Microeconomic Laws of Demand and Supply

In this chapter we introduce the “Laws” of demand and supply. But we must recognize that economics is not an exact science. As Alfred Marshall (Principles of Economics: An Introductory Volume, 1890) explained: “The laws of economics are to be compared with the laws of the tides, rather than with the simple and exact law of gravitation. For the actions of men are so various and uncertain, that the best statement of tendencies, which we can make in a science of human conduct, must needs be inexact and faulty.”

The demand and supply theory we discuss in this chapter is microeconomic rather than macroeconomic. Macroeconomic demand and supply curves, which we cover later in this course, are derived very differently for a number of reasons. For example, in microeconomics we are talking about a specific good or service while in macroeconomics we discuss demand and supply in terms of all goods and services exchanged. You can’t simply add up the microeconomic demand or supply curves for the many different goods and services to arrive at macroeconomic demand and supply curves. Microeconomic demand and supply curves depend on differences in relative prices – the price of one good relative to another good or all other goods and services. If the price of DVD movies declines (DVD movies are put on “sale”), the price of DVDs has fallen relative to the prices of VHS movies, clothes, cars, and cameras. Consumers switch their purchases from other good such as VHS movies to the now cheaper DVDs. In macroeconomics, however, when you switch from purchasing a VHS movie to a DVD movie your total spending doesn’t change. In macroeconomics we generally don’t deal with relative prices between goods and services but only with the “average” price of all goods and services.

In the first two chapters we discussed the reality of scarcity and the need to make choices and mentioned that in modern economies prices serve to allocate scarce resources among unlimited wants. But we never explained how prices are determined. We will attempt to resolve that little oversight in his chapter.

1. Markets and the Role of Prices

Recall that we said a good was scarce as long as the quantity demanded exceeded the quantity supplied at a zero price. When there are more consumers than there are items available freely in nature there must be some way to determine who gets to consume the good and who doesn’t. Scarce resources must somehow be rationed among the many competing needs. In primitive societies it was survival of the fittest. Once humans recognized the benefits of cooperative behavior two competing systems evolved: government dictate and the market system.

When it rests upon a government or benevolent dictator to determine how much is produced and and for whom there has generally been consistent failure. There are many reasons for the inefficiency of governments in allocating scarce resources but such a discussion is beyond the scope of this course. We focus on the market economy, which is the dominant system in the world today. Even dictatorial, communist and socialist governments today rely on markets to reveal scarcity, desires, and needs.

A market is a collections of suppliers and consumers engaged in trade. A market in economics represents a process rather than a specific product or geographic location. A competitive free market refers to many suppliers and many consumers (competitive) engaged in trade without interference from government (free).

 


Competitive Free Market – many suppliers and many consumers (competitive) engaged in trade without interference from government (free).

The market system provides a means for suppliers to reveal scarcity and consumers to reveal their desires. The communication between suppliers and consumers takes place through prices. For example, an increase in price may be a signal to producers that consumer demand for a good has increased. Producers react to the new wants of consumers by reallocating scarce resources such as raw materials and labor from some other good to produce more of the desired good. An increase in price may also be a signal to consumers that the supply of a good has become more scarce. For example, severe cold weather in Florida may destroy an orange crop. The price of oranges rises, which motivates consumers to switch their purchases to another product.

How are prices determined? That’s the topic of this chapter. In a competitive free market, price is determined by demand and supply.

2. Microeconomic Demand and Supply

  • The Law of Demand

The Law of Demand is something you are likely very familiar with but never realized its full role in economic science. If I were to say the average price of DVD movies was $25 each you might be able to make some estimate of how many DVDs you would want and could afford to buy each month. At a lower average price of $15 you might increase your estimate of how many you would purchase. At $10 you would probably be willing to buy even more.

The Law of Demand simply proposes that as the price of a good declines the quantity you would be willing and able to purchase during some period of time increases, given that everything else remains unchanged.

The Law of Demand probably strikes you intuitively as one of those obvious facts of life that needs no elaboration or justification. But in economics we learn never to take anything for granted. The theory behind the Law of Demand is rigorous and complex (called consumer utility maximization). Demand is derived from consumers’ tastes and preferences as constrained by available resources and income. In this course we will not get into those details and leave that for a good microeconomics course. What we are interested in here is how the Law of Demand relates to the behavior of markets.

1. Demand Schedule

We can represent a single person’s decision about how many DVD movies to purchase over a year in a table called a demand schedule. The DVD demand schedule in Table 3-1 shows that as the price of DVDs declines, the quantity purchased by a consumer increases (or, as the price rises the quantity demanded falls).

 

Table 3-1. Single Consumer Demand Schedule

Average Price
of DVD Movies
Quantity
Purchased

$25 0
$20 2
$15 4
$10 6
$5 8

2. Market Demand Schedule

The demand schedule we presented above is for one individual consumer. But what we are really interested in is the total demand for a particular good or service for all the consumers in an economy. To derive a market demand schedule we add up all the individual demand schedules. If the demand schedules for each consumer conform the the Law of Demand then the market demand schedule will also conform to the Law of Demand.

For example, let’s assume we have a market that has only three consumers: Sting, Morrissey, and Ice Cube. We create a market demand schedule in Table 3-2 by adding up the quantities demanded at each price by each consumer.

 

Table 3-2. Market Demand Schedule for DVD Movies

Quantity Purchased
Average Price
of DVD Movies

  Sting   Ice Cube   Morrissey   Total

$25 0 1 0 1
$20 2 2 1 5
$15 4 3 2 9
$10 6 4 3 13
$5 8 5 4 17

The market demand schedule applies to a specific population and to a specific period of time. The number of DVDs demanded by the students at George Mason University will certainly be less that the number demanded by the entire population of the United States. Similarly, the number demanded over the period of a month will be less than for an entire year. But, we usually don’t worry about the details of population or time period when talking about demand and supply theory in this course.

 

3. Demand Curve

The demand curve is a graphic representation of the market demand schedule and the Law of Demand. The demand curve represents the quantities of a good or service that consumers are willing and able to purchase at various prices.

By tradition, the demand curve is drawn with prices on the vertical or y-axis and quantities demanded on the horizontal or x-axis. The demand curve slopes down to right based on the Law of Demand. As the price of a good increases, consumers switch purchases to other goods, reducing the quantity demanded.

Using our market demand schedule for DVD movies in Table 3-2 above, we can draw a demand curve with price on the vertical axis (y-axis) and quantity demanded on the horizontal axis (x-axis), as shown in Figure 3-1.

Market Demand Curve for DVD Movies

 


Figure 3-1. Market Demand Curve for DVD Movies

The Law of Demand implies the following with respect to a demand curve (all of these say exactly the same thing):

 

      • The demand curve is downward sloping
      • The demand curve has a negative slope
      • The demand curve shows an inverse relationship between price and quantity demanded

 

  • The Law of Supply

Just as consumers are influenced by prices so are firms, but in the opposite direction. Consumers like low product prices, firms like high product prices. When product prises rise, firms have an incentive to employ additional scarce resources to increase production.

The Law of Supply states that firms will produce and offer for sale greater quantities of a good or service the higher the market price, given that everything else remains unchanged.

The theory behind the Law of Supply rests on the principle of increasing opportunity costs. When we produce something we use the most efficient resources first. As we increase production we must draw on less efficient resources, which leads to increasing opportunity costs. We will not increase production and incur those higher opportunity costs unless we can sell our product at a higher price.

1. Supply Schedule

We can create individual firm supply schedules and a market supply schedule just as we did for demand. For an individual firm we should expect that as the price of a product increases the firm will be willing to produce more of that product. The higher price may cover additional costs to the firm such as paying labor higher overtime rates. The market supply curve for a particular good or service is then the sum of the supply curves of the individual firms.

The market supply schedule for DVD movies may look something like Table 3-3.

 

Table 3-3. Market Supply Schedule for DVD Movies

Average Price
of DVD Movies
Quantity
Supplied

$25 17
$20 13
$15 9
$10 5
$5 1

2. Supply Curve

The supply curve is a graphic representation of the market supply schedule and the Law of Supply. The supply curve represents the quantities of a good or service that firms are willing to produce and sell at various prices. The supply curve, such as the one for DVDs in Figure 3-2, slopes upwards to right based on the Law of Supply. As the price of a good increases relative to price of all other goods, firms switch resources and production from other goods, increasing the quantity supplied.

Market Supply Curve for DVD Movies
Figure 3-2. Market Supply Curve for DVD Movies

The Law of Supply implies the following with respect to a supply curve (all of these say exactly the same thing):

 

      • The supply curve is upward sloping
      • The supply curve has a positive slope
      • The supply curve shows a direct relationship between price and quantity demanded

 

  • Ceteris Paribus Assumption

When we described the Law of Demand and the Law of Supply we made a similar important statement with respect to both: given that everything else remains unchanged. This is referred to as the ceteris paribus assumption. This is not an assumption we make for convenience but is a necessary condition for each law to hold.

For example, the purpose of a demand curve is to show how the quantity demanded is affected by a change in price, and price alone. It is important that the answer should not be confused by other influences. When we draw a demand curve we hold constant the many other variables that can affect it such as income. What if income declines at the same time prices fall? Lower prices means consumers will buy more, but lower income means consumers will probably buy less. We must try to address each issue in isolation in order to understand the final net impact.

There are many factors that affect consumers’ decisions to buy and firms’ decisions to produce. To isolate the effect of prices on the quantity demanded and supplied we must hold all of these other potential influences constant.

The most important variables covered by the Law of Demand ceteris paribus (everything else unchanged) assumption are:

 

      1. the size of the market (e.g., population)
      2. consumer tastes (preferences)
      3. income
      4. prices of other related goods

 

The Law of Supply ceteris paribus (everything else unchanged) assumption means the following do not change:

 

      • Prices of inputs to the production process (labor, raw materials, cost of capital)
      • Technology
      • The prices of other products from the same resources or production process

 

This does not mean these factors cannot change. The importance of a change in each of these variables will hopefully become clearer later in this chapter when we discuss shifts in the demand and supply curves.

 


Law of Demand – as the price of a good or service increases, the quantity you would be willing and able to purchase during some period of time declines, ceteris paribus.Demand Curve – graphic representation of the Law of Demand. In a graph of price (vertical axis) versus quantity demanded (horizontal axis) the demand curve slopes downward to the right. As price increases the quantity demanded declines.

Law of Supply – as the price of a good or service increases the quantity you would be willing and able to produce during some period of time increases, ceteris paribus.

Supply Curve – graphic representation of the Law of Supply. In a graph of price (vertical axis) versus quantity supplied (horizontal axis) the supply curve slopes upward to the right. As price increases the quantity supplied increases.

Ceteris Paribus – Latin term that used in economics means all other non-price factors that affect the amount we consume or produce do not change.


3. Demand-Supply Equilibrium

When we combine a demand curve and supply curve on the same graph we create a model of demand and supply. The model helps explain how prices and quantities are determined in a market.

  • Equilibrium

A market is in equilibrium when the quantity demanded is equal to quantity supplied at the market price. At the equilibrium market price there are exactly the same number of goods that suppliers are willing to sell as consumers are willing to buy. When a market is is equilibrium there is no tendency for price or quantity to change. Economists often refer to equilibrium as the “market clearing price” where all willing sellers find all willing buyers.

 


Equilibrium Price – the price at which the quantity demanded is equal to the quantity supplied. Other things being unchanged, there is no tendency for this price to change.

The market equilibrium for DVD movies can be identified by comparing our market demand and supply schedules as we do in Table 3-4. Equilibrium occurs at the price where the quantity demanded exactly equals the quantity supplied.

 

Table 3-4. Market Demand and Supply Schedules for DVD Movies

Average Price
of DVD Movies
Quantity
Demanded
Quantity
Supplied

$25 1 17
$20 5 13
$15 9 9   <- Equilibrium
$10 13 5
$5 17 1

A more convenient depiction of market equilibrium is where the demand and supply curves intersect as shown in Figure 3-3.

Figure 3-3. Demand-Supply Equilibrium Demand-Supply Equilibrium

When a market price is below or above the equilibrium level there exists an imbalance between the quantity demanded and the quantity supplied

How can you tell if your market is not in equilibrium? The easiest way for the firm to tell is by monitoring its inventory. When the quantity supplied is not equal to the quantity demanded at the current market price we have either undesired inventory build or undesired inventory decline. Store shelves start overflowing because you are producing more than is being sold or the store shelves go bare because people are buying your product faster than you can make it.

What process occurs to bring the market back into equilibrium? Simple, the market price adjusts. When the quantity supplied by firms is greater than the quantity demanded by consumers there is more being produced than is being consumed. Unsold production starts to accumulate. Firms respond by cutting prices to stimulate demand. Lower prices also means that firms will begin to produce less. In response to the lower prices the quantity demanded increases. This price response continues and the quantity supplied declines and the quantity demanded increases until the desired level of inventory is attained and equilibrium is restored.

When the quantity supplied is less than the quantity demanded the opposite happens. Inventories decline below the desired level. This is a signal for firms to raise prices. With higher prices the quantity demanded declines and firms are motivated by the higher prices to produce more, which returns the market to equilibrium.

The market attains equilibrium as if led by an invisible hand. It requires no leadership or direction from a central planner (such as a government) or a dominant firm. But markets are not always free to function efficiently. We assume the market is perfectly competitive in that there is not a single firm (monopolist) or very small number if firms (oligopolists) that have the power to set market prices. Similarly we assume there is not a single consumer (monopsonist) with market-setting power. And finally, we assume there is no government intervention. Monopolies and monopsonies we leave for a microeconomics course. But in the next section on disequilibrium we will consider briefly the impact of government intervention in the form of price ceilings and price floors.

  • Disequilibrium

Nonequilibrium prices can occur in free markets because of imperfect information and uncertainty, but it usually doesn’t last for long. Governments, however, can impose nonequilibrium prices on markets for extended periods.

Governments in their infinite wisdom often intervene in markets to control prices and prevent them from reaching equilibrium. While the goals of market interference often appear noble, microeconomics lets us evaluate the undesirable consequences. In any free market intervention there will be those who benefit and others who will be hurt. Economics allows us to identify those whose interests are affected and by how much.

A common method of government intervention is the imposition of a price control in the form of a price ceiling or a price floor.

 

Price Ceiling
Figure 3-4. Price Ceiling
Price Floor
Figure 3-5. Price Floor

1. Price Ceiling

A price ceiling sets the maximum price that can be charged in a market. With an effective price ceiling the market price is forced to remain below the equilibrium price level. The “ceiling” prevents the market price from rising to the equilibrium level. The economic consequences are several:

 

      • Market price below the equilibrium level
      • The quantity demanded is greater than the quantity supplied
      • Market shortages will occur
      • Deterioration of product quality
      • Black markets

 

A common example of a price ceiling is rent control. The level or rate of increase in apartment and house rents is restricted in several cities under the goal of providing affordable housing. Perhaps the best known case of rent controls is New York City. People will be motivated to live in the city because of low cost rent controlled housing (increase in quantity demanded). But with restricted rents construction of new rental housing will be reduced and landlords will likely find it more profitable to sell rather than rent existing units (decrease in quantity supplied). Maintenance on rental units will likely deteriorate because the rents aren’t high enough to cover the costs. A black market will also appear where rent controlled housing is subleased at higher prices to those willing and able to pay.

 


Price Ceiling – a legal requirement that maintains the market price below the equilibrium price.Shortage – the amount that the quantity demanded exceeds the quantity supplied when the market price is below the equilibrium price.

We should point out that a shortage is not the same thing as scarcity discussed in the previous chapter. Scarcity is an inescapable consequence of limited resources and unlimited wants. Scarcity cannot be eliminated and prices are one mechanism used to allocate limited resources among the competing demands, Shortages, however, can be eliminated by simply allowing prices to rise to the equilibrium level. At the equilibrium price the quantity demanded equals the quantity supplied and there is no shortage.

2. Price Floor

A price floor is the opposite situation of a price ceiling. A price floor sets the minimum price that can be charged in a market. With an effective price floor the market price is forced to remain above the equilibrium price level. The “floor” prevents the market price from falling to the equilibrium level. The economic consequences of a price floor are:

 

      • Market price above the equilibrium level
      • The quantity supplied is greater than the quantity demanded
      • Surpluses will occur
      • Suppliers compete for customers by improving product quality

 

A common example of a price floor is the minimum wage (first established in 1938 at 25 cents per hour). The minimum wage sets a minimum dollar amount that a firm can pay its employees.

The labor market is like any other market in that there is a supply and demand curves for labor. The quantity of labor supplied increases as the wage rate increases (relative to the price of other goods). If there were no minimum wage it is likely that there would still be many willing (but maybe not happy) to work for a lower wage. Debate in favor of the minimum wage generally focuses on labor and their need to make a decent living. The consequence is that there will be more people entering the labor force because they are willing to work for a higher wage (increase in quantity of labor supplied) but firms will hire fewer workers at the higher wage (decrease in quantity of labor demanded) and there will be a higher unemployment rate (a surplus of labor). Unfortunately, the higher unemployment rate falls hardest on the least experienced and skilled persons working at the lowest wage rates; those probably most in need of making a decent living. However, it is still uncertain how much unemployment is caused by a higher minimum wage.

 


Price Floor – a legal requirement that maintains the market price above the equilibrium price.Surplus – the amount that the quantity supplied exceeds the quantity demanded when the market price is above the equilibrium price

3. The Hard Lesson of Price Controls

When the gasoline price goes up public opinion often swings wildly in favor of price ceilings. When newspapers carry stories of farmers losing their livelihoods because of low product prices sympathy quickly builds for price guarantees or floors. The lesson we should learn is that when you prevent market prices from serving as rationing devices for scarce resources society is always worse off.

Societies are not simply worse off because there are now surpluses or shortages, but because our needs will be less satisfied. With a price ceiling or price floor there will always be less sold in the market place.

With a price ceiling suppliers get the wrong message that the product is less in demand because of the low price. Suppliers reduce their production in favor of other goods. Consumers get the wrong message that the product is not as scarce as it actually is and attempt to increase their purchases. The quantity supplied is less than the quantity demanded and less than the quantity that would be produced in equilibrium.

With a price floor suppliers are motivated to increase production while consumers are motivated to reduce their purchases. The quantity demanded is less than the quantity supplied and less than the quantity that would be purchased in equilibrium.

The quantity actually sold in the market with either a price ceiling or price floor will be less than the quantity sold if the price was at the equilibrium level. With a price ceiling the quantity actually sold will be determined by supply (the quantity supplied will be less than at equilibrium). With a price floor the quantity actually sold will be determined by demand (the quantity demanded will be less than at equilibrium).

 

4. Shifts in Demand and Supply Curves

As we mentioned earlier the ceteris paribus assumption is of critical importance. What happens if income changes, or production technology, or population? The consequence is that the demand and supply curves can shift. When either the demand curve or the supply curve or both shift there will be a change in the equilibrium price or the equilibrium quantity or both.

First we will investigate what can cause the demand curve to shift. Then we will focus on changes in market conditions that will cause the supply curve to shift. Finally we will consider the implications for changes in the equilibrium price and quantity.

  • Demand Curve Shifts

When we defined the ceteris paribus assumption for the Law of Demand above we specifically mentioned that the following do not change:

 

      • the size of the market
      • consumer tastes
      • income
      • prices of other related goods.

 

All of these are directly related to consumers. A change in any one of these will cause the demand curve to shift to the right or left. In other words, at some given price, consumers will be willing and able to purchase either more or less. For example, in Figure 3-6 we show the demand curve shifting to the right. At a price of 30 the quantity demanded increases from 9 to 13. This rightward shift is called “an increase in demand.”

Shift of Demand Curve
Figure 3-6. Shift of Demand Curve

1. Size of the Market and Consumer Tastes

Let’s cover the easy ones first. If the number of consumers in the market increases such as from population growth there should be a greater number of willing and able buyers at some given price. Remember that the market demand curve (schedule) is simply the sum of individual consumer demand curves (schedules). This implies that market demand will increase and the market demand curve shifts to the right. A similar outcome results if there is a change in consumer tastes or desire for a particular product. If a product like low-cut jeans becomes the latest fashion fad, demand at any given price will increase and the demand curve shifts to the right. On the other hand, if there is a decline in the size of the market or a product becomes unfashionable or obsolete then the demand curve shifts to the left.

2. Income: Normal Versus Inferior Goods

You might expect an increase in income to lead to an increase in demand for a product and in most cases you will be right. For normal goods an increase in income means a consumer will purchase more of the good at a particular price, which would cause the demand curve to shift to the right. But there are inferior goods for which an increase in income leads to a decrease in demand.

 


Normal Good – an increase in income leads to an increase in demand (the demand curve shifts to the right).Inferior Good – an increase in income leads to a decrease in demand (the demand curve shifts to the left).

Compare a premium brand ice cream with a generic store-branded ice cream. As your income increases you may begin to purchase more premium ice cream and less of the lower quality generic store-branded ice cream. The premium ice cream is a normal good while the generic store-branded ice cream is an inferior good.

Actually this may not be the best example. Use of the terms normal and inferior in economics are not meant to indicate a good or bad quality product but only a consumer’s response to changes in income. For example, I do most of the remodelling on my home using the scarce resource of my time. I am pretty good at installing hardwood floors and building sheds. But if I had more income I would likely hire a contractor to do the work. The quality difference between my efforts and a contractor’s is minimal, but my effort is an inferior good because my demand for it would decline with increasing income, while the contractor’s effort is a normal good in that higher income leads to an increase in demand.

3. Prices of Other Related Goods: Complements versus Substitutes in Demand

The demand for one good can be affected by the price of another related good. For example, consider our demand curve for DVD movies. The demand for DVD movies depends on how many people own DVD players. As the price of DVD players falls and more people buy DVD players (according to the Law of Demand for DVD players) then the demand for DVD movies will increase and the demand curve for DVD movies will shift to the right. This is an example of complements in demand.

Of course not all products complement each other. Some products may compete with each other like DVD and VHS movies (a more common textbook example is butter and margarine). As the price of VHS movies declines some people will reduce their purchases of DVDs and switch to VHS movies instead. So, as the price of VHS movies declines people buy more VHS movies, the demand for DVDs will decline, and the demand curve for DVDs will shift to the left. This is an example of substitutes in demand.

 


Complements in Demand – goods that are normally consumed together (e.g., DVD players and DVD movies). As the price of one complement declines, demand for the other complement will increase.Substitutes in Demand – goods that are normally consumed in place of each other (e.g., butter and margarine). As the price of one substitute declines, demand for the other substitute will decrease.

We can summarize the price impact of complements or substitutes in demand in Table 3-5. Changes in the prices of complements and substitutes have opposite effects on the demand for a good. As the price of a complement goes up, demand declines. As the price of a substitute goes up, demand increases.

 

Table 3-5. How the Demand Curve for Good A Is Affected
by Changes in the Price of Related Good B

  Change in Price
of Good B
  Change in Demand
for Good A
  Demand Curve for
Good A Shifts
Example

Complements Increase Decrease Left DVD Movies and DVD Players
Substitutes Increase Increase Right DVD movies and VHS movies

Complements and substitutes in demand are goods that are related to each other. Most goods, however, are basically unrelated. We assume that a change in price of one good has no significant effect on the demand curve for other unrelated goods. For example, a decline in the price of hamburger meat may increase the demand for hamburger buns (a complement in demand) and reduce the demand for chicken (a substitute in demand) but it should have no significant effect on the demand for air travel, haircuts, milk, and all other unrelated goods and services. This assumption regarding unrelated goods is not strictly valid, but it is convenient in that simplifies our analyses and models without causing significant problems (remember Occam’s razor in Chapter 1).

4. Change in Demand Versus Change in Quantity Demanded

We have introduced two different ways that the quantity of purchases of a good can change. Because of this we must highlight the specific language we have used to distinguish between the two.

 

      • First we said that according to the Law of Demand that a change in price will lead to a movement along a stable demand curve and result in a change in the quantity demanded. For example, more will be purchased but only at a lower price. The only thing that can change the quantity demanded is a change in the market price. 

         

      • Second we said that if one of the ceteris paribus assumptions is violated (e.g., a change in income) there will be a change in demand. Economists use the term “demand” to refer to the entire demand curve. Consequently when we say there has been an increase in demand we mean that the entire demand curve has shifted to the right. More will now be purchased at the same price. 

 


Change in Quantity Demanded – a movement along a fixed demand curve in response to a change in the price of that good, ceteris paribus (everything else unchanged).Change in Demand – a shift of the demand curve in response to a change in one of the variables assumed to be held constant under the ceteris paribus assumption (e.g., income), holding the good’s price constant.

  • Supply Curve Shifts

When we defined the ceteris paribus assumption for the Law of Supply above we specifically mentioned:

 

      • prices of inputs to the production process (labor, raw materials, cost of capital)
      • production technology
      • prices of other products from the same resources or production process

 

All of these are directly related to the production process. A change in any one of these will cause the supply curve to shift to the right or left. In other words, at some given price, firms will be willing to produce for sale either more or less. For example, in Figure 3-7 we show as increase in supply as a shift of the supply curve to the right.

Shift of Supply Curve
Figure 3-7. Shift of Supply Curve

1. Prices of Inputs and Production Technology

The cost of production is probably one of the most important influences on the position of the supply curve. As the cost of production increases, firms will be forced to reduce production unless they can raise the market price of the final product. At some given price less will now be produced, which means the supply curve will shift to the left.

Costs of production relate to the costs of the human and nonhuman inputs to the production process. An increase in the costs of inputs such as raw materials, energy, or labor will shift the supply curve to the left. For example, as the price of fertilizer goes up, some farmers will find it no longer economical to grow wheat. At some given price less wheat will be produced.

Costs of production can also decline such as from the benefits of technological innovation. With improvements in technology and lower production costs the supply curve will shift to the right. At some given price more will be produced.

2. Prices of Other Products from the Same Production Process

Many production processes yield more than one product from the same inputs. For example, crude oil is refined into propane, motor gasoline, diesel fuel, heating oil, and other products. These are byproducts of the same production process and are referred to as complements in production. If the price of just one of the byproducts changes this affects the profitability of the entire production process and the economics of producing all of the byproducts is affected. When the price of gasoline increases, oil refiners have an incentive to increase their crude oil refinery processing rates to produce more. This also yields increases in the output of all the other byproducts. An increase in the market price of motor gasoline leads to an increase in supply (shift of the supply curve to the right) of the propane, diesel fuel, and heating oil products.

Substitutes in production, on the other hand, are goods that are produced as alternatives to each other using the same inputs to the production process. For example, wheat and rye grains are substitutes in production where either one can be grown on the same field. If the price of rye grain increases, farmers have incentive to switch from growing wheat to growing rye. As the price of rye increases, the supply curve for its substitute in production, wheat, shifts to the left.

We can summarize the price impact of complements or substitutes in supply in Table 3-6. Changes in the prices of complements and substitutes have opposite effects on the supply for a good. As the price of a complement goes up, supply increases. As the price of a substitute goes up, supply declines.

 

Table 3-6. How the Supply Curve for Good A Is Affected
by Changes in the Price of Related Good B

  Change in Price
of Good B
  Change in Supply
of Good A
  Supply Curve for
Good A Shifts
Example

Complements Increase Increase Right beef and leather
Substitutes Increase Decrease Left Rye and wheat grains

Notice that the supply curve response to a change in the price of a complement or substitute in supply in Table 3-6 is opposite of the demand curve response to a change in the price of a complement or substitute in demand in Table 3-5. As the price of a complement in supply goes up, supply increases. As the price of a complement in demand goes up, demand declines.

 


Complements in Production – goods that are normally produced together (e.g., beef and leather). As the price of one complement declines, production of the other complement will decrease.Substitutes in Production – goods that are normally produced in place of each other (e.g., rye and wheat grains). As the price of one substitute declines, production of the other substitute will increase.

3. Change in Supply versus Change in Quantity Supplied

Just like on the demand side we have introduced two different ways that the production quantity of a good can change. Again we must highlight the specific language we have used to distinguish between the two:

 

      • First we said that according to the Law of Supply that a change in price will lead to a movement along a stable supply curve and result in a change in the quantity supplied. For example, more will be produced for sale but only at a higher price. 

         

      • Second we said that if one of the ceteris paribus assumptions is violated (e.g., a change in technology) there will be a change in supply. Economists use the term “supply” to refer to the entire supply curve. Consequently when we say there has been an increase in supply we mean that the entire supply curve has shifted to the right. More will now be produced at the same price. 

 


Change in Quantity Supplied – a movement along a fixed supply curve in response to a change in the price of that good, ceteris paribus (everything else unchanged).Change in Supply – a shift of the supply curve in response to a change in one of the variables assumed to be held constant under the ceteris paribus assumption (e.g., technology), holding the good’s price constant.

  • Changes in Equilibrium

When the demand curve, the supply curve, or both shift there will be a change in the equilibrium price and quantity in the market.

With an increase in demand (demand curve shift to the right) there will be an increase in both the equilibrium price and quantity as shown in Figure 3-8. A decrease in demand leads to a decrease in both the equilibrium price and quantity. Equilibrium price and quantity respond in the same direction as the shift in the demand curve.

An increase in supply (supply curve shifts to the right) produces a higher equilibrium quantity but a lower equilibrium price as shown in Figure 3-9. With supply curve shifts the equilibrium price and quantity change in opposite directions. The equilibrium quantity moves in the same direction as the supply curve but the equilibrium price takes the opposite track.

 

Increase in Demand
Figure 3-8. Increase in Demand
Increase in Supply
Figure 3-9. Increase in Supply

When both the demand curve and the supply curve shift the analysis can be a little trickier. When both curves shift, changes in both equilibrium price and quantity are possible but not certain, and the direction of change for only one of the two can be predicted.

Consider an increase in both supply and demand. An increase in demand leads to a higher equilibrium quantity. An increase in supply also leads to a higher equilibrium quantity. Thus, an increase in both supply and demand must lead to a higher equilibrium quantity. But on the price side we have opposite effects. An increase in demand leads to a higher equilibrium price while an increase in supply leads to a lower equilibrium price. When both demand and supply increase we can’t predict what will happen to the equilibrium price unless we know whether the increase in demand was greater or smaller than the increase in supply and also what the slopes of the demand and supply curves are. We say the change in equilibrium price in this situation is ambiguous.

 

Change in Equilibrium
Price Quantity

Increase in Demand Higher Higher
Increase in Supply Lower Higher
Increase in Both ??? Higher

We can summarize the net effect of shifts in the demand curve, the supply curve, or both on the equilibrium price and quantity in Table 3-7. You can demonstrate each result by drawing demand and supply curves and comparing the starting equilibrium point to the final equilibrium point. To see that some equilibrium price or quantity changes are ambiguous try shifting one curve by only a small amount and then by a large amount.

 

Table 3-7. Effect of Supply and Demand Curve Shifts on Equilibrium Price and Quantity

Change in
Demand
Change in
Supply
Demand
Curve
Shift
Supply
Curve
Shift
Equilibrium
Price
Equilibrium
Quantity

increase no change right no change higher higher
decrease no change left no change lower lower
no change increase no change right lower higher
no change decrease no change left higher lower
increase increase right right ambiguous * higher
decrease decrease left left ambiguous * lower
increase decrease right left higher ambiguous*
decrease increase left right lower ambiguous*

* Ambiguous – may increase, decrease, or stay the same, depending on the size
of the change in demand relative to the change in supply.

5. Can Markets Fail?

So far in this chapter we have focused on the competitive free market system. But before we leave microeconomics and return to the macroeconomics path we should admit that markets are not always perfect. There are situations where markets can fail to allocate scarce resources efficiently. In general these situations provide a role for government. Although these are vital issues in microeconomics and do arise in macroeconomics (as well other other fields in economics such as public choice, industrial organization, etc.), we will subscribe to the principle of Occam’s razor and ignore these problems in this course.

1. Public Goods. A public good is a product or service that is (1) very costly and (2) you cannot exclude persons who do not pay for it from benefitting. National defense is a simple example. If I hire some tribesmen to defend my property against roving bands of barbarians it would be difficult to exclude my neighbors from the benefits even if they don’t contribute. Because the expense may far exceed the benefit I alone might receive I would not hire the defenders. Community action arises when a group recognizes each individual’s benefit may exceed their share of the total expense. But with very large groups it becomes difficult to keep some individuals from “freeriding” on the efforts of others. Governments are formed to compel participation by taxing members of the community to finance public goods such as defense, police, courts, roads, and so on. The incentives (benefits and costs) of an individual acting alone as in a free market can be very different from the incentives of an individual acting in a group. Consequently, a free market can fail to allocate the resources that a group would desire.

2. Externalities. An externality is a cost to consumers that does not appear in the price of a product. Consider pollution. The cost of pollution to a society in terms of health costs, lower quality of life, etc., may far exceed the cost of installing pollution control equipment. The problem becomes acute because pollution affects everyone, even those who don’t consume the product that caused the pollution. For example, I own a boat. Boats create air, water, and noise pollution. As a boat lover I would be reluctant to pay a much higher price for a boat that doesn’t pollute because the benefits of the lower pollution to me as an individual are small. But if I were to consider the combined effect of the pollution on all the non-boaters I might change my mind. But I’m not that saintly. The problem is very similar to that of public goods. The incentives of an individual acting alone can be very different from the incentives of an individual acting in a group. Most people would claim to be ardent environmentalists but scream loudly when the cost hits them directly. Make someone else clean up their act.

3. Market Power. A competitive market exists when there are many buyers and many sellers and no single buyer or seller dictates the market price. When there is only one (monopolist) or just a few firms (oligopolists) in a market, the firms are said to be “price makers” instead of “price takers.” The same can be said when there is just one consumer (monopsonist). The market price is still determined by supply and demand, but the supply curve of a monopolist is derived differently than that for a competitive market. In short, the market price will be higher (and the product quality will likely be lower) and less will be sold than in a competitive market. With a single buyer, the monopsonist’s demand curve will lead to a lower price and again less sold.

 


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