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Chapter 3 Demand, Supply, and Equilibrium
The basic economic problem is scarcity. Human wants are unlimited. Resources are limited.
Because resources are limited, only a limited amount of products can be produced. In the U.S.,
the problem of scarcity is dealt with mainly through markets. This chapter looks at how product
markets determine the price and quantity of goods produced. A product market has two sides.
The buying side is called demand. The selling side is called supply. We will look at demand first.
Demand – the willingness and ability of buyers to buy different quantities of a good at different
prices.
We are interested in the relationship between the various possible prices of a good and the
quantities (amounts) of the good that buyers are willing and able to buy. The relationship between
price and quantity demanded is expressed in the law of demand.
Law of demand – the price and the quantity demanded of a good are inversely related.
Remember from Chapter 1 that an inverse relationship means that as the value of one variable
increases, the value of the other variable decreases. Thus, the law of demand indicates that as
the price of a good increases, the quantity demanded of the good decreases. And as the price of
a good decreases, the quantity demanded of the good increases.
Substitution Effect
The primary reason for the inverse relationship between price and quantity demanded is the
substitution effect. The substitution effect is caused by the basic economic problem of scarcity.
Because of scarcity, a consumer will have only limited income. A consumer will try to obtain as
much consumer satisfaction as possible from that limited income. Thus, other things equal, a
consumer will substitute lower-priced goods for higher-priced goods. This is the substitution
effect.
Example 1A: Darla’s Delectable Donuts lowers the price of its donuts by 10 percent. Darla finds
that she sells a greater quantity of donuts than before. Darla’s donuts are now relatively lowerpriced
compared to the donuts of competing donut shops and compared to alternative products,
e.g. bagels. Thus, consumers buy a greater quantity of Darla’s donuts.
Income Effect
The secondary reason for the inverse relationship between price and quantity demanded is the
income effect. The income effect is also caused by scarcity. Because of scarcity, a consumer will
have only limited income. When the price of a good decreases, a consumer’s income has greater
buying power, allowing the consumer to buy a greater quantity of the good. When the price of a
good increases, a consumer’s income has less buying power, allowing the consumer to buy only
a lesser quantity of the good. This is the income effect.
Example 1B: Darla’s Delectable Donuts lowers the price of its donuts by 10 percent. Darla’s
customers now find that their income has greater buying power. Thus, the lower price allows
Darla’s customers to buy a greater quantity of donuts.
Demand Schedule and Demand Curve
The inverse relationship between price and quantity demanded can be illustrated with a demand
schedule or with a demand curve. A demand schedule is a table showing the different
combinations of price and quantity demanded for a good.
The demand schedule for Good X is shown in Example 2A on the next page:
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3 - 1 Demand, Supply, and Equilibrium