1.Define demand, supply, the law of demand, and the law of supply.

2.Identify the factors that can change demand.

3.Identify the factors that can change supply.

4.Explain how equilibrium price and quantity are determined in a market.

5.Work with supply and demand to predict prices.

6.Identify and discuss the effects of price ceilings and price floors.

n KEY TERMS

•demand• complements

•law of demand • own price

•demand schedule • supply

•demand curve • law of supply

•normal good • supply curve

•inferior good • supply schedule

•substitutes• subsidy

•surplus (excess supply)• disequilibrium

•shortage (excess demand) • equilibrium

•equilibrium price (market-clearing price) • price ceiling

•equilibrium quantity • tie-in sale

•disequilibrium price• price floor

n CHAPTER OUTLINE

I.DEMAND—Demand revolves around the concept of a purchaser’s willingness and ability to buy a particular good/service.

We distinguish between QUANTITY DEMANDED—the amount of a good that individuals are willing and able to buy at a particular price at a particular time—and

DEMAND, the quantity demanded at all prices during a specific time period.

A.THE LAW OF DEMAND—The law of demand holds that as the price of a good rises, the quantity demanded of the good falls, and as the price of a good falls, the quantity demanded of the good rises, ceteris paribus.

That is, the price of a good and the quantity demanded of that good are inversely related, ceteris paribus.

B.Absolute vs. Relative Prices—Prices of goods can be measured in two ways. THE ABSOLUTE PRICE is the money price ($3). 

The relative price is the price of one good measured in terms of another (e.g., the burrito price of a taco is 1/2 burrito/taco).

1.The relative price of good X in terms of Y is calculated by dividing the absolute price of good X by the absolute price of good Y.

C.Quantity Demanded and Price—Quantity demanded falls as price rises. 

1.1. One reason is relative price changes. When the price of one good rises, ceteris paribus, consumers will substitute lower-priced goods.

The second reason is because of diminishing marginal utility.

2.Diminishing Marginal Utility—As a person consumes more of a good, the additional utility of consuming more will eventually decrease. This means that to encourage additional consumption, price must fall.

D.Representing Demand

1.THE DEMAND SCHEDULE—a numerical tabulation of the quantity demanded of a good at different prices. (See Exhibit 1a.)

2.THE DEMAND CURVE—the graphical representation of the relationship between the quantity demanded of a good and the price of the good.(See Exhibit 1b.)

E.The Individual and Market Demand Curves—An individual demand curve represents the price-quantity demanded combinations for a single buyer, such as Smith or Jones. The market demand curve represents the price-quantity demanded combinations for all buyers of a particular good. It is the summation of all of the individual demand curves for a particular item. (See Exhibit 2.)

F.Determinants of Demand—There are certain determinants of demand. These are:

1.Income—As a person’s income rises, her ability to purchase a given good also rises; as income falls, ability to purchase falls.

However, demand requires both ability and willingness to buy.

The actual effect of a change in income on demand depends upon whether the good in question is considered “normal” or “inferior” by the consumer.

a.Normal Goods—A NORMAL GOOD is one that is consumed voluntarily, and for which demand will rise as income rises and fall as income falls.

In this most prevalent case, an increase in income will shift the demand curve to the right, and a decrease will shift the demand curve to the left. (See Exhibit 3.)

b.Inferior Goods—An INFERIOR GOOD is one for which demand will fall as income rises and rise as income falls.

2.Preferences—People’s preferences affect their willingness to buy a good at any given price. A change in preferences in favor of a good will increase demand (shift the demand curve to the right). A change away from the good will do the opposite.

3.Prices of Related Goods

a.SUBSTITUTES—Two goods are considered substitutes if they satisfy similar needs or desires, such as butter and margarine. If the price of a good rises, the demand for its substitute(s) will rise; if the price of a good falls, the demand for its substitute(s) will fall.

b.COMPLEMENTS—Two goods are complements if they are consumed jointly, such as hamburger meat and hamburger buns. If the price of a good rises, the demand for its complement(s) will fall; if the price of a good falls, the demand for its complement(s) will rise.

4.Number of Buyers—The demand for a good in a particular area is related to the number of buyers in that area. If the number of buyers increases, demand will increase (shifting the demand curve to the right). If the number of buyers decreases, demand will fall (shifting the demand curve to the left).

5.Price Expectations—Finally, expectations about future price movements will affect consumer demand. If prices are expected to rise, current demand will increase. If prices are expected to fall, current demand will decrease.

G.Change in Demand vs. Change in Quantity Demanded—A change in demand refers to a shift in the demand curve brought about by a change in any of the nonprice determinants of demand mentioned above.

A change in quantity demanded refers to a movement along a single demand curve in response to a change in the ownprice of the good. (See Exhibit 5b.)

II.SUPPLY—Supply revolves around the concept of a producer’s willingness and ability to provide a particular good/service. 

Quantity supplied is the amount of a good that producers are willing and able to sell at a particular price at a particular time, and supply is the quantity supplied at all prices during a specific time period.

A.THE LAW OF SUPPLY—The law of supply holds that as the price of a good rises, the quantity supplied of the good rises, and as the price of a good falls, the quantity supplied of the good falls, ceteris paribus.

That is, the price of a good and the quantity demanded of that good are directly related, ceteris paribus.

B.THE SUPPLY CURVE—The supply curve is the graphical representation of the relationship between the quantity supplied of good X and the price of good X. In many cases, the supply curve is upward sloping, indicating that quantity supplied will increase as price increases.

However, in some cases the supply curve is vertical, suggesting that supply is fixed regardless of price. The reason for such a situation may be that it takes time to produce additional output, such as the theater example in Exhibit 8a, or that no more of the good can be produced, as in Exhibit 8b.

C.The Individual and Market Supply Curves—

An individual supply curve represents the price-quantity supplied combinations for a single producer,

The market supply curve represents the price-quantity supplied combinations for all producers of a particular good. It is the summation of all of the individual supply curves for a particular item.

D.Determinants of Supply—Much as in the case of demand, a number of factors affect supply.

1.Prices of Relevant Resources—All goods and services require resources—inputs such as labor, capital, land, etc.—in their production.

If the price of an input rises, the supply curve of good X will shift to the left, indicating that less will be produced at any given price. If the price of an input falls, the supply curve of good X will shift to the right.

2.Technology—In Chapter 2 we said that an advance in technology refers to the ability to produce more output with a fixed amount of resources. Under such circumstances, the per-unit cost of production falls, shifting the supply curve to the right.

3.Number of Sellers—The supply of a good in a particular area is related to the number of sellers in that area. If the number of sellers increases, supply will increase (shifting the supply curve to the right). If the number of sellers decreases, supply will decrease (shifting the supply curve to the left).

4.Price Expectations—If the price of a good is expected to be higher in the future, producers may cut back on current production in order to sell more at the high price in the future (i.e., supply curve shifts left). If prices are expected to fall, current production will increase, shifting the supply curve to the right.

5.Taxes and Subsidies—Some taxes increase per-unit costs, leading to a leftward shift in the supply curve for the affected good(s). Some subsidies reduce per-unit costs, leading to a rightward shift in the supply curve for the affected good(s). Removing the tax or subsidy in question would, logically, have the opposite effect.

6.Government Restrictions—Quotas, licensing, and other efforts to restrict supply will shift the supply curve to the left (and possibly make them vertical over some or all of the relevant range). Removing/relaxing such restrictions will increase supply, leading to a rightward shift in the supply curve.

E. Change in Supply vs. Change in Quantity Supplied—Achange in supply refers to a shift in the supply curve brought about by a change in any of the nonprice determinants of supply mentioned above. (See Exhibit 11a.) A change in quantity supplied refers to a movement along a single supply curve in response to a change in the own price of the good. (See Exhibit 11b.)

III.PUTTING SUPPLY AND DEMAND TOGETHER

A.Supply and Demand: The Auction Model—The notion of supply and demand that has been handed down through the years functions much like an auction.

B.EQUILIBRIUM—That blissful price, where quantity supplied just equals quantity demanded, is called the equilibrium (or “MARKET-CLEARING”) price, and the general condition is called equilibrium (identified by point E in Exhibit 13).

C.DISEQUILIBRIUM—Any price at which quantity supplied and quantity demanded are not equal is a disequilibrium price, and the general condition is called disequilibrium.

1.Surplus/Excess Supply—If the quantity supplied at a given price is greater than the quantity demanded at that price, a surplus exists, and the market price must be lowered in order to eliminate any “excess” supply.

2.Shortage/Excess Demand—If the quantity demanded at a given price is greater than the quantity supplied at that price, a shortage exists, and the market price must rise in order to eliminate any “excess” demand.

3.Moving to Equilibrium—If a surplus exists, price must fall in order to entice additional quantity demanded and reduce quantity supplied until the surplus is eliminated.

If a shortage exists, price must rise in order to entice additional supply and reduce quantity demanded until the shortage is eliminated.

D.Consumers’ and Producers’ Surplus—Consumers’ and producers’ surpluses are discussed in terms of their relationships to equilibrium.

1. Consumers’ surplus—is the highest price a buyer is willing to pay minus the price actually paid. Graphically, consumers’ surplus is the triangular area under the demand curve, but above the equilibrium price.

2. Producers’ surplus—is the difference between the equilibrium price and the lowest price the seller would accept.

3.At equilibrium, the values of consumers’ and producers’ surpluses are maximized—That is, no other price of exchange would yield larger values for these two numbers.

E.Changes in Equilibrium Price and Quantity—Equilibrium price and quantity are determined by the interaction of supply and demand. A change in supply, or demand, or both, will necessarily change the equilibrium price, quantity, or both, unless the change in supply and demand perfectly offset one another so that equilibrium remains the same (highly unlikely). Exhibit 16 illustrates eight different cases of changing equilibrium price and/or quantity.

IV.PRICE CONTROLS—The market is not always allowed to operate freely, and thus the ability of price to properly execute the tasks we just discussed is restricted. There are two principal forms of price control: price ceilings and price floors.

A.PRICE CEILINGS—A price ceiling is a government-mandated maximum price above which legal trades cannot be made. If the price ceiling is set below the “natural” equilibrium price for the market in question, any or all of the following may arise:

1.Shortages—At any price below equilibrium, the quantity demanded will exceed the quantity supplied, thus a shortage occurs.

Furthermore, the natural tendency of the market to correct for the shortage by raising price is thwarted by the ceiling; thus any shortage will likely be sustained.

2.Fewer Exchanges—At any price other than the equilibrium price, the quantity sold will always be the lesser of quantity supplied and quantity demanded, since you cannot sell what won’t be bought, nor can you buy what is not for sale. As long as the supply curve is not vertical, the quantity of goods sold will be less with a ceiling than would have been true at the equilibrium price.

3.Nonprice Rationing Devices—Since a price ceiling creates a shortage, and price is no longer capable of fully rationing the distribution of the good, nonprice rationing devices, such as “first-come, first-served” or ration stamps, will likely develop.

4.Buying and Selling at a Prohibited Price—Price ceilings often give rise to black markets. Consumers who are willing to pay a price above the ceiling, to be assured of getting the good, can arrange illicit transactions.

5.Tie-in Sales—Price ceilings often prompt the use of tie-in sales, where one good may be purchased only if another good is purchased with it. For example, to evade rent control, many landlords require potential tenants to rent furniture (uncontrolled price) along with their (price-controlled) apartment.

B.Price Ceilings and the Distortion of Incentives and Information—Price ceilings distort normal economic incentives, often prompting consumers to prefer higher prices to lower prices, if the lower price carries with it all of the potential disruption of a price ceiling.

Furthermore, price ceilings distort information by making the availability of the price-controlled good seem greater than it actually is, since low price is supposed to be an indicator of relatively greater availability.

C.Price Floors—A price floor is a government-mandated minimum price below which legal trades cannot be made. If a price floor is set above the equilibrium price, the following two effects arise:

1.Surpluses—At any price above equilibrium, the quantity supplied will exceed the quantity demanded, thus a surplus occurs. Furthermore, the natural tendency of the market to correct for the surplus by lowering price is thwarted by the floor; thus, any surplus will likely be sustained.

2.Fewer Exchanges—At any price other than the equilibrium price, the quantity sold will always be the lesser of quantity supplied and quantity demanded, since you cannot sell what won’t be bought, nor can you buy what is not for sale. As long as the demand curve is not vertical, the quantity of goods sold will be less with a floor than would have been true at the equilibrium price.