IB Economics SL 2 - Supply and Demand

ECONOMICS SL chapter two - competitive markets: demand and supply

2.1 Introduction to competitive markets MARKETS • A market includes any kind of arrangement where buyers and sellers of goods and services are linked to perform an exchange. • It can be local, national, and international. • Competition is a process in which rivals compete to get an objective. • Market (monopoly) power is the power a seller has over a product’s price.

2.2 Demand LAW OF DEMAND AND DEMAND CURVE • Concerned with the behavior of buyers (both consumers and producers). • The demand of a consumer indicates the quantities of a good the consumer is willing and able to buy at different prices, ceteris paribus. • A demand schedule lists the quantity demanded at different prices. • The graphic to the right is a demand curve. • The law of demand states that there’s a negative causal relationship between the price and Qd. If the price of a good falls, Qd increase, and vice versa, ceteris paribus. • Reasoning of law of demand: each successive good consumed will produce less benefit. Marginal benefit is the extra benefit you get from an extra unit of a good/service. • Market demand is the sum of all individual demand for a good, and also the sum of the marginal benefits.

Demand

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P

P

A B

D

1

D2

D2 Qd

Increase in demand

D1

D Qd

Qd Decrease in demand

Change in Qd

1 COMPETITIVE MARKETS: DEMAND AND SUPPLY

NON-PRICE DETERMINANTS OF DEMAND • Non-price determinants are variables that can influence demand (but not price). The demand curve shifts when there are changes in these determinants. • A normal good is a good that responds to an income increase with a demand increase. • An inferior good will decrease in demand as income increases. • Substitute goods satisfy similar needs, i.e. Coca-Cola and Pepsi. • Complementary goods tend to be used together. • Non-price determinants of demand include: • Income (normal goods) - An increased income will increase demand for normal goods, and vice versa, ceteris paribus. • Income (inferior goods) - An increase in income will decrease the demand for inferior goods, and vice versa, ceteris paribus, because consumers pursue better items. • Preferences and tastes - Demand increases if tastes change to favor the product, and decreases if goods become less popular. • Prices (substitute goods) - A fall in the price of one good will result in a fall in the demand for the other, because consumers change to the cheaper good. • Prices (complementary goods) - A fall in the price of one good will result in an increase in the demand for the other. • Change in demographics - An increase in the amount of buyers will increase demand and shift the market demand curve to the right. MOVEMENTS ALONG A CURVE • A change in price will result in a movement along the demand curve, ceteris paribus. This is called change in quantity demanded. • A change in one of the non-price determinants will shift the demand curve and cause a change in demand.

2 COMPETITIVE MARKETS: DEMAND AND SUPPLY

2.3 Supply LAW OF SUPPLY AND SUPPLY CURVE • Concerned with the behavior of sellers. • The supply of a firm shows the quantities of a good the firm is willing and able to produce and supply at certain prices, ceteris paribus. • A demand schedule can present the different quantities and prices. • The supply curve maps the demand to a chart. • There is a positive causal relationship between the price and quantity demanded. • The law of supply states that as a price of a good increases, the quantity supplied increases, and vice versa, ceteris paribus. • The supply curve slopes up because firms like to produce more output to increase profit. • Market supply is the sum of all individual supplies. • There can be a vertical supply curve. The quantity supplied cannot increase even as price increases. • There is a fixed quantity of a good supplied and there is no time to make more. • There is a fixed quantity of a good because there is no chance of making more of it.

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Supply

S2

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S2

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S1

B A

Qs

Qs Increase in supply

D Qs

Decrease in supply

Change in Qs

NON-PRICE DETERMINANTS OF SUPPLY • Non-price determinants are factors that are not price that influence supply. • Competitive supply of products refers to the production where different goods compete for the same resources, i.e. wheat or corn. • Joint supply of products refers to the production of goods taken from a single product, like milk and beef. • Subsidies are payments given by the government to encourage an increase of production. 3 COMPETITIVE MARKETS: DEMAND AND SUPPLY

• Non-price determinants of supply include: • Costs of factor of production - If the price of a factor increases, production costs increases, and the supply decreases, and vice versa. • Technology - Improved technology can lower costs of production and increases the supply. • Prices (competitive supply) - If the price of good A increases, it will be produced more, and the supply of good B will decrease. • Prices (joint supply) - An increase in price in a good will increase the quantity supplied of that good and an increase in supply for a joint good. • Expectations - A firm can produce less if it expects that they can sell it for a higher price in the future. Supply decreases. If they believe less will be sold later on, supply increases for now. • Taxes - Taxes are treated as costs of production. Taxes will decrease supply. • Subsidies - An increase in subsidies is a decrease in production costs, so supply increases. • Firm amount - Increase in number of firms producing a good will increase supply. • Shocks - Unpredictable events can affect the supply curve. MOVEMENTS ALONG A CURVE • A change in price will cause a movement along the curve, called a change in quantity supplied. • A change in a determinant (non-price) will cause movement of the curve, or a change in supply.

2.4 Market equilibrium: demand and supply MARKET EQUILIBRIUM • If Qd is less than Qs, there is excess supply and the difference is the surplus. • If Qd is greater than Qs, there is excess demand and the difference is called shortage. • In a free market, the price will change during a shortage or surplus so that Qd = Qs. • Equilibrium is the state of balance so there’s no tendency to change. • Market equilibrium is the balance of supply and demand and it is where the demand curve intersects the supply curve. CHANGES IN MARKET EQUILIBRIUM • The market will adjust to a new equilibrium if there is a change in a non-price determinant. 4 COMPETITIVE MARKETS: DEMAND AND SUPPLY

Market Equilibrium P

S

• If the demand curve increases, but the price remains the same, there will be disequilibrium. At this new point, there will be a shortage. As a result, the price will be forced to go up to maintain equilibrium. • If the supply curve increases due to determinant changes but the price remains the same, there will be a surplus because Qs > Qd. The price will fall until equilibrium is reached.

surplus excess supply

equilibrium price

UNAVAILABLE

shortage excess demand D

2.5 Linear demand and supply (HL)

market equilibrium

equilibrium quantity

Q

2.6 The role of the price mechanism and market efficiency PRICES AS SIGNALS AND INCENTIVES • The invisible hand is a phrase used by Adam Smith that co-ordinates decisions of decision-makers without a central authority. • Prices as signals communicate information to decision-makers. • Prices as incentives motivate decision-makers to respond. Example: demand increases in product (strawberry) market • At initial price, there is a shortage, and price rises until shortage disappears. • Higher price signals producers that there is a shortage and incentivizes them to increase quantity supplied. • The new higher price signals consumers that strawberries are more expensive and incentivizes them to buy less. Example: supply increases in resource (labor) market • Increase of labor causes surplus and wage falls until equilibrium. • Falling wage signals firms that there is a surplus and incentivizes them to hire more. • Falling wage also signals workers that there is a lower wage and incentivizes them to offer less services. EFFICIENCY IN COMPETITIVE MARKETS • Allocative efficiency is the producing of a combination of goods most wanted by society. It is achieved when no one can become better off without someone being worse off. • Productive efficiency is the production of goods with the fewest possible resources. • These answer the how to produce and what to produce questions. • A society needs to have productive efficiency to be allocative efficient. 5 COMPETITIVE MARKETS: DEMAND AND SUPPLY

S

=

M

C

SURPLUS • Consumer surplus is the highest price consumers are willing to pay for a good minus the price actually paid. It is the shaded area between the Surplus P demand (marginal benefit) curve and the equilibrium price. • Producer surplus is the price received for selling a good minus the lowest price the firm wants to produce it for. (The lowest price must be enough to cover the cost consumer surplus of producing one more unit). It is between the supply MB = MC producer surplus (marginal cost) curve and equilibrium price. • Social surplus (community surplus) is the sum of CS and PS. • For allocative and productive efficiency to be achieved, MB = MC must hold in all markets. Q • Welfare - the well being of society. Social welfare is maximized when MB = MC. D

=

M B

6 COMPETITIVE MARKETS: DEMAND AND SUPPLY