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Chapter 3: Supply and Demand

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Key Learning Objectives​

  • Understand what a competitive market is.
  • Learn about supply and demand curves.
  • Analyze how these curves determine equilibrium price and quantity.
  • Examine how price movements correct shortages and surpluses.

Competitive Markets​

  • A market with many buyers and sellers where no single participant can influence price.
  • The Supply and Demand Model explains how a competitive market functions.

Five Key Elements of the Model​

  1. Demand Curve
  2. Supply Curve
  3. Factors shifting demand & supply curves
  4. Market equilibrium
  5. Changes in market equilibrium

Demand​

  • Represents buyer behavior.
  • Demand Schedule: Table showing quantity demanded at different prices.
  • Demand Curve: Graphical representation of demand.
  • Law of Demand: Higher price → Lower demand (ceteris paribus).

Shifts in Demand Curve​

  • Increase in demand → Rightward shift.
  • Decrease in demand → Leftward shift.

Movement Along vs. Shift in Demand​

  • Movement occurs when only price changes.
  • Shift occurs due to external factors.

Factors That Shift Demand​

  1. Prices of Related Goods
    • Substitutes: If the price of one increases, demand for the other increases (e.g., coffee & tea).
    • Complements: If the price of one decreases, demand for the other increases (e.g., cars & gasoline).
  2. Income Changes
    • Normal goods: Demand increases with income rise.
    • Inferior goods: Demand decreases with income rise.
  3. Tastes & Preferences: Seasonal trends, fads, and societal changes affect demand.
  4. Expectations: Anticipated future price changes influence current demand.
  5. Number of Consumers: Larger population → Higher demand.

Supply​

  • Represents seller behavior.
  • Supply Schedule: Table showing quantity supplied at different prices.
  • Supply Curve: Graphical representation of supply.
  • Law of Supply: Higher price → Higher quantity supplied.

Shifts in Supply Curve​

  • Increase in supply → Rightward shift.
  • Decrease in supply → Leftward shift.

Movement Along vs. Shift in Supply​

  • Movement occurs when price changes.
  • Shift occurs due to external factors.

Factors That Shift Supply​

  1. Input Prices: Higher input costs → Decreased supply.
  2. Prices of Related Goods
    • Substitutes in production: Higher profitability of one good reduces supply of another.
    • Complements in production: Higher production of one good increases supply of another.
  3. Technology: Improvements increase supply.
  4. Expectations: Expected future price increases → Current supply decreases.
  5. Number of Producers: More producers → Increased supply.

Market Equilibrium​

  • Equilibrium Price (Market-Clearing Price): Where quantity supplied = quantity demanded.
  • Equilibrium Quantity: The quantity exchanged at equilibrium price.

Price Adjustments in the Market​

Surplus (Excess Supply)​

  • Occurs when price is above equilibrium.
  • Leads to price decrease as sellers try to sell excess stock.

Shortage (Excess Demand)​

  • Occurs when price is below equilibrium.
  • Leads to price increase as consumers compete for limited goods.

Shifts in Market Equilibrium​

  • Demand Increase → Higher price & quantity.
  • Demand Decrease → Lower price & quantity.
  • Supply Increase → Lower price, higher quantity.
  • Supply Decrease → Higher price, lower quantity.

Simultaneous Shifts in Supply and Demand​

  • Both Increase → Quantity increases, price change depends on relative shifts.
  • Both Decrease → Quantity decreases, price change depends on relative shifts.
  • Demand Increases, Supply Decreases → Price rises, quantity change depends.
  • Demand Decreases, Supply Increases → Price falls, quantity change depends.

Practice Questions​

  1. If petroleum prices rise, what happens to solar power demand?
    Answer: Demand for solar power increases, demand for cars decreases.

  2. If gasoline prices drop by 50%, what happens to car demand?
    Answer: Car demand increases.

  3. If garden gnomes become trendy again, what happens?
    Answer: Equilibrium price & quantity increase.

  4. If the cost of wood falls, what happens to violin prices?
    Answer: Price decreases, quantity increases.