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Basic Economics

Supply and Demand

A market is defined as a group of buyers and sellers of a particular product or service. Competitive markets are markets with many buyers and sellers, so that each has a very small influence on the price. Supply and demand is the most useful model for a competitive market, and shows how buyers (citizens) and sellers (businesses) interact in that market.

Quantity Demanded & Supplied

The demand for a product is the amount that buyers are willing and able to purchase. Quantity demanded is the demand at a particular price, and is represented as the demand curve. The supply of a product is the amount that producers are willing and able to bring to the market for sale. Quantity supplied is the amount offered for sale at a particular price. The main determinant of supply/demand is the price of the product.

Law of Demand

The Law of Demand states that other things held constant, as the price of a good increases, the quantity demanded will fall. Other factors that can influence demand include:

  1. Income - Generally, as income increases, we are able to buy more of most goods. When demand for a good increases when incomes increase, we call that good a "normal good". When demand for a good decreases when incomes increase, then that good is called an inferior good.
  2. Price of related products - Related goods come in two types, the first of which are "substitutes". Substitutes are similar products that can be used as alternatives. Examples of substitute goods are Coke/Pepsi, and butter/margarine. Usually, people substitute away to the less expensive good. Other related products are classified as "complements". Complements are products that are used in conjunction with each other. Examples of complements are pencil/eraser, left/right shoes, and coffee/sugar.
  3. Tastes and preferences - Tastes are a major determinant of the demand for products, but usually does not change much in the short run.
  4. Expectations - When you expect the price of a good to go up in the future, you tend to increase your demand today. This is another example of the rule of substitution, since you are substituting away from the expected relatively more expensive future consumption.

Demand Curves and Schedules

Demand curves isolate the relationship between quantity demanded and the price of the product, while holding all other influences constant (in latin: ceteris paribus). These curves show how many of a product will be purchased at different prices. Note that demand is represented by the entire curve, not just one point on the curve, and represents all the possible price-quantity choices given the ceteris paribus assumptions. When the price of the product changes, quantity demanded changes, but demand does not change. Price changes involve a movement along the existing demand curve.

Market demand is the summation of all the individual demand curves of those in the market. It is the horizontal sum of individual curves and add up all the quantities demanded at each price. The main interest is in market demand curves, because they are averages of individual behaviour tend to be well-behaved.

When any influence other than the price of the product changes, such as income or tastes, demand changes, and the entire demand curve will shift (either upward or downward). A shift to the right (and up) is called an increase in demand, while a shift to the left (and down) is called a decrease in demand. In example, there are two ways to discourage smoking: raise the price through taxes or; make the taste less desirable.

Law of Supply

As the price of a product rises, ceteris paribus, suppliers will offer more for sale. This implies that price and quantity supplied are positively related. The major factor that influences supply is the "cost of production", and includes:

  1. Input prices - As the prices of inputs such as labour, raw materials, and capital increase, production tends to be less profitable, and less will be produced. This leads to a decrease in supply.
  2. Technology - Technology relates to methods of transforming inputs into outputs. Improvements in technology will reduce the costs of production and make sales more profitable so it tends to increase the supply.
  3. Expectations - If firms expect prices to rise in the future, may try to product less now and more later.

Supply Curves and Schedules

The relationship between the price of a product and the quantity supplied, holding all other things constant is generally sloping upwards. Supply is represented by the entire curve and not just one point on the curve. When the price of the product changes, the quantity supplied changes, but supply does not change. When cost of production changes, supply changes, and the entire supply curve will shift.

Market Supply is the summation of all the individual supply curves, and is the horizontal sum of individual supply curves. It is influenced by the factors that determine individual supply curves, such as cost of production, plus the number of suppliers in the market. In general, the more firms producing a product, the greater the market supply.

When quantity supplied at a given price decreases, the whole curve shifts to the left as there is a decrease in supply. This is generally caused by an increase in the cost of production or decrease in the number of sellers. An increase in wages, cost of raw materials, cost of capital, ceteris paribus, will decrease supply. Sometimes weather may also affect supply, if the raw materials are perishable or unattainable due to transportation problems.

Reaching Equilibrium

We can analyze how markets behave by matching (or combining) the supply and demand curves. Equilibrium is defined as the intersection of supply and demand curves. The equilibrium price is the price where the quantity demanded matches the quantity supplied. The equilibrium quantity is the quantity where price has adjusted so that QD = QS. At the equilibrium price, the quantity that buyers are willing to purchase exactly equals the quantity the producers are willing to sell. Actions of buyers and sellers naturally tend to move a market towards the equilibrium.

Excess Supply/Demand

Excess Supply is where Quantity supplied > Quantity demanded, and results in surpluses at the current price. A large surplus is known as a "glut". In cases of excess supply:

  • price is too high to be at equilibrium
  • suppliers find that inventories increase
  • suppliers react by lowering prices
  • this continues until price falls to equilibrium

Excess Demand occurs when Quantity demanded > Quantity supplied, and results in shortages at current prices. In cases of excess demand:

  • buyers cannot buy all they want at the going price
  • sellers find that their inventories are decreasing
  • sellers can raise prices without losing sales
  • prices increase until market reaches equilibrium

Law of Supply and Demand

In free markets, surpluses and/or shortages tend to be temporary and obey the law of supply and demand, since actions of buyers and sellers tend to match prices back toward their equilibrium levels.