Supply and Demand: Theory 33

CHAPTER 3
Supply and Demand: Theory

One of the most famous and widely used theories in economics is the theory of supply and
demand. This chapter examines supply and demand and the factors that affect supply and
demand. It discusses disequilibrium and movements to market equilibrium, and how changes in
factors affect the market equilibrium.

 CHAPTER OUTLINE
I. INTRODUCTION

A market is any place people come together to trade. Economists often say that every
market has two sides: a buying side and a selling side. The buying side of the market is
usually referred to as the demand side; the selling side is usually referred to as the
supply side.

II. WHAT IS DEMAND?

Demand refers to the willingness and ability of buyers to purchase different quantities of
a good at different prices during a specific time period.

A. The Law of Demand

The law of demand states that as the price of a good rises, the quantity
demanded of the good falls, and as price falls, quantity demanded rises, ceteris
paribus.

B. Four Ways to Represent the Law of Demand

The law of demand can be represented in words, in symbols, in a demand

schedule, and as a demand curve in a price-quantity plane.

C. Why Does Quantity Demanded Go Down as Price Goes Up?

The first reason for the inverse relationship between price and quantity
demanded is that people substitute lower priced goods for higher priced goods.
The second reason has to do with the law of diminishing marginal utility, which
states that for a given time period, the marginal utility gained by consuming equal
successive units of a good will decline as the amount consumed increases.

D. Individual Demand Curve and Market Demand Curve

An individual demand curve represents the price-quantity combinations of a

particular good for a single buyer, while a market demand curve represents the
same thing for all buyers.

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or posted to a publicly accessible website, in whole or in part.
34 Chapter 3

E. A Change in Quantity Demanded Versus a Change in Demand

A “change in quantity demanded” is not the same as a “change in demand.”

Quantity demanded is the number of units of a good that individuals are willing
and able to buy at a particular price, and changes when the price of the good
changes. A change in quantity demanded is represented by a movement from
one point to another point on the same demand curve. The entire demand curve
represents demand. When demand increases, the entire demand curve shifts
rightward. When demand decreases, the entire demand curve shifts leftward.

F. What Factors Cause the Demand Curve to Shift?

Changes in income, preferences, prices of related goods, the number of buyers,

or expectations of future price will cause the demand curve to shift.

G. Movement Factors and Shift Factors

Economists often distinguish between (1) factors that can move us along curves
and (2) factors that can shift curves. The factors that move us along curves are
sometimes called movement factors. In many economic diagrams the movement
factor is on the vertical axis. The factors that actually shift the curves are
sometimes called shift factors. Often, the shift factors do not appear in the
economic diagrams. We just know what they are and that they can shift the
demand curve.

III. SUPPLY

Supply refers to the willingness and ability of sellers to produce and offer to sell different
quantities of a good at different prices during a specific time period.

A. The Law of Supply

The law of supply states that as the price of a good rises, the quantity supplied of
the good rises, and as price falls, quantity supplied falls, ceteris paribus. The law
of supply does not hold if there is no time to produce more units, or if no more
can be produced over any period of time.

B. Why Most Supply Curves are Upward Sloping

An upward sloping supply curve reflects the fact that costs rise when more units
of a good are produced. An individual supply curve represents the price-quantity
combinations of a particular good for a single seller, while a market supply curve
represents the same thing for all sellers.

C. Changes in Supply Mean Shifts in Supply Curves

When supply increases, the entire supply curve shifts rightward. When supply
decreases, the entire supply curve shifts leftward.

D. What Factors Cause the Supply Curve to Shift?

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or posted to a publicly accessible website, in whole or in part.
Supply and Demand: Theory 35

Changes in the prices of relevant resources, technology, the prices of other

goods, the number of sellers, expectations of future price, taxes, subsidies, or
government restrictions will cause the supply curve to shift.

E. A Change in Supply versus a Change in Quantity Supplied

A change in quantity supplied refers to a movement along a supply curve, and

occurs when the price of the good (or own price) changes.

IV. THE MARKET: PUTTING SUPPLY AND DEMAND TOGETHER

A. Supply and Demand at Work at an Auction

An auctioneer will adjust the price of a product to sell the entire stock of the
product offered.

B. The Language of Supply and Demand: A Few Important Terms

A surplus (excess supply) exists if quantity supplied is greater than quantity

demanded. A shortage (excess demand) exists if quantity demanded is greater
than quantity supplied. The price at which quantity demanded equals quantity
supplied is the equilibrium price or market-clearing price. Any other price is a
disequilibrium price. The quantity that corresponds to the equilibrium price is the
equilibrium quantity.

C. Moving to Equilibrium: What Happens to Price When There is a Surplus or

Shortage?

The price falls when there is a surplus and rises when there is a shortage.

D. Speed of Moving to Equilibrium

Not all markets equilibrate at the same speed.

E. Moving to Equilibrium: Maximum and Minimum Prices

The maximum price that buyers are willing to pay for a good and the minimum
price sellers are willing to accept for the good will help determine whether trade
takes place between buyers and sellers. Buyers and sellers trade money for
goods as long as both benefit from the trade. Mutually beneficial trade drives the
market to equilibrium.

F. The Connection Between Equilibrium and Predictions

In the real world, both equilibrium and disequilibrium can exist. As a mental
construct, equilibrium represents a balance of forces from which there is no
tendency to move. Disequilibrium represents an imbalance, from which there is a
tendency to move. When a market is in disequilibrium, the price will move up or
down depending on whether there is ashortage or a surplus. An economist uses
these two mental constructs to predict and explain how the market moves
towards equilibrium.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated,
or posted to a publicly accessible website, in whole or in part.
36 Chapter 3

G. Equilibrium in Terms of Consumers’ and Producers’ Surplus

Consumers’ surplus is the difference between the maximum buying price and the
price paid by the buyer. Producers’ surplus is the difference between the price
received by the producer or seller and the minimum selling price. At equilibrium,
the sum of consumers’ and producers’ surplus is maximized.

H. What Can Change Equilibrium Price and Quantity?

Equilibrium price and quantity are determined by supply and demand. Whenever
one changes or both change, equilibrium price and quantity change.

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated,
or posted to a publicly accessible website, in whole or in part.