The Market Forces of Supply and Demand

CHAPTER

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Wojciech Gerson (1831-1901)

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In this chapter, �look for the answers to these questions

• What factors affect buyers’ demand for goods?
• What factors affect sellers’ supply of goods?
• How do supply and demand determine the price of a good and the quantity sold?
• How do changes in the factors that affect demand or supply affect the market price and quantity of a good?
• How do markets allocate resources?

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Markets and Competition

• A market is a group of buyers and sellers of a particular product.
• A competitive market is one with many buyers and sellers, each has a negligible effect on price.
• In a perfectly competitive market:
• All goods exactly the same
• Buyers & sellers so numerous that no one can affect market price—each is a “price taker”
• In this chapter, we assume markets are perfectly competitive.

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Demand

• The quantity demanded of any good is the amount of the good that buyers are willing and able to purchase.
• Law of demand: the claim that the quantity demanded of a good falls when the price of the good rises, other things equal

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The Demand Schedule

• Demand schedule: �a table that shows the relationship between the price of a good and the quantity demanded
• Example: �Helen’s demand for lattes.
• Notice that Helen’s preferences obey the �law of demand.

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Helen’s Demand Schedule & Curve

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Market Demand versus Individual Demand

• The quantity demanded in the market is the sum of the quantities demanded by all buyers at each price.
• Suppose Helen and Ken are the only two buyers in the Latte market. (Q^d = quantity demanded)

Market Q^d

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The Market Demand Curve for Lattes

P

Q

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Demand Curve Shifters

• The demand curve shows how price affects quantity demanded, other things being equal.
• These “other things” are non-price determinants of demand (i.e., things that determine buyers’ demand for a good, other than the good’s price).
• Changes in them shift the D curve…

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Demand Curve Shifters: # of Buyers

Suppose the number of buyers increases.

Then, at each P, �Q^d will increase �(by 5 in this example).

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Demand Curve Shifters: Income

• Demand for a normal good is positively related to income.
• Increase in income causes �increase in quantity demanded at each price, shifts D curve to the right.

(Demand for an inferior good is negatively related to income. An increase in income shifts D curves for inferior goods to the left.)

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Demand Curve Shifters: Prices of Related Goods

• Two goods are substitutes if � an increase in the price of one � causes an increase in demand for the other.
• Example: pizza and hamburgers. �An increase in the price of pizza � increases demand for hamburgers, � shifting hamburger demand curve to the right.
• Other examples: Coke and Pepsi, �laptops and desktop computers, �CDs and music downloads

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Demand Curve Shifters: Prices of Related Goods

• Two goods are complements if � an increase in the price of one � causes a fall in demand for the other.
• Example: computers and software. �If price of computers rises, � people buy fewer computers, � and therefore less software. �Software demand curve shifts left.
• Other examples: college tuition and textbooks, �bagels and cream cheese, eggs and bacon

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Demand Curve Shifters: Tastes

• Anything that causes a shift in tastes toward a good will increase demand for that good �and shift its D curve to the right.
• Example: �The Atkins diet became popular in the ’90s, �caused an increase in demand for eggs, �shifted the egg demand curve to the right.

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Demand Curve Shifters: Expectations

• Expectations affect consumers’ buying decisions.
• Examples:
• If people expect their incomes to rise, �their demand for meals at expensive restaurants may increase now.
• If the economy sours and people worry about their future job security, demand for new autos may fall now.

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Summary: Variables That Influence Buyers

Variable A change in this variable…

Price …causes a movement � along the D curve

# of buyers …shifts the D curve

Income …shifts the D curve

Price of�related goods …shifts the D curve

Tastes …shifts the D curve

Expectations …shifts the D curve

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ACTIVE LEARNING ₁ �Demand curve

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A. The price of iPods falls

B. The price of music downloads falls

C. The price of CDs falls

Draw a demand curve for music downloads. What happens to it in each of �the following scenarios? Why?

©Enyezdi/Shutterstock.com

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ACTIVE LEARNING ₁ �A. Price of iPods falls

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Music downloads and iPods are complements.

A fall in price of iPods shifts the demand curve for music downloads �to the right.

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ACTIVE LEARNING ₁ �B. Price of music downloads falls

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The D curve �does not shift.

Move down along curve to a point with lower P, higher Q.

Price of music down-loads

Quantity of �music downloads

D₁

P₁

Q₁

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ACTIVE LEARNING ₁ �C. Price of CDs falls

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CDs and �music downloads are substitutes.

A fall in price of CDs shifts demand for music downloads �to the left.

Price of music down-loads

Quantity of �music downloads

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Supply

• The quantity supplied of any good is the amount that sellers are willing and able to sell.
• Law of supply: the claim that the quantity supplied of a good rises when the price of the good rises, other things equal

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The Supply Schedule

• Supply schedule: �A table that shows the relationship between the price of a good and the quantity supplied.
• Example: �Starbucks’ supply of lattes.

• Notice that Starbucks’ supply schedule obeys the �law of supply.

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Starbucks’ Supply Schedule & Curve

P

Q

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Market Supply versus Individual Supply

• The quantity supplied in the market is the sum of �the quantities supplied by all sellers at each price.
• Suppose Starbucks and Peet’s are the only two sellers in this market. (Q^s = quantity supplied)

Market Q^s

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The Market Supply Curve

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Supply Curve Shifters

• The supply curve shows how price affects quantity supplied, other things being equal.
• These “other things” are non-price determinants of supply.
• Changes in them shift the S curve…

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Supply Curve Shifters: Input Prices

• Examples of input prices: � wages, prices of raw materials.
• A fall in input prices makes production �more profitable at each output price, �so firms supply a larger quantity at each price, �and the S curve shifts to the right.

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Supply Curve Shifters: Input Prices

Suppose the price of milk falls.

At each price, the quantity of �lattes supplied �will increase �(by 5 in this example).

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Supply Curve Shifters: Technology

• Technology determines how much inputs are required to produce a unit of output.
• A cost-saving technological improvement has �the same effect as a fall in input prices, �shifts S curve to the right.

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Supply Curve Shifters: # of Sellers

• An increase in the number of sellers increases the quantity supplied at each price,

shifts S curve to the right.

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Supply Curve Shifters: Expectations

• Example:
• Events in the Middle East lead to expectations of higher oil prices.
• In response, owners of Texas oilfields reduce supply now, save some inventory to sell later at the higher price.
• S curve shifts left.
• In general, sellers may adjust supply* when their expectations of future prices change. �(*If good not perishable)

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Summary: Variables that Influence Sellers

Variable A change in this variable…

Price …causes a movement � along the S curve

Input Prices …shifts the S curve

Technology …shifts the S curve

# of Sellers …shifts the S curve

Expectations …shifts the S curve

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ACTIVE LEARNING ₂ �Supply curve

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Draw a supply curve for tax �return preparation software. �What happens to it in each �of the following scenarios?

A. Retailers cut the price of �the software.

B. A technological advance �allows the software to be �produced at lower cost.

C. Professional tax return preparers raise the price of the services they provide.

© v777999/Shutterstock.com

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ACTIVE LEARNING ₂ �A. Fall in price of tax return software

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S curve does �not shift.

Move down �along the curve �to a lower P �and lower Q.

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ACTIVE LEARNING ₂ �B. Fall in cost of producing software

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S curve shifts to the right:

at each price, �Q increases.

Price of tax return software

Quantity of tax return software

S₁

P₁

Q₁

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ACTIVE LEARNING ₂ �C. Professional preparers raise their price

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This shifts the demand curve for tax preparation software, not the supply curve.

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Supply and Demand Together

Equilibrium: �P has reached �the level where �quantity supplied equals �quantity demanded

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Equilibrium price:

the price that equates quantity supplied with quantity demanded

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Equilibrium quantity:

the quantity supplied and demanded at the equilibrium price

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Surplus (a.k.a. excess supply):

when quantity supplied is greater than quantity demanded

Surplus

Example: �If P = $5,

then� Q^D = 9 lattes

and� Q^S = 25 lattes

resulting in a �surplus of 16 lattes

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Surplus (a.k.a. excess supply):

when quantity supplied is greater than quantity demanded

Facing a surplus, �sellers try to increase sales by cutting price.

This causes �Q^D to rise

…which reduces the surplus.

and Q^S to fall…

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Surplus (a.k.a. excess supply):

when quantity supplied is greater than quantity demanded

Facing a surplus, �sellers try to increase sales by cutting price.

This causes �Q^D to rise and Q^S to fall.

Surplus

Prices continue to fall until market reaches equilibrium.

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Shortage (a.k.a. excess demand):

when quantity demanded is greater than quantity supplied

Example: �If P = $1,

then� Q^D = 21 lattes

and� Q^S = 5 lattes

resulting in a �shortage of 16 lattes

Shortage

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Shortage (a.k.a. excess demand):

when quantity demanded is greater than quantity supplied

Facing a shortage, �sellers raise the price,

causing Q^D to fall

…which reduces the shortage.

and Q^S to rise,

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Shortage (a.k.a. excess demand):

when quantity demanded is greater than quantity supplied

Facing a shortage, �sellers raise the price,

causing Q^D to fall

and Q^S to rise.

Shortage

Prices continue to rise until market reaches equilibrium.

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Three Steps to Analyzing Changes in Eq’m

To determine the effects of any event,

1. Decide whether the event shifts S curve, �D curve, or both.

2. Decide in which direction curve shifts.

3. Use supply—demand diagram to see �how the shift changes equilibrium P and Q.

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EXAMPLE: The Market for Hybrid Cars�

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EXAMPLE 1: A Shift in Demand�

EVENT TO BE �ANALYZED: �Increase in price of gas.

STEP 1:

D curve shifts �because price of gas affects demand for hybrids.

S curve does not shift, because price of gas does not affect cost of producing hybrids.

STEP 2:

D shifts right�because high gas price makes hybrids more attractive relative to other cars.

STEP 3:

The shift causes an increase in price �and quantity of hybrid cars.

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EXAMPLE 1: A Shift in Demand�

P₂

Q₂

Notice: �When P rises, producers supply �a larger quantity �of hybrids, even though the S curve has not shifted.

Always be careful to distinguish b/w a shift in a curve and a movement along the curve.

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Terms for Shift vs. Movement Along Curve

• Change in supply: a shift in the S curve

occurs when a non-price determinant of supply changes (like technology or costs)

• Change in the quantity supplied: �a movement along a fixed S curve

occurs when P changes

• Change in demand: a shift in the D curve

occurs when a non-price determinant of demand changes (like income or # of buyers)

• Change in the quantity demanded: �a movement along a fixed D curve

occurs when P changes

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EXAMPLE 2: A Shift in Supply�

EVENT: New technology reduces cost of producing hybrid cars.

STEP 1:

S curve shifts �because event affects cost of production.

D curve does not shift, because production technology is not one of the factors that affect demand.

STEP 2:

S shifts right�because event reduces cost, �makes production more profitable at any given price.

STEP 3:

The shift causes price to fall �and quantity to rise.

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EXAMPLE 3: A Shift in Both Supply �and Demand

EVENTS: �Price of gas rises AND �new technology reduces production costs

STEP 1:

Both curves shift.

STEP 2:

Both shift to the right.

STEP 3:

Q rises, but effect �on P is ambiguous:

If demand increases more than supply, P rises.

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EXAMPLE 3: A Shift in Both Supply �and Demand

STEP 3, cont.

EVENTS: �price of gas rises AND �new technology reduces production costs

But if supply increases more than demand, �P falls.

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ACTIVE LEARNING ₃ �Shifts in supply and demand

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Use the three-step method to analyze the effects of each event on the equilibrium price and quantity of music downloads.

Event A: A fall in the price of CDs

Event B: Sellers of music downloads negotiate a reduction in the royalties they must pay for each song they sell.

Event C: Events A and B both occur.

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ACTIVE LEARNING ₃ �A. Fall in price of CDs

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2. D shifts left

The market for music downloads

1. D curve shifts

3. P and Q both fall.

STEPS

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ACTIVE LEARNING ₃ �B. Fall in cost of royalties

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The market for music downloads

1. S curve shifts

2. S shifts right

3. P falls, �Q rises.

STEPS

(Royalties are part of sellers’ costs)

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ACTIVE LEARNING ₃ �C. Fall in price of CDs and � fall in cost of royalties

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STEPS

1. Both curves shift (see parts A & B).

2. D shifts left, S shifts right.

3. P falls.

Effect on Q is ambiguous: � the fall in demand reduces Q, � the increase in supply increases Q.

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CONCLUSION: �How Prices Allocate Resources

• One of the Ten Principles from Chapter 1:� Markets are usually a good way � to organize economic activity.
• In market economies, prices adjust to balance supply and demand. These equilibrium prices are the signals that guide economic decisions and thereby allocate scarce resources.

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Summary

• A competitive market has many buyers and sellers, each of whom has little or no influence �on the market price.
• Economists use the supply and demand model to analyze competitive markets.
• The downward-sloping demand curve reflects the law of demand, which states that the quantity buyers demand of a good depends negatively on the good’s price.

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Summary

• Besides price, demand depends on buyers’ incomes, tastes, expectations, the prices of substitutes and complements, and number of buyers. �If one of these factors changes, the D curve shifts.
• The upward-sloping supply curve reflects the Law of Supply, which states that the quantity sellers supply depends positively on the good’s price.
• Other determinants of supply include input prices, technology, expectations, and the # of sellers. Changes in these factors shift the S curve.

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Summary

• The intersection of S and D curves determines the market equilibrium. At the equilibrium price, quantity supplied equals quantity demanded.
• If the market price is above equilibrium, �a surplus results, which causes the price to fall. �If the market price is below equilibrium, �a shortage results, causing the price to rise.

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Summary

• We can use the supply-demand diagram to analyze the effects of any event on a market:�First, determine whether the event shifts one or both curves. Second, determine the direction of the shifts. Third, compare the new equilibrium to the initial one.
• In market economies, prices are the signals that guide economic decisions and allocate scarce resources.

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