CHAPTER 3 SUPPLY AND DEMAND

WHAT YOU WILL LEARN IN THIS CHAPTER

 What is a competitive market?
 What are supply and demand curves?
 How do supply and demand curves lead to an equilibrium price and
equilibrium quantity in the market?
 What are shortages and surpluses and why do price movements eliminate
them?

A. COMPETITIVE MARKETS

 A competitive market has many buyers and sellers of the same good or
service, none of whom can influence the price.
 The supply and demand model is a model of how a competitive market
behaves.

B. DEMAND

 Demand represents the behavior of buyers.

Fig 3.1 The Demand Schedule and the Demand Curve

 A demand schedule shows how much of a good or service consumers will

want to buy at different prices.
 A demand curve shows the quantity demanded at various prices.
 The quantity demanded: the quantity that buyers are willing (and able) to
purchase at a particular price.
Fig. 3.2 An Increase in Demand

 A rightward shift in demand is an increase in demand.

 A leftward shift in demand is a decrease in demand.
Fig. 3.3 A Movement Along vs A Shift in Demand

 When price alone changes, there is movement along a demand curve.

 When the demand shifts (a change in some factor other than the current
price), people are buying more (or less) at EVERY price.
Fig 3.4 Graphing Shifts of the Demand Curve

 Any event that increases demand shifts the demand curve rightward.
 Any event that decreases demand shifts the demand curve leftward.
Shifts of the Demand Curve
 There are five principal factors that shift the demand curve:
1. Changes in the prices of related goods and services
2. Changes in Income
3. Changes in Tastes
4. Changes in Expectations
5. Changes in the number of consumers

1. Changes in the Prices of Related Goods

 Two goods are substitutes if a decrease in the price of one leads to a
decrease in demand for the other (or vice versa).
 Substitutes are usually goods that in some way serve a similar function:
coffee and tea, muffins and doughnuts, train rides and air flights.
 When the price of a substitute in consumption rises, the demand for the good
rises.
 Two goods are complements if a decrease in the price of one good leads to
an increase in the demand for the other (or vice versa).
 Consumers often have to buy goods together.
 When the price of a complement in consumption rises, the demand for the
good falls.

2. Changes in Income
 The effect of changes in income on demand depends on the nature of the
good in question.
 A normal good: Demand increases when income increases (and vice versa).
 An inferior good: Demand decreases when income increases (and vice
versa).

3. Changes in Tastes
 Tastes and preferences are subjective and vary among consumers.
Example: Seasonal changes or fads have predictable effects on demand.
o What happens to demand for boots in October?

4. Changes in Expectations
 If consumers have a choice about the timing of a purchase, they buy
according to expectations.
 Buyers adjust current spending in anticipation of the direction of future
prices in order to obtain the lowest possible price.
Example: If prices for the newest Xbox consoles are expected to drop right
before Christmas, what will happen to sales during November?
 Buyers also adjust spending in anticipation of a change in future income.
5. Changes in The Number of Consumers
 As the population of an economy changes, the number of buyers of a
particular good also changes (thereby changing its demand).
Example: population growth in North America eventually leads to higher
demand for natural gas as more homes and businesses need to be heated in
the winter and cooled in the summer.
Fig 3.5 Individual Demand Curves and the Market Demand Curve

 The market demand curve is the horizontal sum of the individual demand
curves of all consumers.

C. SUPPLY
 Supply represents the behavior of sellers.
Fig. 3.6 The Supply Schedule and Supply Curve
  The supply schedule shows the quantity of goods that a supplier will sell at
different prices.
 A supply curve shows the quantity supplied at various prices.
 The quantity supplied is the quantity that producers are willing and able to
sell at a particular price.
Fig. 3.7 An Increase in Supply

 A rightward shift in demand is an increase in demand.

 A leftward shift in demand is a decrease in demand.
Fig. 3.8 Movement Along the Supply Curve vs A Shift of the Supply Curve

 When price alone changes, there is movement along a supply curve.

 When the supply shifts (a change in some factor other than the current price),
suppliers are selling more (or less) at EVERY price.

Understanding Shifts of the Supply Curve

Important supply shifters include changes in:
1. input prices.
 2. the prices of related goods or services.
3. technology.
4. expectations.
5. the number of producers.

Fig 3.9 Graphing Shifts of the Supply Curve

1. Changes in Input Prices

 A decrease in the price of an input (all else equal) increases profits and
encourages more supply (and vice versa).
Example: fuel is a major cost for airlines. When oil prices surged in 2007–
2008, airlines began cutting back on their flight schedules and some went out
of business.
 Inputs used in production have opportunity costs. Sellers will choose to use
inputs whose profit is the highest.

2. Changes in the Prices of Related Goods

 There are substitutes and complements in production processes.
 Complements in production are by-products. From a common source
(cows), we may produce beef AND leather. When we produce more of one
we get more of the other.
 When the price of a complement in production rises, the supply of the good
rises.
 Substitutes in production are competing products. From a common source,
(titanium) we may produce tennis racquets OR golf clubs. When we produce
more of one we get less of the other.
 When the price of a substitute in production rises, the supply of the good
decreases.

3. Changes in Technology
  New, better technology makes sellers willing to offer more at a given price or
sell their quantity at a lower price.
Example: A technological innovation lowers costs and increases supply.
3. Changes in Expectations
 The expectation of a higher price for a good in the future decreases current
supply of the good – if they can store the good (and vice versa).
 Sellers will adjust their current offerings in anticipation of the direction of
future prices in order to obtain the highest possible price.
4. Changes in the Number of Producers
 As producers enter and exit the market, the overall supply changes.
 Entry implies more sellers in the market, increasing supply.
 Exit implies fewer sellers in the market, decreasing supply.

Fig. 3.10 The Individual Supply Curve and the Market Supply Curve

 The market supply curve is the horizontal sum of the individual supply curves
of all producers.

D. SUPPLY, DEMAND AND MARKET EQUILIBRIUM

 When Qs = Qd at a certain price, the market is in equilibrium.
 That is, the amount consumers would purchase at this price is matched
exactly by the amount producers wish to sell.
Fig. 3.11 Finding the Equilibrium Price and Quantity
  The price at which this takes place is the equilibrium price, also referred to as
the market-clearing price. The quantity of the good or service bought and sold
at that price is the equilibrium quantity.
 In well-established markets, there is a uniform price.
Fig. 3.12 A Surplus

 There is a surplus of a good when the quantity supplied exceeds the quantity
demanded. Surpluses occur when the price is above its equilibrium level.
 Surpluses do not last: sellers will reduce price so they can move goods off
the shelves.
 This surplus will push the price down until it reaches equilibrium price of $3.
Fig. 3.13 A Shortage

 There is a shortage when the quantity demanded exceeds the quantity

supplied. Shortages occur when the price is below its equilibrium level.
 Shortages do not last: sellers will increase price to increase revenue.
 This shortage will push the price up until it reaches the equilibrium price of $3.
Fig 3.14 Equilibrium and Shifts of the Demand Curve
  An increase in demand leads to a movement along the supply curve to a
higher equilibrium price and higher equilibrium quantity.
Fig 3.15 Equilibrium and Shifts of the Supply Curve

 An increase in supply leads to a movement along the demand curve to a

lower equilibrium price and higher equilibrium quantity.
Fig. 3.16 Simultaneous Shifts of the Demand Supply Curves

 If the decrease in demand is relatively larger than the increase in supply,

the equilibrium price and quantity falls.
 If the increase in supply is large relative to the decrease in demand, the
equilibrium quantity rises as the equilibrium price falls.
The Four-Step Approach to Solving Supply and Demand Questions
 When solving questions involving shifts of demand and/or supply curves…
 If you are provided schedules, be precise in your answers. You can determine
the values of the new equilibrium price and quantity.
 If you are not provided schedules, you are not expected to be precise.
However, you MUST provide your answers in the following manner:
Step 1: Which curve shifted, and in which direction?
Step 2: Which curve is moved along, and in what direction
Step 3: In which direction did Equilibrium Price move?
Step 4: In which direction did Equilibrium Quantity move?
And You Must Include a Graph
Example:

Question: Consider the market for beef. Incomes increase. Use the 4-Step

Approach to determine what occurs in the market for beef.

Incomes Increase Beef

Solution: ↑D S
↑ Qs
↑ EP P D2
↑ EQ D1
Q