WEEK 2 - Chapter 4: The Market Forces of Supply and Demand

Question 1

What do the terms supply and demand refer to?

Answer 1

The terms supply and demand refer to the behaviour of people as they interact with one another in competitive markets.

Question 2

What is a market?

Answer 2

A market is a group of buyers and sellers of a particular good or service.

The buyers as a group determine the demand for the product and the sellers as a group determine the supply of the product.

Markets take many forms. Sometimes markets are highly organised, such as the sharemarket or the market for some agricultural commodities, like the Sydney fish market.

More often, markets are less organised. For example, consider the market for ice-cream in a particular town.

Question 3

What is competition?

Answer 3

The market for ice-cream, like most markets in the economy, is highly competitive. Each buyer knows that there are several sellers from which to choose. Each seller is aware that their product is similar to that offered by other sellers.

As a result, the price and quantity of ice-cream is not determined by any single buyer or seller. Rather, price and quantity are determined by all buyers and sellers as they interact in the marketplace.

Question 4

What is a competitive market?

Answer 4

Economists use the term competitive market to describe a market in which there are so many buyers and so many sellers that each has a negligible impact on the market price. Each seller has limited control over the price because other sellers are offering similar products.

A seller has little reason to charge less than the going price and if more is charged then buyers will make their purchases elsewhere.

Similarly, no single buyer of ice-cream can influence the price of ice-cream because each buyer purchases only a small amount.

Question 5

How do you reach the highest form of competition?

Answer 5

In this chapter, we assume that markets are perfectly competitive. To reach this highest form of competition, a market must have two characteristics:
. The goods offered for sale are all exactly the same.
. The buyers and sellers are so numerous that no single buyer or seller has any influence over the market price.

Because buyers and sellers in a perfectly competitive market must accept the price the market determines, they are said to be price takers. At the market price, buyers can buy all they want and sellers can sell all they want.

Question 6

What is quantity demanded?

Answer 6

The quantity demanded of any good is the amount of the good that buyers are willing and able to purchase. As we will see, many things determine the quantity demanded of any good, but in our analysis of how markets work, one determinant plays a central role – the price of the good.

Question 7

What is the law of demand?

Answer 7

The claim that, other things being equal, the quantity demanded of a good falls when the price of the good rises.

This explains why the demand curve is downwards sloping.

Question 8

What is a demand schedule?

Answer 8

A table that shows the relationship between the price of a good and the quantity demanded.

Question 9

What is a demand curve?

Answer 9

A graph of the relationship between the price of a good and the quantity demanded.

Question 10

Market Demand Vs Individual Demand.

Answer 10

The demand curve in Figure 4.1 shows an individual’s demand for a product. To analyse how markets work, we need to determine the market demand, which is the sum of all the individual demands for a particular good or service.

The table in Figure 4.2 shows the demand schedules for ice-cream of two people – Catherine and Nicholas. At any price, Catherine’s demand schedule tells us how much ice-cream she buys, and Nicholas’ demand schedule tells us how much ice-cream he buys.

The market demand is the sum of the two individual demands.
The graph in Figure 4.2 shows the demand curves that correspond to these demand schedules. Notice that we add the individual demand curves horizontally to obtain the market demand curve. That is, to find the total quantity demanded at any price, we add the individual quantities found on the horizontal axis of the individual demand curves.

Because we are interested in analysing how markets work, we will work most often with the market demand curve. The market demand curve shows how the total quantity demanded of a good varies as the price of the good varies, while all other factors that affect how much consumers want to buy are held constant.

Question 11

What is ceteris paribus?

Answer 11

A Latin phrase, translated as ‘other things being equal’, used as a reminder that all variables other than the ones being studied are assumed to be constant.

Question 12

Shifts in the demand curve.

Answer 12

Because the market demand curve is drawn holding other things constant, it need not be stable over time. If something happens to alter the quantity demanded at any given price, the demand curve shifts.

Any change that increases the quantity demanded at any given 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.

There are many variables that can shift the demand curve.

Question 13

What variables can alter the demand curve/influence buyers?

Answer 13

. Price - movement 
. Income - shift 
. Prices of related goods - shift 
. Tastes - shift 
. Expectations - shift 
. Number of buyers - shift

Question 14

Income - determinants of demand.

Answer 14

A lower income means that you have less to spend in total, so you would have to spend less on some–and probably most–goods.

As a result there are 2 types of goods which are classified according to their changed demand from income. These goods are normal and inferior goods.

Question 15

What is a normal good?

Answer 15

A good for which, other things being equal, an increase in income leads to an increase in quantity demanded.

If the demand for a good falls when income falls, the good is called a normal good.

Question 16

What is an inferior good?

Answer 16

A good for which, other things being equal, an increase in income leads to a decrease in quantity demanded.

Not all goods are normal goods. If the demand for a good rises when income falls, the good is called an inferior good. An example of an inferior good might be bus rides. As your income falls, you are less likely to buy a car or take a taxi and more likely to take the bus.

Question 17

Prices of related goods - determinants of demand.

Answer 17

Substitutes and compliments impact demand because they result in a good/service either losing or gaining value in the eyes of consumers.

Question 18

What are substitutes?

Answer 18

Two goods for which a decrease in the price of one good leads to a decrease in the demand for the other good (and increase in the price of one good leads to an increase in the demand for the other good).

When a fall in the price of one good reduces the demand for another good, the two goods are called substitutes. Substitutes are often pairs of goods that are used in place of each other, like hot dogs and hamburgers, butter and margarine, and movie tickets and DVD rentals.

Question 19

What are complements?

Answer 19

Two goods for which a decrease in the price of one good leads to an increase in the demand for the other good (or an increase in the price of one good leads to a decrease in the demand for the other good).

When a fall in the price of one good raises the demand for another good, the two goods are called complements. Complements are often pairs of goods that are used together, such as petrol and cars, computers and software, and skis and ski-lift tickets.

Question 20

Tastes - determinants of demand.

Answer 20

The most obvious determinant of your demand is your tastes. If you like ice-cream, you buy more of it.

Economists normally do not try to explain people’s tastes because tastes are based on historical and psychological forces that are beyond the realm of economics.

Economists do, however, examine what happens when tastes change.

Question 21

Expectations - determinants of demand.

Answer 21

Your expectations about the future may affect your demand for a good or service today.

If you expect to earn a higher income next month, you may choose to save less now and spend more of your current income buying ice-cream.

If you expect the price of ice-cream to fall tomorrow, you may be less willing to buy an ice-cream at today’s price.

Question 22

Number of buyers - determinants of demand.

Answer 22

In addition to the preceding factors, which influence the behaviour of individual buyers, market demand depends on the number of these buyers.

If Peter, another consumer of ice-cream, were to join Catherine and Nicholas, the quantity demanded in the market would be higher at every price and the demand curve would shift to the right.

Question 23

Price - determinants of demand.

Answer 23

A curve shifts when there is a change in a relevant variable that is not measured on either axis.

Because the price is on the vertical axis, a change in price represents a movement along the demand curve.

By contrast, income, the prices of related goods, tastes, expectations and the number of buyers are not measured on either axis, so a change in one of these variables shifts the demand curve.

Question 24

What is quantity supplied?

Answer 24

The amount of a good that sellers are willing and able to sell.

Question 25

What is the law of supply?

Answer 25

The claim that, other things being equal, the quantity supplied of a good rises when the price of the good rises.

Question 26

What is a supply schedule?

Answer 26

A table that shows the relationship between the price of a good and the quantity supplied.

Question 27

What is the supply curve?

Answer 27

A graph of the relationship between the price of a good and the quantity supplied.

Question 28

Market supply vs individual supply.

Answer 28

Just as market demand is the sum of the demands of all buyers, market supply is the sum of the supplies of all sellers.

Table 4.5 shows the supply schedules for two ice-cream producers – Tony and Sonia. At any price, Tony’s supply schedule tells us the quantity of ice-cream that Tony supplies, and Sonia’s supply schedule tells us the quantity of ice-cream that Sonia supplies. The market supply is the sum of the supplies from the two individuals.

The graph in Figure 4.6 shows the supply curves that correspond to the supply schedules.

As with demand curves, we add the individual supply curves horizontally to obtain the market supply curve. That is, to find the total quantity supplied at any price, we add the individual quantities

Question 29

Shifts in the supply curve.

Answer 29

Because the market supply curve is drawn holding other things constant, when one of these factors changes the supply curve shifts.

Any change that raises quantity supplied at every price, such as a fall in the price of sugar, shifts the supply curve to the right and is called an increase in supply.

Similarly, any change that reduces the quantity supplied at every price shifts the supply curve to the left and is called a decrease in supply.

There are many variables that can shift the supply curve.

Question 30

What variables can alter the supply curve/influence sellers?

Answer 30

. Price - movement 
. Input prices - shift 
. Technology - shift 
. Expectations - shift
. Number of sellers - shift

Question 31

Input prices - determinants of supply.

Answer 31

When the price of one or more of a good/services inputs rises, producing the good/service is less profitable and sellers supply less.

If input prices rise substantially, some sellers might shut down and supply no ice-cream at all. Thus, the quantity supplied of a good is negatively related to the price of the inputs used to make the good.

Question 32

Technology - determinants of supply.

Answer 32

The technology for turning the inputs into the final good/service is yet another determinant of the quantity supplied.

The invention of the mechanised ice-cream machine, for example, reduced the amount of labour necessary to make ice-cream. By reducing sellers’ costs, the advance in technology raised the quantity of ice-cream supplied.
Expectations
The quantity of ice-cream a seller sup

Question 33

Number of sellers - determinants of supply.

Answer 33

In addition to the preceding factors, which influence the behaviour of individual sellers, market supply depends on the number of sellers.

Eg. If Tony or Sonia were to retire from the ice-cream business, the supply in the market would fall.

Question 34

What is equilibrium?

Answer 34

A situation in which supply and demand have been brought into balance. The price at this intersection is called the equilibrium price and the quantity is called the equilibrium quantity.

Equilibrium is defined by the dictionary as a situation in which various forces are in balance.

At the equilibrium price, the quantity of the good that buyers are willing and able to buy exactly balances the quantity that sellers are willing and able to sell.

Question 35

What is the price sometimes called?

Answer 35

The equilibrium price is sometimes called the market-clearing price because, at this price, everyone in the market has been satisfied – buyers have bought all they want to buy, and sellers have sold all they want to sell.

The actions of buyers and sellers naturally move markets towards the equilibrium of supply and demand.

Question 36

Why do the actions of buyers and sellers naturally move markets towards the equilibrium of supply and demand?

Answer 36

When there is a surplus in the market suppliers respond to the excess supply by cutting their prices:
. Falling prices, in turn, increase the quantity demanded and decrease the quantity supplied.
. These changes represent movements along the supply and demand curves (not shifts in the curves).
. Prices continue to fall until the market reaches the equilibrium.

When there is a shortage of the good demanders are unable to buy all they want at the going price:
. A shortage is sometimes called a situation of excess demand.
. With too many buyers chasing too few goods, sellers can respond to excess demand by raising their prices without losing sales.
. These price increases cause the quantity demanded to fall and the quantity supplied to rise.
. Once again, these changes represent movements along the supply and demand curves and they move the market towards the equilibrium.

Thus, regardless of whether the price starts off too high or too low, the activities of the many buyers and sellers automatically push the market price towards the equilibrium price.

Once the market reaches its equilibrium, all buyers and sellers are satisfied and there is no upward or downward pressure on the price.

Question 37

What is a surplus?

Answer 37

A situation in which quantity supplied is greater than quantity demanded.

Question 38

What is a shortage?

Answer 38

A situation in which quantity demanded is greater than quantity supplied.

Question 39

Why are surpluses and shortages only temporary in most free markets?

Answer 39

Because prices eventually move towards their equilibrium levels.

Indeed, this phenomenon is so pervasive that it is sometimes called the law of supply and demand – the claim that the price of any good adjusts to bring the supply and demand for that good into balance.

Question 40

Types of goods and interactions.

Answer 40

Private goods - private benefits eg. Purchase of coffee.

Collective action - private sacrifice for the greater common good eg. Tackling climate change.

Strategic interactions - private and public goods (cooperative and non-cooperative outcomes).

Question 41

Optimal choice.

Answer 41

Making the most out of scare resources requires making optimal choices:
. Compare benefits to costs
. Take the action if the benefits are at least as great as the costs
. Optimum occurs when marginal benefit equal marginal cost

Question 42

Mechanisms for allocating scarce resources.

Answer 42

Markets: fixed prices, auctions, matching other than price

Hierarchies: central planners and administrators

Question 43

What do markets do?

Answer 43

. Efficiently allocate scarce resources
. Created wealth
. Improve human welfare

Question 44

Law of Demand substitution and income effects.

Answer 44

Substitution effect: as price for apples falls they become relatively cheaper than substitutes (eg. Pears) and quantity demanded for apples rises.

Income effect: as price of apples falls, purchasing power of income rises and more apples are bought.

Question 45

Sources of supply.

Answer 45

. Individuals supply labour effort
. Businesses supply raw materials and finished products
. Organisations supply services

Question 46

Optimum for consumer.

Answer 46

What quantity of a good should a consumer purchase?
Consider marginal benefit and marginal cost.

MB = MC
This will maximise satisfaction, profit, etc.

Question 47

What do prices do?

Answer 47

They reflect scarcity.

Question 48

What is consumer surplus?

Answer 48

The area lying below the Demand curve and above the equilibrium price.

It is the difference between what you are willing to pay and what you do pay.

Eg. Water - enormous consumer surplus, we are willing to lay a lot but we don’t
Vs
Diamonds - small consumer surplus (equilibrium price is high)

Question 49

What is producer surplus?

Answer 49

Difference between what you’re willing to sell and what you do sell.

Question 50

What is Pareto efficiency?

Answer 50

Can’t make any one person better off without making someone else worse off.

Occurs when: P = MB = MC