Chapter 3

Supply and demand: an introduction

Core Principals
- The efficiency principle
- Equilibrium principle

3.1 What, how and for whom? Central planning versus the market
- One approach is for all economic decisions to be made centrally, by an individual or small
number of individuals on behalf of a larger group.
- In centrally planned nations, a central bureaucratic committee established product
targets for the country’s farms and factories, etc.
- There are no pure free-market economies today. Most countries are “mixed economies”,
which means that goods and services are allocated by a combination of free markets,
regulation and other forms of collective control.
- Markets have replaced centralized control for the simple reason that they tend to assign
production tasks and consumption benefits much more effectively.

3.2 Buyers and sellers in markets

- Market – the market for any good or service consists of all the buyers and sellers of that
good or service.

The demand curve

- Demand curve – a representation of the relationship between the amount of a particular
good or service that buyers want to purchase in a given time period and the price of the
good or service.
- Quantity demanded=a-bP, where P is the price.
- Economists put price in the vertical axis of the demand curve and quantity on the
horizontal.
- Always ceteris paribus assumption when dealing with demand curve.
- Law of demand – more of a good will be demanded as the price falls.
- Substitution effect – the change in the quantity demanded of a good or service caused
by a change in price, that results because the good or service becomes more or less
expensive relative to other goods and services
- Income effect – the change in the quantity demanded of a good or service caused by a
change in price that results because of the change in the purchasing power of a buyer’s
income.
- Buyer’s reservation price – the largest dollar amount the buyer would be willing to pay
for a good or service.
- Marginal buyer is the person who purchases the last unit of the good that is sold.
- Horizontal interpretation of the demand curve, we start with price in the vertical axis and
 read the corresponding quantity demanded on the horizontal axis.
- Vertical interpretation is where we start with the quantity on the horizontal axis and
then read the marginal buyer’s reservation price on the vertical axis.
- Demanders are willing to buy less at higher prices.

Supply curve
- Supply curve – a representation of the relationship between the amount of a particular
good or service that sellers want to supply in a given time period and the price of the
good or service.
- The fact that the supply curve sloped upwards may be seen as a consequence of the low-
hanging-fruit principle.
- Suppliers are willing to sell more at higher prices.
- Seller’s reservation price – the smallest dollar amount for which a seller would be willing
to sell an additional unit, generally equal to marginal cost.

3.3 Market equilibrium

- Equilibrium – any situation in which a system is at rest, for example where neither price
nor quantity of a good or service is changing.
- Equilibrium price and equilibrium quantity – the values of price and quantity for which
quantity supplied and quantity demanded are equal.
- Market equilibrium – occurs in a market when all buyers and sellers are satisfied with
their respective quantities at the market price.
- Hence no tendency for production or prices in the market to change.
- Excess supply (surplus) – the amount by which quantity supplied exceeds quantity
demanded when the price of a good exceeds the equilibrium price.
- Excess demand (shortage) – the amount by which quantity demanded exceeds quantity
supplied when the price of a good lies below the equilibrium price.
- Market equilibrium does not necessarily produce an ideal outcome for all market
participants.
- Price ceiling – maximum allowable price, specified by law.
- Price floor – a minimum allowable price, specified by law.

3.4 Predicting and explaining changes in prices and quantities

- Change in the quantity demanded – a movement along the demand curve that occurs in
response to a change in price.
- Change in demand – a shift of the entire demand curve.
- Change in the quantity supplied – a movement along the supply curve that occurs in
response to a change in price.
- Change in supply – a shift of the entire supply curve.
Shifts in the demand curve
- Complements – two goods are complements in consumption if an increase in the price
of one causes a fall in demand for the other, as shown by a leftward shift in the demand
curve for the other.
- Substitutes – two goods are substitutes in consumption if an increase in the price of one
causes a rise in demand for the other, as shown by a rightward shift in the demand curve
for the other.
- Normal goods – a good whose demand curve shifts rightward when the incomes of
buyers increase and leftward when the incomes of buyers decrease.
- Inferior good – a good whose demand curve shifts leftward when the incomes of buyers
increase and rightward when the incomes of buyers decrease.
- Factors that cause an increase in demand and shift the demand curve to the right;
Ø A decrease in the price of complements
Ø An increase in the price of substitutes
Ø An increase in income for a normal good
Ø A decrease in income for an inferior good
Ø An increased preference by buyers for the good or service
Ø An increase in the population of potential buyers
Ø An expectation of higher prices in the future.

Shifts in the supply curve

- Factors that cause an increase in supply and shift the supply curve to the right;
Ø A decrease in the cost of materials, labour, or other inputs used in the production
of the good or service.
Ø An improvement in technology that reduces the cost of producing the good or
service.
Ø An improvement in the weather (especially for agricultural products).
Ø An increase in the number of suppliers.
Ø An expectation of lower prices in the future.

Four simple rules

- An increase in demand will lead to an increase in both the equilibrium price and quantity.
- A decrease in demand will lead to a decrease in both the equilibrium price and quantity.
- An increase in supply will lead to a decrease in the equilibrium price and an increase in
the equilibrium quantity.
- A decrease in supply will lead to an increase in the equilibrium price and a decrease in
the equilibrium quantity.

3.5 Markets and social welfare

Cash on the table
- Buyer’s surplus – the difference between the buyer’s reservation price and the price he
or she actually pays.
- Seller’s surplus – the difference between the price received by the seller and his or her
 reservation price.
- Total surplus (total economic surplus) – the sum of the buyer’s surplus and the seller’s
surplus, or the difference between the buyer’s reservation price and the seller’s
reservation price.
- Cash on the table – a metaphor used by economists to describe unexploited gains from
exchange.

Smart for one, dumb for the group

- Socially optimal quantity – the quantity of a good or service that results in the
maximum possible difference between the total benefits and total costs from producing
and consuming the good or service.
- Efficiency (economic efficiency) – occurs when all goods and services are produced and
consumed at their respective socially optimal levels.
- The efficiency principle – efficiency is an important social goal, because when the
economic pie grows larger, everyone can have a larger slice.
- The equilibrium principle (or the “no cash on the table” principle) – a market in
equilibrium leaves no unexploited opportunities for individuals, but may not exploit all
gains achievable through collective action.
- So long as there is “cash left on the table” in a market, both buyers and sellers will look
for ways to pocket it.
- If those other than buyers benefit from the good, or if people other than sellers bear
costs because of it, market equilibrium need not result in the largest possible surplus of
benefits over costs. I.e. what may be smart for one may be dumb for the group.