Topic 2: Demand and Supply Flashcards
What is the def. of demand, law of demand and ceteris paribus?
- def.*: the quantities of a good that buyers are willing and able to pay at various prices at a particular point in time, ceteris paribus
- law of demand*: the quantity of a good demanded is inversely related to its price
- ceteris paribus*: holding all other factors constant
What are the reasons for the inverse relationship between demand and price?
- Substitution effect
- as the price of the good ↑ consumers substitute away from this good towards a relatively cheaper alternative (e.g. away from oranges towards apples).
- Income effect
- ↓ in price means purchasing power of our existing income has ↑
Define supply and the law of supply
- def.*: the relationship between price and the quantity of a good or service producers are willing and able to produce at a particular point in time, reflects the higher (marginal) costs of producing more units (hence charge more to cover costs) and greater revenues for firms
- law of supply*: the quantity of a good supplied is positively related to its price, ceteris paribus
- the increase in price acts as a signal to firms to allocate more resources to this good
What is a market and what is equilibrium price/quantity also known as?
market: mechanism that coordinates the independent intentions of buyers and sellers
equilibrium price and quantity = market clearing price
Describe the different states a market can be in
Equilibrium
- occurs when the plans of the buyers match the plans of the sellers, QD = QS
- neither a shortage nor a surplus, hence no pressure for a change in price (ceteris paribus)
Surplus
- when QS>QD, market will have a surplus
- firms find they have unsold stock which puts ↓ pressure on prices to get rid of excess stock
- as prices ↓, the quantity demanded will ↑ until it reaches QS at equilibrium price
Shortage
- when QD>QS, market will have a shortage
- firms find that at this rice they are quickly selling out of their good, this creates pressure for ↑ prices, which induces firms to supply more
- as prices ↑, the quantity demanded by consumers will ↓ until it meets QS at equilibrium price
What are non-price determinants of demand?
- causes shifts in the entire demand curve, that is at each and every price, more or less is demanded
1. Changes in the price of related goods - substitutes (alternatives): an ↑ in the price of one leads to an ↑in the demand for the other, ↑Pà↓Q
i. e. if the price of apples increases, some people may substitute towards oranges, shifting the demand curve for oranges to the right - complements (goods that ‘go together’): an ↑ in the price of one leads to a ↓ in the demand for the other, ↑Pà↓Q
i. e. if the price of orange juice squeezers rises, and so fewer oranges are demanded (demand curve for oranges shifts to the left).
2. Consumer income - an increase in income means consumers are willing and able to buy more of this good at each and every price
- types of goods:
- normal goods: as income ↑, demand ↑
- inferior goods: as income ↑, demand ↓
3.Changes in preferences
- although subjective, preferences play a vital role in determining demand
- assume tastes are stable (but can and do change over time)
- changes in preferences
- towards a good or service: demand ↑, shift demand curve to the right
- away from a good or service: demand ↓, shift demand curve to the left.
- Number of buyers
* as population increases the demand for most goods and services will increase, simply because there are more people in the market - Changes in expectations
- if buyers expect prices to ↑ in the future, they buy as much as they can as soon as they can
- if buyers expect prices to ↓ in the future, they delay their purchasing for as long as they can i.e. deflation in Japan in the 1990s and beyond
What are non-price determinants of supply?
1.Price of inputs
- all goods and services require inputs to produce them. If the price of these inputs change, then the overall cost to the producer will also change.
- an ↑ in the price of an input will increase overall costs, and so the supply curve will shift to the left (up)
- a ↓ in the price of an input will decrease overall costs, and so the supply curve will shift to the right (down)
2.Technological change
- technology represents the stock of knowledge about how to combine resources most efficiently.
- i.e. an improvement in technology will lead to a ↓ in the costs of production for firms. Supply curve will shift to the right (or down) – can produce the same amount of output with less inputs/produce more output with the same amount of inputs
- Expected future prices
* if firms expect prices to be higher in the future, they may decrease supply now and increase it in the future - Changes in number of firms
- market supply = the sum of the quantities supplied by all individual sellers
- an ↑ in the number of sellers will therefore lead to an ↑in supply (shift to the right)
Describe historical changes in oil price and reasons why
- 1950s-1960s: relatively steady oil prices as the relative importance of oil was not fully realised by producers and buyers
- before the Yom Kippur War, the price of oil was around $17 per barrel
- after the war, the Arab countries punished supporters of Israel by putting an embargo on exports to those countries including the US
- supply decreased, and the price of crude increased to over $54 per barrel.
- around 1984: ‘oil glut’, POEC countries sold as much oil as they could, massive increase in supply and fall in price
- early 2000s: strong economic growth which translated to high incomes especially in China and the US which led to an increase in price and quantity
lamb supplies are sharply reduced because of a drought in the lamb-raising states, and consumers turn to chicken as a substitute for lamb, describe what happens to price and quantity
- a decrease in supply due to the drought in these lamb-raising areas, fall in quantity demanded and rise in price
- the consumers who substitute away from lamb are captured in the fall in the quantity demanded from Q0 to Q1 induced by the ↑ in price (the substitution effect)
What is the concept of consumer/producer surplus used for?
when people engage in the exchange of goods and services, they do so voluntarily, the concept of consumer and producer surplus is used to gauge how much benefit consumers and producers get from trade.
Define consumer surplus
def.: the difference between the maximum price a consumer is willing to pay for a good and the price they actually pay for that good.
Define producer surplus
def.: the difference between the (marginal) cost of producing a good and the price actually received for that good
Describe market equilibrium
total economic surplus = total consumer surplus + total producer surplus
- this gives us the value of the total gains from the exchange of goods in this market
- in equilibrium, the gains to producers and consumers are therefore maximised
- any deviation from the equilibrium price will result in a smaller total surplus
Describe a DWL
- the reduction in total economic surplus that occurs when the market does not operate at its most efficient point i.e. there are mutually beneficial exchanges that could take place, but which are not
Define an efficient market
one where the total economic surplus is as large as it could possibly be (ceteris paribus), where the marginal benefit of the last unit consumed is equal to the marginal cost of producing it, MB = MC
