Demand and Supply: Foundations of Microeconomics

Introduction

This chapter introduces the analytical framework of demand and supply, which are central to understanding how prices and quantities are determined in markets. The chapter covers the distinction between money and relative prices, the law of demand and supply, and the effects of various factors on market outcomes.

• Law of Demand and Law of Supply

• Distinction between changes in demand vs. changes in quantity demanded

• Distinction between changes in supply vs. changes in quantity supplied

• Market equilibrium and the role of shortages and surpluses

Demand

Definition and Law of Demand

Demand refers to the quantities of a specific good or service that consumers are willing to purchase at various prices, holding other factors constant (ceteris paribus).

• Law of Demand: The quantity demanded is inversely related to price, ceteris paribus. As price increases, quantity demanded decreases, and vice versa.

• Ceteris Paribus: Latin for "all other things being equal." Used to isolate the effect of one variable.

Money Prices vs. Relative Prices

Prices can be expressed in two ways:

• Money Price: The price of a good in terms of currency (e.g., dollars).

• Relative Price: The price of a good in terms of another good. Calculated as the ratio of the money price of one good to another.

Relative price is important for understanding consumer choices, as it reflects opportunity cost.

Example Table: Money Price and Relative Price Comparison

Interpretation: Even if both products' money prices fall, their relative prices may change, affecting competitiveness and demand.

Demand Schedule and Demand Curve

• Demand Schedule: A table showing quantities demanded at different prices over a period.

• Demand Curve: A graphical representation of the demand schedule, with price on the vertical axis and quantity on the horizontal axis. The demand curve slopes downward from left to right.

Market Demand: The sum of all individual consumers' demand for a good at each price.

Example Table: Market Demand Schedule

Movements vs. Shifts in Demand

• Movement along the demand curve: Caused by a change in the good's own price.

• Shift of the demand curve: Caused by changes in non-price determinants (e.g., income, tastes, prices of related goods, expectations, number of buyers).

Determinants of Demand

• Income: Normal goods (demand increases with income), Inferior goods (demand decreases with income).

• Preferences/Tastes: Changes can shift demand outward or inward.

• Prices of Related Goods: Substitutes (increase in price of one increases demand for the other), Complements (increase in price of one decreases demand for the other).

• Expectations: Anticipated future prices or income can affect current demand.

• Number of Buyers: More buyers increase market demand.

Example: Substitutes and Complements

• Substitute: If the price of MacBook increases, demand for Surface Pro increases.

• Complement: If the price of gasoline increases, demand for trucks decreases.

Supply

Definition and Law of Supply

Supply refers to the quantities of a specific good or service that firms are willing to offer for sale at various prices, holding other factors constant.

• Law of Supply: The quantity supplied is directly related to price, ceteris paribus. As price increases, quantity supplied increases, and vice versa.

Supply Schedule and Supply Curve

• Supply Schedule: A table showing quantities supplied at different prices.

• Supply Curve: A graphical representation of the supply schedule, with price on the vertical axis and quantity on the horizontal axis. The supply curve slopes upward from left to right.

Example Table: Market Supply Schedule

Movements vs. Shifts in Supply

• Movement along the supply curve: Caused by a change in the good's own price.

• Shift of the supply curve: Caused by changes in non-price determinants (e.g., input costs, technology, taxes/subsidies, expectations, number of firms).

Determinants of Supply

• Input Costs: Higher input costs decrease supply (shift left); lower input costs increase supply (shift right).

• Technology: Improvements increase supply.

• Taxes and Subsidies: Taxes decrease supply; subsidies increase supply.

• Expectations: If producers expect higher future prices, they may decrease current supply.

• Number of Firms: More firms increase market supply.

Demand and Supply Together: Market Equilibrium

Equilibrium Price and Quantity

The market equilibrium is the price at which quantity demanded equals quantity supplied. At this point, there is no tendency for price to change unless demand or supply shifts.

• Shortage: Occurs when price is below equilibrium; quantity demanded exceeds quantity supplied. Prices tend to rise.

• Surplus: Occurs when price is above equilibrium; quantity supplied exceeds quantity demanded. Prices tend to fall.

Graphical Representation

• The intersection of the demand and supply curves determines the equilibrium price and quantity.

• Market forces push the price toward equilibrium.

Linear Demand and Supply Equations

Demand and supply can be represented by linear equations:

• General form:

• Demand example:

• Supply example:

To find equilibrium:

1. Set and solve for (equilibrium price).

2. Substitute back into either equation to find (equilibrium quantity).

Example Calculation

• Given and

• Set

• Substitute into either equation:

Equilibrium price is $3 units.

Summary Table: Movements vs. Shifts

Key Takeaways

• The law of demand and law of supply explain how price and quantity are determined in markets.

• Movements along curves are due to price changes; shifts are due to other factors.

• Market equilibrium occurs where demand equals supply.

• Shortages and surpluses cause prices to adjust toward equilibrium.