Chapter 3: Demand, Supply and Market Equilibrium
Important Terms: demand, demand schedule, substitute good, change in quantity supplied
complementary goods, equilibrium price, law of demand, change in demand, equilibrium
quantity, diminishing marginal utility, change in quantity demanded, surplus, shortage, income
effect, supply, substitution effect, supply schedule, law of supply, determinants of demand,
determinants of supply, rent control, inferior good, change in supply, price floor
What is the law of demand?
As the price of a good rises, the quantity demanded of the good falls and as the price of a good
falls, the quantity demanded of the good rises, ceteris paribus.
In simple terms: There is an inverse relationship between price and quantity demanded.
Assumption: Many buyers and sellers!!
What is the market demand for a given good?
It is the total demand for the good or service from all the potential buyers in the market.
** What is a perfectively competitive market? **
1. The goods offered for sale are exactly the same,
2. The buyers and sellers are so numerous that no single buyer or seller has influence over
the market price.
3. Buyers and sellers are price takers.
** Change in Quantity Demanded Versus Demand **
Change in quantity demanded is caused by a change in its own price.
Change in demand is caused by a change in one of the determinants or shifters of demand.
Shifters of Demand (Changes in Demand)
1. Tastes and Preferences
2. Number of Buyers
3. Income
a. Normal Good
b. Inferior Good
4. Price of Related Goods
a. Substitute Good
b. Complementary Good
5. Consumer Expectations – hardest one
Is price a shifter or determinant of demand?
No!
Supply
What is the Law of Supply?
As the price of a good rises the quantity supplied of a good rises; and as the price of a good falls,
the quantity supplied of the good falls.
This is a direct relationship!
Supply Schedule
Price Tropicana (OJ) Healthy Juice (OJ) Total
$1 2 3 5
$2 4 6 10
$3 6 9 15
$4 8 12 20
Supply Curve
Change in Quantity Supplied Versus Supply
Change in quantity supplied is caused by a change in its own price.
Change in supply is caused by a change in one of the determinants or shifters of supply.
What are the shifters of supply?
1. Resource Prices
2. Technology
3. Taxes and Subsidies
4. Prices of Other Goods (Substitution in Production)
5. Producer Expectations
6. Number of Sellers
Shortage and Surplus
Graph:
Cheat Sheet
Consumer Surplus
The share of the total surplus that is received by a consumer or consumers in a market
The difference between the maximum buying price a buyer is willing and able to pay for
a good or service and the price actually paid for the good or service.
Producer Surplus
The difference between the actual price a producer receives (or producers receive) and
the minimum acceptable price, the triangular area above the supply curve and below the
market price.
Total Surplus
Total surplus is the total from both consumer and producer surplus.
productive efficiency
The production of a good in the least costly way; occurs when production takes place at
the output level at which per-unit production costs are minimized.
allocative efficiency
The apportionment of resources among firms and industries to obtain the production of
the products most wanted by society (consumers); the output of each product at which its
marginal cost and marginal benefit are equal, and at which the sum of consumer surplus
and producer surplus is maximized.
Conditions for Allocative Efficiency
Marginal Benefit equals marginal cost
“Maximum Willingness to Pay” equals minimal acceptable price
Total surplus is Maximized
Externalities
Externality
A cost or benefit from production or consumption that accrues to someone other than the
immediate buyers and sellers of the product being produced or consumed (see negative
externality and positive externality).
negative externality
A cost imposed without compensation on third parties by the production or consumption
of sellers or buyers. Example: A manufacturer dumps toxic chemicals into a river, killing
fish prized by sports fishers. Also known as an external cost or a spillover cost.
Example: Pollution from a factory, noise pollution from your neighbor
positive externality
A benefit obtained without compensation by third parties from the production or
consumption of sellers or buyers. Example: A beekeeper benefits when a neighboring
farmer plants clover. Also known as an external benefit or a spillover benefit.
Example: Someone cleaning up the park, your neighbor paints their house
Pigovian tax
A tax or charge levied on the production of a product that generates negative externalities.
If set correctly, the tax will precisely offset the overallocation (overproduction) generated
by the negative externality.
Underprovided
Subsidies to buyers
Subsidies to producers
Government provision
asymmetric information
A situation where one party to a market transaction has more information about a product
or service than the other. The result may be an under- or overallocation of resources.
moral hazard problem
The possibility that individuals or institutions will behave more recklessly after they
obtain insurance or similar contracts that shift the financial burden of bad outcomes onto
others. Example: A bank whose deposits are insured against losses may make riskier
loans and investments.
adverse selection problem
A problem arising when information known to one party to a contract or agreement is not
known to the other party, causing the latter to incur major costs. Example: Individuals
who have the poorest health are most likely to buy health insurance.