# Chapter 3: Demand and Supply

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CHAPTER 3: DEMAND AND SUPPLY
SUMMARY
This chapter covers the basics of supply and demand, the model that is central to understanding market
economics. The chapter first examines demand; the variables and assumptions of the model are presented.
Tables of data and graphs are shown to illustrate the various ways we can communicate this information.
Next, the chapter explains the supply side of the market, the variables and assumptions, tables and graphs.
The examples are used to clarify each concept. Then equilibrium analysis is introduced. Supply and
demand is used to explain changes in the market. The chapter ends with a look at the problem of K-12
public education in the United States. Supply and demand is used to illustrate how charter schools and
voucher systems can be used to create competition, and motivate positive changes in our public schools.

CHAPTER OUTLINE

 TEACHING TIP:
The model of supply and demand is central to understanding market economics; therefore, it’s good
to spend a bit more time on this chapter to make sure that students thoroughly understand the ins and
outs of supply and demand analysis.
Carefully go over the assumptions and the variables involved with supply and demand as separate
sides of the market.
Students often have a difficult time talking about one without the other. It’s important to reinforce
the concept of modeling economic activity and the abstract nature of models. Spend some time
clarifying the difference between changes in demand or supply and movement along the curves.

3.1 Demand

I) Demand relates the quantity of a good that consumers would purchase at each of various possible prices
over some period of time, ceteris paribus.
A) Demand is a relationship between market price and quantity demanded at each price; this
relationship can be expressed as a demand schedule or a demand graph.
B) Quantity demanded is a specific amount of the good that is purchased at a given price; this is a
single number associated with a particular price in the demand schedule, or one of the coordinates of
a point on the demand curve.
1) The variables of the model are market price and quantity demanded.
2) Assumptions of the model are the following:
(a) Demand is defined for a period of time.
(b) All other factors are constant; i.e., ceteris paribus.
C) Demand can be communicated by schedule or by graph.
1) Demand schedule is a table of possible prices with an associated quantity demanded at each
price. See Figure 3-1.
2) Demand curve is a graph of the data in the demand schedule. Each point on the line represents a
price and quantity demanded. Price is on the vertical axis, and quantity is on the horizontal axis.
See Figure 3-1.
Direct your students to Active Graph exercise #9 to test this concept
2 Macroeconomics; Explore and Apply

D) The law of demand states that, as price increases, consumers will demand less of the good and vice
versa. This is an inverse, or negative, relationship between price and quantity; this is represented by
a negatively sloped demand curve.
E) Shift in demand vs. a movement along the demand curve is an important distinction to grasp.
1) When price changes, quantity demanded changes inversely. We move to a new line in the
demand schedule or a new point on the original demand curve. This is called a movement along
the demand curve.
2) When other factors of demand change, there is a new quantity demanded for every possible
price. We move to a new schedule of data or a new demand curve. This is called a shift in the
demand curve.
(a) An increase in demand means that at every price consumers will demand more of the good.
This is seen as a rightward shift of the demand curve. See Fig. 3-2(a).
(b) A decrease in demand means that at every price consumers will demand less of the good.
This is seen as a leftward shift of the demand curve. See Fig. 3-2(b).
F) There are a number of factors that cause changes in demand.
Table 3-1 and Figure 3-3 summarize this information.
1) Change in consumer income will change demand. If income increases, demand increases, and
vice versa.
(a) This is true for normal goods, and in fact defines a normal good.
(b) Inferior goods are those goods that consumers will buy less of as income increases.
2) Changes in the prices of substitutes and complements will change demand.
(a) A substitute is something that takes the place of something else. When the price of a
substitute good increases, demand for the good in question will increase, and vice versa.
(b) Example: different brands of coffee, coffee and tea
(c) A complement is a good that goes with another good. When the price of the complement
increases, demand for the good in question decreases, and vice versa.
(d) Example: coffee and sugar, pizza and beer
(e) Whether a good is a complement or a substitute is sometimes a matter of taste and
preference.
3) Changes in taste and preferences will change demand. As the preference for a good increases,
demand for the good in question increases, and vice versa.
4) Changes in population will change demand. As population increases, more of the good in
question will be demanded at every price, and vice versa.
5) Changes in consumer expectations of future prices will change demand. If consumers expect
the price of a good to increase, demand for the good will increase, and vice versa.
G) Snapshot: More Than Nature’s Wrath:
1) This is a discussion of increasing demand by reducing risk with insurance.
2) People build houses in areas that are prone to loss due to acts of nature, like flooding and
hurricanes.
3) Low-interest loans for rebuilding and other types of assistance provided by the government
reduce the risk for the homeowners and businesses.
4) This results in more people wanting to build in these high-risk areas.
5) To reduce this behavior, the trend is to make payments contingent on rebuilding in safer areas.
H) Snapshot: New Coke? Or Old Coke in a New Bottle?
1) In 1985 the Coca-Cola Company introduced New Coke to regain market share lost to Pepsi.
2) Market research was positive, but New Coke was a huge flop.
3) In response to customers wanting Coca-Cola to “Bring back the real thing!” the company re-
introduced the original formula as Coca-Cola Classic.
4) The demand for Coke shifted to the right even though it actually had not changed.
Chapter 3: Demand and Supply 3

 TEACHING TIP: Emphasize the relationship between the table of data and the graph. Make sure
that students understand that the graph is a visual representation of the data. It’s also good to do a
quick review of graphs, especially the idea that each point represents a specific price and quantity
demanded.

3.2 Supply
I) Supply relates the quantity of a good that will be offered for sale at each of various possible prices, over
some period of time, ceteris paribus.
A) Supply is a relationship between market prices and quantity supplied at each price.
B) Quantity supplied is the specific amount of the good that will be offered for sale at a particular price.
C) Variables of the model are market price and quantity supplied.
1) Assumptions of the model are the following:
(a) Supply is defined for a period of time.
(b) All other factors are constant; i.e., ceteris paribus.
D) Supply can be communicated by schedule or by graph.
1) Supply schedule is a table of possible prices with an associated quantity supplied at each price.
2) Supply curve is a graph of the data in the supply schedule. Each point on the line represents a
price and quantity supplied. Price is on the vertical axis, and quantity is on the horizontal axis.
E) The law of supply states that, as price increases, producers will supply more of the good and vice
versa. This is a direct, or positive, relationship between price and quantity; this is represented by a
supply curve that slopes upward to the right.

Direct your students to Active Graph exercise #10 to test this concept.

F) Shift in supply vs. a movement along the supply curve is an important distinction to grasp.
1) When price changes, quantity supplied changes directly, or positively. We move to a new line
in the supply schedule or a new point on the original supply curve. This is called a movement
along the supply curve.
2) When other factors of supply change, there is a new quantity supplied for every possible price.
We move to a new schedule of data or a new supply curve. This is called a shift in the supply
curve.
(a) An increase in supply means that at every price consumers will supply more of the good.
This is seen as a rightward shift of the supply curve. See Fig. 3-5(a).
(b) A decrease in Supply means that at every price consumers will supply less of the good. This
is seen as a leftward shift of the Supply curve. See Fig. 3-5(b).
G) There are a number of factors that cause changes in Supply. Table 3-2 and Figure 3-6 summarize
this information.
1) Changes in producers’ expectations of future prices will shift supply.
2) Changes in the number of firms will change supply. If the number of firms increases, supply
increases, and vice versa.
3) Changes in the prices of inputs will change supply. As input prices increase, supply decreases.
4) Technological changes will increase supply.
5) Restrictions in production will decrease supply.
6) Changes in prices of substitutes will change supply.
7) Changes in prices of jointly produced goods will change supply.
H) Snapshot: The Livestock Gourmet on a Hot Summer Day
1) On very hot days cows and pigs in the area of Cargill corn processing plant get to feast on tasty
wet corn feed because farmers can buy it at a low price.
2) The availability of electricity increases Cargill’s supply of wet feed and the supply curve shifts
out to the right.
4 Macroeconomics; Explore and Apply

3) When it’s very hot, everyone runs his or her air conditioner; this causes a power shortage.
4) Without the electricity to dry and store the feed, Cargill is left with huge piles of perishable wet
feed.
 TEACHING TIP: After you’ve explained the supply curve, emphasize the fact that each point
represents a price and quantity supplied combination. The students need to be able to discriminate
between quantity supplied on the supply curve and quantity demanded on the demand curve.

3.3 Equilibrium—Demand Meets Supply And The Market Clears
I) Market demand & market supply are derived from the individual demand and supply curves.
A) Market demand is the horizontal summation of individual demand curves.
See Figure 3-7.
Direct your students to Active Graph exercise #11 to test this concept.

B) Market supply is the horizontal summation of individual sellers' supply curves.
See Figure 3-8.
Direct your students to Active Graph exercise #12 to test this concept.

C) Market equilibrium is determined by the intersection of supply and demand, and is associated with
a particular equilibrium price and quantity.
See Figure 3-9.
Direct your students to Active Graph exercise #13 to test this concept.

1) The equilibrium price is also called the market-clearing price; it is the one price that clears the
market. This means that quantity supplied equals quantity demanded, and there are no
unsatisfied buyers or sellers at that price; QS = QD.
2) At any price greater than the equilibrium price (P>Peq), there is a surplus in the market, or an
excess of QS over QD (QS > QD).
See Figure 3-9.
3) At any price less than the equilibrium price (P<Peq), there is a shortage in the market, or an
excess of QD over QS (QD > QS).
See Figure 3-9.
4) When there is a surplus in the market, sellers compete for customers by lowering prices until the
market clears; QS = QD.
5) When there is a shortage in the market, buyers compete with each other for goods, allowing
sellers to raise prices until the market clears; QS = QD.
6) This market-clearing process is directed by the invisible hand of the market (Adam Smith).
7) If supply changes there is a movement along the demand curve.
8) If demand changes, there is a movement along the supply curve.
D) Changes in Market Equilibrium
1) Market equilibrium will change whenever the supply or demand curves shift.
2) There are four possibilities when a single curve shifts.
(a) An increase in supply, which shifts the supply curve to the right, will cause a movement
down the demand curve and result in a lower equilibrium price and a greater equilibrium
quantity.
i See Figure 3-10, Case 1.
Direct your students to Smart Graph exercise #5 to test this concept.
Chapter 3: Demand and Supply 5

ii P↓, Q↑.
(b) A decrease in supply, which shifts the supply curve to the left, will cause a movement up the
demand curve and will result in a higher equilibrium price and a smaller equilibrium
quantity.
i See Figure 3-10, Case 2.
Direct your students to Smart Graph exercise #6 to test this concept.

ii P↑, Q↓.
(c) An increase in demand, which shifts the demand curve to the right, will cause a movement
up the supply curve and result in a higher equilibrium price and a greater equilibrium
quantity.
i See Figure 3-10, Case 3.
Direct your students to Smart Graph exercise #7 to test this concept.

ii P↑, Q↑
(d) A decrease in demand, which shifts the demand curve to the left, will cause a movement
down the supply curve and result in a lower equilibrium price and a smaller equilibrium
quantity.
i See Figure 3-10, Case 4.
ii P↓, Q↓
Direct your students to Smart Graph exercise #8 to test this concept.

(e) Here are four cases with a simultaneous shift of supply and demand.
i Demand and supply both increase, or shift to the right.
 Price change is uncertain, and quantity unambiguously increases.
P?, Q↑
 See Table 3-3, Case 5 & Figure 3-11
ii Demand and supply both decrease, or shift to the left.
 Price change is uncertain, and quantity unambiguously decreases.
P?,Q↓
 See Table 3-3, Case 6.
iii Demand increases or shifts right; supply decreases or shifts left.
 Price increases unambiguously and quantity change is uncertain.
P↑, Q?
 See Table 3-3, Case 7.
iv Demand decrease or shifts left; supply increases or shifts right.
 Price decreases unambiguously and quantity change is uncertain.
P↓, Q?
 See Table 3-3, Case 8 and Figure 3-12.

 TEACHING TIP: Emphasize the goal of using this model for equilibrium analysis, and the
usefulness of this model for understanding economic activity in everyday life…. as individuals,
businesses, and society at large. Work through lots of examples of changes in markets, demonstrate
graphically and with tables, and have students work problems as well.
Using local, regional, or national current events examples is a good approach for discussing various
market outcomes. Summarize the event, and analyze it verbally and graphically using supply and
demand.
6 Macroeconomics; Explore and Apply

Use actual news articles to illustrate the precise use of supply and demand language compared to the
way the vocabulary is used in the news media and in ordinary conversation.

3.4 Explore and Apply: Demanding Better Schools, Supplying Better Schools

I) Education is a concern for US President, educators, and parents.
A) The greatest concern is at the K-12 levels.
B) There is less concern at college levels for reasons relating to supply and demand.
1) As the price falls, more students attend school.
2) Federal and state governments support higher education through tax deductions, subsidies, and
financial aid that effectively lowers the price.
C) There are more incentives in lower levels to choose government-provided local public school.
D) The history of free public schooling dates back to the 19th century.
1) Public schools established to promote equal opportunity.
2) Schools in wealthy neighborhoods have more resources.
3) Some schools are simply managed more efficiently and effectively.
4) Schools that are poorly run and inefficient are insulated from competition.
5) The gap between the wealthy, well-run, and/or academically superior schools and the poor
and/or inefficient schools is not going to close on its own.
E) If all schools were private, the invisible hand of the market would cause schools to become more
efficient to compete for students, but differences in income among parents would lead to unequal
opportunities for education.
F) This is the trade-off between equity and efficiency.
G) There have been a number of remedies for this dilemma in the past few years.
1) One solution is the charter school. These are public schools that are established when a group of
parents hire a non-profit organization to run the school. There is significant parental
involvement. If the school meets state guidelines for education, its charter is renewed at the end
of a specified period.
2) Another solution is the voucher system, which promotes greater competition. School vouchers
provide the parents with money that they can spend on the school of their choice.
(a) Milton Friedman proposed the voucher system in 1955.
(b) Voucher systems are underway in a number of states: e.g., Ohio, Florida, and Texas.
(c) Figure 3-13 uses supply and demand to illustrate the effect of vouchers.
(d) With the voucher system the supply of private schools will increase, and the cost will
decrease.
(e) The demand for public schools will decrease as students shift to private schools.
(f) This creates competition for the public schools, which would motivate them to be effective
and efficient in providing educational services.
(g) Opponents of the voucher system fear that the voucher system would have detrimental
effects on the public school system.
i Competition would create incentives to shortchange sound educational objectives for
popular trends.
ii Competition would impede learning in other ways; for example, schools might seek
iii Another issue is the loss of funding with the reduced enrollment, which would make it
even harder for public schools to compete with private schools.
Chapter 3: Demand and Supply 7

EXTENDED APPLICATION: THE AIRLINE INDUSTRY
The airline industry took a heavy blow from the terrorist attacks on September 11, 2001. In the US and
Europe the large airlines lost \$6B in 2001, and expect to lose even more 2002. The low-cost airlines have
remained profitable. We can use supply and demand to look at what happened.

After the September 11 attacks the large airlines’ response was to reduce capacity by 15-20%. They did this
by eliminating flights and reducing their workforce in anticipation of a decrease in ticket sales. Ticket sales
did decrease. The large airlines eventually reduced ticket prices, but they still have not regained what they
lost after September 11. There was the beginning of a recovery in January, but that had ended by summer.

What happened to the smaller, low-cost airlines? Their response was to offer aggressively discounted tickets
for travelers. This has increased their sales by 40% over last year.1

We can use supply and demand to explain what happened in this market. First, let’s look at demand side of
the market. After the terrorist attack people stopped flying because they were afraid of future terrorist
attacks. Security at airports was tightened to prevent this from happening. The new security measures
created delays, congestion, and inconvenience at airports, which also made flying unattractive. This is an
example of a decrease in preference. Another source of decrease in demand was the decision by businesses
to reduce business-related travel. This could be attributed to a perception of the increased cost of air travel
(derived from the increased risk and time loss) relative to other modes of transportation and doing business.
This is an example of a decrease in the price of substitutes. These changes in the external factors in the
market for flying caused a decrease in demand for plane tickets. This can be shown as a left shift in demand.
This causes the equilibrium price and quantity to fall. See the figure below.

S
D

D1
Price

Quantity of plane tickets

The large airlines reduced capacity to counteract the loss of sales and eventually lowered ticket prices but
not by enough to give them the sales they once had. You can show this by shifting supply to the left without
eliminating the entire surplus.
8 Macroeconomics; Explore and Apply

The low-cost airlines slashed ticket prices. This can be seen as a movement down the supply curve to the
new equilibrium. They have actually increased sales.
1
“The Airline Industry”, The Economist, Sep 19, 2002.

EXPERIMENTS AND EXERCISES:
Discussion activity:
To develop a foundation to enhance learning of the basics of supply and demand in this chapter try the
following discussion activity. This can be done as a class or in small groups that report back to the entire
class.

Using small groups, divide the class into groups of eight students. Each group will complete the following
1. The group will choose a product; preferably this will be something that they themselves purchase or
would like to purchase.
2. The group will then divide equally into producers and consumers.
3. Each group will work independently for 10 minutes. It’s important that they don’t use their books,
but brainstorm based on their life experience.
a. The producers will make a list of everything they need to consider in determining how much
of the product they will produce and what price they will charge. This list should contain
changes in the market that would impact production.
b. The consumers will make a list of everything they need to consider in purchasing the good.
Their list should also include changes in the market that would impact their buying decision.
4. When each group is finished, ask the groups to report back to the class what they have written. The
instructor can do have them do this orally, or can give everyone transparency paper and pens to
write up their results for display on an overhead projector.
5. As the instructor begins to cover the supply and demand model, he/she can refer to their work as a
reinforcement of the concepts. This is especially relevant when discussing the variables that cause
changes in supply and demand for a good.

This exercise can also be done as a whole class activity. The class chooses one good. As the students state
factors that influence supply or demand decisions, the instructor can write them on the board and use them
as a bridge to the actual particulars of the model.

This exercise gives the model of supply and demand a context for the students. This will help them to see
the relevancy of supply and demand, and enhance their learning experience. It will allow the instructor to
build on their experience; this is a process that learning theory has shown enhances learning.

Classroom Auction:
In order to meet the needs of students with different learning styles and to liven things up a bit, try a
classroom auction.

Bring in some chocolate, or cans of classic coke, and auction them off to the students. When you’ve sold
everything, get the students to discuss what they noticed about how markets work. Move into an
explanation of buyers and sellers negotiating in the marketplace until there is equilibrium.

Visit www.prenhall.com/ayers for further faculty resources for this chapter.

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