CHAPTER 1 - THE ART AND SCIENCE OF ECONOMIC ANALYSIS



CHAPTER 3 – DEMAND AND SUPPLY ANALYSIS (6e)

Demand

Definition:

A. Law of Demand

What is the most likely relationship between the price of a good and the quantity demanded of that good? The answer is found in the law of demand.

Definition:

Two explanations of the law of demand:

The substitution effect:

The income effect:

Demand Schedule and Demand Curve

Demand may be expressed as a:

Demand schedule (a table indicating prices and quantities demanded for a good)

See Ex. 1(a)

Demand curve (a graph of a demand schedule)

See Ex. 1(b)

The demand curve typically has a downward (negative) slope because of the law of demand, which holds that a higher price will result in a smaller quantity demanded and a lower price will result in a greater quantity demanded.

IMPORTANT TERMINOLOGY DISTINCTION— Quantity Demanded (QD) versus Demand (D):

WARNING: The information in the following two paragraphs may seem easy to you at first, but these are concepts with which many students actually have a great deal of difficulty in practice! It would be wise to study this material VERY CAREFULLY!

Quantity demanded (QD) refers to a particular quantity demanded at a particular price. Quantity demanded is represented by an individual point on the demand curve or row on the demand schedule. When there is a change in the price of the good, this causes a change in quantity demanded and is shown by a movement along the demand curve from one point to another. A movement down to the right along a demand curve represents an increase in quantity demanded in response to a decrease in price, while a movement up to the left along a demand curve represents a decrease in quantity demanded in response to an increase in price.

Demand (D) refers to the entire relation between price and the amount of a good demanded. Demand is represented by the complete D schedule or D curve. When there is a change in some factor other than the price of the good, this causes a change in demand and is shown by a shift of the demand curve. A rightward shift indicates an increase in demand, while a leftward shift indicates a decrease in demand. (See Section II below.)

Shifts of the Demand Curve

The law of demand says that as P decreases, QD increases, and as P increases, QD decreases, all else being equal or other things constant. What happens when all else is not equal or constant? In other words, what happens when something other than a price change affects consumers’ demand for a good?

The major factors that can affect demand (thus shifting the demand curve) are:

A. Changes in Consumer Income

See Ex. 2

Exactly how a change in income affects demand depends on whether the good is a “normal good” or an “inferior good”.

1) Normal good

Definition:

Examples:

2) Inferior good

Definition:

Examples:

Changes in the Prices of Related Goods

We will deal mostly with pairs of goods that are either:

1) Substitutes

Definition:

Examples:

2) Complements

Definition:

Examples:

B. Changes in Consumer Expectations

Examples:

C. Changes in the Number or Composition of Consumers

D. Changes in Consumer Tastes

Supply

Definition:

A. Law of Supply

The most likely relationship between the price of a good and the quantity supplied of that good is found in the law of supply.

Definition:

B. Supply Schedule and Supply Curve

Supply may be expressed as a:

Supply schedule (a table indicating prices and quantities supplied for a good)

See Ex. 3(a)

Supply curve (a graph of the supply schedule)

See Ex. 3(b)

The supply curve typically has an upward (positive) slope because of the law of supply, which holds that a higher price will result in a greater quantity supplied and a lower price will result in a smaller quantity supplied.

IMPORTANT TERMINOLOGY DISTINCTION— Quantity Supplied (QS) versus Supply (S):

WARNING: The same warning applies here; that is, the information in the following two paragraphs may seem easy to you at first, but these are concepts with which many students actually have a great deal of difficulty in practice! It would be wise to study this material VERY CAREFULLY!

Quantity supplied (QS) refers to a particular quantity supplied at a particular price. Quantity supplied is represented by an individual point on the supply curve or row on the supply schedule. When there is a change in the price of the good, this causes a change in quantity supplied and is shown by a movement along the supply curve from one point to another. A movement up to the right along a supply curve represents an increase in quantity supplied in response to an increase in price, while a movement down to the left along a supply curve represents a decrease in quantity supplied in response to a decrease in price.

Supply (S) refers to the entire relation between price and the amount of a good supplied. Supply is represented by the complete S schedule or S curve. When there is a change in some factor other than the price of the good, this causes a change in supply and is shown by a shift of the supply curve. A rightward shift indicates an increase in supply, while a leftward shift indicates a decrease in supply. (See Section IV below.)

Shifts of the Supply Curve

The law of supply says that as P increases, QS increases, and as P decreases, QS decreases, all else being equal or other things constant. What happens when all else is not equal? In other words, what happens when something other than a price change affects producers’ supply of a good?

The major factors that can affect supply (thus shifting the supply curve) are:

A. Changes in Technology

See Ex. 4

Examples:

Changes in the Prices of Relevant Resources

Definition of “relevant resources”:

Examples:

Changes in the Prices of Alternative Goods

Definition of “alternative goods”:

Examples:

Changes in Producer Expectations

Examples:

Changes in the # of Producers

Demand and Supply Create a Market

Market Equilibrium

Definition:

See Ex. 5

Market Disequilibrium: SURPLUS

Definition:

See Ex. 5

Market adjustments:

Market Disequilibrium: SHORTAGE

Definition:

See Ex. 5

Market adjustments:

Changes in Equilibrium Price (Pe) and Equilibrium Quantity (Qe)

A change in one or more of the determinants of demand or supply will lead to a change in Pe and in Qe.

Shifts of the Demand Curve

(See Section II above for factors that change demand, i.e., that shift the demand curve.)

See Ex. 6

Learn this rule: Given an upward-sloping supply curve, a rightward shift of the demand curve will lead to an increase in Pe and an increase in Qe, while a leftward shift of the demand curve will lead to a decrease in Pe and a decrease in Qe.

Shifts of the Supply Curve

(See Section IV above for factors that change supply, i.e., that shift the supply curve.)

See Ex. 7

Learn this rule: Given a downward-sloping demand curve, a rightward shift of the supply curve will lead to a decrease in Pe and an increase in Qe, while a leftward shift of the supply curve will lead to an increase in Pe and a decrease in Qe.

A. Simultaneous Shifts of Demand and Supply Curves

When the demand and supply curves shift at the same time, the impact on equilibrium price and quantity depends on the directions of the shifts and on which curve shifts more.

See Ex. 8

Be able to answer questions like the following: Suppose the demand for pizzas increases dramatically while the supply of pizzas increases only slightly. What will happen to the equilibrium quantity of pizzas? What will happen to the equilibrium price of pizzas? (Hint: draw a graph!)

Disequilibrium Prices

A market is in disequilibrium when QD does not equal QS at the prevailing price. Usually the resulting shortages or surpluses put upward or downward pressure on the price until equilibrium is restored.

But what if the price is not allowed to rise or fall? For example, what if the government imposes a price floor or a price ceiling?

A. Price Floor

Definition:

See Ex. 11(a)

Result:

Price Ceiling

Definition:

See Ex. 11(b)

Result:

END

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