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LECTURE 2 – DEMAND, SUPPLY AND MARKET MECHANISM

What is a market?

A market is the collection of buyers and sellers that, through their interactions,
determine the price of a product. Markets exist in many various forms. A petrol station, a
local shop are examples of small markets. A Warsaw Stock Exchange is a highly sophisticated
market where buyers and sellers of shares and bonds from all over the world are brought into
contact with one another. As our example shows, some markets are local while others are
national or international in scope. Some are highly personal, involving face-to-face contact
between demander and supplier; on the others, suppliers and demanders never see or know
one another.
For the beginning, our concern is with functioning of perfectly competitive market. Such
markets is characterised by large numbers of independent buyers and sellers interested with
exchanging a product. Our concern will be to find out how prices are established on such
markets by demand decisions of consumers and supply decisions of producers.

Demand

Demand is a quantity of a product that consumers are willing and able to buy at a given
price and during a given period of time. A law of demand says: all else being constant, as
price falls, demand rises. Or, alternatively, as price increases, demand falls. There is an
inverse relationship between price and quantity. This relationship can be explained in terms of
income and substitution effects. The income effect says that at lower price one can afford
more of the good without giving up any alternative goods. A decrease in the price of a product
will increase the purchasing power of money income: you are able to buy more of the product
than before. Of course, a higher price will have the opposite effect. The substitution effect
suggests that, at a lower price, a consumer has an incentive to substitute the cheaper good for
similar goods which are now relatively more expensive. To illustrate: a decline in a price of
beef will increase the purchasing power of consumers incomes, making them able to buy
more beef (the income effect). At a lower price, beef is relatively more attractive and it is

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substituted for pork, chicken and fish (the substitution effect). The income and substitution
effects make consumers able and willing to buy more of a product at a low price than at a high
price.

The demand curve

The inverse relationship between product price and its quantity can be presented on a graph
measuring demand on the horizontal axis and price on the vertical axis.

Figure 1. Demand curve

A demand curve slopes downward because the relationship between price and quantity is
inverse. Consumers are usually ready to buy more than price is lower. Graphically, in such a
case, we will move down along the demand curve. If price is higher, demand falls and there
will be a move up along the curve.
When a demand curve is constructed we assume that price is the most important determinant
of demand. But we know that factors other than price can and do affect demand. Therefore, in
locating a given demand curve, we must assume that “other things are equal”, that is, other

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nonprice determinants of demand are constant. When these nonprice determinants in fact
change, the location of demand curve will shift to some new position.

Nonprice determinants of demand

1. Tastes and preferences – A change in consumer tastes or preferences, usually due to


advertising and fashion, means that more will be demanded at the same price. Unfavorable
change in consumers preferences will cause demand to decrease. It is worth noting that
technological change in a form of a new product usually change the consumer tastes. For
example, the development of computers eliminated the demand for writing machines.

2. Number of buyers – it is obvious that increase in a number of consumers on a market will


increase a demand. Fewer consumers mean lower demand.

3. Income – for more goods a rise in income will cause an increase in demand. Consumers
usually buy more cars, computers, TV sets, clothing et cetera as their income increases.
Conversely, the demand for such products will decline in response to a fall in income. Goods
whose demand varies directly with income are called normal goods. Although most products
are normal goods, there are some exceptions. For example, as income increases beyond some
point, the amount of bread or potatoes purchased at each price will probably diminish because
higher income allows consumer to buy more-protein goods such as dairy products and meat.
Goods whose demand varies inversely with income are called inferior goods.

4. Prices of related goods – a given change in a price of related good will change a demand
for a given good. A direction of change depends on a form of relation between goods. If goods
are substitutes, or competing goods, such as butter and margarine, a rise in a price of butter
will cause a rise in a demand for margarine. Conversely, as the price of butter falls, consumers
will buy larger quantities of butter, causing a decrease in demand for margarine. Generally,
when two products are substitutes, the price of one good and the demand for the other
are directly related. In a case of complementary goods a situation is opposite. They are
jointly demanded, so, for example, if the price of petrol falls, you will drive your car more and
this increase your demand for motor oil. Thus petrol and motor oil are jointly demanded –
they are complements. When two goods are complements, the price of one good and the
demand for other are inversely related. Many goods are not related at all – they are

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independent goods. For such goods as butter and cars, potatoes and TV sets, a change in the
price of one good will have no impact upon the demand for the other.

5. Expectations – consumer expectations of higher future prices may induce them to buy now
in order to avoid higher price in the future. Similarly, the expectation of rising incomes may
induce consumers to increase current spending.

We might summarize:
• An increase in the demand for product X can be caused by:
1. a favourable change in consumer tastes
2. an increase in the number of buyers in the market
3. a rise (fall) in income if X is a normal (inferior) good
4. an increase (decrease) in the price of related good Y if Y is a substitute for
(complement to) X
5. expectations of future increases in prices and incomes.
An increase in demand will shift the demand curve to the right (figure 2).

• A decrease in the demand for product X can be caused by:


1. an unfavourable change in consumer tastes
2. a decrease in the number of buyers in the market
3. a rise (fall) in income if X is an inferior (normal) good
4. an increase (decrease) in the price of related good Y if Y is complementary to
(a substitute for) X
5. expectations of future prices and incomes declines.
A decrease in demand will shift the demand curve to the left (figure 2).

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Figure 2. Changes in the demand for a good.

Supply

Supply it is a quantity of a product that a producer is willing and able to produce and
offer for sale on the market at a given price during some period of time. Supply tells us
what quantities of a product will be supplied at various prices, all other factors being constant.
The law of supply says that there is a direct relationship between price and quantity. As price
rises, the corresponding supply also rises’ as price falls, the supply also falls. This means that
producers are willing to produce and offer for sale more of a product at higher price and less
at lower price. To a supplier, a price is a revenue per unit of a product and therefore higher
price will induce the producer to produce more. The supply curve shows graphically
mentioned direct relationship between price and supply (figure 3). The curve is upward
sloping: the higher the price, the higher the supply. Graphically, a drop in price results in
move down along the supply curve. When the price rises, we move up along the curve.

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Figure 3. The supply curve

Nonprice determinants of supply

1. Production cost, including technology and resource prices – they are the major
components of production costs. With lower costs, producers will find it profitable to offer
larger amount of a product at a given price. So decline in resource prices as well as
technological improvement will reduce production costs and thus will increase supply. The
supply curve will shift to the right.

2. Prices of other goods – Changes in the prices of related goods affect the supply of a given
good. For example, a decline in a price of wheat may cause a farmer to produce more corn (a
supply curve for wheat will shift to the left). Conversely, a rise in the price of wheat may
make farmers to decrease supply of corn on the market.

3. Expectations – they can also affect a producer’s current supply. But it is difficult to
generalize in what direction these expectations will change the supply. Producers expecting
higher future prices may reduce current supply (not production) in order to sell higher amount

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of products later, at higher prices. On the other hand, expected price increases may induce
firms to expand production immediately, causing increase in supply.

4. Number of sellers – the larger the number of suppliers, the greater will be market supply.
As more firms enter the industry, the supply curve will shift to the right. When firms leave the
industry, the market supply will diminish and the supply curve will shift to the left.

Figure 4. Shifts of the supply curve.

Market equilibrium

The next step is to put the supply curve and demand curve together. We have done this in
figure 5. The vertical axis shows the price of a good. This is the price that sellers receive for a
given amount of product supplied and the price that buyers will pay for a given quantity
demanded. The horizontal axis shows the total quantity demanded and supplied.

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Figure 5. Market equilibrium mechanism

The two curves intersect at the equilibrium, or market clearing price and quantity. At this price
the quantity supplied and quantity demanded are just equal. The market mechanism is a
tendency in a free market for the price to change until market clears, that is until the
quantity supplied and demanded are equal. At this point, because there is neither excess
demand nor excess supply, there is no pressure for the price to change further. Supply and
demand may not always be in equilibrium, while some market may clear, but rather
slowly. The tendency, however, is for markets to clear.
To understand why markets tend to clear, suppose the price was initially above the market
clearing level – say, c1 in figure 5. Producers will try to produce and sell more than
consumers are willing to buy. A surplus – a situation in which the quantity supplied
exceeds the quantity demanded will result. To sell this surplus – or at least to prevent it
from growing – the producers will begin to lower prices. As price falls, the quantity
demanded increases and quantity supplied decreases until the equilibrium price cr is reached.
The opposite would happen if the price was initially below cr, say at c2. A shortage – a
situation in which the quantity demanded exceeds the quantity supplied will result. The
consumers would be unable to purchase all they would like. This would put upward pressure

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on price as consumers would try to outbid one another for existing supply. Producers would
increase a price and expand output. Again, the price would reach cr.

Changes in market equilibrium

We have seen how demand and supply curves shift in response to changes in incomes,
production costs et cetera. Now we will se how the market equilibrium changes in response to
shifts in the demand and supply curves.
Let’s begin in a shift in a supply curve. In figure 6, the supply curve shifted to the right (from
pd1 to pd3), for example due to a decrease in resource prices. As a result, the market price
drops and the total quantity supplied increases.

Figure 6. Changes in market equilibrium – shifts in supply

Figure 7 shows what happens following a rightward shift in the demand curve (from Pp1 to
Pp2) dresulting from, say, increase in incomes. We will expect higher market price and greater
quantity supplied.

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. Figure 7. Changes in market equilibrium – shifts in demand

In most markets, both the demand and supply curves shift at the same time. In figure 8, for
example, shifts to the right of supply curve and shift to the left of demand curve result in
lower price and higher quantity. In general, changes in price and quantity depend on the
amount by which each curve shifts.

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Figure 8. Changes in market equilibrium – shifts in demand and supply

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