Demand, Supply, and Market Equilibrium

• firm/ An organization that transforms resources The Circular Flow of Economic Activity
(inputs) into products (outputs). Firms are the
primary producing units in a market economy.

is
• entrepreneur/ A person who organizes,
manages, and assumes the risks of a firm,
taking a new idea or a new product and turning
it into a successful business.

• households/ The consuming units in an

economy.

• product or output markets/ The markets in

which goods and services are exchanged.

• input or factor markets/ The markets in which

the resources used to produce goods and
• Here goods and services flow clockwise:
services are exchanged.
Labor services supplied by households flow
to firms, and goods and services produced
• labor market/ The input/factor market in which
by firms flow to households.
households supply work for wages to firms that
demand labor.
• Payment (usually money) flows in the
• capital market/ The input/factor market in
opposite (counterclockwise) direction:
which households supply their savings, for
Payment for goods and services flows from
interest or for claims to future profits, to firms
households to firms, and payment for labor
that demand funds to buy capital goods.
services flows from firms to households.

• land market/ The input/factor market in which

households supply land or other real property • Input and output markets are connected
in exchange for rent. through the behavior of both firms and
households.
• factors of production/ The inputs into the
production process. Land, labor, and capital are • Firms determine the quantities and character
the three key factors of production. of outputs produced and the types and
quantities of inputs demanded.

• Households determine the types and

quantities of products demanded and the
quantities and types of inputs supplied.
 Demand in Product/Output Markets Price and Quantity Demanded: The Law of
Demand
A household’s decision about what quantity of a
particular output, or product, to demand depends • demand schedule/ Shows how much of a given
on a number of factors, including: product a household would be willing to buy at
different prices for a given time period.
1. The price of the product in question
2. The income available to the household • demand curve/ A graph illustrating how much of
3. The household’s amount of accumulated a given product a household would be willing to
wealth Total buy at different prices.
valueofincomeandsavings
4. The prices of other products available to the
household • The relationship between price (P) and quantity
5. The household’s tastes and preferences demanded (q) presented graphically is called a
6. The household’s expectations about future demand curve.
income, wealth, and prices w̅
• Demand curves have a negative slope,
indicating that lower prices cause quantity
demanded to increase.
• quantity demanded/ The amount (number of
units) of a product that a household would buy
• law of demand/ The negative relationship
in a given period if it could buy all it wanted at
between price and quantity demanded: Ceteris
the current market price.
paribus, as price rises, quantity demanded
decreases; as price falls, quantity demanded
• It is important to focus on the price change
increases during a given period of time, all other
alone with the ceteris paribus, or “all else
things remaining constant.
equal,” assumption.

• It is reasonable to expect quantity demanded

Changes in Quantity Demanded versus to fall when price rises, ceteris paribus, and to
Changes in Demand expect quantity demanded to rise when price
falls, ceteris paribus.
• Changes in the price of a product affect the
quantity demanded per period.
• A demand curve has a negative slope.
• Changes in any other factor, such as income
or preferences, affect demand.

• Thus, we say that an increase in the price of

Coca-Cola is likely to cause a decrease in the
quantity of Coca-Cola demanded. However,
we say that an increase in income is likely to
cause an increase in the demand for most
goods.
• Other Properties of Demand Curves To summarize what we know about the shape of demand
curves:
1. They have a negative slope
2. They intersect the quantity (X) axis, a result of time limitations and diminishing marginal utility.
3. They intersect the price (Y) axis, a result of limited income and wealth.

• The actual shape of an individual household demand curve depends on the unique tastes and
preferences of the household and other factors.

Other Determinants of Household Demand

v
Income and Wealth Prices of Other Goods Tastes and Preferences Expectations
and Services
• income/ The sum of all • Changes in • What you decide
a household’s wages, • substitutes/ Goods that preferences can and to buy today
salaries, profits, can serve as do manifest certainly depends
interest payments, replacements for one themselves in market on today’s prices
rents, and other forms another; when the behavior. and your current
of earnings in a given price of one increases, income and
period of time. It is a demand for the other • Within the constraints wealth.
flow measure. increases. of prices and incomes,
overperiod of time preference shapes the • Increasingly,
• wealth or net worth/ • perfect substitutes/ demand curve, but it economic theory
The total value of what Identical products. is difficult to has come to
a household owns generalize about recognize the
minus what it owes. It • complements, tastes and importance of
is a stock measure. complementary goods/ preferences. expectations.
atspecificpoint Goods that “go
together”; a decrease • It is important to
in the price of one understand that
results in an increase in demand depends
demand for the other on more than just
and vice versa. current incomes,
prices, and tastes.

• normal goods Goods for which • inferior goods Goods for which
demand goes up when income is demand tends to fall when
higher and for which demand goes income rises.
down when income is lower.
Shift of Demand versus Movement along a Demand
Curve

• shift of a demand curve The change that takes

place in a demand curve corresponding to a new
relationship between quantity demanded of a
good and price of that good. The shift is
brought about by a change in the original • When income increases, the demand for
conditions. inferior goods shifts to the left, and the
demand for normal goods shifts to the right.
• movement along a demand curve The change in
quantity demanded brought about by a change
in price.
From Household Demand to Market Demand

• When the price of a good changes, we move • market demand/ The sum of all the quantities
along the demand curve for that good. When of a good or service demanded per period by
any other factor that influences demand changes all the households buying in the market for
(income, tastes, and so on), the demand curve that good or service.
shifts, in this case from D0 to D1.
• Total demand in the marketplace is simply the
sum of the demands of all the households
shopping in a particular market. It is the sum
of all the individual demand curves—that is,
the sum of all the individual quantities
demanded at each price.

00 00 0 0

• Change in price of a good or service leads to

change in quantity demanded (movement
along a demand curve).

• Change in income, preferences, or prices of

other goods or services leads to change in
demand (shift of a demand curve).
 Supply in Product/Output Markets The Cost of Production
• For a firm to make a profit, its revenue must
• Firms build factories, hire workers, and buy raw exceed its costs.
materials because they believe they can sell
the products they make for more than it costs • Cost of production depends on a number of
to produce them. factors, including the available technologies
and the prices and quantities of the inputs
• profit/ The difference between revenues and needed by the firm (labor, land, capital,
costs. energy, and so on).

Price and Quantity Supplied: The Law of Supply The Prices of Related Products
Assuming that its objective is to maximize
• quantity supplied/ The amount of a particular
profits, a firm’s decision to supply depends on:
product that a firm would be willing and able to
offer for sale at a particular price during a given
• The price of the good or service.
time period.
• The cost of producing the product, which in
turn depends on:
• supply schedule/ Shows how much of a product
1. The price of required inputs (labor, capital,
firms will sell at alternative prices.
and land) The technologies that can be
used to produce the product.
• law of supply/ The positive relationship between
2. The prices of related products.
price and quantity of a good supplied: An
increase in market price, ceteris paribus, will
lead to an increase in quantity supplied, and a Shift of Supply versus Movement along a Supply
decrease in market price will lead to a decrease Curve
in quantity supplied. • movement along a supply curve The change
in quantity supplied brought about by a
• supply curve/ A graph illustrating how much of a change in price.
product a firm will sell at different prices.
• shift of a supply curve The change that takes
place in a supply curve corresponding to a
Other Determinants of Supply new relationship between quantity supplied
of a good and the price of that good. The
shift is brought about by a change in the
The Cost of Production original conditions.
The Prices of Related
Products
• movements along supply curves (changes in
quantity supplied) and shifts in supply curves
(changes in supply): Change in price of a
good or service leads to change in quantity
supplied (movement along a supply curve).
Change in costs, input prices, technology, or
prices of related goods and services leads to
change in supply (shift of a supply curve).
 From Individual Supply to Market Supply • excess supply or surplus/ The condition that
exists when quantity supplied exceeds
• market supply The sum of all that is supplied quantity demanded at the current price.
each period by all producers of a single
product. • When quantity supplied exceeds quantity
demanded at the current price, the price
• Total supply in the marketplace is the sum of all tends to fall.
the amounts supplied by all the firms selling in
the market. It is the sum of all the individual • When price falls, quantity supplied is likely
quantities supplied at each price. to decrease, and quantity demanded is likely
to increase until an equilibrium price is
reached where quantity supplied and
quantity demanded are equal.

Market Equilibrium with Equations

Market Equilibrium
• When economists work with demand and
• equilibrium/ The condition that exists when supply, they use equations to measure the
quantity supplied and quantity demanded are quantitative size of markets.
equal. At equilibrium, there is no tendency for • Assume demand is a straight (linear) line,
price to change. then the equation of the inverse demand
P = a - b Qd
• Excess Demand or shortage/ The condition that
exists when quantity demanded exceeds • Qd = quantity demanded in units
quantity supplied at the current price. • P = price
• a = y intercept (price at which quantity
demanded is 0)
• b = slope of the demand curve

• demand curve becomes:

Qd = (a/b) - (p/b)
 Assume supply is a straight (linear) line, then the
equation of the inverse supply curve is

P = C + dQs

• where Qs = quantity supplied in units

• c = y intercept (price at which quantity
supplied is 0)
• d = slope of the supply curve

• The supply curve becomes

Qs = (P-C) / d

Changes in Equilibrium
When supply and demand curves shift, the
equilibrium price and quantity change.