Chapter 2 : Supply and demand

Competitive Markets

a market composed of many buyers and sellers acting independently none of whom has any ability to influence the price of a product

What forces determine the price in a competitive market?

• other sellers

• economy at the same time

Demand

an indication of the various quantities of a good/service a consumer is willing and able to buy a various prices during a particular time period, ceteris paribus

Market demand

sum of all individual demands

Law of demand

the negative relationship between the price of a good and the quantity demanded; Ceteris paribus, as the price of a product increases, the quantity demanded of the product will decrease and as the price decreases, quantity demanded increases.

explanation of law of demand : income effect

When the price of a good decreases, consumers gain purchasing power, allowing them to buy more of the same good because their money goes further.

explanation of law of demand : substitution effect

As the price of a good decreases, consumers switch from other substitute goods to this good because its price is comparatively lower.

explanation of law of demand : the law of diminishing marginal utility

This law states that as we consume additional units of something, the satisfaction (utility) we derive for each additional unit (marginal unit) grows smaller (diminishes).

what 3 laws support law of demand and why

Income effect, sub effect, law of diminishing marginal utility - all three help explain why consumers buy more of a good when its price decreases, supporting the Law of Demand.

what does a price change vs demand look like

Causes of a price change in a diagram

change in the good's own price causes movement ALONG the demand curve.

Causes of a demand change

change in a non-price determinant (income, tastes, substitutes, complements, expectations, or number of consumers) causes the entire demand curve to SHIFT

List the determinants of demand

Normal goods, Inferior goods, tastes and pref, complementary goods, sub goods, number of consumers

Normal good

a good where the greater the income, the greater the demand

Inferior good

demand varies inversely with income so the greater the income the smaller the demand

Tastes and preferences

if the product becomes more popular, demand increases. if it becomes less popular, demand decreases

Complementary goods

two or more goods that tend to be used together Price of one ↑ = Demand for complement ↓.

sub goods

two or more goods that satisfy a similar need. Price of one ↑ = Demand for substitute ↑.

number of consumers

demand increases with more consumers resulting in a shift of the market demand curve to the right

Supply

An indication of the various quantities of a good or service a firm is willing and able to produce and provide to a market for sale at different possible prices, during a particular time period, ceteris paribus.

Law of supply

positive relationship between the price of a good and quantity supplied over a time period; as the price of a product rises, the quantity supplied of the product will increase and as the price falls, the quantity supplied will decrease

exception for supply

means that the quantity supplied is fixed and cannot change, regardless of the price. such as land as its a natural resource and this would result in a vertical curve

Law of diminishing returns

As more units of a variable input (like workers) are added to a fixed input (like land or machinery), the additional output produced by each extra worker eventually decreases.

Because the fixed resources become overcrowded or are shared among too many workers, making each additional worker less productive.

Marginal cost what does it repersent on a graph

the upward sloping portion on the supply curve

Marginal Cost

the extra cost of producing one more unit of output

What is the relationship between marginal product and marginal cost?

They have an inverse relationship: MP ↑ = MC ↓; MP ↓ = MC ↑. Lower productivity makes each additional unit more expensive.

What are the non price determinants of supply

resource costs, technology, price of related goods - competitive supply, joint supply, producer price expectations, subsidies, taxes, supply shocks, number of firms

Resource costs

• Costs of inputs used to produce goods (labor, raw materials, rent).

• Effect: Resource costs ↑ = Supply ↓ (left). Resource costs ↓ = Supply ↑ (right).

tech

• Improvements in machinery, equipment, or production methods.

• Effect: Better technology = Supply ↑ (right) because production becomes easier and cheaper

competetitive supply

• Producers can use the same resources to make different products.

• Effect: Price of one good ↑ = Supply of the other good ↓ because producers switch production.

joint supply

• Two goods are produced together from the same production process.

• Effect: Producing more of one good also increases the supply of the other.

prodcer price expectations

• What producers expect prices to be in the future.

• Effect: Expected future prices ↑ = Current supply ↓ because producers hold back goods to sell later.

subsidies

• Government payments to producers to help reduce production costs.

• Effect: Subsidies ↑ = Supply ↑ (right).

taxes

• Government charges on businesses or production.

• Effect: Taxes ↑ = Supply ↓ (left) because production becomes more expensive.

supply shocks

• Unexpected events that suddenly affect production.

• Effect:

  • Positive supply shock = Supply ↑ (right).

  • Negative supply shock = Supply ↓ (left).

Number of firms

• Number of businesses producing a good.

• Effect:

  • More firms = Supply ↑ (right).

  • Fewer firms = Supply ↓ (left).

market equillibrium

when the amount of a good/service demanded by consumers is equal to the amount supplied by producers at a particular price

shortage

excess demand

• Quantity demanded > Quantity supplied.

• Occurs when price is BELOW equilibrium.

surplus

excess supply

• Quantity supplied > Quantity demanded.

• Occurs when price is ABOVE equilibrium.

price mechanism

prices in free competitive markets determine the allocation of resources

Signalling function of prices

The ability of prices, and changes in prices, to communicate information to consumers and producers about the existence of excess demand or excess supply, on the basis of which they make economic decisions.

• High prices signal that a good is scarce or demand is high.

• Low prices signal that a good may be less scarce or demand is low.

Incentive function of prices

The ability of prices, and changes in prices, to convey information to consumers and producers that motivates them to respond in their best self-interest.

Prices motivate consumers and producers to change their behavior.

• Higher prices: Consumers are incentivized to buy less, while producers are incentivized to supply more.

• Lower prices: Consumers are incentivized to buy more, while producers are incentivized to supply less.

Allocative efficiency

allocation of resources that results in producing the combination and quantity of goods and services mostly preferred by consumers

marginal benefit

The extra satisfaction or benefit gained from consuming one additional unit - demand curve

relationships between MB and MC

• MB > MC → Do more; benefit exceeds cost.

• MB < MC → Do less; cost exceeds benefit.

• MB = MC → Allocatively efficient; resources are used optimally

Consumer surplus

The difference between the highest price consumers are willing to pay for a good and the price actually paid. The benefit consumers receive from paying a price lower than what they were willing to pay.

Producer Surplus

The difference between the price received by firms for selling their goods and the lowest price they’re willing to accept to produce the goods. The benefit producers receive when they sell for a price above which they were willing to supply for.

Social Surplus

CS+PS

consumer + producer surplus location on graph?

consumer top triangle - producer bottom triangle

area of trapezoid

½ [(a+b) * c]

What are the limitations of the assumptions of rational behavior

Bias - Anchoring, Rules of thumb, framing, avaliabilty

Anchoring

Use of irrelevant information to make decisions, often due to it being the first piece of information a consumer happens to come across. 

Rules of thumb

Simple guidelines based on experience and common sense

Availability

Use of information that is most recently available, even when this information is not necessarily any more reliable than previously available information.

Framing

Deals with how choices are presented to decision-makers.

Assumptions that consumers make rational decisions

Completeness, Transitivity, Non-Satiation, Perfect information, Utility Maximization

Completeness Assumption

Consumers can compare and rank all available choices.

Transitivity Assumption

Preferences are consistent (if A > B and B > C, then A > C).

Non-Satiation assumption

More of a desirable good is preferred to less.

Perfect Information

Consumers know all relevant prices, quality, and choices.

Utility Maximization

Consumers choose the option that gives them the greatest satisfaction within their budget.

Presence of bias has to led to alternative concepts that can more accurate

bounded rationality, bounded self control, bounded selfishness, imperfect information

Bounded Rationality

Consumers have limited time and information, so they cannot consider every option.

Bounded Self Control

Consumers struggle to resist temptation or prioritize long-term benefits.

Bounded Selfishness

Consumers consider others' well-being, not just their own satisfaction.

Imperfect Information

Consumers don't always know all prices, quality, or alternatives.

Nudge

a method designed to influence cosumers choices in a predictable way - coined by richard thaler and cass in 2008

Default Choice

choice is made by default, as a result of one doing nothing

Restricted Choice

Choice is limited by government or some other authority

Mandated Choice

Choice between alternatives that is made required by the government or other authority

Standard Economic Theory

all firms seek to maximize profit

alternative bussiness objectives

• corporate social responsibility

• market share

• growth and revenue maximization

corporate social responsibility

• avoid pollution

• healthy environment

• human rights and labor explotation

• back to community

market share

percentage of total sales in a market that is earned from a single firm

benefits of growth maximazation

• Higher market share

• Higher profits long-term: Increased sales can lead to greater future profits.

• Reduced competition: Make it harder for smaller firms to compete.

• Increased market power: Gain more influence over prices and the market.

Satisficing

Choosing an option that is good enough rather than searching for the best possible option or maximizing utility.