Chapter 2 - Supply and Demand: How Markets Work Flashcards
Supply and Demand: How Markets Work
Types of goods
- Search goods: qualities of the good can be assessed prior to purchase
- Experience goods: qualities of the good are discovered only after purchase (used car)
- Credence goods: qualities of the good cannot be evaluated in normal use, even after purchase (e.g. health care, repair services, legal and financial advice)
- Giffen good: Increase in price increases demand because of the income effect: if the price of bread rises, poor workers have less income available for meat and need to substitute with more bread
- Veblen/Snob good (social prestige): We purchase things not because we need them but because we want to impress others with our purchasing power. à Price increases à demand increases
Competitive Market
- many buyers and sellers
- Buyers and sellers are price takers
- Each buyer and seller has perfect information
- Goods and services are homogeneous
- Buyers and sellers act independently
- all costs and benefits are accounted for
Monopoly (and Natural Monopoly)
o One seller that controls the price
o Barrier to entry the market
Oligopoly
o Few sellers
o Not always aggressive competition
Monopolistic Competition
o Many sellers
o Slightly differentiated products (e.g. market for magazines)
o Each seller may set price for its own product
law of demand
the quantity demanded of a good falls when the price of the good rises
Demand Function
Q = a - b*P (Q = demand, b = slope, P = price)
Income effect
a fall in the price of milk means that consumers can now afford to buy more with their income
Substitution effect
Milk is lower in price compared to other similar products so some consumers will choose to substitute the more expensive drinks with
the now cheaper milk
Substitutes
two goods for which an increase in the price of one leads to an increase in the demand for the other (e.g. pencils and pens, CocaCola and Pepsi)
Complements
two goods for which an increase in the price of one leads to a decrease in the demand for the other (e.g. coffee and sugar, cars and petrol)
law of supply
he quantity supplied of a good rises when the price of the good rises
Market supply
the sum of all individual supplies for all sellers of a particular good or service
Shifts in the Demand Curve due to increased consumer income
o demand for a normal good will increase.
o demand for a luxury good will increase a lot.
o demand for an inferior good will decrease, e.g. bus
Inelastic Demand
<1 22% decrease in price leads to 11% increase in demand
Elastic Demand
> 1
22% increase in price leads to a 66% decrease in demand
Perfectly Inelastic Demand
=0
an increase in price leaves the quantity untouched
vertical line
Unit elastic Demand
=1
22% increase in price leads to a 22% decrease in demand
Perfectly elastic Demand
= infinity
At exactly X price demand is infinite, above none is bought
Availability of close substitutes (elasticity)
the more substitutes available the more elastic demand
Necessities vs. luxuries (elasticity)
Necessities: more inelastic demand i.e. cigarettes to smokers Luxuries: more elastic demand i.e. holidays
Definition of the market (elasticity)
narrow markets (vanilla ice-cream, special beer) are more elastic demand than broader (food)
Proportion of income devoted to the product (elasticity)
inexpensive is less elastic as consumers are relatively indifferent about price changes
Time horizon (elasticity)
the longer the horizon the more elastic
Spatial differences (elasticity)
more time to come up with alternatives and adjust to the price change
Total Expenditure (and elasticity)
Total Expenditure is the total amount paid by buyers and received by sellers (total revenue) of a good.
- demand is price elastic, price and total expenditure move in opposite directions (less money available for goods)
- demand is price inelastic, price and total expenditure move in same directions. (both increase)
Cross Price Elasticity
< 0 Complements
>0 Substitutes
0 No effects
Income Elasticity
> 0 normal good
1 luxury good
<0 inferior good
