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Chapter 4
1) Price Determination in competitive markets
a) Competition means no buyer or seller can influence the price of the product. Price, and
the basic economic questions discussed in Chapter 2, are determined by overall market
conditions.
b) This implies many buyers and sellers, none holding any degree of monopoly power in the
market.
c) At the other extreme is pure monopoly (one seller) and markets with “price rivalry”
where, due to a market having only a few sellers, the price change one seller makes will
influence competitors to make similar changes. An example of this is the price wars that
occasionally take place in the airline industry.
2) Demand Curves
a) Demand is a set of relationships between price and quantity, from the consumer’s
perspective. In other words, it shows what quantity people will choose to purchase at
each of several possible prices, within a specific period of time.
(1) The logical direction of the Demand Curve is downward-sloping (inverse
relationship between price and quantity) because if nothing changes in the market
except price has decreased, we normally expect people to purchase more of the
good.
b) This assumption that “nothing else changes in the market” is referred to commonly in
economics as “ceteris paribus”, and it allows us to deal with the effect of a designated
change in the market (e.g. price decrease) while holding all other influential market
factors constant.
c) For demand, these other factors are:
Buyers’ income
Buyers’ taste and preferences
Price of complements and substitutes
Buyers’ expectations of future market conditions
Number of buyers in the market
d) Using the Ceteris Paribus assumption, all market factors are held constant, and we then
can deal with the change in only one.
e) Charting Demand
(1) Demand Schedule: A table that simply lists the quantity purchased at each
specific price.
(2) Demand Curve: a graph that shows the line going through the points listed on the
Demand Schedule
f) Law of Demand: Consumers buy more at relatively low prices than at relatively high
prices (ceteris paribus). There are two reasons the quantity of a good demanded inversely
relates to its price:
(1) Income effect: Real Income increases due to a decrease in the price of the good.
This results in more consumption.
(2) Substitution effect: if Price falls for a good, it is relatively cheaper than it was
compared to substitutes leading to an increase in quantity as consumption moves
away from those (now relatively more expensive) substitutes.
Exceptions: Certain rare types of goods
(1) Veblen goods: an increase in price increases quantity due to a perception on the
consumer’s part that a higher price indicates an intangible benefit (e.g. status).
These goods fall in the “luxury goods” category, and are consumed by the
wealthy mostly.
(2) Income inferior goods: Price decreases, quantity decrease in response. Poor
people in developing countries may have most of their diet comprised of rice,
beans, potatoes or a similar low-cost subsistence food. If the price of that food
decreases, they may want to spend the savings to diversify their diet. This allows
them to demand less of the “inferior good”.
Veblen and Inferior goods are the rare exception. Even most luxury and necessity goods
are similar to “normal goods” because a decline in price will cause the consumer to
purchase more of the good.
3) The price changing, whether it increases or decreases, causes what is called “change in
quantity demanded”.
a) This is a very important distinction because the demand for the good itself, the
relationship between how much is purchased at a given price, has not changed; we simply
have moved to a different point along the demand curve to find the new quantity
demanded.
b) Conversely, if it is not the price that has changed but any other demand factor (tastes,
expectations about the good in the future, consumers’ income, or changes in the price of
substitutes or complements for the good) that changes, the entire demand curve does
shift.
As an example, if you expect the price of clothing fall next month, you will logically cut
back on your purchases this month in anticipation of the upcoming sale, or flood of imported
textiles, or whatever it is that is causing you to expect a decrease in price in the future. This
is represented by the entire demand curve making a parallel shift to the left, which means that
whatever price clothes are going for (remember, price in the current month has not changed),
you will buy less than before the change in expectations. This is called a “shift in demand”.
An example of demand shifting to the right could be a change in the price of a substitute or
complement to the good. So if we were looking at demand for airplane tickets for the year, a
complementary good would be something that typically is purchased along with airplane
tickets, such as hotel stays. So if hotels cut prices, demand for airplane tickets will increase.
On the other hand, a substitute for airplane tickets would be alternative forms of travel. So if
train tickets decrease in price, demand for airplane tickets will decrease.
Another factor that will shift demand is a change in market size, meaning if the population
grows or more consumers enter the market for a good, that too will shift demand to the right.
Market demand is made up of the demand schedules of individual buyers added together.
Supply is the set of relationships between the quantities of a good that will be offered for sale
at each of several prices within a specific time period.
4) Supply
a) While the consumers who make up market demands are maximizing satisfaction (utility)
the firms maximizes profits. As such, higher prices for the good will induce the firm to
supply more and lower prices will cause it to supply less. A change in price, ceteris
paribus, will cause a “change in quantity supplied”. Movement along the curve
represents this, just as movement along the demand curve represents “change in quantity
demanded”. On the other hand, a shift in the entire supply curve will occur if, instead of
a price change, there is a change in one of the other factors influencing supply. These
are:
(1) Technology used in production (more broadly, the method of production)
(2) Input prices (raw or intermediate materials that are needed to make output are
called “inputs”). This also refers to the cost associated with any of the four
“factors of production”.
(3) Prices of other goods (specifically, the prices of other goods that the firm could
produce instead).
(4) Expectations about future prices for the good
(5) The firm’s objective (e.g. profit maximizing or something else?)
(6) Number of firms in the industry.
This model assumes many competitors, none of whom can change market price on their
own (no monopoly power).
The Supply Schedule is the chart that shows the relationship between the quantity of a
good that will be offered for sale at each of several prices, and the Supply Curve is the
relationship plotted on the two-dimensional graph.
For simplicity a supply curve is often drawn as the mirror image of the demand curve,
intersecting it and thus forming an “X”. Realistically, at a certain quantity supply will
turn vertical due to scarcity in various resources such as plant of factory production
capacity, storage space, or retailing limitations. In other words, it is unrealistic to think
that suppliers can increase quantity supplied to no end, so at some quantity the line turns
vertical. Demand can increase by but the change will be in price only, not quantity, once
that maximum supply capacity is reached.
In addition to this limit in supply at high prices, there is a limit at very low prices where
suppliers will choose to produce nothing/
Putting together the individual supply curves of all firms in the industry equals market
supply. Therefore, if more firms enter the industry, market supply will shift to the right.
b) Equilibrium price is the price of a good where quantity demanded equals quantity
supplied. It is referred to also as the market clearing price in that firms will not build up
inventories (excess supply) at this price.
Note that since suppliers and consumer act independently, a change in supply will not
cause a change in demand, it causes a change in quantity demanded. A change in
demand will not cause a change in supply, it will cause a change in quantity supplied.