Price Floor and Price Ceiling

Please use the attached chapter for reference in answering question. In 75 to 150 words….

What is the difference between a price floor and price ceiling?

According to the laws of demand and supply and how market equilibrium, efficiency, and equity are reached, do attempts to repeal those laws and market results with price floors and price ceilings justify legislative bodies to implement price controls?

p a r t 2

Markets and

Government

Economics has a great deal to say about how both markets and governments
allocate scarce resources. It gives us insight about the conditions under which
each will likely work well (and each will likely work poorly). The next four
chapters will focus on this topic.

Market allocation of resourc

Business firms purchase resources like materials, labor services, tools, and
machines from households in exchange for income, bidding the resources
away from their alternate uses. The firms then transform the resources into
products like shoes, automobiles, food products, and medical services and
sell them to households. In a market economy, businesses will continue to
supply a good or service only if the revenues from the sale of the product
are sufficient to cover the cost of the resources required for its production.

GovernMent allocation of resources

Resource allocation by the government involves a more complex, three-
sided exchange. In a democratic political setting, a legislative body levies
taxes on voter–citizens, and these revenues are subdivided into budgets,
which are allocated to government bureaus and agencies. In turn, the
bureaus and agencies use the funds from their budgets to supply goods,
services, and income transfers to voter–citizens. The legislative body is like
a board of directors elected by the citizens. Legislators have an incentive to
take action that will attract votes. Voters have an incentive to support
legislators who provide them with goods, services, and transfers that are
highly valued relative to their tax payments. When decisions are made
democratically, political action will require the approval of a legislative majority.

This section will first analyze the operation of markets and then turn to
the political process.

There are two primary methods of allocating
scarce resources: markets and government.

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c h a p t e r 3
Demand, Supply, and
the Market Process

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F o c u s

●● What are the laws of demand and supply?
●● How do consumers decide whether to purchase a good? How
do producers decide whether to supply it?

●● How do buyers and sellers respond to changes in the price
of a good?

●● What role do profits and losses play in an economy? What
must a firm do to make a profit?

●● How is the market price of a good determined?
●● How do markets adjust to changes in demand? How do
they adjust to changes in supply?

●● What is the “invisible hand” principle?

I am convinced that if [the market system] were the result of
deliberate human design, and if the people guided by the price
changes understood that their decisions have significance far
beyond their immediate aim, this mechanism would have been
acclaimed as one of the greatest triumphs of the human mind.
—friedrich hayek, nobel laureate1

From the point of view of physics, it is a miracle that
[7 million New Yorkers are fed each day] without any control
mechanism other than sheer capitalism.
—John h. holland, scientist, santa fe institute2

1Friedrich Hayek, “The Use of Knowledge in Society,” American Economic Review 35 (Sep-
tember 1945): 519–30.
2As quoted by Russell Ruthen in “Adapting to Complexity,” Scientific American 268 (January
1993): 132.

53538_ch03_rev03.indd 42 17/12/13 5:02 PM

T
o those who study art, the Mona Lisa is much
more than a famous painting of a woman. Look-
ing beyond the overall picture, they see and ap-

preciate the brush strokes, colors, and techniques em-
bodied in the painting. similarly, studying economics
can help you to gain an appreciation for the details
behind many things in your everyday life. During your
last visit to the grocery store, you probably noticed the
fruit and vegetable section. Next time, take a moment
to ponder how potatoes from Idaho, oranges from
Florida, apples from Washington, bananas from Hon-
duras, kiwi fruit from New Zealand, and other items
from around the world got there. Literally thousands
of different individuals, working independently, were
involved in the process. Their actions were so well co-
ordinated, in fact, that the amount of each good was
just about right to fill exactly the desires of your lo-
cal community. Furthermore, even the goods shipped
from halfway around the world were fresh and reason-
ably priced.

How does all this happen? The short answer is that
it is the result of market prices and the incentives and
coordination that flow from them. To the economist,
the operation of markets—including your local grocery
market—is like the brush strokes underlying a beauti-
ful painting. Reflecting on this point, Friedrich Hayek
speculates that if the market system had been deliber-
ately designed, it would be “acclaimed as one of the
greatest triumphs of the human mind.” similarly, com-
puter scientist John H. Holland argues that, from the
viewpoint of physics, the feeding of millions of New
Yorkers day after day with very few shortages or
surpluses is a miraculous feat (see the chapter-
opening quotations).

Amazingly, markets coordinate the actions
of millions of individuals without central plan-
ning. There is no individual, political authority, or
central planning committee in charge. considering that
there are more than 300 million Americans with widely
varying skills and desires, and roughly 28 million busi-
nesses producing a vast array of products ranging from
diamond rings to toilet paper, the coordination derived
from markets is indeed an awesome achievement.

This chapter focuses on demand, supply, and the
determination of market prices. For now, we will ana-
lyze the operation of competitive markets—that is,
markets in which buyers and sellers are free to enter
and exit. We will also assume that the property rights
are well defined. Later, we will consider what happens
when these conditions are absent.

on eBay, sellers enter their reserve prices—the
minimum prices they will accept for goods; buyers
enter their maximum bids—the maximum prices they

are willing to pay for goods. The process works the
same way when a person runs a newspaper ad

to sell a car. The seller has in mind a minimum
price he or she will accept for the car. A po-
tential buyer, on the other hand, has in mind
a maximum price he or she will pay for the car.

If the buyer’s maximum price is greater than the
seller’s minimum price, the exchange will occur at a

price somewhere in between. As these examples show,
the buyers’ and sellers’ desires and incentives deter-
mine prices and make markets work. We will begin with
the demand (buyer’s) side, and then turn to the supply
(seller’s) side of the market.

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3-1 consuMer choice
and the law of deMand
Clearly, prices influence our decisions. As the price of a good increases, we have to give
up more of other goods if we want to buy it. Thus, as the price of a good rises, its op-
portunity cost increases (in terms of other goods that must be forgone to purchase it).

the produce section of your local grocery store is a great
place to see economics in action. literally millions of indi-
viduals from around the world have been involved in the
process of getting these goods to the shelves in just the
right quantities. Market prices underlie this feat.

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44 part 2 Markets and GovernMent

This basic principle underlies the law of demand. The law of demand states that there
is an inverse (or negative) relationship between the price of a good or service and the
quantity of it that consumers are willing to purchase. This inverse relationship means
that price and the quantity consumers wish to purchase move in opposite directions. As
the price increases, buyers purchase less—and as the price decreases, buyers purchase
more.

The availability of substitutes—goods that perform similar functions—helps ex-
plain this inverse relationship. No single good is absolutely essential; everything can be
replaced with something else. A chicken sandwich can be substituted for a cheeseburger.
Wood, aluminum, bricks, and glass can take the place of steel. Going to the movies, playing
tennis, watching television, and going to a football game are substitute forms of entertain-
ment. When the price of a good increases, people cut back on their purchases of it and turn
to substitute products.

3-1a the Market deMand schedule
The lower portion of Exhibit 1 shows a hypothetical demand schedule for pizza delivery
in a city. A demand schedule is simply a table listing the various quantities of something
consumers are willing to purchase at different prices. When the price of a large pizza deliv-
ery is $35, only 4,000 people per month order pizza delivery. As the price falls to $25, the
quantity of pizza deliveries demanded rises to 8,000 per month; when the price falls to $10,
the quantity demanded increases to 14,000 per month.

Law of demand
a principle that states there is
an inverse relationship between
the price of a good and the
quantity of it buyers are willing
to purchase. as the price of a
good increases, consumers will
wish to purchase less of it. as
the price decreases, consumers
will wish to purchase more of it.

Substitutes
Products that serve similar
purposes. an increase in
the price of one will cause
an increase in demand for
the other (examples are
hamburgers and tacos, butter
and margarine, Chevrolets and
Fords).

ExHIBIT 1

Law of

Demand

As the demand sched-
ule shown in the table
indicates, the number
of people ordering
pizza delivery (just like
the consumption of other
products) is inversely
related to price. The data
from the table are plotted
as a demand curve in the
graph. The inverse rela-
tionship between price
and amount demanded
reflects the fact that
consumers will substitute
away from a good as it
becomes more expensive.

PRICE QUANTITY (IN THOUSANDS PER MONTH

)

14
16

0
5
10
15
20
25

$35

Quantity (in thousands per month)

Demand

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chapter 3 deMand, suPPly, and the Market ProCess 45

The upper portion of Exhibit 1 shows what the demand schedule would look like if
the various prices and corresponding quantities were plotted on a graph and connected
by a line. This is called the demand curve. When representing the demand schedule
graphically, economists measure price on the vertical or y-axis and the amount demanded on
the horizontal or x-axis. Because of the inverse relationship between price and amount
purchased, the demand curve will have a negative slope—that is, it will slope downward
to the right. More of a good will be purchased as its price decreases. This is the law
of demand.

Read horizontally, the demand curve shows how much of a particular good consumers
are willing to buy at a given price. Read vertically, the demand curve shows how much
consumers value the good. The height of the demand curve at any quantity shows the
maximum price consumers are willing to pay for an additional unit. If consumers value
highly an additional unit of a product, they will be willing to pay a large amount for it.
Conversely, if they place a low value on the additional unit, they will be willing to pay only
a small amount for it.

Because the amount a consumer is willing to pay for a good is directly related to
the good’s value to them, the height of the demand curve indicates the marginal benefit
(or value) consumers receive from additional units. (Recall that we briefly discussed
marginal benefit in Chapter 1.) When viewed in this manner, the demand curve reveals
that as consumers have more and more of a good or service, they value additional units
less and less.

3-1b consuMer surplus
Previously, we indicated that voluntary exchanges make both buyers and sellers better off.
The demand curve can be used to illustrate the gains to consumers. Suppose you value a
particular good at $50, but you are able to purchase it for only $30. Your net gain from
buying the good is the $20 difference. Economists call this net gain of buyers consumer
surplus. Consumer surplus is simply the difference between the maximum amount con-
sumers would be willing to pay and the amount they actually pay for a good.

Exhibit 2 shows the consumer surplus for an entire market. The height of the demand
curve measures how much buyers in the market value each unit of the good. The price
indicates the amount they actually pay. The difference between these two—the triangular
area below the demand curve but above the price paid—is a measure of the total consumer
surplus generated by all exchanges of the good. The size of the consumer surplus, or

Consumer surplus
the difference between the
maximum price consumers are
willing to pay and the price
they actually pay. It is the net
gain derived by the buyers of
the good.

ExHIBIT 2

Consumer Surplus

consumer surplus is the
area below the demand
curve but above the actual
price paid. This area
represents the net gains
to buyers from market
exchange.

P
ri

Quantity/time

Consumer
surplus

Demand

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46 part 2 Markets and GovernMent

triangular area, is affected by the market price. If the market price for the good falls,
more of it will be purchased, resulting in a larger surplus for consumers. Conversely,
if the market price rises, less of it will be purchased, resulting in a smaller surplus (net
gain) for consumers.

Because the value a consumer places on a particular unit of a good is shown by the
corresponding height of the demand curve, we can use the demand curve to clarify the dif-
ference between the marginal value and total value of a good—a distinction we introduced
briefly in Chapter 1. Returning to Exhibit 2, if consumers are currently purchasing

1
units,

the marginal value of the good is indicated by the height of the demand curve at Q
1
—the last

unit consumed (or purchased). So at each quantity, the height of the demand curve shows the
marginal value of that unit, which as you can see declines along a demand curve. The total
value of the good, however, is equal to the combined value of all units purchased. This is the
sum of the value of each unit (the heights along the demand curve) on the x-axis, out to and
including unit Q

1
. This total value is indicated graphically as the entire area under the de-

mand curve out to Q
1
(the triangular area representing consumer surplus plus the unshaded

rectangular area directly below it).
You can see that the total value to consumers of a good can be far greater than the

marginal value of the last unit consumed. When additional units are available at a low price,
the marginal value of a good may be quite low, even though its total value to consumers is
exceedingly high. This is usually the case with water. The value of the first few units of water
consumed per day will be exceedingly high. The consumer surplus derived from these units
will also be large when water is plentiful at a low price. As more and more units are con-
sumed, however, the marginal value of even something as important as water will fall to a low
level. When water is cheap, then, people will use it not only for drinking, cleaning, and cook-
ing but also for washing cars, watering lawns, flushing toilets, and maintaining fish aquari-
ums. Thus, although the total value of water is rather large, its marginal value is quite low.

Consumers will tend to expand their consumption of a good until its price and mar-
ginal value are equal (which occurs at Q

1
in Exhibit 2 at a price of P

1
). Thus, the price of

a good (which equals marginal value) reveals little about the total value derived from the
consumption of it. This is the reason that the market price of diamonds (which reflects their
high marginal value) is greater than the market price of water (which has a low marginal
value), even though the total value of diamonds is far less than the total value of water.
Think of it this way: Beginning from your current levels of consumption, if you were of-
fered a choice between one diamond or one gallon of water right now, which would you
take? You would probably take the diamond, because at the margin it has more value to
you than additional water. However, if given a choice between giving up all of the water
you use or all of the diamonds you have, you would probably keep the water over dia-
monds, because water has more total value to you.

3-1c responsiveness of Quantity
deManded to price chanGes: elastic
and inelastic deMand curves
As we previously noted, the availability of substitutes is the main reason why the demand
curve for a good slopes downward. Some goods, however, are much easier than others to
substitute away from. As the price of tacos rises, most consumers find hamburgers a rea-
sonable substitute. Because of the ease of substitutability, the quantity of tacos demanded
is quite sensitive to a change in their price. Economists would say that the demand for tacos
is relatively elastic because a small price change will cause a rather large change in the
amount purchased. Alternatively, goods like gasoline and electricity have fewer close sub-
stitutes. When their prices rise, it is harder for consumers to find substitutes for these
products. When close substitutes are unavailable, even a large price change may not cause
much of a change in the quantity demanded. In this case, an economist would say that
the demand for such goods is relatively inelastic.

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chapter 3 deMand, suPPly, and the Market ProCess 47

Graphically, this different degree of responsiveness is reflected in the steepness of the
demand curve, as shown in Exhibit 3. The flatter demand curve (

1
, left frame) is for a

product like tacos, for which the quantity purchased is highly responsive to a change in
price. As the price increases from $2.00 to $4.00, the quantity demanded falls sharply from
ten to four units. The steeper demand curve (D

2
, right frame) is for a product like gasoline,

for which the quantity purchased is much less responsive to a change in price. For gasoline,
an increase in price from $2.00 to $4.00 results in only a small reduction in the quantity
purchased (from ten to eight units). An economist would say that the flatter demand curve
D

1
is “relatively elastic,” whereas the steeper demand curve D

2
is “relatively inelastic.” The

availability of substitutes is the main determinant of a product’s elasticity or inelasticity
and thus how flat or steep its demand curve is.

What would a demand curve that was perfectly vertical represent? Economists refer
to this as a “perfectly” inelastic demand curve, meaning that the quantity demanded of the
product never changes—regardless of its price. Although it is tempting to think that the de-
mand curves are vertical for goods essential to human life (or goods that are addictive), this
is inaccurate for two reasons. First, in varying degrees, there are substitutes for everything.
As the price of a good rises, the incentive increases for suppliers to invent even more substi-
tutes. Thus, even for goods that currently have few substitutes, if the price were to rise high
enough, alternatives would be invented and marketed, reducing the quantity demanded of
the original good. Second, our limited incomes restrict our ability to afford goods when
they become very expensive. As the price of a good rises to higher and higher levels, if we
do not cut back on the quantity purchased, we will have less and less income to spend on
other things. Eventually, this will cause us to cut back on our purchases of it. Because of
these two reasons, the demand curve for every good will slope downward to the right.

3-2 chanGes in deMand versus
chanGes in Quantity deManded
The purpose of the demand curve is to show what effect a price change will have on the quan-
tity demanded (or purchased) of a good. Economists refer to a change in the quantity of a good
purchased in response solely to a price change as a “change in quantity demanded.” A change
in quantity demanded is simply a movement along a demand curve from one point to another.

Changes in factors other than a good’s price—such as consumers’ income and the
prices of closely related goods—will also influence the decisions of consumers to purchase

ExHIBIT 3

Elastic and Inelastic
Demand Curves

The responsiveness of
consumer purchases to
a change in price is re-
flected in the steepness
of the demand curve.
The flatter demand curve
(D

1
) for tacos shows a

higher degree of respon-
siveness and is called
relatively elastic, while
the steeper demand
curve (D

2
) for gasoline

shows a lower degree
of responsiveness and is
called relatively inelasticGasoline

8
Quantity/time

Tacos

P
ri
ce
4
Quantity/time

P
ri
ce
$2
$4
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48 part 2 Markets and GovernMent

a good. If one of these other factors changes, the entire demand curve will shift inward or
outward. Economists refer to a shift in the demand curve as a “change in demand.”

Failure to distinguish between a change in demand and a change in quantity demanded
is one of the most common mistakes made by beginning economics students.3 A change in
demand is a shift in the entire demand curve. A change in quantity demanded is a movement
along the same demand curve. The easiest way to distinguish between these two concepts is
the following: If the change in consumer purchases is caused by a change in the price of the
good, it is a change in quantity demanded—a movement along the demand curve; if the change
in consumer purchases is due to a change in anything other than the price of the good (a change
in consumer income, for example), it is a change in demand—a shift in the demand curve.

Let us now take a closer look at some of the factors that cause a “change in demand”—
an inward or outward shift in the entire demand curve.

1. changes in consumer income. An increase in consumer income makes it pos-
sible for consumers to purchase more goods. If you were to win the lottery, or if your boss
were to give you a raise, you would respond by increasing your spending on many products.
Alternatively, when the economy goes into a recession, falling incomes and rising unem-
ployment cause consumers to reduce their purchases of many items. A change in consumer
income will result in consumers buying more or less of a product at all possible prices. When
consumer income increases, in the case of most goods, individuals will purchase more of
the good even if the price is unchanged. This is shown by a shift to the right—an outward
shift—in the demand curve. Such a shift is called an increase in demand. A reduction in con-
sumer income generally causes a shift to the left—an inward shift—in the demand curve,
which is called a decrease in demand. Note that the appropriate terminology here is an in-
crease or a decrease in demand, not an increase or a decrease in quantity demanded.

Exhibit 4 highlights the difference between a change in demand and a change in
quantity demanded. The demand curve D

1
indicates the initial demand curve for tablet

Change in Demand versus Change in Quantity Demanded

Panel (a) shows a change in quantity de-
manded, a movement along the demand
curve D

1
, in response to a change in the price

of tablet computers. Panel (b) shows a change
in demand, a shift of the entire curve, in this
case due to an increase in consumer income.

ExHIBIT 4

P
ri
ce

Q1 Q3

$300

200

100

(a)

P
ri
ce

Quantity of tablet computers per month

D1 D2

$300
200
100

(b)

Quantity of tablet computers per month

Increase in demandIncrease in quantity demanded

3Questions designed to test the ability of students to make this distinction are favorites of many economics instruc-
tors. A word to the wise should be sufficient.

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chapter 3 deMand, suPPly, and the Market ProCess 49

computers. At a price of $300, consumers will purchase Q
1
units. If the price were to decline

to $100, the quantity demanded would increase from Q

1
to Q

3
. The arrow in panel (a) indi-

cates the change in quantity demanded—a movement along the original demand curve D
1
in

response to the change in price. Now, alternatively suppose there were an increase in in-
come that caused the demand for tablet computers to shift from D

1
to D

2
. As indicated by

the arrows in panel (b), the entire demand curve would shift outward. At the higher income
level, consumers would be willing to purchase more tablet computers than before. This is
true at a price of $300, $200, $100, and every other price. The increase in income leads
to an increase in demand—a shift in the entire curve.

2. changes in the number of consumers in the market. Businesses that
sell products in college towns are greatly saddened when summer arrives. As you might
expect in these towns, the demand for many items—from pizza delivery to beer—
falls during the summer. Exhibit 5 shows how the falling number of consumers in the
market caused by students going home for the summer affects the demand for pizza
delivery. With fewer customers, the demand curve shifts inward from D

1
to D

2
. There

is a decrease in demand; pizza stores sell fewer pizzas than before regardless of what price
they originally charged. Had their original price been $20, then demand would fall from
200 pizzas per week to only 100. Alternatively, had their original price been $10, then de-
mand would fall from 300 pizzas to 200. When autumn arrives and the students come back
to town, there will be an increase in demand that will restore the curve to about its original
position. As cities grow and shrink, and as international markets open up to domestic firms,
changes in the number of consumers affect the demand for many products.

3. changes in the price of a related good. Changes in prices of closely related
products also influence the choices of consumers. Related goods may be either substitutes
or complements. When two products perform similar functions or fulfill similar needs, they
are substitutes. Economists define goods as substitutes when there is a direct relationship
between the price of one and the demand for the other—meaning an increase in the price
of one leads to an increase in demand for the other (they move in the same direction). For
example, margarine is a substitute for butter. If the price of butter rises, it will increase the
demand for margarine as consumers substitute margarine for the more expensive butter.
Conversely, lower butter prices will reduce the demand for margarine, shifting the entire
demand curve for margarine to the left.

Gasoline and hybrid cars provide another example of a substitute relationship. As
gasoline prices have risen in recent years, the demand for gas–electric hybrid cars has

A Decrease in
Demand

In college towns, the
demand for pizza
delivery decreases
substantially when stu-
dents go home for the
summer. A decrease in
demand is a leftward
shift in the entire
demand curve. Fewer
pizzas are demanded
at every price.

ExHIBIT 5

P
ri
ce

Quantity of pizzas delivered per week

100 200 300

D2 D1

$20

10
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50 part 2 Markets and GovernMent

increased. Beef and chicken, pencils and pens, apples and oranges, and coffee and tea pro-
vide other examples of goods with substitute relationships.

Other products are consumed jointly, so the demands for them are linked together
as well. Examples of goods that “go together” include peanut butter and jelly, hot dogs
and hot dog buns, and tents and other camping equipment. These goods are called com-
plements. For complements, a decrease in the price of one will not only increase its
quantity demanded; it will also increase the demand for the other good. The reverse is
also true. As a complement becomes more expensive, the quantity demanded of it will
fall, and so will the demand for its complements. For example, if the price of steak rises,
grocery stores can expect to sell fewer bottles of steak sauce, even if the price of steak
sauce remains unchanged.

4. changes in expectations. Consumers’ expectations about the future also can
affect the current demand for a product. If consumers begin to expect that a major hur-
ricane will strike their area, the current demand for batteries and canned food will rise.
Expectations about the future direction of the economy can also affect current demand. If
consumers are pessimistic about the economy, they start spending less, causing the cur-
rent demand for goods to fall. Perhaps most important is how a change in the expected
future price of a good affects current demand. When consumers expect the price of a
product to rise in the near future, their current demand for it will increase. Gasoline is a
good example. If you expect the price to increase soon, you’ll want to fill up your tank
now before the price goes up. In contrast, consumers will delay a purchase if they expect
the item to decrease in price. No doubt you have heard someone say, “I’ll wait until it
goes on sale.” When consumers expect the price of a product to fall, current demand for
it will decline.

5. demographic changes. The demand for many products is strongly influenced
by the demographic composition of the market. An increase in the elderly population in
the United States in recent years has increased the demand for medical care, retirement
housing, and vacation travel. The demand curves for these goods have shifted to the right.
During the 1980s, the number of people aged 15 to 24 fell by more than 5 million. Because
young people are a major part of the U.S. market for jeans, the demand for jeans fell by
more than 100 million pairs over the course of the decade.4 More recently, the increased use
of cell phones and iPods among teenagers has led to a dramatic reduction in the demand
for wristwatches.

6. changes in consumer tastes and preferences. Why do preferences
change? Preferences change because people change and because people acquire new in-
formation. Consider how consumers respond to changing trends in popular diet programs.
The demand for high-carbohydrate foods like white bread has fallen substantially, whereas
the demand for low-carbohydrate foods like beef has risen. This is a major change from the
past, when the demand for beef fell because of the “heart-healthy” eating habits consumers
preferred then. Trends in the markets for clothing, toys, collectibles, and entertainment are
constantly causing changes in the demand for these products as well. Firms may even try
to change consumer preferences for their own products through advertising and informa-
tion brochures.

The accompanying Thumbnail Sketch summarizes the major factors that cause
a change in demand—a shift of the entire demand curve—and points out that quan-
tity demanded (but not demand) will change in response to a change in the price of
a good.

Complements
Products that are usually
consumed jointly (for example,
bread and butter, hot dogs and
hot dog buns). a decrease in
the price of one will cause an
increase in demand for
the other.

4These figures are from Suzanne Tregarthen, “Market for Jeans Shrinks,” The Margin 6, no. 3 (January–February 1991): 28.

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chapter 3 deMand, suPPly, and the Market ProCess 51

3-3 producer choice
and the law of supply
Now let’s shift our focus to producers and the supply side of the market. How does the mar-
ket process determine the amount of each good that will be produced? To figure this out,
we first have to understand what influences the choices of producers. Producers convert
resources into goods and services by doing the following:

1. organizing productive inputs and resources, like land, labor, capital, natural resources,
and intermediate goods;

2. transforming and combining these inputs into goods and services; and
3. selling the final products to consumers.

Producers have to purchase the resources at prices determined by market forces. Pre-
dictably, the owners of these resources will supply the resources only at prices at least
equal to what they could earn elsewhere. Put another way, each resource the producers buy
to make their product has to be bid away from all other potential uses. Its owner has to be
paid its opportunity cost. The sum of the producer’s cost of each resource used to produce
a good will equal the opportunity cost of production.

There is an important difference between the opportunity cost of production and stan-
dard accounting measures of cost. Accountants generally do not count the cost of assets
owned by the firm when they calculate the firm’s cost. But economists do. Economists
consider the fact that the assets owned by the firm could be used some other way—in other
words, that they have an opportunity cost. Unless these opportunity costs are covered, the
resources will eventually be used in other ways.

The opportunity cost of the assets owned by the firm is the earnings these assets could have
generated if they were used in another way. Consider a manufacturer that invests $100 million
in buildings and equipment to produce shirts. Instead of buying buildings and equipment,

Opportunity cost of
production
the total economic cost of
producing a good or service.
the cost component includes
the opportunity cost of all
resources, including those
owned by the firm. the
opportunity cost is equal to the
value of the production of other
goods sacrificed as the result of
producing the good.

This factor changes the quantity demanded of a good:

1. The price of the good: A higher price decreases
the quantity demanded; a lower price increases the
quantity demanded.

These factors change the demand for a good:

1. consumer income: Lower consumer income will
generally decrease demand; higher consumer
income will generally increase demand.

2. Number of consumers in the market: Fewer
consumers decreases demand; more consumers
increases demand.

3a. Price of a substitute good: A decrease in the price
of a substitute decreases the demand for the origi-
nal good; an increase in the price of a substitute
increases the demand for the original good.

3b. Price of a complementary good: An increase in
the price of a complement decreases the demand
for the original good; a decrease in the price of a
complement increases the demand for the original
good.

4. Expected future price of the good: If the price of
a good is expected to fall in the future, the current
demand for it will decrease; if the price of a good is
expected to rise in the future, the current demand
for it will increase.

5. Demographic changes: Population trends in age,
gender, race, and other factors can increase or
decrease demand for specific goods.

6. consumer preferences: changes in consumer tastes
and preferences can increase or decrease demand
for specific goods.

Thumbnail Sketch
Factors That Cause Changes in Demand and Quantity Demanded

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52 part 2 Markets and GovernMent

the manufacturer could simply put the $100 million in the bank and let it draw interest. If the
$100 million were earning, say, 5 percent interest, the firm would make $5 million on that
money in a year’s time. This $5 million in forgone interest is part of the firm’s opportunity cost
of producing shirts. Unlike an accountant, an economist will take that $5 million opportunity
cost into account. If the firm plans to invest the money in shirt-making equipment, it had better
earn more from making the shirts than the $5 million it could earn by simply putting the money
in the bank. If the firm can’t generate enough to cover all of its costs, including the opportu-
nity cost of assets owned by the firm, it will not continue in business. If the firm were earning
only $3 million producing shirts, it might be earning profit on its accounting statement, but it
would be suffering a $2 million economic loss relative to simply putting the money in the bank.

3-3a the role of profits and losses

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Keys to econoMic ProsPerity

profits and losses
Profits direct producers toward activities that increase the value of resources; losses
impose a penalty on those who reduce the value of resources.

Firms earn a profit when the revenues from the goods and services that they supply exceed the
opportunity cost of the resources used to make them. Consumers will not buy goods and services
unless they value them at least as much as their purchase price. For example, Susan would not be
willing to pay $40 for a pair of jeans unless she valued them by at least that amount. At the same
time, the seller’s opportunity cost of supplying a good will reflect the value consumers place
on other goods that could have been produced with those same resources. This is true precisely
because the seller has to bid those resources away from other producers wanting to use them.

Think about what it means when, for example, a firm is able to produce jeans at a cost
of $30 per pair and sell them for $40, thereby reaping a profit of $10 per pair. The $30 op-
portunity cost of the jeans indicates that the resources used to produce the jeans could have
been used to produce other items worth $30 to consumers (perhaps a denim backpack). In
turn, the profit indicates that consumers value the jeans more than other goods that might
have been produced with the resources used to supply the jeans.

The willingness of consumers to pay a price greater than a good’s opportunity cost
indicates that they value the good more than other things that could have been produced
with the same resources. Viewed from this perspective, profit is a reward earned by entre-
preneurs who use resources to produce goods consumers value more highly than the other
goods those resources could have produced. In essence, this profit is a signal that an entre-
preneur has increased the value of the resources under his or her control.

Business decision makers will seek to undertake production of goods and services that
will generate profit. However, things do not always turn out as expected. Sometimes business
firms are unable to sell their products at prices that will cover their costs. Losses occur when
the revenue derived from sales is insufficient to cover the opportunity cost of the resources used
to produce a good or service. Losses indicate that the firm has reduced the value of the resources
it has used. In other words, consumers would have been better off if those resources had been
used to produce something else. In a market economy, losses will eventually cause firms to go
out of business, and the resources they previously utilized will be directed toward other things
valued more highly, or to other firms who can produce those same goods at a lower cost.

Profits and losses play a very important role in a market economy. They determine
which products (and firms) will expand and survive and which will contract and be driven
from the market. Clearly, there is a positive side to business failures. As our preceding dis-
cussion highlights, losses and business failures free up resources being used unwisely so
they can be put to use by other firms providing consumers with more value.

Profit
an excess of sales revenue
relative to the opportunity
cost of production. the cost
component includes the
opportunity cost of all resources,
including those owned by the
firm. therefore, profit accrues
only when the value of the good
produced is greater than the
value of the resources used for
its production.

Loss
a deficit of sales revenue
relative to the opportunity cost
of production. losses are a
penalty imposed on those who
produce goods even though
they are valued less than the
resources required for their
production.

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chapter 3 deMand, suPPly, and the Market ProCess 53

3-3b supply and the
entrepreneur
Entrepreneurs organize the production of new
products. In doing so, they take on significant risk
in deciding what to produce and how to produce
it. Their success or failure depends on how much
consumers eventually value the products they de-
velop relative to other products that could have
been produced with the resources. Entrepreneurs
figure out which projects are likely to be profitable
and then try to persuade a corporation, a banker, or
individual investors to invest the resources needed
to give their new idea a chance. Studies indicate,
however, that only about 55 to 65 percent of the
new products introduced are still on the market five
years later. Being an entrepreneur means you have
to risk failing.

To prosper, entrepreneurs must convert and rearrange resources in a manner that will
increase their value. A person who purchases 100 acres of raw land, puts in streets and a
sewage- disposal system, divides the plot into 1-acre lots, and sells them for 50 percent
more than the opportunity cost of all resources used is clearly an entrepreneur. This entre-
preneur profits because the value of the resources has increased. Sometimes entrepreneur-
ial activity is less complex, though. For example, a 15-year-old who purchases a power
mower and sells lawn services to his neighbors is also an entrepreneur seeking to profit by
increasing the value of his resources—time and equipment.

3-3c Market supply schedule
How will producer–entrepreneurs respond to a change in product price? Other things con-
stant, a higher price will increase the producer’s incentive to supply the good. Established
producers will expand the scale of their operations, and over time new entrepreneurs,
seeking personal gain, will enter the market and begin supplying the product, too. The
law of supply states that there is a direct (or positive) relationship between the price of
a good or service and the amount of it that suppliers are willing to produce. This direct
relationship means that the price and the quantity producers wish to supply move in the
same direction. As the price increases, producers will supply more—and as the price
decreases, they will supply less.

Like the law of demand, the law of supply reflects the basic economic principle that incen-
tives matter. Higher prices increase the reward entrepreneurs get from selling their products.
The more profitable it is to produce a product, the more of it entrepreneurs will be willing to
supply. Conversely, as the price of a product falls, so does its profitability and the incentive to
supply it. Just think about how many hours of tutoring services you would be willing to supply
for different prices. Would you be willing to spend more time tutoring students if instead of
$8 per hour, tutoring paid $50 per hour? The law of supply suggests you would, and producers
of other goods and services are no different.

Exhibit 6 illustrates the law of supply. The curve shown in the exhibit is called a
supply curve. Because there is a direct relationship between a good’s price and the amount
offered for sale by suppliers, the supply curve has a positive slope. It slopes upward to the
right. Read horizontally, the supply curve shows how much of a particular good producers
are willing to produce and sell at a given price. Read vertically, the supply curve reveals im-
portant information about the cost of production. The height of the supply curve indicates
both (1) the minimum price necessary to induce producers to supply that additional unit
and (2) the opportunity cost of producing that additional unit. These are both measured by
the height of the supply curve because the minimum price required to induce a supplier to
sell a unit is precisely the marginal cost of producing it.

Law of supply
a principle that states there is
a direct relationship between
the price of a good and the
quantity of it producers are
willing to supply. as the price
of a good increases, producers
will wish to supply more of it. as
the price decreases, producers
will wish to supply less.

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entrepreneurs who buy raw
land, put in streets and sewer
lines, and divide up the land
into lots for sale will earn a
profit if the revenues derived
from the lot sales exceed
the opportunity cost of the
project. profit is a reward for
increasing the value of the
resources.

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54 part 2 Markets and GovernMent

3-3d producer surplus
We previously used the demand curve to illustrate consumer surplus, the net gains of buy-
ers from market exchanges. The supply curve can be used in a similar manner to illustrate
the net gains of producers and resource suppliers. Suppose that you are an aspiring musi-
cian and are willing to perform a two-hour concert for $500. If a promoter offers to pay you
$750 to perform the concert, you will accept, and receive $250 more than your minimum
price. This $250 net gain represents your producer surplus. In effect, producer surplus is
the difference between the amount a supplier actually receives (based on the market price)
and the minimum price required to induce the supplier to produce the given units (their
marginal cost). The shaded area of Exhibit 7 illustrates the measurement of producer
surplus for an entire market.

It’s important to note that producer surplus represents the gains received by all par-
ties contributing resources to the production of a good. In this respect, producer surplus
is fundamentally different from profit. Profit accrues to the owners of the business firm
producing the good, whereas producer surplus encompasses the net gains derived by all
people who help produce the good, including those employed by or selling resources to
the firm.

Producer surplus
the difference between the
price that suppliers actually
receive and the minimum
price they would be willing
to accept. It measures the
net gains to producers and
resource suppliers from market
exchange. It is not the same as
profit.

ExHIBIT

Producer Surplus

Producer surplus is the
area above the supply
curve but below the
actual sales price. This
area represents the net
gains to producers and
resource suppliers from
production and
exchange.

P
ri
ce
Quantity/time
Q1

Producer
surplus

Supply

P1
©
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en
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ea
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in
g
20
13

Supply Curve

As the price of a product
increases, other things
constant, producers will
increase the amount of
the product supplied to
the market.

ExHIBIT 6

Q2 Q3

Q1
Quantity/time

P
ri
ce
Supply
©
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in
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20
13

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chapter 3 deMand, suPPly, and the Market ProCess 55

3-3e responsiveness of Quantity supplied to price
chanGes: elastic and inelastic supply curves
Like the quantity demanded, the responsiveness of the quantity supplied to a change in
price is different for different goods. The supply curve is said to be elastic when a modest
change in price leads to a large change in quantity supplied. This is generally true when the
additional resources needed to expand output can be obtained with only a small increase in
their price. Consider the supply of soft drinks. The contents of soft drinks—primarily car-
bonated water, sugar, and flavoring—are abundantly available. A sharp increase in the use
of these ingredients by soft drink producers is unlikely to push up their price much. There-
fore, as Exhibit 8 illustrates, if the price of soft drinks were to rise from $1 to $1.50, pro-
ducers would be willing to expand output sharply from 100 million to 200 million cans per
month. A 50 percent increase in price leads to a 100 percent expansion in quantity supplied.
The larger the increase in quantity in response to a higher price, the more elastic the supply
curve. The flatness of the supply curve for soft drinks reflects the fact that it is highly elastic.

In contrast, when the quantity supplied is not very responsive to a change in price, sup-
ply is said to be inelastic. Physicians’ services are an example. If the earnings of doctors
increase from $100 to $150 per hour, there will be some increase in the quantity of the ser-
vices they provide. Some physicians will work longer hours; others may delay retirement.
Yet, these adjustments are likely to result in only a small increase in the quantity supplied
because it takes a long time to train a physician and the number of qualified doctors who are
working in other occupations or who are outside of the labor force is small. Therefore, as
Exhibit 8 (right frame) shows, a 50 percent increase in the price of physician services leads

ALfRED MARSHALL (1842–1924)
British economist Alfred Marshall was one of the most influential economists of his era. Many con-
cepts and tools that form the core of modern microeconomics originated with Marshall in his famous
Principles of Economics, first published in 1890. Marshall introduced the concepts of supply and
demand, equilibrium, elasticity, consumers’ and producers’ surplus, and the idea of distinguishing
between short-run and long-run changes.

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Elastic and Inelastic
Supply Curves

Frame (a) illustrates a sup-
ply curve that is relatively
elastic and therefore the
quantity supplied is highly
responsive to a change in
price. soft drinks provide
an example. Frame (b) illus-
trates a relatively inelastic
supply curve, one in which
the quantity supplied
increases by only a small
amount in response to a
change in price. This is the
case for physician services.

$150

P
ri
ce
10

$100

$1.50

P
ri
ce
100

200

Soft drinks
(millions of cans per month)

Physician services
(millions of hours per month)

(a) (b)

ExHIBIT 8

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56 part 2 Markets and GovernMent

to only a 20 percent expansion in the quantity supplied. Unlike soft drinks, higher prices
for physician services do not generate much increase in quantity supplied. Economists
would say that the supply of physician services is relatively inelastic.

3-4 chanGes in supply versus
chanGes in Quantity supplied
Like demand, it is important to distinguish between a change in the quantity supplied and a change
in supply. When producers change the number of units they are willing to supply in response to a
change in price, this movement along the supply curve is called a “change in quantity supplied.” A
change in any factor other than the price shifts the supply curve and is called a “change in supply.”

As we previously discussed, profit-seeking entrepreneurs will produce a good only if its
sales price is expected to exceed its opportunity cost of production. Therefore, changes that
affect the opportunity cost of supplying a good will also influence the amount of it produc-
ers are willing to supply. These other factors, such as the prices of resources used to make
the good and the level of technology available, are held constant when we draw the supply
curve. The supply curve itself reflects quantity changes only in response to price changes.
Changes in these other factors shift the supply curve. Factors that increase the opportunity
cost of providing a good will discourage production and decrease supply, shifting the entire
curve inward to the left. Conversely, changes that lower the opportunity cost of producers
will encourage production and increase supply, shifting the entire curve outward to the right.

Let us now take a closer look at the primary factors that will cause a change in supply
and shift the entire curve right or left.

1. changes in resource prices. How will an increase in the price of a resource,
such as wages of workers or the materials used to produce a product, affect the supply of a
good? Higher resource prices will increase the cost of production, reducing the profitability
of firms supplying the good. The higher cost will induce firms to reduce their output. With
time, some may even be driven out of business. As Exhibit 9 illustrates, higher resource
prices will reduce the supply of the good, causing a shift to the left in the supply curve from
S

1
to S

2
. Alternatively, a reduction in the price of a resource used to produce a good will

cause an increase in supply—a rightward shift in the supply curve—as firms expand output
in response to the lower costs and increased profitability of supplying the good.

2. changes in technology. Like lower resource prices, technological improvements—the
discovery of new, lower-cost production techniques—reduce production costs, and there-
by increase supply. Technological advances have affected the cost of almost everything.

A Decrease in
Supply

crude oil is a resource
used to produce
gasoline. When the
price of crude oil rises,
it increases the cost of
producing gasoline and
results in a decrease in
the supply of gasoline.

ExHIBIT

P
ri
ce

Quantity of gasoline

S2 S1

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chapter 3 deMand, suPPly, and the Market ProCess 57

Before the invention of the printing press, books had to be handwritten. Just imagine the
massive reduction in cost and increase in the supply of books caused by this single inven-
tion. Similarly, improved farm machinery has vastly expanded the supply of agricultural
products through the years. The field of robotics has reduced the cost of producing air-
planes, automobiles, and other types of machinery. Better computer chips have drastically
reduced the cost of producing electronics. Forty years ago, a simple calculator cost more
than $100 and a microwave oven almost $500. When introduced in the mid-1980s, a cel-
lular telephone cost more than $4,000. You have probably noticed that the prices of flat-
screen computer monitors and plasma-screen televisions have fallen substantially in recent
years. Again, technological advances explain these changes.

3. elements of nature and political disruptions. Natural disasters and chang-
ing political conditions can also alter supply, sometimes dramatically. In some years, good
weather leads to “bumper crops,” increasing the supply of agricultural products. At other
times, freezes or droughts lead to poor harvests, reducing supply. War and political unrest
in the Middle East region have had a major impact on the supply of oil several times during
the past few decades. Factors such as these will alter supply.

4. changes in taxes. If the government increases the taxes on the sellers of a product,
the result will be the same as any other increase in the cost of doing business. The added tax
that sellers have to pay will reduce their willingness to sell the product at any given price.
Each unit must now be sold for a price that covers not only the opportunity cost of produc-
tion, but also the tax. For example, a special tax is levied on commercial airline tickets,
partially to cover the cost of airport security. This tax increases the cost of air travel and
thereby reduces the supply (a shift to the left in the supply curve.)

The accompanying Thumbnail Sketch summarizes the major factors that change supply
(a shift of the entire supply curve) and quantity supplied (a movement along the supply curve).

3-5 how Market prices are deterMined:
deMand and supply interact
Consumer–buyers and producer–sellers make decisions independent of each other, but mar-
ket prices coordinate their choices and influence their actions. To the economist, a market
is not a physical location but an abstract concept that encompasses the forces generated

Market
an abstract concept
encompassing the forces of
demand and supply and the
interaction of buyers and sellers
with the potential for exchange
to occur.

This factor changes the quantity supplied of a good:

1. The price of the good: A lower price decreases
the quantity supplied; a higher price increases the
quantity supplied.

These factors change the supply of a good:

1. Resource prices (the prices of things used to make
the good): Lower resource prices increase supply;
higher resource prices decrease supply.

2. Technological change: A technological improve-
ment increases supply; a technological setback
decreases supply.

3. Weather or political conditions: Favorable weather
or good political conditions increase supply; ad-
verse weather conditions or poor political condi-
tions decrease supply.

4. Taxes imposed on the producers of a good: Lower
taxes increase supply; higher taxes decrease supply.

Thumbnail Sketch
Factors That Cause Changes in Supply and Quantity Supplied

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58 part 2 Markets and GovernMent

by the decisions of buyers and sellers. A market may be quite narrow (for example, the
market for grade A jumbo eggs), or it may be quite broad like when we lump diverse goods
into a single market, such as the market for all “consumer goods.” There is also a wide
range of sophistication among markets. The New York Stock Exchange is a highly formal,
computerized market. Each weekday, buyers and sellers, who seldom meet, electronically
exchange corporate shares they own worth billions of dollars. In contrast, a neighborhood
market for babysitting services or tutoring in economics may be highly informal, bringing
together buyers and sellers primarily by word of mouth.

Equilibrium is a state in which the conflicting forces of demand and supply are in
balance. When a market is in equilibrium, the decisions of consumers and producers
are brought into harmony with one another, and the quantity demanded will equal the
quantity supplied. In equilibrium, it is possible for both buyers and sellers to realize their
choices simultaneously. What could bring these diverse interests into harmony? We will
see that the answer is market prices.

3-5a Market eQuilibriuM
As we have learned, a higher price will reduce the quantity of a good demanded by consum-
ers. Conversely, a higher price will increase the quantity of a good supplied by producers. The
market price of a good will tend to change in a direction that will bring the quantity of a good
consumers want to buy into balance with the quantity producers want to sell. If the price is too
high, the quantity supplied by producers will exceed the quantity demanded. Producers will
be unable to sell as much as they would like unless they reduce their price. Alternatively, if the
price is too low, the quantity demanded by consumers will exceed the quantity supplied. Some
consumers will be unable to get as much as they would like, unless they are willing to pay a
higher price to bid some of the good away from other potential customers. Thus, there will be
a tendency for the price in a market to move toward the price that brings the two into balance.

People have a tendency to think of consumers wanting lower prices and producers
wanting higher prices. Although this is true, price changes frequently trend toward the
middle of the two extremes. When a local store has an excess supply of a particular item,
how does it get rid of it? By having a sale or otherwise lowering its price. Firms often lower
their prices in order to get rid of excess supply.

In contrast, excess demand is solved by consumers bidding up prices. Children’s toys
around Christmas provide a perfect example. When first introduced, items such as the
Nintendo Wii, Webkinz, and the video game Rock Band were immediate successes. The
firms producing these products had not anticipated the overwhelming demand; every child
wanted one for Christmas. Some stores raised their prices, but the demand was so strong
that lines of parents were forming outside stores before they even opened. Often, only the
first few in line were able to get the toys (a sure sign that the store had set the price below
equilibrium). Out in the parking lots, in the classified ads, and on eBay, parents were offer-
ing to pay even higher prices for these items. If stores were not going to set the prices right,
parents in these informal markets would! These examples show that rising prices are often
the result of consumers bidding up prices when excess demand is present. A similar phe-
nomenon can be seen in the market for tickets to a World Series game or a popular music
group’s upcoming concert, as the immediate value of a ticket on the resale market can be
much higher than the original retail price if, at that price, the original quantity supplied is
not adequate to meet the quantity demanded.

As these examples illustrate, whenever quantity supplied and quantity demanded are not
in balance, there is a tendency for price to change in a manner that will correct the imbalance.
It is possible to show this process graphically with the supply and demand curves we have
developed in this chapter. Exhibit 10 shows the supply and demand curves in the market for
a basic calculator. At a high price—$12, for example—producers will plan to supply 600 cal-
culators per day, whereas consumers will choose to purchase only 450. An excess supply of
150 calculators (shown by distance ab in the graph) will result. Unsold calculators will push
the inventories of producers upward. To get rid of some of their calculators in inventory, some
producers will cut their price to increase their sales. Other firms will have to lower their price,

Equilibrium
a state in which the conflicting
forces of demand and supply
are in balance. When a market
is in equilibrium, the decisions
of consumers and producers
are brought into harmony with
one another, and the quantity
demanded will equal the
quantity supplied.

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chapter 3 deMand, suPPly, and the Market ProCess 59

too, as a result, or sell even fewer calculators. This lower price will make supplying calcula-
tors less attractive to producers. Some of them will go out of business. Others will reduce
their output or perhaps produce other products. How low will the price of calculators go?
As the figure shows, when the price has declined to $10, the quantity supplied by producers
and the quantity demanded by consumers will be in balance at 550 calculators per day. At
this price ($10), the quantity demanded by consumers just equals the quantity supplied by
producers, and the choices of the two groups are brought into harmony.

What will happen if the price per calculator is lower—$8, for example? In this case,
the amount demanded by consumers (650 units) will exceed the amount supplied by pro-
ducers (500 units). An excess demand of 150 units (shown by the distance cd in the graph)
will be the result. Some consumers who are unable to purchase the calculators at $8 per
unit because of the inadequate supply would be willing to pay a higher price. Recogniz-
ing this fact, producers will raise their price. As the price increases to $10, producers will
expand their output and consumers will cut down on their consumption. At the $10 price,
equilibrium will be restored.

3-5b efficiency and Market eQuilibriuM
When a market reaches equilibrium, all the gains from trade have been fully realized and
economic efficiency is present. Economists often use economic efficiency as a standard
to measure outcomes under alternative circumstances. The central idea of efficiency is a
cost-versus-benefit comparison. On the one hand, undertaking an economic action will
be efficient only if it generates more benefit than cost. On the other hand, undertaking an
action that generates more cost than benefit is inefficient. For a market to be efficient, all
trades that generate more benefit than cost need to be undertaken. In addition, economic
efficiency requires that no trades creating more cost than benefit be undertaken.

Economic efficiency
a situation in which all of the
potential gains from trade
have been realized. an action
is efficient only if it creates
more benefit than cost. With
well-defined property rights
and competition, market
equilibrium is efficient.

Supply and Demand

The table indicates the
supply and demand
conditions for calculators.
These conditions are also
illustrated by the graph.
When the price exceeds
$10, an excess supply
is present, which places
downward pressure on
price. In contrast, when
the price is less than $10,
an excess demand results,
which causes the price
to rise. Thus, the market
price will tend toward $10,
at which point the quantity
demanded will be equal to
the quantity supplied.

ExHIBIT 10

PRICE OF
CALCULATORS

(DOLLARS)

QUANTITY
SUPPLIED
(PER DAY)

QUANTITY
DEMANDED
(PER DAY)

CONDITION
IN THE

MARKET

DIRECTION
OF PRESSURE

ON PRICE

Excess
supply

P
ri

ce
(

d
o

lla
rs

)
7
Quantity/time

350 450 550 650 750

8
9
10

12
13

Excess
demand

S
D

$13
12
11
10
9
8
7

625
600
575
550
525
500
475

400
450
500
550
600
650
700

Excess supply
Excess supply
Excess supply
Balance
Excess demand
Excess demand
Excess demand

Downward
Downward
Downward
Equilibrium
Upward
Upward
Upward

a b

c d

53538_ch03_rev03.indd 59 17/12/13 5:02 PM

60 part 2 Markets and GovernMent

A closer look at the way that markets work can help us understand the concept
of efficiency. The supply curve reflects producers’ opportunity cost. Each point along
the supply curve indicates the minimum price for which the units of a good could be
produced without a loss to the seller. Assuming no other third parties are affected by
the production of this good, then the height of the supply curve represents the opportu-
nity cost to society of producing and selling the good. On the other side of the market,
each point along the demand curve indicates how consumers value an extra unit of the
good—that is, the maximum amount the consumer is willing to pay for the extra unit.
Again assuming that no other third parties are affected, the height of the demand curve
represents the benefit to society of producing and selling the good. Any time the con-
sumer’s valuation of a unit (the benefit) exceeds the producer’s minimum supply price
(the cost), producing and selling the unit is consistent with economic efficiency. The
trade will result in mutual gain to both parties. When property rights are well defined
and only the buyers and sellers are affected by production and exchange, competitive
market forces will automatically guide a market toward an equilibrium level of output
that satisfies economic efficiency.

Exhibit 11 illustrates why this is true. Suppliers of bicycles will produce additional bi-
cycles as long as the market price exceeds their opportunity cost of production (shown by the
height of the supply curve). Similarly, consumers will continue to purchase additional bikes
as long as their benefit (shown by the height of the demand curve) exceeds the market price.
Eventually, market forces will result in an equilibrium output level of Q and a price of P. At this
point, all the bicycles providing benefits to consumers that exceed the costs to suppliers will be
produced. Economic efficiency is met because all of the potential consumer and producer gains
from exchange (shown by the shaded area) have occurred. As you can see, the point of market
equilibrium is also the point where the combined area showing consumer and producer surplus
is the greatest.

When fewer than Q bicycles are produced, some bicycles valued more by consumers
than the opportunity cost of producing them are not being produced. This is not consistent
with economic efficiency. On the other hand, if output is expanded beyond Q, inefficiency
will also result because some of the bicycles cost more to produce than consumers are will-
ing to pay for them. Prices in competitive markets eventually guide producers and consum-
ers to the level of output consistent with economic efficiency.

Economic Efficiency

When markets are com-
petitive and property
rights are well defined, the
equilibrium reached by a
market satisfies economic
efficiency. All units that
create more benefit (the
buyer’s valuation shown by
the height of the demand
curve) than cost (oppor-
tunity cost of production
shown by the height of the
supply curve) are pro-
duced. This maximizes the
total gains from trade, the
combined area repre-
sented by consumer and
producer surplus.

ExHIBIT 11

P
ri
ce

Bicycles per month

P
D
Q
S

Entire shaded area is
net gains to buyers and

sellers

Consumer
surplus

Producer
surplus

53538_ch03_rev03.indd 60 17/12/13 5:02 PM

chapter 3 deMand, suPPly, and the Market ProCess 61

3-6 how Markets
respond to chanGes
in deMand and supply
How will a market adjust to a change in demand?
Exhibit 12 shows the market adjustment to an increase
in the demand for eggs around Easter. Demand D

1
and

supply S are typical throughout much of the year. Dur-
ing the two weeks before Easter, however, consumer
demand for eggs rises because people purchase them
to decorate, too. This shifts egg demand from D

1
to D

during that time of year. As you can see, the increase in
demand pushes the price upward from P

1
to P

2
(typically

by about 20 cents per dozen) and results in a larger equi-
librium quantity traded (Q

2
rather than Q

1
—an increase

of typically around 600 million eggs). There is a new
equilibrium at point b around Easter (versus point a dur-
ing the rest of the year).

Although consumers may not be happy about paying a higher price for eggs around
Easter, the higher price serves two essential purposes. First, it encourages consumers to
conserve on their usage of eggs. Some consumers may purchase only two dozen eggs
to color, rather than three; other consumers may skip having an omelet for breakfast and
have yogurt instead. These steps on the consumer side of the market help make the eggs
that are available around Easter go further. Second, the higher price is precisely what re-
sults in the additional 600 million eggs being supplied to the market to satisfy this in-
creased consumer demand. Without the price increase, excess demand would be present,
and many consumers would simply be unable to find eggs to purchase around Easter. If
the price remained at P

1
(the equilibrium price throughout most of the year), consumers at

Easter-time would want to purchase more eggs than producers would be willing to supply.
At the higher P

2
price, however, the quantity suppliers are willing to sell is again in balance

with the quantity consumers wish to purchase.
Why were suppliers unwilling to supply the additional 600 million eggs at the origi-

nal price of P
1
? Because at the original equilibrium price of P

1
, suppliers were already

Market Adjustment to
Increase in Demand

Here, we illustrate how the
market for eggs adjusts
to an increase in demand
such as generally occurs
around Easter. Initially
(before the Easter sea-
son), the market for eggs
reflects demand D

1
and

supply S. The increase in
demand (shift from D

1
to

D
2
) pushes price up and

leads to a new equilibrium
at a higher price (P

2
rather

than P
1
) and larger quan-

tity traded (Q
2
)

ExHIBIT 12

Q1
P
ri
ce
Q2
P1
P2
a
b
D1
D2

Eggs per week

the tradition of coloring and
hunting for eggs causes an
increase in demand for eggs
around easter. as exhibit 12
illustrates, this leads to higher
egg prices and costly actions
by producers to supply a
larger quantity during this
period.

ub
.-W

ilh
. D

om
rö

se
/S

hu
tt

er
st

oc
k.

co
m

53538_ch03_rev03.indd 61 17/12/13 5:02 PM

62 part 2 Markets and GovernMent

producing and selling all the eggs that cost less to produce than that price. The additional
eggs desired by consumers around Easter all cost more to produce than the old market
price of P

1
. The higher price of P

2
is what allows suppliers to cover their higher produc-

tion costs associated with these extra eggs. Around Easter, farmers take costly steps to
avoid having the hens molt because hens lay fewer eggs when they are molting. They do
this by changing the quantity and types of feed and by increasing the lighting in the birds’
sheds—both of which mean higher production costs. Farmers also try to build up larger
than normal inventories of eggs before Easter. Eggs are typically about two days old when
consumers buy them at the store, but can be up to seven days old around Easter time.
Building up and maintaining this additional inventory are costly, too.

In a market economy, when the demand for a good increases, its price will rise, which
will (1) motivate consumers to search for substitutes and cut back on additional purchases
of the good and (2) motivate producers to supply more of the good. These two forces will
eventually bring the quantity demanded and quantity supplied back into balance.

It’s important to note that this response on the supply side of the egg market is not a shift
in the supply curve. The supply curve remains unchanged. Rather, there is a movement along
the original supply curve—a change in quantity supplied. The only reason suppliers are will-
ing to alter their behavior (produce more eggs) is because the increased demand has pushed
up the price of eggs. Notice that it is the change in demand (a shift of the demand curve) that
leads to the change in quantity supplied (a movement along the supply curve). Producers are
simply responding to the price movement caused by the change in demand. A movement
along one curve (a change in quantity supplied or a change in quantity demanded) happens
in response to a shift in the other curve (a change in demand or a change in supply).

When the demand for a product declines, the adjustment process sends buyers and
sellers just the opposite signals. Take a piece of paper and see if you can diagram a decrease
in demand and how it will affect price and quantity in a market. If you’ve done it correctly,
a decline in demand (a shift to the left in the demand curve) will lead to a lower price and
a lower quantity traded. What’s going on in the diagram is that the lower price (caused by
lower consumer demand) is reducing the incentive of producers to supply the good. When
consumers no longer want as much of a good, falling market prices signal producers to cut
back production. The reduced output allows these resources to be freed up to go into the
production of other goods consumers want more.

How will markets respond to changes in supply? Exhibit 13 shows the market’s ad-
justment to a decrease in the supply of lemons, such as happened during January 2007 when
freezing temperatures in California destroyed a large portion of the lemon crop. A reduction

Market Adjustment to
a Decrease in Supply

Here, using lemons as
an example, we illustrate
how a market adjusts
to a decrease in supply.
Assume adverse weather
conditions substantially
reduce the supply (shift
from S

1
to S

2
) of lemons.

The reduction in supply
leads to an increase in the
equilibrium price (from P

to P
2
) and a reduction in

the equilibrium quantity
traded (from Q

1
to Q

2
).

ExHIBIT 13

P
ri
ce

Lemons (quantity per week)

D
S1
S2
P2
P1

Q2 Q1

53538_ch03_rev03.indd 62 17/12/13 5:02 PM

chapter 3 deMand, suPPly, and the Market ProCess 63

in supply (shift from S
1
to S

2
) will cause the price of lemons to increase sharply (P

1
to P

2
).

Because of the higher price, consumers will cut back on their consumption of lemons (the
movement along the demand curve from a to b). Some will switch to substitutes—in this
case, probably other varieties of citrus. The higher price also encourages the remaining
lemon suppliers to take additional steps—like more careful harvesting techniques or using
more fertilizer—that allow them to produce more lemons than otherwise would be the case.
The higher prices will rebalance the quantity demanded and quantity supplied.

As the lemon example illustrates, a decrease in supply will lead to higher prices and a
lower equilibrium quantity. How do you think the market price and quantity would adjust to
an increase in supply, as might be caused by a breakthrough in the technology used to harvest
the lemons? Again, try to draw the appropriate supply and demand curves to illustrate this
case. If you do it correctly, the graph you draw will show an increase in supply (a shift to the
right in the supply curve) leading to a lower market price and a larger equilibrium quantity.

The accompanying Thumbnail Sketch summarizes the effect of changes—both in-
creases and decreases—in demand and supply on the equilibrium price and quantity. The
cases listed in the sketch, however, are for when only a single curve shifts. But sometimes
market conditions simultaneously shift both demand and supply. For example, consumer
income might increase at the same time that a technological advance in production occurs.
These two changes will cause both demand and supply to increase at the same time—both
curves will shift to the right. The new equilibrium will definitely be at a larger quantity,
but the direction of the change in price is indeterminate. The price may either increase or
decrease, depending on whether the increase in demand or increase in supply is larger—
which curve shifted the most, in other words.

What will happen if supply increases but demand falls at the same time? Price will
definitely fall, but the new equilibrium quantity may either increase or decrease. Draw the
supply and demand curves for this case and make sure that you understand why.

3-6a invisible hand principle

Keys to econoMic ProsPerity
invisible hand principle
Market prices coordinate the actions of self-interested individuals and direct them toward
activities that promote the general welfare.

changes in demand
1. An increase in demand—shown by a rightward shift

of the demand curve—will cause an increase in both
the equilibrium price and the equilibrium quantity.

2. A decrease in demand—shown by a leftward shift
of the demand curve—will cause a decrease in both
the equilibrium price and the equilibrium quantity.

changes in supply
1. An increase in supply—shown by a rightward shift of

the supply curve—will cause a decrease in the equilib-
rium price and an increase in the equilibrium quantity.

2. A decrease in supply—shown by a leftward shift of the
supply curve—will cause an increase in the equilib-
rium price and a decrease in the equilibrium quantity.

Thumbnail Sketch
How Changes in Demand and Supply Affect Market Price and Quantity

53538_ch03_rev03.indd 63 17/12/13 5:03 PM

64 part 2 Markets and GovernMent

More than 235 years ago, Adam Smith, the father of economics, stressed that personal
self-interest when directed by market prices is a powerful force promoting economic prog-
ress. In a famous passage in his book An Inquiry into the Nature and Causes of the Wealth
of Nations, Smith put it this way:

Every individual is continually exerting himself to find out the most advan-
tageous employment for whatever [income] he can command. It is his own
advantage, indeed, and not that of the society which he has in view. But the
study of his own advantage naturally, or rather necessarily, leads him to prefer
that employment which is most advantageous to society. . . . He intends only
his own gain, and he is in this, as in many other cases, led by an invisible hand
to promote an end which was not part of his intention. By pursuing his own
interest he frequently promotes that of the society more effectually than when
he really intends to promote it.5

The “invisible hand” to which Smith referred was the pricing system––prices deter-
mined by the forces of supply and demand. Smith’s fundamental insight was that market
prices tend to bring the self-interest of individuals into harmony with the betterment of
society. Moreover, when it is directed by market prices, personal self-interest is a powerful
force promoting growth and prosperity.

The tendency of market prices to channel the actions of self-interested individuals into
activities that promote the prosperity of the society is now known as the invisible hand
principle. Let’s take a closer look at this important principle.

3-6b prices and Market order
The invisible hand principle can be difficult to grasp because there is a natural tendency to asso-
ciate order with central direction and control. Surely some central authority must be in charge.
But this is not the case. The pricing system, reflecting the choices of literally millions of con-
sumers, producers, and resource owners, provides the direction. Moreover, the market process
works so automatically that most of us give little thought to it. We simply take it for granted.

Perhaps an example from your everyday life will help you better understand the invis-
ible hand principle. Visualize a busy retail store with 10 checkout lanes. No one is assign-
ing shoppers to checkout lanes. Shoppers are left to choose for themselves. Nonetheless,
they do not all try to get in the same lane. Why? Individuals are always alert for adjustment
opportunities that offer personal gain. When the line at one lane gets long or is held up by a
price check, some shoppers will shift to other lanes and thereby smooth out the flow among
the lanes. Even though central planning is absent, this process of mutual adjustment by
self-interested individuals results in order and social cooperation. A similar phenomenon
occurs on busy interstate highways as drivers switch between lanes for personal gain, with
the end result being the quickest flow of traffic for everyone and for the group as a whole.

The incentive structure generated by markets is a lot like that accompanying the check-
out at a busy retail store or driving on the freeway. Like the number of people in a lane,
profits and losses provide market participants with information about the advantages and
disadvantages of different economic activities. Losses indicate that an economic activity
is congested, and, as a result, producers are unable to cover their costs. In such a case,
successful market participants will shift their resources away from such activities toward
other, more valuable uses. Conversely, profits are indicative of an open lane, the opportu-
nity to experience gain if one shifts into an activity in which the price is high relative to the
per-unit cost. As producers and resource suppliers shift away from activities characterized
by congestion and into those characterized by the opportunity for profit, they enlarge the
flow of economic activity.

Consider the following three vitally important functions performed by market prices.

Invisible hand principle
the tendency of market prices
to direct individuals pursuing
their own interests to engage
in activities promoting the
economic well-being of society.

5Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (New York: Modern Library, 1937), 423.

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chapter 3 deMand, suPPly, and the Market ProCess 65

1. Market prices communicate information to both buyers and sellers that
will promote efficient use of resources and proper response to changing conditions. Prices
provide producers with up-to-date information about which goods consumers most in-
tensely desire and with important information about the abundance of the resources
used in the production process. The cost of production, driven by the opportunity cost of
resources, tells the business decision-maker the relative importance others place on the
alternative uses of those resources. A boom in the housing market might cause lumber
prices to rise. In turn, furniture-makers seeing these higher lumber prices will utilize
substitute raw materials such as metal and plastic in their production processes. Because
of market prices, furniture-makers will conserve on their use of lumber, just as if they
had known that lumber was now more urgently needed for constructing new housing.

Consider another example. Suppose a drought in Brazil severely reduces the supply
of coffee. Coffee prices will rise. Even if consumers do not know about the drought, the
higher prices will provide them with all the information they need to know—it’s time to
cut back on coffee consumption. Market prices register information derived from the
choices of millions of consumers, producers, and resource suppliers, and provide them
with everything they need to know to make wise decisions.

2. Market prices coordinate the actions of market participants. Market
prices also coordinate the choices of buyers and sellers, bringing their decisions into line
with each other. Excess supply will lead to falling prices, which discourage production and
encourage consumption until the excess supply is eliminated. Alternatively, excess demand
will lead to price increases, which encourage consumers to economize on their uses of the
good and suppliers to produce more of it, eliminating the excess demand. Changing market
prices induce responses on both sides of the market that will correct imbalances.

3. Market prices motivate economic players. Market prices establish a reward–
penalty (profit–loss) structure that encourages people to work, cooperate with others, use
efficient production methods, supply goods that are intensely desired by others, and invest for
the future. Self-interested entrepreneurs will seek to produce only the goods consumers value
enough to pay a price sufficient to cover production cost. Self-interest will also encourage pro-
ducers to use efficient production methods and adopt cost-saving technologies because lower
costs will mean greater profits. Firms that fail to do so will be unable to compete successfully
in the marketplace.

At the beginning of this chapter, we asked you to reflect on why the grocery stores
in your local community generally have on hand about the right amount of milk, bread,
vegetables, and other goods. Likewise, how is it that refrigerators, automobiles, and CD
players, produced at different places around the world, make their way to stores near you
in approximately the same numbers that they are demanded by consumers? The invisible
hand principle provides the answer, and it leads to an amazing degree of social cooperation.

Is the concept of the invisible hand really valid? Next time you sit down to have a nice
dinner, think about all the people who help make it possible. It is unlikely that any of them,
from the farmer to the truck driver to the grocer, was motivated by a concern that you have
an enjoyable meal. Market prices, however, bring their interest into harmony with yours.
Farmers who raise the best beef or turkeys receive higher prices, truck drivers and grocers
earn more money if their products are delivered fresh and in good condition, and so on. An
amazing degree of cooperation and order is created by market exchanges—all without the
central direction of any government official.

3-6c coMpetition and property riGhts
As we noted earlier in this chapter, our focus so far has been on markets in which rival
firms can freely enter and exit, and private-property rights are clearly defined and enforced.
The efficiency of market organization is, in fact, dependent upon these two things:
(1) competitive markets and (2) well-defined and enforced private-property rights.

53538_ch03_rev03.indd 65 17/12/13 5:03 PM

66 part 2 Markets and GovernMent

●● The law of demand states that there is an inverse (or negative) rela-
tionship between the price of a good or service and the quantity of
it that consumers are willing to purchase. The height of the demand
curve at any quantity shows the maximum price that consumers are
willing to pay for that unit.

●● The degree of responsiveness of consumer purchases to a change
in price is shown by the steepness of the demand curve. The
more responsive buyers are to a change in price, the flatter, or
more elastic, the demand curve will be. Conversely, the less re-
sponsive buyers are to a change in price, the steeper, or more
inelastic, the demand curve will be.

●● A movement along a demand curve is called a change in quantity
demanded. A shift of the entire curve is called a change in demand.
A change in quantity demanded is caused by a change in the price
of the good (generally in response to a shift of the supply curve). A
change in demand can be caused by several things, including a change
in consumer income or a change in the price of a closely related good.

●● The opportunity cost of producing a good is equal to the cost
incurred by bidding the required resources away from alternative
uses. Profit indicates that the producer has increased the value of
the resources used, whereas a loss indicates that the producer has
reduced the value of the resources used.

●● The law of supply states that there is a direct (or positive) relation-
ship between the price of a good or service and the quantity of it that
producers are willing to supply. The height of the supply curve at
any quantity shows the minimum price necessary to induce suppli-
ers to produce that unit—that is, the opportunity cost of producing it.

●● A movement along a supply curve is called a change in quantity
supplied. A change in quantity supplied is caused by a change in
the price of the good (generally in response to a shift of the de-
mand curve). A shift of the entire supply curve is called a change in
supply. A change in supply can be caused by several factors, such
as a change in resource prices or an improvement in technology.

●● The responsiveness of supply to a change in price is shown by
the steepness of the supply curve. The more willing producers
are to alter the quantity supplied in response to a change in price,
the flatter, or more elastic, the supply curve. Conversely, the less
willing producers are to alter the quantity supplied in response
to a change in price, the steeper, or less elastic, the supply curve.

●● Prices bring the conflicting forces of supply and demand into bal-
ance. There is an automatic tendency for market prices to move
toward the equilibrium price, at which the quantity demanded
equals the quantity supplied.

●● Consumer surplus represents the net gain to buyers from market
trades. Producer surplus represents the net gain to producers and re-
source suppliers from market trades. In equilibrium, competitive mar-
kets maximize these gains, a condition known as economic efficiency.

●● Changes in the prices of goods are caused by changes in sup-
ply and demand. An increase in demand will cause the price and
quantity supplied to rise. Conversely, a decrease in demand will
cause the price and quantity supplied to fall. An increase in sup-
ply, however, will cause the price to fall and quantity demanded
to rise. Conversely, a decrease in supply will cause the price to
rise and quantity demanded to fall.

k e y p o i n t s

Competition, the great regulator, can protect both buyer and seller. It protects consum-
ers from sellers who would charge a price substantially above the cost of production or
withhold a vital resource for an exorbitant amount of money. Similarly, it protects employ-
ees (sellers of their labor) from the power of any single employer (the buyers of labor).
When markets are competitive, both buyers and sellers have alternatives and these alterna-
tives provide them with protection against ill treatment by others.

When property rights are well defined, secure, and tradable, suppliers of goods and
services have to pay resource owners for their use. They will not be permitted to seize and
use scarce resources without compensating the owners. Neither will they be permitted to
use violence (for example, to attack or invade the property of another) to get what they
want. The efficiency of markets hinges on the presence of property rights—after all, people
can’t easily exchange or compete for things they don’t have or can’t get property rights to.
Without well-defined property rights, markets simply cannot function effectively.

LooKing AHeAd Although we incorporated numerous examples designed to enhance your understanding of the
supply-and-demand model throughout this chapter, we have only touched the surface. in various
modified forms, this model is the central tool of economics. The next chapter will explore several
specific applications and extensions of this important model.

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chapter 3 deMand, suPPly, and the Market ProCess 67

c r i t i c a l a n a l y s i s Q u e s t i o n s

1. *Which of the following do you think would lead to an in-
crease in the current demand for beef?

a. higher pork prices

b. higher consumer income

c. higher prices of feed grains used to feed cattle

d. widespread outbreak of mad cow or hoof-and-mouth
disease

e. an increase in the price of beef

2. What is being held constant when a demand curve for a spe-
cific product (shoes or apples, for example) is constructed?
Explain why the demand curve for a product slopes down-
ward to the right.

3. What is the law of supply? How many of the following
“goods” do you think conform to the general law of supply?
Explain your answer in each case.

a. gasoline

b. cheating on exams

c. political favors from legislators

d. the services of heart specialists

e. children

f. legal divorces

4. *Are prices an accurate measure of a good’s total value?
Are prices an accurate measure of a good’s marginal value?
What’s the difference? Can you think of a good that has high
total value but low marginal value? Use this concept to ex-
plain why professional wrestlers earn more than nurses, de-
spite the fact that it is virtually certain that nurses create more
total value for society than do wrestlers.

5. What is being held constant when the supply curve is con-
structed for a specific good like pizza or automobiles? Ex-
plain why the supply curve for a good slopes upward to the
right.

6. Define consumer surplus and producer surplus. What is
meant by economic efficiency, and how does it relate to the
gains of consumers and producers?

7. How is the market price of a good determined? When the mar-
ket for a product is in equilibrium, how will consumers value an
additional unit compared to the opportunity cost of producing
that unit? Why is this important?

8. *“The future of our industrial strength cannot be left to
chance. Somebody has to develop notions about which in-
dustries are winners and which are losers.” Is this statement
by a newspaper columnist true? Who is the “somebody”?

9. What factors determine the cost of producing a good or ser-
vice? Will producers continue to supply a good or service if
consumers are unwilling to pay a price sufficient to cover
the cost?

10. *“Production should be for people and not for profit.” Answer
the following questions concerning this statement:

a. If production is profitable, are people helped or harmed?
Explain.

b. Are people helped more if production results in a loss than
if it leads to profit? Is there a conflict between production
for people and production for profit?

11. What must an entrepreneur do to earn a profit? How do the
actions of firms earning profits influence the value of resources?
What happens to the value of resources when losses are pres-
ent? If a firm making losses goes out of business, is this bad?
Why or why not?

12. *What’s wrong with this way of thinking? “Economists claim
that when the price of something goes up, producers increase
the quantity supplied to the market. But last year, the price
of oranges was really high and the supply of them was really
low. Economists are wrong!”

13. What is the invisible hand principle? Does it indicate that
self-interested behavior within markets will result in actions
that are beneficial to others? What conditions are necessary
for the invisible hand to work well? Why are these conditions
important?

14. What’s wrong with this way of thinking? “Economists argue
that lower prices will result in fewer units being supplied.
However, there are exceptions to this rule. For example, in
1972, a very simple 10-digit electronic calculator sold for
$120. By 2000, the price of the same type of calculator had
declined to less than $5. Yet business firms produced and sold
many more calculators in 2000 than they did in 1972. Lower
prices did not result in less production or in a decline in the
number of calculators supplied.”

15. What is the difference between substitutes and comple-
ments? Indicate two goods that are substitutes for each
other. Indicate two goods that are complements.

16. Do business firms operating in competitive markets have a
strong incentive to serve the interest of consumers? Are they
motivated by a strong desire to help consumers? Are “good
intentions” necessary if individuals are going to engage in
actions that are helpful to others? Discuss.

*Asterisk denotes questions for which answers are given in Appendix B.

●● Market prices communicate information, coordinate the ac-
tions of buyers and sellers, and motivate decision makers to
act. As the invisible hand principle indicates, market prices
are generally able to bring the self-interest of individuals into

harmony with the general welfare of society. The efficiency of
the system is dependent upon two things, however: (1) com-
petitive market conditions and (2) well-defined and secure
property rights.

53538_ch03_rev03.indd 67 17/12/13 5:03 PM

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