Chapter 4: The Market Forces of Supply and Demand

4-1: Markets and Competition

What is a Market?

  • Market: The buyers and sellers of a good or service
    • Buyers determine demand, sellers determine demand
    • Markets can be organized or disorganized
      • Crop market is organized; sellers meet together and determine how much supply there is while buyers gather and auction for goods
      • Smaller, local markets (say, ice cream) are unorganized; ice cream stores are not in contact with each other and buyers don’t meet

What is Competition?

  • Prices are determined by the entire market, as everyone is competing with each other
  • Competitive Market: A market with enough participants (buyers and sellers) that no one individual has a significant impact on the market
    • For this chapter, markets are assumed to be perfectly competitive; all sold goods are exactly the same, and there are enough buyers and sellers that no one can influence the market heavily
    • Buyers and sellers are price takers; they can buy and sell as much as they want but only at the market price
    • Easy entry and exit from the industry in the long-run
  • Many markets are (nearly) perfectly competitive, but some have only one seller, leading to a monopoly

4-2: Demand

The Demand Curve: The Relationship between Price and Quantity Demanded

  • Quantity Demanded: The amount of a good/service that buyers are willing and able to purchase
    • Many factors can affect quantity demanded, but the assumed, simplified market will focus on one: price
    • Law of Demand: Considering everything else equal, price and demand are inverse; when price rises, demand lowers, and vice versa
    • Graphical representation: Screen Shot 2022-10-02 at 10 31 19 PM
    • Above table is an example of a demand schedule, or a table that shows the relationship between price and quantity demanded
    • The graph shown is known as the demand curve which also shows the relationship between price and quantity demanded; typically slopes downwards

Market Demand versus Individual Demand

  • Market Demand is the sum of all of the individual demands for a good or service
    • Example of creating a market demand curve from two individual demand curves: Screen Shot 2022-10-02 at 10 37 50 PM

Shifts in the Demand Curve

  • Income
    • Lower income means that a demand curve falls, as there is less money to spend
    • Normal good: A good whose demand falls when income falls
    • Inferior good: A good whose demand increases when income falls (such as public transportation)
  • Prices of Related Goods
    • Substitutes: Two or more goods that are similar enough to be affected by each otehrs prices
      • If the cost of ice cream goes down, then the demand for frozen yogurt goes down too (because froyo is more expensive and fairly similar)
    • Complements: Two or more goods that will go up or down in demand together depending on their prices
      • If the price of tapioca pearls lowers, then the demand for both pearls and tea will increase
  • Tastes
    • Depending on your tastes, you may buy more or less of a good/service; hard to explain and unscientific
  • Expectations
    • What you expect to happen can affect your behavior; if you think a disaster will occur, you’re more willing to buy more survival goods and less willing to buy unnecessary goods
  • Number of Buyers
    • Adding buyers increases demand and lowering buyers decreases demand

Additional Notes

  • The relationship between demand and quantity demanded is negative for two reasons
    • Substitution effect: When the price of a good goes up, consumers substitute it by buying similar products instead
    • Income effect: When the price of a good goes up, consumers’ purchasing power goes down, and the consumer buys less of the good but more of other goods
  • Law of Diminishing Marginal Utility: The idea that each additional unit of a good that you receive becomes lower in value (or utility) as you receive more
    • Indifference Curve: A curve showing the relationship between two goods that a consumer needs/likes; takes the shape of 1/x and is convex

4-3: Supply

The Supply Curve: The Relationship between Price and Quantity Supplied

  • Quantity Supplied: The amount of a good/service that sellers are willing and able to sell
    • A big determinant is price; when price of ice cream is high, the quantity supplied increases (because sellers want to make a higher profit) and vice versa
    • Law of Supply: Considering everything else equal, price and supply are related; when price rises, supply increases, and vice versa
    • Graphical Representation: Screen Shot 2022-10-02 at 10 51 48 PM
    • Above table is an example of a supply schedule, or a table that shows the relationship between price and quantity supplied
    • The graph shown is known as the supply curve which also shows the relationship between price and quantity supply; typically slopes upwards

Market Supply versus Individual Supply

  • Market supply is the sum of all individual supplies

Shifts in the Supply Curve

  • Input Prices
    • The price of the inputs to make a good/service (ingredients, machinery, manpower) affects the quantity supplied
    • Increase in input price lowers quantity supplied and vice versa
  • Technology
    • Advancements in technology increases the quantity supplied because it becomes cheaper/faster to produce
  • Expectations
    • A firm that expects the popularity of a good/service to rise may produce more of it, and vice versa
    • If the price is expected to decrease, firms will supply more
  • Number of sellers
    • More sellers = more quantity supplied, and vice versa

4-4: Supply and Demand Together

Equilibrium

  • When a supply curve and demand curve are graphed together, there is a singular point of interception
    • That point is called the equilibrium, with the price representing the equilibrium price and the quantity representing the equilibrium quantity
    • Equilibrium point is in perfect balance; the quantity and price is the same that the buyers demand and the sellers supply
  • Naturally, prices and quantity move towards the equilibrium point
    • If there is too much supply compared to demand, then there is a surplus and sellers cannot sell their goods at the current price
      • Sellers have too much supply; begin to cut prices, thus increasing demand, lowering prices, and moving towards equilibrium
    • If there is too much demand compared to supply, then there is a shortage and buyers cannot buy the goods they want due to a lack of availability
      • Sellers are enabled to raise prices, thus lowering demand, increasing prices, and moving towards equilibrium

Screen Shot 2022-10-02 at 11 03 48 PM

  • Theory of equilibrium leads to Law of Supply and Demand: the price of a good naturally adjusts to bring the quantity supplied and quantity demanded into balance

Three Steps to Analyzing Changes in Equilibrium

  • Must analyze events which affect equilibriums with three steps
    • Does it change the supply curve, demand curve, or both?
    • Does it shift the curve to the left or right?
    • Compare the supply-and-demand diagrams to see how the shift affected the equilibrium point
  • Example: A Change in Market Equilibrium Due to a Shift in Demand
    • One summer, it is more hot than usual
      • Hot weather increases demand for ice cream but does not change supply curve
      • More demand shifts the demand curve to the right
      • Demand curve now meets the supply curve at a higher price and quantity
  • Shifts in Curves versus Movements along Curves
    • In the last example, the actual supply curve didn’t move; instead, the equilibrium point moved upwards along the curve
    • A shift in the supply/demand curve is called a “change” while a movement along the supply/demand curve is called a “change in the quantity supplied/demanded”
  • Example: A Change in Market Equilibrium Due to a Shift in Supply
    • One summer, a hurricane destroys a sugarcane crop, increasing the price of sugar
      • Raise in input costs leads to a reduction in the amount of ice cream produced
      • Less supply shifts the supply curve to the left
      • There is now a shortage of ice cream, and the equilibrium point moves left along the demand curve
  • Example: Shifts in Both Supply and Demand
    • Let’s say that the hot weather and hurricane occurred in the same summer
      • Both curves shift; the demand increases because of the heat, and the supply decreases because of a higher input cost
      • Demand curve shifts to the right, and supply curve shifts to the left
      • Depending on the size of the shifts, there are two possible outcomes, but both result in an increase in equilibrium price

Screen Shot 2022-10-02 at 11 17 21 PM

  • Discussion Notes:
    • Price typically falls on the y axis, and quantity falls on the x axis
    • Total revenue (p x q) follows a parabolic shape (goes up, plateaus, then goes down)
    • Elasticity: The change in price divided by the change in quantity; %deltaQ/%deltaP
      • Typically calculated using derivatives, but can use a midpoint formula
        • ∣Q2−Q1(Q1+Q2)/2P2−P1(P1+P2)/2∣| { {Q_2 - Q_1 \over (Q_1 + Q_2) / 2} \over {P_2 - P_1 \over (P_1 + P_2) / 2} } |
      • Unit elastic is when your elasticity is equal to 1; over 1 is elastic, and under 1 is inelastic
      • Goods with substitutes are usually elastic, while necessities are inelastic
      • Decrease in price of an elastic good will increase revenue, while a decrease in price of an inelastic good will decrease revenue
  • Lecture Notes:
    • Supply curves should start above (0, 0) because companies need to cover fixed costs
    • Regular equations for curves start with Q (Q = mP + b), but if P is on the left, then it is called inverse demand/supply