Demand, Supply, and Markets

This is Unit Two of Principles of Macroeconomics, part one of two: demand, supply, and the markets they meet in. Unit one closed on opportunity cost drawn three ways; this unit builds the course's second model. Carry one idea through this lecture. A market has two sides, and most of the mistakes made in this subject come from confusing a movement along a curve with a shift of the whole curve. That distinction is named in the middle of this part, turned into a routine, and then tested where both curves move at once. By the end you will be able to tell demand from quantity demanded, and supply from quantity supplied. To find equilibrium from a schedule and say the size of a shortage or a surplus. To decide which curve an event shifts, and which way. To say when an outcome cannot be determined. And to tell a binding price control from a harmless one.

Five entries setting the model up: what a market is, the two sides of one, and the law that governs each side.

How a market sets a price.

MAC 0101 What a Market Is

A market is any arrangement bringing buyers and sellers together, and demand and supply is the course's second fundamental model, after the frontier. Goods, labor and credit each have a market, with a price, a wage and an interest rate. The price on the vertical axis takes a different name in each, but the diagram does not change.

The buyers' side.

MAC 0102 Demand and Quantity Demanded

Demand is the whole relationship between price and the amount buyers are willing and able to buy; quantity demanded is the amount at one particular price. A schedule lists the pairs, and a curve draws them, with price on the vertical axis. Willing is not enough: without the ability to pay there is no demand a seller can act on.

Which way the relationship runs.

MAC 0103 The Law of Demand

The law of demand says a higher price lowers the quantity demanded, and a lower price raises it, with all other things held unchanged. A shop with too much stock holds a sale, expecting the lower price to move it. It is called a law because study after study has found it, not because it is true by definition.

The sellers' side.

MAC 0104 Supply and Quantity Supplied

Supply is the whole relationship between price and the amount sellers are willing to offer; quantity supplied is the amount at one particular price. The supply curve slopes upward, so higher prices bring more onto the market. The same distinction holds as on the demand side: supply is the curve, and quantity supplied is a point on it.

Why the supply curve rises.

MAC 0105 The Law of Supply

The law of supply says a higher price raises the quantity supplied, because a higher price covers the cost of producing more and raises the profit from doing so. A grower plants more acres when the price rises. Some things cannot be produced in greater quantity at any price, so the law holds for most goods rather than all.

Four entries on where the two sides meet: the balancing price, what happens at any other, and two ways of finding it.

Where the two sides meet.

MAC 0106 Equilibrium

Equilibrium is the price at which quantity demanded equals quantity supplied. It is the only price with no pressure to change, and it sets the equilibrium quantity too. The two curves cross at one point, and that point names both a price and a quantity. Equilibrium does not mean fair or good: it means balanced, and nothing more.

What happens at any other price.

MAC 0107 Surplus and Shortage

Above equilibrium, quantity supplied exceeds quantity demanded and there is a surplus. Below equilibrium, quantity demanded exceeds quantity supplied and there is a shortage. Unsold stock builds up, so sellers cut the price; or buyers compete, so sellers raise it. A surplus pushes the price down and a shortage pushes it up, so both press the market back toward equilibrium.

Reading it off a table.

MAC 0108 Finding Equilibrium from a Schedule

Given a table of prices with quantity demanded and quantity supplied beside each, work down the rows. At each price, subtract quantity supplied from quantity demanded. A positive difference is a shortage of that size, a negative one a surplus of that size, and a zero is the equilibrium price, with the common quantity as the equilibrium quantity. At four dollars buyers want ninety units and sellers offer thirty, a shortage of sixty. At seven dollars both are sixty, so seven dollars is the equilibrium price and sixty the equilibrium quantity. At nine dollars buyers want forty and sellers offer eighty, a surplus of forty. Read the question for which quantity is asked: the size of a shortage is the gap between the two quantities at that price, not the distance from the equilibrium quantity.

Doing the same with equations.

MAC 0109 Solving a Market with Algebra

When demand and supply are given as equations, write each quantity as a function of price, set the two equal because equilibrium is where they are equal, and solve for price. Then put that price back into both equations separately: if they give the same quantity, the arithmetic is right, and if they disagree, the check has caught something. Take quantity demanded as one hundred minus four times price, and quantity supplied as twenty plus two times price. Setting them equal gives eighty equals six price, so price is thirteen and a third, and both equations then return about forty-six and two thirds. Economists put price on the vertical axis although quantity is the variable being explained, which reverses the convention from unit one. The axis does not matter when solving algebraically, but it does when reading a graph.

Four entries on what moves the demand curve, beginning with the distinction the rest of this unit depends on.

The distinction the unit depends on.

MAC 0110 Shift versus Movement Along

A change in a good's own price moves you along its curve, and a change in anything else shifts the whole curve. A sale moves buyers along the curve; a rise in income moves the curve itself. Moving along is a change in quantity demanded, and shifting is a change in demand. This is the subject's most common error.

The first thing that shifts it.

MAC 0111 Income: Normal and Inferior Goods

For a normal good, demand rises when income rises. For an inferior good, demand falls when income rises, because buyers move to something they prefer. Higher income raises demand for fresh fruit and lowers it for canned. Inferior does not mean poor quality: it is defined only by which way demand moves when income moves.

Goods that move each other.

MAC 0112 Substitutes or Complements?

Two goods are related when the price of one shifts demand for the other, and the direction tells you which relation it is. Ask what a fall in the price of the first does to demand for the second. If demand for the second rises, the two are complements, used together. If it falls, they are substitutes, used instead of each other. The test works in reverse as well: a rise in one price raises demand for its substitute and lowers demand for its complement. Cheaper printers raise demand for ink, so those are complements; cheaper tea lowers demand for coffee, so those are substitutes. Do not classify by whether the goods seem similar. Tea and coffee are substitutes because of what the price change does, not because both are hot drinks.

The remaining demand shifters.

MAC 0113 Tastes, Population and Buyer Expectations

Demand also shifts with tastes and preferences, with the size and make-up of the population, and with what buyers expect prices to do next. Expecting a price rise tomorrow, buyers fill the tank today, which raises demand now. An expected future price change shifts demand in the present, which is why expectations sit on the shifter list rather than on the curve.

Two entries on the other curve: what changes the cost of producing, and two shifters the main list leaves out.

What moves the other curve.

MAC 0114 What Shifts Supply

Supply shifts with anything that changes the cost of producing: input prices, natural conditions, technology, and government taxes, regulations and subsidies. A tax raises cost and shifts supply left; a subsidy lowers it and shifts supply right. Better technology shifts supply right because it lowers cost, so more is offered at every price.

Two shifters the list leaves out.

MAC 0115 Seller Expectations and the Number of Sellers

Supply also shifts with what sellers expect and with how many sellers there are. Expecting a higher price later, a seller holds stock back now, as an oil owner expecting a higher price next year leaves more in the ground this year. More sellers shift supply right. A third shifter is the return available from producing something else.

Three entries on working out an event: a routine that settles any of them, the hard step inside it, and what to do when both curves move.

A routine for working it out.

MAC 0116 The Four-Step Process

Four steps settle any event: draw the market before it, decide whether demand or supply moves, decide which way, and compare the new equilibrium with the old. Good weather shifts a crop's supply right, so the price falls and the quantity rises. The quantity rose although demand never moved, and that is a movement along the demand curve.

The hard step, and how to take it.

MAC 0117 Which Curve Shifts, and Which Way

The hard step is the second one, deciding which curve moves. Ask whether the event changes what buyers want at every price, or what sellers offer at every price. If it changes buyers' willingness or ability, it is demand; if it changes the cost or ease of producing, it is supply. Then read the direction from the shift: supply right lowers the price and raises the quantity, supply left raises the price and lowers the quantity, demand right raises both, and demand left lowers both. A pest destroys half a crop. Incomes, tastes and numbers are unchanged, so demand does not move; producing has become harder, so supply shifts left, the price rises and the quantity falls. The classic wrong answer reasons that less is available so buyers demand less, and shifts demand left as well, which would predict a falling price, the opposite of what a ruined harvest does.

When both curves move at once.

MAC 0118 When Both Curves Shift

When demand and supply both shift, one of the two answers is determinate and the other is not. Work each shift separately and note what it does to price and to quantity. Where the two push the same variable the same way, that direction is certain. Where they push it in opposite directions, the outcome depends on which shift is larger, and the honest answer is that it cannot be determined from the information given. Buyers and sellers both come to expect a higher price next month: demand rises now, raising price and raising quantity, while supply falls now, raising price and lowering quantity. Both push the price up, so the price rises for certain, and the change in quantity is indeterminate. Indeterminate is a real answer, not a failure to finish. A question in which both curves move is usually testing whether you will claim certainty about the variable that has none.

Four entries on what happens when a price is set by law: the two kinds, and how to tell a control that bites from one that does nothing.

When a price is set by law.

MAC 0119 Price Controls

A price control is a law setting a price instead of letting the market set it. A ceiling is a legal maximum and a floor a legal minimum. Rent control is a ceiling; the minimum wage is a floor. A control bites only on the binding side of equilibrium, because otherwise the market price is already legal.

The first kind.

MAC 0120 Price Ceilings

A price ceiling is a legal maximum price. Set below equilibrium it binds and creates a lasting shortage, because the price cannot rise to clear the market. At the capped price buyers want more than sellers will offer, and the gap does not close. Set above equilibrium a ceiling does nothing, since the market price is already below it.

The other kind.

MAC 0121 Price Floors

A price floor is a legal minimum price. Set above equilibrium it binds and creates a lasting surplus, because the law stops the price from falling to clear the market. At the floor, sellers offer more than buyers will take, and the excess stays unsold. Set below equilibrium a floor does nothing, because the market price is already above it.

Telling binding from harmless.

MAC 0122 Binding or Not

To decide whether a control matters, compare it with the equilibrium price and remember which direction each kind blocks. A ceiling forbids prices above it, so it binds only when it sits below equilibrium, and then it produces a shortage. A floor forbids prices below it, so it binds only when it sits above equilibrium, and then it produces a surplus. A control that does not bind leaves price and quantity exactly where the market put them. With equilibrium at seven dollars, a ceiling of five binds and leaves buyers wanting ninety against thirty offered, a shortage of sixty, while a ceiling of nine does nothing. A floor of nine binds and leaves sellers offering eighty against forty wanted, a surplus of forty, while a floor of five does nothing. A surplus is the signature of a binding floor, and a shortage of a binding ceiling.

Look at what you can now do. You can tell demand, the whole relationship, from quantity demanded, the amount at one price, and do the same on the supply side. You can find equilibrium from a schedule by subtracting at every price, and size a shortage or a surplus as the gap between the two quantities at that price. You can decide which curve an event shifts by asking whether it changed what buyers want or what producing costs, and read the direction from there. You can say when an outcome cannot be determined, and treat that as an answer rather than as unfinished work. And you can tell a binding price control from a harmless one by comparing it with equilibrium. Part two opens on a ceiling in the housing market.