Module 5 – The Market
5.1 Introduction
 A market exist when individuals, households and firms who want to buy a good or services are in
contact with firms or institutions willing to supply that good or service (or resource)
 Market prices provide information to buyers attempting to maximize utility from their allocation of their
budgets and also to suppliers attempting to maximize their profits
5.2 Market Supply and Demand
 For an exchange to take place, there must be at least one common price at which suppliers would be
willing to sell a quantity of the good and at which individuals would be prepared to buy a quantity of the
good
P2
Supply
P1
Demand
Q1
Q2
 At price P1, consumers would be willing to buy quantity Q1 while suppliers would supply Q2
 At price P2, no exchange could take place because the demand would be zero
 Any consumer willing to buy a good at P1 must prefer the good to the cash P1, similarly any supplier
supply the good at P1 must prefer the cash than the good
Supply
Demand
 Exchange is not possible in the above market because there is no common price at which exchange
could occur
Demand
Supply
 The above is the market demand and supply for fresh air – this is a free good because for every
quantity demanded, the suppliers are willing to supply for free. The supply curve eventually turns up
because if you wanted more you would have to install air conditioning of some sort
 Where the demand curve cuts the supply curve is where there is neither excess supply nor demand in
the market
5.3 Operation of Markets
 If a price causes excess supply or demand in the market, forces in the market will change the price of
the good and the quantity bought and sold until the market is in equilibrium
 Excess demand causes prices rises causes less demand
 Excess supply causes price reduction causes less supply
 The equilibrium price is the price that allows all individuals who wish to buy a good obtain as much as
they wish to at that price, and enables all suppliers who wish to sell the good sell as much as they wish
to at that price – the quantity that is bought/sold is called the equilibrium quantity
 Consumer Surplus is the difference between the price individuals actually pay for a good and the price
they would be willing to pay
B
A
E
 At least on individual is willing to pay price B, but they only have to pay A if this market is in equilibrium,
the consumer surplus is measures by the triangle BAE
 Similarly producers surplus is the difference between the price suppliers actually receive for selling
units and the lower prices they would be willing to accept
A
E
C
 AEC is the producers surplus at the equilibrium price of A
 Information in markets is very important, once the terms of exchanges become known by buyers and
suppliers then the market moves to equilibrium
5.4 Changes in Market Equilibrium
 If a market were in equilibrium and any of the conditions effecting supply or demand were to change,
forces would establish a different equilibrium price and/or quantity
 An increase in demand due to a rise in the price of a substitute good would shift the demand curve up
and so increase the equilibrium price and quantity, cet. par.
Very important:
 An increase in demand refers to a shift in the demand curve
 An increase in the quantity demanded refers to movement along the existing demand curve
…..Similarly with supply
 An increase in supply would cause the supply curve to shift to the right and cause the equilibrium price
to reduce while the quantity would increase
 When an increase in supply and demand occurs simultaneously, the new equilibrium quantity is always
higher but whether the price is higher or lower depends on the relative shift of the two curves
 If the demand increased and the supply decreased, the price will always increase but the quantity may
increase or decrease
 If supply increase and demand decreases, the price will fall but quantity may rise or fall
 If demand and supply falls, quantity would fall but price may rise or fall
Supply increase
Q higher
P lower
P lower
Demand Increases
Demand unchanged
Demand decreases
Supply unchanged
P & Q higher
no change
P lower, Q lower
Supply Decrease
P higher
P higher, Q lower
Q lower
Note:
A decrease in supply could be caused by an increase in production costs – this would mean supply curve
shifts to the left, ie a supplier is willing to supply less goods for the same price
5.5 Intervention in the Market
 Market intervention or market regulation occurs where a non-market force causes the price and
quantity of a good bought and sold in a competitive market to be different from the price/quantity
combination that would occur if the market were allowed to operate freely
 When the price of a good is fixed below the equilibrium level, a price ceiling is said to exist in the
market for that good
 Price alone will not be sufficient to allocate supply – rationing or ‘first come first served’ could be used
S
P1
D
P2
S1
S2




Lets say supply is limited to S1 (supply inelastic)
If the market were left to its own devices, the equilibrium price would be P1
Lets say the organizers of this event feel P1 is to high and set the ceiling price at P2
Demand is for S2 tickets but only S1 are available and so some mechanism needs to be in place to
allocate the S1 tickets
 Black markets spring up when price ceilings are in place – they attempt to force the price back to
equilibrium level
 A black market can exist in the above example because there is demand at prices above P2 for tickets
 When the price of a good is fixed above equilibrium level, a price floor is said to exist in the market for
that good
 Excess supply will exist and some method other than price needs to be in place so the surplus can be
disposed of
 The EU’s system of setting prices for agricultural goods is an example of this
P1
Pe
S1
 If the price of a good is set at P1 (>Pe) then producers will supply an excess quantity for the market as
supply will be greater than demand
 The surplus could be destroyed, stockpiled or the govt could pay the farmers to produce no more than
S1
 Minimum wage causes some low skilled people to be unemployed because the supply will be greater
then demand
5.5.3 Taxes and Subsidies
 If a tax of $1 is imposed on suppliers of a particular good, then the MC increases by $1 and so the
market supply curve will shift upwards by $1 – the demand curve would remain the same
 How much this tax effects the new equilibrium price depends on the elasticity of the demand curve –
the more elastic (horizontal) the less the price will increase due to the tax and so the more the firm
would have to absorb the tax
 The imposition of a tax would cause the consumer and producer surpluses to be reduced
5.6 Dynamic Adjustments to the Market
 The analysis of the change in equilibrium points due to a shift in market curves is called ‘comparative
statics’
 This does not take into account the time necessary for a new equilibrium to be established, nor does it
trace the exact process by which a market adjusts from one point to another
 When the demand for a good changes, price will reach different levels in different time periods
depending on differences in the supply elasiticity
 During the market period, the supply curve may be completely inelastic because quantity supplied
cannot be altered no matter how the demand curve changes
 So during the market period, the price will change dramatically in response to changes in demand
5.6.1 The Effect of Changes in the Short Run
 The supply of the good is more elastic in the short run as opposed to the market period – so
equilibrium price will not change with a change in demand but not as much
5.6.2 The Effect of Changes in the Long Run
 Supply is more elastic than in short run and hence changes in the demand curve produce less dramatic
changes in price
 If the long run supply curve is completely elastic, price would return to its original equilibrium point after
a demand curve shift and the equilibrium quantity would change dramatically
5.6.3 Cyclical patterns in markets
 For markets whose supply of goods and resources changes only after a time lag, the prices for those
goods and resources tends to fluctuate in a cyclical fashion
P1
P3
P
P2
Q1
Q3
Q
Q2
 Farmers are originally at equilibrium at price P and quantity Q but due to foot and mouth they produce
Q1 the next year
 Farmers produce Q1 pigs and get price P1 for them – encouraged by the high price they increase their
supply for next year, using P1 as a guide they produce Q2
 To clear Q2 from the market, they have to accept P2
 This cyclical price movement goes on until they once again achieve equilibrium
 In some markets the price does not converge to equilibrium but in fact moves away
 This occurs in markets where the supply curve is steeper than the demand
 The cobweb model assumes that producers never learn from experience and that there are no
speculators
Remember:
1) An increase in the supply (e.g. due to a reduction in production cost) means the supply curve moves
to the right
2) An increase in demand (e.g due to an increase in the cost of a substitute good) means the demand
curve moves to the right.
3) The more a curve is horizontal the more elastic it is
Review Qs:
1. d
2. b
3. b
4. b
5. a
6. b
7. a
8. a
9. d
10. c
11. c
12. b