ECON101 Study Guide
Unit 2: Supply and Demand
2a. Analyze and apply the mechanics of demand and supply for individuals, companies, and the market
- Define the law of demand.
- What is the relationship between the quantity consumers demand and the price of a good?
- Do we consume fewer or more goods when prices increase or decrease?
- How can we apply the law of demand to respond to these questions?
The Term Ceteris Paribus
The Latin term ceteris paribus means "all other things unchanged". When they study the relationship between two variables, researchers try to keep as many variables fixed as possible, so they can avoid confusing or complicating the effect of one variable on the other.
For example, suppose you want to explore the relationship between car prices and the number of cars sold. When car prices increase, people typically buy fewer cars assuming ceteris paribus or "all other things unchanged". If other variables are not fixed we cannot make this assumption. Let's say the potential buyer's income is not fixed, but increases during the time the car prices increase. We can no longer conclude higher prices will result in fewer car purchases. Customers might buy more cars than before, regardless of the higher prices, because their income increased and they could afford to buy more.
Review the concept of Ceteris Paribus.
- Define and explain the difference between demand and quantity demanded.
- Define a demand shifter.
- Name two real-world examples of the following demand shifters: expectations, demographic characteristics, income, preferences, and the price of related goods and services.
- How do changes in these variables affect the demand curve?
- Explain why price is not a demand shifter.
- Define and explain the difference between substitutes and complements.
- How do substitutes and complements affect demand?
- How do normal and inferior goods, and income affect demand for substitutes and complements?
The market includes buyers and sellers. Demand refers to how consumers behave in the marketplace, such as how much they want or need to buy a commodity.
Review this figure of a demand curve.
A Demand Schedule and a Demand Curve
Students often confuse the concept of demand with quantity demanded.
Think of the term demand as the overall appetite or desire consumers have for a good or product (for example, coffee), in a given area, during a given time.
The specific amount or quantity of coffee consumers want to buy (in other words, the quantity demanded) will change according to the price. Consumers will buy x amount at a certain price, y amount if the price is one dollar less, z amount if the price is one dollar more. This ratio, or line of progression which the demand curve represents, remains the same until a shift occurs.
Quantity demanded refers to a specific point on the demand curve: in the graph (Figure 3.1), a coffee shop will buy 20 million pounds of coffee at $7 per pound. The quantity demanded is 20 million pounds. When the price of a good changes, there is a movement along the demand curve – a change in quantity demanded (in the graph, the coffee shop buys 30 million pounds of coffee when the price falls to $5 per pound).
Demand determinants (also called demand shifters) describe the factors, other than price, that shift demand – changes in these variables cause the demand curve to shift to the right or to the left.
Remember that the demand curve is a ratio plotted on a graph that depicts the relationship between price (the y axis) and quantity demanded (the x axis), so a price fluctuation causes a movement along the demand curve (you can see that points on the demand curve refer to quantity demanded based on a given price). Price fluctuations do not shift the demand curve.
A demand shifter causes a fluctuation in overall consumer demand, irrespective of price. Examples of demand shifters include changes in:
- Consumer preferences: buyers read a report that states drinking one cup of coffee a day is healthy so demand for coffee soars.
- Demographics: a new population moves into town that loves to drink coffee.
- Income: the main employer in town lays off a large number of workers. They can no longer afford to buy expensive coffee drinks.
- Prices of related goods and services: the price of tea drops precipitously and customers decide to switch to tea to save money. In this case, tea is a substitute.
- Consumer or buyer expectations: consumers predict the price of coffee will increase because their government plans to impose a large tariff on coffee. Demand for coffee increases as people try to stock up on coffee at the lower price.
Review this figure, which highlights how a change in price can affect quantity demanded vs. a demand shifter.
An Increase in Demand
Review the concept of demand in:
- Law of Demand
- Price of Related Products and Demand
- Changes in Income, Population, or Preferences
- Normal and Inferior Goods
- Inferior Goods Clarification
- What is the relationship between the quantity or amount of a good that a producer supplies and the price of a good?
- Do producers have an incentive to produce and sell more or less of a good when its price increases or decreases?
- Define and explain the difference between supply and quantity supplied.
- Define a supply shifter.
- Name real-world examples of the following demand shifters: natural events, number of sellers, prices of factors of production, returns from alternative activities, seller expectations; and, technology or innovative changes.
- How do changes in these variables affect the supply curve?
- Explain why price is not a supply shifter.
Supply refers to the amount of a good or product that is available in the marketplace for consumers to buy. Businesses, manufacturers, and sellers often respond to consumer demand by increasing or decreasing the supply of the products they provide them. For example, they may be able to sell off their inventory (their supply) at a higher price to make more money.
Review this figure, which depicts a supply curve.
A Supply Schedule and a Supply Curve
You will see a lot of correlation between the language and methods we use to analyze supply with how we analyze consumer demand. These two variables often work together and affect one another.
As with demand, students often confuse supply and quantity supplied. Think of the term supply as the overall supply of the good itself (coffee in our case), in a given area, during a given time. Supply remains constant unless a shift occurs. Businesses will supply x amount at a certain price, y amount for one more dollar, z amount for two more dollars. This ratio, or the line of progression the supply curve represents, remains the same until a shift occurs.
Quantity supplied is illustrated by a specific point on the supply curve (in the graph, a coffee grower will supply 20 million pounds of coffee at $5 per pound). When the price of a good changes, there is a movement along the supply curve – consider this a change in amount supplied. In the graph, the coffee grower supplies 30 million pounds of coffee when the price increases to $7 per pound.
Coffee growers have an incentive to produce more coffee to sell at the higher price. Perhaps the owner will give employees a small bonus if they work longer hours to harvest more coffee beans, the grower may buy extra beans from a neighboring farm to sell, or the grower knows they will be able to afford to buy a more expensive and effective fertilizer to grow more beans if they know they can sell them at a higher price.
As with the demand curve, remember that the supply curve is a ratio plotted on a graph that depicts the relationship between price (the x axis) and quantity businesses supply (the y axis), so a price fluctuation will cause a movement along the supply curve (you can see that points on the supply curve refer to quantity supplied based on a given price). Price fluctuations do not shift the supply curve.
Supply determinants (also called supply shifters) are factors, other than price, that shift supply – fluctuations in these variables will cause the supply curve to shift up or down.
Examples of supply shifters include:
- Natural events: a nation-wide drought causes your coffee plants to die and supply plummets.
- Number of sellers: a coffee conglomerate moves into your area and floods the market with coffee. Supply soars.
- Prices of factors of production: the price of insecticide skyrockets and your coffee yield decreases because you cannot afford to buy enough insecticide to protect this year's crop.
- Returns from alternative activities: you discover it is more profitable to incorporate organic farming techniques so you can sell your organic coffee a higher price.
- Seller expectations: you predict coffee will be in high demand next year due to a recent trends report from the American Beverage Association.
- Technology or innovative changes: a new model of tractor makes it easier to harvest more coffee beans in less time.
Review the drawing of a supply curve in Figure 3.5 which highlights the difference between supply and a supply shifter. An increase in supply shifts the supply curve to the right. A decrease in supply shifts the supply curve to the left.
An Increase in Supply
Review the concept of supply in:
2b. Determine equilibrium in the market under various situations that either cause movements or shifts in demand and supply
- What will happen in a free market when a sudden 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.
- What will happen in a free market after a sudden surplus?
- Will sellers have an incentive to raise or lower the price to eliminate the surplus?
- What happens to the equilibrium point if the government imposes a price control (such as a price ceiling or a price floor)? Note that government intervention means the market is no longer free and is unable to respond freely. Remember to distinguish between price controls that are binding or effective and those that are not.
In a free market, capitalist economic system, economists say that buyers and sellers will eventually achieve an equilibrium: the point where demand and supply intersect and create an equilibrium price and quantity in the market. Note that a free market will always reach an equilibrium.
As you review this material, it is helpful to draw graphs of demand and supply to analyze the changes in the equilibrium point that result from shifts in demand or supply.
Review the concept of market equilibrium in the following resources. Be sure to practice this section thoroughly by completing any accompanying exercises and practice problems.
- Demand, Supply, and Equilibrium
- Market Equilibrium
- Changes in Market Equilibrium
- Putting Demand and Supply to Work
2c. Apply the concept of elasticity as a measure of responsiveness to various variables
- Define elastic, inelastic, and unit elastic.
- Will products with many substitutes have high or low elasticity?
- What is the elasticity of luxury goods?
- What about the elasticity of goods that people are addicted to (such as cigarettes)?
- How do companies know whether they should raise or lower prices?
While demand and supply indicate what happens to quantity demanded and quantity supplied, with regard to price fluctuations, the concept of elasticity offers a deeper understanding of the exact level of consumer responsiveness. Do buyers and sellers change their behavior a little or a lot when prices fluctuate? It often depends on they type of good.
For example, people consider many goods, such as food, medicine, and water, to be necessities. Consumers will continue to buy them, in the same quantities as they did before, regardless of a price increase. These goods have a low responsiveness to price changes – they are inelastic. On the other hand, people will postpone buying something they do not really need when the price goes up just a little bit. These goods have a high responsiveness to price changes – they are elastic.
Business revenue is also related to elasticity of demand. Think about the company that sells the food, medicine, water, or luxury good. Raising the price may lead to an increase in revenues, but lowering the price may also generate more revenue if consumers buy more items. The company needs to do the math to see which option will generate more revenue. Elasticity of demand will play a role.
There are a number of different types of elasticities: price elasticity of demand, price elasticity of supply, income elasticity of demand, cross-price elasticity of related goods, and more.
Review elasticity in:
- Higher Gasoline Prices: Temporary or Time to Buy a Hybrid?
- Introduction to Elasticity
- Price Elasticity of Demand
- More on Elasticity of Demand
- Constant Unit Elasticity
- More on Elasticity of Demand
- Total Revenue and Elasticity
- More on Total Revenue and Elasticity
- Cross Elasticity of Demand
- Elasticity of Supply
- Elasticity and Strange Percent Changes
- Tax Incidence
- Elasticity and Taxation Quiz
2d. Analyze how the market can be manipulated through price controls or quantity controls
- Define price control and quantity control.
- Define tariff.
- What are the benefits of price controls? Who benefits?
- What problems do price controls cause? Who is hurt?
- Are price controls a good way to guide the market toward "desirable" price levels?
Remember that free markets create an equilibrium at the point where demand and supply intersect. What happens in a market when government or society deems the free market equilibrium price "too high" or "too low"?
For example, the mayors of many large cities are concerned that low-income residents are being forced to move to the suburbs because they cannot afford to rent an apartment downtown. The city suffers when these essential workers cannot afford to live or travel easily downtown; commuting is expensive and time consuming. Similarly, many consider the wage rate for many important jobs "too low", such as when workers do not earn enough to rise above the poverty level. City governments may require businesses to pay a minimum wage to their workers.
Review price and quantity controls in:
- Introducing Supply and Demand
- Government Intervention in Market Prices: Price Floors and Price Ceilings
- Price Controls
- Market Equilibrium and Market Manipulation Quiz
Unit 2 Vocabulary
- Ceteris paribus
- Change in demand
- Change in quantity demanded
- Change in quantity supplied
- Change in supply
- Demand determinant
- Demand shifter
- Inferior good
- Law of demand
- Law of supply
- Luxury good
- Minimum wage law
- Natural event
- Normal good
- Price ceilings
- Price controls
- Price floors
- Quantity control
- Quantity demanded
- Quantity supplied
- Supply shifter
- Unit elastic