Actions

Supply and demand: How markets work

From Baripedia


The Market forces of supply and demand[edit | edit source]

Supply and demand are the two word that economist use most often. Supply and demand are the forces that make the market economies work. They determine the quantity of each good produced and the price at which it is sold. If you want to know how any event or policy will affect the economy, you must think first about how it will affect supply and demand.

Markets and competition[edit | edit source]

The terms supply and demand refer to the behavior of people as they interact with one another in markets. A market is a group of buyers and sellers of a particular good or service. The buyers as a group determine the demand for the product, and the sellers as a group determine the supply of the product.

Competitive markets[edit | edit source]

Markets take many forms. There are highly organized ones and (more often) less organized ones. Most markets in economy are highly competitive. A competitive market is a market in which there are many buyers and many sellers so that each has a negligible impact on the market price. Each seller has limited control over the price because other sellers are offering similar products. A seller has little reason to charge less than the going price, and if he or she charges more, buyers will make their purchases elsewhere. Similarly, no single buyer can influence the price because each buyer purchases only a small amount.

Competition: Perfect and otherwise[edit | edit source]

We assume in this chapter that markets are perfectly competitive. Perfectly competitive markets are defined by two primary characteristics: the goods being offered for sale are the same and the buyers and sellers are so numerous that no single buyer can influence the price. Because buyers and sellers in perfectly competitive markets must accept the price the market determines, they are said to be price takers.

Not all goods and services are sold in perfectly competitive markets. Some markets have only one seller, and this seller sets the price. Such a seller is called a monopoly. Some markets fall between the extremes of perfect competition and monopoly. One such market, called an oligopoly, has a few sellers that do not always compete aggressively.

Another type of market is a monopolistically competitive. It contains many sellers but each offers a slightly different product (like magazines). Because the products are not exactly the same, each seller has some ability to sell the price for its own product.

Demand[edit | edit source]

The demand curve: The relationship between price and quantity demanded The quantity demanded of any good is the amount of the good that buyers are willing and able to purchase. As we shall see, many things determine the quantity demanded of any good, but when analyzing how markets work, one determinant plays a central role – the price of a good.

If the quantity demanded falls as the price rises and rises as the price falls, we say that the quantity demanded is negatively related to the price. This relationship between price and quantity demanded is true for most goods in economy and, in fact, is so pervasive that economists call it the law of demand: other things equal, when the price of a good rises, the quantity demanded of the good falls, and when the price falls, the quantity demanded rises.

A demand schedule is a table that shows the relationship between price of a good and the quantity demanded, holding constant everything else that influences how much consumers of the good want to buy. The downward sloping line relating price and quantity demanded is called the demand curve.

Market demand versus individual demand[edit | edit source]

The market demand is the sum of all the individual demands for a particular good or service. The market demand curve shows how the total quantity demanded of a good varies as the price of the good varies, while all the other factors that affect how much consumers want to buy are held constant.

Shifts in the demand curve[edit | edit source]

The demand curve shows how much of a good people buy at any given price, holding constant the many other factors beyond price that influence consumers’ buying decisions. As a result, this demand curve need not be stable over time. If something happens to alter the quantity demanded at any given price, the curve shifts.

Any change that increases the quantity demanded at every price, the demand curve shifts to the right and is called an increase in demand. Any change that reduces the quantity demanded at every price, the demand curve shifts to the left and is called a decrease in demand.

There are many variables that can shift the demand curve. Here are the most important:

 Income: A lower income means that you have less to spend in total. If the demand for a good falls when income falls, the good is called a normal good.

If the demand for a good rises when the income falls (ex. Bus rides), the good is called an inferior good.

 Prices of related goods: When a fall in the price of one good reduces the demand for another good, the two goods are called substitutes. Substitutes are often pairs of goods that are used in place of each other. When a fall in the price of one good raises the demand of another good, the two goods are called complements. Complements are often pairs of goods that are used together.

 Tastes Economists do, examine what happens when tastes change

 Expectations Your expectations about the future may affect your demand for a good or service of today

Supply[edit | edit source]

The supply curve: The relationship between price and quantity supplied The quantity supplied of any good or service is the amount that sellers are willing and able to sell. There are many determinants of quantity supplied, but once again price plays a special role in our analysis. Because the quantity supplied rises as the price rises and falls as the price falls, we say that the quantity supplied is positively related to the price of the good. This relationship between price and quantity supplied is called the law of supply: other things are equal, when the price of a good rises, the quantity supplied of the good also rises, and when the price falls, the quantity supplied falls as well. The supply schedule is a table that shows the relationship between the price of a good and the quantity supplied, holding constant everything else that influences how much producers of the good want to sell. The curve relating price and quantity is called the supply curve. The supply curve slopes upward because, other things equal, a higher price means a greater quantity supplied.

Market supply versus individual supply[edit | edit source]

Market supply is the sum of the supplies of all sellers. As with demand curves, we sum the individual supply curves horizontally to obtain the market supply curve. The market supply curve shows how the total quantity supplied varies as the price of the good varies.

Shifts in the supply curve[edit | edit source]

Any change that raises quantity supplied at every price shifts the curve to the right and is called an increase in supply. Similarly, any change that reduces the quantity

supplied at every price shifts the curve to the left and is called a decrease in supply. There are many variables that can shift the supply curve. Here are some of the most important

 Input prices the supply of a good is negatively related to the price of the inputs used to make the good.

 Technology by reducing firms’ costs, the advance in technology raises the supply

 Expectations The amount of a good a firm supplies today may depend on its expectations of the future

 Number of sellers

Supply and demand together[edit | edit source]

Equilibrium[edit | edit source]

Equilibrium is a situation in which the price has reached the level where quantity supplied equals quantity demanded. The price at this intersection is called the equilibrium price; the quantity is called the equilibrium quantity. The actions of buyers and sellers naturally move markets towards the equilibrium of supply and demand.

If there is a surplus of the good, suppliers are unable to sell all they want at the going price. A surplus is sometimes called a situation of excess supply. The sellers respond to the surplus by cutting their prices. Falling prices increase the quantity demanded and decrease the quantity supplied. Prices continue to fall until the market reaches the equilibrium. If there is a shortage of the good, demanders are unable to buy all they want at the going price. A shortage is sometimes called a situation of excess demand. Sellers can respond by raising their prices without losing sales. As the price rises, quantity demanded falls, quantity supplied rises and the market moves toward the equilibrium. The law of supply and demand says: the price of any good adjusts to bring the quantity supplied and quantity demanded for that good into balance.

Three steps to analyzing changes in equilibrium[edit | edit source]

The equilibrium price and quantity depend on the position of the supply and demand curves. When some event shifts one of these curves, the equilibrium in the market changes. The analysis of such a change is called comparative statics. When analyzing how some event affects a market, we proceed in three steps. First, we decide whether the event shifts the supply curve, the demand curve or both curves. Secondly, we decide whether the curve shifts to the right or to the left. Thirdly

we use the supply and demand diagram to compare the initial and the new equilibrium, which shows how the shift affects the equilibrium price and quantity.

Supply, Demand and government policies[edit | edit source]

Control on prices[edit | edit source]

A legal maximum on the price at which a good can be sold is called a price ceiling. A legal minimum on the price at which a good can be sold is called a price floor.

How price ceilings affect market outcomes[edit | edit source]

When the government, moved by the complaints and campaign contributions imposes a price ceiling on the market, two outcomes are possible. If the equilibrium price is lower than the ceiling, the price ceiling is not binding. Market can naturally

move the economy to the equilibrium and the price ceiling has no effect on the price or the quantity sold. If the government imposes a price ceiling lower than the equilibrium, the ceiling is a binding constraint on the market. The forces of supply and demand tend to move the price towards the equilibrium price, but when the market price hits the ceiling, it can rise no further. Thus, the market price equals the price ceiling. At this price, the quantity demanded exceeds the quantity supplied. A shortage develops and the buyers do get to pay a lower price, but some buyers can’t buy the good at all. That means. When government imposes a binding price ceiling on a competitive market, a shortage of the good arises and sellers must ration the scarce goods among the large number of potential buyer. The rationing mechanisms that develop under a price ceiling are rarely desirable.

How price floors affect markets outcomes[edit | edit source]

Price floors, like price ceilings, are an attempt by the government to maintain prices at other than equilibrium levels. Whereas price ceilings place a maximum on prices, a price floor places a legal minimum. If the price floor is underneath the equilibrium, the price floor is not binding. Market forces naturally move the economy to the equilibrium and the price floor has no effect. If the equilibrium price is below the floor, the price floor is a binding constraint on the market. The forces of supply and demand tend to move the price towards the equilibrium price, but when the market price hits the floor, it can fall no further. The Market price equals the price floor. At this floor, the quantity supplied exceeds the quantity demanded. A binding price floor causes a surplus. In the case of the price floor, some sellers are unable to sell all they want at the market price. Evaluating price controls

To economists, prices are not the outcome of some haphazard process. Prices, they contend, are the result of the millions of business and consumer decisions that lie behind the supply and demand curves. Prices have the crucial job of balancing supply and demand and, thereby, coordinating economic activity.

Policy makers are led to control prices because they view the market’s outcome as unfair. Price controls are often aimed at helping the poor. But price controls often hurt those they are trying to help.

Taxes[edit | edit source]

All governments, whether national or local, use taxes to raise revenue for public projects, such as roads, schools and national defence.

When the government levies a tax on a good, who bears the burden of the tax? The people buying the good? The people selling the good? Or, if buyers and sellers share the tax burden, what determines how the burden is divided? Tax incidence is the manner in which the burden of a tax is shared among participants in a market

How taxes on buyers affect market outcomes[edit | edit source]

We first consider a tax levied on buyers of a good. The initial impact of the taxis is on the demand of a good. The supply curve is not affected because, for any given price of a good, sellers have the same incentive to provide a good to the market- By contrast, buyers now have to pay tax to the government whenever they buy the good. Thus the tax shifts the demand curve for the good. The direction of the shift is easy to determine. Because the tax on buyers makes buying the good less attractive, buyers demand a smaller quantity of the good at every price. As a result the demand curve shifts to the left. Having determined how the demand curve shifts, we can now see the effect of the tax by comparing the initial equilibrium and the new equilibrium. Because sellers sell less and buyers buy less in the new equilibrium, the tax on the good reduces the size of the goods market. To sum up, the analysis yields two lessons:

  • Taxes discourage market activity. When a good is taxed, the quantity of the good sold is smaller in the new equilibrium.
  • Buyers and sellers share the burden of takes. In the new equilibrium, buyers pay more for the good and sellers receive less.

How taxes on sellers affect market outcomes[edit | edit source]

Now we consider a tax levied on sellers of a good. In this case, the immediate impact of the tax is on the sellers. Because tax is not levied on buyers, the quantity demanded at any given price is the same, thus, the demand curve does not change. By contrast, the tax on sellers makes the business less profitable at any given price, so it shifts the supply curve.

Because the tax on sellers raises the cost of producing and selling the good, it reduces the quantity supplied at every price. The supply curve shifts to the left. The equilibrium price rises and the equilibrium quantity falls. Once again, taxes reduce the size of the market. And once again buyers and sellers share the burden of the tax.

In both cases the tax places a wedge between the price that buyers pay and the price the sellers receive. The wedge between the buyers price and the sellers price is the same, regardless of whether the tax is levied on buyers or sellers. In either case, the wedge shifts the relative position of the supply and demand curves. In the new

equilibrium, buyers and sellers share the burden of the tax. The only difference between taxes on buyers and taxes on seller is who sends the money to the government.

Elastic and Tax incidence[edit | edit source]

A general lesson about how the burden of a tax is divided: a tax burden falls more heavily on the side of the market that is less elastic. Why is that true? In essence, the elasticity measures the willingness of buyers or sellers to leave the market when conditions become unfavorable. A small elasticity of demand means that buyers do not have good alternatives to consuming this particular good. A small elasticity of supply means that sellers do not have good alternatives to producing this particular good. When the good is taxed, the side of the market with fewer good alternatives cannot easily leave the market and must, therefore, bear more of the burden of the tax.

References[edit | edit source]