Essentials of economics – Ch 3
MARKET DEMAND, SUPPLY,
AND ELASTICITY
1. Ceteris Paribus
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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
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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.
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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
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The law of demand states that there is a
negative (inverse) relationship between the
price of good and the quantity demanded,
ceteris paribus.
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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
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2 Factors
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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
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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
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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
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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
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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
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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
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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
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1.
2.
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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.
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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
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“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
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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:
1.
Prices of Other Goods
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Firms must weigh the opportunity costs of
producing one good versus another
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Productive resources are limited, choosing
the right one depends on relative prices
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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.
2.
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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.
3.
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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:
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More G/S can be produced from the same volume of
resources
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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.
4.
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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
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The amount of product for sale can increase for 2
reasons:
1.
2.
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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
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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
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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
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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
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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
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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
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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
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1.
2.
3.
4.
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.
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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
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Increases in demand raise prices and quantities, ceteris
paribus.
Increases in supply lower prices and raise quantities,
ceteris paribus
7. Elasticity and Price
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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
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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:
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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
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1.
2.
3.
Three determinants:
Availability of substitutes;
Relative importance of good in the
budget; and
Adjustment time.
7.1.1 Determinants of Price
Elasticity of Demand
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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
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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
– cont.
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Supply
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.