How the Market System Works

Study Questions

n 1. What is the law of demand?

n 2. What is the law of supply?

n 3. How does a market achieve equilibrium?

n 4. What causes buyers to change their demand behavior?

n 5. What causes sellers (producers) to change their supply behavior?

n 6. What causes the price of a good to change?

n 7. What happens when government imposes a price on the market?

Trade

n Everyone specializes in making one good

n We make an amount available for sale

n We receive income from the sale

n We buy goods we want from other specialists

Types of Trade

n Simple trade

¨ barter

n Modern trade

¨ use money as a medium of exchange

Buyers

n Those willing and able to exchange money for goods

¨ they will buy if they perceive themselves to be better off after the sale

Sellers

n Those willing and able to produce goods and exchange them for money

¨ they will sell if they perceive themselves to be better off after the sale

Mutually Agreeable Trade

n Both buyer and seller perceives that they will be better off after the trade is made than they were before

n Both trade a good that has lower value (to them) for a good that has higher value (to them)

Price

n The rate of exchange in a trade.

n Buyer pays the price (his MC)

¨ it must be less than buyer’s valuation (his MB)

n Seller receives the price (his MB)

¨ it must be more than seller’s cost of acquiring or producing the good (his MC)

How is the Price Set?

n Price is determined by the interaction of:

¨ buyers’ demand behavior, and

¨ sellers’ supply behavior.

Buyers’ Demand Behavior

n Buyers are sensitive to changes in the price.

n Law of demand:

¨ If price rises, buyers will buy less.

¨ If price falls, buyers will buy more.

¨ … assuming nothing else changes.

Figure 2-1. Law of Demand

P rises Q falls As price rises, quantity demanded falls

P falls Q rises As price falls, quantity demanded rises

Table Inverse relationship between P and Q

P Q Graphs as a downward sloping line

9 2

7 6

5 10

3 14

Buyers’ Demand Behavior

n Income effect:

¨ if price rises and your income does not, you can not buy as much as you could before

¨ if price falls and your income does not, you can buy more than you could before

Buyers’ Demand Behavior

n Substitution effect:

¨ if price of good X rises, you switch to lower price substitute good Y.

¨ if price of good X falls, you switch from higher priced substitute good Z.

Sellers’ Supply Behavior

n Sellers are sensitive to changes in the price.

n Law of supply:

¨ If price rises, sellers will produce and want to sell more.

¨ If price falls, sellers will produce and want to sell less.

¨ … assuming nothing else changes.

Figure 2-2. Law of Supply

P rises Q rises As price rises, quantity supplied rises

P falls Q falls As price falls, quantity supplied falls

Table Direct relationship between P and Q

P Q Graphs as an upward sloping line

10 15

8 11

6 7

4 3

Sellers’ Supply Behavior

n Sellers are in business to be profitable:

¨ if price rises and sellers’ costs do not, profit per unit rises, and they want to produce and sell more

¨ if price falls and sellers’ costs do not, profit per unit falls, and they want to produce and sell less

Sellers’ Supply Behavior

n Limited Capacity to Expand Production:

¨ As output increases, so do costs

¨ Thus, sellers will only produce more if prices rises (to cover the added costs)

Creating a Market

n Demand curve represents buyers’ current behavior

n Supply curve represents sellers’ current behavior

n Create a market by letting the demand curve and the supply curve intersect

Figure 2-3. Making a Market

n Buyer behavior (demand) and seller behavior (supply) intersect.

Three Starting Possibilities

n Price starts out too high

¨ surplus situation

n Price starts out too low

¨ shortage situation

n Price starts out just right

¨ equilibrium situation

Figure 2-4. Surplus

n Price is too high.

n Quantity supplied (Qs) exceeds quantity demanded (Qd).

n Qs > Qd

n Price will fall to Pe.

Figure 2-5. Shortage

n Price is too low.

n Quantity demanded (Qd) exceeds quantity supplied (Qs)

n Qd > Qs

n Price will rise to Pe.

Figure 2-6. Equilibrium

n No shortage.

n No surplus.

n Qd = Qs = Qe.

n The price will not rise or fall until there is a shift in demand or in supply.

How Do Prices Change?

n In an equilibrium market, price will not change.

n If order to get price to change, a market must go into disequilibrium.

¨ Either demand behavior changes, or

¨ Supply behavior changes, or both.

Figure 2-7. Demand increases

n Demand shifts right.

n Old equilibrium is upset: Shortage.

n A new equilibrium is established.

n Price rises from P₁ to P₂.

n Quantity rises from Q₁ to Q₂

Figure 2-8. Demand decreases

n Demand shifts left.

n Old equilibrium is upset: Surplus.

n A new equilibrium is established.

n Price falls from P₁ to P₂.

n Quantity falls from Q₁ to Q₂

Determinants of Demand

n Demand increases:

¨ income increases

¨ tastes and preferences increase

¨ number of buyers increase

¨ expectations of higher prices rise

¨ price of substitutes rises

¨ price of a complement falls

n Demand decreases:

¨ income decreases

¨ tastes and preferences decrease

¨ number of buyers decrease

¨ expectations of lower prices rise

¨ price of substitutes falls

¨ price of a complement rises

Figure 2-9. Supply increases

n Supply shifts right.

n Old equilibrium is upset: Surplus.

n A new equilibrium is established.

n Price falls from P₁ to P₂.

n Quantity rises from Q₁ to Q₂.

Figure 2-10. Supply decreases

n Supply shifts left.

n Old equilibrium is upset: Shortage.

n A new equilibrium is established.

n Price rises from P₁ to P₂.

n Quantity falls from Q₁ to Q₂.

Determinants of Supply

n Supply increases:

¨ business costs fall

¨ number of sellers increases

¨ a cost-lowering change in technology is implemented

n Supply decreases:

¨ business costs rise

¨ number of sellers decrease

¨ obsolete, high-cost technology is retained

Figure 2-11. Demand increases and Supply decreases

n 1. Demand shifts right.

n 2. Supply shifts left.

n A new equilibrium is established.

n Price rises from P₁ to P₂.

n Quantity moves to Q₂

What if…?

n One seller sets a higher price than the equilibrium price?

¨ customers will shun him until goods selling at the equilibrium price are all gone

What if…?

n One seller sets his price below equilibrium price?

¨ he will sell out first.

¨ but he could have sold everything at the higher equilibrium price.

What if…?

n Government sets the price?

n Price controls.

¨ no longer a free market

¨ command dictator system is at work

¨ Two kinds:

n price ceiling

n price floor

Figure 2-12. Price Ceiling

n Government sets a maximum legal price

¨ Purpose: to help the buyers

¨ P < Pe

¨ Persistent shortage

Figure 2-13. Price Floor

n Government sets a minimum legal price

¨ Purpose: to help the sellers

¨ P > Pe

¨ Persistent surplus

What if…?

n Government controls quantity, not price?

¨ restricts the amount? Supply shifts left and price rises.

¨ forbids all production? No legal amount is available.

n black market arises

n buyers’ and suppliers’ costs both rise

n product quality decreases

Which System is Best?

n The market system!

¨ individual wants and needs more fully satisfied

¨ participants compete to acquire purchasing power rather than political favor

¨ scarce resources are directed to produce the most valued goods and services

¨ individuals’ behavior changes are immediately accommodated