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How the Market
System Works
Study Questions
1. What is the law of demand?
 2. What is the law of supply?
 3. How does a market achieve
equilibrium?
 4. What causes buyers to change their
demand behavior?

Study Questions
5. What causes sellers (producers) to
change their supply behavior?
 6. What causes the price of a good to
change?
 7. What happens when government
imposes a price on the market?

Trade
Everyone specializes in making one good
 We make an amount available for sale
 We receive income from the sale
 We buy goods we want from other
specialists

Types of Trade

Simple trade
 barter

Modern trade
 use
money as a medium of exchange
What is a Market?
Any Place Where Goods and Services are
Voluntarily Exchanged
(brings together buyers and sellers)
Price is a primary influence in determining
allocation of resources in our free enterprise
economy.
Difference between Price, Value, Utility
Price= value of product in terms of money
Value= has to do with relative scarcity =
exchange value
Utility = satisfaction that good or service can
provide
Buyers

Those willing and able to exchange money
for goods
 they
will buy if they perceive themselves to be
better off after the sale
Sellers

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
Both buyer and seller perceive that they
will be better off after the trade is made
than they were before
 Both trade a good that has lower value (to
them) for a good that has higher value (to
them)

Price
The rate of exchange in a trade.
 Buyer pays the price (buyer’s MC)

 it
must be less than buyer’s valuation (buyer’s
MB)

Seller receives the price (seller’s MB)
 it
must be more than seller’s cost of acquiring
or producing the good (seller’s MC)
How is the Price Set?

Price is determined by the interaction of:
 buyers’
demand behavior, and
 sellers’ supply behavior.
Law of Supply
As the price of the product increases, the
quantity that the supplier tends to
supply also increases.
****Ceteris Paribus Ceteris Paribus
Assumption
[KAY-ter-us PEAR-uh-bus]

Nothing changes except the factor or factors being
studied.
 Other
things “constant” “equal”
Economics as a Science

Ceteris Paribus Assumption
[KAY-ter-us PEAR-uh-bus]
 Nothing
changes except the factor or factors
being studied.
 “Other
things constant”
 “Other
things equal”
Law of supply
= positive relationship between the
quantity of a good supplied and price.
PRICE IS THE INDEPENDENT
VARIABLE
Determinants of Supply
1.
2.
3.
4.
5.
6.
Technique of production (technology)
(ovens, organic farming)
Resource Prices (Factor Costs)– cost of inputs
Taxes and Subsidies
Prices of Other Goods – (decline in wheat will
cause farmer to shift to corn)
Expectations- (farmers expect price to rise..
Hold back production)
Number of sellers in market – more sellers,
greater supply….
Important Concepts
Change in Supply (shifting of curve)
Or
Change in Quantity Supplied (movement
along curve)
Ability to Respond to Price varies
Often the ability of an individual firm to
respond to an increase in price is limited
or constrained by its existing scale of
operations, or capacity, or ability to
obtain resources….. IN SHORT RUN
Examples:
IN LONG RUN… can adjust. The greater
the amount of time producers have to
adjust, the greater their output
response.
Law of Demand
AS THE PRICE OF A GOOD
DECREASES THE QUANTITY
DEMANDED TENDS TO INCREASE….
***Ceteris Paribus
Price once again is the independent
variable!
Wishing for a new boat does not constitute
demand… one must be WILLING AND ABLE to
purchase a boat.
Generally speaking…. The higher the price
obstacle, the less of a product a consumers will
buy.
Bargain days are based on law of demand.
The greater the want satisfaction…. The
greater the utility…
Marginal Utility… How much more utility
do you get adding or subtracting units
(more doughnuts… more cars… more
steak in one day)
DIMINISHING MARGINAL UTILITY.
As the number of units of a product a
consumer has increases, the
satisfying power for each extra unit
decreases.
Utility
Purpose of Utility analysis is to study how
people behave not how they think.
Theory of consumer choice is based on
the idea that each consumer spends
his/her income in a way that yields the
greatest satisfaction.
Determinants of Demand
1.Preferences
2.Prices of Related Goods
3.Number of Buyers
4.Expectations of future price
5.Income
Determinants of Demand
1.
Tastes and preferences
Taste changes throughout our lifetime.
# 2 Determinant: Prices of Related
Goods
Your preference is Coke… price skyrockets….
Affected in the market by substitute goods and complimentary
goods.
*Substitute goods… anything that can be substituted for the
product or service desired…
(Coke/Pepsi,
Millers/Coors,
potato chips/popcorn).
If price of Coke rises… and consumer doesn’t feel strongly
about brand preference… will buy Pepsi until Coke price
declines)
When two products are substitutes, the price of one good
and the demand for the other are DIRECTLY RELATED.
*Complementary Goods… Goods that
“go along with other goods consumer’s
buy”
peanut butter/jelly, beer/pretzels,
milk/cookies, golf balls/golf tees,
When two goods are complements, an
increase in the price of one good
adversely affects the demand for the
other and creates an inverse
relationship.
Independent Goods… No connection
between price and demand (cars/bread)
Determinants Continued
3. Number of buyers
The number of buyers will increase
demand for the product which (if supply
is fixed) will drive up the price.)
Determinant #4
Income- RATHER OBVIOUS HERE.
Show shifts…
Superior or Normal goods= commodities
whose demand varies DIRECTLY with
money income.
INFERIOR OR “POOR MAN’S” GOODS.
Goods whose demand varies inversely with
a change in money income.
5. Expectations…
If you are in medical school or law school,
the expectation of you getting a larger
income when you get out of school will
affect your demand for goods…
Inheriting money, winning the lottery!
IMPORTANT CONCEPTS OF DEMAND
Change in Demand
OR
Change in Quantity Demanded
Terms to Remember
Profit:
TR-TC
Total Revenue
PxQ
Marginal Utility
To maximize utility, consumers should
choose that good which delivers the most
marginal utility per dollar. Optimal utility is then
achieved.
Optimal consumption= mix of output that
maximizes total utility for the limited amount
of income you have to spend.
Figure 2-1. Law of Demand
P
P
Q
Q
As price rises, quantity demanded falls
As price falls, quantity demanded rises
Table
Graph
P
P Q
9 2
7 6
5 10
D
3 14
Q
Buyers’ Demand Behavior

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

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.
Figure 2-2. Law of Supply
P
P
Q
Q
As price rises, quantity supplied rises
As price falls, quantity supplied falls
Table
Graph
P
P Q
S
10 15
8 11
6
7
4
3
Q
Sellers’ Supply Behavior

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

Limited Capacity to Expand Production:
 As
output increases, so do costs
 Thus, sellers will only produce more if prices
rise (to cover the added costs)
 In
Short Run- can not change production
drastically.
Creating a Market
Demand curve represents buyers’ current
behavior
 Supply curve represents sellers’ current
behavior
 Create a market by letting the demand
curve and the supply curve intersect

Figure 2-3. Making a Market

Buyer behavior
(demand) and seller
behavior (supply)
intersect.
P
S
Pe
D
Qe
Q
Three Starting Possibilities

Price starts out too high
 surplus

situation
Price starts out too low
 shortage

situation
Price starts out just right
 equilibrium
situation
Figure 2-4. Surplus




Price is too high.
P
Quantity supplied
Phigh
(Qs) exceeds quantity
demanded (Qd).
Pe
Qs > Qd
Price will fall to Pe.
S
surplus
D
Qd
Qe
Qs
Q
Figure 2-5. Shortage




Price is too low.
Quantity demanded
(Qd) exceeds quantity
supplied (Qs)
Qd > Qs
Price will rise to Pe.
P
S
Pe
Plow
shortage
Qs
Qe
D
Qd
Q
Figure 2-6. Equilibrium




No shortage.
No surplus.
Qd = Qs = Qe.
The price will not rise
or fall until there is a
shift in demand or in
supply.
P
S
Pe
D
Qe
Q
How Do Prices Change?
In an equilibrium market, price will not
change.
 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





Demand shifts right.
Old equilibrium is upset:
Shortage.
A new equilibrium is
established.
Price rises from P1 to P2.
Quantity rises from Q1 to
Q2
P
S
P2
P1
D2
D1
Q1
Q2
Q
Figure 2-8. Demand decreases





Demand shifts left.
Old equilibrium is
upset: Surplus.
A new equilibrium is
established.
Price falls from P1 to
P2.
Quantity falls from Q1
to Q2
P
S
P1
P2
D1
D2
Q2
Q1
Q
Figure 2-9. Supply increases





Supply shifts right.
Old equilibrium is
upset: Surplus.
A new equilibrium is
established.
Price falls from P1 to
P2.
Quantity rises from Q1
to Q2.
P
S1
P1
P2
D
Q1
Q2
Q
S2
Figure 2-10. Supply decreases





Supply shifts left.
Old equilibrium is
upset: Shortage.
A new equilibrium is
established.
Price rises from P1 to
P2.
Quantity falls from Q1
to Q2.
S2
P
S1
P2
P1
D
Q2 Q1
Q
Figure 2-11. Demand increases
and Supply decreases





1. Demand shifts
right.
2. Supply shifts left..
A new equilibrium is
established.
Price rises from P1 to
P2.
Quantity moves to Q2
S2
P
1
2
S1
P2
P1
D2
D1
Q1
Q2
Q
This summarizes how equilibrium P and equilibrium Q
change as demand increases (decreases) and as
supply increases (decreases)
P
Demand increases
P increases
Q increases
P
Q
P
P
Demand decreases
P decreases
Q decreases
Q
Supply increases
P decreases
Q increases
Q
Supply decreases
P increases
Q decreases
Q
What if…?

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…?

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…?
Government sets the price?
 Price controls.

 no
longer a free market
 command dictator system is at work
 Two kinds:
price ceiling
 price floor

Figure 2-12. Price Ceiling

Government sets a maximum legal price
 Purpose:
to help the buyers
P
P
< Pe
 Persistent shortage
S
Pe
Highest legal P
ceiling
price
D
Qs
shortage
Qd
Q
Figure 2-13. Price Floor

Government sets a minimum legal price
 Purpose:
P
to help the sellers
> Pe
 Persistent surplusLowest legal
price
P
surplus
S
P
Pe
floor
D
Qd
Qs
Q
What if…?

Government controls quantity, not price?
 restricts
the amount? Supply shifts left and
price rises.
 forbids all production? No legal amount is
available.
black market arises
 buyers’ and suppliers’ costs both rise
 product quality decreases

Which System is Best?

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
Kiley is my best friend… She
Supplies a lot of love! 