Highlights of Economics from McConnell and Brue by Adrian Vrabie

Chapter 3: Supply and Demand

Understand Demand and Supply and you're 50% and Economist. According to McConnell and Brue:

The model of supply and demand is the economics profession’s greatest contribution to human understanding because it explains the operation of the markets on which we depend for nearly everything that we eat, drink, or consume. The model is so powerful and so widely used that to many people it is economics.

The following is a copy/paste from your assiged reading material. (for those who did not get a copy from the library :) )

This chapter explains how the model works and how it can explain both the quantities that are bought and sold in markets as well as the prices at which they trade.

Markets

Markets bring together buyers (“demanders”) and sellers (“suppliers”). The corner gas station, an e-commerce site, the local music store, a farmer’s roadside stand—all are familiar markets. To keep things simple, we will focus in this chapter on markets in which large numbers of independently acting buyers and sellers come together to buy and sell standardized products. Markets with these characteristics are the economy’s most highly competitive. They include the wheat market, the stock market, and the market for foreign currencies. All such markets involve demand, supply, price, and quantity. As you will soon see, the price is “discovered” through the interacting decisions of buyers and sellers.

Demand

Demand is a schedule or a curve that shows the various amounts of a product that consumers are willing and able to purchase at each of a series of possible prices during a specified period of time.1 Demand shows the quantities of a product that will be purchased at various possible prices, other things equal. Demand can easily be shown in table form.

To be meaningful, the quantities demanded at each price must relate to a specific period—a day, a week, a month. Saying “A consumer will buy 10 bushels of corn at $5 per bushel” is meaningless. Saying “A consumer will buy 10 bushels of corn per week at $5 per bushel” is meaningful. Unless a specific time period is stated, we do not know whether the demand for a product is large or small.

The Law of Demand:

Other things equal, as price falls, the quantity demanded rises, and as price rises, the quantity demanded falls.

In short, there is a negative or inverse relationship between price and quantity demanded. Economists call this inverse relationship the law of demand.

Why the inverse relationship between price and quantity demanded? Let’s look at three explanations, beginning with the simplest one:

• The law of demand is consistent with common sense. People ordinarily do buy more of a product at a low price than at a high price. Price is an obstacle that deters consumers from buying. The higher that obstacle, the less of a product they will buy; the lower the price obstacle, the more they will buy. The fact that businesses have “sales” to clear out unsold items is evidence of their belief in the law of demand.
• In any specific time period, each buyer of a product will derive less satisfaction (or benefit, or utility) from each successive unit of the product consumed. The second Big Mac will yield less satisfaction to the consumer than the first, and the third still less than the second. That is, consumption is subject to diminishing marginal utility. And because successive units of a particular product yield less and less marginal utility, consumers will buy additional units only if the price of those units is progressively reduced.

Income and Substitution Effect

We can also explain the law of demand in terms of income and substitution effects.

• The income effect indicates that a lower price increases the purchasing power of a buyer’s money income, enabling the buyer to purchase more of the product than before. A higher price has the opposite effect.
• The substitution effect suggests that at a lower price buyers have the incentive to substitute what is now a less expensive product for other products that are now relatively more expensive. The product whose price has fallen is now “a better deal” relative to the other products.

Total Market Demand

Assume there are three buyers in a market. The market demand curve D is the horizontal summation of the individual demand curves (D1, D2, and D3) of all the consumers in the market. At the price of $3, for example, the three individual curves yield a total quantity demanded of 100 bushels (= 35 + 39 + 26).

Determinants of the Market Demand

The basic determinants of demand are:

1. consumers’ tastes (preferences)
2. the number of buyers in the market
3. consumers’ incomes
4. the prices of related goods
   • substitute good
   • complementary good
5. consumer expectations

Supply

Supply is a schedule or curve showing the various amounts of a product that producers are willing and able to make available for sale at each of a series of possible prices during a specific period.

The Law of Supply

As price rises, the quantity supplied rises; as price falls, the quantity supplied falls.

Market supply is derived from individual supply in exactly the same way that market demand is derived from individual demand. We sum the quantities supplied by each producer at each price. That is, we obtain the market supply curve by “horizontally adding” the supply curves of the individual producers.

Determinants of Supply

1. resource prices
2. technology
3. taxes and subsidies
4. prices of other goods
5. producer expectations
6. the number of sellers in the market.

A change in any one or more of these determinants of supply, or supply shifters, will move the supply curve for a product either right or left.

Market Equilibrium

The intersection of the downsloping demand curve D and the upsloping supply curve S indicates the equilibrium price and quantity, here $3 and 7000 bushels of corn. The shortages of corn at below equilibrium prices (for example, 7000 bushels at $2) drive up price. The higher prices increase the quantity supplied and reduce the quantity demanded until equilibrium is achieved.