Supplemental Unit 1. Demand, Supply, and Adjustments to
Note: The authors recommend that this feature be read along with Part I, Elements 6, 7, and
11 of Common Sense Economics.
Common Sense Economics highlights how markets work and their impact on the allocation of
resources. This feature will investigate this issue in more detail. It will use graphical analysis
to analyze demand, supply, determination of the market price, and how markets adjust to
The law of demand states that there is a negative relationship between the price of a good and the
quantity purchased. It is merely a reflection of the basic postulate of economics: when an action
becomes more costly, fewer people will choose it. An increase in the price of a product will make it
more costly for buyers to purchase it, and therefore less will be purchased at the higher price.
The availability of substitutes—goods that perform similar functions—underlies the law of
demand. No single good is absolutely essential; everything can be replaced with something else. A
chicken sandwich can be substituted for a cheeseburger. Wheat, oats, and rice can be substituted for
corn. Going to the movies, playing tennis, watching television, and going to a football game are
substitute forms of entertainment. When the price of a good increases, people will turn to substitutes
and cut back on their purchases of the more expensive good. This explains why there is a negative
relationship between price and the quantity of a good demanded.
Exhibit 1 provides a graphic illustration of the law
of demand. Price is measured on the Y-axis and
quantity on the X-axis. The demand curve will slope
downward to the right, because when the price falls,
consumers will purchase a larger quantity.
Correspondingly, an increase in price will cause
buyers to reduce the quantity of their purchasesThe
demand curve isolates the impact of price.
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Other factors that might influence the choices of consumers are held constant. For example,
factors like consumer income, price of related goods, expectations about the future price, and the
preferences of consumers are held constant when the demand
curve is constructed. Changes in these factors will shift the
entire demand curve.
Using beefsteak as an example, Exhibit 2 illustrates an
increase in demand, a shift in the demand curve to the right.
Think how the demand for beefsteak would be affected by an
increase in consumer income or an increase in the prices of
substitute goods like pork, chicken, or turkey. When consumer
income increases or substitute goods become more expensive,
consumers will buy more beefsteaks. This will increase the
demand for beefsteak, causing the demand curve to shift to the right as shown in Exhibit 2.
Economists refer to this shift of the entire demand curve to the right as an ―increase in demand.‖ This
increase in demand should not be confused with an ―increase in quantity demanded,‖ a movement
along the same demand curve in response to a lower price.
Now consider what would happen to the demand for beefsteak if there was a reduction in
consumer income or a decrease in the price of the substitute goods. These changes would lead to a
decrease in the demand for beef, a shift in the entire curve to the left. As we proceed, we will consider
how both increases and decreases in demand affect the market price. But before we can do that, we
must consider the supply side of markets.
The law of supply states that there is a positive relationship between the price of a good and the
quantity of it that producers will supply. Business firms and other producers purchase resources and
combine them into goods and services. The resources have alternative uses so producers will have to
pay resource owners a price sufficient to attract them from other potential users. Thus, product
suppliers will incur costs as they purchase resources. Producers
are in business to make a profit. In order to do so, they will have to
supply products that can be sold for a price that is greater than the
costs of the resources required for their production. As product
prices increase, suppliers will find it profitable to supply more and
more units. This accounts for the direct relationship between the
price of a product and the quantity supplied by producers.
Exhibit 3 displays the supply curve. It indicates the
quantity of a good that producers are willing to supply at alternative
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prices. The law of supply states that this relationship is positive – that producers will supply a larger
quantity as the price of a good rises. Thus, the supply curve for a good or service, beefsteak for
example, will slope upward to the right.
As the price of beefsteak increases, beef producers will find it profitable to produce larger
quantities. The upward sloping supply curve reflects the fact that the incentive of producers to supply
beef (or any other product) increases as its price rises.
As in the case of demand, other things are held constant when the supply curve is
constructed. Put another way, the supply curve isolates the impact of price on the amount supplied.
However, changes in factors that influence costs will affect the position of the supply curve. Factors
that increase the cost of producing a good will cause the supply curve to shift to the left. For example,
an increase in feed grain prices will make it more expensive for farmers to produce cattle.
As Exhibit 4 shows, the higher costs will ―decrease supply,‖
shift the entire curve to the left. More generally, factors like higher
resource prices or taxes that increase the cost of supplying a good
will reduce the market supply of a good.
On the other hand, changes that reduce the cost of
producing a good will shift the supply curve to the right. For
example, an improvement in technology that makes it possible for
producers to achieve a lower per unit costs, will increase supply
(shift the curve to the right).
Demand, Supply, and the Determination of the Market Price
The forces of demand and supply combine to determine the market price. As Exhibit 5 shows, there
will be a tendency for price to move toward a level like $8 per pound, which will bring the quantity
demanded by consumers into equality with the quantity supplied by producers. This price, where the
demand and supply curves intersect, is often referred to as the
―equilibrium‖ or ―market clearing‖ price.
Consider the equilibrium price $8 per pound in Exhibit 5.
What would happen if the price was higher than $8 per pound?
At prices higher than the market clearing price, producers will
want to supply a larger quantity than consumers are willing to
purchase. This would lead to an excess supply and place
downward pressure on price. Thus, above equilibrium prices will
not be sustainable.
On the other hand, if the price was less than $8 per
pound, there would be an exces