• Demand, Supply, and Equilibrium in Markets for Goods and Services• Shifts in Demand and Supply for Goods and Services • Changes in Equilibrium Price and Quantity: The Four-Step Process • Price Ceilings and Price Floors

3 | Demand and Supply – Week 1

Demand, Supply, and Equilibrium in Markets for Goods and Services

The Demand for a Good or a Service

Economists use the term individual or household demand to refer to the amount of some good or service a household or consumer is willing and able to purchase at each price. The market demand is the horizontal sum of all individual demands. All demand is based on needs and wants. But, simply wanting something alone is not good enough to qualify as a demand. Demand is also constrained by one’s ability to pay. If you cannot pay for a good, you have no effective demand for the good. A young boy may really want a new BMW, but most do not have enough buying power to actually buy it and be part of the demand for BMWs.

People who correctly use the term “demand” mean a curve showing the maximum amount of “quantity demanded” for a given price assuming all other factors are held constant. It is the price and those “all other factors” that determine the demand for a good.

(LEFT) - This is demand in tabular form – it shows the maximum quantity demanded at various prices…note that there are no other factors affecting demand that are shown in the table…they are being held constant

(RIGHT) - This is demand in graphical form – it shows the maximum quantity demanded at various prices…again note that there are no other factors affecting demand that are shown in the graph…they are being held constant

“Demand” is a curve, while “quantity demanded” is a point on the horizontal axis. Changes in price cannot shift demand but can alter the quantity demanded. A lower price raises the quantity demanded, but it does not increase demand. The distinction is very important. Neither a change in P not a change in Q can shift demand – one merely moves along a stationary demand curve.

Exogenous variables held constant – the ceteris paribus assumptions

A demand curve is a relationship between two, and only two, variables: quantity on the horizontal axis and price on the vertical axis. The assumption behind a stationary demand curve is that no relevant economic factors, other than the product’s price and quantity, are changing, even hypothetically. Economists call this assumption ceteris paribus, a Latin phrase meaning “other things being equal.” Any given demand is based on the ceteris paribus assumption that all else is held constant.

Demand-side ceteris paribus variables being held constant by assumption

Income, Wealth, and Taxes Tastes and PreferencesQuality of the Good or Service Size and Structure of the PopulationAdvertising Foreign Exchange RateSubstitute Prices Interest RateComplement PricesWeatherExpectations of future price

Supply of a Good or a Service

When economists talk about the supply of a firm, they mean a curve showing the quantities, at various hypothetical prices, that if produced and sold will maximize the profits of the firm, holding all other variables constant. The market supply is the horizontal sum of the individual supplies of all the firms in the industry.

Note how that as price changes from $3 to $4, the quantity supplied changes from 100 units/ time to 120 units/time. This shows that neither price nor quantity can shift supply. The same is true for demand. Only the ceteris paribus variables can shift supply or demand.

Exogenous variables held constant – the ceteris paribus assumptions

A supply curve is a relationship between two, and only two, variables: quantity on the horizontal axis and price on the vertical axis. No relevant economic factors, other than the product’s price and quantity, are changing, even hypothetically. Any given supply is based on the ceteris paribus assumption that all else is held constant.

Supply-side ceteris paribus variables being held constant by assumption

Money wages Number of firms in the industryOther productive factor prices Quality of the good or service Foreign exchange rateWeather Expectations of future price

Individual Supply versus Market Supply

Firm 1 Firm 2 Firm 3 Market

To arrive at the market supply (regardless of the industry, one simply adds together the individual supplies of the firms HORIZONTALLY. What would happen if the individual supplies of the firms were exactly the same curve?

Equilibrium in the Market