中国经济管理大学
MBA课堂
《宏观经济学原理》

Chapter 3: Demand, Supply, and Market Equilibrium

Outline of Text Material
I. Introduction
This chapter and the next discuss how markets work. Taken together they explain how individual and household decisions about demand and firms’ decisions about supply interact. As Adam Smith pointed out, coordination happens without any central planning or direction. Markets and prices answer the three basic questions of what to produce, how to produce, and who will get what is produced.
II. Firms and Households: The Basic Decision-Making Units
A. The two fundamental decision-making units in the economy are firms and households.
B. Households are the consuming units in an economy. Their decisions are based on their tastes and preferences and are constrained by their limited incomes.
C. Firms are the producing units in the economy.
1. A firm exists when a person or group of people decides to produce something.
2. Firms transform inputs into outputs (goods and/or services).
3. Firms can be large or small or in-between.
4. Most firms exist to make a profit for their owners.
D. An entrepreneur is one who organizes, manages, and assumes the risks of a firm.
  TOPIC FOR CLASS DISCUSSION: 
Can students name some entrepreneurs? Can they identify the risks referred to in the previous description??
  TOPIC FOR CLASS DISCUSSION: 
What types of firms exist near your campus? For example, outside the gates of my college is a small pizza shop and a McDonald’s. Who are the entrepreneurs in each firm??
III. Input Markets and Output Markets: The Circular Flow
A. Households and firms interact in both input and output markets.
1. To produce goods and services firms must buy resources in input markets, the markets in which resources are exchanged. Firms buy or rent these inputs from households who own them. These resources are used to produce output which is sold in output or product markets.
??? TEACHING TIP: Students often have difficulty believing that households own all the factors of production. After all, they don’t personally own any land or capital. Point out the important role of indirect ownership. Many households own parts of large corporations through their pension funds, retirement accounts, or other instruments.?
2. Most households earn much of their income by supplying labor in the labor market. They may also earn interest or other returns by lending theirwealth to firms in the capital market. Households may also supply land or other real property in exchange for rent in the land market.
?ngdings 2"?? TEACHING TIP: Students often find it difficult to picture firms as actors in both the input and output markets. Remind them that firms need to buy resources. (A good teaching tool to make this point is a business-to-business telephone directory.)
 The term capital market may be confusing to students who have just grasped that economists do not include money in their definitions of capital and investment. Think of the phrase “capital market” as a single word to avoid this confusion. Or use the more general phrase “assets market” instead.?
B. The circular flow implies that national income must equal national product.
IV. Demand in Product/Output Markets
A. A household’s decision about what quantity of a particular output or product to demand depends on:
1. The price of the product.
2. The income available to the household.
3. The household’s accumulated net wealth.
4. The prices of other products.
5. The household’s tastes and preferences.
6. The household’s expectations about future income, wealth, and prices.
??? TEACHING TIP: It is useful to write this list on one side of the board to help explain the importance of the distinction between “change in quantity demanded” and “change in demand.” (Reserve the other side of the board for the list of supply determinants.) This makes it easy for you to keep referring to the list as you make your way through this section. It comes in handy later as you discuss the distinction between a movement along the demand curve and a shift of the demand curve.?
  TOPIC FOR CLASS DISCUSSION: 
Introduce this analysis by asking students to list the factors that affect their decisions about what to buy and how much. See how many of the factors listed emerge in the class discussion. Relate recent events in the stock market to factor number 3 (and 6) just listed.?
B. Quantity Demanded is the amount of a product that a household would buy in a given period if it could buy all it wanted at the current market price.
1. Emphasize the important role of time. Quantity demanded is a flow.
2. A change in quantity demanded assumes every other factor affecting demand is held constant (cet. par.).
C. Changes in Quantity Demanded Versus Changes in Demand:
1. A change in the price of the product changes quantity demanded. Only a change in price can cause a movement along a demand curve.
2. A change in any other factor affecting demand changes the entire relationship between price and quantity. This is called a change in demand. Changes in demand cause the demand curve to shift.
D. Price and Quantity Demanded: The Law of Demand
1. An individual demand schedule shows the quantities of a product that a household would be willing and able to buy at different prices (cet. par.). A graph of a demand schedule is called a demand curve.
2. Demand Curves Slope Downward
a. There is a negative or inverse relationship between quantity demanded and price. This is called the law of demand.
??»Wingdings 2" TEACHING TIP: The law of demand is based on decades of empirical research. Economists have statistically analyzed data from millions of different markets. The one common fact is that the demand curves always slope downward. Mentioning this fact will help students later if you teach microeconomics and discuss income and substitution effects.?
b. This is reasonable given that consumers have limited income; the more one thing costs the more they must sacrifice other products.
c. Also at work is the Law of Diminishing Marginal Utility: If successive units are worth less to the consumer, the person will not be willing to pay as much for them.
???ngdings 2" TEACHING TIP: A thought experiment can help students “discover” the Law of Diminishing Marginal Utility. Ask them to imagine having one slice of pizza to eat, and ask them to record how much utility this gives them. Use a simple 1 to 10 scale to avoid long discussions about how to measure utility. Then ask them to imagine having a second slice, etc. At some point there may be groans from some students as they imagine being full, while others may keep going. This is a good opportunity to point out the subjectivity of utility as well as differences between individuals. Interject your own tastes and preferences. Ask students to discuss their experience and most will note that they found the utility decreasing at some point. (Be careful—some students may overstate their marginal utilities as they try to persuade you to bring in actual pizzas to test this thought experiment empirically. This can be hazardous to your income.)?
3. Other Properties of Demand Curves
a. Most demand curves intersect the price axis somewhere. There is a maximum price a household (or an entire market) is willing and able to pay for any product.
b. Most demand curves also intersect the quantity axis. Even if you give the product away there is a limit to the quantity that will be consumed.
??? TEACHING TIP: Students may find this hard to believe. Remind them that the analysis refers to consumption within some period of time and ask them to find examples. You may also find it helpful to refer to the previous teaching tip and remind the class about their diminishing marginal utility. At some point, their marginal utility of pizza will reach zero (perhaps even becoming negative).?
E. Other Determinants of Household Demand
1. Income and Wealth
a. Income is the sum of all the wages, salaries, profits, interest payments, rents, and other forms of earnings received by a household during a given period of time. Since income is paid over time, it is a flow variable.
b. Net worth or wealth is the total market value of what a household owns minus the market value of what it owes.
c. Higher income usually causes a household to buy more things. Products for which demand increases as income increases are called normal goods. Products for which demand decreases as income increases are called inferior goods.
??? TEACHING TIP: The only example of an inferior good that has ever worked for me is public transportation. Students understand that when they graduate and get a job (and their income rises) one of the first things they will do is buy a (better) car and stop taking the bus.?
d. Higher wealth also usually causes a household to buy more things.
??? TEACHING TIP: Students (and the media) often confuse income and wealth. Explaining that income is a flow variable and wealth is a stock variable will help, but many will not be convinced. A good illustration of the difference is to ask students whether they would prefer a raise of $100 a week or a one-time gift of $100. Some examples may also help; someone who inherits money and quits his or her job as a result would have no income from wages and salaries but would have wealth. Someone who is a big spender may have high income. By spending most of the income, they have little wealth.
 Emphasize that wealth is the accumulation of past net saving.?
2. Prices of Other Goods and Services
a. If an increase in the price of good A causes the demand for good B to increase (and vice versa) the goods are substitutes.
b. If an increase in the price of good X results in a decrease in the demand for good Y (and vice versa) the goods are complements.
??? TEACHING TIP: When discussing the prices of related goods, students often confuse the difference between products related in demand and those related in supply. Stress that the relationships are completely independent of one another. Students may also make the mistake of assuming that changes in supply cause changes in demand (rather than quantity demanded). For example, they may think an increase in the supply of leather will lead to an increase in the demand for leather jackets, rather than an increase in quantity demanded. It’s impossible to overemphasize the distinction between supply and demand.?
3. Tastes and Preferences
a. As households have a greater preference for a product they buy more of it.
b. Some products are sold based on fad or fashion.
  TOPIC FOR CLASS DISCUSSION: 
The July 25, 2003, Wall Street Journal had a front-page article about a current fashion, “low-rise” pants for women. According to this article women are unable to bend over at the waist or even sit in open-backed chairs without exposing more than they want to. Use this as an entry point to discussing the effect of fashion on demand curves in certain industries.?
4. Expectations
a. Your beliefs about future income or prices will affect your current purchasing decisions.
b. People sometimes mistakenly think certain demand curves slope upward. They are confusing a change in quantity demanded with a change in demand caused by expectations of higher prices in the future.
??? TEACHING TIP: The gold market is a good example of a market in which people make this mistake. Point out that the reason demand for gold sometimes increases when the price rises is expectations that the price will rise even more in the future. This is an outward shift of a downward sloping demand curve.?
F. Shift of Demand Versus Movement Along a Demand Curve
1. Price changes cause the quantity demanded to change. This is a movement along a demand curve.
2. When any of the other factors change, a new relationship between price and quantity is established. This is a shift of the demand curve.
?? TEACHING TIP: If you used the earlier Teaching Tip and have the list of demand determinants on the board, tell students that when the price of the product itself is held constant, a change in one of the other factors is a “change in demand.” When the other factors are held constant, a change in the price of the product is a “change in quantity demanded.” This is a good way to illustrate the use of ceteris paribus.186 \f "Wingdings 2"
G. From Household Demand to Market Demand
1. Market demand is simply the sum of all the quantities of a good or service demanded per period by all the households buying in the market for that good or service.
2. Economists do not actually add up individual demand curves to derive a market demand curve. Instead we use data from the entire market to statistically estimate a demand curve.
  TOPIC FOR CLASS DISCUSSION: 
Find a product that many students in the class purchase. Ask each to write down how many units of the product he/she buys in a week. Add them to illustrate how market demand is calculated. Discuss what would happen if the price changed.?2"
??? TEACHING TIP: The above is a good exercise in moving from data to graphs. Have students develop a table of their data and then graph the results.º"Wingdings 2"
V. Supply in Product/Output Markets
 Supply decisions depend on profit potential. Profit is the difference between total revenue and total cost. Total revenue is price per unit times the number of units sold. It depends on the price of the firm’s product in the market and how much it can sell. Total cost depends on the inputs needed to produce the product, the quantities the firm uses, and input prices.
??? TEACHING TIP: Supply curves usually slope upward because in the short run total revenue usually increases faster than total cost. Taking the most extreme case, tell the class to assume for a moment that per unit cost remains constant as output changes. When the price of the product increases, profit per unit rises as well. Higher profit per unit induces firms to increase output to capture even more profit.?
A. Price and Quantity Supplied: The Law of Supply
1. Quantity supplied is the amount of a particular product that a firm would be willing and able to offer for sale at a particular price during a given time period.
2. A supply schedule shows how much of a product the firm will supply at various prices.
3. A supply curve is a graph of the supply schedule. The upward slope of the supply curve reflects the positive relationship between price and quantity supplied.
??? TEACHING TIP: Like the law of demand, the law of supply is based on both empirical and theoretical research. Be sure to mention the empirical basis for this law, too.?
???ngs 2" TEACHING TIP: You may find this example useful. Ask your students to imagine that they own an apple orchard and that, during the season, the trees can yield a maximum of 10,000 apples. Have three columns: “price,” “quantity supplied,” and “production technique.” Make it clear that the “price” of an apple is determined in the market, and not something that a small orchard owner can affect. However, orchard owners can respond to different prices by producing more or fewer apples.
 At the lowest price, it is probably best to let the apples rot, as there are better uses for one’s time (refer to opportunity cost), and quantity supplied will be low. If price rises slightly, it becomes worthwhile to exert some effort harvesting, and quantity supplied rises. If price rises further, it may pay to buy a ladder and a basket, and so on.
 The final result might look like this:
 

Price Quantity
Supplied 
Technique   
$.02 0 Let the apples rot   
$.05 150 One worker picks up apples from the ground   
$.10 500 Handpick low-hanging apples   
$.15 1,500 Pick using ladder and basket   
$.20 3,000 Hire some workers, buy more ladders   
$.30 4,000 Use insecticide to protect apples and increase yield   
$.40 8,000 Rent apple-picking machinery   
$.50 9,000 Train workers so they will pick more carefully. Fewer apples wasted. 
 
 Be sure to emphasize the difference between supply and quantity supplied. Also stress that the new supply curve is an entirely new relationship, not merely a shift of the old curve. You can show this graphically by depicting a new supply curve with a different slope or shape.?
B. Other Determinants of Supply
1. The Cost of Production
a. Per unit cost depends on a number of factors, including the available technologies and the prices of the inputs needed.
b. When a technological advance lowers the cost of production, output is likely to increase. The supply curve shifts outward.
c. An increase in the price of a variable input that’s a significant fraction of production costs will cause the supply curve to shift inward.
??? TEACHING TIP: Mention that it’s only variable (marginal) production costs that count. Changes in fixed costs don’t shift the short-run supply curve.?
2. The Prices of Related Products
a. If land can be used for corn or soybean production, an increase in the price of one crop can cause farmers to produce more of that crop and decrease the amount supplied of the other.
b. When an increase in the price of one product causes decreased production of another product, the two are substitutes in production.
c. There are also complements in production. An increase in the price of beef will induce ranchers to increase the quantity of beef supplied. There will also be more leather produced from the cowhides.
C. Shift of Supply Versus Movement Along a Supply Curve
1. The supply curve is derived holding everything constant except the price of the product (ceteris paribus). When the price of a product changes, a change in the quantity supplied follows and a movement along the supply curve takes place. This is called a change in quantity supplied.
2. If other factors change there will be a new relationship between price and quantity supplied. The supply curve shifts. This is called a change in supply.
??? TEACHING TIP: If you used the earlier Teaching Tip and have the determinants of demand listed on the board, you can now add the determinants of supply and discuss the effects of changes in them. Again, this is a good way to illustrate the use of ceteris paribus.?
D. From Individual Supply to Market Supply
1. Market supply is simply the sum of the quantities supplied in each period by all producers of the product at each price.
2. The market supply curve also shifts when there is a change in the number of firms producing output in the industry.
?dings 2"?? TEACHING TIP: Refer to the apple orchard example. Now imagine there were 1,000 similar apple orchards around the country, all making similar decisions. At each price for apples, how many would be supplied? Construct a table like the following:
 
Market
Price Quantity
Supplied   
$.02 0   
$.05 150,000   
$.10 500,000   
$.15 1,500,000   
$.20 3,000,000   
$.30 4,000,000   
$.40 8,000,000   
$.50 9,000,000 

 
Graph this supply curve, and mark two points like A and B.
 

 To drive home the origins of the market supply curve, discuss what happens at a typical orchard as we move along the market supply curve from Point A to Point B (orchards are switching from unskilled labor with ladders and baskets to apple-picking machinery operated by skilled labor).?
  TOPIC FOR CLASS DISCUSSION: 
Students generally have less familiarity with supply than demand. After all, everyone has bought something. Not many people have run businesses. Even those who have managed a business rarely reflect on supply decisions. However, students are familiar with themselves as suppliers of labor. That’s a useful starting point for a discussion of supply.?
VI. Market Equilibrium
The operation of the market depends on the interaction between buyers and sellers. Equilibrium occurs when the quantity demanded equals the quantity supplied at the current price. At equilibrium there will be no tendency for the price to change unless something shifts demand or supply.
??? TEACHING TIP: Emphasize that equilibrium means quantity supplied equals quantity demanded, not supply equals demand.?
A. Excess Demand (shortage) exists when the quantity demanded is greater than the quantity supplied at the current price. The price will increase until the shortage is eliminated. This is the process of price rationing: Price increases will distribute what is available to those who are willing and able to pay the most. The higher price will also induce some sellers to increase the quantity supplied.
B. Excess Supply (surplus) exists when the quantity supplied is greater than the quantity demanded at the current price. The price will decrease until the surplus is eliminated.
??»"Wingdings 2" TEACHING TIP: This is another example where the difference in the meanings of words as used in economics as opposed to everyday language may lead to confusion. It is important to stress that excess demand (a shortage) implies that at the existing price quantity demanded exceeds quantity supplied. Even in a famine, there may not be a shortage in economic terms.?
  TOPIC FOR CLASS DISCUSSION: 
Economists usually think of persistent shortages being caused by some interference with the market mechanism. Ask the class if they can think of free markets in which there still seems to be a shortage. There are numerous examples, but one that most will understand is tickets to a hot concert. These tickets are often priced below equilibrium. One reason is to create “buzz” about the event. Some bands claim they keep ticket prices low to be fair to their fans. Ask the class who gains and who loses when the price is set below equilibrium. This can lead to a discussion of the value different people place on their time.?
C. Changes in Equilibrium occur when the supply curve or demand curve shifts. These shifts can create temporary shortages and surpluses and result in price changes.
??? TEACHING TIP: Remind students of the sequence of events in the adjustment to a new equilibrium: When the supply curve shifts it will create excess supply or excess demand. Similarly when the demand curve shifts there will be excess supply or excess demand. Either causes a change in price leading to a new equilibrium quantity demanded and supplied. (For durable goods, there may also be a change in inventories that signals the producers.) Have students compare the initial and new equilibrium points for these shifts, particularly for cases when both curves are shifting. When both curves shift, we can be sure of the direction of change of only one of the two variables.
 Simultaneous shifts of supply and demand can be confusing to students, because unless the student knows which curve shifts more, the ultimate effect on equilibrium price or quantity will be indeterminate. Do a few examples in class to make students feel comfortable with the notion of indeterminacy.?
VII. Demand and Supply in Product Markets: A Review
This chapter has considered the basic way that the forces of supply and demand operate in free markets. This section summarizes the important points.
??? TEACHING TIP: A useful assignment at this point is to have students find a newspaper article that deals with a change in supply or demand for a product (preferably indirectly through a discussion of a change in price or sales). Have them illustrate the changes described in the article with a supply-and-demand graph. If each student answers this alone (possibly at the board), it will be particularly helpful.?
VIII. Looking Ahead: Markets and the Allocation of Resources
This chapter summarizes the ways markets answer the three basic economic questions. If markets are functioning well, resources will flow in the direction of profit opportunities.
A. Demand curves reflect what people are willing and able to pay for products. The more a product is wanted the higher the price will be and the more profitable it will be for firms to produce it. Hence, firms produce what people want.
B. Firms seeking profits strive to keep costs down. This guides their decisions about how to produce (what technology to use).
C. Markets also answer the distribution question. Those who are willing and able to pay the market price get what is produced.
The next chapter begins with a more detailed discussion of these topics.

  Extended Application
Application 1: Supply and Demand in Energy Markets
During the late 1980s, many East Coast colleges purchased expensive equipment to enable them to switch rapidly from oil to natural gas in the event of a sudden oil price increase. In fall 1990, after Iraq invaded Kuwait and oil prices skyrocketed, the colleges put their new equipment to use. But when college administrators received bills from their local utility companies, they found that the price of natural gas had risen as well! Many of these administrators were surprised and angry at the utility companies, accusing them of “gouging” the public. The invasion of Kuwait did not threaten natural gas supplies, they reasoned, so there was no logical reason for a natural gas price hike. Why did the price of oil rise after Iraq’s invasion of Kuwait? Why did the price of natural gas rise? Were the administrators correct in their outrage?
Oil prices rose dramatically immediately after Iraq’s invasion of Kuwait, well before there was any actual disruption of oil supplies to the world market (it takes weeks for disruptions at the wellhead to impact oil deliveries to consuming nations). Thus, it would be incorrect to believe that oil prices rose because of a shift in the supply curve. In fact, the reason for the price change was a change in expectations: Buyers anticipated that supplies to oil-consuming nations might become disrupted in the future, which would cause a future rise in prices. This, in turn, caused speculators to increase their demand for oil, and the demand curve shifted rightward (see the diagram), causing oil prices to rise well before any supply shift occurred.

As for the colleges, the administrators may have made a serious mistake by ignoring the relationship between the oil market and the natural gas market. Natural gas is a substitute for oil. When the price of oil rises, many buyers—not just a few colleges—switch to natural gas as a source of energy. Although utilities buy some of their natural gas in a regulated market where state governments set the price, they also buy gas in unregulated markets where the price is set by supply and demand. When the utility companies increased their demand for natural gas in these unregulated markets, the demand curve for natural gas shifted rightward, and the price paid by the utility companies rose accordingly (see diagram). The utilities then passed on this price increase to their customers. (Many utilities, particularly in California, had switched from oil to natural gas because the latter generated less pollution.)
Had college administrators correctly understood the relationship between oil and natural gas prices, they might have decided that their expensive switching equipment was not a good investment. Perhaps the money could have been better spent on insulation for dorm rooms or on other energy-conserving measures.