The Market Forces of Supply and Demand
Then a cold snap hits Florida, the price of orange juice rises in supermarkets throughout the country. When the weather turns warm in New England every summer, the price of hotel rooms in the Caribbean plummets. When a war breaks out in the Middle East, the price of gasoline in the United States rises and the price of a used Cadillac falls. What do these events have in common?
They all show the workings of supply and demand. I Supply and demand are the two words economists use most often-and for good reason. Supply and demand are the forces that make market economies work. They determine the quantity of each good produced and the price at which it
turn, allocate the economy's and Competition
The terms supply and demand refer to the behavior of people as they interact with one another in competitive markets. Before discussing how buyers and sellers behave, let's first consider more fully what we mean by the terms market and competition.
What Is a Market?
A market is a group of buyers and sellers of a particular good or service. The buyers as a group determine the demand for the product, and the sellers as a group determine the supply of the product.
Markets take many forms. Some markets are highly organized, such as the markets for many agricultural commodities. In these markets, buyers and sellers meet at a specific time and place where an auctioneer helps set prices and arrange sales.
More often, markets are less organized. For example, consider the market force cream in a particular town. Buyers of ice cream do not meet together at any one time. The sellers of ice cream are in different locations and offer somewhat different products. There is no auctioneer calling out the price of ice cream. Each seller posts. a price for an ice-cream cone, and each buyer decides how much ice cream to buy at each store. Nonetheless, these consumers and producers of ice cream are closely connected. The ice-cream buyers are choosing from the various ice-cream sellers to satisfy their cravings, and the ice-cream sellers are all trying to appeal to the same ice-cream buyers to make their businesses successful. Even though it is not as organized, the group of ice-cream buyers and ice-cream sellers forms a market.
What Is Competition?
The market for ice cream, like most markets in the economy, is highly competitive. Each buyer knows that there are several sellers from which to choose, and each seller is aware that his product is similar to that offered by other sellers. As a result, the price and quantity of ice cream sold are not determined by any single buyer or seller. Rather, price and quantity are determined by all buyers and sellers
as they interact in the marketplace.
Economists use the term competitive market to describe a market in which there are so many buyers and so many sellers that each has a negligible impact on the market price. Each seller, of ice cream haş limited control over the price each because other sellers are offering similar products. A seller has little reason to charge less than the going price, and if he charges more, buyers will make their purchases elsewhere. Similarly, no single buyer of ice cream can influence the price of ice cream because each buyer purchases only a small amount.
In this chapter, we assume that markets are perfectly competitive. To reach this highest form of competition, a market must have two characteristics:
(1) The goods offered for sale are all exactly the same, and
(2) the buyers and sellers are so
numerous that no single buyer or seller has any influence over the market price
THE MARKET FORCES
Because buyers and sellers in perfectly competitive markets must accept the price the market determines, they are said to be price takers. At the market price, buyers can buy all they want, and sellers can 'sell all they want.
There are some markets in which the assumption of perfect competition applies perfectly. In the wheat market, for example, there are thousands of farmers who sell wheat and millions of consumers who use wheat and wheat products. Because no single buyer or seller can influence the price of wheat, each takes the market price as given.
Not all goods and services, however, are sold in perfectly competitive markets. Some markets have only one seller, and this seller sets the price, Such a seller is called a monopoly. Your local cable television company, for instance, may be a monopoly. Residents of your town probably have only one company from which to buy cable service. Other markets fall between the extremes of perfect competition and monopoly.
Despite the diversity of market types we find in the world, assuming perfect competition is a useful simplification and, therefore, a natural place to start. Perfectly competitive markets are the easiest to analyze because everyone participating in the market takes the price as given by market conditions. Moreover,
because some degree of competition is present in most markets, many of the lessons that we learn by studying supply and demand under perfect competition apply in more complicated markets as well.
Quick Quiz
What IS a market? What are the characteristics of a perfectly competitive market?
Demand
We begin our study of markets by examining the behavior of buyers. To focus our
thinking, let's keep in mind a particular goodie cream. to same
The Demand Curve: The Relationship between Price and Quantity Demanded
The quantity demanded of any good is the amount of the good that buyers are willing and able to purchase. As we will see, many things determine the quantity demanded of any good, but in our analysis of how markets work, one determinant plays a central role: the price of the good. If the price of ice cream rose to $20 per scoop, you would buy less ice cream. You might buy frozen yogurt
instead. If the price of ice cream fell to $0.20 per scoop, you would buy more. This relationship between price and quantity demanded is true for most goods in the economy and, in fact, is so pervasive that economists call it the law of demand:
Other things being equal, when the price of a good rises, the quantity demanded
of the good falls, and when the price falls, the quantity demanded rises
The table in Figure 1 shows how many ice-creams cones Catherine buys each on the at different prices. If ice cream is free, Catherine eats 12 cones per month. At 50 per cone, Catherine buys 10 cones each month. As the price rises further, she buys fewer and few of cones. When the price reaches $3.00, Catherine doesn't buy the icons at all. This table is a demand schedule, a table that shows the relation-
up between the price of a good and the quantity demanded, holding constant this every thing else that influences how much of the good consumers want to buy.
Then graph in Figure 1 uses the numbers from the table to illustrate the law demand. By convention, the price of ice cream is on the vertical axis, and the price
Market Demand versus Individual Demand
The demand curve in Figure 1 shows an individual's demand for a product. To
analyze how markets work, we need to determine the market demand, the sum of
all the individual demands for a particular good or service.
The table in Figure 2 shows the demand schedules for ice cream of the two
individuals in this market-Catherine and Nicholas. At any price, Catherine's
demand schedule tells us how much ice cream she buys, and Nicholas's demand
schedule tells us how much ice cream he buys. The market demand at each price
is the sum of the two individual demands.
The graph in Figure 2 shows the demand curves that correspond to these
demand schedules. Notice that we sum the individual demand curves horizontally
to obtain the market demand curve. That is, to find the total quantity demanded
at any price, we add the individual quantities, which are found on the horizontal
axis of the individual demand curves. Because we are interested in analyzing how
markets function, we work most often with the market demand curve. The market
demand curve shows how the total quantity demanded of a good varies as the price
of the good varies, while all other factors that affect how much consumers want to
buy are held constant.
less to spend in total, so you would have to spend less on some -and probably
most-goods. If the demand for a good falls when income falls, the good is called
a normal good.
Normal goods are the norm, but not all goods are normal goods. If the demand
for a good rises when income falls, the good is called an inferior good. An example of an inferior good might be bus rides. As your income falls, you are less likely
to buy a car or take a cab and more likely to ride a bus.
Prices of Related Goods Suppose that the price of frozen yogurt falls. The law
of demand says that you will buy more frozen yogurt. At the same time, you will
probably buy less ice cream. Because ice cream and frozen yogurt are both cold,
Sweet, creamy desserts, they satisfy similar desires. When a fall in the price of one
good reduces the demand for another good, the two goods are called substitutes.
Substitutes are often pairs of goods that are used in place of each other, such as
hot dogs and hamburgers, sweaters and sweatshirts, and cinema tickets and film
streaming services.
Now suppose that the price of hot fudge falls. According to the law of demand, in
you will buy more hot fudge. Yet in this case, you will likely buy more ice cream
as well because ice cream and hot fudge are often used together. When a fall in the
price of one good raises the demand for another good, the two goods are called
complements. Complements are often pairs of goods that are used together, such
as gasoline and automobiles, computers and software, and peanut butter and jelly
Tastes The most obvious determinant of your demand is your tastes. If you like
in ice cream, you buy more of it. Economists normally do not try to explain people's tastes because tastes are based on historical and psychological forces that are
beyond the realm of economics, Economists do, however, examine what happens
when tastes change.
Expectations Your expectations about the future may affect your demand for a
good or service today. If you expect to earn a higher income next month, you may
THE MARKET FORCES
choose to save less now and spend more of your current income buying ice cream.
If you expect the price of ice cream to fall tomorrow, you may be less willing to
buy an ice-cream cone at today's price.
Number of Buyers In addition to the preceding factors, which influence the
behavior of individual buyers, market demand depends on the number of these
buyers. If Peter were to join Catherine and Nicholas as another consumer of ice
cream, the quantity demanded in the market would be higher at every price, and
market demand would increase.
Summary The demand curve shows what happens to the quantity demanded of
a good when its price varies, holding constant all the other variables that influence
buy rs. When one of these other variables changes, the demand curve shifts. Table 1
lists the variables that influence how much of a good consumers choose to buy.
If you have trouble remembering whether you need to shift or move along the
demand curve, it helps to recall a lesson from the appendix to Chapter 2. A curve
shifts when there is a change in a relevant variable that is not measured on either
axis. Because the price is on the vertical axis, a change in price represents a movement along the demand curve. By contrast, income, the prices of related goods,
tastes, expectations, and the number of buyers are not measured on either axis, so
a change in one of these variables shifts the demand curve.
TWO WAYS TO REDUCE THE QUANTITY OF SMOKING DEMANDED
CASE
Because smoking can lead to various illnesses, public policymakers
STUDY
often want to reduce the amount that people smoke. There are two
ways that they can attempt to achieve this goal
One way to reduce smoking is to shift the demand curve for cigarettes and other
tobacco products. Public service announcements, mandatory health warnings on
cigarette packages, and the prohibition of cigarette advertising on television are all
policies aimed at reducing the quantity of cigarettes demanded at any given price.
If successful, these policies shift the demand curve for cigarettes to the left, as in
panel (a) of Figure 4.
Alternatively, policymakers can try to raise the price of cigarettes. If the goy
remnant taxes the manufacture of cigarettes, for example, cigarette companies
pass much of this tax on to consumers in the form of higher prices. A higher price
encourages smokers to reduce the numbers of cigarettes' they smoke. In this case,
the reduced amount of smoking does not represent a shift in the demand curve.
If warnings on cigarette packages convince smokers to smoke less, the demand curve
for cigarettes shifts to the left. In panel (a), the demand curve shifts from D, to D
At a price of $4.00 per pack, the quantity demanded falls from 20 to 10 cigarettes per
day, as reflected by the shift from point A to point B. By contrast, if a tax raises the price
of cigarettes, the demand curve does not shift. Instead, we observe a movement to a different point on the demand curve. In panel (b), when the price rises from $4.00 to $8.00,
the quantity demanded falls from 20 to 12 cigarettes per day, as reflected by the
movement from point A to point C.
Instead, it represents a movement along the same demand curve to a point with a
higher price and lower quantity, as in panel (b) of Figure 4.
How much does the amount of smoking respond to changes in the price of
cigarettes? Economists have attempted to answer this question by studying what
happens when the tax on cigarettes changes. They have found that a 10 percent
increase in the price causes a 4 percent reduction in the quantity demanded.
Teenagers are especially sensitive to the price of cigarettes: A 10 percent increase in
the price causes a 12 percent drop in teenage smoking.
A related question is how the price of cigarettes affects the demand for illicit
drugs, such as marijuana. Opponents of cigarette taxes often argue that tobacco
and marijuana are substitutes so that high cigarette prices encourage marijuana
use. By contrast, many experts on substance abuse view tobacco as a "gateway
drug" leading young people to experiment with other harmful substances. Most
studies of the data are consistent with this latter view: They find that lower
cigarette prices are associated with greater use of marijuana. In other words,
tobacco and marijuana appear to be complements rather than substitutes.
Make up an example of a monthly demand schedule for pizza, and graph
Quick Quiz
The implied demand curve. Give an example of something that would shit
this demand curve, and briefly explain your reasoning. Would a change in the price of pizza
shift this demand curve?
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