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.