Principles of Microeconomics Unit 3 Review: Demand and Supply

Key Concepts

• Demand represents the quantity of a good or service that consumers are willing and able to purchase at various prices
• Supply represents the quantity of a good or service that producers are willing and able to sell at various prices
• Market equilibrium occurs when the quantity demanded equals the quantity supplied, resulting in a stable price
• Price elasticity measures the responsiveness of quantity demanded or supplied to changes in price
• Shifts in demand or supply curves occur due to changes in non-price determinants (income, preferences, input costs, technology)
• Movements along demand or supply curves occur due to changes in price, holding all else constant
• Consumer and producer surplus represent the benefits gained by consumers and producers, respectively, from participating in a market

Demand Basics

• Demand is typically represented by a downward-sloping curve on a graph with price on the vertical axis and quantity on the horizontal axis
• The law of demand states that, all else being equal, as the price of a good increases, the quantity demanded decreases, and vice versa
• Factors that influence demand include consumer income, preferences, prices of related goods (substitutes and complements), and expectations about future prices
  • An increase in consumer income typically leads to an increase in demand for normal goods (goods for which demand increases as income rises)
  • A decrease in the price of a substitute good (a good that can be used in place of another) leads to a decrease in demand for the original good
• The demand curve can be derived from the individual demand curves of all consumers in a market
• A demand schedule is a table that shows the quantity demanded at various prices, holding all other factors constant

Supply Basics

• Supply is typically represented by an upward-sloping curve on a graph with price on the vertical axis and quantity on the horizontal axis
• The law of supply states that, all else being equal, as the price of a good increases, the quantity supplied increases, and vice versa
• Factors that influence supply include input prices, technology, expectations about future prices, and the number of sellers in the market
  • An increase in input prices (costs of production) leads to a decrease in supply
  • Improvements in technology that lower production costs lead to an increase in supply
• The supply curve can be derived from the individual supply curves of all producers in a market
• A supply schedule is a table that shows the quantity supplied at various prices, holding all other factors constant
• The price at which a firm is willing to supply a given quantity is based on the firm's marginal cost (the cost of producing one additional unit)

Market Equilibrium

• Market equilibrium occurs at the price and quantity where the demand and supply curves intersect
• At the equilibrium price, the quantity demanded equals the quantity supplied, resulting in a stable market with no shortages or surpluses
• If the price is above the equilibrium price, a surplus occurs, as the quantity supplied exceeds the quantity demanded
  • This puts downward pressure on the price, as sellers compete to sell their excess supply
• If the price is below the equilibrium price, a shortage occurs, as the quantity demanded exceeds the quantity supplied
  • This puts upward pressure on the price, as buyers compete for the limited supply
• In a competitive market, the forces of supply and demand will push the price toward the equilibrium price

Shifts vs. Movements

• A shift in the demand or supply curve occurs when a non-price determinant changes, causing the entire curve to move to a new position
  • For demand, non-price determinants include income, preferences, prices of related goods, and expectations
  • For supply, non-price determinants include input prices, technology, expectations, and the number of sellers
• A movement along the demand or supply curve occurs when the price changes, causing a change in the quantity demanded or supplied
  • A movement along the demand curve is called a change in quantity demanded
  • A movement along the supply curve is called a change in quantity supplied
• It is essential to distinguish between shifts and movements to accurately analyze changes in market conditions
• When both demand and supply shift, the effect on equilibrium price and quantity depends on the relative magnitudes of the shifts

Elasticity

• Elasticity measures the responsiveness of one variable to changes in another variable
• Price elasticity of demand measures the percentage change in quantity demanded in response to a percentage change in price
  • Elastic demand (|elasticity| > 1): Quantity demanded is highly responsive to price changes
  • Inelastic demand (|elasticity| < 1): Quantity demanded is not very responsive to price changes
  • Unit elastic demand (|elasticity| = 1): Percentage change in quantity demanded equals percentage change in price
• Price elasticity of supply measures the percentage change in quantity supplied in response to a percentage change in price
  • Elastic supply (elasticity > 1): Quantity supplied is highly responsive to price changes
  • Inelastic supply (elasticity < 1): Quantity supplied is not very responsive to price changes
  • Unit elastic supply (elasticity = 1): Percentage change in quantity supplied equals percentage change in price
• Factors affecting price elasticity of demand include the availability of substitutes, the proportion of income spent on the good, and the time horizon
• Factors affecting price elasticity of supply include the flexibility of production, the time horizon, and the availability of inputs

Real-World Applications

• Understanding demand and supply is crucial for businesses when setting prices, determining production levels, and making investment decisions
  • A company may choose to increase prices if it faces inelastic demand, as the quantity demanded will not decrease significantly
  • A company may invest in new technology to increase supply and lower costs, allowing it to capture a larger market share
• Governments use the concepts of demand and supply when designing policies, such as taxes, subsidies, and price controls
  • A tax on a good with inelastic demand will generate more revenue than a tax on a good with elastic demand
  • A price ceiling (maximum price) set below the equilibrium price will result in a shortage, while a price floor (minimum price) set above the equilibrium price will result in a surplus
• The concepts of demand and supply can be applied to various markets, such as labor markets, financial markets, and international trade
  • In the labor market, the demand for labor is derived from the demand for the goods and services produced by that labor
  • In international trade, changes in exchange rates can affect the demand and supply of imports and exports

Common Pitfalls

• Confusing a change in demand with a change in quantity demanded, or a change in supply with a change in quantity supplied
  • A change in demand or supply refers to a shift in the entire curve due to a change in a non-price determinant
  • A change in quantity demanded or supplied refers to a movement along the existing curve due to a change in price
• Assuming that a change in price always leads to a change in demand or supply
  • A change in price causes a movement along the existing demand or supply curve, not a shift in the curve
• Ignoring the ceteris paribus (all else being equal) assumption when analyzing changes in demand or supply
  • The ceteris paribus assumption allows us to isolate the effect of a single variable while holding all other variables constant
• Failing to consider the time horizon when analyzing elasticity
  • In the short run, demand and supply tend to be more inelastic, as consumers and producers have less time to adjust to price changes
  • In the long run, demand and supply tend to be more elastic, as consumers and producers have more time to find substitutes or alter production
• Neglecting to account for externalities (costs or benefits imposed on third parties) when evaluating market outcomes
  • Positive externalities (benefits to third parties) may lead to an underallocation of resources in a market
  • Negative externalities (costs to third parties) may lead to an overallocation of resources in a market