2. DEMAND AND SUPPLY How markets determine the price of goods and the quantity sold and consumed?

A market is a place where goods and services are exchanged.

Barter vs. markets

Barter system: goods or services are exchanged for other goods or services. Repair your neighbour's car in return for his or her assistance in your garden. Problem such trade requires a double coincidence of wants, so barter system has high transactions costs. Money is therefore used to conduct trade it is easier. In a market economy, the price of a good or service is determined through the interaction of demand and supply. It is important to know the determinants of demand and supply.

Demand
The relationship between the price of the good and the quantity demanded in a given time period, ceteris paribus represented by a demand schedule:

This may also be represented by a demand curve:

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Note the inverse relationship between the price and the quantity demanded. This is called the law of demand. A change in the price of the good would change the quantity demanded.

Change in demand vs. change in quantity demanded

A change in demand causes a shift in the demand curve (from D to D'). This represents an increase in demand since a larger quantity is demanded at each price.

Market demand
Market demand is the total amount demanded by each individual in the market: the horizontal summation of the individual demand curves for all consumers: 10 + 15 at price = $3.

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Determinants of demand
Factors that could cause a change in demand: tastes and preferences, the prices of related goods, income, the number of consumers, and expectations of future prices and income. Two goods are said to be substitutes if an increase in the price of one results in an increase in the demand for the other: chicken and fish or coffee and tea. A higher price of coffee reduces the quantity of coffee demanded, but increases the demand for tea.

Two goods are complementary if an increase in the price of one results in a reduction in the demand for the other - goods that are consumed together: peanut butter and jelly, cameras and film, Prepared by S. Indalmanie

An increase in the price of DVDs would reduce both the quantity of DVDs demanded and the demand for DVD players.

As income increases, it is expected that the demand for most goods will increase.

Supply
The relationship between the price of a good and the quantity supplied in a given time period, ceteris paribus. The supply relationship may be represented by a supply curve:

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or a supply schedule:

The law of supply: A direct relationship exists between the price of a good and the quantity supplied in a given time period, ceteris paribus - the supply curves will be upward sloping.

Change in quantity supplied vs. change in supply

A change in the price of a good change the quantity supplied, while a change in supply shifts the supply curve - a rightward shift indicates an increase in supply at the same price. A decrease in supply - the supply curve shifts to the left.

Market supply
The market supply curve is the summation of all individual supply curves.

Determinants of supply

the prices of resources, technology and productivity, the expectations of producers,

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the number of producers, and the prices of related goods and services.

An increase in the price of resources reduces the profitability of producing the good or service, so the quantity that suppliers are willing to offer for sale at each price would fall - a leftward shift in supply curve.

A change in technology and changes that increase labour productivity result in lower production costs and higher profitability, more will be supplied.

Equilibrium
Combining the market demand and supply curves on one diagram. These curves intersect at $3 and 60 units the equilibrium price and quantity (D = S).

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Price > $3: (S > D) and we have a surplus, so firms will lower prices until the surplus is gone, at P = $3. At a price below the equilibrium ($3), we have a shortage where D > S and producers will be expected to increase the price until the shortage disappears at P = $3.

Shifts in demand and supply

In this section, we examine what will happen when demand or supply changes. First: the effect of an increase in demand. Result: we have an increase in both S and D, and a new equilibrium level.

A decrease in demand will reduce both S and D and a new equilibrium level.

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An increase in supply will reduce price and increase quantity.

A fall in supply will cause the price to increase but quantity to fall.

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Price ceilings and price floors are two types of price controls
A price ceiling is a legally mandated maximum price or a government-imposed maximum price for a product whilst a price floor is legally mandated minimum price. Below are illustrations of these concepts

If a price ceiling is placed below the market-clearing price, as Pc is in the picture above, the market-clearing price of Pe becomes illegal. At the ceiling price, buyers want to buy more than sellers will make available. In the graph, buyers would like to buy amount Q4 at price Pc, but sellers will sell only Q1. Because they cannot buy as much as they would like at the legal price, buyers will be out of equilibrium which results in a shortage in the market. Note: Since a price ceiling is a legally mandated maximum price .If price ceiling is set at a point below the equilibrium price, then the result would be a shortage of the commodity since QD > QS, e.g. rent controls and regulated food prices. Note: A price floor is a legally mandated minimum price. The purpose of a price floor is to keep the price of a good above a certain price level e.g minimum wage. Prepared by S. Indalmanie

The graph below illustrates a price floor with price Pf. At this price, buyers are in equilibrium, but sellers are not. They would like to sell quantity Q2, but buyers are only willing to take Q3. Since the price is set above the equilibrium level, the result will be a surplus since QS > QD.

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