How the Market System Works

Study Questions

1. What is the law of demand? 2. What is the law of supply? 3. How does a market achieve

equilibrium? 4. What causes buyers to change their

demand behavior?

Study Questions

5. What causes sellers (producers) to change their supply behavior?

6. What causes the price of a good to change?

7. What happens when government imposes a price on the market?

Trade

Everyone specializes in making one good We make an amount available for sale We receive income from the sale We buy goods we want from other

specialists

Types of Trade

Simple tradebarter

Modern tradeuse money as a medium of exchange

What is a Market?Any Place Where Goods and Services are

Voluntarily Exchanged (brings together buyers and sellers)Price is a primary influence in determining

allocation of resources in our free enterprise economy.

Difference between Price, Value, UtilityPrice= value of product in terms of moneyValue= has to do with relative scarcity =

exchange valueUtility = satisfaction that good or service can

provide

Buyers

Those willing and able to exchange money for goods they will buy if they perceive themselves to be

better off after the sale

Sellers

Those willing and able to produce goods and exchange them for money they will sell if they perceive themselves to be

better off after the sale

Mutually Agreeable Trade

Both buyer and seller perceive that they will be better off after the trade is made than they were before

Both trade a good that has lower value (to them) for a good that has higher value (to them)

Price

The rate of exchange in a trade. Buyer pays the price (buyer’s MC)

it must be less than buyer’s valuation (buyer’s MB)

Seller receives the price (seller’s MB) it must be more than seller’s cost of acquiring

or producing the good (seller’s MC)

How is the Price Set?

Price is determined by the interaction of:buyers’ demand behavior, andsellers’ supply behavior.

Law of Supply

As the price of the product increases, the quantity that the supplier tends to supply also increases.

****Ceteris Paribus Ceteris Paribus Assumption[KAY-ter-us PEAR-uh-bus]

Nothing changes except the factor or factors being studied.

Other things “constant” “equal”

Economics as a Science

Ceteris Paribus Assumption[KAY-ter-us PEAR-uh-bus]

Nothing changes except the factor or factors being studied.

“Other things constant”

“Other things equal”

Law of supply

= positive relationship between the quantity of a good supplied and price.

PRICE IS THE INDEPENDENT VARIABLE

Determinants of Supply

1. Technique of production (technology)(ovens, organic farming)

2. Resource Prices (Factor Costs)– cost of inputs3. Taxes and Subsidies4. Prices of Other Goods – (decline in wheat will

cause farmer to shift to corn)5. Expectations- (farmers expect price to rise..

Hold back production)6. Number of sellers in market – more sellers,

greater supply….

Important Concepts

Change in Supply (shifting of curve)

Or

Change in Quantity Supplied (movement along curve)

Ability to Respond to Price varies

Often the ability of an individual firm to respond to an increase in price is limited or constrained by its existing scale of operations, or capacity, or ability to obtain resources….. IN SHORT RUNIN SHORT RUN

Examples:IN LONG RUNIN LONG RUN… can adjust. The greater

the amount of time producers have to adjust, the greater their output response.

Law of Demand

AS THE PRICE OF A GOOD DECREASES THE QUANTITY DEMANDED TENDS TO INCREASE….

***Ceteris Paribus

Price once again is the independent variable!

Wishing for a new boat does not constitute demand… one must be WILLING AND ABLE to purchase a boat.

Generally speaking…. The higher the price obstacle, the less of a product a consumers will buy.

Bargain days are based on law of demand.

The greater the want satisfaction…. The greater the utility…

Marginal Utility… How much more utility do you get adding or subtracting units (more doughnuts… more cars… more steak in one day)

DIMINISHING MARGINAL UTILITY.As the number of units of a product a

consumer has increases, the satisfying power for each extra unit decreases.

Utility

Purpose of Utility analysis is to study how people behave not how they think.

Theory of consumer choice is based on the idea that each consumer spends his/her income in a way that yields the greatest satisfaction.

Determinants of Demand

1.Preferences

2.Prices of Related Goods

3.Number of Buyers

4.Expectations of future price

5.Income

Determinants of Demand

1. Tastes and preferencesTaste changes throughout our lifetime.

# 2 Determinant: Prices of Related Goods

Your preference is Coke… price skyrockets….

Affected in the market by substitute goods and complimentary goods.*Substitute goods… anything that can be substituted for the product or service desired…

(Coke/Pepsi, Millers/Coors, potato chips/popcorn). If price of Coke rises… and consumer doesn’t feel strongly

about brand preference… will buy Pepsi until Coke price declines)

When two products are substitutes, the price of one good and the demand for the other are DIRECTLY RELATED.

*Complementary Goods… Goods that “go along with other goods consumer’s buy”

peanut butter/jelly, beer/pretzels, milk/cookies, golf balls/golf tees,

When two goods are complements, an increase in the price of one good adversely affects the demand for the other and creates an inverse relationship.

Independent Goods… No connection between price and demand (cars/bread)

Determinants Continued

3. Number of buyers

The number of buyers will increase demand for the product which (if supply is fixed) will drive up the price.)

Determinant #4

Income- RATHER OBVIOUS HERE.Show shifts…

Superior or Normal goods= commodities whose demand varies DIRECTLY with money income.

INFERIOR OR “POOR MAN’S” GOODS.Goods whose demand varies inversely with a

change in money income.

5. Expectations…

If you are in medical school or law school, the expectation of you getting a larger income when you get out of school will affect your demand for goods… Inheriting money, winning the lottery!

IMPORTANT CONCEPTS OF DEMAND

Change in Demand

OR

Change in Quantity Demanded

Terms to RememberProfit:

TR-TCTotal Revenue

P x QMarginal Utility

To maximize utility, consumers should choose that good which delivers the most marginal utility per dollar. Optimal utility is then achieved.

Optimal consumption= mix of output that maximizes total utility for the limited amount of income you have to spend.

Figure 2-1. Law of Demand

P Q As price rises, quantity demanded falls

P Q As price falls, quantity demanded rises

Table Graph

P Q

9 2

7 6

5 10

3 14

P

Q

D

Buyers’ Demand Behavior

Income effect: if price rises and your income does not, you

can not buy as much as you could before if price falls and your income does not, you

can buy more than you could before

Buyers’ Demand Behavior

Substitution effect: if price of good X rises, you switch to lower

price substitute good Y. if price of good X falls, you switch from higher

priced substitute good Z.

Figure 2-2. Law of Supply

P Q As price rises, quantity supplied rises

P Q As price falls, quantity supplied falls

Table Graph

P Q

10 15

8 11

6 7

4 3

P

Q

S

Sellers’ Supply Behavior

Sellers are in business to be profitable: if price rises and sellers’ costs do not, profit

per unit rises, and they want to produce and sell more

if price falls and sellers’ costs do not, profit per unit falls, and they want to produce and sell less

Sellers’ Supply Behavior

Limited Capacity to Expand Production:As output increases, so do costsThus, sellers will only produce more if prices

rise (to cover the added costs)

In Short Run- can not change production drastically.

Creating a Market

Demand curve represents buyers’ current behavior

Supply curve represents sellers’ current behavior

Create a market by letting the demand curve and the supply curve intersect

Figure 2-3. Making a Market

Buyer behavior (demand) and seller behavior (supply) intersect.

Q

P

D

S

Pe

Qe

Three Starting Possibilities

Price starts out too highsurplus situation

Price starts out too lowshortage situation

Price starts out just rightequilibrium situation

Figure 2-4. Surplus

Price is too high. Quantity supplied

(Qs) exceeds quantity demanded (Qd).

Qs > Qd Price will fall to Pe.

Q

P

D

S

Pe

Qe

Phigh

Qd Qs

surplus

Figure 2-5. Shortage

Price is too low. Quantity demanded

(Qd) exceeds quantity supplied (Qs)

Qd > Qs Price will rise to Pe.

Q

P

D

S

Pe

Qe

Plow

Qs Qd

shortage

Figure 2-6. Equilibrium

No shortage. No surplus. Qd = Qs = Qe. The price will not rise

or fall until there is a shift in demand or in supply.

Q

P

D

S

Pe

Qe

How Do Prices Change?

In an equilibrium market, price will not change.

If order to get price to change, a market must go into disequilibrium.Either demand behavior changes, orSupply behavior changes, or both.

Figure 2-7. Demand increases

Demand shifts right. Old equilibrium is upset:

Shortage. A new equilibrium is

established. Price rises from P1 to P2.

Quantity rises from Q1 to Q2

D1

Q

P S

P1

Q1

D2

P2

Q2

Figure 2-8. Demand decreases

Demand shifts left. Old equilibrium is

upset: Surplus. A new equilibrium is

established. Price falls from P1 to

P2. Quantity falls from Q1

to Q2 Q

P

D1

S

P1

Q1

D2

P2

Q2

Figure 2-9. Supply increases

Supply shifts right. Old equilibrium is

upset: Surplus. A new equilibrium is

established. Price falls from P1 to

P2. Quantity rises from Q1

to Q2. Q

P

D

S1

P1

Q1

S2

P2

Q2

Figure 2-10. Supply decreases

Supply shifts left. Old equilibrium is

upset: Shortage. A new equilibrium is

established. Price rises from P1 to

P2. Quantity falls from Q1

to Q2.Q

P

D

S1

P1

Q1

S2

P2

Q2

Figure 2-11. Demand increases and Supply decreases 1. Demand shifts

right. 2. Supply shifts left.. A new equilibrium is

established. Price rises from P1 to

P2.

Quantity moves to Q2

D1

Q

P S1

P1

Q1

D2

P2

Q2

1

S2

2

Demand increasesP increasesQ increases

Supply increasesP decreasesQ increases

Demand decreasesP decreasesQ decreases

Supply decreasesP increasesQ decreases

P P

P P

Q

Q

Q

Q

This summarizes how equilibrium P and equilibrium Qchange as demand increases (decreases) and assupply increases (decreases)

What if…?

One seller sets a higher price than the equilibrium price?customers will shun him until goods selling at

the equilibrium price are all gone

What if…?

One seller sets his price below equilibrium price?he will sell out first.but he could have sold everything at the

higher equilibrium price.

What if…?

Government sets the price? Price controls.

no longer a free marketcommand dictator system is at workTwo kinds:

price ceiling price floor

Figure 2-12. Price Ceiling

Government sets a maximum legal pricePurpose: to help the buyersP < PePersistent shortage

P

Q

D

S

ceilingPe

P

Qs Qdshortage

Highest legalprice

Figure 2-13. Price Floor

Government sets a minimum legal pricePurpose: to help the sellersP > PePersistent surplusLowest legal

price

P

Q

D

S

floorPe

P

QsQd

surplus

What if…?

Government controls quantity, not price?restricts the amount? Supply shifts left and

price rises. forbids all production? No legal amount is

available. black market arises buyers’ and suppliers’ costs both rise product quality decreases

Which System is Best?

The market system! individual wants and needs more fully satisfied participants compete to acquire purchasing power

rather than political favor scarce resources are directed to produce the most

valued goods and services individuals’ behavior changes are immediately

accommodated

Kiley is my best friend… SheSupplies a lot of love!