2.1. Competitive Markets (Demand and Supply)

Market

An area over which buyers and sellers come together to negotiate the exchange of a good or service

Demand

The amount of a good or service that consumers are willing and able to buy (at a given price, ceteris paribus)

Law of Demand

As the price of a good or service increases, the quantity demanded of it will decrease as people become less willing and able to buy it.

Explain the law of demand, using the income effect

As the price of good A increases, consumers' real incomes decrease (they can afford to buy less of good A with the same amount of income). Therefore, the quantity demanded of good A decreases.

Explain the law of demand, using the substitution effect

As the price of good A increases, consumers may decide to substitute good A with a different product that is now relatively cheap. Therefore, the quantity demanded of good A decreases.

Explain the law of demand, using the law of diminishing marginal utility

As consumers buy more of a product, the satisfaction gained from buying additional units decreases. Therefore, the price has to decrease in order to encourage the quantity demanded of a product to increase.

Normal Good

A good for which demand increases as income increases.

Inferior Good

A good for which demand decreases as income increases.

Substitutes

Goods that are consumed in place of each other: an increase in the price of one leads to an increase in the demand for the other.

Complements

Goods that are consumed together: an increase in the price of one leads to a decrease in the demand for the other.

Supply

The amount of a good or service that firms are willing and able to produce (at a given price, ceteris paribus).

Law of Supply

As the price of a good or service increases, the quantity supplied of it will increase as firms become more willing and able to produce it.

Explain the law of supply, using profit maximisation.

As the price of good A increases, producers realise they can make more profit from selling good A. As firms are profit maximisers, they will therefore increase the quantity supplied of good A.

Explain the law of supply, using rising marginal costs.

As firms produce more of a product, the cost of producing additional units rises (due to the law of diminishing returns). Therefore, the price has to increase in order to make firms willing to produce more of a product.

Competitive Supply

Goods that are produced in place of each other: they compete for the same factors of production, so producing more of one means producing less of the other.

Joint Supply

Goods that are produced together: it is not possible to produce more of one without producing more of the other.

Equilibrium

Occurs where supply equals demand.

Excess Supply

Occurs when quantity supplied is greater than quantity demanded.

What happens to the market price when there is excess supply, and why?

Firms lower the market price, in order to sell their leftover stock.

Excess Demand

Occurs when quantity demanded is greater than quantity supplied.

What happens to the market price when there is excess demand, and why?

The market price will increase, as there is a shortage of the product which causes a bidding war, in which the price is bid up.

Price Mechanism

A mechanism by which changes in the prices of products help firms to decide what to produce (they produce more of products with increasing prices and less of products with decreasing prices).

If the price of good A is rising, what does this signal to firms? And what does this give them an incentive to do?

SIGNAL: There is excess demand in the market.

INCENTIVE: Reallocate resources to produce more of good A.

If the price of good A is falling, what does this signal to firms? And what does this give them an incentive to do?

SIGNAL: There is excess supply in the market.

INCENTIVE: Reallocate resources to produce less of good A.