Chapter 2

Basic Elements of Supply and Demand

Markets are like the weather—sometimes stormy, sometimes calm, but always changing. Yet a
careful study of markets will reveal certain forces underlying the apparently random movements.
To forecast prices and outputs in individual markets, you must first master the analysis of supply
and demand. Economics has a very powerful tool for explaining such changes in the economic
environment. It is called the theory of supply and demand. This theory shows how consumer
preferences determine consumer demand for commodities, while business costs are the
foundation of the supply of commodities. Using these basic tools, we will see how the market
price is determined where these two curves intersect—where the forces of demand and supply
are just in balance. It is the movement of prices—the price mechanism— which brings supply
and demand into balance or equilibrium.

A. THE DEMAND SCHEDULE

If you demand something, then you 1. Want it, 2. Can afford it, and 3. Plan to buy it. Scarcity
guarantees that many—perhaps most—of our wants will never be satisfied. Demand reflects a
decision about which one wants to satisfy.
The quantity demanded of a good or service is the amount that consumers plan to buy during a
given time period at a particular price. The quantity demanded is not necessarily the same as the
quantity actually bought.Sometimes the quantity demanded exceeds the amount of goods
available, so the quantity bought is less than the quantity demanded. The quantity demanded
is measured as an amount per unit of time. For example, suppose that you buy one cup of coffee
a day. The quantity of coffee that you demand can be expressed as 1 cup per day, 7 cups per
week, or 365 cups per year.
There exists a definite relationship between the market price of a good and the quantity
demanded of that good, other things held constant. This relationship between price and
quantity bought is called the demand schedule, or the demand curve.

Let’s look at a simple example. Table 3-1 presents a hypothetical demand schedule for
cornflakes. At each price, we can determine the quantity of cornflakes that consumers purchase.
For example, at $5 per box, consumers will buy 9 million boxes per year.
At a lower price, more cornflakes are bought. Thus, at a price of $4, the quantity bought is 10
million boxes. At yet a lower price ( P ) equal to $3, the quantity demanded ( Q ) is still greater,
at 12 million. And so forth. We can determine the quantity demanded at each listed price in
Table 3-1

THE DEMAND CURVE

The graphical representation of the demand schedule is the demand curve. We show the demand
curve in Figure 3-2, which graphs the quantity of cornflakes demanded on the horizontal axis
and the price of cornflakes on the vertical axis. Note that quantity and price are inversely related;
that is, Q goes up when P goes down. The curve slopes downward, going from northwest to
southeast. This important property is called the law of downward-sloping demand. It is based on
common sense as well as economic theory and has been empirically tested and verified for

1
practically all commodities—cornflakes, gasoline college education, and illegal drugs being a
few examples.

In the demand curve for cornflakes, price (P) is measured on the vertical axis while quantity
demanded (Q) is measured on the horizontal axis. Each pair of (P, Q) numbers from Table 3-1 is
plotted as a point, and then a smooth curve is passed through the points to give us a demand
curve, DD. The negative slope of the demand curve illustrates the law of downward-sloping
demand.

Law of downward-sloping demand

When the price of a commodity is raised (and other things are held constant), buyers tend to buy
less of the commodity. Similarly, when the price is lowered, other things being constant, quantity
demanded increases. Quantity demanded tends to fall as price rises for two reasons:
1. First is the substitution effect, which occurs because a good becomes relatively more
expensive when its price rises. When the price of good A rises, I will generally substitute
goods B, C, D, . . .for it. For example, as the price of beef rises, I eat more chicken.

2. A higher price generally also reduces quantity demanded through the income effect. This
comes into play because when a price goes up, I find myself somewhat poorer than I was
before. If gasoline prices double, I have in effect less real income, so I will naturally curb
my consumption of gasoline and other goods.

2
Market Demand
Market demand represents the sum total of all individual demands. The market demand is what is
observable in the real world.
The market demand curve is found by adding together the quantities demanded by all individuals
at each price. Does the market demand curve obey the law of downward-sloping demand?
It certainly does. If prices drop, for example, the lower prices attract new customers through the
substitution effect. In addition, a price reduction will induce extra purchases of goods by existing
consumers through both the income and the substitution effects. Conversely, a rise in the price of
a good will cause some of us to buy less.

Forces behind the Demand Curve

A whole array of factors influences how much will be demanded at a given price:
● The average income of consumers is a key determinant of demand. As people’s incomes
rise, individuals tend to buy more of almost everything, even if prices don’t change. Automobile
purchases tend to rise sharply with higher levels of income.
● The size of the market —measured, say, by the population—clearly affects the market
demand curve. California’s 40 million people tend to buy 40 times more apples and cars than do
Rhode Island’s 1 million people.
● The prices and availability of related goods influence the demand for a commodity. A
particularly important connection exists among substitute goods—ones that tend to perform the
same function, such as cornflakes and oatmeal, pens and pencils, small cars and large cars, or oil
and natural gas. Demand for good A tends to be low if the price of substitute product B is low.
(For example, as computer prices fell, what do you think happened to the demand for
typewriters?)
● In addition to these objective elements, there is a set of subjective elements called tastes or
preferences. Tastes represent a variety of cultural and historical influences. They may reflect
genuine psychological or physiological needs (for liquids, love, or excitement). And they may
include artificially contrived cravings (for cigarettes, drugs, or fancy sports cars). They may also
contain a large element of tradition or religion (eating beef is popular in America but taboo in
India, while curried jellyfish is a delicacy in Japan but would make many Americans gag).
● Finally, special influences will affect the demand for particular goods. The demand for
umbrellas is high in rainy Seattle but low in sunny Phoenix; the demand for air conditioners will
rise in hot weather; the demand for automobiles will be low in New York, where public
transportation is plentiful and parking is a nightmare.

3
The determinants of demand are summarized in Table 3-2 , which uses automobiles as an
example.

Shifts in Demand
Why does the demand curve shift?
Because influences other than the good’s price change. Let’s work through an example of how a
change in a non price variable shifts the demand curve. We know that the average income of
Americans rose sharply during the long economic boom of the 1990s. Because there is a
powerful income effect on the demand for automobiles, this means that the quantity of
automobiles demanded at each price will rise. For example, if average incomes rose by 10
percent, the quantity demanded at a price of $10,000 might rise from 10 million to 12 million
units. This would be a shift in the demand curve because the increase in quantity demanded
reflects factors other than the good’s own price. The net effect of the changes in underlying
influences is what we call an increase in demand. An increase in the demand for automobiles is
illustrated in Figure 3-4 as a rightward shift in the demand curve. Note that the shift means that
more cars will be bought at every price.
When there are changes in factors other than a good’s own price which affect the quantity
purchased, we call these changes shifts in demand. Demand increases (or decreases) when the
quantity demanded at each price increases (or decreases).
You can test yourself by answering the following questions: Will a warm winter shift the
demand curve for heating oil leftward or rightward? Why? What will happen to the
demand for baseball tickets if young people lose interest in baseball and watch basketball
instead?

4
As elements underlying demand change, the demand for automobiles is affected. Here we
see the effect of rising average income, increased population, and lower gasoline prices on
the demand for automobiles. We call this shift of the demand curve an increase in demand.

B. THE SUPPLY SCHEDULE

The supply side of a market typically involves the terms on which businesses produce and sell
their products. The supply of tomatoes tells us the quantity of tomatoes that will be sold at
each tomato price. More precisely, the supply schedule relates the quantity supplied of a good
to its market price, other things constant. In considering supply, the other things that are held
constant include input prices, prices of related goods, and government policies. The supply
schedule (or supply curve) for a commodity shows the relationship between its market price and
the amount of that commodity that producers are willing to produce and sell, other things held
constant.

THE SUPPLY CURVE

Table 3-3 shows a hypothetical supply schedule for cornflakes, and Figure 3-5 plots the data
from the table in the form of a supply curve. These data show that at a cornflakes price of $1 per
box, no cornflakes at all will be produced. At such a low price, breakfast cereal manufacturers
might want to devote their factories to producing other types of cereal, like bran flakes, that earn
them more profit than cornflakes. As the price of cornflakes increases, ever ore cornflakes will
be produced. At ever-higher cornflakes prices, cereal makers will find it profitable to add more

5
workers and to buy more automated cornflakes-stuffing machines and even more cornflakes
factories. All these will increase the output of cornflakes at the higher market prices.
Figure 3-5 shows the typical case of an upward- sloping supply curve for an individual
commodity. One important reason for the upward slope is “the law of diminishing returns.”

The supply curve plots the price and quantity pairs from Table 3-3. A smooth curve is
passed through these points to give the upward-sloping supply curve, SS.

Forces behind the Supply Curve

6
In examining the forces determining the supply curve, the fundamental point to grasp is that
producers supply commodities for profit and not for fun or charity. One major element
underlying the supply curve is the cost of production.
When production costs for a good are low relative to the market price, it is profitable for
producers to supply a great deal. When production costs are high relative to price, firms produce
little, switch to the production of other products, or may simply go out of business. Production
costs are primarily determined by the prices of inputs and technological advances.
The prices of inputs such as labor, energy, or machinery obviously have a very important
influence on the cost of producing a given level of output. For example, when oil prices rose
sharply in 2007, the increase raised the price of energy for manufacturers, increased their
production costs, and lowered their supply. By contrast, as computer prices fell over the last three
decades, businesses increasingly substituted computerized processes for other inputs, as for
example in payroll or accounting operations; this increased supply.
An equally important determinant of production costs is technological advances, which consist
of changes that lower the quantity of inputs needed to produce the same quantity of output. Such
advances include everything from scientific breakthroughs to better application of existing
technology or simply reorganization of the flow of work. For example, manufacturers have
become much more efficient in recent years. It takes far fewer hours of labor to produce an
automobile today than it did just 10 years ago. This advance enables car makers to produce more
automobiles at the same cost. To give another example, if Internet commerce allows firms to
compare more easily the prices of necessary inputs, that will lower the cost of production.
But production costs are not the only ingredient that goes into the supply curve. Supply is also
influenced by the prices of related goods, particularly goods that are alternative outputs of the
production process. If the price of one production substitute rises, the supply of another
substitute will decrease. An interesting example occurred in U.S. farming. The government has
raised the subsidy on automotive ethanol to reduce imports of foreign oil. Ethanol is today
primarily made from corn. The increased demand for corn (a shift in the demand curve for corn)
increased the corn price. As a result, farmers planted corn instead of soybeans. The net result was
that the supply of soybeans declined and soybean prices rose. All of this occurred because of a
subsidy to reduce oil imports.
Government policy also has an important impact on the supply curve. We just discussed the
case of ethanol subsidies and corn production. Environmental and health considerations
determine what technologies can be used, while taxes and minimum-wage laws can significantly
affect input prices. Government trade policies have a major impact upon supply. For instance,
when a free-trade agreement opens up the U.S. market to Mexican footwear, the total supply of
footwear in the United States increases.
Finally, special influences affect the supply curve. The weather exerts an important influence on
farming and on the ski industry. The computer industry has been marked by a keen spirit of
innovation, which has led to a continuous flow of new products. Market structure will affect
supply, and expectations about future prices often have an important impact upon supply
decisions.

Table 3-4 highlights the important determinants of supply, using automobiles as an

example.

7
Shifts in Supply
When changes in factors other than a good’s own price affect the quantity supplied, we call these
changes shifts in supply. Supply increases (or decreases) when the amount supplied increases
(or decreases) at each market price.
When automobile prices change, producers change their production and quantity supplied, but
the supply and the supply curve do not shift. By contrast, when other influences affecting supply
change, supply changes and the supply curve shifts.
We can illustrate a shift in supply for the automobile market. Supply would increase if the
introduction of cost-saving computerized design and manufacturing reduced the labor required to
produce cars, if auto workers took a pay cut, if there were lower production costs in Japan, or if
the government repealed environmental regulations on the industry. Any of these elements would
increase the supply of automobiles in the United States at each price.
Figure 3-6 illustrates an increase in the supply of automobiles.
As production costs fall, the supply of automobiles increases. At each price, producers will
supply more automobiles, and the supply curve therefore shifts to the right. (What would
happen to the supply curve if Congress were to put a restrictive quota on automobile
imports?)
To test your understanding of supply shifts, think about the following: What would happen
to the world supply curve for oil if a revolution in Saudi Arabia led to declining oil
production? What happens to the supply curve for computers if Intel introduces a new
computer chip that dramatically increases computing speeds?

8
 C.EQUILIBRIUM OF SUPPLY AND DEMAND
The market equilibrium comes at that price and quantity where the forces of supply and
demand are in balance. At the equilibrium price, the amount that buyers want to buy is just
equal to the amount that sellers want to sell. The reason we call this an equilibrium is that, when
the forces of supply and demand are in balance, there is no reason for price to rise or fall, as long
as other things remain unchanged.

9
The table shows the quantities supplied and demanded at different prices. Only at the
equilibrium price of $3 per box does amount supplied equal amount demanded. At too low
a price there is a shortage and price tends to rise. Too high a price produces a surplus,
which will depress the price.
Let us work through the cornflakes example in Table 3-5 to see how supply and demand
determine a market equilibrium; the numbers in this table come from Tables 3-1 and 3-3 . To
find the market price and quantity, we find a price at which the amounts desired to be bought and
sold just match. If we try a price of $5 per box, will it prevail for long? Clearly not. As row A in
Table 3-5 shows, at $5 producers would like to sell 18 million boxes per year while demanders
want to buy only 9. The amount supplied at $5 exceeds the amount demanded, and stocks of
cornflakes pile up in supermarkets. Because too few consumers are chasing too many cornflakes,
the price of cornflakes will tend to fall, as shown in column (5) of Table 3-5.
Say we try $2. Does that price clear the market? A quick look at row D shows that at $2
consumption exceeds production. Cornflakes begin to disappear from the stores at that price. As
people scramble around to find their desired cornflakes, they will tend to bid up the price of
cornflakes, as shown in column (5) of Table 3-5.
We could try other prices, but we can easily see that the equilibrium price is $3, or row C in
Table 3-5. At $3, consumers’ desired demand exactly equals producers’ desired production, each
of which is 12 units. Only at $3 will consumers and suppliers both be making consistent
decisions.
A market equilibrium comes at the price at which quantity demanded equals quantity supplied.
At that equilibrium, there is no tendency for the price to rise or fall. The equilibrium price is also
called the market-clearing price. This denotes that all supply and demand orders are filled, the
books are “cleared” of orders, and demanders and suppliers are satisfied.

EQUILIBRIUM WITH SUPPLY AND DEMAND CURVES

We often show the market equilibrium through a supply-and-demand diagram like the one in
Figure 3-7; this figure combines the supply curve from Figure 3-5 with the demand curve
from Figure 3-2. Combining the two graphs is possible because they are drawn with exactly the
same variables and units on each axis. We find the market equilibrium by looking for the price

10
at which quantity demanded equals quantity supplied. The equilibrium price comes at the
intersection of the supply and demand curves, at point C.

Start with the initial high price of $5 per box, shown at the top of the price axis in Figure 3-7.
At that price, suppliers want to sell more than demand wan to buy. The result is a surplus, or
excess of quantity supplied over quantity demanded, shown in the figure by the blue line labeled
“Surplus.” The arrows along the curves show the direction that price tends to move when a
market is in surplus.
At a low price of $2 per box, the market shows a shortage, or excess of quantity demanded over
quantity supplied, here shown by the blue line labeled “Shortage.” Under conditions of shortage,
the competition among buyers for limited goods causes the price to rise, as shown in the figure
by the arrows pointing upward.
We now see that the balance or equilibrium of supply and demand comes at point C, where
the supply and demand curves intersect. At point C, where the price is $3 per box and the
quantity is 12 units, the quantities demanded and supplied are equal: there are no shortages or
surpluses; there is no tendency for price to rise or fall. At point C and only at point C, the forces
of supply and demand are in balance and the price has settled at a sustainable level.
The equilibrium price and quantity come where the amount willingly supplied equals the
amount willingly demanded. In a competitive market, this equilibrium is found at the
intersection of the supply and demand curves. There are no shortages or surpluses at the
equilibrium price.

Effect of a Shift in Supply or Demand

11
Let’s change our example to the staff of life, bread. Suppose that a spell of bad weather raises the
price of wheat, a key ingredient of bread. That shifts the supply curve for bread to the left. This is
illustrated in Figure 3-8 (a), where the bread supply curve has shifted from SS to S’S’. In
contrast, the demand curve has not shifted because people’s sandwich demand is unaffected by
farming weather.
What happens in the bread market? The bad harvest causes profit-maximizing bakers to produce
less bread at the old price, so quantity demanded exceeds quantity supplied. The price of bread
therefore rises, encouraging production and thereby raising quantity supplied, while
simultaneously discouraging consumption and lowering quantity demanded. The price continues
to rise until, at the new equilibrium price, the amounts demanded and supplied are once again
equal.
As Figure 3-8 (a) shows, the new equilibrium is found at E’, the intersection of the new
supply curve S’S’ and the original demand curve. Thus a bad harvest (or any leftward shift of the
supply curve) raises prices and, by the law of downward-sloping demand, lowers quantity
demanded. Suppose that new baking technologies lower costs and therefore increase supply.
That means the supply curve shifts down and to the right. Draw in a new S’’’ S’’’ curve, along
with the new equilibrium E’”. Why is the equilibrium price lower? Why is the equilibrium
quantity higher? We can also use our supply-and-demand apparatus to examine how changes in
demand affect the market equilibrium. Suppose that there is a sharp increase in family incomes,
so everyone wants to eat more bread.
This is represented in Figure 3-8 (b) as a “demand shift” in which, at every price, consumers
demand a higher quantity of bread. The demand curve thus shifts rightward from DD to D’D’.
The demand shift produces a shortage of bread at the old price. A scramble for bread ensues.
Prices are bid upward until supply and demand come back into balance at a higher price.
Graphically, the increase in demand has changed the market equilibrium from E to E” in Figure
3-8 (b).

For both examples of shifts—a shift in supply and a shift in demand—a variable underlying the
demand or supply curve has changed. In the case of supply, there might have been a change in
technology or input prices. For the demand shift, one of the influences affecting consumer
demand—incomes, population, the prices of related goods, or tastes—changed and thereby
shifted the demand schedule (see Table 3-6 ).
When the elements underlying demand or supply change, this leads to shifts in demand or
supply and to changes in the market equilibrium of price and quantity.

12
Interpreting Changes in Price and Quantity
An important issue that arises is how to interpret price and quantity changes. We sometimes hear,
“Gasoline demand does not obey the law of downward-sloping demand. From 2003 to 2006
prices rose sharply [as shown in Figure 3 -1], yet U.S. gasoline consumption went up rather
than down. What do you economists say about that!” We cannot provide a definitive explanation
without a careful look at the forces affecting both supply and demand. But the most likely
explanation for the paradox is that the rise in gasoline prices over this period was due to shifts in
demand rather than movements along the demand curve. Sometimes, in simple situations,
looking at price and quantity simultaneously gives you a clue about whether it is the supply
curve or the demand curve that has shifted. For example, a rise in the price of bread
accompanied by a decrease in quantity suggests that the supply curve has shifted to the left (a
decrease in supply). A rise in price accompanied by an increase in quantity indicates that the
demand curve for bread has probably shifted to the right (an increase in demand).
13
Figure 3-9 illustrates the point. In both panel ( a ) and panel ( b ), quantity goes up. But in ( a )
the price rises, and in ( b ) the price falls. Figure 3-9 ( a ) shows the case of an increase in
demand, or a shift in the demand curve. As a result of the shift, the equilibrium quantity
demanded increases from 10 to 15 units. The case of a movement along the demand curve is
shown in Figure 3-9 ( b ). In this case, a supply shift changes the market equilibrium from point
E to point E”. As a result, the quantity demanded changes from 10 to 15 units. But demand does
not change in this second case; rather, quantity demanded increases as consumers move along
their demand curve from E to E” in response to a price change.

14
Supply, Demand, and Immigration
A fascinating and important example of supply and demand, full of complexities, is the role of
immigration in determining wages. If you ask people, they are likely to tell you that immigration
into California or Florida surely lowers the wages of people in those regions. It’s just supply and
demand.

15
They might point to Figure 3-10 ( a ), which shows a supply-and- demand analysis of
immigration. According to this analysis, immigration into a region shifts the supply curve for
labor to the right and pushes down wages.
How can we explain the small impact of immigration on wages? Labor economists emphasize
the high geographic mobility of the American population. This means that new immigrants will
quickly spread around the entire country. Once they arrive, immigrants may move to cities where
they can get jobs—workers tend to move to those cities where the demand for labor is already
rising because of a strong local economy. This point is illustrated in Figure 3-10 ( b ), where a
shift in labor supply to S’ S’ is associated with a higher demand curve, D’ D’. The new
equilibrium wage at E” is the same as the original wage at E . Another factor is that native-born
residents may move out when immigrants move in, so the total supply of labor is unchanged.
This would leave the supply curve for labor in its original position and leave the wage
unchanged. Immigration is a good example for demonstrating the power of the simple tools of
supply and demand.

RATIONING BY PRICES
Let us now take stock of what the market mechanism accomplishes. By determining the
equilibrium prices and quantities, the market allocates or rations out the scarce goods of the
society among the possible uses. Who does the rationing? A planning board? Congress? The
16
president? No. The marketplace, through the interaction of supply and demand, does the
rationing. This is rationing by the purse.
What goods are produced? This is answered by the signals of market prices. High corn prices
stimulate corn production, whereas falling computer prices stimulate a growing demand for
computation. Those who have the most dollar votes have the greatest influence on what goods
are produced.
For whom are goods produced? The power of the purse dictates the distribution of income and
consumption. Those with higher incomes end up with larger houses, fancier cars, and longer
vacations. When backed up by cash, the most urgently felt needs get fulfilled through the
demand curve.
Even the how question is decided by supply and demand. When corn prices are high, farmers
buy expensive tractors and more fertilizer and invest in irrigation systems. When oil prices are
high, oil companies drill in deep offshore waters and employ novel seismic techniques to find
oil.
With this introduction to supply and demand, we begin to see how desires for goods, as
expressed through demands, interact with costs of goods, as reflected in supplies. Further study
will deepen our understanding of these concepts and will show how these tools can be applied to
other important areas. But even this first survey will serve as an indispensable tool for
interpreting the economic world in which we live.

------------------------

17