Unlock document.
This document is partially blurred.
Unlock all pages and 1 million more documents.
Get Access
Chapter 03 - Demand, Supply, and Market Equilibrium
CHAPTER THREE
DEMAND, SUPPLY, AND MARKET EQUILIBRIUM
CHAPTER OVERVIEW
This chapter provides an introduction to demand and supply concepts. Both demand and supply are
defined and illustrated; determinants of demand and supply are listed and explained. The concept of
equilibrium and the effects of changes in demand and supply on equilibrium price and quantity are
explained and illustrated. The chapter also includes brief discussions of efficiency (productive and
allocative), and price controls (floors and ceilings).
WHAT’S NEW?
This chapter is almost identical to the version in 19e.
There is a new learning objective for the chapter, “Characterize and give examples of markets”.
There is a new section in the appendix that introduces students to vertical supply curves and which makes
the point that in any market in which the supply curve is vertical, any shifts in demand will lead to only
changes in the equilibrium price.
There is a new appendix question related to this new section in the appendix.
INSTRUCTIONAL OBJECTIVES
After completing this chapter, students should be able to:
1. Explain who and what demand and supply represent.
2. Differentiate between demand and quantity demanded; and supply and quantity supplied.
3. Graph demand and supply curves when given demand and supply schedules.
4. State the Law of Demand and the Law of Supply, and explain why price and quantity demanded
are inversely related, and why price and quantity supplied are directly related.
5. List the major determinants of demand, and explain how a change in each will affect the demand
curve.
6. List the major determinants of supply, and explain how a change in each will affect the supply
curve.
7. Explain the concept of equilibrium price and quantity.
8. Illustrate graphically equilibrium price and quantity.
9. Explain the rationing function of prices.
10. Define productive and allocative efficiency, and explain how competitive markets
achieve them.
11. Explain and graph the effects of changes in demand and supply on equilibrium price and quantity,
including simultaneous changes in demand and supply.
12. Define price ceilings and price floors, and provide examples.
13. Graph and explain the consequences of government-set prices.
3-1
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 03 - Demand, Supply, and Market Equilibrium
14. Define and identify terms and concepts listed at the end of the chapter.
COMMENTS AND TEACHING SUGGESTIONS
1. Emphasis in this chapter should be placed on: (a) The fact that demand and supply are schedules;
(b) the intuitive understanding of the downward slope of demand and upward slope of supply
curves; (c) the determinants of demand and supply; and (d) the distinction between a shift or
change in demand (supply) and a change in quantity demanded (supplied).
2. Walk through the definition of supply and demand. Emphasize the distinction between a reaction to
price and the influence of other variables. Point out that finding the equilibrium price and quantity
is not the end of the process: It is only the beginning. The market model is powerful because it can
be used to forecast what the likely outcome will be if one of the determinants of demand or the
determinants of supply is changed. Provide examples that use actual numbers on the axis of the
graphs. Most students who have not used graphs extensively will get lost without specific
examples. Approach the process systematically, and offer an example of each type of shift. Spend
extra time on examples of substitute and complementary goods.
3. The concepts introduced in Chapter 3 are extremely important for an understanding of a market
system. In later chapters more sophisticated explanations are introduced. Most instructors will want
to wait until that point to discuss marginal utility, elasticity, and other related ideas. The discussion
of government price controls will help students understand how powerful market forces are. For
example, attempts to control the price of gasoline below its equilibrium level in the 1970’s led to
shortages and long lines at the gas pumps. On the other hand, attempts to support the price of farm
products above equilibrium prices has led to large surpluses in the markets for many agricultural
products in the U.S. and Europe. Usually attempts to control prices are a response to the view that
market prices are not always “fair.” Therefore, government regulation of prices is based on equity
issues. Students may discuss the dilemma: markets may not be always “fair,” but attempts to
interfere with its operation may lead to other problems.
4. Emphasize that the students are already very experienced demanders, and what the instructor is
doing is analyzing their behavior and using the vocabulary of economics when describing this
behavior. Whereas the demand discussion can use real-world examples that are familiar to the
students, the supply discussion is more theoretical. With caution, however, one can use the
example of the labor supply decision to help reify the concept of supply for students. In goods
markets, students can use on-line auctions such as e-bay to sell, for example, old baseball cards. If
a student has a collection and card prices rise, she may be persuaded to offer her own cards for sale.
5. Emphasize that the separate demand and supply discussions are lacking in reality because only one
side of the market is being examined, i.e., demand or supply. Particularly with the changes in the
determinants of supply (the imposition of a tax), students are going to conclude that the market
price will change (increase). Explain that their intuitive conclusion will be correct once demand
and supply are discussed together. Use Alfred Marshall’s scissors analogy to emphasize their
interdependence. Introduce each determinant systematically, offering an example of each type.
Discuss the difference between determinants “change in price of a related good” when it is a
demand determinant as opposed to a supply determinant. There are some products (cars and
pickup trucks) that can be both demand and supply-related products.
3-2
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 03 - Demand, Supply, and Market Equilibrium
6. When graphically showing a “change in demand” and simultaneously a “change in supply,” show
these changes separately on two graphs and ask the students to compare the changes in price and
quantity exchanges.
7. It is useful to point out that in the real world it may be hard to pinpoint the equilibrium price and
quantity exactly, but it is easy to establish when the price is too high because surpluses will
develop, or too low because shortages will result.
8. The “Consider This” box on ticket scalping illustrates the fact that equilibrium price may not be
what many would consider a “fair” price. This is a good opportunity for a discussion of the
fairness of market prices.
9. The Last Word on the market for organs may provide for a lively debate, and is also an opportunity
to tread into the potentially contentious “value of a human life” discussion.
STUDENT STUMBLING BLOCKS
1. Vocabulary in this chapter is extremely important. The word “market” sounds familiar to students
and they have already assigned another “everyday” meaning to the word. The competitive process
described in this chapter does not fit the common experience of most students as they shop at the
mall or at the grocery store. They are accustomed to prices that are “set” by a few producers.
Careful definition of terms is not enough. Repetition and reinforcement with classroom exercises,
homework, assignments from the study guide or computer software are essential in this chapter.
2. Change in quantity demanded (supplied) versus change in demand (supply) are concepts that
students will need to master to be successful in the class and future economic classes. It is also
very easy for the instructor to misstate these changes. We often say “change in demand” when
what we mean is “change in the quantity demanded.” Be careful not to further confuse students
by making this mistake! End-of-chapter questions 2, 4 and review question 4 help clarify the
difference. For both instructor and student this distinction may seem like “nit-picking,” but if the
distinction is not made, more than the usual confusion may result. Whereas the discussion of
demand fits the common experiences of most students, the discussion of supply is more
theoretical and does not.
3. The discussion of price changes of substitutes is potentially problematic for both instructors and
students. The standard argument is that as the price of a good (beef) rises, the demand for its
substitute (chicken) rises. Although we invoke the “all other things equal” assumption to get this
result, there is still the question of why the price of the original good (beef) rose in the first place.
If it rose because of a supply change, then our original conclusion stands. If, however, the
original price rose because of an increase in demand, the total quantity demanded would not fall.
The case can be made that some buyers would substitute, but overall the quantity demanded of
the original good would still rise.
4. Supply shifts often confuse students. When discussing increases or decreases in supply, it is
important to talk about the curves shifting rightward or leftward, as opposed to downward or
upward. Students have enough difficulty with the concepts in this chapter without having to
think about an upward curve shift as a decrease in supply.
3-3
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 03 - Demand, Supply, and Market Equilibrium
5. Exercise caution in demonstrating and discussing the outcome of simultaneous shifts in supply
and demand. When students start by graphing it (or observing a graph you’ve produced), they see
an unambiguous effect on both equilibrium price and quantity. Unless the magnitude of the shifts
is known, the effect on either price or quantity will be indeterminate, but if students see a
particular result they will tend to internalize it. This problem can be mitigated by discussing
simultaneous changes conceptually, so that students can begin to develop an intuitive sense that
something will be uncertain. For example, if both supply and demand increase, it is easy to
convince students that the quantity exchanged will increase. By getting them to acknowledge
(without the graph) that one shift will tend to decrease price, and the other will tend to increase it,
the realization sets in that the final effect on price is indeterminate. This situation presents a
wonderful opportunity to show students why economists often can’t give clear cut answers to
many economic situations.
6. Some students may struggle with the fact that the placement of the price and quantity variables is
inconsistent with the mathematical convention of the independent variable appearing on the
horizontal axis. If you see otherwise intelligent, mathematically inclined students making errors
on their curve shifts, this may be a reason why. Although supply and demand analysis is not the
original source for this expression, you may want to tell them to “mind their Ps and Qs.” You can
also refer them to the “Origin of the Idea” piece on demand and supply on the website so they can
see who to blame.
LECTURE NOTES
I. Learning objectives – After reading this chapter, students should be able to:
A. Characterize and give examples of markets.
B. Describe demand and how it can change.
C. Describe supply and how it can change.
D. Relate how supply and demand 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.
3-4
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 03 - Demand, Supply, and Market 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.
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).
3-5
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 03 - Demand, Supply, and Market Equilibrium
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 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 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.
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.
3-6
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 03 - Demand, Supply, and Market Equilibrium
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 price change and a
change in demand caused by 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.
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.
3-7
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 03 - Demand, Supply, and Market Equilibrium
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.
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.
3-8
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
Chapter 03 - Demand, Supply, and Market Equilibrium
F. Consider This … Ticket Scalping: A Bum Rap!
1. “Scalping” refers to the practice of reselling tickets at a higher-than-original price, which
happens often with athletic and artistic events. Is this “ripping off” justified?
2. Ticket re-sales are voluntary—both buyer and seller must feel that they gain or they
would not agree to the transaction.
3. “Scalping” market simply redistributes assets (tickets) from those who value them less
than money to those who value them more than the money they’re willing to pay.
4. Sponsors may be injured, but if that is the case, they should have priced the tickets
higher.
5. Spectators are not damaged, according to economic theory, because those who want to go
the most are getting the tickets.
6. Conclusion: Both seller and buyer benefit and event sponsors are the only ones who may
lose, but that is due to their own error in pricing and they would have lost from this error
whether or not the scalping took place.
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.
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.
3-9
Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
