51
WHAT’S NEW IN THE SEVENTH EDITION:
The
In the News
feature “Price Increases after Disasters” has been updated with a new article.
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
➢ what a competitive market is.
➢ what determines the demand for a good in a competitive market.
➢ what determines the supply of a good in a competitive market.
➢ how supply and demand together set the price of a good and the quantity sold.
➢ the key role of prices in allocating scarce resources in market economies.
CONTEXT AND PURPOSE:
Chapter 4 is the first chapter in a three-chapter sequence that deals with supply and demand and how
markets work. Chapter 4 shows how supply and demand for a good determines both the quantity
produced and the price at which the good sells. Chapter 5 will add precision to the discussion of supply
and demand by addressing the concept of elasticity—the sensitivity of the quantity supplied and quantity
demanded to changes in economic variables. Chapter 6 will address the impact of government policies on
prices and quantities in markets.
4
THE MARKET FORCES OF
SUPPLY AND DEMAND
52 ❖ Chapter 4/The Market Forces of Supply and Demand
KEY POINTS:
• Economists use the model of supply and demand to analyze competitive markets. In a competitive
market, there are many buyers and sellers, each of whom has little or no influence on the market
price.
• The demand curve shows how the quantity of a good demanded depends on the price. According to
the law of demand, as the price of a good falls, the quantity demanded rises. Therefore, the demand
curve slopes downward.
• The supply curve shows how the quantity of a good supplied depends on the price. According to the
law of supply, as the price of a good rises, the quantity supplied rises. Therefore, the supply curve
slopes upward.
• In addition to price, other determinants of how much producers want to sell include input prices,
technology, expectations, and the number of sellers. If one of these factors changes, the supply
curve shifts.
• The intersection of the supply and demand curves determines the market equilibrium. At the
equilibrium price, the quantity demanded equals the quantity supplied.
• The behavior of buyers and sellers naturally drives markets toward their equilibrium. When the
market price is above the equilibrium price, there is a surplus of the good, which causes the market
price to fall. When the market price is below the equilibrium price, there is a shortage, which causes
the market price to rise.
• To analyze how any event influences a market, we use the supply-and-demand diagram to examine
how the event affects equilibrium price and quantity. To do this we follow three steps. First, we
decide whether the event shifts the supply curve or the demand curve (or both). Second, we decide
which direction the curve shifts. Third, we compare the new equilibrium with the initial equilibrium.
Chapter 4/The Market Forces of Supply and Demand ❖ 53
CHAPTER OUTLINE:
I. Markets and Competition
A. What Is a Market?
2. Markets can take many forms and may be organized (agricultural commodities) or less
organized (ice cream
B. What Is Competition?
C. In this chapter, we will assume that markets are perfectly competitive.
1. Characteristics of a perfectly competitive market:
a. The goods being offered for sale are exactly the same.
2. Because buyers and sellers must accept the market price as given, they are often called
“price takers.”
3. Not all goods are sold in a perfectly competitive market.
You may want to provide students with examples of markets other than the
traditional retail store or the stock market. These include the online advertising sites
such as eBay and Craigslist, the college “career services” department through which
they can look for employment upon graduation, or the market for illegal drugs on a
college campus. Be sure to list the good or service being sold, the buyers, and the
sellers in each example.
Students may find the name for this type of market misleading. You will have to
point out that firms in a competitive market do not face head–to-head rivalry as in
sports competitions.
54 ❖ Chapter 4/The Market Forces of Supply and Demand
D. We will start by studying perfect competition.
1. Perfectly competitive markets are the easiest to analyze because buyers and sellers take the
price as a given.
II. Demand
A. The Demand Curve: The Relationship between Price and Quantity Demanded
2. One important determinant of quantity demanded is the price of the product.
a. Quantity demanded is negatively related to price. This implies that the demand curve is
downward sloping.
b. Definition of law of demand: the claim that, other things being equal, the
quantity demanded of a good falls when the price of the good rises.
Price of Ice-
Cream Cone
Quantity of Cones
Demanded
$2.50
$3.00
$0.00
12
Figure 1
Make sure that you explain that, when we discuss the relationship between quantity
demanded and price, we hold all other variables constant. You will need to
emphasize this more than once to ensure that students understand why a change in
price leads to a movement
along
the demand curve.
Chapter 4/The Market Forces of Supply and Demand ❖ 55
4. Definition of demand curve: a graph of the relationship between the price of a good
and the quantity demanded.
a. Price is generally drawn on the vertical axis.
b. Quantity demanded is represented on the horizontal axis.
B. Market Demand versus Individual Demand
1. The market demand is the sum of all of the individual demands for a particular good or
service.
2. The demand curves are summed horizontally—meaning that the quantities demanded are
added up for each level of price.
3. The market demand curve shows how the total quantity demanded of a good varies with the
price of the good, holding constant all other factors that affect how much consumers want to
buy.
C. Shifts in the Demand Curve
1. Because the market demand curve holds other things constant, it need not be stable over
time.
Figure 2
When you draw the demand curve for the first time, take the time to plot each of the
points from the demand schedule. This way, students who have difficulty with graphs
can see the relationship between the demand schedule and the demand curve. This
is a good opportunity to see if students understand the (
x
,
y
) coordinate system.
ALTERNATIVE CLASSROOM EXAMPLE:
Here is a demand schedule for ink pens:
Price ($)
Quantity Demanded
.05
1000
Students have a difficult time understanding the difference between a change in
price (which causes a movement along the demand curve) and a change in another
.10
.15
.20
.25
56 ❖ Chapter 4/The Market Forces of Supply and Demand
2. If any of these other factors change, the demand curve will shift.
3. Income
a. The relationship between income and quantity demanded depends on what type of good
the product is.
4. Prices of Related Goods
5. Tastes
6. Expectations
a. Future income
Figure 3
Be careful! Students often confuse inferior goods with what economists call “bads.”
One way to differentiate them is to ask students whether they would ever be willing
to pay for such things as pollution or garbage.
Table 1
It would be a good idea to work through an example changing each of these
variables individually. Students will benefit from the discussion and the practice
drawing graphs.
Chapter 4/The Market Forces of Supply and Demand ❖ 57
D.
Case Study: Two Ways to Reduce the Quantity of Smoking Demanded
1. Public service announcements, mandatory health warnings on cigarette packages, and the
prohibition of cigarette advertising on television are policies designed to reduce the demand
for cigarettes (and shift the demand curve to the left).
2. Raising the price of cigarettes (through tobacco taxes) lowers the quantity of cigarettes
demanded.
3. Studies have shown that a 10% increase in the price of cigarettes causes a 4% reduction in
the quantity of cigarettes demanded. For teens, a 10% increase in price leads to a 12% drop
in quantity demanded.
4. Studies have also shown that a decrease in the price of cigarettes is associated with greater
use of marijuana. Thus, it appears that tobacco and marijuana are complements.
III. Supply
A. The Supply Curve: The Relationship between Price and Quantity Supplied
1. Definition of quantity supplied: the amount of a good that sellers are willing and
able to sell.
2. Definition of supply schedule: a table that shows the relationship between the price
of a good and the quantity supplied.
Figure 4
If you have taken enough time teaching demand, students will catch on to supply
more quickly. However, remember that as consumers, students can understand
demand decisions more easily than supply decisions. You may want to point out to
them that they are suppliers (of their time and effort) in the labor market.
Again you will want to point out that everything else is held constant when we
discuss the relationship between price and quantity supplied. Students should
understand that a change in price causes a movement along the supply curve.
58 ❖ Chapter 4/The Market Forces of Supply and Demand
3. Definition of supply curve: a graph of the relationship between the price of a good
and the quantity supplied.
Price of Ice-
Cream Cone
Quantity of
Cones Supplied
$0.00
0
$0.50
0
$1.00
1
B. Market Supply versus Individual Supply
1. The market supply curve can be found by summing individual supply curves.
2. Individual supply curves are summed horizontally at every price.
C. Shifts in the Supply Curve
1. Because the market supply curve holds other things constant, the supply curve will shift if
any of these factors changes.
Figure 5
Figure 7
Figure 6
You will want to take time to emphasize the difference between a “change in supply”
and a “change in quantity supplied.”
$1.50
2
$2.50
4
$3.00
5
Chapter 4/The Market Forces of Supply and Demand ❖ 59
2. Input Prices
IV. Supply and Demand Together
A. Equilibrium
1. The point where the supply and demand curves intersect is called the market’s equilibrium.
4. The equilibrium price is often called the “market-clearing” price because both buyers and
sellers are satisfied at this price.
Table 2
Figure 8
Students will benefit from seeing equilibrium using both a graph and a supply-and–
demand schedule. The schedule will also make it easier for students to understand
concepts such as shortages and surpluses.
60 ❖ Chapter 4/The Market Forces of Supply and Demand
5. Definition of equilibrium quantity: the quantity supplied and the quantity
demanded at the equilibrium price.
Activity 1—A Market Example
Type: In-class demonstration
Topics: Individual demand, market demand, equilibrium price, allocation
Materials needed: A bag of Pepperidge Farm cookies (15 cookies), 5 volunteers
Time: 35 minutes
Class limitations: Works in large lectures or small classes with over 15 students
Purpose
This is an example of a real-world market, where real goods are exchanged for real money. It
is a free market, so there will be no coercion, but participants should think carefully about
their answers because actual trades will take place.
Instructions
Ask five volunteers to participate in a market for Pepperidge Farm cookies. Read some of the
package copy describing these “distinctively delicious” cookies. Write each volunteer’s name
on the board.
Add the individual quantities at each price to find the market demand at that price. This
overall demand is used to find the market equilibrium. Sketch a graph of the market demand.
Supply, in this case, is fixed at the number of cookies in the bag. There are 15 cookies. No
more can be produced, and any leftovers will spoil. This gives a vertical supply curve in the
very short run at
Q
= 15. (Sketch the supply curve.)
Try various prices until the individual quantities sum to 15. This will give the equilibrium price
and quantity.
Distribute the cookies and collect money from each participant.
Points for Discussion
The demand curves display the typical inverse relation between price and quantity. (Remark
Chapter 4/The Market Forces of Supply and Demand ❖ 61
6. If the actual market price is higher than the equilibrium price, there will be a surplus of the
good.
b. To eliminate the surplus, producers will lower the price until the market reaches
equilibrium.
7. If the actual price is lower than the equilibrium price, there will be a shortage of the good.
Figure 9
62 ❖ Chapter 4/The Market Forces of Supply and Demand
Activity 2—Campus Parking
Type: In-class assignment
Topics: Demand, supply, disequilibrium, shortage, rationing
Materials needed: A shortage of student parking on campus
Time: 35 minutes
Class limitations: Works in large lectures or small classes, if there is a campus parking
problem.
Purpose
Nothing seems to generate more heated discussion than campus parking. If your school has a
parking shortage this assignment brings the ideas of price rationing and resource allocation to
an issue close to the students’ hearts.
A. K. Sen’s parable of the bamboo flute is a good introduction to this assignment: An artist
Instruction
Ask the class to answer the following questions. Give them time to write an answer to a
question, then discuss their answers before moving to the next question.
Common Answers and Points for Discussion
1. Write down three things that are true about the parking situation on campus.
2. What two problems do you think are most important?
3. What policies could the administration make to resolve these problems?
Students have many policies to alleviate the situation. The most common suggestion is to ban
Students never suggest raising prices to reach a market solution.
4. Who needs parking the most?
5. Who would pay the most for parking?
6. Use a supply-and-demand graph to analyze this problem.
Chapter 4/The Market Forces of Supply and Demand ❖ 63
B. Three Steps to Analyzing Changes in Equilibrium
1. Decide whether the event shifts the supply or demand curve (or perhaps both).
2. Determine the direction in which the curve shifts.
3. Use the supply-and-demand diagram to see how the shift changes the equilibrium price and
quantity.
C. Example: A change in market equilibrium due to a shift in demand—the effect of hot weather on
the market for ice cream.
Table 3
This three-step process is very important. Students often want to jump to the end
without thinking the change through. They should be provided with numerous
examples so that they can see the benefit of analyzing a change in equilibrium one
step at a time.
Figure 10
Go through changes in supply and demand carefully. Show students why the
equilibrium price must change after one of the curves shifts. For example, point out
7. How would your policy proposals affect the market for parking?
Analysis of the various proposals in a supply-and-demand framework shows some popular
64 ❖ Chapter 4/The Market Forces of Supply and Demand
D. Shifts in Curves versus Movements along Curves
1. A shift in the demand curve is called a “change in demand.” A shift in the supply curve is
called a “change in supply.”
2. A movement along a fixed demand curve is called a “change in quantity demanded.” A
movement along a fixed supply curve is called a “change in quantity supplied.”
E. Example: A change in market equilibrium due to a shift in supply—the effect of a hurricane that
destroys part of the sugar-cane crop and drives up the price of sugar.
F. Example: Shifts in both supply and demand—the effect of hot weather and a hurricane that
destroys part of the sugar cane crop.
G. Summary
Figure 12
ALTERNATIVE CLASSROOM EXAMPLE:
Go through these examples of events that would shift either the demand or supply of #2 lead
pencils:
▪ an increase in the income of consumers
▪ an increase in the use of standardized exams (using opscan forms)
Emphasize that students should not think about the curves shifting “up” and “down”
but rather think about the curves shifting “right” and “left” (or “out” and “in”). Point
out that an increase in demand (or supply) is an increase in the quantity demanded
(supplied) at every price. Thus, it is quantity that is getting larger. Review the same
principle with a decrease in demand (or supply).
It would helpful to students if you draw all four graphs (increase in demand,
decrease in demand, increase in supply, and decrease in supply) on the board at the
same time. Students will be able to see that the end result of each of these four
Figure 11
Chapter 4/The Market Forces of Supply and Demand ❖ 65
2. Table 4 reports the end results of these shifts in supply and demand.
H.
In the News: Price Increases after Disasters
1. When a disaster strikes a region, many good experience an increase in demand or a decrease
in supply resulting in upward pressure on prices.
V. Conclusion: How Prices Allocate Resources
A. The model of supply and demand is a powerful tool for analyzing markets.
B. Supply and demand together determine the prices of the economy’s goods and services.
1. These prices serve as signals that guide the allocation of scarce resources in the economy.
2. Prices determine who produces each good and how much of each good is produced.
Table 4
Make sure that you explain to students that two possible outcomes might result,
depending on the relative sizes of the shifts in the demand and supply curves. Thus,
if they do not know the relative sizes of these shifts, the end effect on either
equilibrium price or equilibrium quantity will be ambiguous. Teach students to shift
each curve using the three-step method and to draw them on separate graphs.
Make a big deal about how well prices serve to allocate resources to their highest
valued uses. For example, suppose that consumers develop an increased taste for
66 ❖ Chapter 4/The Market Forces of Supply and Demand
Activity 3—Supply and Demand Article
Type: Take-home assignment
Topics: Shifts in supply or demand, changing equilibrium
Class limitations: Works in any class
Purpose
This assignment is an excellent way to determine which students need extra help in
understanding supply and demand. Students who have difficulty with it often need remedial
help. Allowing students to correct errors and then resubmit the assignment can be worthwhile
because it is fundamental to their understanding of how markets work.
Instructions
Give the students the following assignment:
Find an article in a recent newspaper or magazine illustrating a change in price or quantity in
some market. Analyze the situation using economic reasoning.
1. Has there been an increase or decrease in demand? Factors that could shift the
demand curve include changes in preferences, changes in income, changes in the
price of substitutes or complements, or changes in the number of consumers in
the market.
Ask students to turn in a copy of the article along with their explanation. Warn students to
avoid advertisements because they contain little information. They should be wary of
commodity and financial markets unless they have a good understanding of the particular
market. Markets for ordinary goods and services are most easily analyzed.
Points for Discussion
Most changes will only shift one curve—either supply or demand—not both. Remind students
that price changes will not cause either curve to shift. (But shifting either curve will change
price.)