Economics Chapter-3 Department of EEE Bangladesh Army International University of Science & Technology

1. CHAPTERCHAPTER 3
Prepared by: Fernando QuijanoPrepared by: Fernando Quijano
and Yvonn Quijanoand Yvonn Quijano
© 2004 Prentice Hall Business Publishing© 2004 Prentice Hall Business Publishing Principles of Economics, 7/ePrinciples of Economics, 7/e Karl Case, Ray FairKarl Case, Ray Fair
Demand, Supply,
and Market Equilibrium
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Firms and Households:
The Basic Decision-Making Units
• A firm is an organization that
transforms resources (inputs) into
products (outputs). Firms are the
primary producing units in a market
economy.
• An entrepreneur is a person who
organizes, manages, and assumes the
risks of a firm, taking a new idea or a
new product and turning it into a
successful business.
• Households are the consuming units in
an economy.

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Input Markets and Output Markets:
The Circular Flow
• Product or output
markets are the markets
in which goods and
services are exchanged.
• Input markets are the
markets in which
resources—labor,
capital, and land—used
to produce products, are
exchanged.

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Input Markets and Output Markets:
The Circular Flow
• Input or factor markets
• The labor market, in which households supply
work for wages to firms that demand labor.
• The capital market, in which households supply
their savings, for interest or for claims to future
profits, to firms that demand funds to buy capital
goods.
• The land market, in which households supply
land or other real property in exchange for rent.

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Input Markets and Output Markets:
The Circular Flow
• The circular flow of
economic activity
shows how firms
and households
interact in input and
output markets.

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Input Markets and Output Markets:
The Circular Flow
• Goods and services flowGoods and services flow
clockwise. Firms provideclockwise. Firms provide
goods and services;goods and services;
households supply laborhouseholds supply labor
services.services.
• Payments (usually money)Payments (usually money)
flow in the oppositeflow in the opposite
direction (counterclockwise)direction (counterclockwise)
as the flow of laboras the flow of labor
services, goods, andservices, goods, and
services.services.

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Demand in Product/Output Markets
• The price of the product in question.
• The income available to the household.
• The household’s amount of accumulated wealth.
• The prices of other products.
• The household’s tastes and preferences.
• The household’s expectations about future.
• A household’s decision about the
quantity of a particular output to
demand depends on:

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Demand in Product/Output Markets
• Quantity demanded is the
amount (number of units)
of a product that a
household wishes to
purchase in a given time
period.

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Changes in Quantity Demanded
Versus Changes in Demand
• The most important relationship in
individual markets is that between
market price and quantity demanded.
• For this reason, we use the ceteris
paribus device, to examine the
relationship between the quantity
demanded of a good per period of time
and the price of that good, while holding
income, wealth, other prices, tastes, and
expectations constant.

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Changes in Quantity Demanded
Versus Changes in Demand
• Changes in price affect the
quantity demanded per period.
• Changes in income, wealth,
other prices, tastes, or
expectations affect demand.

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Price and Quantity Demanded:
The Law of Demand
• A demand schedule
is a table showing
how much of a given
product a household
would be willing to
buy at different prices.
• Demand curves are
usually derived from
demand schedules.
PRICE
(PER
CALL)
QUANTITY
DEMANDED
(CALLS PER
MONTH)
$ 0 30
0,50 25
3,50 7
7,00 3
10,00 1
15,00 0
ANNA'S DEMAND
SCHEDULE FOR
TELEPHONE CALLS

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Price and Quantity Demanded:
The Law of Demand
• The demand curve is
a graph illustrating
how much of a given
product a household
would be willing to buy
at different prices.
PRICE
(PER
CALL)
QUANTITY
DEMANDED
(CALLS PER
MONTH)
$ 0 30
0.50 25
3.50 7
7.00 3
10.00 1
15.00 0
ANNA'S DEMAND
SCHEDULE FOR
TELEPHONE CALLS

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Price and Quantity Demanded:
The Law of Demand
• The law of demand
states that there is a
negative, or inverse,
relationship between
price and the quantity
of a good demanded
and its price.
• This means that
demand curves slope
downward.

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Other Determinants
of Household Demand
i. Income and Wealth
• Income is the sum of all households
wages, salaries, profits, interest
payments, rents, and other forms of
earnings in a given period of time. It is a
flow measure.
• Wealth, or net worth, is the total value
of what a household owns minus what it
owes. It is a stock measure. It is
measured at a point in time.

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Other Determinants
of Household Demand
• Normal Goods are goods for which
demand goes up when income is
higher and for which demand goes
down when income is lower. (movie
tickets, shirts)
• Inferior Goods are goods for which
demand falls when income rises. (low
quality of meat, public transportation)

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Other Determinants
of Household Demand
ii. Prices of other goods and services
• Substitutes are goods that can serve
as replacements for one another; when
the price of one increases, demand for
the other goes up. Perfect substitutes
are identical products.
• Complements are goods that “go
together”; a decrease in the price of one
results in an increase in demand for the
other, and vice versa.

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Shift of Demand Versus
Movement Along a Demand Curve
• A change in demand is not
the same as a change in
quantity demanded.
• A higher price causes lower
quantity demanded and a
move along the demand
curve DA.
• Changes in determinants of
demand, other than price,
cause a change in demand,
or a shift of the entire
demand curve, from DA to DB.

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A Change in Demand Versus
a Change in Quantity Demanded
To summarize:
Change in price of a good or service
leads to
Change in quantity demanded
(Movement along the curve).
Change in income, preferences, or
prices of other goods or services
leads to
Change in demand
(Shift of curve).

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The Impact of a Change in Income
• Higher income
decreases the demand
for an inferior good
• Higher income
increases the demand
for a normal good

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The Impact of a Change
in the Price of Related Goods
• Price of hamburger rises
• Demand for
complement
good
(ketchup)
shifts left
• Demand for
substitute
good
(chicken)
shifts right
• Quantity of hamburger
demanded per month falls

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From Household
Demand to Market Demand
• Demand for a good or service can be
defined for an individual
household, or for a group of
households that make up a market.
• Market demand is the sum of all the
quantities of a good or service
demanded per period by all the
households buying in the market for
that good or service.

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From Household
Demand to Market Demand
• Assuming there are only two households in the
market, market demand is derived as follows:

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Supply in Product/Output Markets
• Supply decisions depend
on profit potential.
• Profit is the difference
between revenues and
costs.

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• A supply schedule is a
table showing how much
of a product firms will
supply at different prices.
• Quantity supplied
represents the number of
units of a product that a
firm would be willing and
able to offer for sale at a
particular price during a
given time period.
PRICE
(PER
BUSHEL)
QUANTITY
SUPPLIED
(THOUSANDS
OF BUSHELS
PER YEAR)
$ 1,20 0
1,75 10
2,25 20
3,00 30
4,00 45
5,00 45
AN INDIVIDUAL
FARMER'S SUPPLY
SCHEDULE FOR
SOYBEANS
Supply in Product/Output Markets

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Price and Quantity Supplied:
The Law of Supply
• AA supply curvesupply curve is a graph illustrating howis a graph illustrating how
much of a product a firm will supply permuch of a product a firm will supply per
period of time at different prices.period of time at different prices.
0
1
2
3
4
5
6
0 10 20 30 40 50
Thousands of bushels of soybeans
produced per year
Priceofsoybeansperbushel($)
PRICE
(PER
BUSHEL)
QUANTITY
SUPPLIED
(THOUSANDS
OF BUSHELS
PER YEAR)
$ 2 0
1,75 10
2,25 20
3,00 30
4,00 45
5,00 45
AN INDIVIDUAL
FARMER'S SUPPLY
SCHEDULE FOR
SOYBEANS

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Price and Quantity Supplied:
The Law of Supply
• The law of supply
states that there is a
positive relationship
between price and
quantity of a good
supplied.
• This means that
supply curves typically
have a positive slope.
0
1
2
3
4
5
6
0 10 20 30 40 50
Thousands of bushels of soybeans
produced per year
Priceofsoybeansperbushel($)

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Other Determinants of Supply
• The price of the good or service.
• The cost of producing the good,
which in turn depends on:
• The price of required inputs
(labor, capital, and land),
• The technologies that can be
used to produce the product,
• The prices of related products.

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• A higher price causesA higher price causes
higher quantityhigher quantity
suppliedsupplied, and a, and a
move alongmove along thethe
supplysupply curve.curve.
• A change in determinantsA change in determinants
of supply other than priceof supply other than price
causes ancauses an increase inincrease in
supplysupply, or a, or a shiftshift of theof the
entire supply curve, fromentire supply curve, from
SSAA toto SSBB..
Shift of Supply Versus
Movement Along a Supply Curve

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• In this example, since the
factor affecting supply is not
the price of soybeans but a
technological change in
soybean production, there is
a shift of the supply curve
rather than a movement
along the supply curve.
• The technological advance means that
more output can be supplied for at any
given price level.
Shift of Supply Curve for Soybeans
Following Development of a New Seed Strain

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To summarize:
Change in price of a good or service
leads to
Change in quantity supplied
(Movement along the curve).
Change in costs, input prices, technology, or prices of
related goods and services
leads to
Change in supply
(Shift of curve).
Shift of Supply Versus
Movement Along a Supply Curve

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From Individual
Supply to Market Supply
• The supply of a good or service can
be defined for an individual firm, or
for a group of firms that make up a
market or an industry.
• Market supply is the sum of all the
quantities of a good or service
supplied per period by all the firms
selling in the market for that good or
service.

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From Individual
Supply to Market Supply
• As with market demand, market
supply is the horizontal summation
of individual firms’ supply curves.

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Market Equilibrium
• Market equilibrium is
the condition that exists
when quantity supplied
and quantity demanded
are equal.
• At equilibrium, there is no
tendency for the market
price to change.

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Market Equilibrium
• Only in equilibrium is
quantity supplied
equal to quantity
demanded.
• At any price levelAt any price level
other thanother than PP00, such as, such as
PP11, quantity supplied, quantity supplied
does not equaldoes not equal
quantity demanded.quantity demanded.

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Excess Demand
• Excess demand, or
shortage, is the condition
that exists when quantity
demanded exceeds
quantity supplied at the
current price.
• When quantity demanded
exceeds quantity supplied,
price tends to rise until
equilibrium is restored.

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Excess Supply
• Excess supply, or surplus,
is the condition that exists
when quantity supplied
exceeds quantity demanded
at the current price.
• When quantity supplied
exceeds quantity demanded,
price tends to fall until
equilibrium is restored.

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Changes in Equilibrium
• Higher demand leads to
higher equilibrium price and
higher equilibrium quantity.
• Higher supply leads to
lower equilibrium price and
higher equilibrium quantity.

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Changes in Equilibrium
• Lower demand leads to
lower price and lower
quantity exchanged.
• Lower supply leads to
higher price and lower
quantity exchanged.