Unit 2: Supply and Demand

2a. Define demand, supply, and market equilibrium

  • What is the Law of Demand?
  • What is the relationship between the quantity consumers demand and the price of a good?
  • What is the difference between demand and quantity demanded?
  • What is the Law of Supply?
  • What is the relationship between the quantity producers supply and the price of a good?
  • What is the difference between supply and quantity supplied?
  • What are the variables that shift the demand curve?
  • What are the variables that shift the supply curve?
  • What is a market equilibrium?

Demand refers to how consumers behave in the marketplace. Specifically, demand shows the relationship between the quantity demanded and the price. Millennials, for example, are willing to pay premium prices for goods and services. Therefore, their demand differs from that of baby boomers. The quantity demanded is the amount that consumers are willing and able to buy at each price. It is crucial to distinguish between the quantity demanded (the dependent variable) and the demand (the function that shows how the quantity demanded changes with the price). 

Review this figure, which depicts a demand curve for coffee.


Figure: A Demand Schedule and a Demand Curve

This simple diagram shows several important microeconomic relationships: 

  1. There is an inverse relationship between price and quantity demanded. Picture yourself as the consumer to understand why. If you take ceteris paribus, this inverse relationship is the Law of Demand.
  2. When the price changes, there is a movement along the demand curve, but there is no shift. 
  3. As the price goes down and the consumer buys more units, satisfaction (utility) increases.

To ensure you do not confuse a movement along the demand curve with a shift, always consider first what happens to the price. If, at the same price, the quantity demanded changes, that indicates a shift in the demand.

Review how changes to demand determinants (income, price of related goods, preferences, number of consumers, and expectations about prices) shift the demand curve. For example, consider how the rise in Chinese middle-class income affects the demand curve for electronic gadgets. Draw the diagram on your own before reviewing the answer, and remember, graphs are just tools to help you understand and summarize complex economic relations.


Make sure you understand why we consider electronic gadgets normal goods in this context.

To review supply and its determinants, we apply the same methodology as we have just done with demand. Supply refers to how producers (firms) behave in the marketplace. Specifically, supply shows the relationship between the quantity supplied and the price. The quantity supplied is the amount that producers are willing and able to buy at each price. It is crucial to distinguish between the quantity supplied (the dependent variable) and the supply (the function that shows how the quantity supplied changes with the price). 

Review this figure, which depicts a supply curve.


Figure: A Supply Schedule and a Supply Curve

This simple diagram shows several important microeconomics relations: 

  1. There is a positive relationship between price and quantity supplied. As the market price increases, producers are willing to produce and sell more units. If you take ceteris paribus, this inverse relationship is the Law of Supply.
  2. When the price changes, there is a movement along the supply curve, but there is no shift. In our graph example, coffee growers are incentivized to produce more coffee to sell at a higher price. 

To ensure you do not confuse a movement along the demand curve with a shift, always consider first what happens to the price. If, at the same price, the quantity supplied changes, that indicates a shift in the supply.

Review how changes to supply determinants (technological change, cost of production (mainly the price of the factors of production), number of producers, possibility of substitution in production, and expectations about the price) shift the supply curve. Consider how automation that allows for higher efficiency, reduced labor costs, and increased production speed, for example, could affect the supply curve for electronic gadgets. Draw the diagram on your own before reviewing the answer.


Due to the relative emphasis on graph analysis in this unit, students often interpret market equilibrium as just the point where supply and demand intersect. Market equilibrium is more than just a point. Market equilibrium is a situation in which both consumers and producers are satisfied with price and quantity. To reinforce your understanding, review a scenario where, for whatever reason, the price is higher than the equilibrium price. How would you explain the situation at a price of 750 yuan? Is there any adjustment?


What will happen in a competitive market when a change in demand or supply causes a shortage to occur at the original price? Think about the effect of a shortage on the price of the good.

To review, see:

 

2b. Determine the equilibrium in a market under situations that cause shifts in demand and supply that affect changes in prices and quantities

  • What is the effect of a change in demand on market price and quantity?
  • What is the effect of a change in supply on market price and quantity?
  • What is the effect on market price and/or quantity of a change in both supply and demand?

We need analytical tools to examine the effects changes have on market price and quantity since the events that alter supply and demand impact the economy. Follow this four-step process to analyze the impact of daily economic events:

  1. How many events are affecting the market?
  2. Do events affect supply, demand, or both?
  3. Do events increase or decrease demand and supply?
  4. Analyze the impact of P and Q in a diagram. Explain the new equilibrium.

For example, we can apply this thinking process to analyze the impact of the reduced global supply of sugar in November 2023 caused by unfavorable weather in key sugar-exporting countries like India and Thailand. If you follow the steps correctly, your answer should indicate an increase in market price and a reduction in market quantity.


Pay attention to situations where both the supply and demand curves shift. If there is no information about the size of the shift, the impact on price or quantity could be undetermined.

To review, see:

 

2c. Explain how demand and supply behave in the labor and financial markets

  • What is a financial market?
  • What is the difference between debt and equity?
  • What is the relationship between risk and return?
  • Who supplies and borrows funds in the financial market?
  • What is the interest rate?
  • Who supplies and who demands labor?
  • What is the equilibrium wage?

We can use the supply and demand framework to review the financial and labor markets. 

Financial markets are critical for firms and consumers since they allocate and provide financial resources connecting savers and borrowers. Economists examine financial markets in more detail in macroeconomics, but we can explore their basic functions in microeconomics. In a financial market, the interest rate is represented on the y-axis as the price, and the x-axis represents the quantity of financial capital.

The interest rate serves as the price of money, factoring in time. You should also be familiar with various types of financial capital and the ability to distinguish between debt (such as bonds) and equity (shares of a company). 

Labor markets are also critical for firms and individuals. The labor market matches individuals who supply work with employers who demand workers. This matching process is based on the skills, qualifications, and preferences of workers and firms, determining the equilibrium wage. You should understand the representation of the labor market in a diagram, with wages on the y-axis and the quantity of hours worked (or the number of workers) on the x-axis. The demand and supply curves behave like those for goods and services. 

To review, see:

 

Unit 2 Vocabulary

Be sure you understand these terms as you study for the final exam. Try to think of the reason why each term is included.

  • debt
  • demand
  • equilibrium wage
  • equity
  • financial markets
  • interest rate
  • labor market
  • Law of Demand
  • Law of Supply
  • market equilibrium
  • quantity demanded
  • quantity supplied
  • supply