This chapter discusses demand, supply, and market equilibrium. It defines key concepts such as demand and supply curves, quantity demanded and supplied, equilibrium price and quantity, excess demand and supply. The chapter explains the laws of demand and supply - that demand curves slope downward and supply curves slope upward. It discusses how individual demand and supply combine to form market demand and supply curves and how equilibrium is reached at the price where quantity demanded equals quantity supplied. The chapter also provides examples and diagrams to illustrate these concepts.

1. Chapter 3
Exchange and
Markets

2. 3-2
Learning Objectives
1.Use opportunity cost to explain the rationale
for specialization and trade
2.Explain how markets allow specialization
and trade
3.List the roles of government in a market
economy

3. 3-3
P R I N C I P L E O F V O L U N T A R Y E X C H A N G E
A voluntary exchange between two people makes both people better off.
Comparative Advantage versus Absolute Advantage
● absolute advantage
The ability of one person or
nation to produce a product at
a lower resource cost than
another person or nation.
● comparative advantage
The ability of one person or
nation to produce a good at a
lower opportunity cost than
another person or nation.
3.1 COMPARATIVE ADVANTAGE
AND EXCHANGE (cont.)

4. 3-4
The Division of Labor and Exchange
In his 1776 book, An Inquiry into the Nature and Causes of the Wealth of Nations,
Adam Smith noted that specialization actually increased productivity through the
division of labor.
Smith listed three reasons for productivity to increase with specialization, with each
worker performing a single production task:
1 Repetition. The more times a worker performs a particular task, the more
proficient the worker becomes at that task.
2 Continuity. A specialized worker doesn’t spend time switching from one task to
another. This is especially important if switching tasks requires a change in
tools or location.
3 Innovation. A specialized worker gains insights into a particular task that lead
to better production methods.
3.1 COMPARATIVE ADVANTAGE
AND EXCHANGE (cont.)

5. 3-5
Comparative Advantage and
International Trade
● import
A product produced in a foreign country and
purchased by residents of the home country.
● export
A product produced in the home country and
sold in another country.

6. 3-6
Outsourcing
When a domestic firm shifts part of its production to a different
country, we say the firm is outsourcing or offshoring.
1 The loss of domestic jobs resulting from outsourcing is a normal
part of a healthy economy, because technology and consumer
preferences change over time.
2 The jobs lost to outsourcing are at least partly offset by jobs
gained through insourcing, jobs that are shifted from overseas to
the United States.
3 The cost savings from outsourcing are substantial, leading to
lower prices for consumers and more output for firms. The jobs
gained from increased output at least partly offset the jobs lost
to outsourcing.
Some recent studies of outsourcing have reached a number of
conclusions:

7. 3-7
● market economy
An economy in which people specialize and exchange
goods and services in markets.
Although it appears that markets arose naturally, a number of social and
government inventions have made them work better:
• Contracts specify the terms of exchange, facilitating exchange between
strangers.
• Insurance reduces the risk entrepreneurs face.
• Patents increase the profitability of inventions, encouraging firms to develop
new products and production processes.
• Accounting rules provide potential investors with reliable information about
the financial performance of a firm.
3.2 MARKETS

8. 3-8
● centrally planned economy
An economy in which a government
bureaucracy decides how much of each good
to produce, how to produce the good, and
who gets the good.
Virtues of Markets
Under a market system, decisions are made by the millions of people who
already have information about consumers’ desires, production
technology, and resources. These decisions are guided by prices of
inputs and outputs.
Prices provide signals about the relative scarcity of a product and help an
economy respond to scarcity.
The market system works by getting each person, motivated by self-
interest, to produce products for other people.
3.2 MARKETS (cont.)

9. 3-9
The Role of Entrepreneurs
Entrepreneurs play a key role in a market economy.
▪ Prices and profits provide signals to entrepreneurs about what to produce.
▪ If a product becomes popular, competition among consumers to obtain it will
increase its price and increase the profits earned by firms producing it.
▪ Entrepreneurs will enter the market and increase production to meet the higher
demand, switching resources from the production of other products.
▪ As entrepreneurs enter the market, they compete for customers, driving the
price back down to the level that generates just enough profit for them to remain
in business.
3.2 MARKETS (cont.)

10. 3-10
Although markets often operate efficiently on their own,
sometimes they do not.
Market failure happens when a market doesn’t generate
the most efficient outcome.
There are several sources of market failure and possible
responses by government. Here is a preview of the topics:
• Pollution.
• Public goods.
• Imperfect information.
• Imperfect competition.
3.3 MARKET FAILURE AND
THE ROLE OF GOVERNMENT

11. 3-11
Government Enforces the Rules of Exchange
• To facilitate exchange, the government helps to enforce contracts by
maintaining a legal system that punishes people who violate them.
This system allows people to trade with the confidence that the
terms of the contracts they enter will be met.
• In the case of consumer goods, the implicit contract is that the
product is safe to use. The government enforces this implicit
contract through product liability or tort law.
• The government disseminates information about consumer
products.
• The government uses antitrust policy to foster competition.
3.3 MARKET FAILURE AND
THE ROLE OF GOVERNMENT (cont.)

12. 3-12
Government Can Reduce Economic Uncertainty
• Given the uncertainty of market economies, most governments
fund a “social safety net” that provides for citizens who fare poorly
in markets.
• Of course, there are private responses to economic uncertainty.
For example, we can buy our own insurance to cover losses.
• Some types of insurance, however, are unavailable in the private
insurance market. As a result, the government steps in to fill the
void.
3.3 MARKET FAILURE AND
THE ROLE OF GOVERNMENT (cont.)

13. 3-13
K E Y T E R M S
absolute advantage
centrally planned economy
comparative advantage
export
import
market economy

14. Chapter 4
Demand, Supply, and
Market Equilibrium

15. 3-15
Learning Objectives
1. Describe and explain the law of demand
2. Describe and explain the law of supply
3. Explain the role of price in reaching a market
equilibrium
4. Describe the effect of a change in demand on the
equilibrium price
5. Describe the effect of a change in supply on the
equilibrium price
6. Use information on price and quantity to
determine what caused a change in price

16. 3-16
DEMAND, SUPPLY, AND MARKET
EQUILIBRIUM
● perfectly competitive market
A market with many buyers and sellers of a
homogeneous product and no barriers to entry.

17. 3-17
● quantity demanded
The amount of a product that consumers are willing
and able to buy.
● demand schedule
A table that shows the relationship between the price of
a product and the quantity demanded, ceteris paribus.
4.1 THE DEMAND CURVE

18. 3-18
Here is a list of the variables that affect an individual consumer’s
decision, using the pizza market as an example:
• The price of the product (for example, the price of a pizza)
• The consumer’s income
• The price of substitute goods (for example, the prices of tacos or
sandwiches or other goods that can be consumed instead of pizza)
• The price of complementary goods (for example, the price of
lemonade or other goods consumed with pizza)
• The consumer’s preferences or tastes and advertising that may
influence preferences
• The consumer’s expectations about future prices
4.1 THE DEMAND CURVE (cont.)

19. 3-19
The Individual Demand Curve and the Law of Demand
● law of demand
There is a negative relationship between price and
quantity demanded, ceteris paribus.
● change in quantity demanded
A change in the quantity consumers are willing and
able to buy when the price changes; represented
graphically by movement along the demand curve.
● individual demand curve
A curve that shows the relationship between the price of a
good and quantity demanded by an individual consumer,
ceteris paribus.
4.1 THE DEMAND CURVE (cont.)

20. 3-20
The Individual Demand
Curve and the Law of
Demand
 FIGURE 4.1
The Individual Demand Curve
According to the law of demand, the
higher the price, the smaller the
quantity demanded, everything else
being equal. Therefore, the demand
curve is negatively sloped: When
the price increases from $6 to $8,
the quantity demanded decreases
from seven pizzas per month (point
c) to four pizzas per month (point
b).
4.1 THE DEMAND CURVE (cont.)

21. 3-21
From Individual Demand to Market Demand
● market demand curve
A curve showing the relationship between price and quantity
demanded by all consumers, ceteris paribus.
 FIGURE 4.2
From Individual to Market
Demand
The market demand equals the
sum of the demands of all
consumers. In this case, there are
only two, so at each price the
market quantity demanded equals
the quantity demanded by Al plus
the quantity demanded by Bea.
At a price of $8, Al’s quantity is
four pizzas (point a) and Bea’s
quantity is two pizzas (point b), so
the market quantity demanded is
six pizzas (point c).
Each consumer obeys the law of
demand, so the market demand
curve is negatively sloped.
4.1 THE DEMAND CURVE (cont.)

22. 3-22
LAW OF DEMAND AND CIGARETTES
APPLYING THE CONCEPTS #1: What is the Law of Demand?
A P P L I C A T I O N 1
• As price decreases and we move downward along the market demand for
cigarettes, the quantity of cigarettes demanded increases for two reasons.
First, people who smoked cigarettes at the original price respond to the
lower price by smoking more. Second, some people start smoking.
• A change in cigarette taxes in Canada illustrates the second effect, the
new-smoker effect. In 1994, several provinces in eastern Canada cut their
cigarette taxes and the price of cigarettes in the provinces decreased by
roughly 50 percent. Researchers tracked the choices of 591 youths from
the Waterloo Smoking Prevention Program, and concluded that the lower
price increased the smoking rate by roughly 17 percent.

23. 3-23
Suppose you ask the manager of a firm, “How much of your product
are you willing to produce and sell?” The manager’s decision about
how much to produce depends on many variables, including the
following, using pizza as an example:
• The price of the product (for example, the price per pizza)
• The wage paid to workers
• The price of materials (for example, the price of dough and
cheese)
• The cost of capital (for example, the cost of a pizza oven)
• The state of production technology (for example, the knowledge
used in making pizza)
• Producers’ expectations about future prices
• Taxes paid to the government or subsidies (payments from the
government to firms to produce a product)
4.2 THE SUPPLY CURVE

24. 3-24
The Individual Supply Curve and the Law of Supply
● supply schedule
A table that shows the relationship between the price
of a product and quantity supplied, ceteris paribus.
● individual supply curve
A curve showing the relationship between price and
quantity supplied by a single firm, ceteris paribus.
● quantity supplied
The amount of a product that firms are willing and
able to sell.
4.2 THE SUPPLY CURVE (cont.)

25. 3-25
The Individual Supply Curve and the Law of Supply
 FIGURE 4.3
The Individual Supply Curve
The supply curve of an individual
supplier is positively sloped,
reflecting the law of supply.
As shown by point a, the quantity
supplied is zero at a price of $2,
indicating that the minimum
supply price is just above $2.
An increase in price increases the
quantity supplied to 100 pizzas at
a price of $4, to 200 pizzas at a
price of $6, and so on.
4.2 THE SUPPLY CURVE (cont.)

26. 3-26
The Individual Supply Curve and the Law of Supply
● law of supply
There is a positive relationship between
price and quantity supplied, ceteris
paribus.
● change in quantity supplied
A change in the quantity firms are willing
and able to sell when the price changes;
represented graphically by movement
along the supply curve.
● minimum supply price
The lowest price at which a product will
be supplied.
4.2 THE SUPPLY CURVE (cont.)

27. 3-27
Why Is the Individual Supply Curve Positively Sloped?
From Individual Supply to Market Supply
● market supply curve
A curve showing the relationship
between the market price and quantity
supplied by all firms, ceteris paribus.
M A R G I N A L P R I N C I P L E
Consistent with the Law of Supply, increase the level of an activity as long as
its marginal benefit exceeds its marginal cost. Choose the level at which the
marginal benefit equals the marginal cost.
4.2 THE SUPPLY CURVE (cont.)

28. 3-28
From Individual Supply to Market Supply
 FIGURE 4.4
From Individual to Market Supply
The market supply is the sum
of the supplies of all firms. In
Panel A, Lola is a low-cost
producer who produces the
first pizza once the price rises
above $2 (shown by point a).
Panel B, Hiram is a high-cost
producer who doesn’t produce
pizza until the price rises
above $6 (shown by point f ).
To draw the market supply
curve, we sum the individual
supply curves horizontally. At a
price of $8, market supply is
400 pizzas (point m), equal to
300 from Lola (point d) plus
100 from Hiram (point g).
4.2 THE SUPPLY CURVE (cont.)

29. 3-29
From Individual Supply to Market Supply
 FIGURE 4.5
The Market Supply
Curve with Many Firms
The market supply is the sum
of the supplies of all firms.
The minimum supply price is
$2 (point a), and the quantity
supplied increases by 10,000
for each $2 increase in price
to 10,000 at a price of $4
(point b), to 20,000 at a price
of $6 (point c), and so on.
4.2 THE SUPPLY CURVE (cont.)

30. 3-30
Why Is the Market Supply Curve Positively Sloped?
To explain the positive slope, consider the two responses by firms to an
increase in price:
• Individual firm. As we saw earlier, a higher price encourages a firm to
increase its output by purchasing more materials and hiring more
workers.
• New firms. In the long run, new firms can enter the market and
existing firms can expand their production facilities to produce more
output.
4.2 THE SUPPLY CURVE (cont.)

31. 3-31
LAW OF SUPPLY AND WOOLYMPICS
APPLYING THE CONCEPTS #2: What is the Law of Supply?
A P P L I C A T I O N 2
• In the 1990s, the world price of wool decreased by about 30 percent, and prices
have remained relatively low since then. Based on the law of supply, we would
expect the quantity of wool supplied in New Zealand and other exporters to
decrease, and that’s what happened. Land that formerly grew grass for wool-
producing sheep has been converted into other uses, including dairy products,
forestry, and the domestication of deer.
• There have been several attempts to revive the wool industry by boosting the
demand for wool and thus increase its price. The United Nations General
Assembly declared 2009 as the International Year of Natural Fibers, with the
objective “to raise awareness and stimulate demand for natural fibers.” In 2012,
the Federated Farmers of New Zealand proposed that sheep shearing be added
to the Commonwealth Games and Olympics as a demonstration sport. Of
course, it’s not obvious that Olympic shearing would increase the demand for
wool, and then there is the problem of what to do with all the sheared wool.
Extreme knitting?

32. 3-32
Excess Demand Causes the Price to Rise
● excess demand (shortage)
A situation in which, at the prevailing
price, the quantity demanded exceeds
the quantity supplied.
Excess Supply Causes the Price to Drop
● excess supply (surplus)
A situation in which the quantity supplied
exceeds the quantity demanded at the
prevailing price.
● market equilibrium
A situation in which the quantity
demanded equals the quantity supplied
at the prevailing market price.
4.3 MARKET EQUILIBRIUM: BRINGING
DEMAND AND SUPPLY TOGETHER

33. 3-33
 FIGURE 4.6
Market Equilibrium
At the market equilibrium (point
a, with price = $8 and quantity =
30,000), the quantity supplied
equals the quantity demanded.
At a price below the equilibrium
price ($6), there is excess
demand—the quantity
demanded at point c exceeds
the quantity supplied at point b.
At a price above the equilibrium
price ($12), there is excess
supply—the quantity supplied at
point e exceeds the quantity
demanded at point d.
4.3 MARKET EQUILIBRIUM: BRINGING
DEMAND AND SUPPLY TOGETHER (cont.)

34. 3-34
Change in Quantity Demanded versus Change in Demand
▼ FIGURE 4.7
Change in Quantity Demanded versus Change in Demand
● change in demand
A shift of the demand curve caused by a change in
a variable other than the price of the product.
(A) A change in price
causes a change in
quantity demanded, a
movement along a single
demand curve. For
example, a decrease in
price causes a move from
point a to point b,
increasing the quantity
demanded.
(B) A change in demand
caused by changes in a
variable other than the
price of the good shifts the
entire demand curve. For
example, an increase in
demand shifts the demand
curve from D1 to D2.
4.4 MARKET EFFECTS OF CHANGES IN
DEMAND

35. 3-35
Increases in Demand Shift the Demand Curve
● normal good
A good for which an increase in income
increases demand.
● inferior good
A good for which an increase in income
decreases demand.
● substitutes
Two goods for which an increase in the price
of one good increases the demand for the
other good.
● complements
Two goods for which a decrease in the price
of one good increases the demand for the
other good.
4.4 MARKET EFFECTS OF CHANGES IN
DEMAND (cont.)

36. 3-36
change in demand
change in quantity demanded
change in quantity supplied
change in supply
complements
demand schedule
excess demand (shortage)
excess supply (surplus)
individual demand curve
individual supply curve
inferior good
K E Y T E R M S
law of demand
law of supply
market demand curve
market equilibrium
market supply curve
minimum supply price
normal good
perfectly competitive market
quantity demanded
quantity supplied
substitutes
supply schedule