THEORY OD DEMAND AND SUPPLY

 A firm is an organization that

transforms resources (inputs) into
products (outputs). Firms are the
primary producing units in a market
economy.
 An entrepreneur is a person who
organizes, manages, and assumes the
risks of a firm, taking a new idea or a
new product and turning it into a
successful business.
 Households are the consuming units in
an economy.
 The circular flow of
economic activity
shows the connections
between firms and
households in input and
output markets.
  Output, or product,
markets are the
markets in which goods
and services are
exchanged.
 Input markets are the

markets in which
resources—labor,
• Payments flow in the opposite capital, and land—used
direction as the physical flow of to produce products,
resources, goods, and services
(counterclockwise). are exchanged.
Input markets include:
 The labor market, in which households
supply work for wages to firms that demand
labor.
 The capital market, in which households
supply their savings, for interest or for
claims to future profits, to firms that
demand funds to buy capital goods.
 The land market, in which households
supply land or other real property in
exchange for rent.
A household’s decision about the quantity of a particular
output to demand depends on:
 The price of the product in question.
 The income available to the household.
 The household’s amount of accumulated
wealth.
 The prices of related products available
to the household.
 The household’s tastes and preferences.
 The household’s expectations about future
income, wealth, and prices.
 Quantity demanded is the
amount (number of units) of a
product that a household would
buy in a given time period if it
could buy all it wanted at the
current market price.
 ANNA'S DEMAND
 A demand
SCHEDULE FOR schedule is a table
TELEPHONE CALLS showing how much
QUANTITY of a given product a
PRICE DEMANDED
(PER (CALLS PER household would be
CALL) MONTH) willing to buy at
$ 0 30
0.50 25
different prices.
3.50 7  Demand curves are
7.00 3
10.00 1
usually derived
15.00 0 from demand
schedules.
 ANNA'S DEMAND
SCHEDULE FOR
 The demand curve
TELEPHONE CALLS is a graph illustrating
QUANTITY how much of a given
PRICE DEMANDED
(PER (CALLS PER product a household
$
CALL)
0
MONTH)
30
would be willing to
0.50 25 buy at different
3.50 7
7.00 3 prices.
10.00 1
15.00 0
 The law of demand
states that there is a
negative, or inverse,
relationship between
price and the quantity
of a good demanded
and its price.

• This means that

demand curves slope
downward.
 Demand curves intersect
the quantity (X)-axis, as a
result of time limitations and
diminishing marginal utility.
 Demand curves intersect
the (Y)-axis, as a result of
limited incomes and wealth.
 Income is the sum of all
households wages, salaries, profits,
interest payments, rents, and other
forms of earnings in a given period
of time. It is a flow measure.
 Wealth, or net worth, is the total

value of what a household owns

minus what it owes. It is a stock
measure.
 Normal Goods are goods for which
demand goes up when income is
higher and for which demand goes
down when income is lower.
 Inferior Goods are goods for which
demand falls when income rises.
 Substitutes are goods that can serve
as replacements for one another; when
the price of one increases, demand for
the other goes up. Perfect
substitutes are identical products.
 Complements are goods that “go

together”; a decrease in the price of

one results in an increase in demand
for the other, and vice versa.
• A change in demand is
not the same as a change
in quantity demanded.
• In this example, a higher
price causes lower
quantity demanded.
• Changes in determinants
of demand, other than
price, cause a change in
demand, or a shift of the
entire demand curve, from
DA to DB.
• When demand shifts to
the right, demand
increases. This causes
quantity demanded to be
greater than it was prior to
the shift, for each and
every price level.
To summarize:
Change in price of a good or service
leads to

Change in quantity demanded

(Movement along the curve).

Change in income, preferences, or

prices of other goods or services
leads to

Change in demand
(Shift of curve).
• Higher income • Higher income
decreases the demand increases the demand
for an inferior good for a normal good
 • Demand for complement good
(ketchup) shifts left

• Demand for substitute good (chicken)

shifts right

• Price of hamburger rises

• Quantity of hamburger
demanded falls
 Demand for a good or service can
be defined for an individual
household, or for a group of
households that make up a market.
 Market demand is the sum of all

the quantities of a good or service

demanded per period by all the
households buying in the market for
that good or service.
 Assuming there are only two households in the
market, market demand is derived as follows:
CLARENCE BROWN'S • A supply schedule is a table
SUPPLY SCHEDULE showing how much of a product
FOR SOYBEANS
firms will supply at different
QUANTITY
SUPPLIED prices.
PRICE (THOUSANDS
(PER OF BUSHELS • Quantity supplied represents the
BUSHEL) PER YEAR)
$ 2 0 number of units of a product that
1.75
2.25
10
20
a firm would be willing and able to
3.00 30 offer for sale at a particular price
4.00
5.00
45
45
during a given time period.
• A supply curve is a graph illustrating how much
of a product a firm will supply at different prices.
CLARENCE BROWN'S 6

Price of soybeans per bushel ($)

SUPPLY SCHEDULE
FOR SOYBEANS 5
QUANTITY
SUPPLIED
4
PRICE (THOUSANDS
(PER OF BUSHELS
3
BUSHEL) PER YEAR) 2
$ 2 0
1.75 10 1
2.25 20
3.00 30 0
4.00 45
5.00 45 0 10 20 30 40 50
Thousands of bushels of soybeans
produced per year
 6  The law of
Price of soybeans per bushel ($)

5 supply states that

4 there is a positive
3 relationship
2
between price and
1
quantity of a good
0
0 10 20 30 40 50
supplied.
Thousands of bushels of soybeans  This means that
produced per year
supply curves
typically have a
positive slope.
 The price of the good or service.
 The cost of producing the good, which in
turn depends on:
◦ The price of required inputs (labor,
capital, and land),
◦ The technologies that can be used
to produce the product,
 The prices of related products.
 • A change in supply is
not the same as a
change in quantity
supplied.
• In this example, a higher
price causes higher
quantity supplied, and
a move along the
demand curve.
• In this example, changes in determinants of supply, other
than price, cause an increase in supply, or a shift of the
entire supply curve, from SA to SB.
• When supply shifts
to the right, supply
increases. This
causes quantity
supplied to be
greater than it was
prior to the shift, for
each and every price
level.
To summarize:
Change in price of a good or service
leads to

Change in quantity supplied

(Movement along the curve).

Change in costs, input prices, technology, or prices of

related goods and services
leads to

Change in supply
(Shift of curve).
 The supply of a good or service can be
defined for an individual firm, or for a group
of firms that make up a market or an
industry.
 Market supply is the sum of all the

quantities of a good or service supplied per

period by all the firms selling in the market
for that good or service.
 As with market demand, market supply is
the horizontal summation of individual
firms’ supply curves.
 The operation of the market
depends on the interaction
between buyers and sellers.
 An equilibrium is the condition

that exists when quantity

supplied and quantity
demanded are equal.
 At equilibrium, there is no

tendency for the market price

to change.
 Only in equilibrium
is quantity
supplied equal to
quantity
demanded.
• At any price level
other than P0, the
wishes of buyers
and sellers do not
coincide.
 Excess demand, or
shortage, is the
condition that exists
when quantity
demanded exceeds
quantity supplied at
the current
• When quantityprice.
demanded
exceeds quantity
supplied, price tends to
rise until equilibrium is
restored.
 Excess supply, or
surplus, is the condition
that exists when quantity
supplied exceeds quantity
demanded at the current
price.

• When quantity supplied

exceeds quantity
demanded, price tends to
fall until equilibrium is
restored.
 Higher demand leads to  Higher supply leads to
higher equilibrium price lower equilibrium price
and higher equilibrium and higher equilibrium
quantity. quantity.
 Lower demand leads to  Lower supply leads to
lower price and lower higher price and lower
quantity exchanged. quantity exchanged.
• The relative magnitudes of change in supply and
demand determine the outcome of market equilibrium.
• When supply and demand both increase, quantity
will increase, but price may go up or down.