How markets work 1.2
Demand-the quantity of a good or service that consumers are willing and able to buy at a given
price, at a particular time
Marketsare where Goods and Services are Bought and Sold- opportunity for buyers and sellers to
interact in order to establish a price
§ Buyers and sellers can exchange goods and services
§ The price charged for and quantity sold is determined by demand and supply in a market
§ The level of demand and supply are shown using diagrams- demonstrate the price level and
quantity demanded/ supplied of goods or services
A demand curve shows the relationship between price and quantity demanded. At any given point
along the curve it shows the quantity that would be bought at a particular price
The law of demand shows the inverse relationship between price and quantity, assuming all other
variables remain constant
Movements and shifts of the demand curve:
A movement along the demand curve- from A to B, is caused by a change in the
price of the good. A shift of the demand curve, for example D1 to D2, is caused by a
change in any of the factors which affect demand, the conditions of demand.
A movement from A to B is a contraction in demand, the quantity demanded falls
because of an increase in price. A movement from A to C is an extension in demand,
the quantity demanded rises due to a decrease in price. Movements along the curve
are not called increases or decreases- this only occurs when the curve shifts.
A shift from D1 to D2 is a decrease in demand, because fewer goods are demanded
at each and every price. For example, at price P only Q2 goods are demanded rather
than Q1 goods. A shift from D1 to D3 is an increase in demand, as more goods are
demanded at each and every price. Now, Q3 goods are demanded at price P
,Factors that cause a shift in Demand
Pirates:
§ P- Population. The larger the population, the higher the demand. Changing the structure of the population also
affects demand, such as the distribution of different age groups.
§ I-Income. If consumers have more disposable income, they are able to afford more goods, so demand increases.
§ R- Related goods.-substitutes or complements. A substitute can replace another good, such as two different brands
of TV. If the price of the substitute falls, the quantity demanded of the original good will fall because consumers will
switch to the cheaper option. A complement goes with another good, such as strawberries and cream. If the price of
strawberries increases, the demand for cream will fall because fewer people will be buying strawberries, and hence
fewer people will be buying cream.
§ Advertising. This will increase consumer loyalty to the good and increase demand.
§ T- Tastes and fashions. The demand curve will also shift if consumer tastes change. E.g. demand for physical books
might fall, if consumers start preferring to read e-books.
§ E- Expectations. This is of future price changes. If speculators expect the price of shares in a company to increase in
the future, demand is likely to increase in the present.
§ S- Seasons. Demand changes according to the season. Summer, the demand for ice cream, sun lotions increases.
Demand curve to shift left: Demand curve to shifts right:
§ Decrease in population § Increase in population
§ Decreased income= decreased demand- § Increased income= decreased demand- inferior goods
inferior goods § Decrease price of complement goods
§ Changes in tech § Decrease price in substitutes
§ Increase price of complement goods § Hot weather= Increase demand for ice creams
§ Increase price in substitutes § Increase advertising (trends)
§ Cold weather= decrease demand for ice
creams Income effect- prices fall= consumers afford a greater quantity of
§ Decrease advertising goods and services (assuming income is fixed). Demand for goods and
services increases
Substitute goods- an increase in price of one
good will increase the quantity demand of the Substitution effect- price of one good falls, consumers buy more of
other. E.g. Persil and Ariel washing pods the cheaper good and less of the more costly good. Demand for
cheaper good increases & demand for costlier good decreases
Complement goods- an increase in the price of
one good will cause a decrease in the quantity Derived demand: demand for one good is linked to the
demanded of the other. E.g. flights to Dubai demand for a related good. Demand for bricks is derived
and sun cream. Buy one, naturally buy another from the demand for the building of new houses. The
demand for labour is derived from the goods the labour
Normal Goods-income increases people demand more of produces.
a good. Demand curve shifts right
Composite demand:The good demanded has more than
Inferior good- people demand less of if their income one use. Assuming there is a fixed supply of milk, increase in
increases. Rise in income demand curve shifts left- switch the demand for cheese will mean more cheese is supplied,
to expensive goods and therefore less butter can be supplied.
Equal distribution of income-demand curve for luxury Joint demand: This is when goods are bought together,
goods shift left, demand curve for other items shift right. such as a camera and a memory card.
As there’s fewer rich people who can afford luxury items,
Joint Supply- increase or decrease in supply of goods leads
more people can afford everyday items
to an increase or decrease in supply of a by product
, Market Supply
Supply is the quantity of a good or service that a producer is willing and able to supply onto the given
market at a given price in a given time period
Basic law of supply- as the price of a product rises, businesses expand supply to the market
Supply curves are upward sloping because:
§ If price increases, it is more profitable for firms to supply the good, so supply increases.
§ High prices encourage new firms to enter the market, because it seems profitable, so supply
increases.
§ With larger outputs, firm’s costs increase, so they need to charge a higher price to cover the
costs
Movements and shifts of the supply curve:
A movement along the supply curve, for example from A to B, is caused by a
change in the price of the good. A shift ofthe supply curve, for example S1 to
S2, is caused by a change in any of the factors which affect supply, the
conditions of supply.
A movement from A to B is a contraction in supply,the quantity supplied
fallsbecause of a decrease in price. A movement from A to C is an extension in
supply, the quantity supplied rises due to an increase in price. Movements
along the curve are not called increases or decreases- this only occurs when
the curve shifts.
A shift from S1 to S2 is a decrease in supply, because fewer goods are supplied
at each and every price. For example, at price P only Q2 goods are supplied
rather than Q1 goods. A shift from S1 to S3 is an increase in supply, as more
goods are supplied at each and every price. Now, Q3 goods are supplied at
price P.
Factors causing a shift in supply:
P-Productivity. Higher productivity causes an outward shift in supply, because average costs for the firm fall.
I-IIndirect taxes. Inward shift in supply.
N- Number of firms. The more firms there are, the larger the supply.
T-Technology. More advanced the technology causes an outward shift in supply.
S- Subsidies. Subsidies cause an outward shift in supply.
W-Weather. This is particularly for agricultural produce. Favourable conditions will increase supply.
C-Costs of production. If costs of production fall, the firm can afford to supply more. If costs rise, such as with higher
wages, there will be an inward shift in supply.
Also, a depreciation in the exchange rate will increase the cost of imports, which will cause an inward shift in supply. A
depreciation in the pound against the US dollar causes a reduction in the purchasing power of the pound when buying
goods in dollars. This makes it more expensive for firms to import raw materials from the USA.
,Factors-Shift to the right: Factors- shift to the left
§ Increase in CELL (Capital, enterprise, land, § Decrease in CELL
labour) § Increased weather
§ Decrease in weather § Increase costs
§ Decrease in costs of production
Costs = Supply
shifts right (out)
Costs = Supply
§ Shifts left
(in)
Joint Supply is where goods and services are supplied together.
§ The production of one good involves the production of another- example of when markets are interrelated
§ If the price of a product increases, the supply of it and any join products will increase
Competitive supply
§ Where 2 or more alternative goods can be produced from the same factors of production (CELL)
Market Equilibrium is where supply equals demand
§ At equilibrium, price and output are stable- there’s a balance in the market and supply is
equal to demand. All products presented for sale are sold and the market is cleared
§ In a free market, supply and demand determine the equilibrium price and quantity
§ This free interaction of supply and demand = market forces
Disequilibrium:
§ Market is not at a stable price and quantity
§ Economic pressures arise to move the market
towards a stable price and quantity
, Excess Supply and demand doesn’t exist in a free market
Excess supply:
If the price is set higher than the equilibrium, then there is excess supply.
At price P2, suppliers are willing to supply QS but consumers only
demand QD, meaning there is excess supply of the orange shaded area.
Prices would have to fall.
As a result, firms have unsold goods. This will encourage them to put on
sales to sell the excess goods, causing prices to fall and supply to
contract to P1. As a result, demand will extend to P1. The market will
now be in equilibrium.
Excess Demand
If price is set below equilibrium, then there is excess demand. At the
price P2, suppliers are willing to supply QS but consumers demand QD,
meaning there is excess demand of the orange shaded area.
As a result, there is a shortage in the market. Firms know they can
charge higher prices and still sell their goods, so this will cause an
extension in supply and they will now charge P1 for quantity Q1. This
higher price will lead to a contraction in demand. The prices are now
in equilibrium.
This is a shortage in the market.
This pushes prices up and causes
firms to supply more. Since prices
Assumptions of the equilibrium model increase, demand will contract.
§ Perfect competition Once supply meets demand
§ Ceteris paribus again, price will reach the market
§ Independence between supply
clearing price, P1.
and demand
, Shifts in Demand or Supply curves change the market equilibrium
The price mechanismdetermines the market price. Adam Smith called this ‘the invisible hand of the market’. Resources
are allocated through the price mechanism in a free market economy. The economic problem of scarce resources is
solved through this mechanism. The price moves resources to where they are demanded or where there is a shortage,
and removes resources from where there is a surplus.
The price mechanism uses three main functions to allocate resources:
Allocate-allocating scarce resources among competing uses
Rationing-When there are scarce resources, price increases due to the excess of demand. The increase in price
discourages demand and consequently rations resources. For example, plane tickets might rise as seats are sold,
because spaces are running out. This is a disincentive to some consumers to purchase the tickets, which rations the
tickets.
Incentive - This encourages a change in behaviour of a consumer or producer. For example, a high price would
encourage firms to supply more to the market, because it is more profitable to do so.
Signalling -The price acts as a signal to consumers and new firms entering the market. The price changes show where
resources are needed in the market. A high price signals firms to enter the market because it is profitable. However, this
encourages consumers to reduce demand and therefore leave the market. This shifts the demand and supply curves.
Advantages of the PM Disadvantages of the price mechanism Unintended consequences of pm
§ It is allocatively Some goods objectively shouldn’t be Market failure can arise through
efficient produced through the PM. E.g being unintended consequences
§ There is no time cost able to buy an organ through the
as no one needs to be price mechanism isn’t necessarily fair People who donate bone marrow might
paid to monitor it § There will be missing markets for do it for reasons outside of the price
§ The process is some goods e.g. street lighting mechanism
efficient as prices are § Huge disparity in wages for low skill Offering payment, may discourage them
as low as possible and high skill workers, increasing
from donating, could lower the total
§ Consumers have inequality amount of bone marrow donators
control over what § The price mechanism usually- no
producers make moral overlay or beliefs before a Michael Sandel- social vs market norms.
government intervenes Sometimes social norms rule our lives
, Elasticity:
Price increases demand decreases
Price increases, demand decreases. Demand isn’t very
responsive to changes in price. Inelastic demand,
necessities, products that have nosubstitutes
Examples of inelastic demand
§ Petrol – those with cars will need to buy petrol to get to work
§ Cigarettes – People who smoke become addicted so willing to pay a higher price
§ Salt – no close substitutes
§ Chocolate – no close substitutes
§ Goods where firms have monopoly power. For example, Apple computers, iPhone, Microsoft Windows, rail fares
for commuters.
§ Water – when you are in the desert and very thirsty
Factors that make demand inelastic
§ No substitutes. If you have a car, there is no alternative but to buy petrol to fill up the car. If you rely on the train
to get to work, the train firm can increase prices with little fall in demand.
§ Little competition. If a firm has monopoly power then it is able to charge higher prices. For example, prices on
motorway service stations tend to be higher, because consumers can’t choose where to buy food, without leaving
the motorway.
§ Bought infrequently. If you buy a good infrequently, such as salt, you are less likely to be sensitive to price.
§ A small percentage of income. A good like salt is a small percentage of income, therefore you will tend to be less
concerned about price.
§ Short-run. In the short-run, demand tends to be more price inelastic. It takes time for consumers to look for
alternatives.
§ Location. If you have the best location, then demand will be more inelastic. Hotels with great sea view can charge
more than one in the suburbs.
