Demand, Supply, and Market Equilibrium
In this chapter we presented the basic framework of demand and supply analysis. The market was divided into two different groups of participants: consumers and producers. Demand analysis focuses on the behavior of consumers, while supply analysis examines the behavior of producers. The demand and supply curves together determine the price and output that occur in a market. The impact of changing market circumstances on equilibrium price and output is determined by making the appropriate shifts in either demand or supply and comparing equilibriums before and after the change.
The general demand function specifies how the quantity demanded of a good is related to six variables that jointly determine the amount of a good or service consumers are willing and able to buy. By holding constant the five determinants of demand—income, the price of related goods, consumer tastes, expected price, and the number of consumers—and letting only the price of the good vary, a demand function is derived. The law of demand states that quantity demanded and price are inversely related, all other variables influencing demand held constant. Whenever the price of a good changes, a “change in quantity demanded” occurs, which is represented by a movement along a fixed demand curve. A point on the demand curve shows either the maximum amount of a good that will be purchased if a given price is charged or the maximum price consumers will pay for a specific amount of the good. The five determinants of demand are also called the demandshifting variables because their values determine the location of the demand curve. Table 2.4 summarizes how demand curves shift when each of the determinants of demand changes value.
For producers, the general supply function shows how six variables—the price of the product, the price of inputs, the prices of goods related in production, the state of technology, the expected price of the good, and the number of firms or amount of productive capacity—jointly determine the amount of a good or service producers are willing to supply. Quantity supplied and price are directly related, all other variables influencing supply held constant. When the price of a good changes, a change in quantity supplied occurs, which is represented by a movement along a fixed supply curve. Apoint on the supply curve shows either the maximum amount of a good that will be offered for sale at a given price or the minimum price (the supply price) necessary to induce producers voluntarily to offer a particular quantity for sale. The five determinants of supply (PI, Pr, T, Pe, and F) are also called the supply-shifting variables because their values determine the location of the supply curve. Table 2.8 summarizes how supply curves shift when each of the determinants of supply changes value.
The equilibrium price and quantity in a market are determined by the intersection of demand and supply curves. At the point of intersection, quantity demanded equals quantity supplied, and the market clears. Since the location of the demand and supply curves is determined by the five determinants of demand and
the five determinants of supply, a change in any one of these 10 variables will result in a new equilibrium point. When demand increases and supply remains constant, price and quantity sold both rise. A decrease in demand, supply constant, causes both price and quantity sold to fall. When supply increases and demand remains constant, price falls and quantity sold rises. A decrease in supply, demand constant, causes price to rise and quantity sold to fall.
When buyers and sellers voluntarily engage in market exchange, both consumers and producers enjoy a net gain from the exchange. The net gain to consumers, known as consumer surplus, arises because the equilibrium price consumers pay is less than the value they place on the units they purchase. Total consumer surplus from market exchange is measured by the area under demand above market price up to the equilibrium quantity. The net gain to producers, known as producer surplus, develops because the equilibrium price suppliers receive is greater than the minimum price they would be willing to accept to produce. The total producer surplus is equal to the area below market price and above supply up to the equilibrium quantity. Since consumers and producers are all members of society, the net gain to society arising from market exchange—called social surplus—is the sum of consumer surplus and producer surplus.
When both supply and demand shift simultaneously, it is possible to predict either the direction in which price changes or the direction in which quantity changes, but not both. The change in equilibrium quantity or price is said to be indeterminate when the direction of change depends upon the relative magnitudes by which demand and supply shift. The four possible cases for simultaneous shifts in demand and supply are summarized in Figure 2.10.
Sometimes the government imposes either a ceiling price or a floor price, which interferes with the market mechanism and prevents price from freely moving up or down to clear the market. When government sets a ceiling price below the equilibrium price, a shortage results because consumers wish to buy more of the good than producers are willing to sell at the ceiling price. If government sets a floor price above the equilibrium price, a surplus results because producers offer for sale more of the good than buyers wish to purchase at the higher floor price.
In this chapter we had two purposes. The first was to show you how managers can use economic theory to make predictions about the effect of exogenous events upon prices. We showed what to expect about price and quantity in specific markets when certain variables change or are expected to change. As we will show in later chapters, the ability to make correct forecasts under difficult conditions separates good (successful) managers from those who are not so good (unsuccessful). The second purpose was to prepare you for the material we will present in the following chapters. These chapters will show how demand and supply functions are derived from the behavior of consumers and firms and how these functions can be estimated. A thorough understanding of the material set forth in this chapter is essential to developing the ability to use and interpret demand and supply estimations and make accurate forecasts.