Chapter 3 - Interaction of Supply and Demand

Market price is determined by

both supply and demand

According to the law of demand​, there is an inverse relationship between price and quantity demanded. That​ is, the demand curve for goods and services slopes downward.​ Why?

When the price of a good​ increases, consumers' purchasing power​ falls, and they cannot buy as much of the good as they did prior to the price change.

The distinction between substitutes and complements is

substitute goods are used for the same purposes while complementary goods are used together.

In​ general, the term ​"ceteris paribus​" means

all else equal. Ceteris paribus ​(​"all else ​equal"​) condition The requirement that when analyzing the relationship between two variables—such as price and quantity demanded—other variables must be held constant. That​ is, we assume that the only event that affects our consumption of a good or service is the price. In​ reality, the economy is much more complex.​ However, in order to create models—simplified versions of the economy—and make distinct statements about the effect of changes in price on amount​ consumed, we hold other factors that affect consumption constant.

In the diagram to the​ right, when demand decreases​, a surplus develops at the original price. Equilibrium price will fall and equilibrium quantity will fall as a new equilibrium is established.

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In the diagram to the​ right, when supply decreases​, a shortage develops at the original price. Equilibrium price will rise and equilibrium quantity will fall as a new equilibrium is established.

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Consider the figure to the right and assume that it is the market for​ health-care services. When the​ "baby boomer" generation​ retires, the number of people who require health care increases by​ 30%, and, as a​ result, the number of​ health-care providers also​ increases, but by only​ 25%. What is the effect on the price of​ health-care services over​ time?

It increases because demand increased by more than supply. Whether the price of a product rises or falls over time depends on whether demand shifts by more than supply. When we consider the effect of a simultaneous increase in both supply and​ demand, the following rule​ applies: If demand increases by more than​ supply, the equilibrium price rises. If demand increases by less than​ supply, the equilibrium price falls. In this​ case, demand increases by more than supply increases.

According to the law of​ supply,

there is a positive relationship between price and quantity supplied. as the price of a product​ increases, firms will supply more of it to the market. Law of supply The rule​ that, holding everything else​ constant, increases in price cause increases in the quantity​ supplied, and decreases in price cause decreases in the quantity supplied. There is a positive relationship between price and quantity supplied.​ Therefore, the supply curve slopes upward. A change in quantity supplied is shown as a movement along the supply curve from one point to another.

According to the law of​ demand,

there is an inverse relationship between price and quantity demanded. Law of Demand The rule​ that, holding everything else​ constant, when the price of a product​ falls, the quantity demanded of the product will​ increase, and when the price of a product​ rises, the quantity demanded of the product will decrease. That​ is, there is an inverse relationship between price and quantity demanded. This is shown as a movement along the demand curve from any point to another.

The distinction between a normal and an inferior good is

when income​ increases, demand for a normal good increases while demand for an inferior good falls. Normal good: A good for which the demand increases as income rises and decreases as income falls. Inferior good: A good for which the demand increases as income falls and decreases as income rises.

A perfectly competitive market is a market that meets the conditions of

​(1) many buyers and​ sellers, (2) all firms selling identical​ products, and​ (3) no barriers to new firms entering the market. The model of demand and supply assumes that we are analyzing a perfectly competitive market. In a perfectly competitive​ market, there are many buyers and​ sellers, all the products sold are​ identical, and there are no barriers to new firms entering the market. These assumptions are very restrictive and apply exactly to only a few​ markets, such as the markets for wheat and other agricultural products. Experience has​ shown, however, that the model of demand and supply can be very useful in analyzing markets where competition among sellers is​ intense, even if there are relatively few sellers and the products being sold are not identical.

Consider the following​ statement: ​"An increase in supply decreases the equilibrium price. The decrease in price increases​ demand." The statement is

​false: decreases in price affect the quantity​ demanded, not demand. When a shift in the demand curve​ and/or the supply curve changes the equilibrium​ price, the resulting price change does not cause a further shift in the demand or supply curve. Changes in the price of a good or service only affect the quantity supplied or the quantity demanded. Changes in price do not affect the supply and demand curves. A change in quantity demanded or quantity supplied is the result of a change in the​ good's own price and causes a movement along the curve. A change in demand or supply is the result of changes in factors other than the​ good's own price and causes a shift in the entire curve.