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Demand, Supply and Pricing Prices produce a rationing effect in a market economy. If there is a shortage of a good or service it results in higher prices. Higher prices result in a reduction in the quantity demanded. How demand is influenced • Substitute effect- when the price of a good increases people will by less of the good and they will look for substitutes. • Income effect- when the price rises people buy less because it takes a greater portion of their income and when the price goes down they may buy more of the good. Changes in quantity demanded versus shifts in demand • A change in the quantity demanded is movement along the demand line due to changes in price • A shift in demand is a whole new demand line caused by outside circumstances Causes of shift in demand • Change in income • Consumer expectations • Population (number of buyers) • Changes in tastes, advertising, styles • Prices of substitutes • Prices of complementary goods (things that go along with the other good such as, peanut butter and jelly Elasticity of demand • A good is elastic if the quantity demanded changes due to a price change. A good is inelastic if people buy almost the same amount even if there is a price change. Factors that affect elasticity • 1. available substitutes • 2. portion of income- relative importance • 3. Change over time (long vs. short run) Test for Elasticity of Demand Price Up Down Up Down Total Revenue Down Up Up Down Elasticity Elastic Elastic Inelastic Inelastic Supply • Supply is the amount of goods and services that producers are willing to offer at different prices. Often producers face higher marginal costs to produce more of their product so they want higher prices to cover their costs. Market entry costs also affect the number of goods produced. • Supply elasticity is determined by TIME. Supply usually can not change much in the short run but may be adjusted over the long-run. Causes for changes in Supply • 1. • 2. • 3. • 4. • 5. • 6. Change in future expectations Changes in the number of suppliers Changes in production costs Changes in technology Changes in the price of substitutes Changes in taxes. subsidies and regulations Market Price or Equilibrium Price • The intersection of the supply and demand lines. This is the only price where supply equals demands. At this price there will be no surpluses or shortages. P Q Government’s influence on Supply • Price floors- a price that is set higher than the market price by the government to help suppliers by setting minimum prices to encourage more production (farm price supports, minimum wage etc) Government influence on supply • Price ceilings- a price set below the market clearing price to help consumers from playing very high market prices (rent controls for low income housing) Advantages of Prices • Higher price an incentive to produce more • Prices are signal of consumer demand • Flexibility- if there is a shift in supply or demand prices can change quickly to meet the change • Price system is free- no government control is needed. Prices adjust automatically