Chapter 4/Supply and Demand: An Initial Look
CHAPTER 4
SUPPLY AND DEMAND: AN INITIAL LOOK
Chapter 4 introduces students to the basic analytical structure of markets, through the use of the
supply-demand diagram. It then indicates what sorts of problems arise when the government
interferes with freely functioning markets.
CHAPTER OUTLINE
THE INVISIBLE HAND
When markets are interfered with, undesirable side effects almost always result.
DEMAND AND QUANTITY DEMANDED
The quantity demanded of any good depends on many factors, one of which is price.
Normally, when the price of a commodity rises, the quantity demanded falls.
Shifts of the Demand Curve
A change in the price of a good produces a movement along the demand curve.
A change in any other factor influencing demand shifts the entire demand curve.
Determinants of Demand (items that shift the demand curve):
1. consumer incomes
2. population
3. consumer preferences
4. prices and availability of related goods
SUPPLY AND QUANTITY SUPPLIED
The quantity supplied of any good depends on many factors, one of which is price.
Normally, when the price of a commodity rises, the quantity supplied rises.
Shifts of the Supply Curve
Determinants of Supply (items that shift the supply curve):
1. size of the industry
2. technological progress
3. prices of inputs
Chapter 4/Supply and Demand: An Initial Look
4. prices of related outputs
SUPPLY AND DEMAND EQUILIBRIUM
There is normally a single equilibrium price for each commodity, at which the quantity
supplied equals the quantity demanded.
EFFECTS OF DEMAND SHIFTS ON SUPPLY-DEMAND EQUILIBRIUM
If the demand curve shifts outward (to the right) without a change in the supply curve, the
equilibrium price and quantity will both increase.
SUPPLY SHIFTS AND SUPPLY–DEMAND EQUILIBRIUM
An outward shift (to the right) of the supply curve without a change in the demand curve will
lower the equilibrium price and raise the equilibrium quantity.
BATTLING THE INVISIBLE HAND: THE MARKET FIGHTS BACK
Restraining the Market Mechanism: Price Ceilings
Government-imposed price ceilings may reduce the price, but they also typically have the
following effects:
1. persistent shortages
2. development of an illegal “black” market
3. higher (than free-market) illegal “black” market prices
4. illicit suppliers obtain a significant portion of the price
5. reduction of investment in the industry
Case Study: Rent Controls in New York City
The unintended consequences of a price floor are clearly illustrated by rent controls
established in cities such as New York.
Chapter 4/Supply and Demand: An Initial Look
Restraining the Market Mechanism: Price Floors
Government-imposed price floors may increase the price, but they also typically lead to:
1. persistent surpluses
2. disposal problems
Case Study: Farm Price Supports and the Case of Sugar Prices
The U.S. agricultural support program was established as a temporary response to industry
results during the Great Depression.
A Can of Worms
Other difficulties that often occur when price floors or ceilings are imposed include:
1. favoritism and corruption
2. unenforceability
A SIMPLE BUT POWERFUL LESSON
The lessons in this chapter are simple, obvious, and powerful, but often neglected and
misunderstood.
MARGIN DEFINITIONS
Invisible Hand: a phrase coined by Adam Smith to describe how, by pursuing their own
self-interests, people in a market system seem to be “led by an invisible hand” to promote
societal well-being as a whole.
Chapter 4/Supply and Demand: An Initial Look
Demand Curve: a graphical depiction of a demand schedule. It shows how the quantity
demanded of some product during a specified period of time will change as the price of that
product changes, holding all other determinants of quantity demanded constant.
Shift in a Demand Curve: occurs when any variable other than price changes. If consumers
want to buy more at any and all given prices than they wanted previously, the demand curve
shifts to the right (or outward). If they desire less at any given price, the demand curve shifts to
the left (or inward).
Shortage: an excess of quantity demanded over quantity supplied. When there is a shortage,
buyers cannot purchase the quantities they desire at the current price.
Surplus: an excess of quantity supplied over quantity demanded. When there is a surplus, sellers
cannot sell the quantities they desire to supply at the current price.
Equilibrium: a situation in which there are no inherent forces that produce change. Changes
MAJOR IDEAS
1. When markets are functioning well, prices give appropriate signals to both buyers and
sellers.
2. Markets generally move toward an equilibrium price at which the quantity supplied
equals the quantity demanded and at equilibrium there are no inherent forces to change.
3. Government interference with free markets usually has unintended, detrimental side
effects.
ON TEACHING THE CHAPTER
Supply and demand is the most fundamental concept in economics and in this course. Unless
students understand this material fully, they will have difficulty with almost everything else in
Chapter 4/Supply and Demand: An Initial Look
the book. The goal, therefore, should be to get to the point that supply and demand analysis is
second nature to the students, not something that has to be laboriously reconstructed each time it
is encountered. This will not happen, of course, in the first lecture and the first pass through the
chapter. Instructors should think of a variety of complementary ways of presenting this material
at this point in the course, and should then reinforce the ideas continuously as the course
proceeds.
Students are familiar with prices in their personal lives, but for the most part they think of
them simply as mechanisms for transferring money from one person to another. A high price, for
example, means to them that the buyer is penalized and the seller rewarded. One of the
challenges of this chapter is to help students to see prices as signals and incentives. A rise in the
price of bread signals a shortage of bread, and it is an incentive for buyers to economize and
sellers to produce more, thus eliminating the shortage.
The topic of price floors and price ceilings is probably the first one in this course that is
genuinely troubling to many students—that is to say, both counterintuitive and perhaps even
morally objectionable. Many students will have a strong conviction, for example, that rent
control is the best way to deal with the housing shortage they see around them, and that an
One example of artificially low prices to which most students easily relate is the market for
tickets to popular rock concerts. Performers often set prices below the equilibrium price
(purportedly to keep the concert affordable to the “average” fan). The resulting shortage
illustrates several of the problems associated with price ceilings such as long queues for tickets
and illegal ticket scalping.
Chapter 4/Supply and Demand: An Initial Look
When discussing price floors, it also makes sense to bring up the minimum wage law and the
labor market. Illustrating unemployment as an example of a labor surplus helps students
PROBLEMS
1. Use supply and demand curves to show the change in the price of bread and the quantity
sold, when these events occur:
a) The population grows.
b) People’s incomes fall and unemployment increases in a recession.
c) The price of potatoes rises.
d) The price of butter rises.
e) A drought occurs in the wheat-growing regions.
f) To protect farmers’ incomes, the government sets an effective price floor for wheat.
g) To protect consumers from inflation, the government sets an effective price ceiling for
bread.
Solution:
Figure 4.1
Chapter 4/Supply and Demand: An Initial Look
2. In the United States and Western Europe, farmers are strong enough politically to
persuade their governments to set price floors for many crops. In many less-developed
countries, governments that are worried about the standard of living of their urban
populations impose price ceilings on food staples like rice and wheat. Use supply and
demand curves to show how these policies can help to explain the food surpluses in the
rich countries and the shortages in the poor countries.
Solution:
Chapter 4/Supply and Demand: An Initial Look
3. These are the supply and demand schedules for good X:
Quantity Quantity
Price Supplied Demanded
$10 18 3
9 16 4
8 14 5
7 12 6
6 10 7
5 8 8
4 6 9
3 4 10
2 2 11
1 0 12
a) What is the equilibrium price and quantity? At this equilibrium, what is the
producer’s revenue?
b) If the government sets a price of $8 for X, what will be the price, quantity, and
revenue? Will there be a shortage or surplus of X?
c) If the government sets a price of $3, answer the same questions as in b).
d) Suppose the demand for X increases, so that at each price, consumers want to buy
three more units of the good. What happens to price, quantity, and revenue? Why has
the quantity sold not increased by three units?
Solution:
a) Equilibrium price is $5 and quantity demanded and supplied is eight.
b) Price = $8
Quantity demanded = 5 units
Chapter 4/Supply and Demand: An Initial Look
4. a) Compare the slopes of the demand curves in these two cases:
(i) the demand for food sold by Ma and Pa Smalltimer, who run a corner grocery
downtown.
(ii) the demand for passenger tickets sold by Monopoly Railroad, which operates the
only trains that go through town.
b) Which company is likely to benefit more by raising its prices? Why?
Solution:
a) Availability of substitutes is one of the determinants of the slope of the demand curve.
The demand curve of Ma and Pa Smalltimer will have a higher slope as substitutes
are available in the market for the food supplied by the company. This higher slope
DISCUSSION QUESTIONS
1. The government of the former Soviet Union kept consumer prices artificially low.
Shortages of goods were massive, the typical experience of shoppers being to line up for
many hours and then find that the goods were not available. The Russian Republic, which
succeeded the Soviet Union, tried to move to a market system, in which prices were set
by supply and demand. Do you think this was a good idea? Who was helped and who was
hurt? Are the benefits from a shift to the market likely to occur immediately or take a
long time?
Suggested Answer: Student answers concerning the merits of the idea will vary. The
Russian experience points to the necessity of proper structures required for a free market.
The benefits of a free market economy cannot be derived overnight. As opposed to strict
2. In 1973, the countries producing most of the world’s oil united under the Organization of
Petroleum Exporting Countries (OPEC) and tripled the price of oil, and then in 1979 they
tripled it again. In the 1970s, the strategy was very successful for OPEC, bringing its
Chapter 4/Supply and Demand: An Initial Look
members vastly increased revenues. In the 1980s, however, huge surpluses of oil arose in
the world, and the price collapsed. Use demand curves for oil to discuss why the price
increase and then the decrease may have occurred. What happened to the slope of the
world demand curve for oil over a period of years?
Suggested Answer: Students have to discuss the impact of the OPEC decision on the
supply curve of oil. The supply curve of oil shifted upward as OPEC reduced the supply,
3. The United States has a perpetual farming problem. The prices of food seem to be falling
constantly. Many farmers cannot make a living, abandon their farms, and move to the
city. The demand curve for food as a whole is quite steep (that is, the quantity of food
bought is not very sensitive to changes in price). Technological changes and productivity
improvements in American farming have been rapid and continuous. What are the
advantages and disadvantages of trying to solve the problem by setting price floors for
agricultural output?
Suggested Answer: Students may come up with different arguments for and against the
price floor. Price floors are aimed at protecting the interests of the farmers. Farmers will
benefit from the high price of the products they produce. Farming will become profitable
4. Consider the coordination problems inherent in providing food for the people of New
York City. Every day, millions of people walk into a store and find particular food
products they want. Large amounts of staples need to be available, as well as smaller
amounts of a huge number of ethnic and specialty foods. Some of the food is grown
nearby, and some of it comes from around the world. Some products have a long shelf
life, but others are fresh and needs to be put on shelves just shortly before being bought.
If you were asked to be in charge of coordinating the provisions of food for New York
City, you would probably flee in panic; even with the most modern computers you could
not do the job adequately. In fact there is no coordinator of food for New York, and still
the job of provisioning the city gets done very well, every day. Using the concepts of
supply and demand, show how the decentralized market achieves this task.
Suggested Answer: Students should consider the ability of free markets to efficiently
allocate resources in a society. In a decentralized market, the allocation of society’s goods
Chapter 4/Supply and Demand: An Initial Look
5. The quantity demanded of college education from many of the elite U.S. universities far
exceeds the quantity supplied. This is evidenced by the very small acceptance rates at
schools like Stanford and Harvard. This shortage appears to be persistent given the fact
that these acceptance rates have remained very low for a very long time. Is this situation
contrary to the concept of equilibrium presented in this chapter? Why or why not?
Suggested Answer: This proposition violates the concept of market equilibrium.
However, excess supply could reduce the perceived utility or premium that these