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

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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.

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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).

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An Increase 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

A Decrease in Demand 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

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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.

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An Increase 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

A Decrease in Supply 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.

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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.)

= 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.)

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

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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.

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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

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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

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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

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