Introduction: The Core of a Market Economy

The concepts of supply and demand are two of the most fundamental in economics.
They are the forces that make market economies work, determining the quantity of
each good produced and the price at which it is sold.1 This chapter introduces the
model of supply and demand, examining how buyers and sellers behave and interact.
This model is a powerful tool for analysis, explaining how prices allocate an economy's
scarce resources.1

Part I: Markets and Competition

A market is a group of buyers and sellers of a particular good or service. Buyers as a

group determine the demand for the product, and sellers as a group determine the
supply.1 Markets can take many forms, from highly organized agricultural markets to
less formal markets like the one for ice cream in a town.1

This chapter focuses on competitive markets, in which there are so many buyers and
sellers that each has a negligible impact on the market price. In a perfectly
competitive market, two conditions are met: (1) the goods offered for sale are all
exactly the same, and (2) the buyers and sellers are so numerous that no single
participant can influence the market price. Because they must accept the price the
market determines, buyers and sellers in such markets are called price takers.1

Part II: Demand

Demand represents the behavior of buyers in a market.1

2.1 The Demand Curve

The quantity demanded of a good is the amount that buyers are willing and able to
purchase. The central determinant of quantity demanded is the good's price. This
relationship is captured by the law of demand: other things being equal, when the
price of a good rises, the quantity demanded falls, and when the price falls, the
quantity demanded rises.1

A demand schedule is a table showing the relationship between price and quantity
demanded. The demand curve is a downward-sloping line that graphs this
relationship, with price on the vertical axis and quantity on the horizontal axis.1

2.2 Market Demand and Shifts in the Curve

Market demand is the sum of all individual demands for a good or service. It is found
by adding the individual demand curves horizontally.1 The market demand curve
shows how the total quantity demanded varies as the price changes, holding all other
factors constant. When one of these other factors changes, the entire demand curve

shifts.1

Key variables that can shift the demand curve include:

●​ Income: A decrease in income lowers demand for a normal good but raises
demand for an inferior good.1
●​ Prices of Related Goods: A fall in the price of a substitute (e.g., frozen yogurt)
reduces the demand for another good (e.g., ice cream). A fall in the price of a
complement (e.g., hot fudge) raises the demand for another good (e.g., ice
cream).1
●​ Tastes: Changes in consumer preferences will shift demand.1
●​ Expectations: Beliefs about the future, such as an expected price increase, can
affect demand today.1
●​ Number of Buyers: More buyers increase the market demand.1

Part III: Supply

Supply represents the behavior of sellers in a market.1

3.1 The Supply Curve

The quantity supplied of a good is the amount that sellers are willing and able to sell.
The primary determinant of quantity supplied is the price. The law of supply states
that, other things being equal, when the price of a good rises, the quantity supplied
also rises, and when the price falls, the quantity supplied falls.1

A supply schedule is a table showing the relationship between price and quantity
supplied. The supply curve is an upward-sloping line that graphs this relationship.1

3.2 Market Supply and Shifts in the Curve

Market supply is the sum of the supplies of all sellers, calculated by summing
individual supply curves horizontally.1 The market supply curve shows how the total
quantity supplied varies as the price changes, holding other factors constant. When
these other factors change, the supply curve

shifts.1

Key variables that can shift the supply curve include:

●​ Input Prices: The supply of a good is negatively related to the price of the inputs
used to make it. If the price of sugar rises, the supply of ice cream decreases.1
●​ Technology: An advance in technology that reduces production costs will
increase supply.1
●​ Expectations: If a firm expects the price of its good to rise in the future, it may
reduce its supply today to sell more later.1
●​ Number of Sellers: If sellers exit the market, the supply will decrease.1
Part IV: Supply and Demand Together

4.1 Equilibrium

The intersection of the supply and demand curves is the market's equilibrium. The
price at this intersection is the equilibrium price, and the quantity is the equilibrium
quantity. At this point, the quantity of the good that buyers are willing to buy exactly
balances the quantity that sellers are willing to sell. This is also known as the
market-clearing price.1

The actions of buyers and sellers naturally move markets toward this equilibrium.
●​ Surplus (Excess Supply): If the market price is above the equilibrium price,
quantity supplied exceeds quantity demanded. Sellers will cut prices to increase
sales, moving the price down toward equilibrium.1
●​ Shortage (Excess Demand): If the market price is below the equilibrium price,
quantity demanded exceeds quantity supplied. With too many buyers chasing too
few goods, sellers can raise their prices, moving the price up toward equilibrium.1

This phenomenon is called the law of supply and demand: the price of any good
adjusts to bring the quantity supplied and quantity demanded for that good into
balance.1

4.2 Analyzing Changes in Equilibrium

To analyze how any event affects a market, we use a three-step process:

1.​ Decide whether the event shifts the supply curve, the demand curve, or both.
2.​ Decide in which direction the curve shifts.
3.​ Use the supply-and-demand diagram to see how the shift changes the
equilibrium price and quantity.1

For example, a heat wave that shifts the demand for ice cream to the right leads to a
higher equilibrium price and quantity. A hurricane that raises the price of sugar and
shifts the supply of ice cream to the left leads to a higher equilibrium price and a
lower equilibrium quantity.1

Conclusion: How Prices Allocate Resources

The model of supply and demand is a powerful analytical tool that applies to most
markets. It demonstrates one of the Ten Principles of Economics: that markets are
usually a good way to organize economic activity. In market economies, prices are the
signals that guide the allocation of scarce resources. They are determined by the
forces of supply and demand and ensure that resources are directed toward their
competing uses.1

Concept Description

Competitive Market A market with many buyers and sellers where

each has a negligible impact on the market
price.1

Law of Demand The claim that, other things being equal, the
quantity demanded of a good falls when its
price rises.1

Law of Supply The claim that, other things being equal, the
quantity supplied of a good rises when its price
rises.1

Equilibrium A situation where the market price has reached

the level at which quantity supplied equals
quantity demanded.1

Surplus A situation in which quantity supplied is greater

than quantity demanded, occurring when the
price is above equilibrium.1

Shortage A situation in which quantity demanded is

greater than quantity supplied, occurring when
the price is below equilibrium.1
Works cited

1.​ Principles of Economics (N. Gregory Mankiw-2.pdf