ECON1101: Macroeconomics 1

Chapter 3: Supply and demand

Centrally-planned, market and mixed economies
In centrally-planned economies, economic decisions are made by an
individual, or a small number of individuals, on behalf of a larger group.
In free-market economies, people make economic decisions for themselves.
Mixed economies combine free markets and regulations.

Market
A market for any good or service consists of all the buyers and sellers of that
good or service.

The demand curve

The demand curve shows the relationship between the amount of a particular
good or service demanded by buyers in a given time period, and the price of that
good or service.

Why the demand curve slopes downwards

1. The substitution effect is the change in the quantity demanded of a
good or service caused by a change in price, because the good or service
becomes more or less expensive relative to other goods and services.
2. The income effect is the change in the quantity demanded of a good or
service caused by a change in price, because of the change in the
purchasing power of a buyers income.
3. A buyers reservation price is the highest price that buyer would be
willing to pay for a particular good or service. In most markets, different
buyers have different reservation prices. A higher price will satisfy the
cost-benefit principle for fewer buyers than a lower price.

Horizontal vs. vertical interpretation of the demand curve

The horizontal interpretation of the demand curve is a reading of the
demand curve where we start with price on the vertical axis and read the
corresponding quantity demanded on the horizontal axis.
The vertical interpretation of the demand curve is a reading of the
demand curve where we start with quantity demanded on the horizontal
axis and then read the marginal buyers reservation price on the vertical
axis.

The supply curve

The supply curve shows the relationship between the amount of a particular
good or service supplied by sellers in a given time period, and the price of that
good or service.

Why the supply curve slopes upwards

A sellers reservation price is lowest price for which a seller would be
willing to sell an additional unit of a good or service. In most markets,
different sellers have different opportunity costs and, therefore,
reservation prices. A higher price will satisfy cost-benefit principle for more
sellers than a lower price.

Market equilibrium
Market equilibrium occurs in a market when all buyers and sellers are satisfied
with their respective quantities at the market price (when quantity demanded
equals quantity supplied).

Excess supply and demand

Excess supply (or surplus) is the amount by which quantity supplied exceeds
quantity demanded when the price of a good or service exceeds the equilibrium
price. It motivates sellers to lower their prices until the equilibrium price is
reached.
Excess demand (or shortage) is the amount by which quantity demanded
exceeds quantity supplied when the price of a good or service lies below the
equilibrium price. It motivates buyer to offer higher prices until the equilibrium
price is reached.

Price ceiling and price floor

A price ceiling is a maximum allowable price, specified by law. A price ceiling
set below the equilibrium price creates excess demand.
A price floor is a minimum allowable price, specified by law. A price floor set
above the equilibrium price creates excess supply.

Change in quantity demanded or supplied

A change in the quantity demanded is a movement along the demand curve
that occurs in response to a change in price.
A change in the quantity supplied is a movement along the supply curve that
occur in response to a change in price.

Change in demand
A change in demand is a shift of the entire demand curve.

What causes a change in demand

1. Complements Two goods are complements in consumption if the price of
one and the demand for the other are negatively correlated (e.g. tennis
courts and tennis balls).
2. Substitutes Two goods are substitutes in consumption if the price of one
and the demand for the other are positively correlated (e.g. traditional
mail and email).
3. Normal goods A normal good is one whose demand is positively
correlated with the income of buyers (e.g. restaurant meals).
4. Inferior goods An inferior good is one whose demand is negatively
correlated with the income of buyers (e.g. junk food).
5. Changes in preferences
6. Changes in the number of buyers (e.g. an ageing population increases the
demand for medical services)
7. Expected future price changes (e.g. an expected future price hike
increases current demand)

Change in supply
A change in supply is a shift of the entire supply curve.

What causes a change in supply

1.
2.
3.
4.
5.

Changes in the cost of inputs (e.g. materials and labour)

Technological improvements that reduce production costs
Changes in the weather (especially for agricultural products)
Changes in the number of suppliers
Expected future price changes

Market equilibrium & changes in demand or supply

1. An increase in demand causes an increase in the equilibrium price and
quantity.
2. A decrease in demand curves a decrease in the equilibrium price and
quantity.
3. An increase in supply causes a decrease in equilibrium price and an
increase in equilibrium quantity.
4. A decrease in supply causes an increase in equilibrium price and a
decrease in equilibrium quantity.

Simultaneous changes in demand and supply

1. An increase in demand and a decrease in supply will increase the
equilibrium price. What happens to equilibrium quantity depends on the
relative changes in demand and supply.

2. A decrease in demand and an increase in supply will decrease the

equilibrium price. What happens to the equilibrium quantity depends on
the relative changes in demand and supply.

Surplus
A buyers surplus is the difference between the buyers reservation price and
the price they actually pay.
A sellers surplus is the difference between the price received by the seller and
their reservation price.
The total economic surplus is the sum of the buyers and sellers surpluses or,
equivalently, the difference between the buyers and sellers reservation prices.

Social optimality
The social optimal quantity of a good or service results in the maximum
possible difference between the total benefits and the total costs from producing
and consuming that good or service.

Efficiency
Economic efficiency is when all goods and services are produced at their
respective socially optimal levels.
The efficiency principle states that efficiency is an important social goal
because when the economic pie grows larger, it is possible for everyone to
have a larger slice.

Are markets socially optimal?

The market equilibrium is only socially optimal if the demand and supply
curves fully reflect all the costs and benefits.
The equilibrium principle (or no cash on the table principle) states
that the market equilibrium leaves no unexploited opportunities (cash on
the table) for individuals, but may not necessarily exploit all gains
achievable through collective action.