Chapter 3 Macroeconomics- Market At Work (Supply and Demand)

Chapter 3 Macroeconomics- Market At Work (Supply and Demand) Fundamentals of Markets • Market economy: resources are allocated among households and firms with little or no government interference • Adam Smith founded capitalism/modern market economy • Invisible hand: a process that guides resources to their highest-valued use o Ex: using nice leather in expensive cars • Competitive market: a market in which there are so many buyers and sellers that each has only a small impact on the market price and output. In fact, the impact is so small that it is negligible. (there’s many offers of the same thing) • Imperfect market: a market in which either the buyer or the seller can influence the market price (things are rare/valuable/significant) o The more unusual a product being sold is, the more control the seller has • Market power: a firm’s ability to influence the price of a good or service by controlling its supply, demand, or both • Monopoly: one company controls the whole market for a certain good or service Demand • Quantity demanded: the amount of a good or service that buyers are willing and able to purchase at the current price • Law of demand: states that, all other things being equal, the quantity demanded falls when the price rises, and the quantity demanded rises when the price falls • Demand schedule: A table that shows the relationship between the price of a good and the quantity demanded • Demand curve: a graph of the relationship between the prices in the demand schedule and the quantity demanded at those prices. o For simplicity, the demand “curve” is often drawn as a straight line. o the independent variable, which is the price, is on the y axis o the dependent variable, which is the quantity demanded, is on the x axis o A price change causes a movement along a given demand curve, but it cannot cause a shift of the demand curve. • Market demand: the sum of all the individual quantities demanded by each buyer in a market at each price Factors that change demand: • • • • • • • Purchasing power: how much you can afford Normal good: something consumers choose to purchase (ex: a meal at a restaurant) o When income goes up, the demand for normal goods increases and the demand curve shifts to the right Inferior good: a good purchased out of necessity rather than choice (ex: rooms in a boarding home, something not desirable but necessary) o As income goes up, consumers buy less of an inferior good because they can afford something better. Complements: two goods that are used together (ex: toothbrush and toothpaste) Substitutes: two goods used in place of each other (Ex: Xbox v PlayStation) An expectation of a lower price in the future will therefore decrease current demand. o Ex: if people think a sale will happen, they’re more likely to wait for it Higher taxes lower demand Supply • price level and quantity supplied are positively related • • • • quantity supplied: the amount of a good or service that producers are willing and able to sell at the current price law of supply: states that, all other things being equal, the quantity supplied increases when the price rises, and the quantity supplied falls when the price falls supply schedule: a table that shows the relationship between the price of a good and the quantity supplied supply curve: a graph of the relationship between the prices in the supply schedule and the quantity supplied at those prices • market supply: the sum of the quantities supplied by each seller in the market at each price • When a variable other than the price changes, the entire supply curve shifts • A price change causes a movement along the supply curve, not a shift in the curve. Factors that change supply: Decreased prices decreases supply? • • • Inputs: resources used in the production process. o may include workers, equipment, raw materials, buildings, and capital goods o cost of inputs declines, profits improve o cost of inputs decline, so does the supply Technology: knowledge that producers use to make their products Taxes lower profits (supply curve shifts to the left, overall supply declines) • • • • Subsidy: a payment made by the government to encourage the consumption or production of a good or service (has opposite effect as taxes do) More sellers > curve to the right because increased production Price expectations: if a seller expects a time where price will increase, said seller may want to delay sales until then (ex: florists on valentine’s) When the supply expands more rapidly than the demand, there’s an increase in quantity sold and a lower price Equilibrium • • • • Equilibrium: where the demand curve and the supply curve intersect o the two opposing forces of supply and demand are perfectly balanced Equilibrium price: the price that makes the quantity supplied equal the quantity demanded o aka market clearing price because there is no surplus or shortage Equilibrium quantity: the amount of supplies that equals the quantity demanded o the price clears the market Law of supply and demand: the idea that market prices adjust to bring the quantity supplied and the quantity demanded into balance. Surpluses and Shortages • • • Shortage: (excess demand) when the quantity supplied is less than the quantity demanded o As the market price increases in response to the shortage, sellers continue to increase the quantity that they offer Surplus: (excess supply) when the quantity supplied is greater than the quantity demanded. In competitive markets, surpluses and shortages are resolved through the process of price adjustment. Big Ideas✷ How do supply and demand interact to create equilibrium? • Supply and demand work together in a market-clearing process that leads to equilibrium, the balancing point between the two forces. The market-clearing price and output are determined at the equilibrium point. • When the price is above the equilibrium point, a surplus exists and inventories build up. Suppliers lower their price in an effort to sell the unwanted goods. The process continues until the equilibrium price is reached. • When the price is below the equilibrium point, a shortage exists and inventories are depleted. Suppliers raise the price until the equilibrium point is reached. What determines demand? • The law of demand states that, all other things being equal, quantity demanded falls when the price rises, and rises when the price falls. • The demand curve is downward sloping. • A price change causes a movement along the demand curve, not a shift of the curve. • Changes in taste, preferences, price expectations, number of buyers, taxes What determines supply? • Supply curve=upward sloping • Price change causes movement along the supply curve • Changes in: o Cost of input o Changes in technology o Taxes o Subsidies o Number of sellers o Price expectations Questions: Imagine an illness with two cures—drug X and drug Y made by the same firm. Two events recently happened. First, a study was released showing that drug X is less effective than drug Y. Second, the ingredients used to produce drug X increased in price. What are the consequences of these events? The demand for drug X shifts to the left, and the supply curve for drug X shifts to the left. The result is an unknown change in the equilibrium price for drug X and a fall in the equilibrium quantity of drug X. Relationships: • Price and demand: inverse • cost of inputs and profits: inverse • cost of inputs and supply: inverse • Equilibrium price and supply: inverse • Equilibrium price and equilibrium quantity: inverse??? • Income and demand of inferior goods: inverse • Taxes and supply: positive • Price and supply: positive • Cost of inputs and equilibrium price: positive • Equilibrium quantity and supply: positive • Equilibrium price and demand: positive • Number of firms and supply: positive • Subsidies and supply: positive • Income and demand of normal goods: positive • Shortage and price: positive (a shortage causes pressure on price) • Price of complementary good and demand of main good: positive Right is increase, left is decrease Cost of inputs does not change demand Change in supply does not change demand unless it’s a necessary good Subsidies do not change demand When the demand curve shifts, the equilibrium price and the equilibrium quantity sold move in the same direction. When the supply curve shifts, equilibrium price and equilibrium quantity sold move in opposite directions. When both shift, one or the other will be unknown. When firms in a market expect the price of their products to rise, the supply curve of their goods decrease, causing the equilibrium price to fall.