Demand and Supply

 

Demand

1. Demand is the relationship between the price of a good and the quantity of it that consumers are willing to buy at that price.

2. Demand curve: A graphical representation of the law of demand. It slopes downward (for most goods) because, all else constant, the quantity demanded rises (falls) as the price falls (rises).

   1. A change in price is represented by movements along the demand curve; demand is still the same, but the quantity demanded changes as the price changes.

   2. The demand curve will shift to the left or right when anything other than the price of the good has changed.

   3. The market demand curve is the horizontal sum of all individual demand curves.

3. Changes in price also affect the demand for related goods.

   1. Substitutes: Goods that can be used in place of another good. If the price of a good rises (falls), the demand for its substitute goods will rise (fall).

      Example: Coke^® and Pepsi^®.

   2. Complements: Goods that are normally used in conjunction with another good. If the price of a good rises (falls), the demand for its complement goods will fall (rise).

      Example: Left shoes and right shoes.

4. The relationship between demand and price is caused by two main effects:

   1. Income effect: A change in price affects overall purchase power.

   2. Substitution effect: A change in price affects not only the absolute price of the good but also the relative price of the good, leading to changes in the purchasing of substitute goods.

5. The effects are different for different types of goods:

   1. Normal goods: When income rises (falls), demand increases (decreases). Most goods are normal.

   2. Inferior goods: When income rises (falls), demand decreases (increases), because better goods can be afforded.

      Example: Generic-label foods.

   3. Giffen goods: Quantity demanded rises (falls) as the price rises (falls). Giffen goods are inferior goods with strong income effects.

      Example: Potatoes during the Irish Potato Famine.

   4. Veblen goods (or snob goods): Quantity demanded rises (falls) as price rises (falls) because the goods are purchased to demonstrate one’s wealth to others. Also known as conspicuous consumption.

      Example: Designer-label clothing.

 

Supply

1. Supply is the relationship between the price of a good and the quantity of it that firms are willing to produce at that price.

2. Supply curve: A graphical representation of the law of supply. It slopes upward because quantity supplied rises as price rises, with other things constant.

   1. A change in price is represented by movements along the supply curve; supply is still the same, but the quantity supplied changes as the price changes.

   2. The supply curve will shift to the left or right when anything other than the price of the good has changed. Such factors include: changes in prices of inputs used in production, changes in technology, changes in supplier expectations about future prices, changes in taxes and subsidies.

   3. The market supply curve is the horizontal sum of all individual supply curves.

 

Market Equilibrium

1. A market economy allows the rise and fall of prices to guide actions in the economy. This “invisible hand” pricing mechanism coordinates individuals’ decisions so that prices will always adjust to achieve market equilibrium and scarce resources will be best allocated.

   1. When the quantity supplied exceeds the quantity demanded (surplus), prices tend to fall.

   2. When the quantity demanded exceeds the quantity supplied (shortage), prices tend to rise.

   3. When the quantity demanded equals the quantity supplied, prices have no tendency to change and the market is in equilibrium.