Macroeconomics

Eighth Edition

Chapter 3
Where Prices Come From:
The Interaction of Demand
and Supply

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Chapter Outline
3.1 The Demand Side of the Market
3.2 The Supply Side of the Market
3.3 Market Equilibrium: Putting Demand and Supply Together
3.4 The Effect of Demand and Supply Shifts on Equilibrium

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A Basketball Player Takes a Tumble
—And So Does Nike
Nike has the largest market
share among athletic shoe
firms.
When Duke University’s Zion
Williamson’s Nike athletic shoe
split open in a 2018-19 game,
Nike was subject to intense
criticism on social media.
Suppose fans’ desire to buy
Nikes decreases; how would
this affect the price of Nikes
and how many Nikes are sold?
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Our Model of a Market
To analyze the market for Nike athletic shoes or anything
else, we need a model of how buyers and sellers behave.
The model we use in this chapter is a perfectly competitive
market, a market with (1) many buyers and sellers, (2) all
firms selling identical products, and (3) no barriers to new
firms entering the market.
While these assumptions are quite restrictive, the model is
still useful for analyzing many markets.

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3.1 The Demand Side of the Market
List and describe the variables that influence demand.

We begin our analysis of where prices come from by

investigating how buyers behave.
• We refer to this as market demand, the demand by all
the consumers of a given good or service.

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Figure 3.1 A Demand Schedule and a
Demand Curve (1 of 3)

Demand schedule: A table that shows the relationship between the

price of a product and the quantity of the product demanded.
Demand curve: A curve that shows the relationship between the price
of a product and the quantity of the product demanded.

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Figure 3.1 A Demand Schedule and a
Demand Curve (2 of 3)

When drawing the demand curve, we assume ceteris paribus.

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.

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Figure 3.1 A Demand Schedule and a
Demand Curve (3 of 3)

Quantity demanded: The amount of a good or service that a consumer is willing

and able to purchase at a given price.
Law of demand: A rule that states 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.
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What Explains the Law of Demand?
When the price of a good falls, two effects take place:
1. Consumers substitute toward the good whose price has fallen.
2. Consumers have more purchasing power, which is like an
increase in income.

We call these the substitution effect and the income effect:

Substitution effect: The change in the quantity demanded of a good
that results from a change in price, making the good more or less
expensive relative to other goods, holding constant the effect of the
price change on consumer purchasing power.
Income effect: The change in the quantity demanded of a good that
results from the effect of a change in the good’s price on a consumers’
purchasing power, holding all other factors constant.

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Figure 3.2 Shifting the Demand Curve (1 of 2)

A change in something
other than price that
affects demand causes
the entire demand curve
to shift.
A shift to the right (D1 to
D2) is an increase in
demand.
A shift to the left (D1 to
D3) is a decrease in
demand.
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Figure 3.2 Shifting the Demand Curve (2 of 2)

As the demand curve

shifts, the quantity
demanded will change,
even if the price
doesn’t change.
The quantity demanded
changes at every
possible price.

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Variables That Shift Market Demand
Income
• Increase in income increases demand if product is normal,
decreases demand if product is inferior.

Prices of related goods

• Increase in price of related good increases demand if products are
substitutes, decreases demand if products are complements.

Tastes
Population and demographics
Expected future prices
We will discuss how each of these affects demand.

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Changes in Income of Consumers
Normal goods: Goods for which the demand increases as
income rises and decreases as income falls.

Examples: New clothes

Restaurant meals
Vacations
Inferior goods: Goods for which the demand increases
as income falls and decreases as income rises.

Examples: Second-hand clothes

Instant noodles

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Effects of Changes in Income
An increase in income would increase
the demand for new clothes, ceteris
paribus.

However the same increase in

income would likely decrease the
demand for second-hand clothes.

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Changes in the Price of Related Goods
Substitutes: Goods and services that can be used for the
same purpose.

Examples: Big Mac and Whopper

Ford F-150 and Dodge Ram
Jeans and Khakis
Complements: Goods and services that are used together.
Examples: Big Mac and McDonald’s fries
Hot dogs and hot dog buns
Left shoes and right shoes
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Effects of Changes in the Price of
Related Goods
An increase in the price of a Big Mac
would increase the demand for
Whoppers.

However the same increase in the

price of a Big Mac would decrease
the demand for McDonald’s fries.

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Apply the Concept: Are There Enough
Complements for Virtual Reality Headsets?
Virtual reality headsets are
potential superior substitutes
for game consoles like Sony
Playstation or Microsoft Xbox.
But those consoles already
have many complements:
games produced for them.
For now, sales of virtual reality
headsets are lagging; one main
reason is the lack of desirable
complements—games.

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Changes in Tastes
Tastes
If consumers’ tastes change, they may buy more or less of the
product.

Example: If consumers become more concerned about eating

healthily, they might decrease their demand for fast food.

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Changes in Population/Demographics
Demographics: The characteristics of a population with respect to age,
race, and gender.
Increases in the number of people buying something will increase the
amount demanded.

Example: An increase in the elderly population increases the demand

for medical care.

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Changes in Expectations About Future
Prices
Consumers decide which products to buy,
but also when to buy them.
• Future products are substitutes for
current products.
• An expected increase in the price
tomorrow increases demand today.
• An expected decrease in the price
tomorrow decreases demand today.
Example: If you found out the price of
gasoline would go up tomorrow, you
would increase your demand today.

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Apply the Concept: Apple’s Policy on
Product Speculation
Apple strongly discourages its employees from speculating
about when a new model will appear. Why?
Suppose a customer learns that a new iPad model will be
available next month.
• The new model is a potential substitute for the current
model.
• The price of the current model will likely fall next month.
• Both effects decrease current demand (bad for Apple!).

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Figure 3.3 A Change in Demand v s ersu

Change in Quantity Demanded

A change in the price of the
product being examined
causes a movement along
the demand curve.
• This is a change in
quantity demanded.
Any other change affecting
demand causes the entire
demand curve to shift.
• This is a change in
demand.

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Apply the Concept: Forecasting the
Demand for Athletic Shoes (1 of 2)
To forecast future demand for
athletic shoes, manufacturers
need to anticipate how demand
will change:
• How will incomes change?
• How will the availability of
substitutes change?
• How will consumers’ tastes
change?
• How will consumer
demographics change?
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Apply the Concept: Forecasting the
Demand for Athletic Shoes (2 of 2)
How will the following changes
affect the demand for athletic
shoes?
• Younger consumers are running
less but working out in group
classes more.
• Women are more likely to wear
casual shoes.
• Incomes are rising in developing
countries such as China and
India.
• Population growth in North
America and Europe is slowing.
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3.2 The Supply Side of the Market
List and describe the variables that influence supply.

There are some similarities, and some important

differences between the demand and supply sides of the
market.
In this section we examine the market supply, i.e. the
decisions of (generally) firms about how much of a product
to provide at various prices.

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Figure 3.4 A Supply Schedule and
Supply Curve (1 of 2)

Supply schedule: A table that shows the relationship between the price
of a product and the quantity of the product supplied.
Supply curve: A curve that shows the relationship between the price of
a product and the quantity of the product supplied.

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Figure 3.4 A Supply Schedule and
Supply Curve (2 of 2)

Quantity supplied: The amount of a good or service that a firm is willing

and able to supply at a given price.
Law of supply: A rule that states that, holding everything else constant,
increases in price cause increases in the quantity supplied, and decreases
in price cause decreases in the quantity supplied.
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Figure 3.5 Shifting the Supply Curve (1 of 2)
A change in something other
than price that affects supply
causes the entire supply
curve to shift.
• A shift to the right (S1 to S3)
is an increase in supply.
• A shift to the left (S1 to S2) is
a decrease in supply.

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Figure 3.5 Shifting the Supply Curve (2 of 2)
As the supply curve shifts,
the quantity supplied will
change, even if the price
doesn’t change.
The quantity supplied
changes at every possible
price.

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What Factors Influence Market Supply?
Prices of inputs
Technological change
Prices of related goods in production
Number of firms in the market
Expected future prices

We will discuss how each of these affects supply.

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Change in Prices of Inputs
Inputs are things used in the
production of a good or service.
For an athletic shoe, inputs include
the rubber, plastic, and labor.
An increase in the price of an
input decreases the profitability of
selling the good, causing a
decrease in supply.
A decrease in the price of an
input increases the profitability of
selling the good, causing an
increase in supply.

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Technological Change
A firm may experience a positive or
negative change in its ability to
produce a given level of output with
a given quantity of inputs. We call
this a technological change.
Examples:
• A new, more efficient way of
producing shoes would
increase their supply.
• Governmental restrictions on
how much workers are allowed
to work might decrease the
supply of athletic shoes.

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Prices of Related Goods in Production
Many firms can produce and sell alternative
products: substitutes in production.
Example: An Illinois farmer can plant
corn or soybeans. If the price of
soybeans rises, he will plant (supply)
less corn.
Sometimes, two products are necessarily
produced together: complements in
production
Example: Cattle provide both beef and
leather. An increase in the price of beef
encourages more cattle farming, and
hence increase the supply of leather.

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Number of Firms and Expected Future
Prices
More firms in the market will result
in more product available at a
given price (greater supply).
Fewer firms  supply decreases.

If a firm anticipates that the price of

its product will be higher in the
future, it might decrease its supply
today in order to increase it in the
future.

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Apply the Concept: Fracking, the U.S.
Oil Boom, and Expected Oil Prices

The development of hydraulic fracturing (fracking) disrupted the world oil

market, propelling the U.S. to be the world’s largest oil producer.
In 2016, U.S. oil producers believed the price of oil was temporarily low.
They reduced current production, intending to sell more later when prices
recovered.
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Figure 3.6 A Change in Supply Versus
a Change in Quantity Supplied
A change in the price of the
product being examined
causes a movement along
the supply curve.
• This is a change in
quantity supplied.
Any other change affecting
supply causes the entire
supply curve to shift.
• This is a change in
supply.
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3.3 Market Equilibrium: Putting Demand
and Supply Together
Use a graph to illustrate market equilibrium.

Market equilibrium is a situation in which quantity

demanded equals quantity supplied.
Recall that markets with many buyers and sellers are
perfectly competitive markets; a market equilibrium in
one of these markets is called a competitive market
equilibrium.
There are ~35 firms selling athletic shoes; we will
assume this is enough to generate competitive behavior
in the market for athletic shoes.

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Figure 3.7 Market Equilibrium
At a price of $100,
• consumers want to buy 10 million
pairs of shoes per week, and
• producers want to sell 10 million
pairs of shoes per week.

We say the equilibrium price in

this market is $100, and the
equilibrium quantity is 10 million
pairs of shoes per week.

Since buyers and sellers want to

trade the same quantity at the
price of $100, we do not expect the
price to change.

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Figure 3.8 The Effect of Surpluses and
Shortages on the Market Price (1 of 2)
What if the price were $125
instead?
At a price of $125,
• consumers want to buy 9 million
pairs of shoes, while
• producers want to sell 11 million
pairs.

This gives a surplus of 2 million

pairs; a situation in which quantity
supplied is greater than quantity
demanded.

Prediction: sellers will compete

amongst themselves, driving the
price down.

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Figure 3.8 The Effect of Surpluses and
Shortages on the Market Price (2 of 2)
Now what if the price were $50?
At a price of $50,
• consumers want to buy 12
million pairs of shoes, while
• producers want to sell 8 million.

This gives a shortage of 4 million

pairs of shoes; a situation in which
quantity demanded is greater than
quantity supplied.

Prediction: sellers will realize they

can increase the price and still sell
as many pairs of shoes, so the
price will rise.

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Demand and Supply Both Count
Price is determined by the interaction of buyers and
sellers.
Neither group can dictate price in a competitive market
(i.e. one with many buyers and sellers).
However changes in supply and/or demand will affect
the price and quantity traded.

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Figure 3.9 The Effect of an Increase in
Demand on Equilibrium
Suppose incomes increase.
What happens to the
equilibrium in the athletic
shoe market?
Athletic shoes are a normal
good, so as income rises,
demand shifts to the right
(D1 to D2).

• Equilibrium price rises (P1

to P2).
• Equilibrium quantity rises
(Q1 to Q2).
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Figure 3.10 The Effect of an Increase in
Supply on Equilibrium (1 of 2)
The graph shows the market
for athletic shoes as a new
shoemaker, Allbirds, enters
the market.
When Allbirds enters, more
shoes are supplied at any
given price—an increase in
supply from S1 to S2.
• Equilibrium price falls from
P1 to P2.
• Equilibrium quantity rises
from Q1 to Q2.
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Figure 3.10 The Effect of an Increase in
Supply on Equilibrium (2 of 2)
By how much will price
fall? By how much will
quantity rise?
We cannot say, without
knowing more
information.
For now, we can only
predict that price will fall
and quantity traded will
rise.

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Table 3.3 How Shifts in Demand and Supply Affect
Equilibrium Price (P) and Quantity (Q) (1 of 2)
Supply Curve Supply Curve Shifts to Supply Curve Shifts to
Blank
Unchanged the Right the Left

Q unchanged Q increases Q decreases

Demand Curve Unchanged
P unchanged P decreases P increases

Demand Curve Shifts to the Q increases

Blank Blank
Right P increases

Demand Curve Shifts to the Q decreases

Blank Blank
Left P decreases

The table summarizes what happens when the demand curve shifts or
the supply curve shifts, with the other curve remaining unchanged.

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Figure 3.11 Shifts in Demand and
Supply over Time (1 of 3)
Over time, it is likely that
both demand and supply
will change.
For example, as new
firms enter the market for
athletic shoes and
incomes increase, we
expect:
• The supply curve will
shift to the right, and
• The demand curve will
shift to the right.

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Figure 3.11 Shifts in Demand and
Supply over Time (2 of 3)
What does our model predict?

S   (P  and Q  )
D   (P  and Q  )
So we can be sure
equilibrium quantity will
rise, but the effect on
equilibrium price is not
clear.
This panel shows demand
shifting more than supply:
equilibrium price and
quantity both rise.

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Figure 3.11 Shifts in Demand and
Supply over Time (3 of 3)
This panel shows supply
shifting more than demand:
quantity rises, but
equilibrium price falls.
Without knowing the relative
size of the changes, the
effect on equilibrium price is
ambiguous.
It is possible, but unlikely,
that the equilibrium price will
remain unchanged.

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Apply the Concept: Higher Demand for
Cobalt—But Lower Prices? (1 of 2)
Demand for Teslas and other
electric cars has been rising,
increasing the demand for
minerals contained in their
batteries, such as cobalt and
lithium.
But the price of these
minerals decreased during
2018 and 2019 despite the
increased demand. How
could this be?

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Apply the Concept: Higher Demand for
Cobalt—But Lower Prices? (2 of 2)
Firms that mine these
minerals were aware
that demand was
increasing, and
increased their supply
substantially.
The increase in supply
was greater than the
increase in demand,
pushing down the price
of cobalt (graphed) and
lithium.

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Shifts of a Curve v s Movements Along aersu

Curve
Suppose an increase in supply occurs. We now know:
• Equilibrium quantity will increase, and
• Equilibrium price will decrease.

It is tempting to believe the decrease in price will cause an increase in

demand. But this is incorrect.
• The decrease in price will cause a movement along the demand curve
but not an increase in demand.
• Why? The demand curve already describes how much of the good
consumers want to buy, at any given price.
• When the price change occurs, we just look at the demand curve to
see what happens to how much consumers want to buy.

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Homework
• Read Ch. 3 material in textbook
• Ch. 3 Homework in MyEconLab
• Ch. 3 quizzes in MyEconLab.

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