Unit 2: Demand, Supply and Price Determination Flashcards
Market
a system where buyers and sellers interact to exchange goods, services or resources. In a market there is demand and supply. The higher the number of buyers and sellers, the more competitive the market is.
Types of Markets
- Product Market
- Factor Market
- Financial Market
Normal Goods
goods for which demand increases as income rises and vice versa
e.g. clothing, as people earn more money, they tend to buy more or higher quality clothing
Inferior Goods
goods for which demand decreases as income rises and increases as income falls ceteris paribus.
e.g. instant noodles, when people have lower incomes, they buy more instant noodles as a cheap food option.
Demand
amount buyers are willing and financially able to buy at a specific price during a particular period of time
Law of Demand
Buyers tend to buy less at higher prices, ceteris paribus
Why does the Demand curve slope downwards
Substitution effect and Income effect
Substitution Effect (S.E.)
The substitution effect occurs when a change in the price of a good causes consumers to switch to or substitute that good with another similar, but cheaper good. The extent depends on the number and closeness of substitutes
e.g. if the price of butter increases, consumers may look for a cheaper alternative and start buying margarin instead
Income Effect
refers to the change in the quantity demanded of a good or service as a result of a change in a consumer’s real income or purchasing power. The extent depends on the proportion spent on the good relative to income
e.g. if the price of coffee decreases, people have more money left over in their budget after purchasing the coffee, effectively increasing you real income or purchasing power
Demand Curve
Movement along vs shift (demand)
Movement along: caused by a change in the product’s own price
Shift: caused by a change in anything other than the product’s own price
Competitive Demand vs Joint Demand
Competitive Demand: they are alternatives to each other, meaning that if the price of one good increases, the demand for the other good will likely increase as well
e.g. Pepsi and Coca-Cola
Joint Demand: they are used together, so the demand for one good is directly related to the demand for another. An increase in the demand for one good leads to an increase in the demand for the other
e.g. printers and ink
Determinants of demand
- Price of the good or service
- Income levels (normal vs inferior goods)
- Price of other goods (complementary or substitutes)
- Consumer preferences
- Expectations
- Population
- Advertising
Supply
amount suppliers are prepared to sell at a specific price during a particular period of time
Law of Supply
suppliers are prepared to sell more at higher prices, ceteris paribus
Why does the Supply curve slope upwards
- Profit Motive
- Diminishing Returns
Diminishing Returns
for one additional unit of output, more and more factor inputs are required, hence costs rise so price increases
Profit Motive
refers to the drive or incentive for firms to maximize their profits i.e. charge more, sell more
Supply Curve
shows how much a seller is prepared to sell at different market prices
Movement along vs shift (supply)
Movement along: caused by a change in the product’s own price
Shift: caused by a change in anything other than the product’s own price
Competitive Supply vs Joint Supply
Competitive Supply: goods produced using the same resources, meaning producing more of one good reduces the resources available to produce another
e.g. rice or sugarcane, electricity or heat
Joint Supply: when the production of one good automatically results in the production of another.
e.g. beef and leather, petrol, diesel and kerosene
Determinants of Supply
- Price of the good or service
- Cost of production
- Prices of related goods (complementary or substitutes)
- Expectations
- Number of sellers
- Natural conditions
Equilibrium
price at which both parties satisfy their plans simultaneously. There is no motive to change price, resulting in a stable market condition.
Disequilibrium
price at which only one party fulfills its intentions, the other is left dissatisfied
Dissatisfied buyers
buyers are dissatisfied when they cannot purchase the quantity of goods they want at the prevailing price, this occurs when demand exceeds supply, leading to a shortage in the market.
Price is below the equilibrium level and there are not enough goods available for all buyers willing to pay at the current price
Sellers’ market
Dissatisfied Suppliers
suppliers are dissatisfied when they cannot sell all the goods they have produced at the prevailing price. This occurs when supply exceeds demand, leading to a surplus in the market
Price is above the equilibrium level, there are more goods in the market than buyers are willing to purchase at the current price
Buyers’ market
Market mechanism
refers to the process by which the forces of demand and supply interact to determine the equilibrium price and quantity of goods and services in a market. it is a self regulating system that allocates resources efficiently without the need for central planning.
It ensures convergence towards equilibrium.
Price signals of the Market Mechanism
- A rising price signals producers to increase supply and consumers to reduce demand
- A falling price signals producers to reduce supply and consumers to increase demand
Consumer surplus
the difference between the maximum price consumers are willing to pay and how much they actually end up paying
Producer surplus
the difference between the minimum price at which sellers are prepared to sell and how much they actually end up receiving
Society’s welfare
refers to the overall wellbeing and quality of life of individuals within a society encompassing both material and non-material aspects. It is the summation of both consumer and producer surplus
Advantages of a free market
- Society’s welfare is at its greatest - resources are allocated efficiently and hence, both CS and PS are maximized
- Signaling function - higher prices for producers signal increased demand prompting them to supply more, while for consumers it signals scarcity, encouraging them to consume less
- Incentive function - higher prices discourage consumption and incentivizes producers to supply more.
- Rationing function - ensures that scarce resources are distributed based on consumer’s willingness to pay, helping allocate resources efficiently in situations of limited supply
Disadvantages of a free market
- Inequality - wealth and income gaps can widen, as the system rewards those who own resources or have skills in demand
- Market failures - externalities and public goods
- Short term focus - businesses focus on immediate profits over long term sustainability
