Market Forces of Supply & Demand

Introduction: Definitions

Supply (S) & Demand (D): Represent people interacting in markets.
Market: The collective S & D for a particular good or service.
Consumers: Buyers or customers.
Producers: Sellers, suppliers, firms, or companies.
Product Market (Output Market): Consumers DEMAND, and producers SUPPLY.
Labor & Capital Markets (Input/Factor/Resource Markets): Consumers (workers & savers) SUPPLY, and producers (firms) DEMAND.

Prices allocate scarce outputs and inputs.
- They determine which outputs are produced and in what quantity.
- They determine the quantity of each input used per output.

Demand
- Shifts of vs. movements along the demand curve.
  - Movements along: Total price effect = Substitution effect + Income effect.
  - Shifts: Complements & substitutes.
Supply
- Shifts of vs. movements along the supply curve.
Supply & demand taken together
- Minimum and maximum prices.
  - Introduction to regression analysis.
Supply & demand combined & shifts of demand or supply
- Who pays a cost increase ≠ who bears it & who receives a cost decrease ≠ who enjoys it
Possibly simultaneous shifts in demand & supply curves
Elasticity

Demand Curve/Function: Relationship between price (p) and quantity demanded (Qd).
Quantity Demanded (Qd): Quantity of goods buyers are willing and able to buy per price (p).
Law of Demand: Price (p) increases, then Quantity demanded (Qd) decreases. This illustrates an inverse relationship between price and quantity demanded.
Q_d = f(p), where the function is negative.

Illustrates the relationship between the price of milk (€/litre) and the quantity demanded (litre/month).

A graph showing the relationship between price and quantity demanded. Conventionally, price (independent variable) is on the Y-axis, and quantity demanded (dependent variable) is on the X-axis.

Alfred Marshall, a father of neoclassical microeconomics, placed price on the Y-axis.
He wrote the first textbook of neoclassical economics (1890).

Uber Rides in USA: Estimated using regression analysis by holding constant other factors influencing Qd besides price, such as the willingness to pay.
- Each point on the curve represents the horizontal sum of individual demand curves at a given price.
Petrol: Estimated as a function of price using regression analysis, holding constant other factors influencing demand.

Movement Along the Demand Curve: A "ceteris paribus" change. Factors other than price that influence Qd are held constant. It illustrates the isolated effect of a price change on Qd.
Shift of the Demand Curve: Also known as a "shock to" the demand curve. This is caused by a change in a factor, other than price, influencing Qd. It abandons the "ceteris paribus" perspective.

Total Price Effect (TPE): The combined impact of the substitution effect (SE) and income effect (IE) due to a price change.
When the price of milk increases, the quantity demanded decreases due to the combined substitution and income effects.

Results from changes in relative prices.
If the price of milk increases, consumers substitute it with relatively cheaper similar products.

Results from changes in purchasing power.
If the price of milk increases, consumers can afford less milk with the same income, leading to a decrease in quantity demanded.

Developed the breakdown of the total price effect into substitution and income effects.

Income effect may go in the same direction as the price change (while the substitution effect always goes in the opposite direction).
Example: 13th Century Wheat
- Price of wheat increases.
- (Opposite-direction) substitution effect: substitutes for wheat (other foodstuffs, like rye) = (relatively) cheaper -> Qd of wheat decreases.
- (Same-direction) income effect: price increases -> income decreases -> quantity demanded of an inferior good increases (inferior good = Qd increases if income decreases; normal good = Qd increases if income increases).
- Total Price Effect (TPE) = SE + IE = AMBIGUOUS here. Perhaps the IE > SE.
- Paradox: Price of staple like wheat may increase the Qd of wheat.
Ambiguous: Uncertain whether the combined net effect of SE & IE makes TPE either positive or negative.

A cut in labor taxes by the government could encourage people to work more -> net hourly wage increases.
- Substitution Effect: people work more because the price of leisure increases (price of leisure = net wage = opportunity cost of leisure).
- Income Effect: net hourly wage increases -> the same income with less hours worked can be achieved. Middle class/richer people may work less hours.
- TPE = SE + IE = Overall ambiguous.
- Tax cuts = risky policy because the demand curve for leisure = positively sloped!

The return for government budget of labor tax rate decrease may be small because most tax revenues are generated from the rich/middle class.
Return for government budget = tax revenue increases & government expenditure decreases in the second round (thanks to working more) thanks to tax rate decrease, though such a tax cut decreases tax revenue in the first round ( = tax revenue decreases per hour worked).
Example: How large is the expected return for the govt budget of (labour) tax cuts decided in 2014 by the Belgian government?

In case of a tax increase on labor, it is POORER (rather than richer) people who risk to work less. How so?
Answer: IE leading to working more < SE leading to working less; explain

Lowering taxes on labour provided by richer people is a risky attempt to make richer people work more hours because perhaps: oIE increases their Qd for leisure more than SE decreases it
Lowering taxes on labour provided by poorer people is a less risky attempt to make poorer people work more hours because probably: oIE decreases their Qd for leisure more than SE increases it