MacroeconomicsChapter 3: Where Prices Come From – The Interaction of Demand and Supply

Perfectly competitive market: Market where there are many buyers and sellers, all the products sold are identical, no barriers to new firms entering the market

Supply and demand model often successful in predicting changes in quantities and prices

Demand Side of the Market Demand is what a consumer wants to buy AND is capable of buying Demand Schedules and Demand Curves

o Demand schedules: table that shows the relationship between the price of a product and the quantity of the product demanded

o Quantity demanded: Amount of a good or serve that a consumer is willing and able to purchase at a given price

o Demand curve: Relationship between price and quantityo Market demand: Represented by demand curve, demand by all the

consumers of a given good or service

Law of demand: Inverse relationship between price and quantity due to a combination of the substitution effect and the income effect

o Holding everything else constant except price – when price falls, demand goes up and vice versa

o Substitution effect: change in the quantity demanded of a good that results from the effect of a change in the price making the good more or less expensive relative to other goods that are substitutes

o Income effect: Purchasing power increases as price of goods fall and income of consumers remains constant (or increases)

Ceteris paribus condition: Holding everything else constant

Variables that Shift Market Demando Income: As income increases, so does demand for a good (normally)

Normal good: Demand increases for this good when income increases (whole grain pasta)

Inferior good: Demand decreases for this good as income increases (instant noodles)

o Prices of Related Goods Substitutes: Goods and services that can be used for the same

purpose Can buy a substitute in place of a specific good; when substitute

prices go up, demand curve shifts to the right, and vice versa EX: tablets drove the demand curve of e-readers to the left

Complements: Goods and services used together When demand increases for one, demand for the other

increases as well EX: Smartphones and apps

o Tastes Strong advertising makes consumers more willing to spend more,

and the demand curve shifts to the right. When consumer taste increases, demand curve shifts to the right,

and vice versao Population and demographics

Characteristics of a population with respect to age, race, and gender that can affect the demand curve.

o Expected future prices If prices are expected to rise, consumers will buy more of the

good now to save money; demand curve shifts to the right. Opposite applies if prices are expected to fall

o See table 3.1 on page 76

A Change in Demand VS a Change in Quantity Demandedo Change in demand: shift in the demand curve, that is, a change in a

variable other than priceo Changed in the quantity demanded: Movement along the demand curve

and a change in price

The Supply Side of the Market Quantity supplied: the amount of a good or service that a firm is willing and able

to supply at a given priceo Ex: holding all other variables constant, when the price of goods

increases, profit increases, and so does quantity supplied Supply schedule and Supply Curves

o Supply schedule: table that shows the relationship between the price of a product and the quantity of the product supplied

o Supply curve: curve that shows the relationship between the price of a product and the quantity of the product supplied

The Law of Supply: Market supply curve should slope upward; holding everything else constant, increases in price cause increases in price

Variables that Shift Market Supplyo Prices of Inputs

Input: anything used in the production of a good or service As input increases, supply decreases

o Technological change: Positive or negative change in the ability of a firm to produce a given level of output with a given quantity of inputs

Positive change = increase in productivity = increase in quantity supplied (opposite for negative)

o Prices of Substitutes in Production Substitutes in production: Alternative products that a firm could

produce Ex: If smartphones are more profitable to make than tablets, the

supply curve for smartphones will shift to the righto Number of Firms in the Market

When new firms enter the market, supply curve shifts to the right because there is another producer of the good/ service

o Expected Future Prices If product price is expected to increase in the future, a firm will

hold off on supplying all of its goods at the moment and wait until the prices go up, supply curve will shift to the left

If input prices are expected to drop, a firm may wait to produce more in an effort to save money

o See graph 3.2 on page 81

A change in supply versus a change in the quantity supplied (similar to demand)o Change in supply: Shift of the supply curve when a variable other than

price changeso Change in quantity supplied: movement along the supply curve as a result

of a change in product price

Market Equilibrium: Putting Demand and Supply Together Market equilibrium: Point at which quantity demanded equals quantity supplied Competitive market equilibrium: Market equilibrium with many buyers At any other price of quantity, no other economic unit will make a different

decision – both firms and consumers are happy

How markets eliminate surpluses and shortageso When quantity supplied is greater than demand, a surplus occurs. This

can happen when the price of a good, set by a firm, is above the equilibrium point

With goods piling up, firms must slash prices to increases sales, which will push the market towards equilibrium – the market will only reach equilibrium when the price of the product set by the firm is the equilibrium price.

o When quantity supplied is less than the demand, a shortage occurs. This can happen if price set by a firm is below the equilibrium price.

With a shortage of goods, firms will increase prices which will push the market back to equilibrium – the market will only reach equilibrium of the price set by firms is the equilibrium price.

o “At a competitive equilibrium, all consumers willing to pay the market price will be able to buy as much of the product as they want, and all firms willing to accept the market price will be able to sell as much of the product as they want. AS a result, there will be no reason for the price to change unless either the demand curve or supply curve shifts”

o Demand and supply go hand in hand

The Effect of Demand and Supply Shifts on Equilibrium The effect of shifts in demand AND supply on equilibrium

o See figure 3.11 and table 3.3 on page 88 (below)

Shifts in a curve versus movements along a curve Changes in price do not shift curves For demand or supply to increase or decrease, the entire curve must shift due to

another variable