Part 2.

How Markets Work

Chapter 4: The Market Forces of Supply and Demand
Chapter 5: Elasticity and Its Application
Chapter 6: Supply, Demand, and Government Policies
Chapter 4: The Market Forces of Supply and Demand
1. MARKET AND COMPETITION
Supply and demand
- Words economists use most often, the forces that make market economies work
- Refer to the behavior of people as they interact with one another in competitive markets
Market -> A group of buyers and sellers of a particular good or service
Buyers as a group Sellers as a group
Determine the demand for the product Determine the supply of the product
Markets take many forms
Highly organized Less organized
Markets for many agricultural commodities Market for ice cream in a particular town

Competitive market -> Market in which there are many buyers and many sellers
- Each has a negligible impact on market price
- Price and quantity are determined by all buyers and sellers
-> As they interact in the marketplace
Perfectly competitive market -> Goods offered for sale are all exactly the same
- Buyers and sellers are so numerous
-> No single buyer or seller has any influence over the market price
-> Price takers
- At the market price
-> Buyers can buy all they want
-> Sellers can sell all they want
Monopoly
-> The only seller in the market -> Sets the price
Other markets
-> Between perfect competition and monopoly
2. DEMAND - The Relationship between Price and Quantity Demanded
a. Quantity demanded
-> Amount of a good that buyers are willing and able to purchase
b. Law of demand
- Other things equal
- When the price of a good rises, the quantity demanded of the good falls
- When the price falls, the quantity demanded rises
c. Demand -> Relationship between the price of a good and quantity demanded
- Demand schedule: a table
- Demand curve: a graph
-> Price on the vertical axis
-> Quantity on the horizontal axis
d. Individual demand -> An individual’s demand for a product
e. Market demand
- Sum of all individual demands for a good or service
f. Market demand curve
- Sum the individual demand curves horizontally
- Total quantity demanded of a good varies
-> As the price of the good varies
-> Other things constant

Shifts in the demand curve

Increase in demand Decrease in demand

Any change that increases the quantity demanded at every Any change that decreases the quantity demanded at every
price price
Demand curve shifts right Demand curve shifts left

Variables that can shift the demand curve-> Income, Prices of related goods, Tastes, Expectations, Number of buyers
Income
Prices of related goods
Tastes
Expectations about the future
Number of buyers increases
Normal good Inferior good
-> Other things constant -> Other things constant
-> An increase in income leads to an -> An increase in income leads to a
increase in demand decrease in demand
Substitutes, two goods – thay thế Complements, two goods – bổ sung
-> An increase in the price of one -> An increase in the price of one
-> Leads to an increase in the -> Leads to a decrease in the
demand for the other demand for the other
Change in tastes: changes the demand
Expect an increase in income Expect higher prices
-> Increase in current demand -> Increase in current demand
Market demand increases
3. SUPPLY -> The Relationship between Price and Quantity Supplied
a. Quantity supplied
-> Amount of a good that Sellers are willing and able to sell
b. Law of supply
-> Other things equal
-> When the price of a good rises, the quantity supplied of the good also rises
-> When the price falls, the quantity supplied falls as well
c. Supply -> Relationship between the price of a good and the quantity supplied
- Supply schedule: a table
- Supply curve: a graph
-> Price on the vertical axis
-> Quantity on the horizontal axis
d. Individual supply -> A seller’s individual supply
e. Market supply
- Sum of the supplies of all sellers for a good or service
f. Market supply curve
- Sum of individual supply curves horizontally – chiều ngang
- Total quantity supplied of a good varies
-> As the price of the good varies
-> All other factors that affect how much suppliers want to sell are hold constant

Shifts in supply

Increase in supply Decrease in supply

-> Any change that increases the quantity supplied at every price -> Any change that decreases the quantity supplied at every price
-> Supply curve shifts right -> Supply curve shifts left
Variables that can shift the supply curve-> Input prices, Technology, Expectations about future, Number of sellers
Input prices - Supply is negatively related to prices of inputs
- Higher input prices: decrease in supply
Technology - Advance in technology: reduces firms’ costs: increase
in supply
Expectations about future - Affect current supply
- Expected higher prices -> Decrease in current supply
Number of sellers, increases Market supply increases

4. SUPPLY AND DEMAND TOGETHER

a. Equilibrium
- Various forces are in balance
- A situation in which market price has reached the level where
QUANTITY SUPPLIED = QUANTITY DEMANDED
- Supply and demand curves intersect
b. Equilibrium price and Equilibrium quantity
Equilibrium price Equilibrium quantity
- Balances quantity supplied and quantity demanded -Quantity supplied and quantity demanded at the
- Market-clearing price equilibrium price
c. Surplus and Shortage
Upward pressure on price
Movements along the demand and supply curves
Decrease in quantity demanded
Increase in quantity supplied

Surplus
QUANTITY SUPPLIED > QUANTITY DEMANDED
- Excess supply -> nguồn cung dư thừa
- Downward pressure on price
-> Movements along the demand and supply curves
Increase in quantity demanded
Decrease in quantity supplied
Shortage
QUANTITY DEMANDED > QUANTITY SUPPLIED
- Excess demand -> nguồn cầu cao
- Upward pressure on price
-> Movements along the demand and supply curves
Decrease in quantity demanded
Increase in quantity supplied

d. Law of supply and demand

- The price of any good adjusts (điều chỉnh giá để đưa về trạng thái cân bằng)
-> To bring the quantity supplied and the quantity demanded for that good into balance
- In most markets
 -> Surpluses and shortages are temporary
Three steps to analyzing changes in equilibrium
1. Decide whether the event shifts the supply curve, the demand curve, or, in some cases, both curves
2. Decide whether the curve shifts to the right or to the left
3. Use the supply-and-demand diagram
- Compare the initial and the new equilibrium
- Effects on equilibrium price and quantity
e. Shifts vs. movements along curves
- Shift in the supply curve -> Change in supply - Shift in the demand curve -> Change in demand
- Movement along a fixed supply curve -> Change in - Movement along a fixed demand curve -> Change in
the quantity supplied the quantity demanded

f. How Prices Allocate Resources

- Supply and demand together -> Determine the prices of the economy’s many different goods and services
- Prices
-> Signals that guide the allocation of resources
-> Mechanism for rationing scarce resources
-> Determine who produces each good and how much is produced
Chapter 5: Elasticity and Its Application
1. ELASTICITY OF DEMAND
a. Elasticity
- Measure of the responsiveness of quantity demanded or quantity supplied
- To a change in one of its determinants
b. Price elasticity of demand -> How much the quantity demanded of a good responds to a change in the price of that good

PERCENTAGE CHANGE∈QUANTITY DEMANDED

PRICE ELASTICITY OF DEMAND =
PERCENTAGE CHANGE∈QUANTITY
Elastic demand -> Quantity demanded responds substantially to changes in price
Inelastic demand -> Quantity demanded responds only slightly to changes in price
Determinants of price elasticity of demand

Availability of close substitutes
Necessities versus luxuries
Definition of the market
Time horizon
Goods with close substitutes: more elastic demand
Necessities: inelastic demand
Luxuries: elastic demand
Narrowly defined markets: more elastic demand
Demand is more elastic over longer time horizons

c. Computing the price elasticity of demand

- Percentage change in quantity demanded divided by percentage change in price
- Use absolute value (drop the minus sign)
- Midpoint method -> Two points: (Q1, P1) and (Q2, P2)
(Q2  Q1 )/[(Q2  Q1 )/ 2 ]
Price elasticity of demand 
(P2  P1 )/[(P2  P1 )/ 2 ]
Variety of demand curves
Demand is elastic Price elasticity of demand > 1
Demand is inelastic Price elasticity of demand < 1
Demand has unit elasticity Price elasticity of demand = 1
Demand is perfectly inelastic Price elasticity of demand = 0
Demand curve is vertical
Demand is perfectly elastic Price elasticity of demand = infinity
Demand curve is horizontal
 The flatter the demand curve -> The greater the price elasticity of demand

d. Total Revenue and the Price Elasticity of Demand

- Total revenue, TR
-> Amount paid by buyers and received by sellers of a good
- > Price of the good times the quantity sold (P × Q)
- For a price increase
-> If demand is inelastic, TR increases
-> If demand is elastic, TR decreases

When demand is inelastic (elasticity < 1) P and TR move in the same direction -> If P ↑, TR also ↑
When demand is elastic (elasticity > 1) P and TR move in opposite directions -> If P ↑, TR ↓
If demand is unit elastic (elasticity = 1) Total revenue remains constant when the price changes
e. Elasticity and Total Revenue along a Linear Demand Curve
f. Other Demand Elasticities
Income How much the quantity Percentage change∈quantity demanded
elasticity demanded of a good the percentage change∈income
of demand responds to a change in
consumers’ income
Normal goods: Positive Necessities Luxuries
income elasticity -> Smaller income elasticities -> Large income elasticities

Inferior goods: Negative

income elasticities
Cross-price How much the quantity Percentage change∈quantity demanded of the first good
elasticity of demanded of one good the percentage change ∈ price of the second good
demand responds to a change in the
price of another good
Substitutes -> Goods typically used in place of one another
-> Positive cross-price elasticity

Complements -> Goods that are typically used together

-> Negative cross-price elasticity
2. THE ELASTICITY OF SUPPLY.
a. Price elasticity of supply
-> How much the quantity supplied of a good responds to a change in the price of that good
PERCENTAGE CHANGE∈QUANTITY SUPPLIED
PRICE ELASTICITY OF SUPPLY =
DIVIDED BY THE PERCENTAGE CHANGE∈PRICE
-> Depends on the flexibility of sellers to change the amount of the good they produce
Elastic supply -> Quantity supplied responds substantially to changes in the price
Inelastic supply -> Quantity supplied responds only slightly to changes in the price
Determinant of price elasticity of supply -> Time period -> Supply is more elastic in the long run
b. Computing price elasticity of supply
-> Percentage change in quantity supplied divided by percentage change in price
-> Always positive
Midpoint method -> Two points: (Q1, P1) and (Q2, P2)
(Q2  Q1 ) / [(Q2  Q1 ) / 2 ]
Price elasticity of supply 
(P2  P1 ) / [(P2  P1 ) / 2 ]
c. Variety of supply curves
Supply is unit elastic Price elasticity of supply = 1
Supply is elastic Price elasticity of supply > 1
Supply is inelastic Price elasticity of supply < 1
 Supply is perfectly inelastic Price elasticity of supply = 0
Supply curve is vertical
Supply is perfectly elastic Price elasticity of supply = infinity
Supply curve is horizontal

3. THREE APPLICATIONS OF SUPPLY, DEMAND, AND ELASTICITY

a. Can Good News for Farming Be Bad News for Farmers?
- New hybrid of wheat – increase production per acre by 20%
-> Supply curve shifts to the right
-> Higher quantity and lower price
-> Demand is inelastic: total revenue falls
- Paradox of public policy
-> Induce farmers not to plant crops
b. Why Did OPEC Fail to Keep the Price of Oil High?
- Increase in prices: 1973 – 1974, 1971 – 1981
- Short-run: supply and demand are inelastic
-> Decrease in supply: large increase in price
- Long-run: supply and demand are elastic
-> Decrease in supply: small increase in price
c. Does Drug Interdiction Increase or Decrease Drug-related Crime?
- Increase the number of federal agents devoted to the war on drugs
-> Illegal drugs: supply curve shifts left -> Higher price and lower quantity
- Amount of drug-related crimes
-> Inelastic demand for drugs
-> Higher drugs price: higher total revenue
-> Increase drug-related crime
- Policy of drug education
-> Reduce demand for illegal drugs -> Lower quantity -> Lower price
-> Left shift of demand curve -> Reduce drug-related crime
Chapter 6: Supply, Demand, and Government Policies
1. Price controls
- Policymakers believe that the market price of a good or service is unfair to buyers or sellers
- Can generate inequities
Taxes
- To raise revenue for public purposes
- To influence market outcomes
Price ceiling and price floor
PRICE CEILING – giá trần PRICE FLOOR – giá sàn
definition - A legal maximum on the price at - A legal minimum on the price at which a good can
which a good can be sold be sold
- Rent-control laws - Minimum wage laws
 How price Not binding
affect market - Set above the equilibrium price
outcomes - No effect on the price or quantity sold
Binding constraint
- Set below the equilibrium price: Shortage
- Sellers must ration the scarce goods
- Rationing mechanisms: long lines,
discrimination according to sellers bias
Not binding
- Set below the equilibrium price
- No effect on the market
Binding constraint
- Set above the equilibrium price: Surplus
- Some sellers are unable to sell what they want
- Rationing mechanisms: not desirable

2. Evaluating Price Controls

Markets are usually a good way to organize economic activity
- Economists usually oppose price ceilings and price floors
- Prices are not the outcome of some haphazard process
- Prices have the crucial job of balancing supply and demand
-> Coordinating economic activity
Governments can sometimes improve market outcomes
- Want to use price controls
-> Because of unfair market outcome
-> Aimed at helping the poor
- Often hurt those they are trying to help
- Other ways of helping those in need
-> Rent subsidies
-> Wage subsidies (earned income tax credit)

3. Taxes
a. Government uses taxes
- To raise revenue for public projects
- Roads, schools, and national defense
Tax incidence -> Manner in which the burden of a tax is shared among participants in a market
b.
How taxes on sellers affect market outcomes How taxes on buyers affect market outcomes

- Immediate impact on sellers: shift in supply - Initial impact on the demand

- Supply curve shifts left
- Higher equilibrium price
- Lower equilibrium quantity
- The tax reduces the size of the market
- Taxes discourage market activity
- Buyers and sellers share the burden of tax
- Buyers pay more, are worse off
- Sellers receive less, are worse off
-> Get the higher price but pay the tax
-> Overall: effective price fall
- Demand curve shifts left
- Lower equilibrium price
- Lower equilibrium quantity
- The tax reduces the size of the market
- How taxes on buyers affect market outcomes
- Buyers and sellers share the burden of tax
- Sellers get a lower price, are worse off
- Buyers pay a lower market price, are worse off
-> Effective price (with tax) rises
c. Taxes levied on sellers and taxes levied on buyers are equivalent
- Wedge between the price that buyers pay and the price that sellers receive
-> The same, regardless of whether the tax is levied on buyers or sellers
- Shifts the relative position of the supply and demand curves
-> Buyers and sellers share the tax burden

d. Elasticity and tax incidence

Very elastic supply and relatively inelastic Relatively inelastic supply and very elastic demand
demand
-> Sellers bear a small burden of tax -> Sellers bear most of the tax burden
-> Buyers bear most of the burden -> Buyers bear a small burden

e. Tax burden
- Falls more heavily on the side of the market that is less elastic
- Small elasticity of demand
-> Buyers do not have good alternatives to consuming this good
- Small elasticity of supply
-> Sellers do not have good alternatives to producing this good