Topic 2 MarketPriceDetermination

Topic 2:
Introduction to Market Price Determination

 Probably no branch of economics is more widely
misunderstood than that of how prices are
determined by interaction of demand and supply.
 The process of establishing a market price was so
mysterious to early writers that Adam Smith observed
that markets seem to be “led by an invisible hand.”
 Vladimir Lenin, no fan of free markets noted that
markets were like a car that “is steered by something
illegal, something unlawful, something that comes
from
God knows where.”
MARKETS
 The interaction of potential buyers and potential sellers
establishes a market.
 It is important to distinguish between a marketplace and
a market.
 A marketplace is a physical facility where buyers and sellers
can come together.
 A market—the interaction between potential buyers and
potential sellers of a good or service—can occur at any
number of locations, or simply over the Internet.
 Frequently a regional/national market is composed of
numerous smaller interrelated markets.
MARKETS
 In discussing any market, it is important to specify
the temporal & spatial dimensions of the market.
 The market for corn in October in Mason City, Iowa, is
composed of grain elevators willing to buy corn and
farmers willing to sell their recent harvest.
 The market for corn in Chicago in April is composed of
grain traders (such as elevator operators in Mason
City) as sellers and industrial users or exporters as
buyers.
• The two markets are distinct but highly interrelated.
– It is important to appreciate that the forces which
determine market price are identical in every market.
MARKETS
 It is assumed of markets in a perfect competition that
there are so many buyers, and so many sellers, each
is insignificant relative to the market.
 As a consequence, no buyer or seller can influence
the price in the market by his or her actions.
 Both buyers and sellers are price takers.
 The only decision buyers & sellers make is whether or

not to trade at the price given by the market.
MARKETS
 The shopper at a typical supermarket is an
example of a price taker.
 So insignificant relative to the total size of the market
that her buying decisions cannot influence price levels.
 The typical farmer selling steer calves at auction is
also a price taker.
 Because he is such a small seller relative to the size of
the national market that a decision to withdraw from
the auction would have no perceptible impact on the
general price level, on that day.
DEMAND AND SUPPLY
DEMAND AND SUPPLY - DEMAND
 Demand can be defined as the quantities of a
good buyers are willing to purchase at a series of
alternative prices, in a given market, during a given
period of time, ceteris paribus.
 Demand is a relationship between quantity & price—at
different prices, different quantities will be demanded.
 Demand is a series of these possible price-quantity
combinations, and refers to the desires or intentions
of buyers, rather than their actual purchases.
 Demand shows how much buyers are willing to
purchase at various prices, ceteris paribus—whether or
not those prices are actually observed in the market.
 Demand is a two-dimensional concept—the two
dimensions being price and quantity.
 The relationship between the two dimensions is demand.
 The impact of the time and place dimensions in
the definition of demand is of obvious importance.
 Demand for turkeys is much different around the end
of November than the rest of the year.
 Few Florida stores have snow shovels on the shelf.
 The quantity demanded is a one-dimensional

concept that refers to how much of a good or
service a buyer is willing to purchase…
 At a single, specified price.
 In a given market.
 At a given time.
 Certeris paribus.
 The demand relationship can be described in words, with a
schedule, as a graph, or an equation.
 The relationship is the same regardless of method.
A hypothetical
demand schedule
of the relationship
between prices for
ground beef &
quantities demanded
in the New York City
metro area in a
typical week is
shown here.
 When the price increases, the quantity consumers would
be willing to purchase is reduced, for several reasons.
As the beef gets

more expensive,
ceteris paribus,
consumers react
by either switching
from ground beef
to another meat,
or giving up meat
altogether for one
or two meals per
week.
 For a change in price, quantity demanded changes, but the
demand relationship remains unchanged.
 Demand refers to the price-quantity relationship illustrated.
A change in price
causes a jump to
a different point
on the schedule,
but it does not
change the
schedule itself.
 For a change in price, quantity demanded changes, but the
demand relationship remains unchanged.
 Demand refers to the price-quantity relationship illustrated.
A change in price
does not cause a
change in demand,
but it does cause
a change in the
quantity demanded.
 As in all demand schedules, this one is defined by the
ceteris paribus assumption that everything other than
price & quantity demanded stays constant.
Demand is a
relationship, but not
a point on that
relationship.
Quantity demanded
is not a relationship,
but a point on that
relationship.
 Our demand relationship shows how

consumers would react to different prices for
ground beef.
 Assuming prices for chicken, pork, and other cuts of
beef all remained the same.
 If the price of ground beef increases while that
of chicken remains constant, the relative price
of ground beef to chicken has increased.
 The information contained in the demand schedule
can easily be converted into a demand curve—a
common two-dimensional graph.
A graph show
the relationship
between two
variables.
In this case, the
price & quantity
demanded of
ground beef.
 The vertical axis measures different prices per
pound of ground beef, while the horizontal axis
shows different quantities demanded per week.
Price-quantity
combinations in
the schedule are
transferred to the
two-dimensional
graph, marked
by a small dot
at the appropriate
coordinates.
 The first dot on the left is at a price of $2.75/lb, &
quantity consumed at this price is 1.9 million lb.
 A dot is entered for each price/quantity demanded.
The dots can be

connected by a
smooth line to
produce a
demand curve.
 The demand curve is a visual presentation of the
demand relationship & allows for easy interpolation of
prices between those in a demand schedule.
For instance, at
a price of $1.60,
approximately
12 million lb of
ground beef
would be the
quantity
demanded.
DEMAND AND SUPPLY - SUPPLY
 Supply is defined as quantities of a good sellers
are willing to offer at a series of alternative
prices.
 In a given market.
 During a given time period.
 Ceteris paribus.
 This definition is identical with that of demand,
except that supply is a relationship between
prices and quantities that sellers are willing to
offer.
• Supply describes a relationship, not a quantity.
– As with demand, it is important to distinguish between
supply and the quantity supplied.
 Quantity supplied is a one-dimensional concept that
refers to how much of a good or service a seller is
willing to offer at a single, specified price.
 In a given market; at a given time; ceteris paribus.
 Shown are a supply schedule & supply curve
for ground beef in the New York City metro area.
When the price of ground beef increases,

sellers offer greater quantities for sale.
 This direct relationship between prices & quantities
supplied is expected for several reasons.
 If prices are relatively low, some suppliers might sell
in another market, such as Boston or Pittsburgh.
 As prices in New York fall, ceteris paribus, the quantity
of ground beef offered will also decline.
 A second reason is that suppliers will react to relatively
low prices by building up inventories of ground beef.
 Thus reducing the quantity supplied at the low prices.
 If suppliers feel the price is relatively high, they will draw
down inventories, increasing the quantity supplied.
 As in demand, time & space dimensions are an
important part of the concept of supply.
 It takes a year to significantly increase the output
of grain crops.
 Several years are required to expand beef production.
 Beefslaughter over the intervening period must be reduced
to accomplish the expansion.
 The supply curve was derived from the supply schedule the same
way the demand curve was derived from a demand schedule.
 The axes are labeled in the same manner as a
demand curve since the variables being graphed are exactly the
same.
 The upward slope of the supply curve shows a positive
relationship between prices and the quantity supplied.
PRICE DETERMINATION
 Interaction of demand/supply is fundamental to

the process of price determination & market
clearing.
 While a perfectly competitive market operates
with no external controls or regulations on trading,
the market price will adjust to clear the market of
goods.
 By
equating the quantity demanded with the
quantity supplied.
PRICE DETERMINATION
Illustrated
 Recall that both is theand
supply combined schedules
demand refer to willingnessof demand
or intentions
and supply of ground beef in New York City.
of sellers and buyers in the market, not to actual transactions.
– At $2.15, intentions of buyers are consistent with sellers.

– At this price, the quantity willingly demanded is equal to
the quantity willingly supplied and the market is cleared.
– In this market a price of $2.15 is the equilibrium price.
PRICE DETERMINATION
 The same supply & demand relationships are shown
as a graph.
 With the equilibrium point where the two curves cross.
The market-clearing
or equilibrium price
is the one unique
price at which the
quantity willingly
supplied is equal
to the quantity
willingly demanded.
PRICE DETERMINATION
 For free, competitive markets, market price always
moves toward the equilibrium price.
 Until stable equilibrium, that just clears the market.
At any price other
than $2.15, either
a product surplus
or a shortage will
develop in the
market.
This puts pressure
on the price of the
product to move
back toward the
equilibrium price.
PRICE DETERMINATION
 At $2.75/lb, New York retailers would be willing
to offer 13.6 million lb of ground beef for sale in
a typical week.
Note, however, consumers A difference of 11.7 million pounds

desire to purchase only 1.9 between what the sellers are willing
million pounds at that price. to sell, and what buyers are willing
to buy, at $2.75/lb.
PRICE DETERMINATION
 As the week draws to a close, each butcher would
want to get rid of excess ground beef not sold.
• What would he do?
– He would lower his price to encourage consumers to
eat more ground beef, and buy from his shop rather
than from his competitors.
– All of his competitors do the same, so the average
or market typical price would move downward.
• This illustrates the basic principle that in a free
market, the existence of a surplus creates a
downward pressure on market price.
– The butcher lowers his price voluntarily to protect his
own self-interest—no central planning agency needed.
PRICE DETERMINATION
 The same automatic adjustment mechanism
takes place if the market price should wander
below the equilibrium price level.
 A a shortage will develop, and consumers, in their
own individual self-interest, will bid against one
another for
the limited quantity available.
 Prices will likely rise, as signs of shortages—declining
inventories, customer lines, panic buying—appear.
• A market price below the equilibrium price will
cause a shortage, inducing market prices to rise.
– As long as the market is not constrained by any type
of external regulation.
PRICE DETERMINATION
 Prices below the equilibrium level causes shortages, as
the quantity consumers want to consume is greater
than the quantity retailers want to provide.
Pressure will auto-
matically develop,
to correct the errant
price, where the
intentions or wants
are inconsistent.
The pressures
are created by the
perceived self-
interests of buyers
and sellers as they
interact in a market.
PRICE DETERMINATION
 At a price of $1.75/lb, the quantity being taken off the
market (quantity demanded) is greater than the
quantity coming on the market (quantity supplied).
As sellers see their

inventories being
drawn down, it is
natural that they
would increase
the price.
They perceive that
the market could
bear a higher price.
PRICE DETERMINATION
 Pressure for movement back toward equilibrium is
ensured, as price determination in a price allocation
system is an automatic, self-correcting process.
The important point

is large numbers of
buyers and sellers,
out of self-interest,
automatically drive
prices to equilibrium
levels.
SUPPLY & DEMAND - CHANGES
 Market equilibrium will remain stable until
disturbed again by some external force.
 If the price in a market changes due to an external
force, there will be some initial disruption
 Market forces will automatically correct for that
disruption as rapidly as possible.
 When market price is pushed to the level of a new
equilibrium price, a stable equilibrium will prevail
until some force external to the market again
causes a change in the equilibrium price.
 Some disturbances to a stable pond will cause

the equilibrium level of the pond to change.
 Ifa large boulder is thrown into a small pond, it
disturbs the equilibrium situation of the water,
causing the new equilibrium level to be higher than
the previous level.
 A demand/supply shift due to an external

disturbance will cause the same thing in a market.
 i.e., a change in a ceteris paribus condition
 There will be an initial disequilibrium because the
new equilibrium price will be either higher or lower
than the previous market price.
 Resulting in a surplus or shortage that will generate
pressures on the market price to move to a new level
where a stable equilibrium can be attained again.
A demand
curve shift
using the
New York
beef prices.
• Assume that one of the ceteris paribus conditions

for the demand relationships shown in the previous
figures was that the price of chicken was $0.80/lb.
– Previous demand schedules showed how much ground
beef consumers were willing to buy at alternative prices,
assuming the $0.80 price of chicken remained constant.
A demand
curve shift
using the
New York
beef prices.
• The data in the center column of show what would

happen to the ground beef demand if the chicken
price were to fall to $0.60/lb, ceteris paribus.
– Consumers might have two meals of chicken per week
instead of one—substituting now cheaper chicken for
ground beef in the diet.
 The chicken price decline encourages consumers to
substitute chicken for beef, causing an inward shift
of the ground beef demand curve to D*D*.
As a result of
the inward shift of
the beef demand
curve, consumers
demand a lesser
quantity of beef
at every price for
beef.
 At the old equilibrium price, $2.15, there is now
market disequilibriumm, and suppliers are still
willing to supply 7.75 million lb/wk at $2.15.
Consumers are
no longer willing
to consume that
much ground
beef at that price.
 As many consumers switched to cheaper chicken, they
will purchase only 2 million lb of beef at $2.15,
 A ground beef surplus develops on the New York market.
The existence of
the surplus will
automatically
force retail outlets
to lower ground
beef prices until
a new equilibrium
price is found.
 A new equilibrium in the ground beef market will be
established at a price of approximately $1.90.
 5.7 million lb/wk traded, as the market-clearing quantity.
The final effect of
a price decline in
chicken on the
beef market is
causing the ground
beef equilibrium
price, and quantity
traded, to decline
as a result of a
shift in the demand
relationship for
ground beef.
 A review of what occurred in the previous example:
 The ground beef market was in equilibrium at $2.15.
 A change in a ceteris paribus condition caused a shift
of the entire ground beef demand curve.
 This, in turn, caused the equilibrium price to decline to
a new equilibrium level at $1.90.
• It is important to realize the decline in the price is
the result of a change in ceteris paribus conditions.
An illustration of a very simple (but important)
principle of economics that market prices are the
result of the interaction of supply and demand,
rather than the cause of supply and demand.
 A frequent mistake of the beginning student is to
think the price of ground beef will determine the
supply & demand of ground beef in a given market.
 To the contrary, supply & demand determine price.
 An equilibrium price will not change unless there
is a shift in the supply or demand for the product.
 Supply and demand shift only if there is a change
in the ceteris paribus conditions.
 The direction of causality for price
determination in a free, competitive
market will always be as shown:
 A change in the price of chicken, ceteris

paribus, will cause a shift in the demand for
beef.
 A change in the price of beef is the result of a
shift in the demand or supply of beef.
 It is never the cause of it.
SUPPLY & DEMAND - DEMAND SHIFTERS
 Six important demand shifters can be identified:
 Prices of substitute goods—alternative goods that
can satisfy a want.
 Inthe earlier example, a change in the price of chicken
caused a shift in the demand for beef.
 Prices of complementary goods—that are normally
consumed together or jointly.
 Tires& gasoline are complements—if you consume gas,
you also consume tires.
 Consumers’ income—demand for big-ticket (durable)
goods is very sensitive to changes in consumers’
income.
 Also sensitive are nonessential goods.
SUPPLY & DEMAND - DEMAND SHIFTERS
 Six important demand shifters can be identified:
– Tastes and preferences—which change over time,
with implications for the demand for some goods.
• Over the past 30 or 40 years, demand for coffee has shifted
significantly inward, while bottled water demand water has
shifted outward.
– Expectations—on a normal day, Florida supermarket
shelves are filled with bottled water for sale, but two
days before a hurricane, not a single bottle is found.
• Due to changed expectations, demand for bottled water
shifted significantly outward.
– Demographics—the fastest growing segment of our
population today is the age group over 90 years.
• This drastically affects the demand for prescription drugs.
SUPPLY & DEMAND - SUPPLY SHIFTERS
 Supply shifts occur with a change in any one of the
ceteris paribus conditions for which the supply
relationship was drawn.
 Supply is a relationship between changes in prices
and changes in quantities of a good.
 Assuming that, as these changes occur, everything else
remains unchanged.
 If something included in “everything else” changes, the
fundamental supply relationship changes, causing a
supply shift.
 Five major supply shifters can be identified:
 Prices of inputs—as input prices increase, quantities of
a good producers are willing to produce at each price of
the good is reduced.
 Farmers use a lot of energy, for equipment or in the form of
fertilizers, chemicals, etc., derived from petroleum.
 If the price of energy goes up, ceteris paribus, the supply
curve of food will shift inward.
 Technology—adoption of technology that improves
production efficiency will affect of shifting the supply
curve outward.
 As most farmers adopted genetically modified seed corn,
the supply curve of corn shifted outward.
 Five major supply shifters can be identified:
– Taxes and subsidies—as taxes increase (or subsidies
decrease), production cost increases & firms are willing
to produce fewer units at each alternative product price.
• An increase in taxes, ceteris paribus, causes an inward shift
of the supply curve.
– Expectations—about future events affect current supply.
• When corn farmers expect future corn prices to be higher, they
will hold corn off the market, shifting the supply curve inward.
– Number of firms—increases shift supply curves outward.
• At a given price, firms produce unit numbers maximizing profit.
• If product price does not change & additional firms enter the
industry, the total quantity produced will increase, causing an
outward shift of the supply curve.
SUPPLY OR DEMAND
 A final warning for the beginning student of

market price determination:
 In99.9% of cases, change in a ceteris paribus
condition will cause a shift in either the supply or
demand curve, but not both.
 It is very important that the agricultural
producer be able to evaluate how changes in
the economic environment will affect his or her
operations.

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Topic 2 MarketPriceDetermination

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Topic 2:

Introduction to Market Price Determination

 The only decision buyers & sellers make is whether or

 The quantity demanded is a one-dimensional

As the beef gets

 Our demand relationship shows how

The dots can be

When the price of ground beef increases,

 Interaction of demand/supply is fundamental to

– At $2.15, intentions of buyers are consistent with sellers.

Note, however, consumers A difference of 11.7 million pounds

As sellers see their

The important point

 Some disturbances to a stable pond will cause

 A demand/supply shift due to an external

• Assume that one of the ceteris paribus conditions

• The data in the center column of show what would

 A change in the price of chicken, ceteris

 A final warning for the beginning student of

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