Supply and Demand

Introduction to Markets and Competitive Markets

Markets are fundamental to microeconomics, serving as the arenas where buyers and sellers interact to exchange goods and services. A competitive market is one in which no individual buyer or seller has the power to influence the market price, and all participants act as price takers. This concept is central to understanding how prices and quantities are determined in microeconomics.

• Market: Any arrangement that allows buyers and sellers to exchange goods and services.

• Competitive Market: A market where all participants are too small to affect the aggregate outcome; prices are determined by overall supply and demand.

• Price Mechanism: The process by which prices adjust to balance supply and demand.

• Fixed-Price Mechanism: Sellers offer goods at a set price, and buyers can purchase any quantity at that price, as long as supplies last.

• Relative Price: The price of one good in terms of another, representing the opportunity cost for buyers.

Additional info: The competitive market model is an idealization, often compared to a 'spherical cow in a vacuum' in physics, meaning it simplifies reality to focus on core mechanisms.

Demand

Quantity Demanded and the Law of Demand

The quantity demanded of a good or service is the amount that consumers are willing and able to purchase at a given price, within a specific time frame. The Law of Demand states that, ceteris paribus (all other things being equal), as the price of a good increases, the quantity demanded decreases, and vice versa.

• Demand Function: Specifies the relationship between the price of a good and the quantity demanded.

• Demand Curve: A graphical representation of the demand function, typically downward sloping.

• Demand Schedule: A table showing quantities demanded at various prices.

• Ceteris Paribus: Latin for 'all other things being equal,' used to isolate the effect of one variable.

• Income Effect: Higher prices reduce consumers' purchasing power, lowering quantity demanded.

• Substitution Effect: Higher prices make alternatives more attractive, reducing quantity demanded.

Example Demand Schedule:

Shifts in Demand and Demand Shifters

A change in quantity demanded is a movement along the demand curve due to a price change. A change in demand is a shift of the entire demand curve, caused by factors other than price.

• Price of Related Goods: Substitutes (inverse relation), Complements (parallel relation).

• Income or Wealth: Normal goods (demand rises with income), Inferior goods (demand falls with income).

• Expected Future Prices: Anticipation of higher prices increases current demand.

• Population: More consumers increase demand.

• Preferences and Tastes: Changes in consumer preferences shift demand.

Additional info: Examples of substitutes include butter and margarine; complements include printers and ink cartridges.

Supply

Quantity Supplied and the Law of Supply

The quantity supplied is the amount that sellers are willing and able to produce and sell at a given price. The Law of Supply states that, other things equal, as the price of a good increases, the quantity supplied increases, and vice versa.

• Supply Function: Specifies the relationship between the price of a good and the quantity supplied.

• Supply Curve: A graphical representation of the supply function, typically upward sloping.

• Supply Schedule: A table showing quantities supplied at various prices.

• Marginal Cost: The cost of producing one more unit, which typically increases with quantity.

Example Supply Schedule:

Shifts in Supply and Supply Shifters

A change in quantity supplied is a movement along the supply curve due to a price change. A change in supply is a shift of the entire supply curve, caused by factors other than price.

• Price of Inputs: Higher input costs decrease supply.

• Production Substitutes: Alternative uses for resources can shift supply.

• Expected Future Prices: Anticipation of higher prices may decrease current supply.

• Number of Suppliers: More suppliers increase market supply.

• Technology: Technological improvements increase supply.

• State of Nature: Weather and natural events can affect supply.

Market Equilibrium

Equilibrium Price and Quantity

Market equilibrium occurs where the quantity demanded equals the quantity supplied. The corresponding price is the equilibrium price (P^*), and the quantity is the equilibrium quantity (Q^*). At this point, there is no tendency for price to change unless an external factor shifts demand or supply.

• Excess Supply (Surplus): Occurs when quantity supplied exceeds quantity demanded at a given price; leads to downward pressure on price.

• Excess Demand (Shortage): Occurs when quantity demanded exceeds quantity supplied at a given price; leads to upward pressure on price.

Example Equilibrium Table:

Adjustment Dynamics

Prices and quantities adjust in response to surpluses and shortages. If there is a surplus, suppliers reduce prices to increase sales. If there is a shortage, suppliers can raise prices. This dynamic process moves the market toward equilibrium.

Comparative Statics

Analyzing Shifts in Demand and Supply

Comparative statics examines how changes in external factors (such as demand or supply shifters) affect equilibrium price and quantity. The direction of change depends on which curve shifts and the magnitude of the shift.

• Increase in Demand: Raises both equilibrium price and quantity.

• Decrease in Supply: Raises equilibrium price but lowers equilibrium quantity.

• Simultaneous Shifts: The effect on price or quantity depends on the relative magnitude of the shifts.

Additional info: Comparative statics is a key tool for policy analysis and predicting market outcomes.

Solving for Equilibrium Algebraically

Linear Demand and Supply Functions

Market equilibrium can be found algebraically by setting the demand and supply equations equal to each other and solving for price and quantity.

• Linear Demand:

• Linear Supply:

• Equilibrium Condition:

Solving for Equilibrium:

• Set demand equal to supply:

• Solve for :

• Substitute into either equation to find : or

Example:

• Demand:

• Supply:

• Set equal:

• Solve:

• Find price: