Demand, Supply, and Price

Introduction

This topic explores the fundamental question of how markets work by developing a simple model of demand and supply. By analyzing these forces, we can understand how market prices and quantities are determined and how changes in external (exogenous) variables affect market outcomes.

• Key Point: Demand and supply are the primary forces driving market outcomes.

• Key Point: Economic models help isolate the effect of individual variables using the ceteris paribus assumption.

Ceteris Paribus

To analyze the effect of a change in one variable, economists use the ceteris paribus assumption, meaning "all other things being equal." This allows us to focus on the impact of a single factor while holding others constant.

• Definition: Ceteris paribus is Latin for "holding all other variables constant."

• Application: Used in economic theory to understand the importance of each variable in isolation.

Demand

Determinants of Demand

Demand for a product is influenced by several factors. A robust theory of consumer demand is essential for analyzing market structure, taxation, and cartel behavior.

• Key Point: Demand is not just about the quantity purchased, but the entire relationship between price and quantity desired.

Quantity Demanded

Quantity Demanded is the amount of a good or service that consumers wish to purchase during a specific time period. It is a desired quantity, not necessarily the amount actually bought if supply is limited.

• Definition: The amount consumers want to buy at a given price over a period of time.

• Example: 1 million units per day.

Determinants of Quantity Demanded

The total amount demanded in a market depends on several key variables:

• Product's own price

• Consumer's income

• Prices of other products

• Consumers' preferences ("tastes")

• Population

• Significant changes in weather

Law of Demand

The Law of Demand states that, ceteris paribus, the price of a product and the quantity demanded are negatively related. As price decreases, quantity demanded increases, and vice versa.

• Key Point: Consumers substitute away from more expensive products and toward cheaper alternatives.

• Example: If the price of apples rises, consumers may buy fewer apples and more pears.

Demand Schedule and Demand Curve

There are two main ways to represent the law of demand:

• Demand Schedule: A table showing the relationship between price and quantity demanded.

• Demand Curve: A graphical representation of the relationship between price and quantity demanded.

Demand: Refers to the entire relationship between quantity desired and all possible prices, not just a single point.

Shifts in the Demand Curve

The demand curve is drawn assuming all factors except price are constant. If other determinants change (e.g., income, preferences), the entire demand curve shifts.

• Rightward Shift: Increase in demand at every price (e.g., higher income).

• Leftward Shift: Decrease in demand at every price (e.g., lower population).

Common Factors Causing Shifts

• Consumers’ income

• Prices of other goods (complements and substitutes)

• Consumers’ preferences

• Population

• Significant changes in weather

Normal vs. Inferior Goods

• Normal Goods: Quantity demanded increases as income rises.

• Inferior Goods: Quantity demanded decreases as income rises.

• Example: As income increases, demand for public transit (inferior) may fall, while demand for taxis (normal) rises.

Complements and Substitutes

• Complements: Goods consumed together (e.g., hamburgers and buns). If the price of one rises, demand for both falls.

• Substitutes: Goods that can replace each other (e.g., hamburgers and hot dogs). If the price of one rises, demand for the other increases.

Supply

Determinants of Supply

Supply refers to the amount of a good or service producers are willing to offer for sale at a given price over a specific time period.

• Quantity Supplied: The amount producers are willing to sell at a given price.

Law of Supply

The Law of Supply states that, ceteris paribus, the price of a product and the quantity supplied are positively related. As price increases, quantity supplied increases.

• Key Point: Higher prices make production more profitable, encouraging increased supply.

Supply Schedule and Supply Curve

• Supply Schedule: A table showing the relationship between price and quantity supplied.

• Supply Curve: A graphical representation of the relationship between price and quantity supplied.

Shifts in the Supply Curve

The supply curve is drawn assuming all factors except price are constant. Changes in other determinants shift the entire supply curve.

• Rightward Shift: Increase in supply at every price (e.g., technological improvement).

• Leftward Shift: Decrease in supply at every price (e.g., higher input costs).

Common Factors Causing Shifts

• Price of inputs

• Technology

• Government taxes or subsidies

• Prices of other products

• Significant changes in weather

• Number of suppliers

Market Equilibrium

Determination of Price

Market equilibrium occurs where the quantity demanded equals the quantity supplied. This is known as the market-clearing price.

• Excess Demand: Quantity demanded exceeds quantity supplied at a given price.

• Excess Supply: Quantity supplied exceeds quantity demanded at a given price.

Changes in Market Equilibrium

Shifts in demand or supply curves lead to changes in equilibrium price and quantity. There are four main scenarios:

• Increase in demand: Higher equilibrium price and quantity.

• Decrease in demand: Lower equilibrium price and quantity.

• Increase in supply: Lower equilibrium price, higher quantity.

• Decrease in supply: Higher equilibrium price, lower quantity.

Endogenous vs. Exogenous Variables

• Endogenous Variable: Explained within the theory (e.g., price, quantity).

• Exogenous Variable: Determined outside the theory (e.g., income, technology).

• Comparative Statics: Analyzing the effect of a change in a single exogenous variable on equilibrium.

Numerical Example

Consider a market with the following demand and supply equations:

• Demand:

• Supply:

To find equilibrium:

• Set

• Substitute into either equation to find :

Summary

• Quantity demanded and quantity supplied are determined by price and other factors.

• Shifts in demand or supply curves result from changes in determinants other than price.

• Market equilibrium is where quantity demanded equals quantity supplied.

• Comparative statics allows prediction of market changes following shifts in exogenous variables.