Chapter 3: Where Prices Come From – The Interaction of Demand and Supply

Introduction

This chapter explores how prices are determined in markets through the interaction of demand and supply. It introduces the model of a perfectly competitive market and explains the mechanisms that lead to market equilibrium, as well as the effects of shifts in demand and supply.

Our Model of a Market

Perfectly Competitive Market

To analyze markets such as those for Nike athletic shoes or reusable water bottles, economists use the model of a perfectly competitive market. This model is characterized by:

• Many buyers and sellers

• Identical products sold by all firms

• No barriers to entry for new firms

Although these assumptions are restrictive, the model is useful for analyzing many real-world markets.

The Demand Side of the Market

Demand Schedule and Demand Curve

The demand schedule is a table that shows the relationship between the price of a product and the quantity demanded. The demand curve is a graphical representation of this relationship.

The law of demand states that, holding everything else constant, when the price of a product falls, the quantity demanded increases, and when the price rises, the quantity demanded decreases.

Ceteris Paribus

When drawing the demand curve, economists assume ceteris paribus ("all else equal"), meaning that all other variables are held constant when analyzing the relationship between price and quantity demanded.

What Explains the Law of Demand?

• Substitution Effect: When the price of a good falls, consumers substitute toward the cheaper good, making it more attractive relative to other goods.

• Income Effect: A lower price increases consumers' purchasing power, allowing them to buy more.

Both effects contribute to the law of demand.

Shifting the Demand Curve

A change in a variable other than price that affects demand causes the entire demand curve to shift:

• Shift to the right: Increase in demand

• Shift to the left: Decrease in demand

When the demand curve shifts, the quantity demanded changes at every possible price, even if the price itself does not change.

Variables That Shift Market Demand

• Income: Increases demand for normal goods, decreases demand for inferior goods

• Prices of related goods:

  • Substitutes: Higher price of a substitute increases demand

  • Complements: Higher price of a complement decreases demand

• Tastes

• Population and demographics

• Expected future prices

• Natural disasters and pandemics

The Supply Side of the Market

Supply Schedule and Supply Curve

The supply schedule is a table showing the relationship between the price of a product and the quantity supplied. The supply curve graphically represents this relationship.

The law of supply states that, holding everything else constant, increases in price cause increases in quantity supplied, and decreases in price cause decreases in quantity supplied.

Shifting the Supply Curve

A change in a variable other than price that affects supply causes the entire supply curve to shift:

• Shift to the right: Increase in supply

• Shift to the left: Decrease in supply

When the supply curve shifts, the quantity supplied changes at every possible price, even if the price itself does not change.

Variables That Shift Market Supply

• Prices of inputs

• Technological change

• Prices of related goods in production (substitutes and complements)

• Number of firms in the market

• Expected future prices

• Natural disasters and pandemics

Market Equilibrium: Putting Demand and Supply Together

Market Equilibrium

Market equilibrium occurs when quantity demanded equals quantity supplied. In a perfectly competitive market, this is called a competitive market equilibrium.

• Equilibrium price (): The price at which the market clears

• Equilibrium quantity (): The quantity bought and sold at the equilibrium price

Example: If the equilibrium price of reusable water bottles is $20, and the equilibrium quantity is 5 million bottles per week, buyers and sellers both want to transact at this price and quantity.

Surpluses and Shortages

• Surplus: Quantity supplied exceeds quantity demanded at a given price. This leads to downward pressure on price.

• Shortage: Quantity demanded exceeds quantity supplied at a given price. This leads to upward pressure on price.

The Effect of Demand and Supply Shifts on Equilibrium

Predicting Changes in Price and Quantity

Changes in demand or supply shift the respective curves, affecting equilibrium price and quantity. The direction of change depends on which curve shifts and by how much.

Shifts vs. Movements Along Curves

• A shift in demand or supply refers to a change in the entire curve due to a non-price factor.

• A movement along the curve refers to a change in quantity demanded or supplied due to a change in price.

Example Applications

• Increase in income: If reusable water bottles are a normal good, an increase in income shifts the demand curve right, raising both equilibrium price and quantity.

• Entry of a new firm: If a new producer enters the market, supply increases, shifting the supply curve right, lowering equilibrium price and raising equilibrium quantity.

Key Equations

• Demand function:

• Supply function:

• Equilibrium condition:

Additional info:

• Real-world markets may not be perfectly competitive, but the model provides a useful framework for analysis.

• Demographic changes and technological advances can have significant effects on both demand and supply over time.