Chapter 03 - Demand, Supply, and Market Equilibrium

CHAPTER THREE
DEMAND, SUPPLY, AND MARKET EQUILIBRIUM

NOTES
I. Learning objectives – After reading this chapter, students should be able to:
A. Characterize and give examples of markets.
B. Describe demand and explain how it can change.
C. Describe supply and explain how it can change.
D. Relate how supply and demand interact to determine market equilibrium.
E. Explain how changes in supply and demand affect equilibrium prices and quantities.
F. Identify what government-set prices are and how they can cause product surpluses and shortages.
G. (Appendix) Illustrate how supply and demand analysis can provide insights on actual-economy
situations.
II. Markets
A. A market, as introduced in Chapter 2, is an institution or mechanism that brings together buyers
(demanders) and sellers (suppliers) of particular goods and services.
B. This chapter focuses on competitive markets with:
1. a large number of independent buyers and sellers.
2. standardized goods.
3. prices that are “discovered” through the interaction of buyers and sellers. No individual can
dictate the market price.
C. The goal of the chapter is to explain the way in which markets adjust to changes and the role of
prices in bringing the markets toward equilibrium.
III. Demand
A. Demand is a schedule that shows the various amounts of a product that consumers are willing and
able to buy at each specific price in a series of possible prices during a specified time period.
1. Example of demand schedule for corn is Figure 3.1.
2. The schedule shows how much buyers are willing and able to purchase at five possible prices.
3. The market price depends on demand and supply.
4. To be meaningful, the demand schedule must have a period of time associated with it.
B. Law of demand is a fundamental characteristic of demand behavior.
1. Other things being equal, as price increases, the corresponding quantity demanded falls.
2. Restated, there is an inverse relationship between price and quantity demanded.
3. Note the “other-things-equal” assumption refers to consumer income and tastes, prices of
related goods, and other things besides the price of the product being discussed.
4. Explanation of the law of demand:
a. Diminishing marginal utility: The decrease in added satisfaction that results as one
consumes additional units of a good or service, i.e., the second “Big Mac” yields less
extra satisfaction (or utility) than the first.

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Chapter 03 - Demand, Supply, and Market Equilibrium

b. Income effect: A lower price increases the purchasing power of money income enabling
the consumer to buy more at lower price (or less at a higher price) without having to
reduce consumption of other goods.
c. Substitution effect: A lower price gives an incentive to substitute the lower-priced good
for now relatively higher-priced goods.
C. The demand curve:
1. Illustrates the inverse relationship between price and quantity (see corn example, Figure 3.1).
2. The downward slope indicates lower quantity (horizontal axis) at higher price (vertical axis),
higher quantity at lower price, reflecting the Law of Demand.
D. Individual vs. market demand:
1. Transition from an individual to a market demand schedule is accomplished by summing
individual quantities at various price levels.
2. Market curve is horizontal sum of individual curves (see corn example, Figure 3.2).
E. Class example: This is a good place to involve the class if your classroom setting allows. Select
an item that students typically buy, such as a can of soft drink or donuts. It works especially well
if one student already has the item, and you can use that student for your individual demand
schedule. Select five to ten representative prices for the item and create a demand schedule based
on this student’s responses. It is usually interesting to include the zero price to see how many the
student would want if the item were free. You can then construct an individual demand schedule
on board or overhead transparency. Don’t worry if it isn’t a straight line, it will undoubtedly still
represent the law of demand. If your class isn’t too large, you could then construct a class market
schedule using a show of fingers to indicate amounts students would purchase at each price level.
F. There are several determinants of demand or the “other things,” besides price, which affect
demand. Changes in determinants cause changes in demand.
1. Table 3.1 provides additional examples.
a. Tastes—favorable change leads to increase in demand; unfavorable change leads to
decrease.
b. Number of buyers—more buyers lead to an increase in demand; fewer buyers lead to a
decrease.
c. Income—more leads to an increase in demand; less leads to a decrease in demand for
normal goods. (The rare case of goods whose demand varies inversely with income is
called inferior goods).
d. Prices of related goods also affect demand.
I. Substitute goods (those that can be used in place of each other): The price of the
substitute good and demand for the other good are directly related. If the price of
Coke rises (because of a supply decrease), demand for Pepsi should increase.
II. Complementary goods (those that are used together like tennis balls and rackets):
When goods are complements, there is an inverse relationship between the price
of one and the demand for the other.
e. Consumer expectations—consumer views about future prices and income can shift
demand.
2. A summary of what can cause an increase in demand:
a. Favorable change in consumer tastes.
b. Increase in the number of buyers.
c. Rising income if product is a normal good.
d. Falling incomes if product is an inferior good.
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Chapter 03 - Demand, Supply, and Market Equilibrium

e. Increase in the price of a substitute good.

f. Decrease in the price of a complementary good.
g. Consumers expect higher prices or incomes in the future.
3. A summary of what can cause a decrease in demand:
a. Unfavorable change in consumer tastes.
b. Decrease in number of buyers.
c. Falling income if product is a normal good.
d. Rising income if product is an inferior good.
e. Decrease in price of a substitute good.
f. Increase in price of a complementary good.
g. Consumers’ expectations of lower prices or incomes in the future.
G. Review the distinction between a change in quantity demanded caused by a price change and a
change in demand caused by a change in determinants.
IV. Supply
A. Supply is a schedule that shows amounts of a product a producer is willing and able to produce
and sell at each specific price in a series of possible prices during a specified time period.
1. A supply schedule portrays this such as the corn example in Figure 3.4.
2. Schedule shows what quantities will be offered at various prices or what price will be
required to induce various quantities to be offered.
B. Law of supply:
1. Producers will produce and sell more of their product at a high price than at a low price.
2. Restated: There is a direct relationship between price and quantity supplied.
3. Explanation: Given product costs, a higher price means greater profits and thus an incentive
to increase the quantity supplied.
4. Beyond some production quantity producers usually encounter increasing costs per added
unit of output.
5. Note: A detailed explanation of diminishing returns is probably not necessary at this point
and can be delayed until a later consideration of the costs of production.
C. The supply curve:
1. The graph of supply schedule appears in Figure 3.5, which graphs data from table on the
right.
2. It shows a direct relationship in an upward sloping curve.
D. Determinants of supply:
1. A change in any of the supply determinants causes a change in supply and a shift in the
supply curve. An increase in supply involves a rightward shift, and a decrease in supply
involves a leftward shift.
2. Six basic determinants of supply, other than price. (See examples of curve shifts in Figure
3.5, and the summary Table 3.2)
a. Resource prices—a rise in resource prices will cause a decrease in supply or leftward
shift in supply curve; a decrease in resource prices will cause an increase in supply or
rightward shift in the supply curve.
b. Technology—a technological improvement means more efficient production and lower
costs, so an increase in supply, or rightward shift in the curve results.

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Chapter 03 - Demand, Supply, and Market Equilibrium

c. Taxes and subsidies—a business tax is treated as a cost, so decreases supply; a subsidy
lowers cost of production, so increases supply.
d. Prices of related goods—if price of substitute production good rises, producers might
shift production toward the higher priced good, causing a decrease in supply of the
original good.
e. Producer expectations—expectations about the future price of a product can cause
producers to increase or decrease current supply.
f. Number of sellers—generally, the larger the number of sellers the greater the supply.
E. Review the distinction between a change in quantity supplied due to price changes and a change
or shift in supply due to change in determinants of supply.
V. Market Equilibrium
A. Review the text example, key graph figure 3.6, which combines data from supply and demand
schedules for corn.
B. Have students find the point where quantity supplied equals the quantity demanded, and note this
equilibrium price and quantity. Emphasize the correct terminology!
1. At prices above this equilibrium, note that there is an excess quantity or surplus.
2. At prices below this equilibrium, note that there is an excess quantity demanded or shortage.
C. Market clearing or market price is another name for equilibrium price.
D. Graphically, note that the equilibrium price and quantity are where the supply and demand curves
intersect (See Figure 3.6). This is an IMPORTANT point for students to recognize and remember.
Note that it is NOT correct to say supply equals demand!
E. Rationing function of prices is the ability of competitive forces of supply and demand to establish
a price where buying and selling decisions are coordinated.
F. Consider This … Uber and Dynamic Pricing
1. The ride sharing service known as Uber rose to prominence by offering consumers an
alternative to government-regulated taxi companies by matching people who need a ride with
people who are willing to use their own vehicles to provide rides, via the internet.
2. Uber makes money by taking a percentage of the fare.
3. Uber is innovative in a number of ways: Empowering anyone to become a paid driver;
breaking up local taxi monopolies; and making it effortless to arrange a quick pick-up.
4. Uber's most interesting feature is dynamic pricing, which means they are constantly adjusting
prices in real-time to equalize quantity supplied and quantity demanded.
5. Dynamic pricing results in shorter wait times for both drivers and riders. For example, if
demand suddenly increases in a particular area, then the price is set higher (a surge price)
encouraging more drivers to converge on the area.
6. The short wait times created by Uber's use of dynamic pricing stand in sharp contrast to taxi
fares, which are fixed by law and unable to adjust to changes in demand and supply.
G. Efficient allocation—productive and allocative efficiency
1. Competitive markets generate productive efficiency—the production of any particular good in
the least costly way. Sellers that don’t achieve the least-cost combination of inputs will be
unprofitable and have difficulty competing in the market.
2. The competitive process also generates allocative efficiency—producing the combination of
goods and services most valued by society.

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Chapter 03 - Demand, Supply, and Market Equilibrium

3. Allocative efficiency requires that there be productive efficiency. Productive efficiency can
occur without allocative efficiency. Goods can be produced in the least costly method without
being the most wanted by society.
4. Allocative and productive efficiency occur at the equilibrium price and quantity in a
competitive market. Resources are neither over- nor underallocated based on society’s wants.
VI. Changes in Supply and Demand, and Equilibrium
A. Changing demand with supply held constant:
1. Increase in demand will have effect of increasing equilibrium price and quantity
(Figure 3.7a).
2. Decrease in demand will have effect of decreasing equilibrium price and quantity
(Figure 3.7b).
B. Changing supply with demand held constant:
1. Increase in supply will have effect of decreasing equilibrium price and increasing quantity
(Fig 3.7c).
2. Decrease in supply will have effect of increasing equilibrium price and decreasing quantity
(Fig 3.7d).
C. Complex cases—when both supply and demand shift (see Table 3.3):
1. If supply increases and demand decreases, price declines, but new equilibrium quantity
depends on relative sizes of shifts in demand and supply.
2. If supply decreases and demand increases, price rises, but new equilibrium quantity depends
again on relative sizes of shifts in demand and supply.
3. If supply and demand change in the same direction (both increase or both decrease), the
change in equilibrium quantity will be in the direction of the shift but the change in
equilibrium price now depends on the relative shifts in demand and supply.
D. Consider This … Salsa and Coffee Beans
1. Demand is an inverse relationship between price and quantity demanded, other things equal
(unchanged). Supply is a direct relationship showing the relationship between price and
quantity supplied, other things equal (unchanged). It can appear that these rules have been
violated over time, when tracking the price and the quantity sold of a product such as salsa or
coffee.
2. Many factors other than price determine the outcome.
3. If neither the buyers nor the sellers have changed, the equilibrium price will remain the same.
4. The most important distinction to make is to determine if a change has occurred because of
something that has affected the buyers or something that is influencing the sellers.
5. A change in any of the determinants of demand will shift the demand curve and cause a
change in quantity supplied. (See Figure 3.7 a & b)
6. A change in any of the determinants of supply will shift the supply curve and cause a change
in the quantity demanded. (See Figure 3.7 c & d)
7. Confusion results if “other things” (determinants) change and one does not take this into
account. For example, sometimes more is demanded at higher prices because incomes rise,
but if that fact is ignored, the law of demand seems to be violated. If income changes,
however, there is a shift or increase in demand that could cause more to be purchased at a
higher price. In this example, “other things” did not remain constant.

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Chapter 03 - Demand, Supply, and Market Equilibrium

VII. Application: Government-Set Prices (Ceilings and Floors)

A. Government-set prices prevent the market from reaching the equilibrium price and quantity.
B. Price ceilings (gasoline).
1. The maximum legal price a seller may charge, typically placed below equilibrium.
2. Shortages result as quantity demanded exceeds quantity supplied (Figure 3.8).
3. Alternative methods of rationing must emerge to take the places of the price mechanism.
These may be formal (rationing coupons) or informal (lines at the pump).
4. Black markets may emerge to satisfy the unmet consumer demand.
5. Another example: Rent controls in large cities—intended to keep housing affordable but
resulting in housing shortages.
C. Price floors (wheat)
1. The minimum legal price a seller may charge, typically placed above equilibrium.
2. Surpluses result as quantity supplied exceeds quantity demanded (Figure 3.9).
3. Resources are overallocated to the production of wheat and consumers pay higher than
efficient prices for wheat-based goods.
4. Another example: Minimum wage
5. Note: The federal minimum wage, for example, will be below equilibrium in some labor
markets (large cities). In that case the price floor has no effect.
VIII. LAST WORD: Student Loans and Tuition Costs
A. Since 1958 the federal government has attempted to make college more affordable by offering
student loans. These loans are subsidized and guaranteed by the government
B. Has access to student loans been helpful?
1. At first glance the answer is yes. School tuition has increased significantly from the 1971-
1972 school year to the 2014-2015 school year. Access to loans appears to have helped
students cover the additional costs.
2. The problem is that the hypothesis that student loans helped students keep up with the rising
costs of higher education might have the cause backwards. Let's think of things in the other
direction. By increasing access and the amount of student loans the demand for higher
education increases which puts upward pressure on the price of college for a given supply
schedule.
3. In fact, evidence suggests this is the case. For every increase the $1 of student loans tuition
costs increase by $0.70 (70 cents). That is, the rising cost of higher education is the result of
increasing the amount of student loans.
4. This suggests that student loans are the wrong approach for the government to be taking in its
attempt to increase higher education.
5. An Alternative Approach
6. The government could subsidize supply rather than demand. By subsidizing universities the
supply schedule would shift to the right for a given demand schedule, causing tuition to
actually fall for students.
7. This was the approach taken after WWII, when heavily subsidized state university systems
expanded rapidly.

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