Unit 2: Supply and Demand
In this unit we introduce the ceteris paribus assumption, which is crucial to building correlations among economic variables. When using ceteris paribus, we assume that all variables—with the exception of those in explicit consideration—will remain constant. We then examine the supply and demand models and the resulting market equilibrium that occurs where the supply curve and the demand curve intersect. We also explore what causes movements along the curve and the set of factors that cause the curves to shift, affecting both price and quantity, before discussing the meaning and significance of elasticity.
Next, we explore what happens when a market fails to produce a reasonable equilibrium. This situation typically occurs when either the market is not competitive or complete, or its participants are ill-informed. We evaluate various ways the government can address these failures and begin to understand the intricate relationship between government and economics.
Completing this unit should take you approximately 18 hours.
Upon successful completion of this unit, you will be able to:
- analyze and apply the mechanics of demand and supply for individuals, firms, and the market;
- determine equilibrium in the market under various situations that either cause movements or shifts in demand and supply;
- apply the concept of elasticity as a measure of responsiveness to various variables; and
- analyze how the market can be manipulated through price controls or quantity controls.
2.1: The Ceteris Paribus Assumption
The Latin phrase ceteris paribus means “all other things remaining equal.” Because there are multiple factors influencing any one variable, economists apply this assumption in order to segregate the effect that one factor has on the variable in the question, keeping all other factors unchanged. In other words, if we want to examine the effect of one (independent) variable on another (dependent) variable, we need to ensure, through the ceteris paribus assumption, that the effect of other independent variables on the dependent variable is constant. We will encounter this term quite often throughout this course.
Read this brief text to learn the formal definition of ceteris paribus. As a practice activity, identify a variable and list the multiple factors that may be influencing it. For example, say you are planning to request an increase in your salary. What are the factors that influence your salary? Do you think you can attribute the change in your salary to any one of these factors if all of the factors influencing it were simultaneously changing?
2.2: Demand
Read this section to learn about the theory of demand. Attempt the "Try It" problem. Use the data from the text to practice constructing and drawing the demand curve on your own, either on a paper or in Excel. Take a moment to read through the stated learning outcomes for this chapter of the text, which you can find at the beginning of each section. These outcomes should be your goals as you read through the chapter. This reading also covers the topics outlined in subunits 2.2.1 and 2.2.2.
Watch this video about the law of demand.
The demand curve shows the relationship between the price of a good and the quantity demanded at each price. The demand curve is negatively sloped because of the inverse relationship between price and quantity demanded. For example, assuming that the ceteris paribus condition applies, i.e., all other factors affecting demand remain unchanged, if the price of an iPhone drops, what do you think will happen to the demand for the iPhone? Conversely, if the price increases, would more people be buying the iPhone or less.
Pay special attention to movement along the curve versus shifts of the curve. The former refers to changes in the quantity demanded due to price changes. The latter refers to the breakdown of the ceteris paribus condition. In order to understand shifts in demand curve, you need to know that price remains constant and the shift of the demand curve is in response to changes in other factors that affect demand, including changes in the prices of related goods, changes in income, changes in tastes, and changes in expectations.
The resulting effect is that a rightward shift of the curve indicates an increase in demand and signifies that at any given price, consumers demand a larger quantity of the good than before, while a decrease in demand refers to a leftward shift of the curve and signifies that at any given price, consumers demand a smaller quantity of the good than before.
Watch this video about the price of related products and demand.
Watch this video about changes in income, population, and preferences.
Watch this video about normal and inferior goods.
Watch this video about normal and inferior goods.
2.3: Supply
Read this section to learn about the theory of supply. Attempt the "Try It" problem. Use the data from the text to practice drawing the supply curve on your own, either on paper or in Excel. Take a moment to read through the stated learning outcomes for this chapter of the text, which you can find at the beginning of each section. These outcomes should be your goals as you read through the chapter.
Watch this video about the law of supply.
The supply curve is a mirror reflection of the demand curve. You should recognize that the supply curve operates from the firm's point of view, such that if a product is highly priced, the firm will want to supply more of it. As such, it is a positively sloped curve indicating the positive relationship between price of the good and quantity supplied.
The demand curve is similar to the supply curve in that an increase in supply refers to a rightward shift of the curve and signifies that there will be a larger quantity of the good than before; a decrease in supply refers to a leftward shift of the curve and signifies that there will be a lesser quantity of the good than before. This section will present the three principal factors that shift the supply curve: changes in input prices, changes in technology, and changes in expectations.
Watch this video about the factors affecting supply.
2.4: Market Equilibrium
When left alone, a market will move to equilibrium; in other words, the market price will move to the level at which the quantity supplied equals the quantity demanded. However, this outcome can be both desirable and undesirable for buyers or sellers.
Read this section to learn how demand and supply interact with one another to determine prices and quantities that may or may not be optimal. Attempt the "Try It” problem. Take a moment to read through the stated learning outcomes for this chapter of the text, which you can find at the beginning of each section. These outcomes should be your goals as you read through the chapter.
Watch this video about market equilibrium.
Watch this video about changes in market equilibrium.
Read this section to learn about some applications of the demand and supply model. Attempt the "Try It” problem.
Read each section of this chapter for a mathematical exposition of the demand and supply model. The chapter also covers price ceilings and price floor analysis as well as quantity regulations.
2.5: Manipulating the Market: Price Controls
Read this section to learn why the government sometimes chooses to control prices. Attempt the "Try It" problem. Take a moment to read through the stated learning outcomes for this chapter of the text, which you can find at the beginning of each section.
To use this simulation, you must download and install the Mathematica Viewer from the Wolfram Demonstrations Project. Although this software is free, it is a sizable download. This activity is therefore optional.
Seeing how the market responds to various control mechanisms proves instructive, as the same action can have different consequences, depending upon the initial conditions of the system to which it is applied.
Once you have downloaded the software to your desktop, open the simulation and read the instructions. Manipulate the three variables and note how varying combinations of elasticity of demand, elasticity of supply, and the price control point ("set price") can affect total surplus. It is worth noting that two prices can result in the same quantity consumed. Notice how when the price is set above equilibrium, the amount of shortage is a function of both the elasticities of demand and supply. Similarly, with set prices below equilibrium, the amount of surplus is a function of the various elasticities of demand and supply.
You should take care to note the relationship between surplus quantities and reduced total surplus (consumer surplus plus producer surplus). Intervention prevents markets from operating freely and results in less consumption than at equilibrium and therefore results in an inefficient market.
Take this quiz to check your understanding of supply and demand, markets in equilibrium, and market manipulation.
- 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.
2.6: Elasticity
Read this pamphlet and attempt the questions before viewing the answers. The answers are provided to you as a self-check.
Read this chapter to learn about the concept of elasticity. Be sure to read the sections following the introduction.
Watch this lecture, focusing on both how elasticity is calculated as well as its potential implications for health care. Consider if you agree or disagree with the possible social and health implications of changing the overall elasticity of demand for national health systems.
Watch this video about price elasticity of demand.
Watch this video about elasticity of demand.
Watch this video about constant unit elasticity.
Watch this video about total revenue and elasticity.
Watch this video about total revenue and elasticity.
Watch this video about cross elasticity of demand.
Watch this video about elasticity of supply.
Watch this video about elasticity and strange percent changes.
To use this simulation, you must download and install the Mathematica Viewer from the Wolfram Demonstrations Project. Although this software is free, it is a sizable download. This activity is therefore optional.
This guided simulation is meant to show you how a tax is shared between the producer and the buyer. The buyer pays their share of the tax as part of the transaction, and the seller sells less and receives less revenue. This lost revenue is one way that producers "pay" their share of the tax.
Once you have downloaded the software package to your desktop, open the demonstration and read all the instructions. Set the sliders so that the elasticities of both supply and demand equal 1.50 and the tax is 0.75. In this case, the tax incidence is shared equally between the producer and the buyer. In addition to each having 50% of the tax burden, they also share equally in the deadweight loss.
Now increase the slope of the demand curve (making demand less elastic). What happens to tax incidence? Whose share increases? Record the results in your notes, then decrease the slope of the demand curve. What happens to deadweight loss, and how is the tax incidence shared?
Finally, set demand at is max elasticity and supply at its minimum elasticity. What do you observe? Record the result and then set the sliders to the opposite: demand elasticity at a minimum and elastisticity of supply at a maximum.
In which markets would the producers or sellers be the most vocal about a tax increase? Under what circumstances would buyers be more vocal about a tax increase? Record your thoughts in your notes. (Hint: It has a lot to do with whether the market is for a necessity good or a luxury good.)
Take this quiz to check your understanding of elasticity, taxation, and deadweight loss.
- 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.
Unit 2 Review
Read these notes for a brief review of the theory covered in subunits 2.1-2.5.
Read the first topic of these notes, "Price Elasticity of Supply," for a brief review of the theory covered in subunit 2.6.
Read these notes for a brief review of the theory covered in subunit 2.6.
Unit 2 Assessment
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.