Principles of Economics Chapter 3: Demand, Supply, and Market Equilibrium

© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
CHAPTERCHAPTER 33
Prepared by: Fernando QuijanoPrepared by: Fernando Quijano
and Yvonn Quijanoand Yvonn Quijano
Demand, Supply, andDemand, Supply, and
Market EquilibriumMarket Equilibrium

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
The Basic Decision-Making UnitsThe Basic Decision-Making Units
• AA firmfirm is an organization that transformsis an organization that transforms
resources (inputs) into products (outputs).resources (inputs) into products (outputs).
Firms are the primary producing units in aFirms are the primary producing units in a
market economy.market economy.
• AnAn entrepreneurentrepreneur is a person who organizes,is a person who organizes,
manages, and assumes the risks of a firm,manages, and assumes the risks of a firm,
taking a new idea or a new product andtaking a new idea or a new product and
turning it into a successful business.turning it into a successful business.
• HouseholdsHouseholds are the consuming units in anare the consuming units in an
economy.economy.

The Circular Flow of Economic ActivityThe Circular Flow of Economic Activity
• TheThe circular flow ofcircular flow of
economic activityeconomic activity showsshows
the connections betweenthe connections between
firms and households infirms and households in
input and output markets.input and output markets.

Input Markets and Output MarketsInput Markets and Output Markets
• Output, or product,Output, or product,
marketsmarkets are the marketsare the markets
in which goods andin which goods and
services are exchanged.services are exchanged.
• Input marketsInput markets are theare the
markets in whichmarkets in which
resources—labor, capital,resources—labor, capital,
and land—used toand land—used to
produce products, areproduce products, are
exchanged.exchanged.
• Payments flow in the oppositePayments flow in the opposite
direction as the physical flow ofdirection as the physical flow of
resources, goods, and servicesresources, goods, and services
(counterclockwise).(counterclockwise).

Input MarketsInput Markets
Input markets include:Input markets include:
• TheThe labor marketlabor market, in which households supply, in which households supply
work for wages to firms that demand labor.work for wages to firms that demand labor.
• TheThe capital marketcapital market, in which households supply, in which households supply
their savings, for interest or for claims to futuretheir savings, for interest or for claims to future
profits, to firms that demand funds to buy capitalprofits, to firms that demand funds to buy capital
goods.goods.
• TheThe land marketland market, in which households supply, in which households supply
land or other real property in exchange for rent.land or other real property in exchange for rent.

Determinants of Household DemandDeterminants of Household Demand
• TheThe price of the productprice of the product in question.in question.
• TheThe incomeincome available to the household.available to the household.
• The household’s amount ofThe household’s amount of accumulated wealthaccumulated wealth..
• TheThe prices of related productsprices of related products available to theavailable to the
household.household.
• The household’sThe household’s tastes and preferencestastes and preferences..
• The household’sThe household’s expectationsexpectations about futureabout future
income, wealth, and prices.income, wealth, and prices.
A household’s decision about the quantity of a particularA household’s decision about the quantity of a particular
output to demand depends on:output to demand depends on:

Quantity DemandedQuantity Demanded
• Quantity demandedQuantity demanded is the amountis the amount
(number of units) of a product that a(number of units) of a product that a
household would buy in a given timehousehold would buy in a given time
period if it could buy all it wanted atperiod if it could buy all it wanted at
the current market price.the current market price.

Demand in Output MarketsDemand in Output Markets
• AA demand scheduledemand schedule
is a table showingis a table showing
how much of a givenhow much of a given
product a householdproduct a household
would be willing towould be willing to
buy at different prices.buy at different prices.
• Demand curves areDemand curves are
usually derived fromusually derived from
demand schedules.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

The Demand CurveThe Demand Curve
• TheThe demand curvedemand curve isis
a graph illustratinga graph illustrating
how much of a givenhow much of a given
product a householdproduct a household
would be willing towould be willing to
buy at different prices.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

The Law of DemandThe Law of Demand
• TheThe law of demandlaw of demand
states that there is astates that there is a
negative, or inverse,negative, or inverse,
relationship betweenrelationship between
price and the quantityprice and the quantity
of a good demandedof a good demanded
and its price.and its price.
• This means thatThis means that
demand curves slopedemand curves slope
downward.downward.

Other Properties of Demand CurvesOther Properties of Demand Curves
• Demand curves intersectDemand curves intersect
the quantity (the quantity (XX)-axis, as a)-axis, as a
result of time limitations andresult of time limitations and
diminishing marginal utility.diminishing marginal utility.
• Demand curves intersectDemand curves intersect
the (the (YY)-axis, as a result of)-axis, as a result of
limited incomes and wealth.limited incomes and wealth.

Income and WealthIncome and Wealth
• IncomeIncome is the sum of all householdsis the sum of all households
wages, salaries, profits, interestwages, salaries, profits, interest
payments, rents, and other forms ofpayments, rents, and other forms of
earnings in a given period of time. It isearnings in a given period of time. It is
aa flowflow measure.measure.
• WealthWealth, or, or net worthnet worth, is the total value, is the total value
of what a household owns minus whatof what a household owns minus what
it owesit owes.. It is aIt is a stockstock measure.measure.

Related Goods and ServicesRelated Goods and Services
• Normal GoodsNormal Goods are goods for whichare goods for which
demand goes up when income isdemand goes up when income is
higher and for which demand goeshigher and for which demand goes
down when income is lower.down when income is lower.
• Inferior Goods are goods for which
demand falls when income rises.

Related Goods and ServicesRelated Goods and Services
• SubstitutesSubstitutes are goods that can serve asare goods that can serve as
replacements for one another; when thereplacements for one another; when the
price of one increases, demand for theprice of one increases, demand for the
other goes up.other goes up. Perfect substitutesPerfect substitutes areare
identical products.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.

Shift of Demand Versus Movement Along aShift of Demand Versus Movement Along a
Demand CurveDemand Curve
• A change inA change in demanddemand isis
not the same as a changenot the same as a change
inin quantity demandedquantity demanded..
• In this example, a higherIn this example, a higher
price causes lowerprice causes lower
quantity demandedquantity demanded..
• Changes in determinantsChanges in determinants
of demand, other thanof demand, other than
price, cause a change inprice, cause a change in
demanddemand, or a, or a shiftshift of theof the
entire demand curve, fromentire demand curve, from
DDAA toto DDBB..

• When demand shifts to
the right, demand
increases. This causes
quantity demanded to be
greater than it was prior to
the shift, for each and
every price level.
A Change in Demand Versus a Change inA Change in Demand Versus a Change in

A Change in Demand Versus a Change inA Change in Demand Versus a Change in
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).

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

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

From Household to Market DemandFrom Household to Market Demand
• Demand for a good or service can beDemand for a good or service can be
defined for andefined for an individual householdindividual household, or, or
for a group of households that make up afor a group of households that make up a
marketmarket..
• Market demandMarket demand is the sum of all theis the sum of all the
quantities of a good or service demandedquantities of a good or service demanded
per period by all the households buying inper period by all the households buying in
the market for that good or service.the market for that good or service.

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

Supply in Output MarketsSupply in Output Markets
• AA supply schedulesupply schedule is a tableis a table
showing how much of a productshowing how much of a product
firms will supply at differentfirms will supply at different
prices.prices.
• Quantity suppliedQuantity supplied represents therepresents the
number of units of a product thatnumber of units of a product that
a firm would be willing and able toa firm would be willing and able to
offer for sale at a particular priceoffer for sale at a particular price
during a given time period.during a given time period.
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
CLARENCE BROWN'S
SUPPLY SCHEDULE
FOR SOYBEANS

The Supply Curve andThe Supply Curve and
the Supply Schedulethe Supply Schedule
• AA supply curvesupply curve is a graph illustrating how muchis a graph illustrating how much
of a product a firm will supply at different prices.of a product a firm will supply 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
CLARENCE BROWN'S
SUPPLY SCHEDULE
FOR SOYBEANS

The Law of SupplyThe Law of Supply
• TheThe law of supplylaw of supply
states that there is astates that there is a
positive relationshippositive relationship
between price andbetween price and
quantity of a goodquantity of a good
supplied.supplied.
• This means thatThis means that
supply curvessupply curves
typically have atypically have a
positive slope.positive slope.
0
1
2
3
4
5
6
0 10 20 30 40 50
Thousands of bushels of soybeans
produced per year
Priceofsoybeansperbushel($)

Determinants of SupplyDeterminants of Supply
• TheThe priceprice of the good or service.of the good or service.
• TheThe costcost of producing the good, which inof producing the good, which in
turn depends on:turn depends on:
• TheThe price of required inputsprice of required inputs (labor,(labor,
capital, and land),capital, and land),
• TheThe technologiestechnologies that can be used tothat can be used to
produce the product,produce the product,
• TheThe prices of related products.prices of related products.

A Change in Supply VersusA Change in Supply Versus
a Change in Quantity Supplieda Change in Quantity Supplied
• A change inA change in supplysupply isis
not the same as anot the same as a
change inchange in quantityquantity
suppliedsupplied..
• In this example, a higherIn this example, a higher
price causesprice causes higherhigher
quantity suppliedquantity supplied, and, and
aa move alongmove along thethe
demand curve.demand curve.
• In this example, changes in determinants of supply, otherIn this example, changes in determinants of supply, other
than price, cause anthan price, cause an increase in supplyincrease in supply, or a, or a shiftshift of theof the
entire supply curve, fromentire supply curve, from SSAA toto SSBB..

• When supply shifts
to the right, supply
increases. This
causes quantity
supplied to be
greater than it was
prior to the shift, for
each and every price
level.

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).

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

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

• The operation of the marketThe operation of the market
depends on the interactiondepends on the interaction
between buyers and sellers.between buyers and sellers.
• AnAn equilibriumequilibrium is the conditionis the condition
that exists when quantity suppliedthat exists when quantity supplied
and quantity demanded are equal.and quantity demanded are equal.
• At equilibrium, there is no tendencyAt equilibrium, there is no tendency
for the market price to change.for the market price to change.

• Only in equilibrium isOnly in equilibrium is
quantity suppliedquantity supplied
equal to quantityequal to quantity
demanded.demanded.
• At any price levelAt any price level
other thanother than PP00, the, the
wishes of buyerswishes of buyers
and sellers do notand sellers do not
coincide.coincide.

Market DisequilibriaMarket Disequilibria
• Excess demandExcess demand, or, or
shortage, is the conditionshortage, is the condition
that exists when quantitythat exists when quantity
demanded exceedsdemanded exceeds
quantity supplied at thequantity supplied at the
current price.current price.
• When quantity demandedWhen quantity demanded
exceeds quantityexceeds quantity
supplied, price tends tosupplied, price tends to
rise until equilibrium isrise until equilibrium is
restored.restored.

Market DisequilibriaMarket Disequilibria
• Excess supplyExcess supply, or, or
surplus, is the conditionsurplus, is the condition
that exists when quantitythat exists when quantity
supplied exceeds quantitysupplied exceeds quantity
demanded at the currentdemanded at the current
price.price.
• When quantity suppliedWhen quantity supplied
exceeds quantityexceeds quantity
demanded, price tends todemanded, price tends to
fall until equilibrium isfall until equilibrium is
restored.restored.

Increases in Demand and SupplyIncreases in Demand and Supply
• Higher demandHigher demand leads toleads to
higher equilibrium price andhigher equilibrium price and
higher equilibrium quantity.higher equilibrium quantity.
• Higher supplyHigher supply leads toleads to
lower equilibrium price andlower equilibrium price and
higher equilibrium quantity.higher equilibrium quantity.

Decreases in Demand and SupplyDecreases in Demand and Supply
• Lower demandLower demand leads toleads to
lower price and lowerlower price and lower
quantity exchanged.quantity exchanged.
• Lower supplyLower supply leads toleads to
higher price and lowerhigher price and lower
quantity exchanged.quantity exchanged.

Relative Magnitudes of ChangeRelative Magnitudes of Change
• The relative magnitudes of change in supply andThe relative magnitudes of change in supply and
demand determine the outcome of market equilibrium.demand determine the outcome of market equilibrium.

Relative Magnitudes of ChangeRelative Magnitudes of Change
• When supply and demand both increase, quantityWhen supply and demand both increase, quantity
will increase, but price may go up or down.will increase, but price may go up or down.

Principles of Economics Chapter 3: Demand, Supply, and Market Equilibrium

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Principles of Economics Chapter 3: Demand, Supply, and Market Equilibrium