1.1 - Competitive Markets: Demand and Supply

1.1 - Competitive Markets: Demand and Supply Markets A market is when buyers and sellers are in contact with one another with the purpose of exchange. Hence, it involves the interaction of supply and demand. Both parties must be present for a market to exist, however they do not have to be physically present. Supply, demand, price and the equilibrium price and quantity are all important to the functioning of the market. When specific factors of markets are studied, economists assume that all other factors are constant, using the Latin term ‘ceteris paribus’.

Demand The Law of Demand Demand is the quantity of a product that will be bought per unit time at a given price. It indicates how much the consumers are willing to pay for the product. The law of demand is that as the price of a product increases, the demand for the product will decrease, and vice versa. Ergo, there is a negative causal relationship between price and the quantity demanded, provided all other factors remain constant. The Demand Curve Since the law of demand shows a negative relationship between price and quantity demanded, it follows that a graph of this model would likewise show a downward trend. It is represented as a linear function because all the other factors are assumed to be constant. A demand curve shows the relationship for one market. Non-Price Determinants of Demand In reality, the relationship between price and demand is affected by other elements, meaning that the graph would not be perfectly linear. These factors include: o Number of consumers in the market (or population) o Consumers tastes and preferences

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o Consumer price expectations o Advertising o Prices of substitute goods o Price of complementary goods (things used in conjunction with the product) o For example, buying a gaming console may depend on the price of the games o Personal income When these factors change, it causes a shift in the demand curve. A shift in demand is demonstrated graphically as follows:

A shift to the right, indicated by D2, corresponds to an increase in demand. A shift to the left, indicated by D3, corresponds to a decrease in demand.

Movements Along and Shifts of the Demand Curve As explained before, shifts in the demand curve occur when factors other than price and quantity demanded change. The curve itself moves. On the other hand, movements along the demand curve are caused by a change in price. Using the graph, the quantity demanded at any given price can be found. As seen here, as the price decreases from P1 to P2, the quantity demanded increases from Q1 to Q2.

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HL - Linear Demand Functions, Demand Schedules and Graphs The demand function can be written in the form of the equation: 𝑸𝒅 = 𝒂 − 𝒃𝑷 Where: Qd = quantity demanded a = determines the intercepts (change indicates a shift in the demand curve) b = determines slope of the curve (how sensitive consumers are to price) P = price For IB Economics, you must be able to plot this equation with the following coefficients: 𝑸𝒅 = 𝟔𝟎 − 𝟓𝑷

According to this function, an increase in price by one unit will cause a decrease in the quantity demanded by five units. Hence, the slope of the demand curve and the demand function are both -5. If the coefficient a is changed, this alters the x- and y-intercepts on the graph and causes the demand curve to shift. This can be seen if a is changed to 30 (D2):

This shows that decreasing the magnitude of a indicates a decrease in demand. Likewise, increasing the magnitude of a would show an increase in demand for the product. This means that the non-price determinants of demand will affect a.

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On the other hand, as mentioned before, the coefficient b shows how sensitive consumers are to changes in price. It alters the gradient of the slope. If the value of b is decreased to 2 (D2), it causes the following changes:

Although it cannot be clearly seen on this graph, the x-intercept remains the same. The manipulations shown here demonstrate that as the value of b decreases, the demand for a product decreases les rapidly. Hence, the market is less price-sensitive. Small changes in price can have smaller effect on demand.

Supply The Law of Supply The supply is the amount of product that a supplier is able to produce and sell at a given price, given that all other factors are constant (ceteris paribus). According to the law of supply, there is a positive causal relationship between price and supply. Hence, as the price increases, the supply will also increase. Producers can afford to increase supply if the price is higher and they can make a higher profit.

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The Supply Curve The supply curve is the graphical representation of the law of supply. If all the other factors are constant, then the relationship between price and quantity supplied is linear.

The Non-Price Determinants of Supply Other factors will affect the supply of a product. These include: o Costs of factors of production 

Land, labour, capital, entrepreneurship

o Technological changes o Prices of related goods (things that are produced together) o Expectations o Indirect taxes and subsidies (affects costs of production) o Number of firms in the market producing the same thing Movements Along and Shifts of the Supply Curve The concept here is the same as for the demand curve. A movement along the supply curve is when the price changes, thereby causing a change in quantity supplied. The graph shows that an increase in price corresponds to an increase in supply.

On the other hand, shifts in the supply curve occur when non-price determinants of supply change. This causes the curve itself to move. A shift to the right (S2) indicates an increase in supply, whilst a shift to the left (S3) indicates a decrease in supply.

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HL - Linear Supply Functions, Equations and Graphs The supply function can be represented according to the equation: 𝑸𝒔 = 𝒄 + 𝒅𝑷 Where: Qs = quantity supplied c = determines the intercepts (changes cause shifts in the supply curve) d = gradient of the curve (indicates how price-sensitive the producers are) P = price For IB Economics, you need to be able to work with the form: 𝑸𝒔 = −𝟑𝟎 + 𝟐𝟎𝑷

On this graph, a change in price of one unit corresponds to an increase in the quantity supplied of 20 units. Looking at the equation, it can be seen that this is the value of d. Hence, d is the slope of the graph. If the value for c is changed to -15, the following change occurs:

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Changing the value of c causes the supply curve to shift. Increasing the value causes a shift to the left, whilst decreasing it causes a shift to the right. As a result, decreasing c will decrease the quantity supplied at a given price. The effect of changing d is shown below, where d is decreased to 10 (S2).

Decreasing the value of d causes the graph to become steeper. As a result, smaller values of d lead to a smaller change in quantity supplied as the price increases.

Market Equilibrium Equilibrium and Changes to Equilibrium Market equilibrium occurs at the point where the supply curve and the demand curve intersect. This means that the quantity demanded is equal to the quantity supplied. If there is a shift in either the demand or supply curves, a new equilibrium will be found. If the price is below equilibrium, demand will increase, but suppliers will not be able to produce sufficient product.

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There will sometimes be no equilibrium if the minimum price suppliers can sell at is above the maximum price consumers can pay. Excess demand occurs when supply is too low to meet demand. To overcome this, prices will increase, thereby reducing demand and forming a new equilibrium. At the higher price, fewer consumers will be able to purchase the product, thus causing supply and demand to be equal. Excess supply is when demand is too low to meet the supply. This is overcome by reducing prices to increase the demand and form a new equilibrium. More consumers can afford the product, raising demand to equate with the supply.

HL - Calculating and Illustrating Equilibrium Using Linear Equations In earlier sections, it was shown that demand curves and supply curves can be represented as linear equations. These allow the equilibrium price and quantity to be found mathematically. This is done by equating the functions: 𝟔𝟎 − 𝟓𝑷 = −𝟑𝟎 + 𝟐𝟎𝑷 Solving algebraically, this gives an equilibrium price of 3.6. Substituting this price into the functions, the equilibrium quantity is found to be 42. Alternatively, this can be determined from the graphs of these functions:

If you are asked to find the quantity of excess supply or demand, simply find the difference between the supply or demand at that price (whichever is in excess) and the equilibrium value.

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The Role of the Price Mechanism Resource Allocation Scarcity is when there is an unlimited need that must be met with limited resources. The factors of production (land, labour, capital and entrepreneurship) are limited, and may cause demand to exceed the supply. This leads to the question “What to produce?” which is answered by assessing the potential profits from supplying a certain product. This is compared with other products, leading businesses to supply the product with the greatest profit. However, choosing to supply one item causes the business to incur an opportunity cost. This is the best alternative decision that is forgone when a decision is made. Whenever there are two choices to a decision, then there is an opportunity cost. This means that the business may choose to invest in something that will be profitable or beneficial in the long term. The opportunity cost of it is that there may have been another option to do something that would have paid off straight away, however over time it may not have the same return. The business can only afford to have one or the other - they choose one at the cost of investing in the other. Under these conditions, competition becomes essential. Price is determined by supply and demand in a market at equilibrium. In addition, it has a signalling function by indicating where resources should be used. When changes occur that increase the equilibrium price, producers know that supply needs to increase. Furthermore, price acts as an incentive to both producers and consumers. Producers seek to increase their profit margin, whilst consumers seek for the lowest price available. A change in price can cause reallocation of resources to areas where demand is higher.

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Market Efficiency Consumer Surplus This is the difference between the price consumers are willing to pay and the actual price of a product. It indicates how much consumers benefit at a particular price. Producer Surplus This is the difference between the price that suppliers are willing to sell at, and the actual selling price. Allocative Efficiency Based on the diagram above, it is clear that the best allocation of resources is such that the price is at equilibrium, creating equal benefit for producers and consumers. This way, total welfare is maximised and the market reaches allocative efficiency. In addition, the marginal cost, or benefit to producers, is equal to the marginal benefit, or benefit to consumers. As such, at equilibrium, everyone in the community has maximum benefits.

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