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Chapter 6 Demand

Factors Affecting Market Demand


1. Price of Good or Service - Consumers must decide whether they are willing and able to pay the nominated price - Some goods are necessities > people will need to buy them regardless of the price o If the price goes up people will reduce their demand for other goods (luxury items) 2. Price of Other Goods and Services - Goods which are substitutes for each other have inverse demands > when people demand more of one they demand less of the other o Price increases for one good lead to more demand for the other - Goods which are complements for each other have demands which move together > less demand for one means less demand for the other o Price increases for one good will affect the demand for the other 3. Expected Future Price - If consumers expect that the price of a good will increase they will bring forward their consumption > increase current demand o E.g. increase in home building before GST was implemented in 2000 4. Changes in Consumer Tastes and Preferences - As consumer tastes change so will the demand for particular products > e.g. clothing - Innovation and new technology leads consumers to demand new products > less demand for the old products o E.g. DVD players demanded at the expense of VHS players 5. Level of Income - As people earn more they are willing and able to purchase more goods and services o Demand for luxury goods mainly affected - A change in income distribution can cause changes in demand for particular goods o E.g. high income earners earning more means more demand for luxury goods - Consumer expectations about future levels of income can also influence demand o Consumers will not buy luxury goods if their economic outlook is uncertain or they feared losing their job 6. The Size of the Population and Age Distribution - Population size will affect the total amount demanded - Age distribution will change products demanded > e.g. retirement villages for an ageing population

The Demand Curve


The Law of Demand states that the quantity of a good demanded by consumers falls as the price of the good rises A demand schedule is a table which places the quantity of demand against the price of a product

The data in the demand schedule can be graphed to create a demand curve o Price is plotted on the vertical axis and quantity on the horizontal axis o It slopes downwards from left to right

1. Movements along the Curve - Any change in price will result in a change in demand = a movement along the curve - These are referred to as expansions and contractions in demand

A contraction in demand occurs when an increase in price from P1 to P2 causes the quantity demanded to fall from Q1 to Q2. An expansion in demand occurs when a decrease in price from P1 to P3 causes the quantity demanded to rise from Q1 to Q3.

2. Shifts of the Curve - A change in any factor other than price that influences demand will cause the curve to shift A movement to the right is an increase in demand o Means that people are more willing and able to buy more of each product at each price point o Consumers willingly buy a given quantity at a higher price than before - A movement to the left is a decrease in demand o Consumers are can only buy less of the product at each possible price point o At a given price consumers will buy less of a product than before

Price Elasticity of Demand


Measures the responsiveness or sensitivity of the quantity demanded of a particular product to changes in its price o Elastic demand is very responsive to changes in price (total output goes down) o Unit elastic demand is proportionally responsive to changes in price (total output remains the same) o Inelastic demand has a weak response to changes in price (total output goes up) Business firms need to understand price elasticity of demand for the goods they sell in order to decide on their optimal pricing strategy o For goods with an elastic demand the best strategy is to lower prices greater volume sold bigger total output o For goods with inelastic demand raising prices small reduction in sales greater total output

The government needs to understand price elasticity of demand when pricing the goods and services that it provides for the community (e.g. public transport) Needs to be able to predict the effects of changes in the level of any indirect taxes, such as sales taxes, excise duties and special levies o Can accurately predict the amount that will be demanded and amount of revenue that will be raised o Governments tend to charge indirect taxes on goods with an inelastic demand, (e.g. alcohol, petrol and tobacco)

Measuring Price Elasticity of Demand - Look at the effect of changes in price on the total revenue earnt by the producer - Total outlay is found by multiplying the price by the quantity that would be demanded at that price (P x Q) - If the total outlay moves in the same direction as the price change inelastic demand - If the total outlay moves in the opposite direction to the price change elastic demand - If the total outlay remains the same unit elastic demand Graphing Elasticity The demand curve should not be used as a measure of the price elasticity o Even in linear curves the elasticity will vary upper part is elastic but at lower levels it is inelastic Perfectly Elastic Demand is when consumers demand an infinite quantity at a certain price by nothing at a price above this (theoretical situation) Can occur in the case of an individual seller in a perfectly competitive market o Cant sell above market price b/c all customers will move o Wont sell below when can sell at market price Perfectly Inelastic Demand is when consumers are willing to pay any price to obtain a given quantity of a good Very unusual but could occur e.g. in the case of a terminally ill person

Factors Affecting Elasticity of Demand


1. Whether the Good is a Luxury or a Necessity - Necessities (e.g. bread, milk) tend to have an inelastic demand - The price elasticity is greater for luxury items (e.g. dining at expensive restaurants) 2. Whether the Good has Any Close Substitutes - Goods and services with close substitutes (e.g. cereal tend to have elastic demand) o If the price raises for one people will switch to another equally good brand demand contracts more than proportionally - Goods and services with few or no substitutes (e.g. water supply will have inelastic demand) 3. The expenditure on the product as a proportion of income - Goods that take up a small proportion of income (e.g. disposable goods) tend to have a lower price elasticity - Demand for expensive items are more elastic (e.g. people will buy chewing gum after a 10% price increase but not a new car)

4. The length of time subsequent to a price change - When the price of a product changes the quantity demanded may not initially change o Consumers take time to become aware and adjust to price changes o If the price increased consumers will seek out alternatives and substitute products make demand more responsive o If the price has fallen it will take time for consumers to become aware will switch away from other products - Way that consumers respond is dependent on durability of goods o After an initial price change durable goods have a more elastic demand than nondurable goods (e.g. Rise in price of new cars repairing old cars rather than buying new) o This elasticity declines over time (e.g. Old cars have to be replaced sometime) 5. Whether a good is habit-forming (addictive) or not - Addictive goods have a inelastic demand as despite price changes people tent to continue with the same habits

Chapter 7 Supply
Factors Affecting Market Supply
1. The Price of the Good or Service Itself - The market price influence the producers ability and willingness to supply it o If it is too low some producers may not be able to cover the costs of production - Expectations of future prices also have impacts on supply o If a supplier believes the price will rise in the future supply will increase and vice versa 2. The Price of Other Goods and Services - The quantity of any good supplied will be affected by the quantity of other goods supplied at that time o If the price to supply a good rose but the price to supply a different good remained the same it may become more profitable to supply the second good 3. The State of Technology - Improvements in technology lower production costs and allow more firms to supply more goods at a given price (e.g. production lines in the motor vehicle industry) - Also allow firms to adjust production runs to quickly accommodate changing demand patterns 4. Changes in the Cost of Factors of Production - The costs of factors of production very important to supply o A rise in the price of a factor of production often leads to a decrease in the supply of the goods and services that rely on that input (e.g. movie production companies increase their prices small cinemas go out of business less places to see a movie lower supply) 5. The Quantity of the Good Available - The quantity of the good available is an overall limiting factor that affects supply (e.g. the supply of oil is limited by the amount of oil in the world)

The number of suppliers also affects the quantity of the good or service available (e.g. more energy drink companies means more supply)

6. Climactic and Seasonal Influence - Affect agricultural production (e.g. drought)

The Supply Curve


The Law of Supply states that as the price of a certain product rises the quantity supplied by producers will rise A supply schedule shows the quantity of a good that will be supplied over a range of price points at a given time The data in the demand schedule can be graphed to create a supply curve o Price is plotted on the vertical axis and quantity on the horizontal axis o It upwards from left to right

1. Movements along the Curve - Any change in price will result in a change in supply = a movement along the curve - These are referred to as expansions and contractions in supply - A contraction in supply occurs when an increase in price from P1 to P2 causes the quantity demanded to fall from Q1 to Q2. - An expansion in supply occurs when a decrease in price from P1 to P3 causes the quantity demanded to rise from Q1 to Q3. 2. Shifts of the Curve - A change in any factor other than price that influences supply will cause the curve to shift A movement to the right is an increase in supply o Means that producers are more willing and able to supply more of each product at each price point o Producers willingly supply a given quantity at a higher price than before - A movement to the left is a decrease in supply o Producers can only supply less of the product at each possible price point o At a given price producers will supply less of a product than before

Price Elasticity of Supply


Measures the responsiveness or sensitivity of the quantity supplied of a particular product to changes in its price o Measured by the percentage change in the quantity supplied for a 1% change in price o Elastic supply is very responsive to changes in price (greater than proportion) o Unit elastic supply is proportionally responsive to changes in price (total output remains the same)

o Inelastic demand has a weak response to changes in price (total output goes up) Graphing Elasticity - The supply curve should not be used as a measure of the price elasticity - Perfectly Elastic Supply occurs when suppliers would supply an infinite amount of a good at a certain price but none below that price o Highly unlikely in reality - Perfectly Inelastic Supply occurs when no matter the price, the supply is fixed at a certain point o May occur with the supply of a certain piece of art where the quantity cannot be increased

Factors Affecting Elasticity of Supply


1. Time Lags After A Price Change - The more time producers have to respond to a price change the more elastic the supply - Immediately after a change producers are restricted from increasing supply o Can only increase by working existing factors of production harder o Can vary some inputs (workers, raw materials) o In the time immediately after a price change supply is generally virtually inelastic - In the long run any of the inputs can be increased > supply becomes elastic 2. The Ability to Hold and Store Stock - It is possible to hold goods (inventory) and not offer them for sale when the price is low o Affects supply elasticity > the easier it is to hold, the more elastic the stock - Perishable items are inelastic (food) - Durable items are more elastic (furniture) 3. Excess Capacity - Exists when a firm is not using its existing resources to their full capacity o Supply is elastic > firms can respond quickly by using existing resources more intensively

Chapter 9 Market Equilibrium


Market Equilibrium
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A market economy determines how much of a good or service is supplied and at what price This analysis uses pure competition (no individual can set prices/influence market outcomes directly) and that there is no government intervention The price mechanism determines the equilibrium in the market o The interplay of the forces of supply and demand which determine the prices Market equilibrium is when at a certain price level, the quantity supplied and the quantity demanded of a particular commodity are equal o The market clears (there is no excess supply or demand) o There is no tendency for change in either price or quantity o Occurs where the demand and supply curves intersect

Demand Exceeds Supply o Competition among buyers for the limited quantity > price is bid up o Expansion in supply and a contraction in demand o Will continue until there is no excess demand = market equilibrium (market is cleared)

Supply Exceeds Demand o There is a glut in the market (excess supply o Suppliers will offer to sell at a lower price to remove excess supply o Expansion in demand and a contraction in supply o Will continue until there is no excess supply (the market clears and there is equilibrium)

This is the market forces interacting to bring about the equilibrium price that clears the market and eliminates any excess supply or demand

Changes in Equilibrium
The equilibrium price and quantity can be changed by any circumstances that lead to a shift in either or both the supply and demand curves o Caused by changes in the conditions behind supply and demand not a change in the price When there is an increase in demand or supply the equilibrium price changes to become the new intersection point of the curves o An increase in demand raises both equilibrium price and quantity

o An increase in demand lowers both equilibrium price and quantity

o An increase in supply lowers equilibrium price and raises equilibrium quantity

o An decrease in supply raises equilibrium price and lowers equilibrium quantity

The Role of the Market


In a market economy the price mechanism is the main determinant of the solution to the economic problem o Attempts to solve the economic problem in product markets for goods and services o The demand curve represents the wants of individuals o The supply curve represents the production of firms with limited resources. o The interaction of demand and supply determines a price and quantity that best satisfies individual wants with the limited resources available to firms Producers will only produce things for which there is demand o Higher opportunity cost in producing other goods when the price of a product rises The quantity produced and sold is also determined through the interactions of supply and demand o More demand = higher price > producers will reallocate resources Information about tastes and preferences is conveyed through relative price changes o No need for central coordination or direct information The price mechanism also plays a central role in the markets for the factors of production or factor markets o Demand and supply determines the price paid for the factors of production and thus the share of total output that is received by individuals o Those who possess resources (including skills) or produce goods and services that are scarce and in high demand will command higher incomes and a greater proportion of total output The market mechanism also ensures allocative efficiency in the economy o The demand curve gave us an indication of the value that consumers place on a certain product o The supply curve gave us an indication of producers costs in supplying that product. o The market mechanism ensures that equilibrium is reached at the intersection of those two curves o Production continues to increase until the point where the value to consumers of the last good produced is equal to the cost to producers Competition among producers means they are responsive to consumer demand and attempt to minimise their costs of production o In order to remain competitive in the market and maintain their profitability o Means that the most cost-efficient methods of production are utilised

Government Intervention in the Marketplace


Markets can be effective at resolving the basic issues but can create unsatisfactory outcomes o The market price may be too high or too low

o The equilibrium quantity may be too high or low or some goods may not be produced at all When markets do not produce the desired outcomes it is called market failure o The price mechanism takes account of the private costs and benefits of production (i.e. to producers and consumers o Does not take into account social costs and benefits (that are borne and enjoyed by the whole of society) o When this occurs, governments may intervene in the market.

1. Price Intervention - When the market determined price is too high (public transport) or low (unskilled labour) o Governments can impose price ceilings (maximum) or floors (minimums) - The main reason for influencing prices in this way is to affect the distribution of income o Price ceilings will redistribute money from sellers to buyers o Price floors will redistribute money from buyers to sellers. - This can lead to a market disequilibrium where there is an over or under supply 2. Quantity Intervention - The quantity of some goods and services provided by the market may be too high or too low o Individual business firms and individual consumers often do not consider the social costs and benefits (externalities) of the production and consumption of certain goods and services. o These are not taken into account in the operation of the price mechanism. - Individual producers consider the obvious costs they incur in order to supply the product, including the cost of labour, raw materials and electricity o Not social costs (or negative externalities) of the production process (pollution and environmental damage) - The government can artificially restrict production levels o Laws (such as issuing pollution emission permits) o Imposing taxes on businesses, which increase their production costs and reduce production levels o Making the individual business pay for the social costs created by production is known as internalising the externality - Individual consumers do not consider the social benefits (positive externalities) that come with their individual consumption of some goods and services o museums, public parks, art galleries and public transport - The government may intervene to promote this consumption o subsidies to consumers (or producers) to lower prices and increase consumption - Some goods and services will not be provided by individual firms at all o Once provided, producers would not be able to exclude those who are unwilling to pay from using and obtaining the benefits of those public goods o National defence, the police service, public roads and cleaning up waterways o Everyone benefits but will not contribute voluntarily (collective action problem) - government intervenes to supply these items and finances them with its tax revenue Problem Market Price Too High Government Action Price Ceiling Outcome Reduces Price (quantity

Market Price Too Low Market quantity Too High (negative externalities) Market Quantity Too Low (positive externalities) Market quantity Does not provide good or service (public goods)

Price Floor Taxes Subsidies Government Provides Goods or Service

shortage) = disequilibrium Increases Price (quantity exceeds = disequilibrium Increases equilibrium price, reduces equilibrium quantity Reduces equilibrium price, Increases equilibrium quantity Government must collect taxation good or service good or service revenue to finance its supply of public goods

Markets Glossary
Word Demand Market Demand Income Distribution Elasticity Ceteris Paribus Demand Schedule Demand Curve Expansion Contraction Price Elasticity of Demand Elastic Demand Unit Elastic Demand Inelastic Demand Total Outlay Method Supply Contraction of Supply Expansion of Supply Elasticity of Supply Definition quantity of a particular good or service that consumers are willing and able to purchase at various price levels at a given point in time demand by all consumers for a particular good or service which is obtained by summing all individual demand the way in which an economys income is spread among the members of different social and socioeconomic groups. Responsiveness of the quantity demanded to a change in price the assumption that all other factors apart from the one examined remain constant which allow us to isolate relationships between particular variables A table which places the price of a product against the quantity demanded at that price point A graphical representation of the data in a demand schedule a decrease in the price of a good or service causes an increase in quantity demanded and is shown by a downward movement along the demand curve an increase in the price of a good or service causes a decrease in quantity demanded and is shown by an upward movement along the demand curve measures the responsiveness of quantity demanded to a change in price and is calculated as the percentage change in quantity demanded divided by the percentage change in price A strong response to changes in price (price moves in the opposite direction to revenue) A proportional response to changes in price (total amount spent by consumers remains the same) A weak response to price change (revenue moves in the same direction as price a way to calculate the price elasticity of demand by looking at the effect of changes in price on the revenue earned by the producer When a decrease in the price of a good or service causes a decrease in quantity supplied. Shown by a downward movement along the supply curve When an increase in the price of a good or service causes an increase in quantity supplied. Shown by an upward movement along the supply curve. Measures the responsiveness of quantity supplied to a change in price. It is calculated as the percentage change in quantity supplied divided by the percentage change in price Where producers are willing to supply an infinite quantity of a good or service at a particular price but nothing at all at a price below this. This situation can be represented by a horizontal supply curve

Perfectly Elastic Supply

Perfectly Inelastic Supply Inventory Price Mechanism

Equilibrium

Production Market Factor Market Allocative Efficiency Market Failure

Where producers are willing to supply a given quantity of a good or service regardless of price. This situation can be represented by a vertical supply curve. Inventory is the total stock of goods and services held by a firm at a particular point in time, which is intended for sale to consumers. Price mechanism is the process by which the forces of supply and demand interact to determine the market price at which goods and services are sold and the quantity produced Equilibrium is achieved in an individual market when any consumer who is willing to pay the market price for a good or service is satisfied, and any producer who offers their goods or services at the market price is able to sell their produce. It occurs when quantity demanded is equal to quantity supplied, i.e. when the market clears. Product market is the interaction of demand for and supply of the outputs of production, i.e. goods and services. A market for any input into the production process, including land, labour, capital and enterprise. The economys ability to allocate resources to satisfy consumer wants. When the price mechanism make take account of private benefits and costs of production to consumers and producers, but it fails to take into account indirect costs such as damage to the environment Goods that are not produced in sufficient quantity by the private sector because private individuals do not place sufficient value on those goods, i.e. they involve positive externalities that are not fully enjoyed by the individual consumer. Merit goods include education and health care. Goods that private firms are unwilling to supply as they are not able to restrict usage and benefits to those willing to pay for the good. Because of this, governments should provide these goods.

Merit Goods

Public Goods