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The Model of Supply and Demand

The supply and demand model is used to explain how a perfectly competitive market operates.

The purpose of the model of supply and demand is to predict changes in market quantity and price based on changes in supply and demand conditions.

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Market Demand

Market demand shows how much of a particular product are consumers willing to buy during a particular time period, all else being equal.

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The Determinants of Demand

The main determinants of demand include:

The price of the product

Consumer income

The price of related goods—substitutes and complements

The number of consumers

Consumer preferences—tastes and advertising

Consumer expectations about future prices

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The Individual Demand Curve

The individual demand curve shows the relationship between the price of a good and the quantity that a single consumer is willing to buy, or quantity demanded.

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The Individual Demand Curve and The Law of Demand

The negative slope of the individual demand curve reflects the law of demand.

Demand schedule

Individual Demand Curve

Law of Demand: The higher the price, the smaller the quantity demanded, ceteris paribus.

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The “Ceteris Paribus” Assumption

To obtain various points on the individual demand curve for pizzas we assume that only the price of pizzas changes, while other determinants of the demand for pizzas (income, tastes and preferences, the price of related goods, etc.) remain constant, or ceteris paribus.

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A Change in Quantity Demanded

A change in quantity demanded is caused by a change in the price of the good, which causes a movement along the demand curve.

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Income and Substitution Effects

The reason why the slope of the individual demand curve is negative, involves the substitution and income effects.

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The Substitution Effect

The substitution effect describes a change in consumption resulting from a change in the price of one good relative to the price of other goods.

The lower the price of a good, the smaller the sacrifice associated with consumption of a good.

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The Income Effect

The income effect describes the change in consumption resulting from an increase in the consumer’s real income, or the income in terms of the goods the money can buy. Real income is the consumer’s income

measured in terms of the goods it can buy.

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From Individual to Market Demand

Market demand is the sum of the quantities demanded by all consumers in the market, or the sum of individual demand curves.

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From Individual to Market Demand

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The Market Demand Curve and The Law of Demand

Since the slope of the individual demand curve is negative, it follows that the slope of the market demand curve is also negative, reflecting the law of demand.

Market demand schedule

Market Demand

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Market Supply

The supply curve shows the relationship between price and the quantity that producers are willing to sell during a particular time period, all else being equal.

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The Determinants of Supply

The main determinants of supply include:

The price of the product

The cost of inputs

The state of production technology

The number of producers

Producer expectations about future prices

Taxes or subsidies from the government

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The Marginal Principle and the Output Decision

The decision to produce a given quantity of output is based on the marginal principle.

Marginal PRINCIPLEIncrease the level of an activity if its marginal benefit exceeds its marginal cost, but reduce the level if the marginal cost exceeds the marginal benefit. If possible, pick the level at which the marginal benefit equals the marginal cost.

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The Marginal Principle and the Output Decision

The optimal quantity of output is the one that satisfies the marginal principle—where marginal cost equals marginal benefit.

As price rises, marginal benefit intersects marginal cost at a higher output level.

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Individual Supply and the Law of Supply

The positive slope of the curve reflects the law of supply.

The individual supply curve shows the relationship between the price and the quantity supplied by a single firm, ceteris paribus.

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Individual Supply and the Law of Supply

Law of Supply: The higher the price, the larger the quantity supplied, ceteris paribus.

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Individual Supply to Market Supply

The market supply curve for a particular good shows the relationship between the price of the good and the quantity that all producers together are willing to sell, ceteris paribus.

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Individual Supply to Market Supply