Chapter 4: Demand, Supply & Markets

Factors Influencing Supply/Demand, Quantity Supplied/Demand, Equilibrium


This chapter is all about building & understanding an economic model of markets and the relationship between supply & demand. Famous economist, Alfred Marshall, once said that supply and demand are like two halves of a scissor; you don’t know which half is doing the work.

To make the model as easy as possible to understand, we will assume ceteris-paribus (Latin for “with other conditions staying constant”) for all examples.

Definitions

  • Market: Any situation where buyers and sellers can negotiate a transaction, and exchange goods & services. It is often a physical place, but it doesn’t have to be due to e-commerce. Markets answer the question of how much is produced, what resources are uses, and who gets the goods.
  • Economic Model: A simplified explanation of an aspect of the economy, by focusing on specific relationships and making simplified assumptions.
  • Demand: Demand, graphically, is a line connecting all the quantity demanded points at each price. It describes the entire demand function, rather than one point.
  • Supply: Supply, graphically, is a line connecting all the quantity supplied points at each price. It describes the entire supply function, rather than one point.
  • Quantity Demanded: The specific amount of quantity that is desired at a given price point. On a demand curve, quantity demanded is simply a point.
  • Quantity Supplied: The specific amount of quantity that is produced (and sent to the market) at a given price point. On a supply curve, quantity supplied is simply a point.
  • Shortage: Occurs when there’s more quantity demanded than quantity supplied at a given price. This will create an upward pressure on prices as producers will increase prices to maximize profits and consumers will bid a higher price. As market price increases, quantity supplied increases & quantity demanded decreases until they equal each other.
  • Surplus: Occurs when there’s more quantity supplied than quantity demanded at a given price. This will create a downward pressure on prices as producers will sell their goods at a lower price and consumers start bargaining for a lower price. As market price decreases, quantity supplied decreases & quantity demanded decreases until it they equal each other.

What Factors Influence Demand

Price (ONLY AFFECTS QUANTITY DEMANDED)

The Law of Demand states that as price increases, quantity demanded decreases, and vice versa.

2 Reasons the Law of Demand works

  • Substitutes: Most goods have workable substitutes. When a good becomes expensive, we are able to switch to a relatively cheaper substitute. When a substitute good becomes cheaper, we are able to switch away from the current good we were using because it has become relatively more expensive.
  • Static Incomes: When the price of a good increases, we have to consume less of something, unless we want to use a greater percentage of our income. Either we consume less of other goods or reduce consumption of the good whose price increased.

Exceptions to the Law of Demand

  • Necessity: If a good is extremely necessary and there are no viable substitutions (like insulin), a small price increase is unlikely to cause a decrease in quantity demanded. This is known as elasticity and will be the focus of Chapter 5.
  • Textbook Example: A poor student eats instant noodle soup 6 days a week, and on the 7th day treats themselves to a relatively more expensive meal. If the price of instant noodle soup increases one day, the student will no longer be able to treat themselves at the end of the week. So they switch from eating 6 instant noodle soups a week to eating it every day. This is an example of price increases, while quantity demanded also increases.

Tastes & Preferences

Demand can change as a population’s tastes change, or as ideal preferences evolve. Yesterday, the main feature of a mobile phone was to call and text. Today, the main features are call, text, internet, games, storage, camera, etc.

Income

As consumers’ income increases, many will buy more goods. However, which goods they buy depends on if the good is normal or inferior:

  • Normal Goods are goods whose demands increase as a consumer’s income increases. Most goods are normal. Such as cars and vacations.
  • Inferior Goods are goods who demand decrease as a consumer’s income increases. Such as bus tickets or instant noodle soup.
  • Demand of necessities doesn’t change drastically due to an increase or decrease in income, such as water, toilet paper, salt, etc. If before an increase in income a good is necessary, then its demand usually isn’t going to change when income increases.

Whether a good is normal or inferior is relative per person!

Prices of Related Goods (substitutions or complements)

Substitutes are goods that can be substitutes for one another. Therefore, when the price of one good increases, demand for its substitutes increases. But if the price of a Jaguar increases, very few consumers would switch to Chevy trucks. Perhaps Jaguars and Chevy trucks are not substitute goods for most people.

Complements are goods that are often used and bought together. Therefore, when the price of a good increases, demand for all its complements decreases. Coffee & cream, tennis rackets & tennis balls, bicycles & bicycle helmets, smart phones & ear buds, cars & gas, etc.

Expectations of Future Prices or Future Incomes

Expectations of future changes also affect demand of goods & services today. If consumers expect higher prices in the future, demand for a good will increase now. This is because they want to a) avoid higher prices in the future or b) sell the good at a higher price later on.

Also, if consumers expect to receive a higher income in the future, their demand for normal goods will increase now.

Potential Number of Buyers (Population)

As population increases, there will be more potential consumers of a good. This means that demand increases. Similarly, if population of consumers decreases, then demand decreases.

What Factors Influence Supply

Price (ONLY AFFECTS QUANTITY SUPPLIED)

The Law of Supply states that as price increases, quantity supplied will increase, and vice versa. The reason this law works is because a higher price is a higher incentive for suppliers to produce. This means that suppliers who are already supplying the good will increase production, and other suppliers will switch from producing other goods to producing the now highly priced good.

It can also work backwards, sometimes production will cause prices to increase. As production increases (for example, due to increased demand), increasing marginal cost will sometimes cause prices to eventually go up.

Prices of Inputs

An increase in the prices of any of the inputs will decrease profits, which in turn decreases incentive for producers to supply. This means that an increase in prices of inputs decreases supply, and a decrease in prices of inputs increases supply.

Inputs include wages, raw materials, suppliers, rent, utilities, etc. Taxes and subsidies can also change the prices of inputs.

Technology

If new ways of producing goods are created so fewer resources are used to produce the output, the effect is similar to a decrease in the price of an input (it will increase supply).

Very rarely does a technology ever deteriorate.

Expectations of Future Prices

If suppliers expect prices to increase in the future, the amount of good brought to the market now may decrease.

If supplier expect prices to decrease in the future, the amount of good brought to the market now may increase.

Number of Sellers

If there are more sellers for a particular good, supply for that good will increase. If sellers leave the market, supply for that good will decrease.

Prices of Other Goods

If the price of a good increases, all supply of goods that have inputs similar to that good will decrease because the price of the input in common with that good will increase (due to increased demand for that input).

For example, if the prices of lumber increases due to an increased demand in wood furniture, the supply of paper will decrease as the prices of its input has increased (lumber).

Another example, if the prices of pumpkins increases, some melon farmers will likely switch over to planting pumpkins which will reduce the supply of melons.

Weather

If, due to a natural disaster, the resources used in a product is destroyed or ruined, the supply of the product will decrease as the cost of inputs will increase.

Market Equilibrium

Market is in equilibrium when quantity supplied equals quantity demanded. When this is true, the price is known as equilibrium price and the quantity is known as the equilibrium quantity.

The adjustment process of moving from one equilibrium to another is often known as the law of supply & demand. The law states that given a change in supply or demand conditions, the price and quantity in a market will eventually move towards an equilibrium level.

To explain the process of adjustment:

  1. State the factor changing supply or demand, and explain its effects (e.g. technology improved, which caused an increase in supply).
  2. State whether a shortage or surplus was created (e.g. supply increase caused a surplus).
  3. State how & why price will start to change (e.g. surplus will mean that producers will reduce their prices to make sure they sell as many goods as possible).
  4. State how quantity demanded/quantity supplied changes (e.g. a decrease in price will cause quantity supplied to decrease and quantity demanded to increase due to the law of demand and law of supply).
  5. State how surplus/shortage shrinks until quantity supplied is equal to quantity demanded (e.g. the surplus will shrink as suppliers produce less and consumers buy more. This will continue until quantity demanded and quantity supplied is equal to each other).
  6. Compare new equilibrium price and equilibrium quantity with old market equilibrium (e.g. the new equilibrium price will be lower than before and the equilibrium quantity will be greater than before).

What if Demand & Supply Change at The Same Time?

If there’s ever a change in supply AND demand, you can look at their new market equilibrium one at a time and figure out the overall effect. Unfortunately, this method makes it at least one equilibrium value indeterminate.

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