Lectures in Economics 7

Lectures following Rüdiger Dornbusch’ works (7)


An example: the shift of the demand curve for tea

When the price of coffee dropped back toward the initial level, accordingly, the quantity demanded increased. The increase in the equilibrium price of coffee should have affected the demands for other goods and thus spread to other markets. We would have expected the demand for tea, which is a substitute for coffee, to shift. The quantity of tea demanded at the given price of tea should have risen. Thus there should have been an increase in the price of tea and an increase in the quantity of tea consumed. In fact, this is what happened. The quantity of tea consumed in the United States in 1977 was slightly higher than the quantity consumed in 1976. The price of tea in 1977 was nearly double the price in 1976.

Thus the increased price of coffee shifted the demand curve for tea, leading to a higher price for tea and a higher quantity demanded.

The other example we will consider involves technological innovation and cost reductions on the supply side that work to shift the supply schedule. We will take the case of digital watches. Table 3-5 shows the relevant data.
The price of digital watches declined from $76 to only $33 between 1975 and 1979. The reduction in price led to an increase in the quantity demanded from 4.2 million watches to 19.7 million. Once again, demand is seen to be responsive to price.
The free market is one method to solve the three basic economic problems What is produced? How? For whom?
This chapter has shown how supply and demand, determine price and output and explain how supply and demand through markets solve economic problems.

In Figure 3-I 1 we show a demand schedule and a supply schedule at point E, the equilibrium price and the equilibrium quantity. The free market “decides” how many of a particular good to produce by price at which the quantity equals the quantity supplied.
FIGURE 3-11 THE FREE MARKET AN BASIC ECONOMIC QUESTIONS. The free market price is P0, and the equilibrium quantity supplied is Qa. Consumers who are able to pay at least Po per unit will receive the output; consumers who are willing to pay 0 receive none.

The quantity amount depends both on the position of the supply schedule and on the position of the demand schedule. If at each price consumers demanded a larger quantity, DD would be located farther to the right, and the equilibrium quantity would be higher. If at each price the quantity supplied were lower, the supply schedule would be farther to the left, and the equilibrium quantity would be lower. Thus the free-market answer to the question of how much of a good to produce is determined by both supply and demand conditions. Other things being equal, more of a good will be produced in market equilibrium the higher the quantity demanded is at each price (the farther to the right the demand schedule) and the higher the quantity supplied at each price (the farther to the right the supply schedule).

The free market tells us for whom the goods are produced. They are produced for all those willing to pay the price Po per unit of the good. The free market also tells us how goods are produced, but to understand the answer to that question we have to learn more about the production side of the economy.

It is worth emphasizing that although the free market solves the basic economic problems, its answers may be controversial. The free market does not provide enough food for everybody to go without hunger, and it does not provide enough medical care for everybody to be healthy. It provides enough food for those willing and able to pay, and it also provides enough medical care for them. The answers given by a free market, therefore, may differ very radically from what society may want to see as an allocation of resources. It is for this reason that government intervention in the free market through regulation, taxation, and the redistribution of income is so pervasive throughout the world.


1 Demand is the quantity ofa good buyers want to buy at each price. The lower the price, the greater the quantity demanded. The demand curve shows graphically the relationship between price and the quantity demanded. It slopes downward.
2 Supply is the quantity of a good sellers want to sell at each price. The higher the price, the larger the quantity supplied. The supply curve shows the relationship between price and the quantity of the good sellers want to sell. It slopes upward.
3 The market clears or is in equilibrium when the price is at the level at which the quantity demanded and the quantity supplied are equal. This is the point at which the demand and supply curves intersect. At prices below the equilibrium price there is an excess demand (or a shortage), and this tends to raise prices. At prices above the equilibrium price there is an excess supply (or a surplus), and this tends to cause prices to fall. Thus in a free market, prices tend to move toward the equilibrium level.
4 The factors that are assumed to be constant along a given demand curve are the prices of related goods, consumer income, and consumer tastes and habits.

5 An increase in the price of a substitute will increase the quantity of a good demanded at each price, and an increase in the complement will reduce the quantity demanded. An increased income increases the demand for the good if the good is normal, an increase in income reduces the demand for a good, if the good is inferior.
6 The main factors determining the position of the supply: technology, input costs, and government regulation and taxes: increase in input costs will reduce the quantity supplied. Any factor increasing demand causes the demand curve to move to the right and increases both the price and the quantity being sold. Any factor reducing supply causes the supply curve to move to the left, increasing price and reducing the quantity bought.

Demand Supply
Quantity demanded
Quantity supplied Equilibrium price
Excess demand (shortage) Excess supply (surplus) Equilibrium quantity, Substitute,
Normal goods, Inferior goods,
Shift of demand curve. Shift of supply curve,
Free market Price controls
Floor price
Ceiling price
Movement along demand curve


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