MECO 111-Chapter 4

4-1 Markets and Competition

The terms supply and demand refer to the behavior of people as they interact with
one another in competitive markets

4-1a What Is a Market?

market: a group of buyers and sellers of a particular good or service
The buyers as a group determine the demand for the product, and the sellers as a
group
determine the supply of the product.

Markets take many forms. Some markets are highly organized, such as the markets for
many agricultural commodities.

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 In these markets, buyers and sellers meet at a specific time and place where an
auctioneer helps set prices and arrange sales.

More often, markets are less organized

4-1b What Is Competition?

competitive market: a market in which there are many buyers and many sellers so that
each
has a negligible impact on the market price
Each buyer knows that there are several sellers from which to choose, and each seller
is aware that his product is similar to that offered by other sellers.
Rather, price and quantity are determined by all buyers and sellers as they interact in
the marketplace.
Economists use the term competitive market to describe a market in which there are so
many buyers and so many sellers that each has a negligible impact on the market price
To reach perfectly competitive, highest form of competition, a market must have two
characteristics: (1) The goods offered for sale are all exactly the same, and
(2) the buyers and sellers are so numerous that no single buyer or seller has any
influence over the market price.

Because buyers and sellers in perfectly competitive markets must accept the price the
market determines, they are said to be price takers. At the market price, buyers can buy
all they want, and sellers can sell all they want.
There are some markets in which the assumption of perfect competition applies
perfectly
Not all goods and services, however, are sold in perfectly competitive markets.
Some markets have only one seller, and this seller sets the price. Such a seller is called
a monopoly.

Perfectly competitive markets are the easiest to analyze because everyone participating
in the market takes the price as given by market conditions.
Moreover, because some degree of competition is present in most markets, many of the
lessons that we learn by studying supply and demand under perfect competition apply

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 in more complicated markets as well.

4-2 Demand
4-2a The Demand Curve: The Relationship between
Price and Quantity Demanded
The quantity demanded of any good is the amount of the good that buyers are
willing and able to purchase.

law of demand the claim that, other things being equal, the quantity demanded of a
good falls when the price of the good rises
a demand schedule, a table that shows the relationship between the price of a good
and the quantity demanded, holding constant everything else that influences how much
of the good consumers want to buy.
The line relating price and quantity demanded is called the demand curve. The demand
curve slopes downward because, other things being equal, a lower price means a
greater quantity demanded.

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 4-2b Market Demand versus Individual Demand
To analyze how markets work, we need to determine the market demand, the sum of
all the individual demands for a particular good or service.
The market demand at each price is the sum of the two individual demands.

The graph in Figure 2 shows the demand curves that correspond to these demand
schedules.

Notice that we sum the individual demand curves horizontally to obtain the market
demand curve. That is, to find the total quantity demanded at any price, we add the
individual quantities, which are found on the horizontal axis of the individual demand
curves.

Because we are interested in analyzing how markets function, we work most often with
the market demand curve.

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 The market demand curve shows how the total quantity demanded of a good varies as
the price
of the good varies, while all other factors that affect how much consumers want to
buy are held constant.

4-2c Shifts in the Demand Curve

Because the market demand curve holds other things constant, it need not be stable
over time. If something happens to alter the quantity demanded at any given price, the
demand curve shifts.

Any change that reduces the quantity demanded at every price shifts the demand curve
to the left and is called a decrease in demand.

There are many variables that can shift the demand curve. Let’s consider the most
important.

Income
A lower income means that you have less to spend in total, so you would have to spend
less on some—and probably most—goods.

If the demand for a good falls when income falls, the good is called a normal good.
Normal goods are the norm, but not all goods are normal goods. If the demand for a
good rises when income falls, the good is called an inferior good.

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 Prices of Related Goods
When a fall in the price of one good reduces the demand for another good, the two
goods are called substitutes.
Substitutes are often pairs of goods that are used in place of each other, such as hot
dogs and hamburgers, sweaters and sweatshirts, and cinema tickets and film streaming
services.

When a fall in the price of one good raises the demand for another good, the two goods
are called
complements.

Complements are often pairs of goods that are used together, such as gasoline and
automobiles, computers and software, and peanut butter and jelly

Tastes
The most obvious determinant of your demand is your tastes. If you like ice cream, you
buy more of it. Economists normally do not try to explain people’s tastes because tastes
are based on historical and psychological forces that are beyond the realm of
economics. Economists do, however, examine what happens when tastes change.

Expectations
Expectations Your expectations about the future may affect your demand for a good or
service today. If you expect to earn a higher income next month, you may choose to
save less now and spend more of your current income buying ice cream.
If you expect the price of ice cream to fall tomorrow, you may be less willing to buy an
ice-cream cone at today’s price.

Number of Buyers:
In addition to the preceding factors, which influence the behavior of individual buyers,
market demand depends on the number of these buyers. If Peter were to join Catherine
and Nicholas as another consumer of ice cream, the quantity demanded in the market
would be higher at every price, and market demand would increase

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 4-3 Supply
4-3a The Supply Curve: The Relationship between Price
and Quantity Supplied
The quantity supplied of any good or service is the amount that sellers are willing and
able to sell. There are many determinants of quantity supplied, but once again, price
plays a special role in our analysis.
When the price of ice cream is high, selling ice cream is profitable, and so the quantity
supplied is large. Sellers of ice cream work long hours, buy many ice-cream machines,
and hire many
workers.

This relationship between price and quantity supplied is called the law of supply: Other
things
being equal, when the price of a good rises, the quantity supplied of the good also
rises, and when the price falls, the quantity supplied falls as well.

law of supply: the claim that, other things being equal, the quantity supplied of a good
rises when the price of the good rises

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 This is the supply schedule, a table that shows the relationship between the price of a
good and the quantity supplied, holding constant everything else that influences how
much of the good producers want to sell.

The graph in Figure 5 uses the numbers from the table to illustrate the law of supply.
The curve relating price and quantity supplied is called the supply curve.
The supply curve slopes upward because, other things being equal, a higher price
means a greater quantity supplied.

4-3b Market Supply versus Individual Supply

Just as market demand is the sum of the demands of all buyers, market supply
is the sum of the supplies of all sellers.

The table in Figure 6 shows the supply schedules for the two ice-cream producers in the
market—Ben and Jerry.

At any price, Ben’s supply schedule tells us the quantity of ice cream that Ben supplies,
and Jerry’s supply schedule tells us the quantity of ice cream that Jerry supplies.

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 The market supply is the sum of the two individual supplies.
The graph in Figure 6 shows the supply curves that correspond to the supply schedules.
As with demand curves, we sum the individual supply curves horizontally to obtain the
market supply curve. That is, to find the total quantity supplied at any price, we add the
individual quantities, which are found on the horizontal axis of the individual supply
curves.

The market supply curve shows how the total quantity supplied varies as the price of the
good varies, holding constant all other factors that influence producers’ decisions about
how much to sell.

4-3c Shifts in the Supply Curve

Because the market supply curve is drawn holding other things constant, when one of
these factors changes, the supply curve shifts.

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 For example, suppose the price of sugar falls. Sugar is an input in the production of ice
cream, so the fall in the price of sugar makes selling ice cream more profitable.
This raises the supply of ice cream: At any given price, sellers are now willing to
produce a larger quantity. As a result, the supply curve for ice cream shifts to the right.

Figure 7 illustrates shifts in supply. Any change that raises quantity supplied at every
price, such as a fall in the price of sugar, shifts the supply curve to the right and is called
an increase in supply.
Any change that reduces the quantity supplied at every price shifts the supply curve to
the left and is called a decrease in supply.

There are many variables that can shift the supply curve.

Input
Prices To produce their output of ice cream, sellers use various inputs: cream, sugar,
flavoring, ice-cream machines, the buildings in which the ice cream is made, and the
labor of workers who mix the ingredients and operate the machines.

When the price of one or more of these inputs rises, producing ice cream is less
profitable, and firms supply less ice cream. If input prices rise substantially, a firm might
shut down and supply no ice cream at all.

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 Thus, the supply of a good is negatively related to the price of the inputs used to make
the good.

Technology
The technology for turning inputs into ice cream is another determinant of supply. The
invention of the mechanized ice-cream machine, for example, reduced the amount of
labor necessary to make ice cream.
By reducing firms’ costs, the advance in technology raised the supply of ice cream.

Expectations
The amount of ice cream a firm supplies today may depend on its expectations about
the future. For example, if a firm expects the price of ice cream to rise in the future, it
will put some of its current production into storage and supply less to the market today.

Number of Sellers
In addition to the preceding factors, which influence the behavior of individual sellers,
market supply depends on the number of these sellers. If Ben or Jerry were to retire
from the ice-cream business, the supply in the market would fall.

The supply curve shows what happens to the quantity supplied of a good when its price
varies, holding constant all the other variables that influence sellers. When one of these
other variables changes, the supply curve shifts. Table 2 lists the variables that
influence how much of a good producers choose to sell.
The price is on the vertical axis, so a change in price represents a movement along the
supply curve. By contrast, because input prices, technology, expectations, and the
number of sellers are not
measured on either axis, a change in one of these variables shifts the supply curve.

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 4-4 Supply and Demand Together
4-4a Equilibrium
equilibrium: a situation in which the market price has reached the level at which
quantity supplied equals quantity demanded

equilibrium price: the price that balances quantity supplied and quantity demanded

equilibrium quantity: the quantity supplied and the quantity demanded at the
equilibrium price
Figure 8 shows the market supply curve and market demand curve together.

Notice that there is one point at which the supply and demand curves intersect.
This point is called the market’s equilibrium. The price at this intersection is
called the equilibrium price, and the quantity is called the equilibrium quantity. Here the
equilibrium price is $2.00 per cone, and the equilibrium quantity is 7 ice-cream cones.

The dictionary defines the word equilibrium as a situation in which various forces are in
balance. This definition applies to a market’s equilibrium as well.

At the equilibrium price, the quantity of the good that buyers are willing and able to buy
exactly balances the quantity that sellers are willing and able to sell.

The equilibrium price is sometimes called the market-clearing price because, at this
price, everyone in the market has been satisfied: Buyers have bought all they want to

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 buy, and sellers have sold all they want to sell.

The actions of buyers and sellers naturally move markets toward the equilibrium of
supply and demand. To see why, consider what happens when the market price is not
equal to the equilibrium price.
surplus: a situation in which quantity supplied is greater than quantity demanded
shortage: a situation in which quantity demanded is greater than quantity supplied
Suppose first that the market price is above the equilibrium price, as in panel (a) of
Figure 9.

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 At a price of $2.50 per cone, the quantity of the good supplied (10 cones) exceeds the
quantity demanded (4 cones).

There is a surplus of the good: Suppliers are unable to sell all they want at the going
price.
A surplus is sometimes called a situation of excess supply.
When there is a surplus in the ice-cream market, sellers of ice cream find their freezers
increasingly full of ice cream they would like to sell but cannot.
They respond to the surplus by cutting their prices. Falling prices, in turn, increase the
quantity demanded and decrease the quantity supplied. These changes represent
movements along the supply and demand curves, not shifts in the curves. Prices
continue to fall until the market
reaches the equilibrium.
Suppose now that the market price is below the equilibrium price, as in panel (b) of
Figure 9.

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 In this case, the price is $1.50 per cone, and the quantity of the good demanded
exceeds the quantity supplied.
There is a shortage of the good: Demanders are unable to buy all they want at the going
price. A shortage is sometimes called a situation of excess demand.

When a shortage occurs in the ice cream market, buyers have to wait in long lines for a
chance to buy one of the few cones available.
With too many buyers chasing too few goods, sellers can respond to the shortage by
raising their prices without losing sales.
These price increases cause the quantity demanded to fall and the quantity supplied to
rise. Once again, these changes represent movements along the supply and demand
curves, and
they move the market toward the equilibrium.
Thus, regardless of whether the price starts off too high or too low, the activities of the
many buyers and sellers automatically push the market price toward the equilibrium
price.
Once the market reaches its equilibrium, all buyers and sellers are satisfied, and there
is no upward or downward pressure on the price.

How quickly equilibrium is reached varies from market to market depending on how
quickly prices adjust.
In most free markets, surpluses and shortages are only temporary because prices
eventually move toward their equilibrium levels.
Indeed, this phenomenon is so pervasive that it is called the law of supply and demand:
The price of any good adjusts to bring the quantity supplied and quantity demanded for
that good into balance.
law of supply and demand: the claim that the price of any good adjusts to bring the
quantity supplied and the quantity demanded for that good into balance

4-4b Three Steps to Analyzing Changes in Equilibrium

Equilibrium presents the price and quantity of the good that buyers purchase and sellers
produce.

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 The equilibrium price and quantity depend on the position of the supply and demand
curves. When some event shifts one of these curves, the equilibrium in the market
changes, resulting in a new price and a new quantity exchanged between buyers and
sellers.

When analyzing how some event affects the equilibrium in a market, we proceed in
three steps. First, we decide whether the event shifts the supply curve, the demand
curve, or, in some cases, both.
Second, we decide whether the curve shifts to the right or to the left.
Third, we use the supply-and-demand diagram to compare the initial equilibrium with
the new one, which shows how the shift affects the equilibrium price and quantity.
Table 3 summarizes these three steps.

Example: A Change in Market Equilibrium Due to a Shift in

Demand
The hot weather affects the demand curve by changing people’s taste for
ice cream. That is, the weather changes the amount of ice cream that people
want to buy at any given price. The supply curve is unchanged because the
weather does not directly affect the firms that sell ice cream.
2. Because hot weather makes people want to eat more ice cream, the demand
curve shifts to the right. Figure 10 shows this increase in demand as a shift in
the demand curve from D1
to D2
. This shift indicates that the quantity of ice
cream demanded is higher at every price.
3. At the old price of $2, there is now an excess demand for ice cream, and this
shortage induces firms to raise the price. As Figure 10 shows, the increase in
demand raises the equilibrium price from $2.00 to $2.50 and the equilibrium

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 quantity from 7 to 10 cones. In other words, the hot weather increases both the
price of ice cream and the quantity of ice cream sold

Shifts in Curves versus Movements along Curves

Notice that when hot weather increases the demand for ice cream and drives up the
price, the quantity of ice cream that firms supply rises, even though the supply curve
remains the same. In
this case, economists say there has been an increase in “quantity supplied” but no
change in “supply.”
Supply refers to the position of the supply curve, whereas the quantity supplied refers to
the amount suppliers wish to sell. In this example, supply does not change because the
weather does not alter firms’ desire to sell at any given price.
Instead, the hot weather alters consumers’ desire to buy at any given price and thereby
shifts the demand curve to the right.
The increase in demand causes the equilibrium price to rise. When the price rises, the
quantity supplied rises.
This increase in quantity supplied is represented by the movement along the supply
curve.

To summarize, a shift in the supply curve is called a “change in supply,” and a shift in

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 the demand curve is called a “change in demand.” A movement along a fixed supply
curve is called a “change in the quantity supplied,” and a movement along a fixed
demand curve is called a “change in the quantity demanded.”

Example: A Change in Market Equilibrium Due to a Shift in Supply

Suppose that during another summer, a hurricane destroys part of the sugarcane crop
and
drives up the price of sugar. How does this event affect the market for ice cream?
Once again, to answer this question, we follow our three steps.

1. The change in the price of sugar, an input for making ice cream, affects the
supply curve. By raising the costs of production, it reduces the amount of
ice cream that firms produce and sell at any given price. The demand curve
does not change because the higher cost of inputs does not directly affect the
amount of ice cream consumers wish to buy.

2. The supply curve shifts to the left because, at every price, the total amount that
firms are willing and able to sell is reduced. Figure 11 illustrates this decrease
in supply as a shift in the supply curve from S1
to S2
.

3. At the old price of $2, there is now an excess demand for ice cream, and this
shortage causes firms to raise the price. As Figure 11 shows, the shift in the supply
curve raises the equilibrium price from $2.00 to $2.50 and lowers the equilibrium
quantity from 7 to 4 cones. As a result of the sugar price increase, the price of ice
cream rises, and the quantity of ice cream
sold falls.

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 Example: Shifts in Both Supply and Demand
Now suppose that the heat wave
and the hurricane occur during the same summer. To analyze this combination of
events, we again follow our three steps.

1. We determine that both curves must shift. The hot weather affects the
demand curve because it alters the amount of ice cream that consumers want
to buy at any given price. At the same time, when the hurricane drives up
sugar prices, it alters the supply curve for ice cream because it changes the
amount of ice cream that firms want to sell at any given price.

2. The curves shift in the same directions as they did in our previous analysis:
The demand curve shifts to the right, and the supply curve shifts to the left.
Figure 12 illustrates these shifts.

3. As Figure 12 shows, two possible outcomes might result depending on

the relative size of the demand and supply shifts. In both cases, the
equilibrium price rises. In panel (a), where demand increases substantially
while supply falls just a little, the equilibrium quantity also rises. By
contrast, in panel (b), where supply falls substantially while demand rises
just a little, the equilibrium quantity falls. Thus, these events certainly raise
the price of ice cream, but their impact on the amount of ice cream sold is
ambiguous (that is, it could go either way).

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 4-5 Conclusion: How Prices Allocate
Resource
One of the Ten Principles of Economics discussed in Chapter 1 is that markets are
usually a good way to organize economic activity.
In any economic system, scarce resources have to be allocated among competing
uses. Market economies harness the forces of supply and demand to serve that end.

Supply and demand together determine the prices of the economy’s many different
goods and services; prices in turn are the signals that guide the allocation of resources.

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 For example, consider the allocation of beachfront land. Because the amount of this
land is limited, not everyone can enjoy the luxury of living by the beach. Who gets this
resource? The answer is whoever is willing and able to pay the price. The price of
beachfront land adjusts until the quantity of land demanded exactly balances the
quantity supplied. Thus, in market economies, prices are the mechanism for rationing
scarce resources.

Similarly, prices determine who produces each good and how much is produced. For
instance, consider farming. Because we need food to survive, it is crucial that some
people work on farms.
What determines who is a farmer and who is not? In a free society, there is no
government planning agency making this decision and ensuring an adequate supply of
food. Instead, the allocation of workers to farms is based on the job decisions of millions
of workers.

This decentralized system works well because these decisions depend on prices. The
prices of food and the wages of farmworkers (the price of their labor) adjust to ensure
that enough people choose to be farmers.

If a person had never seen a market economy in action, the whole idea might seem
preposterous. Economies are enormous groups of people engaged in a multitude of
interdependent activities. What prevents decentralized decision making from
degenerating into chaos? What coordinates the actions of the millions of people with
their varying abilities and desires? What ensures that
what needs to be done is in fact done? The answer, in a word, is prices. If an invisible
hand guides market economies, as Adam Smith famously suggested, then the price
system is the baton that the invisible hand uses to conduct the economic orchestra.
law of demand and supply

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