Supply, Demand, and the Market Process
Demand - The Consumers
1. Demand Schedule - shows the quantity and price of a good, which consumers are willing to buy, ceteris
- Note - demand has a time unit!
- Demand curve is a graph of the demand
|Buyer's demand for coffee (per year)|
($ per pound)
|Buyer's Demand Curve|
- Law of Demand - as the market price increases, the quantity demanded for a good decreases, ceteris
- Common sense
- When products are expensive, people buy less
- The principle behind business discounts
- Law of Diminishing Marginal Utility - consuming additional units of a good yield less and less additional utility i.e. satisfaction.
- Example: Hypothetical case for pizza
- utils are fictional units for satisfaction
- 1st slice, a person receives 100 utils (lots of satisfaction), so he values it at $5 per slice.
- 2nd slice, a person receives 20 utils (some gain in utility), so he values it at $3 per slice.
- 3rd slice, a person receives 5 utils (very little gain in utility), so he values it at $1 per slice.
- Total utility = 125 utils; total spent = $9 for 3 slices of pizza
- Composed of two effects.
- Income effect - as a product's price decreases, a constant income buys more
- Example: Monthly income is $1,000 and price of beef decreased
- Income effect - you can buy more beef with fixed income
- Substitution effect - as price of a product decreases, people start buying it and “substitute away” from more expensive, similar goods.
- Price change affects consumer's behavior
- Example: As the price decreases for Coca-Cola relative to Pepsi, people substitute Coke for Pepsi
2. Market Demand Function
- Two people are in the market.
- Each person has their demand function.
- The quantity denoted by q is for a person, while Q is the total market quantity.
- Likewise, demand by a consumer is denoted by d, while market demand is D.
- Market demand - at each market price, horizontally sum the quantity that each consumer buys.
Changes in Demand Versus Changes in Quantity Demanded
|1. "Change in Demand" - the demand curve shifts. Shift curves only "left" or "right." Do not think of shifting curves "up" or "down."
"Change in Quantity Demanded" - movement along the same demand curve, because the price changed.
|Movement along Demand Curve|
2. Shifting the demand curve to the right; demand increases
- Normal good - as income increases, people have more money, and buy more, ceteris paribus
- Inferior good - as income decreases, people have less money and buy more inferior goods, ceteris paribus
- Number of consumers increases
- More people in the market to buy goods, ceteris paribus
- Price of other goods
- Substitute good's price increases
- The price of DVD's increases, therefore, the demand increases for VCR tapes, ceteris paribus
- Complement good's price decreases
- The price of DVD's decreases, therefore, the demand for DVD players increases, ceteris paribus
- Expectations - consumer expectations of future prices, future availability, or future income.
- During 1999 people believed widespread water shortages would occur from Y2K. Thus, demand for water increased during 1999, ceteris paribus.
- Demographic changes - population of infants is greatly increasing, demand increases for baby goods, ceteris paribus.
- Changes in consumer tastes and preferences - for example, a report stated coffee reduced colon cancer, demand for coffee increases, ceteris paribus.
- Weather - if the summer is very hot, then people drink more Pepsi, ceteris paribus
||If the opposite occurs, then the demand curves will shift left, i.e. decrease.
Supply - The Producers
1. Opportunity cost of production -all production costs are opportunity costs. The labor, machines, and other resources could produce other goods.
Profits = Total Revenue - Total Costs
- Role of Profits and Losses
- Profit: Total revenue > total cost
- Consumer's value > resource value
- Industry expands
- Loss: Total revenue < total cost
- Consumer's value < resource value
- Industry contracts
- Resources should be used to produce something else
- Supply schedule - shows the quantity and price of a good that firms are willing to produce/sell, ceteris paribus. A supply curve is a graph of the supply schedule.
- Law of Supply - as the good's price increases, then quality supplied increases, ceteris paribus.
- As the price increases, the producers receive more revenue.
- Note - as production increases, then production costs may increase. The higher price off-sets the additional production costs.
- Note - the supply schedule has a time unit
|Farmers' Supply of Tomatoes (per week)|
($ per pound)
2. The short-run market supply is the horizontal sum of the all firms' short-run supply curves. (Just like the demand curve). Market supply is derived from two firms below:
Changes in Supply Versus Changes in Quantity Supplied
1. "Change in Supply" - entire supply curve shifts. Shift curves only "left" or "right." Do not think of shifting curves "up" or "down."
"Change in Quantity Supplied" - movement along the same supply curve in response to a price change.
|Movement along Supply Curve|
2. Shifting the supply curve to the right; supply increases.
- Resource prices
- Labor wages or resource materials' price decreases, firms can supply more because of lower production costs
- Technological advances
- Technology allows firms to produce more output, using the same levels of resources
- Nature and political disruptions
- Favorable weather for growing crops, resolving wars, etc.
- Decrease in taxes or increase government subsidies
- Decrease business cost and firms can provide more at each price
- Price of other goods
- Price for corn increases, so non-corn farmers start growing corn
- Producer's expectations of future prices.
- Firms expect sugar prices to be higher next year. Some firms hoard sugar now, and sell the supply of sugar for next year
- Number of sellers
- More sellers in the market means more is produced
||If the opposite occurs, then the supply curves will shift left, i.e. decrease.|
How Market Prices Are Determined
- Market - an institution that brings buyers and sellers together for specific goods and services.
- New York Stock Exchange - market for buyers and sellers of stock for well-known corporations
- Foreign currency market
- Commodity market
- The markets are perfectly competitive, i.e. large number of independent buyers and sellers
- No government intervention
- Perfect knowledge of prices
- Equilibrium - a state of rest; market price and quantity do not change
- Equilibrium price - market price where the forces of supply and demand are equal
- Equilibrium quantity - market quantity where the forces of supply and demand are equal
|The Market for Potato Chips|
- At $2, quantity supplied = quantity demanded:
- Equilibrium price = $2
- Equilibrium quantity = 10 units
- At $3, quantity supplied > quantity demanded:
- Suppliers have to much product, so price falls until it equals $2
- At $1 , quantity supplied < quantity demanded:
- Consumers demand more than what is in stock, so they bid prices up until it equals $2
How Markets Respond to Changes in Supply and Demand
- Price of chicken increases (Substitute)
- Demand for beef increases (shifts right)
- Consumers substitute beef for chicken
- Equilibrium price and quantity increase
- Scientists found Nutrasweet causes brain cancer (Tastes and Preferences)
- Demand decreases (shifts left)
- Equilibrium price and quantity decrease
- Technological advances in making computer chips
- Supply increase (shifts right)
- "cheaper computer chips"
- Equilibrium price decreases
- Quantity increases
- Labor unions are successful in raising workers' wages at car factories
- Supply decreases (shifts left)
- Production cost increase
- Equilibrium price increases
- Quantity decreases
Economics of Price Controls
Price controls - government mandated prices. Government thinks price is too high or too low.
1. Price ceilings - a legally established maximum price that sellers may charge.
- Government thinks rent is too expensive. The market price is P*, but the government sets maximum price at P~.
- Rent control price < market rent:
- Direct effect (When P* > P~).
- Quantity demanded (Qd) > quantity supplied (Qs).
- Shortage does not disappear, because of the price control
- Secondary effects of price ceilings.
- Long waiting lists.
- "Under the table" payments to landlord.
- Buying expensive furniture from landlord.
- The lower price (i.e. rent) causes investors to avoid investing in new housing.
- The quality of housing will deteriorate.
- Less maintenance and repairs, which lower costs.
||If P~ > P*, then the price control has no effect on the market.
2. Price Floor - a legally established minimum price that buyers must pay.
- Government thinks workers' wages are too low and set the minimum wage rate to $5.30 per hour (P~).
- Employers demand workers, while employees supply labor.
- Direct effect (When P~ > P*).
- Quantity supplied (Qs) > quantity demanded (Qd).
- i.e. unemployment in this case
|Labor Market (Unskilled workers)|
- Secondary effects of price ceilings.
- Employers reduce the following benefits.
- Health insurance
- Job training
- Pension plans
- Minimum wage usually hurts unskilled labor, the poor, and teenagers.
||If P* > P~ , then the price control has no effect on the market, such as professional jobs which pay more than $5.30 per hour.|
- Black Market - markets that operate outside the legal system
- Also called the hidden economy or underground economy
- Illegal products and services
- Avoid high taxes
- Avoid costly regulations
- Circumvent price controls
- Decline in civic loyalty to government
- Black markets have:
- More defective products
- Higher profits
- Higher risk:
- Court fines and fees
- Jail or prison sentence
- Greater violence from enforcing contracts
- demand schedule
- demand curve
- law of demand
- diminishing marginal utility
- income effect
- substitution effect
- normal goods
- inferior goods
- substitute good
- complement good
- change in demand
- change in quantity demanded
- opportunity cost of production
- supply schedule
- law of supply
- supply curve
- change in supply
- change in quantity supplied
- equilibrium price
- equilibrium quantity
- price ceiling
- price floor
- black markets