PART B

Markets, demand and supply

The ‘market’ is the coming together of buyers and sellers whether in a street market,
a shop, an auction, a mail order system, the Internet or whatever. As we shall see,
market prices are determined by the interaction of demand (buyers) and supply
(sellers).

When the price is determined by the market, the firm is called a price taker.
Competitive markets also imply that consumers are price takers.

Chapter 2

The working of competitive markets

2.1. The price mechanism under perfect competition.

In a free market individuals can make their own economic decisions. Free market
One in which there is an absence of government intervention. Individual producers
and consumers are free to make their own economic decisions.

For simplicity we will examine the case of a perfectly competitive market. This is
where both producers and consumers are too numerous to have any control over
prices: a situation where everyone is a price taker. In such markets, the demand and
supply decisions of consumers and firms are transmitted to each other through their
effect on prices: through the price mechanism. The prices that result are the prices
that firms have to accept.

The working of the price mechanism

We now look at how the price mechanism works to eliminate shortages and
surpluses. A shortage of a product causes its market price to rise and this, as we
shall see, eliminates the shortage. A surplus causes price to fall and this eliminates
the surplus.

The price will continue rising until the shortage has thereby been eliminated. The
price will continue falling until the surplus has thereby been eliminated. This price,
where demand equals supply, is called the equilibrium price. Equilibrium price is the
price where the quantity demanded equals the quantity supplied; the price where
there is no shortage or surplus.
The effect of changes in demand and supply
1. A change in demand
2. A change in supply

Changes in demand or supply cause markets to adjust. Whenever such changes

occur, the resulting ‘disequilibrium’ will bring an automatic change in prices, thereby
restoring ‘equilibrium’ (i.e. a balance of demand and supply).

2.2. Demand
General relationship between price and consumption: when the price of a good rises,
the quantity demanded will fall. This relationship is known as the law of demand and
there are two reasons behind it:
People feel poorer. They are not able to afford to buy so much of the good with
their money. The purchasing power of their income (their real income) has fallen.
This is called the income effect of a price rise.
The good is now dearer relative to other goods. People thus switch to alternative
or ‘substitute’ goods. This is called the substitution effect of a price rise.

The demand curve

Demand curve A graph showing the relationship between the price of a good and the
quantity of the good demanded over a given time period. Price is measured on the
vertical axis; quantity demanded is measured on the horizontal axis. A demand curve
can be for an individual consumer or a group of consumers, or more usually for the
whole market.

Other determinants of demand

Price is not the only factor that determines how much of a good people will buy. Here
are some other factors that might affect your demand for a product:
1. Tastes.
2. The number and price of substitute goods.
3. The number and price of complementary goods.
4. Income.
5. Expectations of future price changes.
movements along and shifts in the demand curve
A demand curve is constructed on the assumption that ‘other things remain equal’
(ceteris paribus). To distinguish between shifts in and movements along demand
curves, it is usual to distinguish between a change in demand and a change in the
quantity demanded. A shift indemand is referred to as a change in demand,
whereas a movement along the demand curve, as a result of a change in price, is
referred to as a change in the quantity demanded.

2.3. Supply
Supply and price
The general relationship between supply and price: when the price of a good rises,
the quantity supplied will also rise. There are three reasons for this.
As firms supply more, they are likely to find that, beyond a certain level of output,
costs rise more and more rapidly. Only if price rises will it be worth producing
more and incurring these higher costs.
The higher the price of the good, the more profitable it becomes to produce.
Given time, if the price of a good remains high, new producers will be
encouraged to set up in production. Total market supply thus rises.

Other determinants of supply

As with demand, supply is not determined simply by price. The other determinants of
supply are as follows. The costs of production, The profitability of alternative
products (substitutes in supply), The profitability of goods in joint supply, Nature,
‘random shocks’ and other unpredictable events, The aims of producers.
Expectations of future price changes.

Movements along and shifts in the supply curve

A movement along a supply curve is often referred to as a change in the quantity
supplied, whereas a shift in the supply curve is simply referred to as a change in
supply.

Change in the quantity supplied The term used for a movement along the supply
curve to a new point. It occurs when there is a change in price. Change in supply.
The term used for a shift in the supply curve. It occurs when a determinant other
than price changes.

2.4. Price and output determination

Equilibrium price and output
We can now combine our analysis of demand and supply. This will show how the
actual price of a product and the actual quantity bought and sold are determined in a
free and competitive market.
Demand and supply curves
The determination of equilibrium price and output can be shown using demand and
supply curves. Equilibrium is where the two curves intersect.

Movement to a new equilibrium

The equilibrium price will remain unchanged only so long as the demand and
supply curves remain unchanged. If either of the curves shifts, a new equilibrium will
be formed.

A change in demand
If one of the determinants of demand changes (other than price), the whole demand
curve will shift. This will lead to a movement along the supply curve to the new
intersection point.

A change in supply
Likewise, if one of the determinants of supply changes (other than price), the whole
supply curve will shift. This will lead to a movement along the demand curve to the
new intersection point.

2.5. Elasticity of demand and supply

Price elasticity of demand
We call the responsiveness of demand to a change in price the price elasticity of
demand. If we know the price elasticity of demand for a product, we can predict the
effect on price and quantity when the supply curve for that product shifts.

Defining price elasticity of demand

What we want to compare is the size of the change in quantity demanded of a given
product with the size of the change in its price.

Three things should be noted about the figure that is calculated for elasticity.
1. The use of proportionate or percentage measures.
2. The sign (positive or negative).
3. The value (greater or less than 1). If we now ignore the sign and just concentrate
on the value of the figure, this tells us whether demand is elastic or inelastic.
Elastic demand («. 1). This is where a change in price causes a
proportionately larger change in the quantity demanded. In this case the price
elasticity of demand will be greater than 1, since we are dividing a larger
figure by a smaller figure.
Inelastic demand («, 1). This is where a change in price causes a
proportionately smaller change in the quantity demanded. In this case the
price elasticity of demand will be less than 1, since we are dividing a smaller
figure by a larger figure.
 Unit elastic demand («5 1). This is where the quantity demanded changes
proportionately the same as price. This will give an elasticity equal to 1, since
we are divid- ing a figure by itself.

The determinants of price elasticity of demand

The number and closeness of substitute goods. This is the main determinant of price
elasticity of demand. The more substitutes there are for a good and the closer they
are as substitutes, the greater will be the price elasticity of demand.

The proportion of income spent. The higher the proportion of our income we spend
on a good, the more we will have to reduce our consumption of it following a rise in
price: the more elastic will be the demand.

The time period. Another important determinant is the time period.

Price elasticity of demand and consumer expenditure

One of the most important applications of price elasticity of demand concerns its
relationship with the total amount of money consumers spend on a product. Total
consumer expenditure (TE) is simply price multiplied by quantity purchased:
TE 5 P 3 Q

For example, if consumers buy 3 million units (Q) at a price of £2 per unit (P), they
will spend a total of £6 million (TE).

Total consumer expenditure is the same as the total revenue (TR) received by firms
from the sale of the product (before any taxes or other deductions). What will happen
to consumer expenditure, and hence firms’ revenue, if there is a change in price?
The answer depends on the price elasticity of demand. Elastic demand. As price
rises, so quantity demanded falls, and vice versa. When demand is elastic, quantity
changes proportionately more than price.

Inelastic demand. When demand is inelastic, price changes proportionately more

than quantity. Thus the change in price has a bigger effect on total expenditure than
does the change in quantity.

Other elasticities
Two of the biggest determinants of demand are consumer incomes and the prices of
substitute or complementary goods. Firms will want to know just how responsive
demand will be if these factors change. That is: they will want to know the income
elasticity of demand – the respon- siveness of demand to a change in consumers’
incomes (Y) – and the cross-price elasticity of demand – the responsive- ness of
demand for their good to a change in the price of another good (whether a
substitute or a complement).
Demand and the consumer
3.1. Demand and the firm
In practice, however, most firms are not price takers; they have some discretion in
choosing their price. Such firms face a downward-sloping demand curve. In general,
the less price elastic the demand, the better it will be for firms, because this
will give them more power over prices.

3.2. Understanding consumer behavior

In this section we examine the nature of consumer behaviour and in particular relate
consumer demand to the amount of satisfaction that consumers get from products.

Marginal utility
An important concept for helping understand the nature of demand is marginal utility
(MU). This is the additional utility you get from consuming an extra unit of a product. .
Clearly, the nature and amount of utility that people get varies from one product to
another, and from one person to another, but there is a simple rule that applies to
virtually all people and all products: the principle of diminishing marginal utility.

The principle of diminishing marginal utility. As you consume more of a product, and
thus become more satisfied, so your desire for additional units of it will decline.

Consumer surplus
Consumer surplus: The difference between how much a consumer is willing to pay
for a good and how much they actually pay for it.

Marginal utility and the demand curve for a good

We can now see how marginal utility relates to a down ward sloping demand curve.
As the price of a good falls, it will be worth buying extra units. You will buy more
because the price will now be below the amount you are prepared to pay. This
represents the optimal consumption point, as rational consumers will aim to
maximize their consumer surplus.

An individual’s demand curve

Individual people’s demand curves for any good are the same as their marginal utility
curves for that good, measured in money.

The firm’s demand curve

The firm’s demand curve will simply be the (horizontal) sum of all individuals’
demand curves for its product. The shape of the demand curve. The price elasticity
of demand will reflect the rate at which MU diminishes. Shifts in the demand curve.
The problem of imperfect information
So far we have assumed that when people buy goods and services, they know
exactly what price they will pay and how much utility they will gain. In many cases
this is a reasonable assumption. Risk is where an outcome may or may not occur,
but where the probability of it occurring is known. Uncertainty is where the probability
is not known.

Insurance: a way of removing risks

Insurance is a means of eliminating, or at least reducing, risk for people. The answer
is that the insurance company is able to spread its risks.

The spreading of risks

This is an application of the law of large numbers. What is unpredictable for an
individual becomes highly predictable in the mass. The more people the insurance
company insures, the more predictable is the total outcome.

The spreading of risks does not just require that there should be a large number of
policies. It also requires that the risks should be independent. Insurance companies
also tend to offer a diverse range of insurance (houses, cars, travel, health, life) and
this diversification allows the company to spread its risk: this time across many
products. The more types of insurance a company offers, the greater is likely to be
the independence of the risks.

3.3. Behavioural economics

Up to now we have assumed that consumers behave rationally trying to get best
value for money by making choices between products that will maximize their
consumer surplus.

Explaining ‘irrational’ consumer choices

How options are framed
The choices people make are influenced by the context in which they are made;
people will often make different choices when they are presented, or framed, in
different ways.

Too much choice

Choice is generally thought to be a good thing. But can we have too much choice?
Choice should allow us to maximize our utility by making ‘better’ decisions.

Bounded rationality
A person might want to maximize consumer surplus, but faces complex choices and
imperfect information.
Relativity matters
This does not disprove that our choices depend on our perceived utility. But it does
demonstrate that our satisfaction often depends on our consumption relative to that
of other people, such as our peers.

Herding and ‘groupthink’

Being influenced by what other people buy, and thus making relative choices, can
lead to herd behaviour. A fashion might catch on; people might grab an item in a sale
because other people seem to be grabbing it as well; people might buy a particular
share on the stock market because other people are buying it.

Sunk costs
When buying products, ‘rational’ consumers will weigh up the additional benefits and
costs of their purchases (i.e. the utility gained against the money spent on the
products). This must imply that costs already incurred in the past are irrelevant.
These are called sunk costs. Yet when we look at how people actually behave, they
do seem to be influenced by sunk costs.

When emotions take over

In many cases, the experience of the emotion of desire when contemplating buying
something, such as a bar of chocolate, is merely an aid to rational behaviour.

Relevance to economic policy

Governments, in designing policy, will normally attempt to change people’s
behaviour both consumers and producers. They might want to encourage people to
choose to work harder, to save more, to recycle rubbish, to use their cars less, to eat
more healthily, and so on.

3.4. Estimating and Predicting demand

Methods of collecting data on consumer behaviour
There are three general approaches to gathering information about consumers.
These are: observations of market behaviour, market surveys and market
experiments.

Market observations
The firm can gather data on how demand for its product has changed over time.
Virtually all firms will have detailed information on their sales broken down by week,
month, year, etc. They will also tend to have information on how sales have varied
from one part of the market to another.

Market surveys
1. A random sample
2. Clarity of the question
3. Avoidance of leading question
 4. Truthful respone
5. Stability of Demand

Market experiments
Rather than asking consumers questions and getting them to imagine how they
would behave, the market experiment involves observing consumer behaviour under
simulated conditions. It can be used to observe consumer reactions to a new product
or to changes in an existing product and so this method is particularly useful when
information is scarce.

Another type of market experiment involves confining a marketing campaign to a

particular town or region. The campaign could involve advertising, or giving out free
samples, or discounting the price, or introducing an improved version of the product,
but each confined to that particular locality.

Simple time series analysis

Simple time series analysis involves directly projecting from past sales data into the
future. Using simple time series analysis assumes that demand in the future will
continue to behave in the same way as in the past.

The decomposition of time paths

One way in which the analysis of past data can be made more sophisticated is to
identify different elements in the time path of sales.

Trends. These are increases or decreases in demand over a number of years.

Cyclical fluctuations. In practice, the level of actual sales will not follow the trend line
precisely. One reason for this is the cyclical upswings and downswings in business
activity in the economy as a whole. Seasonal fluctuations. The demand for many
products also depends on the time of year. Short-term shifts in demand or supply.
Finally, the actual sales line will also reflect various short-term shifts in demand or
supply, causing it to diverge from the smooth seasonal variations line.

Barometric forecasting
Assume that you are a manager of a furniture business and are wondering whether
to invest in new capital equipment. Barometric forecasting involves the use of
leading indicators, such as housing starts, when attempting to predict the future.
Barometric forecasting: A technique used to predict future economic trends based
upon analyzing patterns of time series data.

3.5. Stimulating Demand

Non price competition: Competition in terms of product promotion (advertising,
packaging, etc.) or product development.
Product differentiation
Central to non-price competition is product differentiation. Product differentiation:
Where a firm’s product is in some way distinct from its rivals’ products. In the context
of growth strategies, this is where a business upgrades existing products or services
so as to make them different from those of rival firms.

Features of a product
A product has many dimensions, and a strategy to differentiate a product may focus
on one or more of these. Dimensions include:
1. Technical standards.
2. Quality standards.
3. Design characteristics
4. Service characteristics.

Market segmentation
Different features of a product will appeal to different consumers. Where features are
quite distinct, and where particular features or groups of features can be seen to
appeal to a particular category of consumers, it might be useful for producers to
divide the market into segments. Market niche: A part of a market (or new market)
that has not been filled by an existing brand or business.

Product/market strategy
Once the nature and strength of consumer demand (both current and potential) have
been identified, the business will set about meeting and influencing this demand.
These choices can be shown in a growth vector matrix. The four cells show the
possible combinations of answers to the above questions: cell A – market
penetration (current product, current mar- ket); cell B – product development (new
product, current market); cell C – market development (current product, new market);
cell D – diversification (new product, new market).
The marketing mix
In order to differentiate the firm’s product from those of its rivals, there are four
variables that can be adjusted. These are as follows:
Product considerations
Price considerations
Place (distribution) considerations
Promotion considerations

Advertising
In fact, there is a bit more to it than this. Advertisers are trying to do two things:
■ Shift the product’s demand curve to the right.
■ Make it less price elastic.

Advertising and the state of the economy

One final thing to consider is the impact of booms and recessions on marketing and
advertising, a topic discussed in the blog, ‘Advertising’s role in the economy’.
Marketing expenditure can be a huge expense for a firm, and so varying the amount
spent on advertising as the state of the economy changes can be a sensible
strategy.