How Markets Work

Demand

Introduction• Economics is about choices that people make to

face scarcity and how those choices are affected by incentives.

• Prices act as incentives.• The demand & supply model is the main tool of

Economics . It tells us how people respond to prices and how prices are determined by demand & supply.

• This model helps us to answer the economic questions : What How , and for whom are

goods and services are produced?

Prices And Markets • Prices of goods and services are determined by

demand and supply of these goods and services in the markets.

• A market has two sides : buyers & sellers.• Examples of goods and services:• Some markets are physical places where buyers

& sellers meet.• Some markets are groups of people around the

world who never meet , but connected through Internet. Examples: E-commerce markets and

currency markets.

Money Prices & Relative Prices

• A Money Price of a good is the amount of money must be paid in exchange of it.

• A Relative Price is the ratio of the price of one good to another and it is an opportunity cost.

• Example :• If the money price of coffee is 1 SR and the

money price of gum is 0.5 SR , then the relative price of coffee to gum= 1 /0.5 = 2 : 1 and it is the opportunity cost of a cup of coffee : To get one cup of coffee ,you must give up two packs of gum.

Demand

• If you demand something that means:• You want it. • You can afford it ,and• Plan to buy it.• Demand reflect a choice : What wants to be

satisfied and by what goods and services.

The Quantity Demanded

• The quantity demanded of goods & services is the amount that consumer plan to buy during a period of time at a particular price.

• Many factors influence buying plans and price is one of them.

The Law of Demand

• Other things remain the same , the higher the price of a good , the smaller the quantity demanded and the lower the price of a good , the greater the quantity demanded.

Substitution Effect and Income Effect

• To explain why a higher price reduce the quantity demanded ?

• For two reasons:• Substitution Effect: When the price of a good

rises . Other things remaining the same, its relative price ( the opportunity cost) rises.

As the opportunity cost of a good rises , the incentive to reduce its use and switch to a substitute becomes stronger.

Income Effect

• When the price of a good rises , Other things remaining the same , people face a higher price and an unchanged income. They cannot pay for all goods and services that they used to buy. So when the price of a good rises , Other things remaining the same , they must decrease the quantities of some goods and services specially the good whose price has increased.

The Demand Curve• It shows the inverse relationship between

the quantity demanded of a good and its price , other things that affect demand being the same.

Quantity Demanded

Price

A Demand Schedule

• It lists the quantity demanded at each price other things that influence demand being the same. Example:

Point Price Quantity demanded

A0.522

B115

C1.510

D27

E2.55

The Demand Curve

1.5

0.5

1

2

2.5

18102 4 6 8 12 14 16 20 22

How Markets Work

A Change in Demand

A Change in Demand

• When a factor that affects the buying plan other than the price of the good changes , there is a change in demand.

• Increase in demand means movement of the demand curve to the right and quantity demanded increases at each price.

• Decrease in demand means movement of the demand curve to the left and quantity demanded decreases at each price.

Increase & Decrease of the Demand Curve

Increase in Demand Decrease in Demand P P

Q Q

Factors bring Changes in Demand

1. The Prices of Related Goods: The related goods are: Substitutes &Complement. A substitute is a good that can be used in

place of another one. There is positive relationship between the price of a substitute and the demand for the good. If the price of tea rises the demand for coffee increases and vise versa.

Factors bring Changes in Demand

A complement is a good is used with another one to satisfy the same needs.

There is negative relationship between the price of a complement and the demand for the good. If the price of sugar rises the demand for tea decreases and vise versa.

Factors bring Changes in Demand

2. Expected Future Prices: If the price of a good is expected to rise in

the future , and if the good can be stored , the demand for the good increases today and vise versa. Examples.

Factors bring Changes in Demand

3. Income: Consumers’ income influences demand.• When income increases , consumers buy more of

most goods and when income decreases , consumers buy less of most goods.

• The positive relationship between income and demand for the good is true for most goods, they are the normal goods. But the relationship between income and demand for the good is negative for few goods; the inferior goods.

• Example: air travel and long – distance bus trips.

Factors bring Changes in Demand

4. Expected Future Income & Credit: When income is expected to increase in the

future . Or when credit is easy to obtain , the demand might increase now. Example.

5. Population : Demand depends on the size and the age

structure of the population . The larger the population ,the greater the

demand for all goods and services and vise versa.

Factors bring Changes in Demand• Also ,the larger the proportion of the

population in a given age group , the greater is the demand for the goods and services used by that group. Example.

6.Preferences: Demand depends on preferences . Preferences determine the value that

people place on each good and service. Preferences are affected by things such as

weather , information and fashion.

A change in the quantity demanded

• A change in the quantity demanded = movement along the demand curve

• If the price of the good changes, but no other influence on buying plans changes, that means we have movement along the demand curve ; there is a change in the quantity demanded as price changes.

• Examples:

A Change in Demand

• If the price of a good remains constant ,but some other influence on buyers’ plans changes, there is a change in the demand of the good.

A Change in Demand =A Shift of the Demand Curve Examples:

Table 3.1 p.62

• It summarizes what we have studied.• The law of demand• The change in the quantity demanded due to

the changes in the price of the good.• Changes in demand happen as a result of the

change in the other factors except the price of the good .

: The Law of Demand demanded The quantity of the good

Decreases if:The price of the

good rises.

Increases if:The price of the good

falls.

Changes in DemandThe demand for the good

Decreases if :1. The price of a

substitute falls.2.The price of a

complement rises.3.The price of the good

is expected to fall.

Increases if :1. The price of a

substitute rises.2.The price of a

complement falls.3.The price of the good

is expected to rise.

Changes in DemandThe demand for the good

Decreases if :4.Income falls.5.Expected Income falls

or credit becomes harder to get.

6.The population decreases.

Increases if :4.Income rises.5.Expected future

Income rises or credit becomes easier to get.

6.The population increases.

How Markets Work

Supply

Supply

• If firm supplies a good or a service , the firm:1.Has the resources and technology to produce

it ,2.Can make profit from producing it , and3.Plan to produce & sell it.

The Quantity Supplied

The quantity supplied of a good or a service is the amount that producers plan to sell during a given time period at a particular price.

The Law of Supply• The law of supply states:• Other things remaining the same, the higher the

price , the greater is the quantity supplied; and the lower the price , the smaller is the quantity supplied.

• The reason for the positive relationship: When price rises , other things remaining the same , producers can bear higher costs by increasing the quantity supplied.

• Remember : Opportunity cost ( the cost of the last unit produced of the good measured by the decrease in the quantity of the other good ) increases as the production of the good increases.

Supply ScheduleThe supply schedule lists the quantity supplied at each price when all other things that affect producers’ planned sales remain the same.

The supply curve shows the relationship between the quantity supplied of a good and its price when all other things that affect

producers’ planned sales remain the same .

The Supply Schedule of Energy Bar

Price The Quantity Supplied

A0.50

B16

C1.510

D213

E2.515

The Supply Curve of Energy Bar

Price

Quantity Supplied

0.5

How Markets Work

A Change in Supply

A Change in Supply

• When any other factor affecting supply of a good other than its price changes , there is a change in supply curve it would shift to the right or to the left.

• We are going to study these factors and their effects on the supply curve.

A Change in Supply• The Prices of Factors of Production : If the

prices of factors of production rise , supply decreases .The prices of factors of production are costs of production , if they increase this means higher costs and lower profits so producers decrease production at each price and supply curve shifts to the left.

A Change in Supply• Prices of Related Goods Produced:• If price of a substitute rises , firms switch

production from the good to the substitute and supply decreases ,and vice versa. ( example: Energy bar & energy gel).

• If a price of a complement rises , the supply of the good increases and vice versa.

• Example : Beef and cowhide are complements in production ; they must be produced together.

A Change in Supply• Expected Future Price: If the price of the

good is expected to rise , supply decreases today and increases in the future.

• The Number of Suppliers:• The larger the number of suppliers , the

greater is the supply of the good. As firms enter an industry , the supply increases.

A Change in Supply

• Technology: • It means the way that factors of production

are used to produce a good.• If technology improves and we use new

method that lowers costs of production , production of the good increases and supply shifts to the right.

A Change in Supply

• The State of Nature :• This includes all natural forces that influence

production.• Good weather can increase the supply of

agricultural goods and vice versa.• Extreme natural event such as earthquakes ,

tornados, and hurricanes can influence supply.

A Change in Quantity Supplied VS. a Change in Supply

• A change in quantity supplied means movement along the curve and it happens when the price of the good changes.

• a change in supply means that the entire supply curve shifts, it happens when any of the other factors that influence supply other than the price of the good changes

Table 3.2 p. 67The Law of Supply

supplied good The quantity of the

Decreases if:The price of the good

falls.

Increases if:The price of the good

rises.

Changes in SupplyThe supply of the good

Decreases if :1. The price o a factor of

production used to produce it rises.

2. The price of a substitute in production rises.

3. The price of a complement in production falls.

4. The price of the good is expected to rise.

Increases if :1. The price o a factor of

production used to produce it falls.

2. The price of a substitute in production falls.

3. The price of a complement in production rises.

4. The price of the good is expected to fall.

Changes in SupplyThe supply of the good

Decreases if :5. The number of

suppliers decreases.6. A technology change

decreases production of the good.

7. A natural event decreases production of the good .

Increases if :5. The number of

suppliers increases.6. A technology change

increases production of the good.

7. A natural event increases production of the good

Market Equilibrium

Market Equilibrium

• Equilibrium in a market occurs when the price balances the plans of buyers and plans of sellers.

• The equilibrium price is the price at which the quantity demanded equals the quantity supplied.

• The equilibrium quantity is the quantity bought & sold at the equilibrium price .

Price as a Regulator• The price of a good regulates the quantity

demands and supplied.• If price is too low , the quantity demanded >

the quantity supplied , and we have a shortage . The shortage bids up price till we reach equilibrium.

• If price is too high , the quantity supplied > the quantity demanded , and we have a surplus . The surplus e bids down the price till we reach equilibrium.

A Figure Shows Equilibrium P

P2

P*

P1

A Shortage

q* Q

SD A Surplus

Market EquilibriumTable p. 68 shows :The equilibrium price at which Qd = QsAbove the equilibrium price : Qs > Qd A surplus

Below the equilibrium price : Qd > Qs A shortage

Price per unit

QdQsShortage (−)Or

Surplus (+)

millions of bars per week

0.5220− 22

1156− 9

1.510100

2713+6

2.5515+10

Price Adjustment

A shortage forces the price up: • When there is a shortage ,producers raise

the price. When price rises Qd decreases and Qs increases until we reach equilibrium.

A surplus forces the price down: • When there is a surplus ,producers cut the

price. When price falls Qs decreases and Qd increases until we reach equilibrium.

The Effects of changes in Demand and Supply on Market Equilibrium

PP. 70-71

An Increase in Demand

• When number of consumers or income of consumers increases ,or other things that cause demand increases , the demand curve shifts to the right . . Both the equilibrium price and quantity increase.

Equilibrium price rises & Equilibrium quantity increases

When demand increases

P

Q

SD2

D1

A Decrease in Demand

• When number of consumers or income of consumers decreases ,or other things that cause demand decreases , the demand curve shifts to the left . Both the equilibrium price and quantity decrease.

Equilibrium price falls & equilibrium quantity decreases

When demand decreases

P

Q

D1D2 S

An Increase in Supply

• If costs of production fall or producers use a new technology that cause increase in supply , or other things happen that increase supply , supply curve shifts to the right.

• The equilibrium price decreases and the equilibrium quantity increases.

Equilibrium Price Falls & Equilibrium Quantity Increases

When Supply Increases

P

Q

S1

S2

D

A Decrease in Supply

• If costs of production rise or producers switch to a substitute, or other things happen that decrease supply , supply curve shifts to the left.

• The equilibrium price rises and the equilibrium quantity decreases.

Equilibrium Price Rises & Equilibrium Quantity Decreases

When Supply Decreases

P

D

S2

S1

Q