Slides for Economics CHapter 4, Exams of Economics

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THE MARKET FORCES OF

SUPPLY AND DEMAND

Chapter 4

PART TWO: SUPPLY AND

DEMAND I:

HOW MARKETS WORK

What we learn in Part Two?

• (^) Part Two introduces the model of supply and demand in a market economy
• (^) Supply and demand is the basic tool of economic analysis
• (^) In Principle Five and Chapter 3 we learned that specialisation and trade makes everybody better off
• (^) Principle Five tells us that markets are a good way to organise economic activity
• (^) Now we must see how markets work to achieve this result
• (^) Markets work through supply and demand

Plan of this chapter

• (^) We start by defining market types such as competition, monopoly, oligopoly, etc.
• (^) Then examine the factors that determine the demand for a good or service in a competitive market
• (^) Next we look at the determinants of the supply of a good or service again in a competitive market
• (^) Supply and demand come together to set the price of the good or service and the quantity sold
• (^) We establish how changes in demand or in supply conditions affect the price and quantity
• (^) And look at the key role of prices in allocation scarce resources of society

Market forces of

supply and demand

• (^) Supply and demand are certainly the two words that economists use most often
• (^) Supply and demand are the forces that make market economies work efficiently
• (^) Supply and demand determine the quantity of each good produced and the price at which it is sold
• (^) Any event or policy that affects the economy will work through its impact on supply and demand of some goods
• (^) Modern microeconomics is about supply, demand, and the market equilibrium that results from their interaction

A Competitive Market

• (^) A competitive market is a market
  • (^) with many buyers and sellers
  • (^) that is not controlled by any one person
  • (^) in which a narrow range of prices are established that buyers and sellers act upon
• (^) The number of buyers and sellers are an important part of the definition of competition
• (^) The second element is that a buyer or seller cannot influence prices by his own actions alone
• (^) When these two characteristics exist the market is called competitive

Types of markets

• (^) Economic theory distinguishes among four different types of markets
• (^) Perfect Competition
  • (^) Competitive market where products are the same
• (^) Monopoly
  • (^) One seller, and seller controls price
• (^) Oligopoly
  • (^) Few sellers
  • (^) Not always aggressive competition
• (^) Monopolistic Competition
  • (^) Many sellers
  • (^) Differentiated products

Demand for Ice Cream

**Price of Ice-Cream Cone

$3.

0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of Ice-Cream Cones**

Price Quantity

Law of Demand

• (^) The law of demand states that there is an inverse relationship between price and quantity demanded. **Price of Ice-Cream Cone

$3.

0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of Ice-Cream Cones**

Demand function

• (^) We can present the determinants of demand by the symbols of a function

Q = F ( P , Y , P

n

, P

e

• (^) It is called the demand function
  • (^) P = price of the good or service
  • (^) Y = income
  • P n = prices of other goods and services
  • P e = expectations about the change in price
  • (^) fashion and tastes of consumers

Demand function

• (^) What is the meaning of the demand function Q = F ( P , Y , P n

, P

e

• (^) We we look at the relation between price and quantity demanded while we keep other factors as constant
• (^) In other words, P is the only independent variable, the others are kept constant
• (^) Changes in income, other prices, price expectations and tastes will cause a shift in the demand curve
• (^) Whereas changes in price only affect quantities
• (^) Change in prices changes the quantity demanded by not the demand function

Effect of an increase in income:

normal good

• As income

increases the

demand for a

normal good

will increase.

Price of Ice-Cream Cones Quantity of Ice-Cream Cones Demand curve, D (^1) Demand curve, D (^2) 0 Increase in demand

Effect of an increase in income

inferior good

• As income

increases the

demand for

an inferior

good will

decrease.

Price of Ice-Cream Cones Quantity of Ice-Cream Cones Demand curve, D (^3) Demand curve, D (^1) 0 Decrease in demand

Ceteris Paribus

• (^) Attention to one aspect of the analysis so far
• (^) We change one constant at a time while we keep the others constant
• (^) For example, when we look at the effect of a change in income we keep the prices of related products plus tastes plus price expectations unchanged
• (^) Economic theory uses a short-cut to express this method
• (^) Ceteris paribus is a Latin phrase that means that all variables other than the ones being studied are assumed to be constant

Change in Quantity Demanded

versus Change in Demand

• (^) The distinction between change in demand and change in quantity demanded is vital to understand the analysis of demand
• (^) Change in Quantity Demanded
  • (^) Movement along the demand curve.
  • (^) Caused by a change in the price of the product
• (^) Change in Demand
  • (^) A shift in the demand curve, either to the left or right
  • (^) Caused by a change in a determinant other than the price (income, tastes, etc)