Chapter Three – Demand and Supply
What makes the price of coffee double in just two years and then fall by 50 percent? Why do some
prices rise, some fall, and some fluctuate? We explain how markets determine prices and why prices
Markets and Prices
A market is any arrangement that enables buyers and sellers to get information and do business with
each other. A competitive market is a market that has many buyers and many sellers so no single buyer
or seller can influence the price. The money price of a good is the amount of money that must be given
up to buy it. The opportunity cost of an action is the highest valued alternative forgone. The relative
price of a good which is the ratio of its money price to the money price of the next best alternative good
is its opportunity cost.
If you demand something, then you want it, can afford it and plan to buy it. Wants are the unlimited
desires or wishes people have for goods and services. Demand reflects a decision about which wants to
satisfy. The quantity demanded of a good or service is the amount that consumers plan to buy during a
particular time period, and at a particular price.
The law of demand states: Other things remaining the same, the higher the price of a good, the smaller
is the quantity demanded; and the lower the price of a good, the larger is the quantity demanded.
The law of demand results from substitution effect and income effect. Substitution Effect happens
when the relative price (opportunity cost) of a good or service rises, people seek substitutes for it, so the
quantity demanded of the good or service decreases. Income Effect happens when the price of a good
or service rises relative to income, people cannot afford all the things they previously bought, so the
quantity demanded of the good or service decreases.
The term demand refers to the entire relationship between
the price of the good and quantity demanded of the good. A
demand curve shows the relationship between the quantity
demanded of a good and its price when all other influences
on consumers’ planned purchases remain the same. A demand curve is also a willingness-and-ability-to-pay curve. Willingness to pay measures marginal
benefit. The smaller the quantity available, the higher is the price that someone is willing to pay for
When some influence on buying plans other than the price of the good, there is a change in demand.
The quantity of the good that people plan to buy changes at each and every price, so there is a new
demand curve. When demand increases, the demand curve shifts rightward. When demand decreases,
the demand curve shifts leftward. Six main factors that change demand are: The prices of related goods,
expected future prices, income, expected future income and credit, population and preferences.
Prices of related goods - A substitute is a good that can be used in place of another good. A complement
is a good that is used in conjunction with another good. When the price of substitute for an energy bar
rises or when the price of a complement of an energy bar falls, the demand for energy bars increases.
Expected future prices - If the expected future price of a good rises, current demand for the good
increases and the demand curve shifts rightward.
Income - When income increases, consumers buy more of most goods and the demand curve shifts
rightward. A normal good is one for which demand increases as income increases. An inferior good is a
good for which demand decreases as income increases.
Expected future income and credit - When expected future income increases or when credit is easy to
obtain, the demand might increase now.
Population - The larger the population, the greater is the demand for all goods.
Preferences - People with the same income have different demands if they have different preferences.
When there is a change in price, there is a change in the quantity demanded and therefore there is a
movement along the demand curve. If the price remains the same but one of the other influences on
buyers’ plans changes, there is a change in demand and the demand curve shifts. Supply
If a firm supplies a good or service, then the firm has the resources and the technology to produce it,
can profit from producing it and plans to produce and sell it. Resources and technology determine what
it is possible to produce. Supply reflects a decision about which technologically feasible items to
produce. The quantity supplied of a good or service is the amount that producers plan to sell during a
given time period at a particular price.
The law of supply states: Other things remaining the same, the higher the price of a good, the greater is
the quantity supplied; and the lower the price of a good, the smaller is the qua