EKN11EB Notes Learning unit 3

Introduction

Markets are a place where buyers and sellers are brought together, and it can take on many forms
like grocery stores or the stock exchange that is an example of a more sophisticated market. We will
focus in this unit on highly competitive markets consisting of a very large number of independent
buyers and sellers of standardized products.

Slide 3

Demand is the various amounts of a product that consumers are willing to buy at a series of possible
prices in a specified period. This is illustrated on a demand schedule or table as can be seen in figure
3.1 on page 54.

The law of demand is the inverse relationship between prices and quantity demanded. As prices fall
the quantity demanded will rise and if prices rise then quantity demanded will fall. This is true if all
other related things stay the same. This is important because there are other factors that will
influence the amount people are willing to purchase and not only price. If the price of Coke drops,
we can safely say that more Coke will be consumed unless the price of Pepsi drops more than Coke.
In this case we may purchase less Coke because Pepsi is an even better option. Therefor we have to
say other things equal which means that the price of a related product like Pepsi must stay where it
was when the price of Coke drops.

This inverse relationship exists because:

Common sense tells us that the ability of consumers will increases or decrease as price falls or rises.
Because of diminishing marginal utility. As you consume more of the same product the satisfaction
or utility will decrease because each additional unit adds less additional satisfaction. The income
effect also underlines the law of demand. As the price decreases and buyers demand more because
their purchasing power increased, the substitution of cheaper products take place because buyers
move their purchases from other products to these products that are relatively cheaper.

Slide 4

The demand curve is a down-sloping curve indicating the inverse relationship we discussed above.
Market demand is the total of the demand of all the individual buyers. The values on the left hand
side we call a schedule or table and these price quantity combinations are reflected as points on the
demand curve.

Slide 5

We have now focused on price as a factor that will determine the quantity of goods consumers will
demand and we said that other things must stay equal or the same. These other things will also
impact demand and in reality, they will also change as price changes. They are called the
determinants of demand and when they change, we will see a change in demand and not a change
in quantity demanded only.

Study page 56 and 57 where the 6 determinants of demand are discussed:

Consumer tastes – if a product becomes more popular, then consumers will demand more of the
product at each price. This higher demand at the same price will mean that the demand curve will
shift to the right. If a product becomes less popular, the opposite will take place and the demand
curve will shift to the left.
The number of buyers – Demand will increase at each price if more buyers are available in a certain
market, and it will decrease if fewer buyers are available. Think of the migration of people to larger
cities which caused more demand for goods and services in cities at the same prices and less
demand at the same prices for goods and services in the rural areas the migrated from.

Change in consumer income – If incomes rise, consumers will buy more goods that are called
normal goods and fewer goods that are called inferior goods. If incomes drop, consumers will buy
fewer normal goods and more inferior goods. Examples of inferior goods are cabbage, secondhand
goods and retread tires that consumers will seek out to buy when their incomes drop.

The prices of related goods – A price change of one product can also influence demand for another
product. A substitute product can easily be replaced by another product (Pepsi and Coke) then as
price of Coke goes up, demand for Pepsi will go up (direct relationship). As price of Coke goes down
demand for Pepsi will also go down because more Coke will be demanded. Complimentary products
are used together like computers and software or cell phones and data. If the price of the one goes
up the demand for the other will go down and vice versa (inverse relationship).

Consumer expectations – Higher future prices may increase demand for the product now so that the
anticipated higher prices can be avoided.

Population growth – Higher population will also increase demand as was the case the number of
buyers increasing.

Slide 6 and 7

A change in quantity demanded happens when price changes and a new quantity is demanded by
the consumer. This is reflected as a movement on the curve and in other words a new price
quantity combination on the demand schedule.

A change in demand (not quantity demanded) happens when one of the determinants of demand
changes. If this happens the demand schedule is not valid anymore. The price quantity
combinations on the existing demand schedule will change meaning that at each price a new
quantity will be demanded. The result is that if these new points are plotted you will see that a new
curve to the right or left of the existing demand curve will form. This change in demand, we call a
movement of the curve.

SUPPLY

Slide 8

Let us now look at the other side of the equation. Our focus was on the role of the consumer during
our study of demand. When we study supply, we must focus on the role of the producer or the
supplier of products or services.

Producers look at prices to determine how much they are willing to supply. For the producer a high
price is an incentive to produce more, and a low price is a reason or incentive to produce less. Page
59 figure 3.4 shows a supply schedule and supply curve. Take note that the relationship between
price and quantity that will be supplied is directly related. This means that they move in the same
direction and the supply curve will be sloping upwards. As you can remember, this is opposite to the
demand curve which is a down sloping curve because the relationship between price and quantity
demanded is inverse.
Slide 9

The supply curve and schedule are indicated here. Note the positive relationship resulting in the
upwards sloping supply curve.

The law of supply is identified as this positive relationship between price and quantity supplied.
Producers will shift resources to produce more of a certain product when prices increase. A farmer
may plant more of a certain crop with a high price in the place of a crop with a lower price and this
we call the shifting of resources.

Slide 10

Determinants of supply

These factors are called the shifters of the supply curve. In other words, they move the supply curve
to the left or the right because they change the values in the supply schedule. At each price
suppliers are willing to supply more or less than in the original supply curve. These factors are called
the determinants of supply.

Resource prices – When resource prices drop, it increases the profits of the supplier and more will
be produced at each price in the demand schedule. A new supply schedule becomes applicable with
different values and therefor the shift of the supply curve will be to the right.

The opposite is true when resource prices increase. At every given price profit will decrease and less
will be supplied resulting in a new schedule and a shift of the supply curve to the left.

Technology – Improvements in technology will enable the supplier to produce more with fewer
resources. This decreases the cost of production and more profit which will cause more supply of
this product.

Taxes and subsidies – These act as an incentive or disincentive to supply. More taxes imposed by
government will cause supply to drop because it adds to the production cost. Sometimes subsidies
are provided if a government wants more of a certain product to be produced. European farmers
receive subsidies on certain products of which the farmers don’t produce enough of. This means
that governments assist the farmer with production costs.

Prices of other goods – The higher prices of other products will move suppliers to shift to these
products because they are more profitable.

Producer expectations – The current willingness to supply a product may be affected by higher
expected future prices. Farmers may harvest maize and decide to store it until prices go up in
future.

Number of sellers in the market - Firms will enter and leave industries for various reasons and this
will cause supply to increase when sellers increase and vice versa.

Slide 11 and 12

Keep in mind that a change in quantity supplied will only be as a result of a change in price. When a
determinant of supply changes it will result in a change in supply. Slide 12 shows clearly what this
looks like. The whole curve will shift either to the left or the right. In this case a change in price was
not the reason, but a change in one of the determinants of supply, which in turn will change the
schedule (new price quantity combinations).
Slide 13

Market equilibrium

A competitive market consists of buyers and sellers. The equilibrium price is the price where the
market is cleared of all products or services because supply and demand match exactly. Markets
will always try to return to this point because both the consumer and the supplier are happy. There
is no surplus or shortage of product or service at this specific price. If the price drops below this
point it becomes a bargain for buyers and they will demand more, while sellers will supply less
(lower profits) resulting in a shortage. Now buyers are willing to pay more when there is a shortage,
and this drives prices up again towards equilibrium.

Slide 14

If prices rise above equilibrium buyers demand less and suppliers will supply more resulting in a
surplus which will be rectified again by sellers accepting lower prices and buyers being more willing
to demand at these lower prices.

Slide 15

Through these actions the resources of society are allocated efficiently. Suppliers will not produce
products for which there is no supply and in doing so resources are not wasted. The result is
productive efficiency (producing at lowest cost) and allocative efficiency (those products valued the
highest by consumers). This is a very important outcome caused by competitive markets.

Study figure 3.7 on page 66 to understand how fluctuations in demand and supply will affect price
and quantity demanded and supplied respectively. Take note of the block in the right-hand corner
indicating these movements.

In graph (a) a shift to the right of the demand curve due to a change in the determinants of demand
will cause price and quantity to increase. You can see this by noting the new intersection point of
the supply and demand curve. Note that supply remain unchanged.

In graph (b) a shift of the demand curve to the left due to a change in the determinants of demand
will cause price and quantity to decrease. Note that supply remains unchanged.

In graph (c) demand is unchanged, but a change in the determinants of supply causes supply to shift
to the right (an increase). The result is price drops and quantity increases.

In graph (d) demand is still unchanged and supply moves to the left (a decrease). The result is that
price increases while quantity decreases.

Slide 16

In reality we cannot keep demand or supply unchanged and only allow the other to move. Both
demand and supply will move in different directions at the same time. These multiple moves will
influence price and quantity. Use figure 3.7 and slide 16 to understand how simultaneous moves of
the demand and supply curve will influence price and quantity.

Note that if both these shifts will increase price then price will increase, but if the shift in demand
and supply cause a move in opposite directions, we call this indeterminate. We don’t know how
strong these opposite forces are, so we call this move indeterminate.
Slide 17

This discussion is on the various practical applications of what we discussed in this learning unit. It
shows through examples of price ceilings and price floors that any interference in the natural
workings of a competitive market will have negative results like surpluses and shortages. Although
the intention may be good the result is bad.

Rent controls is an attempt to regulate the rental price to help tenants but the result is that supply
will reduce dramatically resulting in a shortage of rental units.

The minimum wage is also an example of an attempt to assist the workers by forcing wages to be
higher than the equilibrium wage rate. The result is that the demand for labour will decrease
because of the inflated wage rate. Although the intention was to help the employee, it causes more
unemployment. The wage rate should be left alone so that the equilibrium is obtained, and this will
reduce unemployment.