Competitive markets: Demand and supply (2.1–2.6)

Competitive Market

A market in which there are many buyers and sellers of a homogeneous (identical) product, where no single buyer or seller can influence the market price. Price is determined by the interaction of supply and demand. EXAMPLE: Agricultural markets (wheat, coffee), foreign exchange markets, stock markets.

Market

Any arrangement that brings buyers and sellers together to exchange goods and services. Markets do not need to be physical places — they can be online, over the phone, or through any other means of communication. EXAMPLE: eBay is a market; the Vienna vegetable market is a market; the global oil market is a market.

Demand

The quantity of a good or service that consumers are willing AND able to purchase at various prices over a given time period, ceteris paribus. Note: both willingness and ability to pay are required — desire alone does not constitute demand.

Law of Demand

As the price of a good rises, the quantity demanded falls, ceteris paribus. As price falls, quantity demanded rises. This inverse (negative) relationship exists because of the substitution effect and the income effect. EXAMPLE: When the price of train tickets rises, some commuters switch to cycling or driving (substitution) and feel poorer in real terms (income effect).

Substitution Effect (Demand)

When the price of a good rises, it becomes relatively more expensive compared to its substitutes, so consumers switch away from it toward cheaper alternatives. Contributes to the downward slope of the demand curve. EXAMPLE: A rise in beef prices causes consumers to buy more chicken instead.

Income Effect (Demand)

When the price of a good rises, the real purchasing power of consumers falls — they can afford less even if their nominal income is unchanged. This reinforces the downward slope of the demand curve. EXAMPLE: A rise in rent prices reduces households' real income, causing them to spend less on other goods.

Individual Demand

The demand of a single consumer for a good or service at various prices, ceteris paribus. Adding all individual demand curves horizontally gives the market demand curve.

Market Demand

The total quantity of a good demanded by all consumers in a market at various prices, ceteris paribus. Found by horizontal summation of individual demand curves. EXAMPLE: If consumer A demands 4 units and consumer B demands 6 units at €10, market demand at €10 = 10 units.

Demand Schedule

A table showing the quantities of a good that consumers are willing and able to buy at different prices, ceteris paribus. The data in a demand schedule is used to plot a demand curve.

Demand Curve

A graph showing the relationship between the price of a good and the quantity demanded, ceteris paribus. Slopes downward from left to right (negative slope) reflecting the Law of Demand. Y-axis = Price (P). X-axis = Quantity Demanded (Qd).

DIAGRAM — Demand Curve

Draw axes: Y-axis = "Price (P)", X-axis = "Quantity Demanded (Qd)". Draw a straight downward-sloping line from upper-left to lower-right, labelled "D". Mark point A at high price P1 with low Qd1, and point B at low price P2 with high Qd2. The movement from A to B along the curve = change in quantity demanded caused by a price change only.

Change in Quantity Demanded (Movement Along the Demand Curve)

A change in the amount consumers buy caused ONLY by a change in the good's own price. Shown as a movement along the existing demand curve — upward (price rises → Qd falls) or downward (price falls → Qd rises). The demand curve itself does NOT shift. EXAMPLE: Price of coffee rises from €2 to €3 → movement up along demand curve, Qd falls.

Change in Demand (Shift of the Demand Curve)

A change in demand caused by any factor OTHER than the good's own price. The entire demand curve shifts. Rightward shift = increase in demand (more demanded at every price). Leftward shift = decrease in demand. EXAMPLE: A rise in consumer incomes increases demand for restaurant meals → demand curve shifts right.

Determinants of Demand (Non-Price Factors)

Factors that shift the demand curve: (1) Income (2) Prices of related goods — substitutes and complements (3) Tastes and preferences (4) Expectations of future prices (5) Number of consumers in the market (6) Advertising and information. A change in any of these shifts the entire demand curve left or right.

Income — Normal Goods

For normal goods, an increase in consumer income causes demand to increase (shift right). A fall in income causes demand to decrease (shift left). EXAMPLE: As Austrian household incomes rose through the 2010s, demand for foreign holidays and organic food increased.

Income — Inferior Goods

For inferior goods, an increase in consumer income causes demand to DECREASE (shift left) — consumers switch to better-quality alternatives. A fall in income increases demand for inferior goods (shift right). EXAMPLE: As incomes rise, demand for bus travel falls as people buy cars; demand for instant noodles falls as people eat at restaurants.

Normal Good

A good for which demand increases as consumer income increases — a positive relationship between income and demand. The majority of goods are normal goods. EXAMPLE: Cars, holidays, smartphones, organic food, gym memberships.

Inferior Good

A good for which demand decreases as consumer income increases — a negative relationship between income and demand. EXAMPLE: Bus travel, instant noodles, own-brand supermarket products, second-hand clothing.

Substitute Goods

Goods that can replace each other in consumption — they satisfy similar needs. A rise in the price of one substitute increases the demand for the other (consumers switch). EXAMPLE: Tea and coffee; Pepsi and Coca-Cola; butter and margarine; train and plane travel. On diagram: rise in price of Good X → demand curve for substitute Good Y shifts RIGHT.

Complement Goods

Goods that are consumed together — a rise in the price of one DECREASES demand for the other, because less of both are used together. EXAMPLE: Cars and petrol; printers and ink cartridges; smartphones and phone cases; bread and butter. On diagram: rise in price of Good X → demand curve for complement Good Y shifts LEFT.

Tastes and Preferences

If a good becomes more fashionable or desirable, demand increases (shift right). If tastes shift away from it, demand decreases (shift left). Influenced by advertising, social trends, health information. EXAMPLE: Growing health awareness → increased demand for plant-based foods; declining print media readership → decreased demand for newspapers.

Expectations of Future Prices

If consumers expect prices to rise in the future, they buy more now → current demand increases (shift right). If they expect prices to fall, they delay purchases → current demand decreases (shift left). EXAMPLE: Consumers expecting a petrol price rise fill their tanks now → current demand for petrol rises.

Number of Consumers

An increase in the number of buyers in a market increases market demand (shift right). A decrease reduces it (shift left). EXAMPLE: Population growth in Vienna increases demand for housing. Opening a new market to international buyers increases demand.

Advertising

Successful advertising increases consumer awareness and shifts tastes toward a product → demand curve shifts RIGHT. EXAMPLE: A McDonald's advertising campaign increases demand for McDonald's meals at every price level.

DIAGRAM — Shift of Demand Curve

Draw axes with original demand curve D1 (downward sloping). Draw D2 to the RIGHT of D1 = increase in demand (more demanded at every price). Draw D3 to the LEFT of D1 = decrease in demand. At any given price P, the quantity on D2 > D1 > D3. Label shifts with arrows and reasons.

Supply

The quantity of a good or service that producers are willing AND able to offer for sale at various prices over a given time period, ceteris paribus. Both willingness and ability to produce are required.

Law of Supply

As the price of a good rises, the quantity supplied increases, ceteris paribus. As price falls, quantity supplied falls. This positive relationship exists because higher prices make production more profitable, incentivising existing firms to produce more and attracting new firms into the market.

Supply Schedule

A table showing the quantities of a good that producers are willing and able to supply at different prices over a given time period, ceteris paribus. Used to plot the supply curve.

Supply Curve

A graph showing the relationship between the price of a good and the quantity supplied, ceteris paribus. Slopes upward from left to right (positive slope) reflecting the Law of Supply. Y-axis = Price (P). X-axis = Quantity Supplied (Qs).

DIAGRAM — Supply Curve

Draw axes: Y-axis = "Price (P)", X-axis = "Quantity Supplied (Qs)". Draw a straight upward-sloping line from lower-left to upper-right, labelled "S". Mark point A at low price P1 with low Qs1, and point B at high price P2 with high Qs2. Movement from A to B = change in quantity supplied caused by a price change only.

Change in Quantity Supplied (Movement Along the Supply Curve)

A change in the amount producers supply caused ONLY by a change in the good's own price. Shown as a movement along the existing supply curve — upward (price rises → Qs rises) or downward (price falls → Qs falls). The supply curve itself does NOT shift. EXAMPLE: Price of wheat rises → farmers supply more wheat → movement up along supply curve.

Change in Supply (Shift of the Supply Curve)

A change in supply caused by any factor OTHER than the good's own price. The entire supply curve shifts. Rightward shift = increase in supply (more supplied at every price). Leftward shift = decrease in supply. EXAMPLE: A new harvesting technology reduces costs → supply of wheat increases → supply curve shifts right.

Determinants of Supply (Non-Price Factors)

Factors that shift the supply curve: (1) Costs of production (2) Technology (3) Prices of related goods in production — substitutes and complements in production (4) Number of firms (5) Expectations of future prices (6) Government intervention — taxes and subsidies (7) Natural conditions/weather.

Costs of Production

The most important supply shifter. If production costs rise (wages, raw materials, energy), supply DECREASES (left shift) — firms need a higher price to justify producing the same output. If costs fall, supply INCREASES (right shift). EXAMPLE: A rise in global oil prices increases transport and energy costs for most industries → supply shifts left.

Technology

Improvements in technology reduce production costs and increase efficiency → supply curve shifts RIGHT (more can be supplied at every price). EXAMPLE: Automation in car manufacturing reduces labour costs → supply of cars increases. Technology improvements are the main driver of long-run supply growth.

Prices of Related Goods in Production — Substitutes in Production

Goods that compete for the same productive resources. If the price of a substitute in production rises, producers reallocate resources toward it → supply of the original good DECREASES (left shift). EXAMPLE: If soybean prices rise, farmers switch land from corn to soybeans → supply of corn shifts left.

Prices of Related Goods in Production — Joint Supply (Complements in Production)

Goods produced together as part of the same production process. An increase in production of one automatically increases supply of the other. EXAMPLE: Beef and leather are in joint supply — more cattle slaughtered for beef → more leather available → supply of leather shifts right.

Number of Firms

More firms entering the market → market supply INCREASES (right shift). Firms exiting → market supply DECREASES (left shift). EXAMPLE: New coffee shops opening in a city → supply of coffee increases → supply curve shifts right.

Expectations of Future Prices

If producers expect future prices to rise, they may withhold current supply (store inventory) → current supply DECREASES (left shift). If they expect prices to fall, they increase current supply. EXAMPLE: Oil producers expecting higher prices next quarter reduce current output to sell more later at higher prices.

Government Intervention — Indirect Taxes

An indirect tax (e.g. excise duty, VAT) imposed on producers increases their costs → supply curve shifts LEFT (upward) by the amount of the tax per unit. At every quantity, producers now require a price that is higher by the tax amount. EXAMPLE: A €2 per unit excise tax on cigarettes → supply curve shifts left by €2 vertically (from S1 to S2).

Government Intervention — Subsidies

A subsidy is a payment by the government to producers that reduces their costs → supply curve shifts RIGHT (downward) by the amount of the subsidy per unit. At every quantity, producers now accept a lower price because costs are covered. EXAMPLE: Government subsidises solar panel producers → supply of solar panels increases → S shifts right.

Natural Conditions and Weather

Particularly important for agricultural goods. Favourable weather → supply increases (right shift). Drought, floods, disease → supply decreases (left shift). EXAMPLE: A drought in Australia reduces wheat yields → supply of wheat shifts left → price rises. A bumper harvest shifts supply right → price falls.

DIAGRAM — Shift of Supply Curve

Draw axes with original supply curve S1 (upward sloping). Draw S2 to the RIGHT of S1 = increase in supply (more supplied at every price). Draw S3 to the LEFT of S1 = decrease in supply. At any given price P, quantity on S2 > S1 > S3. Label with arrows and a reason for each shift.

Competitive Market Equilibrium

The price at which the quantity demanded by consumers exactly equals the quantity supplied by producers. At equilibrium: Qd = Qs. There is no surplus and no shortage. The market clears. The equilibrium price is also called the market-clearing price.

DIAGRAM — Market Equilibrium

Draw a downward-sloping demand curve D and an upward-sloping supply curve S on the same axes. Where they intersect: label the equilibrium price P* on the Y-axis and equilibrium quantity Q* on the X-axis. Draw dotted lines from the intersection point to both axes. This intersection is the market equilibrium — the only price at which Qd = Qs.

Excess Demand (Shortage)

When the market price is BELOW equilibrium: Qd > Qs. Consumers want to buy more than producers are willing to supply at that price. Result: upward pressure on price → price rises back toward equilibrium. DIAGRAM: Mark a price P1 below P*. Read off Qd1 (on demand curve) and Qs1 (on supply curve). Qd1 > Qs1. The horizontal gap between them = the shortage. Arrow pointing upward on price axis shows pressure for price to rise.

Excess Supply (Surplus)

When the market price is ABOVE equilibrium: Qs > Qd. Producers supply more than consumers are willing to buy at that price. Result: downward pressure on price → price falls back toward equilibrium. DIAGRAM: Mark a price P2 above P*. Read off Qs2 (on supply curve) and Qd2 (on demand curve). Qs2 > Qd2. The horizontal gap = the surplus. Arrow pointing downward shows pressure for price to fall.

The Price Mechanism

The process by which prices coordinate economic decisions in a market economy. Functions: (1) SIGNALLING — prices signal to producers and consumers about relative scarcity and value. (2) INCENTIVISING — rising prices incentivise producers to supply more; falling prices incentivise consumers to buy more. (3) RATIONING — prices ration scarce goods among consumers (those willing and able to pay get the good). Together these functions bring markets to equilibrium without central coordination.

Effect of a Shift in Demand on Equilibrium

If demand INCREASES (D shifts right): at original price P1 there is now excess demand → price is bid up → new equilibrium at higher P* and higher Q. If demand DECREASES (D shifts left): excess supply at original price → price falls → new equilibrium at lower P and lower Q. DIAGRAM: Show original D1/S intersection, then shift D to D2, show new intersection at higher/lower P and Q*.

Effect of a Shift in Supply on Equilibrium

If supply INCREASES (S shifts right): at original price there is now excess supply → price is pushed down → new equilibrium at lower P* and higher Q. If supply DECREASES (S shifts left): excess demand at original price → price rises → new equilibrium at higher P and lower Q*. DIAGRAM: Show original D/S1 intersection, then shift S to S2, show new intersection.

Simultaneous Shifts of Demand and Supply

When both curves shift at the same time, the effect on price and quantity depends on the relative size of the shifts. EXAMPLE 1: Demand increases AND supply increases → Q* definitely rises, but effect on P* is uncertain (depends on which shift is larger). EXAMPLE 2: Demand increases AND supply decreases → P* definitely rises, but effect on Q* is uncertain. Always draw the diagram to determine the outcome.

Consumer Surplus

The difference between what consumers are WILLING to pay for a good and what they ACTUALLY pay (the market price). Represents a welfare gain to consumers. Shown on a diagram as the area above the price line and below the demand curve, to the left of Q*. EXAMPLE: You are willing to pay €80 for a concert ticket but the market price is €50 → your consumer surplus = €30.

DIAGRAM — Consumer Surplus

Draw supply and demand curves intersecting at (Q, P). Shade the triangle above P* and below the demand curve, to the left of Q. Label it "CS" (Consumer Surplus). The area of this triangle = ½ × base (Q) × height (maximum WTP − P*). A price fall increases CS; a price rise decreases CS.

Producer Surplus

The difference between the price producers ACTUALLY RECEIVE and the minimum price they would have been WILLING to accept (their marginal cost). Represents a welfare gain to producers. Shown as the area below the price line and above the supply curve, to the left of Q*. EXAMPLE: A farmer is willing to sell wheat for €150/tonne but receives €200/tonne → producer surplus = €50/tonne.

DIAGRAM — Producer Surplus

Draw supply and demand curves intersecting at (Q, P). Shade the triangle below P* and above the supply curve, to the left of Q*. Label it "PS" (Producer Surplus). A price rise increases PS; a price fall decreases PS.

Total Surplus (Social/Community Surplus)

Total Surplus = Consumer Surplus + Producer Surplus. The total welfare gain to society from all market transactions. At competitive equilibrium, total surplus is MAXIMISED — this is allocative efficiency. Any deviation from equilibrium (price controls, taxes, monopoly) creates a deadweight loss and reduces total surplus.

DIAGRAM — Total Surplus

Draw supply and demand curves intersecting at (Q, P). Shade CS triangle (above P, below D). Shade PS triangle (below P, above S). Total shaded area = Total Surplus. At equilibrium this is the maximum possible — no other price/quantity combination produces a larger total surplus.

Deadweight Loss

The loss of total surplus (CS + PS) that occurs when a market does not operate at the competitive equilibrium. Shown as a triangle between the supply and demand curves, between the actual quantity traded and the equilibrium quantity Q. Caused by: price controls, indirect taxes, subsidies, monopoly, externalities. EXAMPLE: A price ceiling below equilibrium reduces quantity traded below Q → deadweight loss triangle appears between Qs and Qd.

Allocative Efficiency

Achieved when resources are allocated to their highest-valued uses — when the economy produces the combination of goods and services that maximises total surplus. In a competitive market: achieved at equilibrium (P* and Q) where P = MC (price equals marginal cost). Any output level other than Q is allocatively inefficient.

Productive Efficiency

Achieved when goods are produced at the lowest possible cost per unit — using the least amount of resources. In a competitive market: firms are forced to minimise costs to survive. Productive efficiency does not guarantee allocative efficiency — a firm can be productively efficient but produce the wrong combination of goods.

The Role of the Price Mechanism — Signalling

Prices signal information to buyers and sellers. A rising price signals that a good is becoming more scarce or more valued → signals producers to supply more and consumers to economise. A falling price signals abundance → signals producers to reduce output. This information function coordinates millions of decisions without central planning.

The Role of the Price Mechanism — Incentivising

Rising prices create profit incentives for producers to increase supply and for new firms to enter the market. Falling prices incentivise consumers to increase purchases. These incentives cause automatic market adjustment toward equilibrium without government intervention.

The Role of the Price Mechanism — Rationing

When a good is scarce, the price mechanism rations it among consumers — only those willing and able to pay the equilibrium price receive the good. This ensures goods go to those who value them most highly (as measured by willingness to pay). Criticism: rationing by price excludes low-income consumers even if they need the good — a key argument for government intervention.

Critique of Maximising Behaviour — Consumers (HL)

Standard economic theory assumes consumers are rational utility maximisers — they always make decisions that maximise their satisfaction given their budget. Behavioural economics critiques this: consumers often display bounded rationality (limited information/cognitive ability), are influenced by emotions, make inconsistent choices, follow habits, and are subject to cognitive biases. EXAMPLE: People buy lottery tickets despite negative expected value — irrational by standard theory.

Critique of Maximising Behaviour — Producers (HL)

Standard theory assumes firms are rational profit maximisers. In reality: managers may pursue sales maximisation, growth, or personal objectives (principal-agent problem). Firms face imperfect information about costs and demand. Satisficing (achieving a satisfactory rather than maximum profit) may be more realistic. EXAMPLE: A manager may avoid a risky but profit-maximising project to protect their own job — not profit-maximising behaviour.

Bounded Rationality (HL)

The concept from behavioural economics that individuals make decisions using simplified rules of thumb (heuristics) because they have limited information, limited cognitive ability, and limited time. They are rational within their constraints but do not always achieve the optimal outcome that standard theory predicts. Introduced by Herbert Simon.

Rational Behaviour Assumption — Limitations (HL)

The assumption that all economic agents always make perfectly rational, utility/profit-maximising decisions is criticised because: (1) Information is imperfect and costly to obtain. (2) Cognitive biases affect decision-making (anchoring, loss aversion, present bias). (3) Social and emotional factors influence choices. (4) Habits and inertia prevent optimal adjustments. Behavioural economics incorporates these insights into more realistic models.

Market Efficiency — Summary

A competitive market in equilibrium is both productively efficient (goods produced at lowest cost) and allocatively efficient (resources allocated to highest-valued uses, P = MC, total surplus maximised). This is the theoretical case for free markets. However, market failures (externalities, public goods, information asymmetry, market power) mean real markets often fail to achieve this efficiency — justifying government intervention (covered in Chapters 4–7).

Real World Example — Demand Shift (COVID-19)

During COVID-19 lockdowns (2020): demand for restaurant meals fell sharply (D shifted left) → price pressure downward, many restaurants closed. Simultaneously demand for home delivery food surged (D shifted right) → prices and quantity both rose. This illustrates simultaneous demand shifts in related markets responding to a change in consumer circumstances and preferences.

Real World Example — Supply Shift (Ukraine War 2022)

Russia's invasion of Ukraine (February 2022) reduced the global supply of wheat and sunflower oil (Ukraine and Russia produce ~30% of global wheat exports) → supply curve shifted LEFT → global food prices surged. This is a real-world example of a negative supply shock affecting equilibrium: S shifts left → P* rises, Q* falls. Led to food inflation particularly affecting lower-income countries dependent on wheat imports.