Economics Chapter 3

* Chapter 3
Demand, Supply, and Prices
*Demand- the desire to own something and
the ability to pay for it

*Both must be present
*Law of Demand- when a goods price is
lower, consumers will buy more of it. When
the price is higher, consumer will buy less
of it
*Chapter 3 Section 1:
Fundamentals of Demand
*Law of Demand results from two

overlapping patterns:
*Substitution effect
*Income Effect
*Substitution effect- takes place
when a consumer reacts to the rise

in the price of one good by
consuming less of that good and
more of a substitute good
*Can also apply to a drop in prices
*Income effect- if the price for the good
goes up and you cannot afford to buy as

much of it, but dont consumer another
good in its place
*Ex: movie tickets
* Remember demand is judged on how much of

an item we buy and not on how much money
we spend on an item
*Demand schedule- table that lists the
quantity of a good that a person will

purchase at various prices in a market
*Market Demand Schedule- quantities

demanded at various prices by all
consumers in the market
*Demand Curve- graphic representation of a

demand schedule
*Vertical axis- lowest prices at the
bottom, highest prices at the top
*Horizontal axis- lowest quantity on the
left, highest quantity on the right
*Limitations:
*Cannot predict market changes
*Shifts in demand are not always connected

to price
*Ceteris paribus-all other things held
constant
*Demand schedule assumes everything
but price remains constant
*Demand schedules and demand curves
are only accurate if ceteris paribus
remains true
Shifts in Demand
*When we drop the ceteris paribus
rule- we no longer move along the

demand curve, instead the entire
curve shifts
Shifts in Demand
* Non-price determinants- factors that can lead

to the shifting of demand up or down
* Income
* Consumer expectations
* Demographics
* Consumer taste
* Advertising
Shifts in Demand
*Income:
*Normal goods- goods that consumers
demand more of when their income

increases
*Inferior goods- goods that you would buy
in smaller quantities, or not at all, if
your income were to rise and you could
afford something better
*Shift to the right = increase in demand
*Shift to the left= decrease in demand
Shifts in Demand
* Consumer expectations:
* Expectations about the future
* Could be the future of that particular item
* Demographics
* The statistical characteristics of populations

* Age
* Race
* Gender
* Occupation
* Income levels
Shifts in Demand
* Population:
* Changes in population of a market effect the

demand in that market
* Consumer taste and advertising:
* Advertising and publicity play a role in demand
Shifts in Demand
* Price of Related Goods:
* Complements: two goods that are bought and
used together
* Substitutes: goods that are used in place of one
another
Shifts in Demand
*Elasticity of Demand- the way
consumers react to price changes

*How drastically buyers will cut
back or increase their demand for
a good when the price rise or falls
Elasticity of Demand
*Inelastic- if you buy the same amount or
just a little less of a good after a large

price increase
*Relatively unresponsive to price changes
*Elastic- if you buy much less of a good
after a small price increase
*Very responsive to price changes
* Increases and decreases
*Elasticity of the good-Percentage of
change in the quantity of the good

demanded divided by the percentage
of change in the price of the good
*Because of the law of demand- elasticity

is always negative
* For simplicity- this negative is dropped
*Elasticity of demand changes at different

price levels
*Less than 1= inelastic
*Greater than 1= elastic
*Elasticity = 1- unitary elastic
* Percentage change in quantity demand is
exactly equal to percentage change in price
*Factors Affecting Elasticity

*Availability of substitutes
*Lack of good substitutes tends to make

a good inelastic
*Relative importance
*How much of your budget you spend on

the good
* Larger percentage more likely to be elastic
*Factors Affecting Elasticity Cont.

*Necessity versus luxury
* The more of a necessity the more inelastic
* Can change person to person

*Change over time
* Demand can sometimes become more elastic

over time
* Elasticity helps us measure how consumers
respond to price changes for different products
* Elasticity of demand determines how a change in

prices will affect a firms total revenue or
income
* Total Revenue- amount of money the company
receives by selling its goods
* Price
* Quantity sold
*A firm could lose revenue by
increasing its price- depends on the

demand and elasticity of the product
*If demand is inelastic- typically
can increase in price= increase in
revenue
*Supply- Amount of a good or service that is

available
*Law of Supply- producers offer more of a
good or service as its price increases and
less as its price falls
*Quantity supplied- how much of a good or
service a producer is willing and able to
sell at a specific price
*Chapter 3 Section 4
Fundamentals of Supply
*Producers may also be called a supplier,
company or owner
*Whoever supplies a product to market
*Price increase is also an incentive for new
firms to enter the market to earn their own
profits
*Individual firms and firms changing their
level of production and firms entering or
exiting the market- combine to create the
law of supply
*If a firm is already earning a profit for a
good or service, then an increase in the

price- ceteris paribus- will increase the
firms profits
*The search for profit drives the suppliers
decision
*One benefit of the economic system of the
United States is the markets are open to
new suppliers
*Supply schedule- relationship between
price and quantity supplied for a specific

good or service
*How much of a good or service a supplier
will offer at various price
* 2 variables
* Price number supplied
* Very specific set of conditions

* Other factors could change the supply
schedule
*When a factor other than price
changes- a new supply schedule must

be made
*Market supply schedule- all firms in
a particular market
*Also reflects the law of supply
*Market supply curve- graph of market
supply schedule
*Elasticity of supply- measures how firms
will respond to changes in the price of a
good or service
*Elasticity is greater than 1- supply is very
sensitive to price change
*Elasticity less than 1= supply is inelasticnot very sensitive to price change
*Elasticity = to 1 unitary elastic
*Key factor is time- how long does it take
supply to change their output

*Supply become more elastic over time
*Marginal product of labor- change in output

from hiring one more worker
*Adding extra workers can result in
specialization
Costs of Production
* Increasing marginal returns- when adding a worker
adds more to the output than the previous worker

* Diminishing marginal returns- produce less and less
output from each additional unit of labor
* Happens because workers have a limited amount
of capital- any human-made resource used to
produce other things
*Negative marginal return- when adding one

more worker decreases output
Costs of Production
* Production Costs: Fixed Costs and Variable

Costs
* Fixed Cost- cost that doesnt change, no matter

how much of a good is produced
* Cost of a building
* Property taxes
* Etc.
Costs of Production
* Variable Costs- costs that rise or fall depending

on the quantity produced
* Labor
* Materials
* Electricity
* Etc
* Total Cost= Fixed Costs + Variable Costs
Costs of Production
* Marginal Cost- additional cost of producing one

more unit
* Firms basic goal = to maximize profit
* Profit = total revenue total cost
* Marginal Revenue- additional income from

selling one more unit of a good
* Ideal output- stop when marginal revenue=
marginal costs
* Any other quantity will generate less profit
Costs of Production
* Average cost= total cost divided by quantity

produced
* Operating cost- the cost of operating the
facility
* Includes variable costs but not fixed costs

* If operating costs are lower than total revenuefactory will stay open (at least temporarily)
* Eventually if firm is losing money they will change

their fixed costs (selling property, etc.)
Costs of Production
*Several factors can lead to a shift in the
supply curve
*Any changes in the cost of an input used
to produce a good will affect supply
*Relationship between marginal revenue
and cost
Changes in Supply
*Advance in technology can lower
production costs in many industries

*Typically technology lowers costs
and increases supply at all price
levels
*Rightward shift in supply curve
Changes in Supply
* Subsidy- government payment that supports a

business or market
* Excise tax- tax on the production or sale of a
good
* Often used to discourage the sale of the good

* Ex: cigarettes
* Can cause decrease
* Shift left
Changes in Supply
*Regulation: government intervention in a
market that affects the price, quantity, or

quality of the a good
*Import restrictions
*Expectations about price
Changes in Supply
* Changes in the number of competitors

* Cost of Transportation
* Cost of Energy
* ETC.
Changes in Supply
*Prices are effected by the laws of supply
and demand and by government action

*Equilibrium- the point at which demand
and supply come together
*Quantity demanded = quantity supplied
*When a market is at equilibrium, both
buyers and sellers benefit
* Chapter 3 Section 7:
Equilibrium and Price Controls
* Disequilibrium- any other price

* Shortage- excess demand- below equilibrium
price
* Need to raise price
* Surplus- quantity supplied exceeds quantity

demanded
* Above equilibrium price

* Need to lower their price
* Government can intervene to control prices
* Price ceiling- maximum price that can be legally

charged for a good or service
* Set below equilibrium price
* Price floor- minimum price set by the
government, that must be paid for a good or

service
* Minimum wage- minimum price employers can pay

for one hour labor
*The market will tend toward
equilibrium
*Shift of the entire demand or supply
curve will change the quantity
supplied, quantity demanded, and
the equilibrium price
* Chapter 3 Section 8
Changes in Market Equilibrium
* Inventory- the quantity of goods that a firm has

on hand
* Inventory gets larger in a surplus
* Will cause the price to be lowered
* Lack of inventory in a shortage

* Will cause the price to rise
* Market equilibrium follows the intersection of
the demand curve and the supply curve as that

point moves downward along the demand curve
* Equilibrium is a moving target that changes
as market condition change
* Sales
* Rebates
*Shortage also causes search costs to
appear
*Search costs- the financial and
opportunity costs that consumers pay
in searching for a product or service
*When demand increases, both the
equilibrium price and equilibrium
quantity increases
* Price changes solve problems of shortages and
surpluses
* Prices are nearly always the most efficient way
to allocate, or distribute, resources
* Prices help move land, labor, and capital into
the hands of producers and finished goods into
the hands of buyers
Prices at work
* Advantages of Price:
* Common Language- without it, we would be back

to the barter system
* Barter- exchange one type of good or service for
another
* No accurate way to measure demand for a product

* Inconvenient, impractical, and inefficient
Prices at work
* Prices are signals to producers or consumer on

how to adjust
* Incentive for producers to produce and supply
more goods that are in demand and will
encourage new firms to enter a market
Prices at work
* Prices are signals of which products to produce

more of
* Low price signals the product is being over
produced
* Low price indicates that the product carries a
low opportunity cost for the consumer and
offers a chance to get a good deal
Prices at work
* Prices are responsive and flexible to market
conditions
* Prices change easily with shortage or surplus
* Supply shock- sudden shortage of a good
* Supply shock creates a shortage because
suppliers can no longer meet consumer demand
Prices at work
* Rationing- system of allocating goods and

services using criteria other than price
* Takes central planning
* Price system is free
* Costs nothing to administer
Prices at work
* Market-based economy has the diversity of
goods and services that consumer can buy

* Prices provided an easy way to narrow choices
to a certain price range
* Prices are also responsive
Prices at work
* A market system, with its responsive prices,

ensures that resources go to the uses
consumers value most highly
* Resource use will also adjust relatively quickly to

the changing demands of consumers
* Efficient resources allocation goes hand in
hand with profit incentive

* Exceptions: imperfect competition, negative
externalities, imperfect information
Prices at work

Economics Chapter 3

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Economics Chapter 3

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* Chapter 3

Demand, Supply, and Prices

*Demand- the desire to own something and

the ability to pay for it

*Law of Demand results from two

*Substitution effect- takes place

when a consumer reacts to the rise

*Income effect- if the price for the good

goes up and you cannot afford to buy as

* Remember demand is judged on how much of

*Demand schedule- table that lists the

quantity of a good that a person will

*Market Demand Schedule- quantities

*Demand Curve- graphic representation of a

*Shifts in demand are not always connected

*When we drop the ceteris paribus

rule- we no longer move along the

* Non-price determinants- factors that can lead

demand more of when their income

* Expectations about the future

* Could be the future of that particular item

* The statistical characteristics of populations

* Changes in population of a market effect the

* Consumer taste and advertising:

* Advertising and publicity play a role in demand

* Price of Related Goods:

* Complements: two goods that are bought and

*Elasticity of Demand- the way

consumers react to price changes

*Inelastic- if you buy the same amount or

just a little less of a good after a large

* Increases and decreases

*Elasticity of the good-Percentage of

change in the quantity of the good

*Because of the law of demand- elasticity

* For simplicity- this negative is dropped

*Elasticity of demand changes at different

* Percentage change in quantity demand is

exactly equal to percentage change in price

*Factors Affecting Elasticity

*Lack of good substitutes tends to make

*How much of your budget you spend on

* Larger percentage more likely to be elastic

*Factors Affecting Elasticity Cont.

* The more of a necessity the more inelastic

* Can change person to person

* Demand can sometimes become more elastic

* Elasticity helps us measure how consumers

respond to price changes for different products

* Elasticity of demand determines how a change in

*A firm could lose revenue by

increasing its price- depends on the

*Supply- Amount of a good or service that is

*Producers may also be called a supplier,

*If a firm is already earning a profit for a

good or service, then an increase in the

*Supply schedule- relationship between

price and quantity supplied for a specific

* Price number supplied

* Very specific set of conditions

*When a factor other than price

changes- a new supply schedule must

*Market supply curve- graph of market

*Key factor is time- how long does it take