Chapter 3 – Demand and Supply
Markets and Prices
Amarket has two sides: buyers and sellers. Most markets are unorganized collection of buyers
and sellers. Markets vary in the intensity of competition that buyers and sellers face.
In everyday life, the price of an object is the number of dollars that must be given up in exchange
for it. Economists refer to this price as a money price.
The opportunity cost of an action is the highest valued alternative forgone. The ratio of one price
to another is called a relative price and a relative price is an opportunity cost. The normal way of
expressing a relative price is in terms of a “basket” of all goods and services. To calculate this
relative price, we divide the money price of a good by the money price of “basket” of all goods
(called a price index). The resulting relative price tell us the opportunity cost of the good in terms
of how much of the “basket” we must give up to buy it.
If you want something, then you
1. Want it.
2. Can afford it, and
3. Plan to buy it.
Demand reflects a decision which wants to satisfy. The quantity demanded of a good or service is
the amount that consumers plan to buy during a given period of time at a particular price. The
quantity demanded is measured as an amount per unit of time. We look first at the relationship
between the quantity demanded of a good and its price. We ask: How, other things remaining the
same, does the quantity demanded of a good change as its changes? The Law of Demand
provides the answer. 2
Law of Demand
The Law of Demand states
Other things remaining the same, the higher the price of a good, the smaller id the
quantity demanded; and the lower the price of a good, the greater is the quantity demanded.
Why does the higher price reduce the quantity demanded? For two reasons:
Substitution Effect – When the price of a good rises, other things remaining the same, its
relative price, its opportunity cost, rises.As the opportunity cost of a good rises, the
incentive to economize on its use and switch to a substitute becomes stronger.
Income Effect When a price rises, other things remaining the same, the price rises relative
to income. Faced with a higher price and an unchanged income, people cannot afford to
buy all the things they previously bought. They must decrease the quantities demanded.
The term demand refers to the entire relationship between the price of a good and the
quantity demanded of that good. Demand is illustrated by demand the curve and the demand
schedule. The term quantity demanded refers to a point on a demand curve – the quantity
demanded at a particular price.
Ademand 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 schedule lists the quantities demanded at each price, when all the other influences
on consumers’planned purchases remain the same. 3
The points on the demand curve corresponds to the rows of the demand schedule. 4 5
Another way of looking at the demand curve is a willingness-and-ability-to-pay curve. The
willingness and ability to pay is a measure of marginal benefit.
When any factor that influences the buying plans changes, other than the price of the good,
there is a change in demand. When demand increases, the demand curve shifts rightward,
and the quantity demanded at each price is greater. 6
Six main factors bring changes in demand. They are changes in
The prices of related goods Asubstitute is a good that can be used instead of another
good. If the prise of the substitude rises, then people will buy less of a substitude
good and the demand for the original good will increase.Acompliment is a good that
used in conjunction with another good. If the price of the complement good falls, the 7
people will by more of the complement and more of the original good, thus the
quantity demanded for original good will increase.
Expected future prices If the expected future price of the good rises and if the good
can be stored, the opportunity cost of obtaining the good for future use is loewr today
then it will be in the future. They buy more of the good now, so the dmand for the
good today increases. Similary, if the future expected price of the good falls, then
opportunity cost of the good buying today is high relative then it is expected to be in
the future, so the demand decreases today and increases in the future.
Income Consumer income influences demand. When income increases, consumer
buy more of the most goods.Anormal good is one for which demand increases as
income increases. An inferior good is one for which decreases as income increases.
Expected future income and credit When expected future income increases or
credit becomes easier to get, demand for the good might increase now.
Population Demand also depends on the size and structure of the population. The
larger the population, the greater the demand for all goods and services
Preferences Demand depends on preferences. Preferences dtermine the value that
people place on each good and service.
Changes in the influences on the buying plans bring either a change in the quantity demanded or
a change in demand. Apoint on the demand curve shows the quantity demanded at a given price,
so a movement along the demand curve shows a change in the quantity demanded. The shift of
the demand curve shows a change in demand. 8 9
If a firm supplies good or service, the firm
1. Has the resources and technology to produce it.
2. Can profit from producing it, and
3. Plans to produce it and sell it 10
Supply reflects a decision about which technologically feasible items to produce. The quantity
supplied of a good or service is the amount producers plan to sell during a given time period of a
particular price. The quantity supplied is not the necessary the same amount as the quantity
actually sold. We look first at the relationship between the quantities supplied of the good and its
price. The question: How does the quantity supplied of a good change as its price changes when
other things when other things remain the same?
The Law of Supply
The law of supply states:
Other things remain the same, the higher the price of a good, the greater is the quantity
supplied; and the lower the price of the good, the smaller is the quantity supplied.
Why does a higher price increase the quantity supplied? It is because marginal cost increases.As
the quantity produced of any good increases, the marginal cost of producing the good increases.
When the price of a good rises, other things remaining the same, producers are willing to incur a
higher marginal cost so they increase production
Supply Curve and Supply Schedule
The term supply refers to the entire relationship between the price of a good and the quantity
supplied of it. Supply is illustrated by the supply curve and the supply schedule. The term
quantity supplied refers to a point on the supply curve – the quantity supplied at a particular
price. Asupply curve shows the relationship between the quantities supplied of a good and its
price when all other influences on producers’planned sales remain the same. 11 12
Asupply schedule lists the quantities supplied at each price when all the other influences on
producers’planned sales remain the same. To make a supply curve we graph the quantity
supplied on x-axis and the price on y-axis.
The supply curve can be interpreted as a minimum-supply-price curve – a curve that shows the
lowest price at which someone is willing to sell. This lowest price is the marginal cost. If a small
quantity is produced, the lowest price at which someone is willing to sell one more unit is low.
But as the quantity produced increases, the marginal cost of each additional unit rises, so the
lowest price at which someone is willing to sell an additional unit rises along the supply curve.
A Change in Supply
When any factor that influences selling plans other than the price of the good changes, there is a
change in supply. Six main factors bring changes in supply.
The prices of factors of production – If the price of a factor of production rises, the
lowest price that a producer is willing to accept for that good rises, so supply decreases.
The prices of related goods produced – If the price of good2 rises, firms switch
production from good1 to good2. The supply of good1 decreases (good1 and good2 are
substitutes in production – can be produced using the same