Markets: Demand, Supply, and Market Equilibrium

Markets

• Market failures can occur in a free market. These failures often lead to inefficient allocation of resources, justifying government intervention to correct these inefficiencies.

• Prices are set in a free market through demand and supply interaction. This interaction determines the equilibrium price and quantity.

Demand

• Demand Definition: The quantity of a good or service that consumers are willing and able to purchase at a given price and time.

• Types of Demand:

  • Individual demand: The demand of a single consumer.

  • Market demand: The sum of all individual demands for a product.

  • Aggregate demand: The total demand for all goods and services in an economy.

• Law of Demand: As the price of a good or service increases, the quantity demanded decreases, assuming all other factors remain constant (ceteris paribus).

• Demand Curve: A graphical representation showing the relationship between the price of a good or service and the quantity demanded over a period of time.

Factors Affecting Demand:

• Price: The most direct factor; as price changes, quantity demanded moves along the demand curve.

• Income: Affects consumers' ability to purchase goods and services. (Normal vs. Inferior Goods)

• Population: A larger population generally leads to higher demand for most goods and services.

• Tastes: Consumer preferences and tastes play a significant role in determining demand.

• Prices of substitutes and complements: Changes in the prices of related goods can shift the demand curve.

• Expected future prices: Expectations about future price changes can influence current demand.

Movements Along the Demand Curve vs. Shifts of the Demand Curve

• Movement along the line (Expansion or Contraction): A change in the price of the good itself causes a movement along the demand curve. Expansion occurs when price decreases, leading to increased quantity demanded, and contraction occurs when price increases, leading to decreased quantity demanded.

• Shift of the line (Increase or Decrease): A change in any factor other than the price of the good itself causes a shift in the entire demand curve. An increase shifts the curve to the right, and a decrease shifts it to the left.

• If demand rises due to a change in price, it is NOT considered an increase in demand; it is simply a movement along the existing demand curve.

Examples:

• If the price of a PS5 decreased, it would cause a movement along the demand curve, specifically an expansion of demand.

• If the price of an Xbox decreased, it would cause a shift in the demand curve for PS5s. This is because Xbox is a substitute good for PS5.

Increase in Demand

• Five possible reasons for an increase in demand:

  • A rise in incomes: Consumers have more money to spend.

  • A rise in population: More consumers in the market.

  • A change in tastes: Increased preference for the product.

  • A rise in the price of substitute goods: Makes the product more attractive.

  • A fall in the price of complementary goods: Makes the product more attractive.

Price Elasticity of Demand

• Definition: Responsiveness of the quantity demanded of a good or service to a change in its price. It measures how much the quantity demanded changes in response to a change in price.
  

  *If a big change in price leads to a big change in demand, there is elastic demand. Elastic demand means that consumers are highly responsive to price changes.

• If demand drops to zero with an increase in price, demand is perfectly elastic (e.g. demand for a perfect substitute). This is represented by a horizontal demand curve.

• If a big change in price leads to a small change in demand, there is inelastic demand. Inelastic demand means that consumers are not very responsive to price changes.

• If demand doesn't change at all, demand is perfectly inelastic (e.g. for life-saving medicine). This is represented by a vertical demand curve.

• If a change in price is proportional to the change in demand, there is unit elastic demand. This means that the percentage change in quantity demanded is equal to the percentage change in price.

Importance of Knowing Elasticity of Demand

• Government: Needs to know the elasticity of demand for different products when imposing taxes to determine how much revenue they would make. Taxes on goods with inelastic demand generate more revenue because demand remains relatively constant despite the tax.

  • Addictive goods such as cigarettes or alcohol have relatively inelastic demand, where demand will still be relatively high regardless of the introduction of a tax. This allows governments to collect significant tax revenue.

• Firms: If demand is inelastic, firms will increase the price to make more profits, as the quantity demanded will not decrease significantly. The government will raise taxes on it to increase revenue because they know it will still generate sufficient tax revenue.

Factors Affecting Elasticity of Demand

• Necessities and luxuries: Necessities tend to have inelastic demand, while luxuries have elastic demand.

• Existence of close substitutes: Goods with many close substitutes have high elasticity of demand.

• Proportion of income spent on the good: Goods that take up a large proportion of income tend to have higher elasticity of demand.

• The length of time since a price change: Demand tends to become more elastic over time as consumers find alternatives.

• Addictive nature of the product: Addictive products tend to have inelastic demand.

• Goods with many substitutes have high elasticity of demand: Consumers can easily switch to alternatives if the price increases.

Examples of Elasticity

• Medicine is considered to have inelastic demand because people need it regardless of the price.

• Gasoline: Inelastic demand, especially in the short term, because people need to drive.

How to Measure Elasticity

• If the price rises and total outlay (spending) increases, then demand is inelastic because consumers are willing to spend more despite the higher price.

• If the price rises and total outlay (spending) decreases, then demand is elastic because consumers reduce their quantity demanded significantly in response to the higher price.

Supply

• Supply Definition: The quantity of a good or service that firms are willing and able to produce and sell at a given price and time.

• Types of Supply:

  • Individual supply: The supply of a single firm.

  • Market supply: The sum of all individual firms' supplies for a product.

  • Aggregate Supply: The total supply of all goods and services in an economy.

• Law of Supply: As the price of a good or service increases, the quantity supplied increases, assuming all other factors remain constant (ceteris paribus).

• The Supply Curve ‘Supply’ is the quantity that firms are willing to produce and sell at each price level.

Factors Affecting Supply

• Price of inputs: Lower input costs increase supply.

• Technology: Advances in technology can increase supply.

• Price of alternative products: If the price of an alternative product increases, the supply of the original product may decrease.

• Expected future prices: Expectations about future prices can influence current supply.

• Number of producers: More producers increase supply.

Movement along the Line vs. Shift of the Line

*The price

*Number of producers

*Price of inputs

*Technology

*Price of alternative products

*Expected future prices

Elasticity of Supply

• Elasticity of supply: Refers to how responsive the quantity supplied of a product is to a change in its price. It measures the percentage change in quantity supplied relative to the percentage change in price.

• If a big change in price leads to a big change in supply, there is elastic supply. This means producers can quickly respond to price changes.

• If supply drops to zero with a decrease in price, supply is perfectly elastic. This is represented by a horizontal supply curve.

• If a big change in price leads to a small change in supply, there is inelastic supply. This means producers cannot easily change the quantity supplied in response to price changes.

• If supply doesn't change at all, supply is perfectly inelastic. This is represented by a vertical supply curve.

• Supply is more elastic if:

  • There has been a long time since the price change (Time lag since the price change): Producers have more time to adjust production.

  • The product is non-perishable and easy to store (Ability to hold and store stock): Producers can store and release stock as needed.

  • The firm has excess capacity (e.g. the factory is not being fully used): Producers can increase production without significant additional costs.

Market Equilibrium

• Prices are set by the interaction between supply and demand. The equilibrium price is where the quantity demanded equals the quantity supplied.

• A free market may result in the production of undesirable goods and services and non-production of desirable ones. This is because profitability, not social welfare, drives production decisions.

• A free market can lead to the abuse of market power. Firms with significant market power can manipulate prices and reduce output.

• The government can intervene to control prices.

  *What are the costs and benefits of price ceilings and price floors?

  *How are price controls shown on a diagram?

Point of Supply and Demand

• If there is a situation of excess demand (a shortage of supply), consumers will bid the price up resulting in a contraction in demand. The higher prices will incentivize suppliers to produce more of that product expanding supply. This continues until quantity demanded equals quantity supplied, reaching equilibrium.

• If there is a situation of excess supply, consumers will turn to other suppliers and negotiate the price down, resulting in a fall of price. As the price falls, demand expands while supply contracts, since some suppliers can no longer afford to sell at the lower price. This continues until quantity demanded equals quantity supplied, reaching equilibrium.

Market Failures

• When the free market fails to allocate resources efficiently, leading to suboptimal outcomes.

• There are three main market failures:

  • Public Goods

  • Non-rival: One person's consumption does not reduce the amount available for others.

  • Non-exclusive: It is impossible to prevent people from consuming the good, regardless of whether they have paid for it.

  • Merit Goods

  • Beneficial but is under-consumed due to its benefits being underestimated. Education and healthcare are examples.

  • (Something harmful and over-consumed is a demerit good): e.g., alcohol or cigarettes.

  • Externalities

  • A transaction between two parties that has an impact on a third party who is not directly involved in the transaction.

  • Can be positive or negative: Positive externalities benefit third parties, while negative externalities impose costs on them.

Market Structures

• Another market failure is when there is so little competition that firms don’t have to lower their prices, leading to higher prices and reduced output.

Price Controls

• Price Ceiling: A maximum legal price that can be charged for a good or service.

• Price Floor: A minimum legal price that can be charged for a good or service.