Fundamental Questions

1. What is a market?

2. What is demand?

3. What is supply?

4. How is price determined by demand and supply?

5. What causes price to change?

6. What happens when price is not allowed to change with market forces?

Teaching Objectives

The primary purpose of this chapter is to develop the concepts of demand and supply and explain how they combine to produce equilibrium prices and quantities.

The unique features of this chapter are the treatment of barter versus money exchange and a discussion of the nature of market equilibrium in the real world. There is also a section on impact on the market of price ceilings and floors.

The concepts that warrant special coverage are the graphic construction of demand and supply curves, how a movement along one curve compares to a shift in the entire curve, and how equilibrium prices and quantities are obtained. The concept of equilibrium appears often in the course, so an understanding of it is imperative.

Key Term Review

market
barter
double coincidence of wants
transaction costs
relative price
demand
quantity demanded
law of demand
determinants of demand
demand schedule
demand curve
substitute goods
complementary goods
exchange rate
supply
quantity supplied
law of supply
determinants of supply
supply schedule
supply curve
productivity
equilibrium
disequilibrium
surplus
shortage
price floor
price ceiling

Lecture Outline and Teaching Strategies

1. Markets

1.a. Market definition: A market is the place where buyers and sellers come together and set prices and quantities.

Teaching Strategy: Try giving a real-world example of markets that students can conceptualize, for example, the market for stereos, the market for illegal drugs, and a local painter working on a "cash only" basis.

1.b. Barter and money exchanges: Barter is the exchange of goods when a double coincidence of wants exists.

Teaching Strategy: Try generating a discussion in class to see if a double coincidence of wants exists among the students.

1.c. Relative price: The value of a good in terms of another good is its relative price. Relative prices measure the opportunity costs of goods and resources.

Teaching Strategy: Try to demonstrate that relative price actually measures opportunity cost (what you must give up to get one unit of a good or service). If milk costs $1 per carton and cookies cost $.50 per package, than 1 carton of milk "costs" two packages of cookies.

Ask your students to consider how many different prices there are in an economy with 5 goods. Use this example to also explain why money makes exchanging goods and services more efficient.

2. Demand

2.a. The law of demand: The quantity of a well-defined good or service that people are willing and able to purchase during a particular period of time decreases as the price of that good rises, ceteris paribus.

Teaching Strategy: There are two points that economists advance to argue for a downward-sloping demand curve-the income and substitution effects. The income effect takes place when a change in the price of a good alters the consumer's purchasing power. When the price of a good changes and in turn the demand for a substitute good changes, the substitution effect is at work.

Teaching Strategy: When beer prices fall during a Friday afternoon happy hour, bar patrons substitute more beer for other goods they could consume (the substitution effect). In addition, the increase in their purchasing power due to the cheaper beer allows them to buy more pretzels and pizza (the income effect).

2.b. The demand schedule: This is a list of the quantities of a good that consumers demand at different prices, ceteris paribus.

Teaching Strategy: Try asking students who would purchase personal computers at different prices. Then, from their responses, generate a demand schedule.

2.c. The demand curve: This is a downward-sloping curve that is made from the combinations of price and quantity demanded in the demand schedule.

Teaching Strategy: Derive a demand curve from the demand schedule given in 2.b.

2.d. From individual demand curves to a market curve: A market curve is the horizontal summation of all individual demand curves.

2.e. Changes in demand and changes in quantity demanded: Compare a movement along a demand curve to a shift in the entire curve. The determinants of demand are income, tastes, the prices of related goods, expectations, and the number of buyers.

Teaching Strategy: Ask your students to redraw their demand curves given that they receive $1,000 in lottery winnings.

2.f. International effects: With U.S. prices held constant, demand curves for U.S. goods will shift as exchange rates vary and foreign purchases change.

Use the example of how demand is affected by changes in the exchange rate to show how the U.S. economy is affected by the rest of the world.

3. Supply

3.a. The law of supply: The quantity of a good producers will sell is positively related to price, ceteris paribus.

Teaching Strategy: Try focusing the law of supply around the profit motive of producers, that is, rational self-interest (covered in Chapter 1).

3.b. The supply schedule and supply curve: The supply curve is composed of all the combinations of prices and quantities supplied that are listed in the supply schedule.

3.c. From individual supply curves to the market supply: The market supply curve is the summation of all the individual supply curves. It is the horizontal summation-the total amount provided by all producers at each price.

3.d. Changes in supply and changes in the quantity supplied: A change in quantity supplied occurs when only the product price changes and all other factors are held constant.

Teaching Strategy: Try to show a change in quantity supplied as a movement along a stationary supply curve, as shown in Figure 6(b) in the text. A change in supply occurs when the quantity supplied at every price changes due to a change in a factor other than product price, such as resource prices, technology, producer expectations, number of producers, or prices of related goods.

Teaching Strategy: Try to show how higher wages obtained by the United Auto Workers will cause the supply curve for automobiles to shift to the left. Refer to Figure 6(a) in the text.

3.e. International effects: With U.S. prices held constant, supply curves for U.S. goods will shift as exchange rates vary and foreign purchases change.

Teaching Strategy: Use the example of how supply is affected by events in other parts of the world to show how manufacturing costs can be affected by exchange rates.

4. Equilibrium: Putting Demand and Supply Together

4.a. Determination of equilibrium: Quantity demanded equals quantity supplied at a set price.

Teaching Strategy: Try polling your class in terms of demand for automobiles and then draw the demand curve. Then draw a market supply curve, generate quantity demanded and quantity supplied at different prices, and show surpluses, shortages, and equilibrium.

4.b. Changes in the equilibrium price: demand shifts.

Teaching Strategy: Try having all your students imagine that they win $5,000 each in the lottery, reconstruct the demand curve, and show new equilibrium price and quantity for cars.

4.c. Changes in the equilibrium price: supply shifts.

Teaching Strategy: Try showing the results of the UAW's obtaining a wage increase on the equilibrium price and quantity of cars.

4.d. Equilibrium in reality: In reality, it is common for quantities demanded and quantities supplied not to be equal.

Demonstrate to your class how the size of a shortage from a price ceiling and the size of the surplus from a price floor depend on the slopes of the supply and demand curves.

4.d.1. Price ceilings and price floors: Situations where the price is not allowed to decrease below a certain level or not allowed to rise to its equilibrium level are not uncommon.