3 demand, supply and the market

Full note set with Examples and Questions: http://www.executioncycle.lkblog.com/2012/06/my-business-economics-and-financial.html

Demand, Supply and the Market

Market is any place people come together to trade. Trade or exchange may take place at a physical or

virtual location. In a market economy, the price of a good is determined by the interaction of demand

and supply.

Demand

The willingness and ability of buyers to purchase different quantities of a good at different prices during

a specific time period. [Ceteris paribus]

Demand schedule and curve

A demand schedule is the numerical representation of the law of demand. Curve represents the

graphical representation of the demand schedule and law of demand.

Law of demand

An inverse relationship exists between the price of a good and the quantity demanded in a given

time period, ceteris paribus.

As the price of a good rises, the quantity demanded of the good falls and as the price of a good

falls, the quantity demanded of the good rises [ceteris paribus]

Reasons:

substitution effect

income effect


Determinants of demand

Price of the product

Income

Preferences

Prices of substitute goods

Prices of complementary goods

Expectations of future prices

Other than that growth of population, number of buyers in the market, living standards, advertisements,

age and sex composition in population, etc influence to market demand.

Change in quantity demanded vs. change in demand

Income

Normal Good - A good the demand for which rises (falls) as income rises (falls).

Inferior Good - A good the demand for which falls (rises) as income rises (falls).

Neutral Good - A good the demand for which does not change as income rises or falls.


Substitutes

Substitute goods are two goods that satisfy similar needs or desires.

If two goods are substitutes, the demand for one rises as the price of the other rises (or the

demand for one falls as the price of the other falls).

Complements

Two goods that are used jointly in consumption.

If two goods are complements, the demand for one rises as the price of the other falls (or the

demand for one falls as the price of the other rises).


An Increase in Demand A Decrease in Demand

Price of a substitute rises Price of a complement falls Expected future price rises Income rises (normal good) or income falls (inferior good) Preferences move toward the good Population increases

Price of a substitute falls Price of a complement rises Expected future price falls Income falls (normal good) or income rises (inferior good) Preferences move away from the good Population falls.

Market demand is the horizontal summation of individual consumer demand curves


Supply

Supply refers to the willingness and ability of sellers to produce and offer to sell different quantities of a

good at different prices during a specific time period.

Law of supply - As the price of a good rises, the quantity supplied of the good rises, and as the price of a

good falls, the quantity supplied of the good falls, ceteris paribus.

The law of supply is the result of the law of increasing cost.

As the quantity of a goods produced rises, the marginal opportunity cost rises.

Sellers will only produce and sell an additional unit of a good if the price rise above the

marginal opportunity cost of producing the additional unit.

Fixed Supply

Determinants of supply

Price of relevant product [Change in the quantity supplied]

Prices of relevant resources

Technology

Number of sellers

Expectation of future prices

Taxes and subsidies

Government restrictions

The only factor that can directly cause a change in the quantity supplied of a good is a change in the

price of the good or own price.


An Increase in Supply A Decrease in Supply

Price of inputs fall More efficient technology Expected future price fall (i.e. natural resource production) Firms grow in size Number of firms in the industry grows

Price of inputs rise Expected future price rise (natural resources) Loss of technological knowledge Firms decline in size Number of firms in the industry shrinks

Market equilibrium Equilibrium in a market is the price quantity combination from which there is no tendency for buyers or

sellers to move away. Graphically, equilibrium is the intersection point of the supply and demand

curves.


Consumer and Producer Surplus

Consumer Surplus (the difference between the maximum price a buyer is willing and able to pay for a

good or service and the price actually paid.)

𝐶𝑆 = 𝑀𝑎𝑥𝑖𝑚𝑢𝑚 𝑏𝑢𝑦𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 − 𝑃𝑟𝑖𝑐𝑒 𝑝𝑎𝑖𝑑

Producer Surplus (the difference between the price sellers receive for a good and the minimum or

lowest price for which they would have sold the good.)

𝑃𝑆 = 𝑃𝑟𝑖𝑐𝑒 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑑 − 𝑀𝑖𝑛𝑖𝑚𝑢𝑚 𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒


Equilibrium Price and Quantity Demand rises (Effects of Supply and Demand Curve Shifts)


Demand and Supply as Equations

We can write Q-demanded and Q-Supplied as a equation of P (Price). And we can solve these to get

supply/demand for a specific prize and get the equilibrium price (as Qd =Qs at equilibrium)

Price Controls

Price Ceiling - A government-mandated maximum price above which legal trades cannot be made. A

price at or below the ceiling is legal.

To protect the consumers.

Put to essential goods.

Government has to establish some formal system to distribute the excess supply. Otherwise it will lead

to black market.


Price Floor - A government-mandated minimum price below which legal trades cannot be made. A price

at or above the price floor is legal.

Government has to buy the excess otherwise higher price prompts imports of goods and inefficiencies in

allocation of resources.

Elasticity

When price rises, what happens to demand? Demand falls BUT! How much does demand fall?

Elasticity measures the extent to which demand will change

Four basic types used:

Price elasticity of demand

Price elasticity of supply

Income elasticity of demand

Cross elasticity


Price Elasticity of Demand

Where % change in demand is greater than % change in price – elastic

Where % change in demand is less than % change in price - inelastic

Income and Cross Elasticity of Demand

Income Elasticity of Demand:

A positive sign denotes a normal good

A negative sign denotes an inferior good


Cross Elasticity:

The responsiveness of demand of one good to changes in the price of a related good – either a

substitute or a complement

Goods that are complements: Cross Elasticity will have negative sign (inverse relationship)

Goods that are substitutes: Cross Elasticity will have a positive sign (positive relationship)

Importance of Elasticity

Relationship between changes in price and total revenue

Importance in determining what goods to tax (tax revenue)

Importance in analyzing time lags in production

Influences the behavior of a firm