1.1 Competitive Markets: Demand and Supply

Market

Arrangement allowing buyers and sellers to come together and make an exchange

Competitive market

Market where price of good, service, or factor of production is determined by interactions between small buyers and sellers

No one entity can set price due to this

Demand

Quantity of a good that buyers (consumers) are willing and able to buy at various prices over a time period

Individual demand is demand of single buyer

Market demand is demand of all buyers in market

Law of demand

Law stating demand curve shows negative relationship between price and quantity of good demanded

Law of demand illustrated by demand curve, which is downwards sloping

Why demand curve is downwards sloping

Consumer derive marginal benefit from consuming one unit of goods and services

Marginal benefit decreases with units of good consumed, thus consumers will only buy more goods if price falls

Movement along demand curve vs Shift of demand curve

Movement along demand curve can only be caused by change in price of a good

Shift of demand curve can only be caused by change in non-price determinant of demand

Non-price determinants of demand

Changes in consumer preferences -
Demand increases when tastes change in favor of a good

Changes in number of buyers -
Demand increases with no. of buyers in markets

Changes in income -
Demand increases with income for normal goods
Demand decreases with increase in income for inferior goods

Changes in prices of related goods -
Demand decreases with increase in demand for substitutes
Demand increases demand for complementary goods

Supply

Quantity of good that sellers are willing and able to produce and sell at various prices over a time period

Individual supply is supply of single seller

Market supply is supply of all sellers in market

Law of supply

Law stating supply curve has positive relationship between price and quantity of good supplied

Law of supply illustrated by supply curve, which is upwards sloping

Why supply curve is upwards sloping

As price of good increases, revenue increases, and production of good becomes more profitable

Reason for higher profitability is that firms are better able to cover costs of production with higher revenue

Movement along supply curve vs Shift of supply curve

Movement along supply curve can only be caused by change in price of a good

Shift of supply curve can only be caused by change in non-price determinant of supply

Non-price determinants of supply

Changes in costs of production -
Supply increases when cost of factors of production decrease

Changes in indirect tax -
Supply increases when indirect tax is decreased

Changes in number of firms in market -
Supply increases with number of firms in market

Changes in subsidy -
Supply increases if subsidy for product increases

Technological changes -
Supply increases with technological improvements

Changes in expectations -
Supply increases if firms expect future price will decrease

Changes in prices of related goods -

Supply for a good increases when it is in joint supply with another good whose supply increases
Supply for a good increases when it is in competitive supply with another good whose supply decreases

Market equilibrium

Position of balance between demand and supply where Q_d = Q_s

If P > P_e then excess supply (surplus)

If P < P_e then excess demand (shortage)

Equilibrium will always be achieved in free, competitive market.

When do changes in equilibrium occur?

Only changes when there is shift in demand or supply due to non-price determinant

Price mechanism

Prices determined in markets play a crucial role in allocating resources to the production of specific goods

Price signals the presence of shortage or surplus (excess demand/supply) to producers and consumers

Price also incentivizes producers and consumers to increase or decrease production and consumption respectively

This signalling/incentive function results in equilibrium being restored due to pressure along the demand and supply curves

Consumer surplus

Producer surplus

Social surplus

Benefit received by consumer buying good at lower price than they are willing to pay

Benefit received by producer selling good at higher price than they are willing to receive

Sum of producer and social surplus

In free competitive market, all 3 are maximum

Allocative efficiency

Best allocation of resources from society’s point of view, resulting in no externalities

Marginal benefit

Marginal cost

Extra benefit to consumer from consuming one more unit of a good

Extra cost to producer from producing one more unit of a good