THE MARKET SYSTEM

Demand, Supply and Price Determination

INTRODUCTION: DEMAND & SUPPLY IN ACTION

After 2008/09 crisis the price of tea went up http://news.bbc.co.uk/1/hi/business/7882822.stm

1. 2. 3. 4.

Define the terms supply and demand Why as the price of tea risen? Identify two factors that affect the consumer demand for tea in the UK Why is demand for tea rising during the recession?

THE MARKET SYSTEM

Market consists of:
Consumers - create a demand for a product Producers create the supply of a product Goods and services the product

Demand
The quantity of goods and services that will be bought at a given price level over a period of time.

Effective demand is how much consumers CAN afford to buy and WOULD buy and not what they would like to buy.

INDIVIDUAL AND MARKET DEMAND

Market demand consists of the sum of all individual demand schedules in the market Represented by a demand curve At higher prices, consumers generally willing to purchase less than at lower prices inverse relationship between price and quantity demanded (with a few exceptions) Demand curve negative slope, downward sloping from left to right

CETERIS PARIBUS
What does this mean?
All other things being equal/unchanged As a number of different factors will influence a particular economic variable such as inflation, in order to analyse the effect of a change in just one of the factors, it is assumed that all its other factors remain constant .

When drawing a demand curve, economists assume all factors are held constant except one the PRICE of the product itself. Ceteris paribus, as price rises, demand falls. N.B Of course, in reality all other things do not remain constant! Later, we learn to consider changes in the other given factors in order to critically evaluate a particular economic relationship.

A DOWNWARD SLOPING DEMAND CURVE

The demand curve slopes

Price ()

downwards from left to right (a negative slope) indicating an INVERSE RELATIONSHIP between

10

price and the quantity demanded.

A change in PRICE causes a MOVEMENT along the curve

Demand
100 150

Quantity Demanded (000s)

WHY IS THE DEMAND CURVE DOWNWARD SLOPING?

Questions
30 seconds! What is REAL income? Real income : what consumers can buy with their money income at a GIVEN PRICE. It is income with price changes taken account of. It reflects the purchasing power of the income.

All other things being equal (ceteris paribus) what happens to REAL income then if price of a good falls? How will this affect demand? This is effect is called the INCOME EFFECT

WHY IS THE DEMAND CURVE DOWNWARD SLOPING?

Assume you like Crunchie bars and Mars bars equally and tend to buy both. If the price of Mars bars falls, which bar will you switch to buying more of? Though you like both bars the same, Crunchies are now relatively less expensive. As a rational consumer youre likely to switch to buying the relatively cheaper option. This is called the SUBSTITUTION EFFECT. Though this is common sense, its important to use ECONOMIC TERMINOLOGY

WHY IS THE DEMAND CURVE DOWNWARD SLOPING?

Question: If you were to eat three Mars bars how much value
would you place on eating the 3rd bar vs the 1st?? In economics this is called DIMINISHING MARGINAL UTILITY. It is one of the factors in falling price with increasing quantity demanded
Most benefit or utility is generated by the first unit of a good consumed because it satisfies all or a large part of the immediate need or desire. A second unit consumed would generate less utility - perhaps even zero, given that the consumer now has less need or less desire. With less benefit derived, the rational consumer is prepared to pay much less for the second, and subsequent, units, because the marginal utility falls . Thus the third reason for why the demand curve is downward sloping, relates to diminishing marginal utility!

WHY IS THE DEMAND CURVE DOWNWARD SLOPING?

The demand curve is downward sloping due to:

1) The INCOME EFFECT 2) The SUBSTITUTION EFFECT 3) DIMINISHING MARGINAL UTILITY

Whilst the INCOME EFFECT, SUBSTITUTION EFFECT and DIMINISHING MARGINAL UTILITY seem like basic common sense the point is to make sure you use the ECONOMIC TERMINOLOGY

DEMAND CURVE: MOVEMENTS VS SHIFTS

MOVEMENTS
Changes in the PRICE of a good or service cause MOVEMENTS up or down the demand curve. A FALL in price causes an EXTENSION or EXPANSION in demand shown by a movement down the curve. A RISE in price causes a CONTRACTION in demand, shown by a movement up the curve.

SHIFTS
Changes in any FACTOR other than the PRICE of the good/service itself cause SHIFTS to the right or the left of the demand curve. That is, there is a rise or fall in demand at EVERY price

FACTORS INFLUENCING DEMAND

BRAINSTORM!
Identify changes in TWO (non-price) factors that may cause an OUTWARD SHIFT of the demand curve

Identify changes that may cause an INWARD SHIFT of the demand curve

NON-PRICE FACTORS CAUSE SHIFTS

Price ()
Changes in any of
the factors affecting demand other than price
10

cause the entire

demand curve to shift to the left (less demanded at each price) or to the right (more demanded at each price).
10 100

D1 D2
200

Demand

Quantity Demanded (000s)

FACTORS INFLUENCING DEMAND

D = f (Pn,PnPn-1, Y, T, P, A, E)
Where:

Pn = Price PnPn-1 = Prices of other goods substitutes and complements Y = Income the level and distribution of income T = Tastes and fashions P = The level and structure of the population A = Advertising E = Expectations of consumers

DEMAND AND INCOME

When income rises the demand for NORMAL GOODS rise

This causes the demand curve to SHIFT OUTWARD

A fall in income has the opposite effect An INFERIOR GOOD is where the demand for a good falls as your income rises, causing an INWARD SHIFT of the demand curve

IN PAIRS: BRAINSTORM! Give TWO examples of normal goods

Give TWO examples of inferior goods. Hint: Think about the type of goods whose demand may increase during a recession.

SUBSTITUTE GOODS
Goods which are in competitive demand and act as replacements for each other
As the price of good X rises the demand for good Y rises For e.g. A RISE in the price of Nike Fly competitor, K-Swiss Blade running shoes should cause a substitute effect away from K-Swiss, and rise in demand for Nike Fly. The size of the effect will depend on the strength of the substitutes. A fall in the monthly call charges of Orange services may cause a decrease in demand for O2

IN PAIRS: BRAINSTORM examples of substitutes

COMPLEMENTS
Goods which are in Joint demand.

A rise in the price of a compliment to Good X should cause a fall in demand for Good Y and vice versa
Example a rise in price for Blue Ray players would cause an fall in demand for Blue Ray discs

Example a decrease in price for flights to New York would lead to a rise in demand for hotel rooms in that city.
IN PAIRS: BRAINSTORM examples

CHANGES IN TASTES/PREFERENCES
Consumer tastes can be volatile leading to unexpected fluctuations in demand Fashions and trends change Technology also advances You may have a blacklist of products which annoy you due to the adverts or unethical business practises

IN PAIRS: BRAINSTORM examples

OTHER IMPACTS ON DEMAND

Many goods are bought on credit using borrowed money (credit cards, store cards, hire purchase etc.)
Demand for them may therefore be sensitive to what?
The Interest rate

Examples of interest sensitive goods are new furniture and motor vehicles durable goods The demand for housing is also affected by changes in mortgage rates.
The income you have left after paying tax AND all necessary bills, such as food and monthly mortgage, is called DISCRETIONARY INCOME. If mortgage rates rise discretionary income falls.

SHIFTING THE DEMAND CURVE

Changes in any of the factors other than price causes the demand curve to shift either: Left/inward (Less demanded at every price) or Right/outward (More demanded at every price)

EXCEPTIONS TO THE LAWS OF DEMAND.

There are TWO possible reasons why demand may increase even when the price of a good or service is increasing
1. Ostentatious Consumption
Some goods are luxury items. Some consumers are prepared to pay for the snob value effect. Examples?

2. Speculative Demand
Potential buyers are interested in making a profit or a capital gain Speculative demand may therefore grow when prices are rising Examples?

DEMAND - EXERCISE
Sketch demand curves for the following situations, and think about how you expect the demand curve to change, if at all :
A - Demand for chocolate following a campaign highlighting the dangers of obesity
B - Demand for oranges following an increase in the price of apples C - Demand for oranges following a decrease in the price of oranges D - Demand for DVDs following a decrease in the price of DVD players E - Demand for Sky+ following an increase in the price of Virgin Media F Demand for private transport following an increase in consumer incomes G - Demand for public transport following an increase in consumer incomes. H Demand for consumer durables following an increase in the interest rate

DEMAND
A market is a set of arrangements enabling transactions to take place Market demand for a good depends on the price of the good, the price of other goods, consumer income and preferences and the number of potential consumers The relationship between the demand for a product and its price is known as the demand schedule

The demand curve shows this relationship graphically, and is downward sloping
A change in price induces a movement ALONG the demand curve, non-price factors cause a SHIFT The demand for a NORMAL good rises when incomes rise, demand for an INFERIOR good will fall Goods or services may be related to each other by either being a substitute or a compliment For some products, demand may be related to expected FUTURE prices .

SUPPLY
Definition: The amount of goods and services that producers are willing to supply / sell at a given price

In virtually all cases supply increases as price increases and vice versa Why do you think this is?
This is because producers are aiming to make profit If the good is sold at a high price they will make more profit. If it is sold at a low price they will either make very little profit or even a loss.

THE SUPPLY CURVE

Changes in any of the factors OTHER than the price of good/service cause a shift in the supply curve A shift in supply to the left the amount producers offer for sale at every price will be less

A shift in supply to the right the amount producers wish to sell at every price increases
HINT: Be careful to not confuse supply going up and down with the direction of the shift!

SUPPLY FACTORS
Like demand, it is possible that supply will change for reasons OTHER than price.
What factors do you think would cause supply to rise or fall (at every price level)? Hint: what factors influence a firms cost of production and profit margin?
Availability of factors of production e.g. labour Cost (factors & raw materials) Subsidies

Taxes

Subsidies

Technology

FACTORS INFLUENCING SUPPLY

S = f (Pn, Pn..Pn-1,H, N,F1..Fm,E,Sp)

Where: Pn = Price Pn..Pn-1 = Profitability of other goods in production and prices of goods in joint supply H = Technology N = Natural shocks F1..Fm = Costs of production E = Expectations of producers Sp = Social factors

Supply may increase due to:

_ _ _ _ in cost of raw materials _ _ _ _ efficient production _ _ _ _ _ _ _ _ in productivity

_ _ _ technology
_ _ _ in expected prices for a product -------- in land availability

The Supply Curve

Price
S1 Supply S2
Like for demand curve, changes in 4

NON-PRICE FACTORS
will cause the entire supply curve to shift. A shift to the left

results in a lower
supply at EVERY 100 400 900 PRICE; a shift to the right indicates a greater supply at EVERY PRICE.

Quantity Bought and Sold (000s)

THE SUPPLY CURVE

Price
7

Supply

The supply curve slopes UPWARDS from left to right indicating a POSITIVE relationship between supply and price.

As price rises, it
incentivises producers to offer more for sale 200 800 whereas a fall in price would lead to the quantity supplied to fall.

Quantity Bought and Sold (000s)

THE SUPPLY CURVE

So as we have seen:
If the price of a good/service varies, we move ALONG the supply curve. Other factors will cause a SHIFT in the curve.

There are three main reasons why supply curves for most products slope upwards from left to right
Individually:
1) Why is it that when price rises individual firms will want to supply more? Use key terms 2) What will a price rise in a particular good/service signal to firms outside that market about that market? 3) Extension question: as a firm increases output, cost per unit may start to rise why is this? (clue: more resources are being used up).

AN UPWARD SLOPING SUPPLY CURVE

1. The Profit Motive
When the market price rises (e.g. due to an increase in consumer demand) it becomes more profitable for businesses to increase output. Higher prices signal to firms that they can increase profits by satisfying demand.

2. Production and costs

When output rises, a firms production costs may rise. A higher price is therefore needed to justify the extra output and cover these extra costs of production. As we will learn this called RISING MARGINAL COST; simply because the greater the output, the more raw materials, labour etc. will be required for each additional unit.

3. New Market Entrants

Higher prices SIGNAL profitability to other firms, hence to enter the market with their factors of production, leading to an expansion in the supply in the market.

SUPPLY FACTORS: PRODUCTION COSTS

Give an example what might cause cost of production to fall for firms or a particular firm, and thus for a firm to increase its supply.
LOWER costs of production mean that a business can supply more at every price A publishing company may benefit from a fall in the price of paper, for example These costs savings may be passed down the SUPPLY CHAIN to wholesalers and retailers, resulting in lower prices for consumers What if costs INCREASE? E.g. due to an increase in DERIVED DEMAND for inputs (firms competing for resources). A rise in the cost of oil would mean an increase in the cost of supplying electricity Energy is typically around 5% of the cost of production processes

Higher prices will therefore cause higher INPUT costs for many industries, causing a fall in market supply and higher prices if these costs are passed to consumers.

SUPPLY FACTORS: EXCHANGE RATES AND PRODUCTION TECHNOLOGY

What would happen to the cost of production for firms if the exchange rate (value of the pound fell), assume firms import some of their inputs/resources?
A fall in the exchange rate causes an increase in the price of imported components and raw materials (because firms get less foreign currency per 1 for e.g.) This will (other things being equal) lead to a decrease in supply in some industries

Example:
If the pound falls 10% against the Euro, then it is more expensive for British car manufacturers to import rubber and glass from suppliers in Western Europe PRODUCTION COSTS HAVE INCREASED AND SUPPLY FALLS

What would happen to the cost of production for firms with an advance in production technology? Explain using key terms.
Changes in production technology: These can change quickly. In industries where technological change is rapid we see increases in supply and lower prices for consumers. Digital cameras are an example. This is because productivity rises with the efficiency of new technology.

SUPPLY FACTORS: GOVERNMENT TAXES

A tax effectively increases the costs faced by producers
An increase in the tax rate on a good or service will therefore shift the supply curve in which direction? Draw a demand and supply curve diagram and show what happens to supply what happens to output and price.
To the LEFT less is supplied at each price level as producers must pay more tax.

SUPPLY FACTORS: GOVERNMENT SUBSIDIES

A subsidy effectively reduces the costs faced by producers An subsidy will therefore shift the supply curve in which direction? To the RIGHT more is supplied at each price level due to the subsidy which producers receive

SUPPLY OTHER THINGS TO NOTE

Climactic Conditions and Production Yields For commodities such as coffee, climactic conditions can have a major impact on market supply Changes in climate can have a dramatic effect on the prices for such goods as coffee, cocoa and tea What happens if weather conditions are unfavourable? The harvest will be poor, there will be lower yields and supply will decrease What will happen to price of the crop if supply falls?

SUPPLY - EXERCISE
For each of the following situations, decide whether the demand or supply curve would move, and in which direction: Consumers are convinced by arguments about the benefits of organic vegetables A new process is developed that reduces the amount of inputs that firms need in order to produce bicycles There is a severe frost in Brazil that affects the coffee crop The government increases the rate of VAT Real incomes rise The price of tea falls what happens in the market for coffee?

The price of sugar falls what happens in the market for coffee??
A subsidy is provided by the govt for the production of electric cars The economy enters recession and the trade weighted exchange rate falls by 5%

SUPPLY SUMMARY
Assuming other things being equal, firms in a competitive market can be expected to supply more output at a higher price

The supply curve traces out this positive relationship between price and quantity supplied
Changes in production costs, technology, taxes and subsidies or the price of related goods may induce movements of the supply curve, with firms being prepared to sell more (or less) output at any given price Expectations about future prices may affect current supply decisions.

The Market
Price () S1

S
A The shift shortage in the supply in curve the market to the would left would drive up lead prices to less as products some consumers being available are prepared for sale to at every pay more. price. The Suppliers price will would continue only to rise be until able to the offer 100 shortage units for hassale been at a competed price of 5 away but consumers and a new still desire equilibrium to purchase 600. position This has creates been a market reached. shortage. (S < D)

Shortage

D
100 350 600

Quantity Bought and Sold (000s)

THE MARKET
Price ()

S
Inshift A an attempt in the to demand get rid of curve surplus to the left stock, producers will reduce will accept the lower demand prices. Lower to 300 from 500 prices in turn at a price ofsome attract 5. Suppliers do consumers to not buy. have The process the information continues until or the time to adjust surplus supply disappears and immediately equilibrium is and still offer once again 600 for sale at 5. This reached. results in a market D surplus (S > D)

Surplus
5

D1
300 450 600

Quantity Bought and Sold (000s)

COMPOSITE DEMAND
Where goods have more than one use an increase in the demand for one leads to a fall in supply of the other
Milk used for cheese, yoghurts, cream, butter, etc. If more milk is used for cheese, ceteris paribus there is less available for butter

Come up with some other examples..

COMPOSITE DEMAND
S Milk
Price Price

S1 S Cheese

20

9 6

10

Shortage

D1

D 100 130 20 50 80
Quantity bought and sold

D
Quantity bought and sold

DERIVED DEMAND
Where the demand for one good is dependent on the demand for another related good An increased demand for cars and increased demand for steel Factor markets derived demand. An increased demand for houses increased demand for construction workers (though market rigidities may interfere in the relationships)

Come up with some other examples..

DERIVED DEMAND
Price (000s) S Houses Wage Rate ( per hour) 20 200 S Plasterers

180 D1

12

Shortage

D1 D 80 90 120 Quantity hired

D 100 130

Quantity bought and sold

JOINT SUPPLY
Where an increase/decrease in the supply of one good leads to an increase/decrease in the supply of another For e.g. Lamb/wool, oil/fuels, milk/dairy products, cocoa/husks, etc.

Come up with some other examples..

JOINT SUPPLY
Price

S Oil

S Petrol
Price

S1

15

10

Surplus

D1

D 100 150 80 95
Quantity bought and sold

D 120
Quantity bought and sold

JUNE 2010

JANUARY 2010

JANUARY 2009

UARY 2011 Q9B

ANSWER