Unit 2: The Market Forces of Demand and Supply—The Basics
2.1.1 Markets and Competition
The government may have a limited role in the direct production of goods and services, but
it will determine the institutional arrangements—the rules of the game—within which
markets operate. These institutional arrangements are critical for economic success.
Markets cannot function effectively without a stable and secure set of economic and political
institutions. Some societies have been much more successful than others in finding the
correct institutional framework that will promote economic development. ―Pure‖ market
economy has never existed. Thousands of economic decisions are made each day outside of
markets. Corporations, for example, would not exist in a ―pure‖ market economy, as a
corporation organizes production on the basis of internal decision rules, not markets.
The textbook authors identify the main characteristics of a perfectly competitive market:
i. The goods are all the same.
ii. There are so many buyers and sellers that no single buyer or seller can influence the
iii. Buyers and sellers ―must accept the price the market determines,‖ so they are
considered to be price takers.
2.2.1 The Law of Demand
Many factors might influence how much of a particular good or service consumers will
purchase—the income of the consumer, his or her tastes and preferences, the price of the
good in question, the prices of other goods perhaps, and expectations about future events.
Economists begin by focusing on the relationship between the amount of a good consumers
are willing and able to purchase and the price of that good. This doesn’t mean that other
factors are not important, but merely that we will assume, for the moment, that these other
factors are not changing. This allows us to explore the relationship between price and
We define demand as a schedule or curve showing the amount of a good or service
consumers are able and willing to purchase at a set of possible prices during a specified
period of time.
The Law of Demand states simply that there is an inverse or negative relationship
between price and quantity demanded, all else equal. The ―all else equal‖ statement merely
means that we are holding others factors constant; that is, we are making a statement
about demand assuming that all other factors do not change. This law appears to be quite
reasonable. It states that, other things equal, as the price of a good falls, the amount consumers will purchase will rise.
Figure 2.1: Demand for movie tickets
Demand can be represented on a simple
graph. Figure 2.1, left, shows the demand
for movie tickets per week in St. Albert,
AB. The demand curve slopes downward.
At a relatively high price of $8 per ticket,
the theatres only sell 600 tickets per
week. If the price drops to $4 per ticket
however, the theatres will sell 1,000
tickets per week. At the higher price,
consumers decide to visit movie theatres
less often and to spend some of their
dollars elsewhere (at the video rental
store perhaps). Consumers face a range
of choices, and if the price of one good
rises, they will tend to consume less of it.
Price may be the most important factor influencing the quantity demanded, but it is not the
only factor. At all prices, demand is likely to change if
a. incomes change
b. consumer preferences change
c. the prices of related goods change
d. the number of consumers change
e. consumer expectations about future prices and incomes change.
How shall we go about introducing such factors? We begin by recognizing that if one of the
above five factors change, it will shift the entire demand curve. For example, if incomes
rise, we would expect that the amount consumers wish to purchase, at all prices, will rise as
well. Similarly, if the number of consumers in the market increases, then at each price, the
total quantity that all consumers would like to purchase will rise.
These five factors are the major determinants of demand. If a determinant of demand
changes, then the entire demand curve will shift, either to the left or the right.
It is very important that you are able to distinguish between a movement along a fixed or
given demand curve and a shift in the entire demand curve—many students are confused by
Remember If the price of X changes it can only cause a movement along a fixed demand curve
for X. It cannot shift the demand curve for X.
If one of the five determinants of demand changes, it can only cause the entire
demand curve to shift outward or inward. It cannot cause a movement along a fixed
Consider Figure 2.2, below. D i1 the initial demand curve for television sets. Now, let us
assume that incomes rise by 20 percent. The rise in incomes causes the entire demand
curve to shift to the right, to 2 .
Figure 2.2: Demand for television sets
Reread pages 73–77 of the textbook to review how the other determinants of demand cause
the demand curve to shift.
Note: It is important to remember that when price falls and, therefore, consumers purchase
more of a good, we do not say that demand has increased, but rather that the quantity
demanded has increased. This is shown as a movement along a fixed demand curve, not a
shift in the demand curve. However, if one of the determinants of demand changes, then
the entire demand curve will shift.
We will soon present a simple demand and supply model. You will need to be able to use
this model to predict how market price and market quantity change when you are given a
specific change in economic circumstances.
You should follow this procedure when faced with this kind of problem.
1. Draw your own demand and supply diagram.
2. Determine if the change presented will cause the demand curve or the supply curve
3. Using your diagram, draw the new demand or supply and calculate the new market
price and quantity.
You will be given many opportunities to practice this model in this course. 2.3.1 Law of Supply
The Law of Supply states that as price increases, other things equal, the quantity of a
good or service firms are able and willing to supply will increase. The law of supply is shown
in Figure 2.3, below. S (the red line) is called the supply curve. It shows that at the
relatively low price of $2 per kg, firms will only supply 10,000 kg per week, but if the price
were higher, say $5 per kg, firms would be willing to supply 30,000 kg per week.
Figure 2.3: Supply of sugar
When we say that firms will produce more if prices are higher, we must again invoke the
assumption of ―other things equal,‖ which means, as before, that we are assuming that
other variables are constant, or unchanging.
Determinants of Supply
There are five determinants of supply:
factor or input prices
prices of other related goods
the number of sellers in the market
future price expectations.
If one of these determinants changes, if will cause the entire supply curve to shift either left
2.4.1 Market Equilibrium
Economists sometimes say that the forces of demand interact with the forces of supply to
produce two r