1.2. How Markets Work

Define demand

quantity of goods and services that consumers are willing and able to purchase at a given time or price

What do consumers do?

buy + demand

What do producers do?

sell + supply

What does a demand curve look like?

What two things can happen to a demand curve

movement

shift

Types of demand curve shifts

• increase
  → shifts right/outward

• decrease
  → shifts left/inward

What type of factor causes a shift of the demand curve?

non-price factor

Factors that may cause a shift in the demand curve (conditions of demand)

1. income

2. consumer preferences

3. prices of related goods

4. tastes and preferences

5. population and demographics

6. expectations

Demand Curve Shift Factors: Income

• as consumer income changes, the demand for goods and services shift
  
  → Normal goods: Demand increases with rising income (e.g. luxury cars)
  → Inferior goods: Demand increases with falling income (e.g. generic brands)

Demand Curve Shift Factors: Consumer preferences

• changes in consumer preferences leads to shifts in demand
  → e.g. increased awareness of health = shift towards healthier food coices

Demand Curve Shift Factors: Prices of Related Goods

• complementary goods: decrease in price of one good increases demand for its complementary good
  → e.g. decreased price of peanut butter = increased demand for jam
  
  

• substitute goods: increase in price of one good increases demand for substitute
  → e.g. increased price of Coke = increased demand for Pepsi

Demand Curve Shift Factors: Tastes and Preferences

• trends can influence demand

Demand Curve Shift Factors: Population & Demographics

• changes in population size or age demographics can affect demand
  → e.g. aging population = increased demand for healthcare

Demand Curve Shift Factors: Expectations

• future expectations about prices, income or other factors can affect current demand
  → e.g. if consumer expects a future shortage of a product, they may increase current demand

Types of movement along demand curve

expansion

contraction

Causes of expansion of demand curve

• decrease in price

• = increase in quantity demanded

Cause of contraction of demand curve

• increase in price

• = decrease in quantity demanded

What causes the downwards sloping shape of a demand curve?

• diminishing marginal utility

• real income effect

• substitution effect

Diminishing marginal utility (DMU)

• DMU states that as a consumer consumes more units of a service, the additional satisfaction/utility derived from each additional unit decreases

• This reflects the idea that people value the first unit the most and subsequent units less

How does DMU cause downwards sloping of a demand curve?

price must decrease for consumers to continue to buy more units of a product

→ e.g. if a consumer buys ice cream, the first scoop provides high utility but by the fifth scoop, the utility of each additional scoop decrease

→ therefore price must decrease for consumer to continue to buy more scoops

Real income effect

• demand changes as a consumer’s real income (purchasing power)

• real income changes as the price of goods changes

• when the price of a good falls, the consumer’s real income increases because they can now afford more of the good

• when the price of a good rises, real income decreases

Substitution effect

• the effect of the change in demand of a good when its price changes, making it more or less expensive relative to other goods

• consumers will choose substitutes if they are cheaper

Define supply

the quantity of goods and services that producers are willing and able to supply at a given time and price

Supply curve

Positive direct relationship

Movement along a supply curve

all else being equal, as the price of a good or service increases, quantity supplied also increases and vice versa

Shifts of a supply curve

when factors other than price cause a change in the quantity supplied at every price level

Factors that cause a shift in supply

1. Production costs

2. Technological advancements

3. Government policies & regulations

4. Natural Disasters & Weather Conditions

5. Changes in Expectations

6. Government Intervention in International Trade

7. Natural Resource Availability

Shift in Supply: Production Costs

• changes in the cost of inputs such as labour, raw materials and energy

• increase in the price of inputs = increase cost of production = decreased supply

Shift in Supply: Technological Advancements

• technological improvements = lower production costs = increased supply

Shift in Supply: Government Policies & Regulations

• government policies such as taxes, subsidies and regulations can affect supply

• e.g. increased taxes = increased cost of production = decreased supply

• e.g. increased subsidies = decreased cost of production = increased supply

Shift in Supply: Natural Disasters & Weather Conditions

• natural disasters such as hurricanes and droughts can disrupt production and reduce supply

Shift in Supply: Changes in Expectations

• producers may adjust their supply based on their expectations of future prices or market conditions

• e.g. if farmers expect coffee prices to rise in the future, they may reduce current supply to take advantage of higher places later

Shift in Supply: Government Intervention in International Trade

• trade policies such as tariffs and quotas can affect the supply of imported goods

• e.g. imposing tariffs on steel imports can reduce the supply of foreign steel in the domestic market

Shift in Supply: Natural Resource Availability

• the availability of natural resources, like minerals and fossil fuels, can impact supply

• e.g. depletion of oil reserves = reduction in oil supply

Define price mechanism

The price mechanism is the interaction of demand and supply in the free market, which determines prices. These prices allocate resources efficiently. Adam Smith called this process the ‘invisible hand’

Three functions of the price mechanism

• Rationing

• Incentive

• Signalling

Functions of the price mechanism: rationining

prices allocate scarce resources to those who are willing to pay

at a high price, the good is rationed to those who can afford it

Functions of the price mechanism: incentive

price changes motivate producers and consumers

incentive of producer = maximise profit

incentive of consumer = maximise utility

Functions of the price mechanism: signalling

• high price signals producers to enter the market

• high price signals a decrease in the utility of money, signalling the consumer to leave the market

Which are the different types of market that the price mechanism is involved in?

• local markets

• national markets

• global markets

Excess supply diagram

Excess demand diagram

Excess demand and excess supply result in a _____________ of ______ resources

misallocation, scarce

Excess supply and demand are fixed by the…

price mechanism

Increased price = ___________ in demand and _________ in supply

contraction

extension

Decreased price = ___________ in demand and _________ in supply

extension

contraction

Fixing Excess demand (e.g. local honey becomes more popular- increased trend)

• Excess demand = Qd > Qs
  → there is a misallocation of resources

• Excess demand is fixed by the price mechanism
  → market forces of supply and demand allocate resources with the ‘invisible hand’

• Price increases

• Signal to the producer: The higher price signals to producers that demand has increased and supply is scarce, prompting them to enter the market

• Signal to the consumer: Higher price signals decrease in utility for the consumer

• Incentive for the producer: Higher price = more profit

• Disincentive to the consumer: higher price = lower utility

• Rationing: Higher price rations the good to those who can afford it

An increase in price results in a contraction in demand and extension in supply returning the market to equilibrium

Fixing Excess Supply

• Excess supply = Qs > Qd
  → there is a misallocation of resources

• Excess supply is fixed by the price mechanism
  → market forces of supply and demand allocate resources with the ‘invisible hand’

• Price decreases

• Signal to the producer: The lower price signals to producers that demand has decreased and supply is in excess, prompting them to leave the market

• Signal to the consumer: Lower price signals increase in utility for the consumer

• Incentive for the consumer: lower price = more utility

• Disincentive to the producer: lower price = lower profit

• Rationing: Lower price means good is less rationed

A decrease in price results in an extension in demand and contraction in supply returning the market to equilibrium

Define consumer surplus

The difference between what a consumer is willing to pay and what they actually pay

Define producer surplus

The difference between the price a producer is willing to sell for and what they actually sell for

Consumer and producer surplus on a supply and demand diagram

Impact of increased supply on consumer surplus

increased supply = increased consumer surplus:

Consumers pay a lower price and a larger quantity is consumed. The area of consumer surplus has increased from area ABP1 to area ACP2.

Impact of increased supply on producer surplus

increased supply = increased producer surplus

Producer surplus also increases as quantity sold rises, and producers' become more willing to supply at the lower price. The producer surplus has increased from area DEP1 to FGP2.

Impact of increased demand on consumer surplus

increased demand = increased consumer surplus

Consumers are willing to pay more for the good, and more is consumed. The consumer surplus increases from area ABP1 to area CDP2.

Impact of increased demand on producer surplus

increased demand = increased producer surplus

Producers receive a higher price and sell more. The producer surplus increases from area EFP1 to EFP2.

Impact of decreased supply/demand on consumer/producer surplus

decreased supply/demand = decreased consumer/producer surplus

Define price elasticity of demand (PED)

PED measures the responsiveness of quantity demanded to a change in price

PED equation

PED will always be negative because as price increases, quantity demanded decreases

Ignore the negative when using PED value

e.g. PED= -2.6 is used as 2.6

Types of PED

• perfectly inelastic

• perfectly elastic

• relatively inelastic

• relatively elastic

• unitary price elastic

PED = 0

• Perfectly inelastic

• Quantity demanded is unresponsive to price changes

• e.g. essential medicine

PED = ∞ (infinity)

• perfectly elastic

• quantity demanded is extremely responsive to price changes

• theoretical

0 < PED < 1

• Relatively inelastic

• Demand is not (very) responsive to price changes

PED > 1

• Relatively elastic

• Demand is (quite) responsive to price changes

PED = 1

• Unitary elastic

• Quantity demanded changes by the exact same percentage as the price

Key determinants of PED

• Number & Closeness of Substitutes: More/better substitutes mean higher (more elastic) PED as consumers can easily switch if price rises.

• Necessity vs. Luxury: Necessities tend to be price inelastic as consumers must purchase them regardless of price; luxuries tend to be elastic as consumers can forego them if prices rise.

• Addictiveness: Addictive goods (e.g., cigarettes) often have inelastic demand because consumers find it hard to reduce consumption even if prices rise.

• Proportion of Income: Goods that take a large portion of income tend to be more price elastic as price changes significantly affect consumers' budgets.

• Time Period: In the short run, demand is often more inelastic as consumers are slow to respond to price changes. In the long run, demand can become more elastic as consumers find alternatives or adjust their habits.