Chapter 3
Supply, Demand, and the Market Process
OUTLINE
I. Consumer Choice and Law of Demand
A. Law of Demand
1. Law of Demand: There is an inverse relationship between the price of a good and
the quantity consumers are willing to purchase.
a. As price of a good rises, consumers buy less.
B. Market Demand Schedule
1. The height of the demand curve at any quantity shows the maximum price that
consumers are willing to pay for that additional unit.
C. Consumer Surplus
1. Consumer Surplus: the area below the demand curve but above the actual price paid.
2. Lower market prices will increase consumer surplus.
D. Elastic and Inelastic Demand Curves
1. Elastic demand: quantity demanded is sensitive to small price changes.
a. Easy to substitute away from good.
2. Inelastic demand: quantity demanded is not sensitive to price changes.
b. Difficult to substitute away from good.
II. Changes in Demand Versus Changes in Quantity Demanded
A. Changes in Demand and Quantity Demanded
2. Change in Quantity Demanded: movement along the same demand curve in
response to a price change.
B. Demand Curve Shifters
1. Changes in Consumer Income
3. Change in Price of Related Good
5. Demographic Changes
6. Changes in Consumer Tastes and Preferences
III. Producer Choice and Law of Supply
A. Producers
1.
2. Firms will not stay in business for long unless they are able to cover the cost of all
resources employed, including the opportunity cost of those owned by the firm.
B. Role of Profits and Losses
2. Firms supplying goods for which consumers are willing to pay more than the
opportunity cost of resources used will make a profit.
3. Firms making a profit will expand and those with a loss will contract.
C. Law of Supply
1. Law of Supply: there is a positive relationship between the price of a product and
the amount of it that will be supplied.
a. As the price of a product rises, producers will be willing to supply more.
D. Market Supply Schedule
1. The height of the supply curve shows two points about the cost of production.
a. The minimum price necessary to induce producers to supply that additional
unit.
b. The opportunity cost of producing the additional unit of the good.
E. Producer Surplus
1. Producer Surplus : The area above the supply curve but below the actual sales
price.
a. Producer surplus is the difference between the minimum amount required to
induce producers to produce a good and the amount they actually receive.
F. Elastic and Inelastic Supply Curves
1. Elastic supply: quantity supplied is sensitive to small price changes.
2. Inelastic supply: quantity supplied is not sensitive to price changes.
IV. Changes in Supply Versus Changes in Quantity Supplied
A. Changes in Supply and Quantity Supplied
2. Change in Quantity Supplied: movement along the same supply curve in response
to a price change.
B. Supply Curve Shifters
1. Changes in Resource Prices
3. Elements of Nature and Political Disruptions
4. Changes in Taxes
V. How Market Prices are Determined: Supply and Demand Interact
A. Prices bring the conflicting forces of supply and demand into balance.
1. There is an automatic tendency for market prices to move toward the equilibrium
price, at which the quantity demanded equals the quantity supplied.
VI. How Markets Respond to Changes in Demand and Supply
A. Effects of a Change in Demand
2. If Demand increases, the equilibrium price and quantity will rise.
Chapter 3/Supply, Demand, and the Market Process 41
B. Effects of a Change in Supply
1. If Supply decreases, the equilibrium price will rise and the equilibrium quantity
will fall.
2. If Supply increases, the equilibrium price will fall and the equilibrium quantity will
rise.
VII. Invisible Hand Principle
A. Invisible Hand
1. Invisible Hand: the tendency of market prices to direct individuals pursuing their
own interest into productive activities that also promote the economic well-being
of society.
B. Communicating Information
2. Without the information provided by market price it would be impossible for
decision-makers to determine how intensely a good was desired relative to its
opportunity cost.
C. Coordinating Actions of Market Participants
1. Price changes bring the decisions of buyers and sellers into harmony.
2. Price changes create profits and losses which change production levels.
D. Prices and Market Order
1. Market order is the result of market prices, not central planning.
E. Qualifications
1. The efficiency of market organization is dependent upon:
a. The presence of competitive markets.
b. Well-defined and enforced private property rights.
OBJECTIVES
In this chapter, we illustrate how markets work and why pricing signals are so important. Basic
supply and demand analysis is developed. However, the text places greater emphasis than most
textbooks on (a) the market as a process and (b) the period of time needed for purchasers and
suppliers to respond fully to changes in market prices. In our judgment, this adds realism to the
material and helps to convince the student that market prices really do matter. It also lays the
groundwork for future discussions on (a) the search theory of unemployment, (b) uncertainty as to
whether an increase in demand is temporary or permanent, and (c) adjustment of secondary markets
42 Chapter 3/Supply, Demand, and the Market Process
IMPORTANT POINTS AND TEACHING SUGGESTIONS
1. Our experience suggests that failure to distinguish between changes in demand and changes in
quantity demanded is among the most common mistakes in economics. Use Exhibit four to
2. Consumer choices underlie the demand curve. Changes in factors (other than product price)
3. Changes in one market often have feedback effects that alter the market conditions for
5. The impact of Alfred Marshall on modern economics has been enormous. The outstanding
economist feature profiles his contribution to the development of economics.
6. Economists often neglect one of the most important functions of market prices the ability to
summarize and communicate information. The section in Chapter three on the invisible hand
8. A marble in a perfectly rounded bowl provides an analogy that may help students understand
the process of adjustment toward equilibrium and the role of comparative static equilibria. A
marble placed at the exact bottom of the bowl with no momentum will tend to stay there
9. A useful extension of the supermarket lines example for spontaneous coordination would be to
see what would happen to traffic if the rules of the road were unpredictable (e.g., what if the
10. A good illustration of markets in action is the response of Canadians to tax differences on
cigarettes in the United States and Canada. As a result of taxes, Canadian-blend cigarettes are
12.
have the same analysis as change in the explicit costs of resources hired in markets.
13. In applying supply and demand analysis, students can be shown that if either curve shifts, it
will result in either a shortage or surplus at the current price, which is what sets the market
adjustment process in motion.
GAMES
1. A Market Example
Type: In-Class Demonstration
Topics: Individual demand, market demand, equilibrium price, allocation
Textbook: Chapter 3: Supply, Demand, and the Market Process
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 since actual trades will take place.
Instructions
Ask for five volunteers to participate in a market, a market for Pepperidge Farm Milano cookies.
Ask the volunteers how many cookies they would be willing to buy at various prices. Record
these prices and quantities.
44 Chapter 3/Supply, Demand, and the Market Process
real money.
At this point there will be five individual demand curves, which can be graphed if desired.
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.
An example:
How many of these cookies, if any, would you be willing to buy at a price of $10 per cookie?
How many cookies would you be willing to buy at a price of $0.01 per cookie?
How many cookies, if any, would you be willing to buy at a price of $0.50 per cookie?
How many cookies, if any, would you be willing to buy at a price of $0.25 per cookie?
Our volunteers give the responses below. The market quantity is the sum of the individual
quantities at each price.
Maria Ricardo Amy Jay Market
Price Quantity
$10 0 0 0 0 0
We look at the intersection of this supply curve with the market demand curve to find our
equilibrium point. In this example, our equilibrium will occur at some price below 25¢ and above
1¢.
For Example:
Maria Ricardo Amy Jay Market
Chapter 3/Supply, Demand, and the Market Process 45
This is the equilibrium price. At this price the market clears. Once the price is established, we
allocate the goods based on individual demand, so Maria buys two cookies at 20¢ each, Ricardo
buys five cookies, Amy, three and Jay, five.
Points for discussion
The demand curves display the typical inverse relation between price and quantity. Remark on
any unusual patter
2. Supply and Demand Article
Type: Take-home assignment
Topics: shifts in supply or demand, changing equilibrium
Textbook: Chapter 3: Supply, Demand, and the Market Process
Class limitations: works in any class
Purpose
This assignment is an excellent discriminator. Students who have difficulty with it often need
remedial help. Allowing students to correct errors and then resubmit the assignment can be
worthwhile since it is fundamental to their understanding of how markets work.
Instructions
Warn students to avoid advertisements since 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.)
Equilibrium points are not fixed. They change when supply or demand changes. Prices will not
necessarily return to their previous levels nor will quantities.
Remind the class of the fundamental relations:
2. Increases in supply cause price to decrease and quantity to increase.
4. Decreases in supply cause price increases and quantity decreases.
46 Chapter 3/Supply, Demand, and the Market Process
Name _________________________ Course _______________________
Supply & Demand
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.
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, and changes in the number of consumers in the market.
Has there been an increase or decrease in supply? Factors that could shift the supply curve include
3. Campus Parking
Type: In-Class Assignment
Topics: demand, supply, disequilibrium, shortage, rationing
Textbook: Chapter 3: Supply, Demand, and the Market Process
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
ion to this assignment: An artist makes
a beautiful instrument that becomes famous throughout the country. A number of claimants arise,
each of whom argues that they deserve the flute: the artist who created it, the most-talented
musician, the poorest, most-needy citizen, and the hardest-working musician, etc. Who deserves
the flute? Students will have different opinions on who is most deserving but many will accept a
market solution the person who is willing to pay the most (who has the highest marginal benefit,
given the existing distribution of wealth and income). The allocation of campus parking spots
makes a nice parallel.
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 and 2. Write down three things that are true about the parking situation on campus. What two
problems do you think are most important?
3. What policies could the administration take 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 and 5. Who needs parking the most? Who would pay the most for parking?
6. Use a supply and demand graph to analyze this problem.
7. How would your policy proposals affect the market for parking?
Chapter 3/Supply, Demand, and the Market Process 49
Name _________________________ Course _________________
Campus Parking
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 take to resolve these problems?
4. Who needs parking the most?
5. Who would pay the most for parking?
7. How would your policy proposals effect the market for parking?
4. Cold Soda
Type: In-Class demonstration
Topics: Demand, substitutes and changing demand
Textbook: Chapter 3: Supply, Demand, and the Market Process
Materials Needed: a teaching assistant to tally quantities
Time: 15 minutes
Class limitations: works in large classes
Purpose
Students answer a series of questions about their willingness to pay. A teaching assistant collects
their answers and then sums their responses, while the instructor lectures on other material. Two
demand curves are found from the class responses, one with, and one without a substitute good.
These are shared with the class.
Instructions
Ask the students to answer the following questions. These are hypothetical questions; no
exchange will actually take place.
1. -cold Pepsi-Cola. If I offered to sell you a Pepsi for $1.50
would you be willing to buy one? (Yes or no?)
2.
3.
4.
5.
6. -cold Pepsi-Cola and one full of ice-cold
Coca-Cola. I am going to repeat my offers to sell Pepsi, but now consider the availability of
Coke. Assume Coke is available as an alternative, and the price of Coke is always $0.75. You
7.
9.
10.
11.
Points for discussion
Use the first five questions to draw a demand curve for Pepsi. More students will be willing to buy
Pepsi as its price decreases.
5. Value of a Time Machine
Type: In-Class Demonstration
Topics: Consumer surplus
Textbook: Chapter 3: Supply, Demand, and the Market Process
Materials Needed: none
Time: 10 minutes
Class limitations: works in any size class
Purpose
than on money that is actually exchanged. This example puts a specific dollar value on consumer
surplus.
Instructions
forward in time. We want to identify the va
Choose four student names and use them in the following example.
o go back to the time of the
-to-pay. She would like to see 200 years
On the board write:
Scott $3000
Carol $2500
Steve $800
Jeanne $200
curve for the time machine. Consumer surplus is the difference
Chapter 3/Supply, Demand, and the Market Process 53
Points for discussion
HINTS FOR ANSWERING CRITICAL ANALYSIS QUESTIONS
14. Questions for thought: What happened to the cost of producing calculators during the period?
How would this affect the supply curve and price of the calculators?
16. Business firms do have a strong incentive to serve the interest of consumers, but this is not