded of the good or service decreases.

 Demand
- A rise in the price (other things remaining the same) brings a decrease in the
quantity demanded and a movement up along the demand curve.

- A fall in the price (other things remaining the same) brings an increase in the
quantity demanded and a movement down along the demand curve.

- When some influence on buying plans other than the price of the good
changes, there is a change in demand for that good.

- The quantity of the good that people plan to buy changes at each and every price, so there is a new demand curve.
- When demand increases, the demand curve shifts rightward.
- When demand decreases, the demand curve shifts leftward.
 Factors Change Demand
  The prices of related goods
- A substitute is a good that can be used in place of another good.
- A complement is a good that is used in conjunction with another good.

 Expected future prices

- If the price of a good is expected to rise in the future, current demand for the good increases and the
demand curve shifts rightward.

 Income
- When income increases, consumers
buy more of most goods and the
demand curve shifts rightward.
- A normal good is one for which
demand increases as income
increases.
- An inferior good is a good for which
demand decreases as income
increases.

 Expected future income and credit

- When income is expected to increase in the future or when credit is easy to obtain, the demand might
increase now.

 Population
- The larger the population, the greater is the demand for all goods.

 Preferences
- People with the same income have different demands if they have different preferences

 When the price of the good changes and other things remain the same, the
quantity demanded changes and there is a movement along the demand
curve.

 If the price remains the same but one of the other influences on buyers’
plans changes, demand changes and the demand curve shifts.

 Supply
 If a firm supplies a good or service, then the firm
- Has the resources and the technology to produce it,
- Can profit from producing it,
- Has made a definite plan to produce and sell it.

o Resources & technology determine what it is possible to produce. Supply reflects a decision about which
technologically feasible items to produce.

o The quantity supplied of a good or service is the amount that producers plan to sell during a given time period at a
particular price.

 The Low Of Supply

- The higher the price of a good, the greater is the quantity supplied
- The lower the price of a good, the smaller is the quantity supplied.

- The law of supply results from the general tendency for the marginal cost of producing a good or service to
increase as the quantity produced increases.

- The term Supply refers to the entire relationship between the quantity supplied and the price of a good.

- The supply curve shows the relationship between the quantity supplied of a good and its price when all other
influences on producers’ planned sales remain the same.

- A rise in the price, other things remaining the

same, brings an increase in the quantity
supplied.

- When some influence on selling plans other

than the price of the good changes, there is a
change in supply of that good.

- The quantity of the good that producers plan to

sell changes at each and every price, so there is a new supply curve.

- When supply increases, the supply curve shifts rightward.

- When supply decreases, the supply curve shifts leftward.

- When the price of the good changes and other influences on sellers’ plans remain the same, the quantity supplied
changes and there is a movement along the supply curve.

- If the price remains the same but some other influence on sellers’ plans changes, supply changes and the supply
curve shifts.
 Main Factors Change Supply Of A Good:
 The prices of factors of production
- If the price of a factor of production used to produce a good rise, the minimum price that a supplier is
willing to accept for producing each quantity of that good rises.

- So a rise in the price of a factor of production decreases supply and shifts the supply curve leftward.

 The prices of related goods produced

- A substitute in production for a good is another good that can be produced using the same resources.
- The supply of a good increases if the price of a substitute in production falls.

- Goods are complements in production if they must be produced together.

- The supply of a good increases if the price of a complement in production rises.

 Expected future prices

- If the price of a good is expected to rise in the future, supply of the good today decreases and the supply
curve shifts leftward.

 The number of suppliers

- The larger the number of suppliers of a good, the greater is the supply of the good.
- An increase in the number of suppliers shifts the supply curve rightward.

 Technology
- Advances in technology create new products and lower the cost of producing existing products.
- So advances in technology increase supply and shift the supply curve rightward.

 State of nature
- The state of nature includes all the natural forces that influence production—for example, the weather.
- A natural disaster decreases supply and shifts the supply curve leftward.

 Market Equilibrium
- Equilibrium is a situation in which opposing forces balance each other.
- Equilibrium in a market occurs when the price balances the plans of buyers and sellers.

- The equilibrium price is the price at which the quantity demanded equals the quantity supplied.
- The equilibrium quantity is the quantity bought and sold at the equilibrium price.
- Price regulates buying and selling plans.
- Price adjusts when plans don’t match.

- Shortage: Occurs when quantity demanded

exceeds quantity supplied.

- Surplus: Occurs when quantity supplied

exceeds quantity demanded.

- At prices above the equilibrium price, a surplus

forces the price down.
- At prices below the equilibrium price, a shortage forces the price up.
- At the equilibrium price, buyers’ plans and sellers’ plans agree and the price doesn’t change until some event
changes either demand or supply.
 Predicting Changes in Price and Quantity
  Increase In Demand:
- when demand increases the demand curve shifts rightward, at the original price,
there is now a shortage.

- The price rises, and the quantity supplied increases along the supply curve.

 Increase In Supply
- when supply increases the supply curve shifts rightward, at the original
price, there is now a surplus.

- The price falls, and the quantity demanded increases along the demand
curve.

- A change in demand or supply or both demand and supply changes the

equilibrium price and the equilibrium quantity.

- When demand decreases, the equilibrium price falls and the equilibrium quantity decreases.

- When supply decreases, the equilibrium price rises and the equilibrium quantity decreases.

 Increase in Both Demand and Supply

- An increase in demand and an increase in supply increase the equilibrium quantity.

- The change in equilibrium price is uncertain because the increase in

demand raises the equilibrium price and the increase in supply lowers
it.

 Decrease in Both Demand and Supply

- A decrease in both demand and supply decreases the equilibrium
quantity.

- The change in equilibrium price is uncertain because the decrease in demand lowers the equilibrium price
and the decrease in supply raises it.

 Decrease in Demand and Increase in Supply

- A decrease in demand and an increase in supply lowers the
equilibrium price.
 - The change in equilibrium quantity is uncertain because the decrease in demand decreases the
equilibrium quantity and the increase in supply increases it.

 Increase in Demand and Decrease in Supply

- An increase in demand and a decrease in supply raises the equilibrium
price.

- The change in equilibrium quantity is uncertain because the increase in

demand increases the equilibrium quantity and the decrease in supply
decreases it.

 Elasticity

 Price Elasticity of Demand

- The price elasticity of demand is a units-free measure of the responsiveness of the quantity demanded of
a good to a change in its price when all other influences on buying plans remain the same.

- The price elasticity of demand is calculated by using the formula

Percentage Of Change In The Quantity Demanded / Percentage Of Change in The Price

- Unit-Free Measure: Elasticity is a ratio of percentages, so a change in the units of measurement of price or
quantity leaves the elasticity value the same.

- Minus Sign & Elasticity:

o The formula yields a negative value, because price and quantity move in opposite directions.

o But it is the magnitude, or absolute value, that reveals how responsive the quantity change has been to a
price change.

 Inelastic and Elastic Demand

- Demand can be inelastic, unit elastic, or elastic, and can range from zero to infinity.
 - If the quantity demanded doesn’t change when the price changes, the price elasticity of demand is zero and the good
has a perfectly inelastic demand.

- If the percentage change in the quantity demanded is smaller than the percentage change in price, the price
elasticity of demand is less than 1 and the good has inelastic demand.

- If the percentage change in the quantity demanded is greater than the percentage change in price, the price
elasticity of demand is greater than 1 and the good has elastic demand.

 The Factors That Influence Elasticity Of Demand

- The closeness of substitutes:
o The closer the substitutes for a good or service, the more elastic is the demand for the good or service.
o Necessities, such as food or housing, generally have inelastic demand.
o Luxuries, such as exotic vacations, generally have elastic demand.

- The proportion of income spent on the good

o The greater the proportion of income consumers spend on a good, the larger is the elasticity of demand for
that good.

- The time elapsed since a price change

o The more time consumers have to adjust to a price change, or the longer that a good can be stored without
losing its value, the more elastic is the demand for that good.

 Total Revenue and Elasticity

- The Total Revenue from the sale of a good or service equals the price of the good multiplied by the quantity sold.
- When the price changes, total revenue also changes, but a rise in price doesn’t always increase total revenue.

- The change in total revenue due to a change in price depends on the elasticity of demand

o If demand is Elastic, a 1 percent price cut increases the quantity sold by more than 1 percent, and total
revenue increases.

o If demand is Inelastic, a 1 percent price cut increases the quantity sold by less than 1 percent, and total
revenues decreases.

o If demand is Unit Elastic, a 1 percent price cut increases the quantity sold by 1 percent, and total revenue
remains unchanged.

- The Total Revenue Test is a method of estimating the price elasticity of demand by observing the change in total
revenue that results from a price change (when all other influences on the quantity sold remain the same).

- If a price cut increases total revenue, demand is elastic.

- If a price cut decreases total revenue, demand is inelastic.
- If a price cut leaves total revenue unchanged, demand is unit elastic.

 Elasticity of Supply
- The elasticity of supply measures the responsiveness of the quantity supplied to a change in the price of a good,
when all other influences on selling plans remain the same.

- The elasticity of supply is calculated by using the formula:

= Percentage change in quantity supplied / percentage change in price

- Supply is perfectly inelastic if the supply curve is vertical and the elasticity of supply is 0.
- Supply is unit elastic if the supply curve is linear and passes through the origin. (Note that slope is irrelevant.)

- Supply is perfectly elastic if the supply curve is horizontal and the elasticity of supply is
infinite.

 The Factors That Influence the Elasticity of Supply

- Resource substitution possibilities:
o The easier it is to substitute among the resources used to produce a good or
service, the greater is its elasticity of supply.

- Time frame for supply decision.

o The more time that passes after a price change, the greater is the elasticity of supply.
o Momentary supply is perfectly inelastic. The quantity supplied immediately following a price change is
constant.
o Short-run supply is somewhat elastic.
o Long-run supply is the most elastic.

 What is Government
- The entity that has a monopoly over the legitimate use of force to modify the actions of adults.
 - An institutional process through which individuals collectively make choices and carry out activities.

- The most fundamental function of government is the protection of individuals and their property against
acts of aggression.

 Gross Domestic Product (GDP)

- GDP or gross domestic product is the market value of all final goods and services produced in a country in a
given time period.

- This definition has four parts:

o Market value: Goods and services are valued at their market prices.

o Final goods and services: A final good (or service) is an item bought by its final user during a
specified time period.
A final good contrasts with an intermediate good, which is an item that is produced by one
firm, bought by another firm, and used as a component of a final good or service.

o Produced within a country: GDP measures production within a country domestic production.

o In a given time period: GDP measures production during a specific time period, normally a
year or a quarter of a year.

 Households and Firms

- Households sell and firms buy the services of labor, capital, and land in factor markets.

- For these factor services, firms pay income to households: wages for labor services, interest for the use of
capital, and rent for the use of land. A fourth factor of production, entrepreneurship, receives profit.

- In the figure, the blue flow, Y, shows total income paid by firms to households.

- Firms sell and households buy consumer goods and

services in the goods market.

- Consumption expenditure is the total payment for

consumer goods and services, shown by the red
flow labeled (C).

- Firms buy and sell new capital equipment in the

goods market and put unsold output into inventory.
 - The purchase of new plant, equipment, and buildings and the additions to inventories are investment,
shown by the red flow labeled (I).

 Governments
- Governments buy goods and services from firms and their expenditure on goods and services is called
Government Expenditure.

- Government expenditure is shown as the red flow (G).

- Governments finance their expenditure with taxes and pay financial transfers to households, such as
unemployment benefits, and pay subsidies to firms.

- These financial transfers are not part of the circular flow of expenditure and income.

 Rest of the World

- Firms in the United States sell goods and services to
the rest of the world—Exports
- buy goods and services from the rest of the world
—Imports.

- The value of exports (X) minus the value of imports

(M) is called net exports, the red flow (X – M).

- If net exports are positive, the net flow of goods

and services is from U.S. firms to the rest of the
world.

- If net exports are negative, the net flow of goods

and services is from the rest of the world to U.S.
firms.

- The circular flow shows two ways of measuring GDP.

- Total expenditure on final goods and services equals
GDP.
- GDP = C + I + G + (X – M).

- Firms pay out all their receipts from the sale of final
goods, so income equals expenditure,
- Y = C + I + G + (X – M).