Essentials of economics – Ch 3 MARKET DEMAND, SUPPLY, AND ELASTICITY

1. Ceteris Paribus Economic theory zeroes in on the most important factors that explain an economic phenomenon. Ceteris paribus describes the relationship between two factors when all other relevant factors do not change. (“Other things being equal”)

2. Market Demand Markets bring buyers and sellers together – buyers who want goods are not necessary going to buy them. Wants refers to goods and services people would accept if it is given away free. We demand that quality of a good we are actually prepared to buy with our limited income at prevailing prices.

2. Market Demand – cont. Demand refers to what economic agents actually do when confronted with opportunity cost and limited income – where having more of one good means having less of another. Demand is thus that amount of a good that people are actually prepared to buy at prevailing prices and income. The demand curve shows the quantities demanded at different prices.

2.1 The Law of Demand: Income and Substitution Effects The law of demand states that there is a negative (inverse) relationship between the price of good and the quantity demanded, ceteris paribus. The quantity demanded is the amount of a good or service (G/S) we are willing and able to buy at the prevailing price. This law states that quantity demanded as price lowers.

2.1 The Law of Demand: Income and Substitution Effects 2 Factors The principle of substitution: as the goods price falls its relative price falls. It’s cheaper than the substitute; it’s a better buy; we purchase more! As price falls; we can buy the G/S we are used to and more! When the price of a good falls, people buy more because its relative price has fallen (the substitution effect), and the price reduction increase in purchasing power leads to greater purchases of good, including the good itself (the income effect). The law of demand is thus explained by substitution and income effect.

3. The Demand Curve The demand curve shows the quantities of the good demanded at different prices, all other factors held constant. The ceteris paribus relationship between price and quantity demanded is negative because of the law of demand. As price goes up, the quantity demand goes down.

3.1 Shifts in Demand Factors such as prices of goods, income, preference, the number of buyers, or expectations can change the quantity of goods people are prepared to buy – the demand curve shifts: Demand increase when the demand curve shifts to the right. Demand decrease when the demand curve shifts to the left.

3.1.1 Prices of related goods Two goods are substitutes if the demand for one rises when the price of the other rises or if demands fall when the price of the other falls. Two goods are compliments if the demand for one rises when the price of the other falls or when the demand for one falls when the price of the other rises.

3.1.2 Income As income rises, people tend to spend more on most, but not all, G/S Goods are classified as normal or inferior. The demand for a normal good increases (its demand curve shifts to the right) as income rises. The demand for an inferior good fall (its demand curve shifts to the left) as income rises.

3.1.3 Preferences Preferences are what people like or dislike without regards to their budgets. Preferences show the structure of wants when goods are given away free.

3.1.4 The number of potential buyers More buyers in the market, the demand rise, market change: Populations grow, immigration increase, people move from North to South Removal of trade barriers

3.1.5 Expectations Law of demand states that the quantity demanded is negatively related to the current price of goods. People’s expectation of how the price will behave in the future can affect demand. Their expectation that the price will rise can increase the demand, even if no change in current price

3.2 Shifts in Demand Curves versus Movements Along a Demand Curve Two reasons why the amount of a particular good that people are prepared to purchase can differ: The price of good can change. Other factors that affect purchases as well as the good’s current price can change. Both (1 and 2) results in increased sales, but are easily confused.

3.2 Shifts in Demand Curves versus Movements Along a Demand Curve-cont. An increase in demand occurs when the demand curve shifts to the right. Consumers are now willing to purchase more of the good at each price. An increase in quantity demanded occurs when the price of the good falls and there is a movement down the demand curve.

4. Market Supply “Universal law of supply” – the higher the price, the greater the quantity supplied. The quantity supplied of a G/S is the amount offered for sale at a given price.

4.1 The Supply Curve The supply curve shows the quantities of a good supplied at different prices, all other factors that effect supply being held constant. A positive relationship means more is supplied as a higher price.

4.2 Shifts in supply Four factors can cause changes: Prices of Other Goods Firms must weigh the opportunity costs of producing one good versus another Productive resources are limited, choosing the right one depends on relative prices As the price of other goods increase, the supply of the good should fall (its supply curve shifts to the left

4.2 Shifts in supply – cont. Prices of Inputs Goods are produced by combining land, labor, and capital resources An increase in input process causes a reduction in supply (the supply curve shifts to the left).

4.2 Shifts in supply – cont. Technology Changes Cost of production are determined by resource prices and by the efficiency with which resources are used. The state of technology dictates this efficiency Technology is accumulated scientific and technical knowledge about how to produce specific goods and services As technology advances: More G/S can be produced from the same volume of resources Cost of production fall and firms are willing to supply more of the G/S at the same price as before Improvement in technology cause supply to increase (the supply curve shifts to the right)

4.2 Shifts in supply – cont. Number of Sellers As more sellers enter the market, larger quantities of goods are offered to buyers at the same price as before. An increase in the number of sellers causes supply to increase (the supply curve shifts to the right).

4.3 Shifts in Supply Curves versus Movements Along a Supply Curve The amount of product for sale can increase for 2 reasons: The price can rise. A factor other than current price can change. An increase in supply occurs when the supply curve shifts to the right. Sellers are now willing to offer more for sale at each price. An increase in quantity supplied occurs when the price of the good rises, and there is a movement up the supply curve. More is offered for sale, but the supply curve has not budged.

4.4 Independence of Supply and Demand Shifts in supply do not cause shifts in demand, and visa versa The factors that increase the demand for a good are different from the factors that change the supply of the good

5. Equilibrium: Supply and Demand Together The demand curve explains what consumers are prepared to buy at different prices The supply curve explains what producers are prepared to sell at different prices

5.1 Shortages and Surpluses A shortage results if the quantity demanded exceeds the quantity supplied at the prevailing price. A surplus results when the quantity supplied exceeds the quantity demanded at the current price.

5.2 Equilibrium The equilibrium or market-clearing price is the price at which the quantity demanded equals the quantity supplied by producers It is called the equilibrium price because there is no automatic tendency to move away from it The equilibrium of supply and demand is stationary - the price will tend not to change once the equilibrium price is reached

6. Changes in Equilibrium Equilibrium connects quantity demanded with quantity supplied Stable = movement away from the equilibrium price creates the shortages and surpluses that automatically return the market to equilibrium Prices change because of shifts in supply and demand curves

6.1 Changes in Demand When the prices of substitutes rise, the prices of the complements fall, preferences change in favor of the product, the number of buyers expands, or higher prices are expected in the future Increases in demand cause both the equilibrium price and quantity to increase. The demand curve shifts to the right Reduction in demand causes both the equilibrium price and quantity to fall. The demand curve shifts to the left

6.2 Changes in Supply Factors that influence supply: Reduction in the price of other products; Reduction in the price of relevant resources; Increase in number of sellers; and Technological improvements.

6.2 Changes in Supply – cont. An increase in supply causes the equilibrium price to fall and the equilibrium quantity to rise. A decrease in supply causes the equilibrium price to rise and the equilibrium quantity to fall. Generalizations Increases in demand raise prices and quantities, ceteris paribus. Increases in supply lower prices and raise quantities, ceteris paribus

7. Elasticity and Price Elasticity measures responsiveness of quantity supplied or quantity demanded to price changes. If firms do not increase quantity supplied when the price rises, an increase in demand will push up the prices substantially = higher equilibrium price. If people are not prepared to buy more at a lower price, an increase in supply will result in much lower prices, thus a much lower equilibrium price.

7.1 Price Elasticity of Demand The price elasticity of demand is the absolute value of the percentage change in quantity demanded divided by the percentage change in price. Law of demand: if the price rises – the quantity demand falls. Elasticity of demand are divided into 3 categories: Price elasticity of demand is greater than 1, demand is elastic. Price elasticity of demand is equal to 1, demand is unitary elastic. Price elasticity of demand is less than 1, demand is inelastic An elastic demand curve has a less steep slope than an inelastic curve.

7.1.1 Determinants of Price Elasticity of Demand Three determinants: Availability of substitutes; Relative importance of good in the budget; and Adjustment time.

7.1.1 Determinants of Price Elasticity of Demand The greater the number of substitutes, the more elastic is the demand. Goods that make up a small fraction of the consumer’s budget (salt etc.) are more inelastic in demand than products that make up a large portion of the budget (gasoline). The longer the time period people have to adjust to price changes, the more elastic is the demand.

7.2 Price Elasticity of Supply Elasticity of supply measures the responsiveness of producers to changes. The price elasticity of supply is the percentage change in quantity supplied divided by the percentage change in price. Elasticity of supply are also divided into 3 categories: elastic (elasticity of supply greater than 1), inelastic (elasticity of supply less than 1), and unitary elastic (elasticity of supply equals 1).

7.2 Price Elasticity of Supply – cont. The most important determinant is the amount of time producers have to adjust to the price change. The more time the producer has to adjust to price changes, the greater the elasticity of supply. As the price rises, the producer may have limited flexibility to respond.