Principles of Economics 1.2 - Supply & Demand*

Question 1

What’s the ‘law of demand’?

Answer 1

The claim that when the price of a good rises,
the quantity demanded falls Think about something you enjoy to buy regularly. If it becomes more
expensive, even though you like it, you would naturally buy less of it.
* Now extrapolate this to the whole population. If some product becomes
more expensive, then people want to buy less in general.

Question 2

What does ‘disaggregated level’ mean?

Answer 2

Individual markets, houeholds etc.

Question 3

What’s the name for ‘the claim that when the price of a good rises,
the quantity demanded falls’?

Answer 3

Law of Demand

Question 4

What’s the ‘law of supply’?

Answer 4

The claim that when the price of a good rises,
the quantity supplied rises. Imagine that you run a company. If you can receive more for each unit
you sell, you want to produce & sell more units

Question 5

What’s the name for ‘the claim that when the price of a good rises,
the quantity supplied rises’?

Answer 5

The Law of Supply

Question 6

Explain the concept of ‘partial equilibrium analysis’

Answer 6

The economy is complex, and so to simplify matters we typically
focus our attention on specific markets (this is what we call
“partial equilibrium analysis”).
* Markets are defined in terms of their product and geography E.g. “the market for on-licence beer in Birmingham”
* We actually analyse markets as snapshots in time (though we do
not always explicitly acknowledge the time element) E.g. “the market for on-licence beer in Birmingham today”
* Thus, a market can be characterised in terms of the product, the
location, and the point in time

Question 7

What’s the name for the idea that economists typically focus on specific markets because the economy is complex

Answer 7

Partial Equilibrium Analysis

Question 8

What is the ‘Supply & Demand’ model used to do?

Answer 8

Analyse markets

Question 9

Which model can be used to analyse markets? State some assumptions

Answer 9

We can analyse markets using the Supply and Demand model
(or the “Demand and Supply model” if you prefer).
* Some assumptions of the basic model:
1. There are many buyers and sellers (Adam Smith’s ‘Invisible Hand’ dictates that one change of one individual’s buying habits wouldn’t affect the market equilibrium, it would take a large number of people for the equilibrium to change)
2. Each buyer/seller has perfect information (or at least “equal”
information).
3. Firms produce and sell homogenous goods (i.e. identical products).
4. The homogenous goods sell at a uniform price

What does Adam Smith’s invisible hand say that gives one of the assumpti

Question 10

What does ‘supply and demand’ refer to?

Answer 10

The behaviour of people as they interact with one another in markets

Question 11

What’s a market?

Answer 11

A group of buyers and sellers of a particular good or service

Question 12

What’s the name for ‘a group of buyers and sellers of a particular good or service’?

Answer 12

A market

Question 13

In supply & demand, what do the buyers determine?

Answer 13

Demand for a product

Question 14

In supply & demand, who determines demand?

Answer 14

Buyers

Question 15

In supply & demand, what do the sellers determine?

Answer 15

Supply of a product

Question 16

In supply & demand, who determines supply?

Answer 16

Sellers

Question 17

Describe the history of the competitive market model

Answer 17

The market model represents a neo-classical explanation of how resources are allocated. This analysis was developed in the nineteenth century and follows on from the work of Adam Smith

Question 18

Describe the fundamental concept of the supply & demand model

Answer 18

• One of the fundamental outcomes of the market model is that if the assumptions hold, the resulting allocation of resources
  will be ‘efficient’. What this means is that the price buyers pay for goods in the market is a reflection of
  the value (or utility) they get from acquiring the goods, and that the price producers receive is a reflection
  of the cost of production including an element of profit which is sufficient to keep them in that line of
  production. If consumers and producers are both maximizing benefits and minimizing costs, it is assumed that society must be maximizing welfare, because the goods and services produced are those which are
  most desirable and in demand
• The competitive model of supply and demand which leads to this ‘efficient’ outcome is based on the
  following assumptions:
  1. There are many buyers and sellers in the market.
  2. No individual buyer and seller is big enough or has the power to be able to influence price.
  3. There is freedom of entry and exit to and from the market.
  4. Goods produced are homogenous (identical).
  5. Buyers and sellers act independently and only consider their own position in making decisions.
  6. There are clearly defined property rights which mean that producers and consumers consider all costs
  and benefits when making decisions

Question 19

Briefly describe the debate of government intervention in the ‘supply & demand model’

Answer 19

You will find there are economists who believe that markets are the most effective way we have yet
discovered to allocate scarce resources. This further implies that government intervention in markets
should be kept to a minimum. There are others who say that the model is so flawed that there is a much
bigger role for government to play in the economy

Question 20

Why has the market model been criticised?

Answer 20

The market model has been criticized because it is based on a number of value judgements. Consumers attempting to maximize utility include an assumption that more
is preferred to less and that this is desirable. Producers seeking to maximize profit will attempt to produce an output that minimizes cost and reduces waste to a minimum, and that this is also desirable. Whether
these are desirable is subject to considerable debate and are essentially normative value judgements

Question 21

When does competition exist?

Answer 21

Competition exists when two or more firms are rivals for customers

Question 22

What exists when 2 or more firms are rivals for customers?

Answer 22

Competition

Question 23

What’s a ‘competitive market’?

Answer 23

A market in which there are many buyers and sellers so that each has a negligible impact on the
market price

Question 24

What’s the name for ‘a market in which there are many buyers and sellers so that each has a negligible impact on the market price’?

Answer 24

A competitive market

Question 25

What are other terms for a ‘competitive market’?

Answer 25

‘perfectly competitive market’ or ‘perfect competition’

Question 26

Explain whether sellers are price makers or takers in competitive markets

Answer 26

Because there are many buyers and sellers in a perfectly competitive market, neither has any power to influence
price – they must accept the price the market determines, and they are said to be price-takers. Each seller has no control over the price, because other sellers are offering identical products and each seller only supplies a very small amount in relation to the total supply of the market.

Question 27

Discuss the factor of homogenous goods in competitive markets

Answer 27

Because products are homogenous, a seller has little reason to charge less than the going price, and
if they charge more, buyers will make their purchases elsewhere. Similarly, no single buyer can influence
the price because each buyer purchases only a small amount relative to the size of the market. Buyers
make their decisions based on the utility (or satisfaction) they gain from consumption, and in doing so are
independent of the decisions of suppliers. Buyers and sellers make decisions independently and goods
are homogenous. This implies that there is no need for advertising or branding and that both producers
and consumers consider all costs and benefits, including the costs and benefits which may affect a third
party, when making decisions. For example, producers will consider the costs to society of the pollution
they create in production

Question 28

State an example of a market in which the assumption of perfect competition almost perfectly applies

Answer 28

The market for milk

Question 29

Define ‘quantity demanded’

Answer 29

The amount of a good that buyers are willing and able to purchase at different prices

Question 30

What does ‘the amount of a good that buyers are willing and able to purchase at different prices’ define?

Answer 30

Quantity demanded

Question 31

Which determinant plays a central role in determining the quantity demanded of a good?

Answer 31

Price

Question 32

Describe the relationship between quantity demanded and price of a good. What is this relationship referred to as?

Answer 32

Inversely related. It’s the ‘law of demand’

Question 33

What’s the ‘law of demand’? Why is called a ‘law’?

Answer 33

The claim that, other things being equal (ceteris paribus), the quantity demanded of a good falls when
the price of the good rises. It’s called a law because the relationship is observed so often in the economy

Question 34

What’s a ‘demand schedule’?

Answer 34

A table that shows the relationship between the
price of a good and the quantity demanded, holding constant everything else that influences how much
consumers of the good want to buy

Question 35

What’s the name for ‘a table that shows the relationship between the price of a good and the quantity demanded, holding constant everything else that influences how much consumers of the good want to buy’?

Answer 35

A demand schedule

Question 36

What’s a ‘demand curve’?

Answer 36

A (usually downward sloping) graph of the relationship between the price of a good and the quantity demanded

Question 37

What’s the name for ‘a graph of the relationship between the price of a good and the quantity demanded’?

Answer 37

A demand curve

Question 38

What would be said is occurring if there’s a change in the price of a good, ceteris paribus, resulting in a change in quantity demanded

Answer 38

A movement along the demand curve

Question 39

What’s happening when there’s a ‘movement along the demand curve’?

Answer 39

There’s a change in the price of a good, ceteris paribus, resulting in a change in quantity demanded

Question 40

Explain the reasons for a movement along the demand curve

Answer 40

• There are two reasons:
  1. The income effect: If we assume that incomes remain constant, then a fall in the price of a product means that consumers can now afford to buy more with their income. In other words, their real income, what a given amount of money can buy at any point in time, has increased, and part of the increase in quantity demanded can be put down to this effect.
  2. The substitution effect: Now that the product is lower in price compared to other products, some consumers will choose to substitute the more expensive product with the now cheaper product. This switch accounts for the remaining part of the increase in quantity demanded.

Question 41

What’s ‘market demand’?

Answer 41

The sum of all the individual demands for a particular good or service

Question 42

What’s the name for ‘the
sum of all the individual demands for a particular good or service’?

Answer 42

Market Demand

Question 43

What is a shift in the position of the demand curve referred to as?

Answer 43

Change in demand

Question 44

Explain what a change in demand is

Answer 44

The individual and market demand curves shown were drawn under the assumption of ceteris paribus - other things being equal with the only variable changing being price. If any of the factors affecting demand change, other than a change in price, this will cause a shift in the position of the demand curve, which is referred to as a change in demand. If any of the factors affecting demand other than price change then the amount consumers wish to
purchase changes, whatever the price.

Question 45

Describe what it means when a demand curve shifts to the left or right

Answer 45

Any change that increases the quantity demanded at every price shifts the demand curve to the right and is called an increase in demand. Any change that reduces the quantity demanded at every price shifts the demand curve to the left and is called a decrease in demand.

Question 46

State the main factors that cause a shift in demand

Answer 46

• Prices of other (related) goods
• Income
• Tastes
• The size & structure of the population
• Advertising
• Expectations of Consumers

Question 47

Elaborate on how ‘prices of other (related) goods’ causes a shift in demand of a product

Answer 47

• Change in price of substitute goods for this product will inversely affect this product’s demand even if its price is unchanged. The more closely related substitute products are the more effect we might see on
  demand if the price of one of the substitutes changes
• Change in price of complements for this product will proportionately affect this product’s demand even if its price is unchanged.

Question 48

Explain what substitutes are

Answer 48

They are two goods for which an increase in the price of one leads to an increase in the demand for the other (and vice versa). Substitutes are often pairs of goods that are used in place of each other as they satisfy similar desires, such as butter and spreads, pullovers and sweatshirts, and cinema tickets
and film streaming. This is because the increase in the price of one product would lower its demand (according to the law of demand) as consumers are more reluctant to pay this higher price; so some switch to the next best alternative that’s the cheaper - the substitute. So demand in this substitute increases even though its price may not have changed

Question 49

What’s the name for ‘two goods for which an increase in the price of one leads to an increase in the demand for the other (and vice versa)’?

Answer 49

Substitutes

Question 50

What’s monopsony?

Answer 50

When we have one buyer and many sellers in a market

Question 51

What’s the name for ‘when we have one buyer and many sellers in a market’?

Answer 51

Monopsony

Question 52

Explain what it means when we refer to ‘demand’

Answer 52

When we talk about demand, we are talking about the cumulative demand of the population of consumers in our market of interest. If we add up the quantities that each consumer wants to buy at
each price, we get cumulative demand (i.e. “market demand”)
* We can show this information on a demand schedule or a demand curve

Question 53

What’s the prominent Latin phrase used in Economics when looking at models and what does it translate to?

Answer 53

‘ceteris paribus’ which translates to “all else equal”

Question 54

Give the factors that directly affect demand (3)

Answer 54

• The number of consumers.
• Consumers’ income levels.
• Tastes/preferences.
• The prices of other goods (substitutes and complements)

Question 55

How is a demand curve drawn, considering the factors that directly affect it?

Answer 55

A given demand curve is drawn downward sloping, assuming that the factors are fixed. If any one of these things changes, the demand curve shifts. If
these things are unchanged, the demand curve is unchanged.

Question 56

Describe the concept of ‘supply’

Answer 56

• When we talk about supply, we are talking about the cumulative
  supply of the population of producers in our market of interest. For example, consider “the market for on-licence beer in
  Birmingham today” once again; If a pub can get £2 for a pint of beer, how many is it willing to supply? If a pub can get £2.01… etc.
• If we add up the quantities that each firm in a market is willing
  to supply at each price, we get cumulative supply (i.e. “market
  supply”).
• We can show this on a supply schedule or a supply curve
• Note that as the price increases the quantity that producers are
  willing to supply increases

Question 57

What does a ‘supply curve’ do?

Answer 57

It depicts the relationship between the price of a good and the quantity that is supplied, holding all else constant, “ceteris paribus”

Question 58

State the factors that directly affect supply (3)

Answer 58

• The number of sellers.
• The cost of inputs (production costs).
• The level of technology.
• Laws, rules and regulations.
• The existence of and extent of sellers’ outside options

Question 59

How is a supply curve drawn, considering the factors that directly affect it?

Answer 59

A given supply curve is drawn upward sloping, assuming that the factors that directly affect it are fixed.
* If any one of these things changes, the supply curve shifts. If
these things are unchanged, the supply curve is unchanged

Question 60

Describe & explain equilibrium in a market on a supply & demand model

Answer 60

• Market equilibrium is achieved where the demand curve meets the
  supply curve… We denote by P* and Q* the prevailing market price
  and quantity of the good that is bought and sold.
• The market price is determined where the amount that consumers
  are willing to buy coincides with the amount suppliers are willing
  to sell (emphasis on willingness)
• This is how the model looks: y-axis labelled ‘P’ (for price); x-axis labelled ‘Q’ (for quantity); upward sloping curve ‘S’ (for supply); downward sloping curve ‘D’ (for demand); where ‘S’ and ‘D’ intersect, there’s a vertical line going to x-axis, where at the x-axis is says ‘Q*’ (for equilibrium quantity); where ‘S’ and ‘D’ intersect, there’s a horizontal line going to y-axis, where at the y-axis is says ‘P’ *(for equilibrium price)

Question 61

Describe how D&S can be represented

Answer 61

D & S can be represented both graphically & mathematically:
* Graphical depiction - as curves
* Mathematical depiction - as schedules or as functions

Question 62

Elaborate on the fact that consumers’ income levels affect demand

Answer 62

Generally, if people have more money (income) then their spending habits go up

Question 63

Elaborate on the fact that consumers’ tastes & preferences affect demand

Answer 63

If trends change and there’s a shift in preference towards a certain product, its demand would rise

Question 65

Elaborate on the fact that a firm’s cost of inputs affect supply

Answer 65

If the cost of producing a product goes up, a firm would be less inclined to produce more & more of this product

Question 66

Describe how demand can be shown as a function

Answer 66

• A general functional form: QD = F(n, P, Y, T, PS, PC) where n is the number of consumers, P is the price of the good in question, Y is income, T represents tastes, PS is the price of
  substitutes, and PC is the price of complements.
• A specific functional form (a made-up example):
  QD = 50n - 2000P + 2Y + 30T + 500PS - 300PC (price of complementary goods is negative in the equation which makes sense because if a complementary good became more expensive, demand would go down which would also decrease the demand of this good because it’s complementary to the other good). For simplicity, we will often use something that looks more like:
  QD = 9000 - 2000P (example). The constant represents the quantity demanded by the market when the price of the product is 0

Question 67

Elaborate on the fact that level of technology affect supply

Answer 67

If tech makes the production process cheaper, faster or more efficient, profits would increase so a firm would want to produce more of that product

Question 68

Elaborate on the fact that the existence of and extent of sellers’ outside options affect supply

Answer 68

If the firm could make a different product that may be more profitable, then the firm may switch industries altogether or simply make less of the former product and more of the latter product. Either way, supply of the former product decreases

Question 69

Describe how supply can be shown as a function

Answer 69

• A general functional form: QS = F(m, P, PI, λ, R, πO) where m is the number of sellers, P is the price of the good in question, PI is the price of inputs, λ is a measure of technology, R
  denotes regulations and πO stands for sellers’ outside options.
• A specific functional form (a made-up example):
  QS = 10m + 1000P - 500PI + 5λ - 20R - 3πO. For simplicity, we will often use something that looks more like:
  QS = 1000P (for example). There’s usually an absence of a constant because of the fact that if there WAS a constant, that would imply that a firm is producing a good despite there being no demand, so essentially they’d be giving out the product for free. But this is ILLOGICAL so usually there’s no constant

Question 70

If supply & demand were to change simultaeneously, what would the impact on equilibrium be determined by?

Answer 70

1. The relative size and direction of the change(s).
2. The shape of the demand and supply curves

Question 71

Explain income elasticity of demand

Answer 71

• Income elasticity of demand is the percentage change in quantity
  demanded divided by the percentage change in income.
• For example, suppose that a 5% rise in income causes the quantity of
  a good that is demanded to rise by 15%. In this example, the value of
  the IED would be 3.
• In the case of this elasticity, it is not always positive or always
  negative, but rather IED can be either – and the sign tells you
  something about the particular good in question.
• If IED is positive, it is what we call a “normal good”.
• If IED is negative, it is what we call an “inferior good”.