CHAPTER 3
SUPPLY AND DEMAND
MASTERY GOALS
The objectives of this chapter are to:
1. Describe the characteristics that define a market including the use of aggregation.
2. Distinguish between product markets and resource markets using the circular flow model.
3. Use a demand schedule and a demand curve to demonstrate the law of demand.
4. Distinguish between perfectly competitive and imperfectly competitive markets.
5. Explain the difference between a change in demand (shi& of the curve) and a change in
quantity demanded (movement along the curve).
6. List the variables that will lead to a change in demand, and give examples of each.
7. Use a supply schedule and a supply curve to demonstrate the law of supply.
8. Explain the difference between a change in supply (shi& of the curve) and a change in
quantity supplied (movement along the curve).
9. List the variables that will lead to a change in supply, and give examples of each.
10. Define the notion of equilibrium.
11. Explain how equilibrium price and quantity are determined in a competitive market.
12. Explain what will happen in a competitive market a&er a shi& of the supply curve, the
demand curve, or both.
13. Define the terms shortage and surplus and explain why they do not normally result from
changes in demand or supply.
14. Describe the three steps economists take to answer almost any question about the
economy.
THE CHAPTER IN A NUTSHELL
The model of “supply and demand” is designed to explain how prices are determined in a
perfectly competitive market. Chapter 3 describes how the model of supply and demand works,
and explains how to use it.
The chapter begins by defining a market as a group of buyers and sellers with the potential to
trade with each other. Markets can be characterized in several ways but always include some
level of aggregation, whereby a group of distinct things into a single whole. The circular flow
model is used to show how goods, resources and payments flow.
In economics, a market is defined not by its location, but by its participants. For the most part,
in the market for consumer goods, the text views business firms as the only sellers, and
households as the only buyers. Markets can be imperfectly competitive or perfectly
competitive, depending on whether or not the participants have the power to influence the
price of the product being traded.
The supply and demand model is designed to explain how prices are determined in perfectly
competitive markets. Separately, the supply and demand curves tell us about the choices that
households and firms would like to make, not about what will actually happen in a market. To
know what will actually happen, we need to consider both curves together.
The law of demand states that a good’s price and the quantity demanded are negatively related,
as long as everything else remains the same. This is shown with a demand schedule and a
demand curve. A movement along an existing demand curve is called a change in quantity
demanded and can only occur as the result of a change in the price of the good itself. A shi& to a
new demand curve can occur if something other than the price of the good itself changes. A
shi& is referred to as a change in demand. Variables that shi& the demand curve include income
and wealth, prices of substitutes and complements, population, expected price, and tastes.
The law of supply states that a good’s price and the quantity supplied are positively related, if
everything else remains the same. A supply schedule and a supply curve show this positive
relationship. A change in quantity supplied occurs when the price of the good itself changes,
and is shown as a movement along an existing supply curve. A shi& of the supply curve is called
a change in supply, and occurs when a variable other than the price of the good changes.
Variables that shi& the supply curve include input prices, prices of alternate goods, technology,
number of firms, expected price, and changes in weather and other natural events.
The model of supply and demand shows how market equilibrium is determined, and
demonstrates what happens when demand or supply shi&s. An increase in demand or a
decrease in supply will ordinarily not cause a shortage, but rather will lead to a new equilibrium
with a higher price. Similarly, a decrease in demand or an increase in supply will ordinarily not
cause a surplus but, rather, a new equilibrium with a lower price. A shi& of one curve causes a
movement along the other curve to the new equilibrium point. When both curves shi&, and we
know the directions of the shi&s, we can determine the direction of either price or quantity—
but not both. The direction of the other will depend on which curve shi&s by more.
Economists take three distinct steps to answer almost any question about the economy. Step #1
is to decide which market or markets best suit the problem being analyzed, and identify the
decision makers (buyers and sellers) who interact in that market. Step #2 is to describe the
conditions necessary for equilibrium in the market, and a method for determining that
equilibrium. Step #3 is to explore how events or government policies change the market
equilibrium. The three-step procedure helps us understand how markets operate, predict
important changes in the economy and prepare for them, and design government policies to
accomplish our social goals and avoid policies that are likely to backfire.
The chapter ends with a real-world example – oil prices spiking in 2007 – 2008. An appendix to
Chapter 3 shows how to solve for equilibrium algebraically.
In order presented in chapter.
Aggregation: The process of combining distinct things into a single whole.
Markets: A group of buyers and sellers with the potential to trade with each other.
Circular ow: A simple model that shows how goods, resources, and dollar payments flow
between households and firms.
Product markets: Markets in which firms sell goods and services to households.
Resource markets: Markets in which households that own resources sell them to firms.
Perfectly competitive market: (informal definition) A market in which no buyer or seller
has the power to influence the price.
Quantity demanded: The quantity of a good that all buyers in a market would choose to
buy during a period of time, given their constraints.
Law of demand: As the price of a good increases, the quantity demanded decreases.
Ceteris paribus: Latin for “all else remaining the same.”
Demand Schedule: A list showing the quantities of a good that consumers would choose to
purchase at different prices, with all other variables held constant.
Demand Curve: A graph of a demand schedule, a curve showing the quantity of a good or
service demanded at various prices, with all other variables held constant.
Change in quantity demanded: A movement along a demand curve in response to a
change in price.
Change in demand: A shi& of a demand curve in response to a change in some variable
other than price.
Income: The amount that a person or firm earns over a particular period.
Normal good: A good that people demand more of as their income rises.
Inferior good: A good that people demand less of as their income rises.
Wealth: The total value of everything a person or firm owns, at a point in time, minus the
total amount owed.
Substitute: A good that can be used in place of some other good and that fulfills more or less
the same purpose.
Complement: A good that is used together with some other good.
Quantity supplied: The specific amount of a good that all sellers in a market would choose
to sell over some time period, given their constraints.
Law of supply: As the price of a good increases, the quantity supplied increases.
Supply schedule: A list showing the quantities of a good or service that firms would choose
to produce and sell at different prices, with all other variables held constant.
Supply curve: A graph of a supply schedule, showing the quantity of a good or service
supplied at various prices, with all other variables held constant.
Change in quantity supplied: A movement along a supply curve in response to a change
in price.
Change in supply: A shi& of a supply curve in response to a change in some variable other
than price.
Alternate goods: Other goods that firms could produce instead of the good in question.
Alternate market: A market other than the one being analyzed in which the same good
could be sold.
Equilibrium price: The market price, that once achieved, remains constant until either the
demand curve or supply curve shi&s.
Equilibrium quantity: The market quantity bought and sold per period that, once achieved,
remains constant until either the demand curve or supply curve shi&s.
Excess demand: At a given price, the amount by which quantity supplied exceeds quantity
demanded.
Excess supply: At a given price, the amount by which quantity supplied exceeds quantity
demanded.
TEACHING TIPS
1. A lot of confusion can be avoided by pointing out something very early: When drawing
either the supply curve or the demand curve, we graph the dependent variable
(quantity) on the horizontal axis and the independent variable (price) on the vertical
axis. (This is done not only for supply and demand, but for many other diagrams in
economics as well.) Students have become accustomed to the opposite convention.
Unless this quirky way of graphing is pointed out to them, they will quite naturally think
that, for example, changes in quantity demanded cause changes in price, rather than the
other way around.
2. To help students understand the difference between a change in demand and a change
in quantity demanded, emphasize the two-dimensional nature of the demand curve
graph.
Our two axes represent two variables: price and quantity demanded. Every time the
price of the good itself changes, we slide along the existing demand curve. This is called
a change in quantity demanded.
If we used a third, fourth, or fi&h dimension, then we could assign important
independent variables to each of those axes. However, since we limit ourselves to two
dimensions, we have to find another way to show the effect of the other important
variables on the number of units demanded.
Every time we construct a demand curve, we are assuming that the other important
variables have been assigned values that don’t change and are “embedded” in the
demand curve; that is, the demand curve is drawn for particular values of those other
variables.
Of course, when one or more of these variables does change, our existing demand curve
is no longer valid. We have to draw a new demand curve. This is called a change in
demand.
(This same method can be used to help students understand the difference between a
change in supply and a change in quantity supplied.)
3. Sections on “Change in Quantity Demanded vs. Change in Demand” and “Change in
Quantity Supplied vs. Change in Supply” discuss two of the most common confusions
students have when thinking about supply and demand. This material comes in handy in
class discussion if you ask students to come up with determinants of demand or supply
themselves. For example, if you ask the class to suggest variables that might affect
quantity demanded, someone will usually say, “The amount available.” This is a good
opportunity to point out that demand is a hypothetical concept—the amount of a good
that households would choose to buy at each price. We don’t know how much they will
actually be able to buy until we put demand together with supply. And even then,
“availability” will affect quantity demanded only via its e$ect on the price people must
pay for the good—an e$ect that we have already incorporated by listing the price as a
factor of demand. “Availability” certainly has no place as a separate factor of demand.
Similarly, when coming up with the determinants of supply, someone will usually offer
“the amount that people want to buy.” You can point out that supply, too, is a
hypothetical concept—the amount that suppliers would choose to supply and sell at
each price. Whether they can actually sell that quantity isn’t known until supply and
demand are put together. And once again, demand will affect supply only via its e$ect on
price—an e$ect that we have already incorporated by listing the price as a factor of
supply.
4. Group the determinants of demand into two categories: those that are positively related
to demand (income if the good is normal, wealth, price of a substitute, population,
expected price, and tastes for the product) and those that are negatively related to
demand (income if the good is inferior, price of a complement). As a starting point for
learning them, have students suggest an acronym for the variables in each of these
groups. Do the same with the factors that shi& the supply curve.
5. The authors explain that a change in supply or demand will ordinarily not cause a
shortage or surplus, but rather lead to a new equilibrium at a different price. It is helpful
to stress the logic behind this important conclusion. Any shortage or surplus would
cause the price of the good to change. The price change, in turn, would lead to
movements along the existing supply and demand curves that would eliminate the
shortage or surplus. (It’s helpful to go through the case of a shortage and a surplus
separately, to reinforce this point.)
DISCUSSION STARTERS
1. Have students bring to class news articles demonstrating factors that shi& supply or
demand. They should be able to identify the market, and explain how the change in a
factor affects price or quantity traded in the market in question (or both!). As a group or
individual project, you can ask students to submit a set of news articles, each one
demonstrating a different factor. If you do so, have them highlight the market, the factor
in question, and the way that price or quantity traded changed.
2. Ask students to describe what happens to the demand for Coca-Cola products when the
temperature changes (demand is positively related to the temperature). In 1999, the
Coca-Cola Company began testing vending machines that use thermometers to adjust
the price of its products according to the temperature. Explain the e$ect these vending
machines have on the speed of market adjustment. Ask them if they’ve ever wanted to
buy a so&-drink on a very hot day, only to find that the vending machines are sold out.
How would widespread use of such vending machines affect the availability of so&
drinks on hot summer days?
3. An outbreak of the H1N1 (Swine) flu virus in 2008 – 2009 caused a significant impact on
the prices of pork, including hog futures. See
hMp://www.cnn.com/2009/HEALTH/04/30/pork.industry.impact/index.html for further
information. Discuss the effect of the outbreak on the demand for pork and hog
futures.