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Chapter 4

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Bridget O' Shaughnessy

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Unit 2: The Market Forces of Demand and Supply—The Basics 2.1.1 Markets and Competition The government may have a limited role in the direct production of goods and services, but it will determine the institutional arrangements—the rules of the game—within which markets operate. These institutional arrangements are critical for economic success. Markets cannot function effectively without a stable and secure set of economic and political institutions. Some societies have been much more successful than others in finding the correct institutional framework that will promote economic development. ―Pure‖ market economy has never existed. Thousands of economic decisions are made each day outside of markets. Corporations, for example, would not exist in a ―pure‖ market economy, as a corporation organizes production on the basis of internal decision rules, not markets. The textbook authors identify the main characteristics of a perfectly competitive market: i. The goods are all the same. ii. There are so many buyers and sellers that no single buyer or seller can influence the market price. iii. Buyers and sellers ―must accept the price the market determines,‖ so they are considered to be price takers. 2.2.1 The Law of Demand Many factors might influence how much of a particular good or service consumers will purchase—the income of the consumer, his or her tastes and preferences, the price of the good in question, the prices of other goods perhaps, and expectations about future events. Economists begin by focusing on the relationship between the amount of a good consumers are willing and able to purchase and the price of that good. This doesn’t mean that other factors are not important, but merely that we will assume, for the moment, that these other factors are not changing. This allows us to explore the relationship between price and quantity demanded. We define demand as a schedule or curve showing the amount of a good or service consumers are able and willing to purchase at a set of possible prices during a specified period of time. The Law of Demand states simply that there is an inverse or negative relationship between price and quantity demanded, all else equal. The ―all else equal‖ statement merely means that we are holding others factors constant; that is, we are making a statement about demand assuming that all other factors do not change. This law appears to be quite reasonable. It states that, other things equal, as the price of a good falls, the amount consumers will purchase will rise. Figure 2.1: Demand for movie tickets Demand can be represented on a simple graph. Figure 2.1, left, shows the demand for movie tickets per week in St. Albert, AB. The demand curve slopes downward. At a relatively high price of $8 per ticket, the theatres only sell 600 tickets per week. If the price drops to $4 per ticket however, the theatres will sell 1,000 tickets per week. At the higher price, consumers decide to visit movie theatres less often and to spend some of their dollars elsewhere (at the video rental store perhaps). Consumers face a range of choices, and if the price of one good rises, they will tend to consume less of it. Price may be the most important factor influencing the quantity demanded, but it is not the only factor. At all prices, demand is likely to change if a. incomes change b. consumer preferences change c. the prices of related goods change d. the number of consumers change e. consumer expectations about future prices and incomes change. How shall we go about introducing such factors? We begin by recognizing that if one of the above five factors change, it will shift the entire demand curve. For example, if incomes rise, we would expect that the amount consumers wish to purchase, at all prices, will rise as well. Similarly, if the number of consumers in the market increases, then at each price, the total quantity that all consumers would like to purchase will rise. These five factors are the major determinants of demand. If a determinant of demand changes, then the entire demand curve will shift, either to the left or the right. It is very important that you are able to distinguish between a movement along a fixed or given demand curve and a shift in the entire demand curve—many students are confused by this distinction. Remember  If the price of X changes it can only cause a movement along a fixed demand curve for X. It cannot shift the demand curve for X.  If one of the five determinants of demand changes, it can only cause the entire demand curve to shift outward or inward. It cannot cause a movement along a fixed demand curve. Consider Figure 2.2, below. D i1 the initial demand curve for television sets. Now, let us assume that incomes rise by 20 percent. The rise in incomes causes the entire demand curve to shift to the right, to 2 . Figure 2.2: Demand for television sets Reread pages 73–77 of the textbook to review how the other determinants of demand cause the demand curve to shift. Note: It is important to remember that when price falls and, therefore, consumers purchase more of a good, we do not say that demand has increased, but rather that the quantity demanded has increased. This is shown as a movement along a fixed demand curve, not a shift in the demand curve. However, if one of the determinants of demand changes, then the entire demand curve will shift. We will soon present a simple demand and supply model. You will need to be able to use this model to predict how market price and market quantity change when you are given a specific change in economic circumstances. You should follow this procedure when faced with this kind of problem. 1. Draw your own demand and supply diagram. 2. Determine if the change presented will cause the demand curve or the supply curve to shift. 3. Using your diagram, draw the new demand or supply and calculate the new market price and quantity. You will be given many opportunities to practice this model in this course. 2.3.1 Law of Supply The Law of Supply states that as price increases, other things equal, the quantity of a good or service firms are able and willing to supply will increase. The law of supply is shown in Figure 2.3, below. S (the red line) is called the supply curve. It shows that at the relatively low price of $2 per kg, firms will only supply 10,000 kg per week, but if the price were higher, say $5 per kg, firms would be willing to supply 30,000 kg per week. Figure 2.3: Supply of sugar When we say that firms will produce more if prices are higher, we must again invoke the assumption of ―other things equal,‖ which means, as before, that we are assuming that other variables are constant, or unchanging. Determinants of Supply There are five determinants of supply:  factor or input prices  technology  prices of other related goods  the number of sellers in the market  future price expectations. If one of these determinants changes, if will cause the entire supply curve to shift either left or right. 2.4.1 Market Equilibrium Economists sometimes say that the forces of demand interact with the forces of supply to produce two r
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