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This chapter provides an introduction to demand and supply concepts. Both demand and supply are defined and illustrated; determinants of demand and supply are listed and explained. The concept of equilibrium and the effects of changes in demand and supply on equilibrium price and quantity are explained and illustrated. The chapter also includes brief discussions of efficiency (productive and allocative) and price controls (floors and ceilings). In the Last Word, you can read how creation of a legal market for human organs could reduce the shortages of kidneys, lungs, and other needed organs available for transplant.

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In this chapter, the focus is on markets that are competitive. This requires large numbers of buyers and sellers acting independently. An example of a local market is the farmer’s market that brings together buyers and sellers of produce in the summer. An example of a national market is the US real estate market and the New York Stock Exchange is an international market.

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To be part of the demand for a good, consumers have to be willing and able to purchase the good. When deriving demand, we are assuming that the only factor that causes consumers to buy more or less is the price of the good. It is assumed that all other factors that influence the amount that consumers will buy are constant. Market demand is derived by summing the individuals’ demand curves.

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An inverse relationship exists between price and quantity demanded. Prices act as obstacles for buyers and keep them from being able to buy everything that they want. So, it makes sense that with a limited income, consumers will buy more at lower prices.

Diminishing marginal utility refers to the decrease in added satisfaction that results as one consumes additional units of a good or service, i.e., the second “Big Mac” yields less extra satisfaction (or utility) than the first. Because additional units yield less utility, the price has to be lower to make up for less utility.

The income effect occurs as a lower price increases the purchasing power of money income; this enables the consumer to buy more at a lower price (or less at a higher price) without having to reduce consumption of other goods.

The substitution effect is when a lower price gives an incentive to substitute the lower-priced good for the now relatively higher-priced goods.

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The demand curve illustrates the inverse relationship between price and quantity. The downward slope indicates a lower quantity (horizontal axis) at a higher price (vertical axis), and a higher quantity at a lower price, reflecting the law of demand.

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There are three buyers in the market for corn. The market demand is the horizontal summation of the individual demand curves of all of the consumers in the market. At a price of $3, for example, the three individual curves yield a total quantity demanded of 100 bushels.

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Changes in the demand for corn will be brought about by a change in one or more of the determinants of demand. An increase in demand is shown as a shift of the demand curve to the right, as from D1 to D2. A decrease in demand is shown as a shift of the demand curve to the left, as from D1 to D3.

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These changes in demand are to be distinguished from a change in quantity demanded, which is caused by a change in the price of the product and is shown by a movement from one point to another point on a fixed demand curve.

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Determinants are those things that can shift the entire demand curve causing demand to change. When most consumers experience the same change in tastes for a particular good, the demand for the good will change. If there is a preferable change in tastes, demand will increase. On the other hand, if there is an unfavorable change in tastes, demand will fall.

If there are more buyers in the market for a good, demand will increase, whereas when there are fewer buyers in the market for a good, demand will decrease.

Normal goods are goods that we buy more of as our incomes increase. Most of the goods that we buy are normal goods. We buy fewer normal goods when our income decreases.

Inferior goods are goods we buy more of as our income decreases. We buy fewer inferior goods if our income increases.

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Complementary goods are goods that we consume jointly. It isn’t beneficial to have one without its complement. When the price of one complement increases, the demand for the other complement decreases. When the price of one complement decreases, the demand for the other complement increases. Some examples are cell phones and cell phone service, tuition and textbooks.

Substitute goods are goods that we use in place of another. A perfect substitute is a good that we use in place of the other without any loss of satisfaction. If the price of one good increases, the demand for its substitute increases. If the price of one good decreases, the demand for the other substitute decreases. Some examples are Colgate and Crest toothpaste, Nike and Reebok shoes.

If consumers expect the future price of a product to be higher, they increase their current demand for the product.

If consumers expect the future price of a product to be lower, they decrease their current demand for the product.

If consumers expect their future income to rise, they increase purchases now. If consumers believe their future income will be less, they reduce their demand for some products.

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A change in one or more of these determinants will change demand and shift the demand curve.

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To be part of the supply of a good, producers have to be willing and able to produce the good. When creating supply, we are assuming that the only factor that causes firms to produce more or less is the price of the good. It is assumed that all other factors that influence the amount that firms will produce are constant. Market supply is created by summing the individual firms’ supply curves.

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Producers are willing to produce and sell more of their product at a high price than at a low price. There is a direct relationship between price and quantity supplied. Given product costs, a higher price means greater profits and thus an incentive to increase the quantity supplied. Beyond some level of output, producers usually encounter increasing costs per added unit of output.

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Because price and quantity supplied are directly related, the supply curve graphs as an upsloping curve. Other things equal, producers will offer more of a product for sale as its price rises and less of the product for sale as its price falls.

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A change in one or more of the determinants of supply causes a change in supply. An increase in supply is shown as a rightward shift of the supply curve, as from S1 to S2. A decrease in supply is depicted as a leftward shift of the curve, as from S1 to S3.

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These changes in supply are to be distinguished from a change in quantity supplied, which is caused by a change in the price of the product and is shown by a movement from one point to another point on a fixed supply curve.

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If resource prices (input prices) go up, supply decreases. If resource prices (input prices) go down, supply increases.

If technology increases, supply increases. If we adopt, or use, less efficient technology, supply decreases.

If the number of sellers increases, supply increases. Economic profits in the market draw producers from less profitable markets into this market. If the number of sellers decreases, supply decreases. Economic losses in the market cause producers to leave market.

If taxes are increased on a specific product, supply decreases. If taxes are decreased, or eliminated on a specific product, supply increases. If subsidies are increased on a specific product, supply increases. If subsidies are decreased on a specific product, supply decreases.

If the price of another good that the producer could produce with the same resources rises, the supply decreases for the product the producers are currently producing.

If the price of another good that the producer could produce with the same resources falls, the supply increases for the product the producers are currently producing.

If producers expect that the price of the product they are producing will be higher in the future, they cut back on current supply and supply will decrease. If producers expect the price of the product they are producing will be lower in the future, they increase current supply to take advantage of the currently higher price.

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A change in one or more of these determinants will change supply and shift the curve.

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The equilibrium price is also known as the market-clearing price. Graphically, note that the equilibrium price and quantity are where the supply and demand curves intersect. It is important to note that it is not correct to say supply equals demand.

The rationing function of prices is the ability of competitive forces of supply and demand to establish a price where buying and selling decisions are coordinated.

At prices above this equilibrium, note that there is an excess quantity supplied, or a surplus.

At prices below this equilibrium, note that there is an excess quantity demanded, or shortage.

At equilibrium the markets are economically efficient.

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Competitive markets generate productive efficiency that is the production of any particular good in the least costly way. Sellers that don’t achieve the least-cost combination of inputs will be unprofitable and have difficulty competing in the market.

The competitive process also generates allocative efficiency which is producing the combination of goods and services most valued by society. Allocative efficiency requires that there be productive efficiency. Productive efficiency can occur without allocative efficiency. Goods can be produced in the least costly method without being the most wanted by society. Allocative and productive efficiency occur at the equilibrium price and quantity in a competitive market. Resources are neither over-allocated nor under-allocated based on society’s wants.

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The intersection of the downsloping demand curve, D, and the upsloping supply curve, S, indicates the equilibrium price of $3 and equilibrium quantity of 7,000 bushels of corn per week.

The shortages of corn at below-equilibrium prices (for example, 7000 bushels at $2) drive up the price. The higher prices increase the quantity supplied and reduce the quantity demanded until equilibrium is achieved. The surpluses caused by above-equilibrium prices (for example, 6000 bushels at $4) push the price down. As price drops, the quantity demanded rises and the quantity supplied falls until equilibrium is established. At the equilibrium price and quantity, there are neither shortages nor surpluses of corn.

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Prices automatically rise and fall and bring a market closer to equilibrium. Prices are the best tool for eliminating market shortages and surpluses.

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An increase in demand results in an increase in price and an increase in quantity exchanged.

A decrease in demand results in a decrease in price and a decrease in the quantity exchanged.

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An increase in supply results in a decrease in price and an increase in the quantity exchanged.

A decrease in supply results in an increase in price and a decrease in the quantity exchanged.

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These cases demonstrate what happens to equilibrium price and equilibrium quantity when supply and demand shifts occur simultaneously.

If supply increases and demand decreases, price declines, but the new equilibrium quantity depends on the relative sizes of shifts in demand and supply.

If supply decreases and demand increases, price rises, but the new equilibrium quantity depends on the relative sizes of shifts in demand and supply.

If supply and demand change in the same direction (both increase or both decrease), the change in equilibrium quantity will be in the direction of the shift but the change in equilibrium price now depends on the relative shifts in demand and supply.

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Price ceilings are maximum prices that can be charged on a good. Price ceilings are set on goods that are considered to be necessities, but the equilibrium price is so high that many people are unable to purchase the item. To be effective, the price ceiling must be set below the equilibrium price. When price ceilings are placed on a good, this creates a chronic shortage which makes it difficult to determine how to ration the limited output for all of the consumers who are willing and able to buy the good. The shortages often lead to black markets where the good is sold at a higher price than the price ceiling. Price ceilings distort the efficient allocation of resources.

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A price ceiling is a maximum legal price such as Pc. When the ceiling price is below the equilibrium price, a persistent product shortage results. Here that shortage is shown by the horizontal distance between Qd and Qs.

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A price floor is a minimum price fixed by the government. A price at or above the price floor is legal; a price below it is not.

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A price floor is a minimum legal price such as Pf. When the price floor is above the equilibrium price, a persistent product surplus results. Here that surplus is shown by the horizontal distance between Qs and Qd.

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Organ transplants have become increasingly common, but not everyone who needs a transplant can get one. In 2012, there were 116,000 Americans on the waiting list for transplants. It is estimated that there are 6,900 deaths per year in the U.S. because not enough organs are available.

Why shortages? No market exists for human organs. The demand curve for human organs would resemble others in that a greater quantity would be demanded at low prices than at higher prices. Donated organs that are rationed by a waiting list have a zero price. The existing supply is perfectly inelastic, and there is a fixed quantity offered by willing donors. There is a shortage of human organs because at a zero price the quantity demanded exceeds the quantity supplied.

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The first negative effect is a moral objection that turning human organs into commodities commercializes human beings and diminishes the special nature of human life.

An analytical critique based on the elasticity of supply suggests that the likely increase in the actual number of usable organs for transplants would not be great. A health cost concern suggests that a market for body organs would greatly increase the cost of health care.

Prohibitions on a human organ market have given rise to a worldwide, $1 billion-per-year illegal market. There is concern that those willing to participate in an illegal market such as this may also be willing to take extreme measures to solicit organs from unwilling donors.

Supporters of legalizing the market for organs argue that it would increase the supply of legal organs, drive down the price of organs, and reduce the harvesting of organs from unwilling sellers (the lower price would make it less profitable).

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