Unit 2: Supply and Demand
In this unit, we introduce the demand and supply model and the resulting market equilibrium for price and quantity. We will explore how markets are constantly affected by changes that affect prices and quantities. If the market is unaffected by failures or government intervention, we will see that prices and quantities tend to move toward the equilibrium benchmark.
"During the last decades, several challenges have significantly affected the egg industry, such as the increasing consumer demand for animal welfare, the need for more sustainable food production, and the growing human health and food security issues related to egg consumption."
(Agnese Rondoni et al., Trends in Food Science & Technology, 2020)
When you finish this unit, you will be able to analyze how these changes affect the prices of eggs and the quantity of eggs available in the market.
Completing this unit should take you approximately 5 hours.
Upon successful completion of this unit, you will be able to:
- define demand, supply, and market equilibrium;
- determine the equilibrium in a market under situations that cause shifts in demand and supply that affect changes in prices and quantities; and
- explain how demand and supply behave in the labor and financial markets.
2.1: Introduction to Demand and Supply
Let's say you buy a shirt for $45. To make this transaction possible, you made a decision that you were willing to pay $45 or more for that shirt. Concurrently, the seller had to decide they would not sell the shirt for less than $45. How did your interests align with those of the seller in this scenario?
2.2: Demand for Goods and Services
Here, we focus on isolating the demand for goods and services. Our objective is to establish a law that explains demand behavior. We emphasize the distinction between the quantity demanded (a variable) and the demand (a function that shows the collection of price-quantity demanded combinations) to better understand the key factors influencing demand.
Read this section. Make sure you understand the difference between the quantity demanded and the demand.
Watch this video to review the law of demand and how to graphically obtain the demand curve from a demand schedule that gives you information on the quantity demanded at each price.
While the information in the previous reading and video seems straightforward, confusing demand with quantity demanded is easy. Watch this video that reviews the difference and introduces the factors that change demand.
Now that you understand that demand represents the quantity of a good or service, consumers are willing and able to buy at each price (quantity demanded is the dependent variable reacting to changes in the independent variable – price), we can delve deeper into the factors influencing changes in demand for a product or service.
Read this section to ensure you understand why, for example, a rise in income, ceteris paribus, shifts the market demand for airplane tickets to Hawaii outward, resulting in a greater quantity demand at the same price. If you find yourself overwhelmed with new concepts, it is either time for a break or to review the concepts we have introduced so far in this course. If you decide to take a break, consider the opportunity cost!
When demand changes due to an income change, we must investigate how the quantity demanded reacts at the same price. If the quantity demanded of a product or service moves in the same direction as income, we call it a normal good or service. If it moves in the opposite direction, we call it an inferior good or service. Watch this video on normal and inferior goods.
Watch this video to ensure you understand that changes in the prices of related goods (substitutes or complements) affect the demand for a given product or service. Try to find examples that fit your consumption patterns and repeat the reasoning with your own examples.
Another factor that affects demand is the change in expected future prices. Have you ever delayed a purchase because you believed the price would drop? In this scenario, the current price remains unchanged, but your willingness to buy has shifted. Watch this video to understand how the distinction between current and expected prices can impact the demand curve.
How do you feel now about the egg question/challenge posed at the beginning of this unit? Make sure you can graph demand shifts. Figure 3.9 summarizes the factors that can change demand and shift demand curves. Read the section. Review changes to demand when the product price does not change.
2.3: Supply of Goods and Services
In life, we often spend more time consuming (demanding) goods and services than producing (supplying) them. Perhaps that is why students tend to find analyzing supply more complex. In this section, we examine the law of supply, which explains why producers supply more units as the price of a product rises. We differentiate between quantity supplied (a variable) and supply (a function) and explore the factors that shift the supply curve, just as we did with demand in the previous section. Remember, we are examining supply in isolation from demand. In section 2.4, we will bring them together and analyze their interaction.
Read this section. Make sure you understand the difference between the quantity supplied and the supply.
Watch this video to review the law of supply and how to obtain the supply curve from a supply schedule graphically. Make sure you understand that, as prices rise, producers are incentivized to produce more units.
Just like we did with demand, it is essential to highlight that supply (a function) is not the same as quantity supplied (a variable). Supply is the relationship between a range of prices and the quantities supplied at those prices. On the other hand, quantity supplied is a certain point on the supply curve that indicates the number of units produced at a given price.
We can interpret supply as a function representing the minimum price a firm will accept to produce a specific quantity of a good or service. This supply function can change, as producers may choose to offer more or fewer units at the same price based on various factors. Can you think of factors that encourage a firm to produce more units at the same price?
Watch this video to review the law of supply and to see how factors affecting supply shift the supply curve.
Figure 3.15 summarizes the factors that change the supply of goods and services. Read the section on Summing Up Factors That Change Supply. Use this section to review changes to supply when the price of the product does not change.
2.4: Market Equilibrium and Demand and Supply Changes
Now, you should be ready to place demand and supply together in the same analytical framework to analyze the entire market. As we move into the core concepts of microeconomics, remember to practice with the concepts and relations that you just learned.
Recall the question at the beginning of this unit. How do your interests, as a consumer, align with those of a seller when seeking to purchase a specific good or service?
In this section, we combine the relation between demand and supply into the demand and supply framework (model). The demand and supply model enables us to answer the following complex questions:
- Why did the price of aluminum cans rise during the COVID-19 pandemic?
- Why did the price of eggs sharply increase in January of 2023 in the U.S.?
- Why did Blockbuster file for bankruptcy in 2010 and close most of its stores?
- What do you expect to happen to the price of electric cars in the near future?
Watch this video on market equilibrium using a graph so you can see how the demand and supply curves come together in the market.
Read this text on the four-step process that identifies the equilibrium price. Do you understand the difference between a shift in demand or supply and a movement along the demand or supply curve? Can you think of real-world examples that can cause these to occur?
Watch this video on how changes in demand and/or supply affect the market price and/or the market quantity. In Unit 1, we discussed using graphs to represent a simplified economic reality. Changes in demand and/or supply will shift the relevant curve. Consequently, it will affect the price and quantity, and the market will reach a new equilibrium point.
Before we move on to the next section, try to solve the following questions, which cover central concepts in microeconomics you should understand.
2.5: Application of Market Equilibrium to the Analysis of the Labor Market and the Financial Markets
In Unit 1, we discussed how economics intimidates some students because it uses mathematics, complex language, and abstract concepts. And yet, you are already equipped to tackle this complex question. In recent years, the world demand curve for copper shifted rightward due to continued economic growth in China and other emerging economies. Also, the costs of extracting the copper increased due to higher energy prices. What is the result?'
We can use the simple demand and supply framework we developed in the previous sections to analyze almost any market. Most of us are especially interested in the labor market. In the circular flow model, we observed that we can consider labor as an input for producing goods and services.
Labor, as an input, is owned by consumers (households). Consider this: only you can make the decision regarding whether you want to work or not (supply your labor). In this sense, workers establish the supply of labor (hours of work) while firms determine the demand for labor. So, what appears on the vertical axis of our labor market graph where we place prices? Yes, wages!
Read this text and watch the video that follows on the interaction between demand and supply in labor markets. Think about what equilibrium wage and equilibrium quantity mean in the labor market. This framework enables us to analyze the impact of government regulations such as the minimum wage. It also helps us understand the impact of other real-world events, such as migration, the COVID-19 pandemic, and the trade-off between leisure and work.
The Great Resignation refers to the large increase in the number of people who quit their jobs since the summer of 2021 in many high-income countries. Read this abstract and introduction from this study for a multidisciplinary introduction to what lies behind this phenomenon. Use the demand and supply framework applied to the labor market to reflect on how the Great Resignation affects the labor market in terms of quantity (number of workers and hours) and price (wages).
Besides the labor market, we can also apply the basic tools of supply and demand to analyze financial markets. Some students find the term "financial" intimidating because they associate it with complex financial instruments. However, if you think of the financial market as a place where borrowers and lenders come together, it will seem less intimidating and make much more sense.
Read this text introducing financial markets. Try to relate what you learn in this introduction to what you have already studied in this unit by answering this question: Why do firms need to do to raise funds when consumer demand is high?
Now, we can use the supply and demand framework to explore how financial markets function. Since we usually measure price on the Y-axis, let's start by introducing the concept of the interest rate. Watch this video, which explains what the interest rate is and offers tips for steering clear of financial troubles.
The demand side of a financial market is usually comprised of firms that seek to raise funds. Read this section to understand the relationship between financial capital and a firm's profits and analyze how firms choose between sources of financial capital.
On the supply side, we can find households and firms that have accumulated savings and expect a given rate of return for the supply of these savings. Read this text to study the relationship between savers, banks, and borrowers and understand the differences between bonds, stocks, mutual funds, and commercial banks' deposits. Make sure you understand the trade-offs between return and risk.
Ultimately, financial markets help allocate the economy's scarce resources to their most efficient uses by connecting borrowers (who demand financial capital) and savers (who supply financial capital).
Unit 2 Assessment
- Receive a grade
Take this assessment to see how well you understood this unit.
- This assessment does not count towards your grade. It is just for practice!
- You will see the correct answers when you submit your answers. Use this to help you study for the final exam!
- You can take this assessment as many times as you want, whenever you want.