supply and demand - how markets work

Supply and DemandHow Markets Work

Marginal Values

The DIAMOND-WATER PARADOX:• Why are diamonds so much more expensive than water?• Even though water is obviously important to human

activity (life cannot exist without water), the price of water is relatively low. Alternatively, diamonds are much less important to human existence, but the price of diamonds is substantially higher.

• Clarification of the diamond-water paradox results by differentiating between total utility and marginal utility.

Marginal Values• Marginal Utility: This is the extra satisfaction of wants

and needs obtained from consuming one additional unit of good. That is, marginal utility is the incremental satisfaction generated by, and the value of, a single unit of a good.

• Values (and our choices) depend on the situation we face.

• Just about anything could be more valuable than anything else under appropriate circumstances: The exact same diamond or glass of water may be valued differently by different people, and even valued differently at different times by the same person.

• Economists use the term “Margin”(Decisions are made “at the Margin”)

Diminishing Marginal Utility• The key to the marginal utility difference

between water and diamonds is the law of diminishing marginal utility:

• as more of a good is consumed, eventually each additional unit of the good provides less additional utility - that is, marginal utility decreases. Each subsequent unit of a good is valued less than the previous one.

• Because diamonds are substantially less plentiful, marginal utility is much higher. The law of diminishing marginal utility is not active to the same degree for diamonds as it is for water.

Everyday Choices Are Marginal Choices

Example: Study vs. Spending Time with Girlfriend?

The ‘economic way of thinking’ favors attention to• marginal benefits• marginal costs

There are no “all-or-nothing” decisions

Economic theory is sometimes referred to as marginalism or marginal analysis because it emphasizes the effects of additional benefits and additional costs.

Law of Demand

• Law of Demand: the inverse relationship between the price of a good and the quantity consumers are willing to purchase.• As the price of a good rises, consumers buy

less.• The availability of substitutes (goods that

perform similar functions) explains this negative relationship.

Market Demand Schedule• A market demand schedule is a table that

shows the quantity of a good people will demand at varying prices.

• Consider the market for cellular phone service. A market demand schedule lays out the quantity of cell phone service demanded in the market at various prices.

• We can graph these points (the different prices and respective quantities demanded) to make a demand curve for cell phone service.

Market Demand Schedule

Cellular phone service price(avg. monthly

bill)

Cellular phone

subscribers(millions)

$ 92 7.6$ 73 16.0 $ 58 33.7 $ 46 55.3

$ 143 2.1

$ 41 69.2

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Price(monthly bill)

Quantity(million subscribers)

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60 7010

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Demand

Market Demand Schedule

• Notice how the law of demand is reflected by the shape of the demand curve.

• As the price of a good rises … consumers buy less.

• NOTE: “Demand” is not a specific number, but rather a relationship among many numbers (= a schedule or curve).

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Demand

Normal Goods vs. Inferior Goods

• Goods and services can be categorized according to the effect of the changes in income on demand.

• If an increase in income leads to an increase in demand, then the product is a NORMAL GOOD (luxury cars, steakhouse dinner…)

• Occasionally however, an increase in income may result in a DECREASE for demand of a particular good. If this happens, we are dealing with an INFERIOR GOOD. Typically, inferior goods are low-budget items, where if you had more money you would buy something else, something nicer instead (subway tickets, cheap noodles, generic brands...)

Normal Goods vs. Inferior Goods

The distinction between normal and inferior products is important for business decisions. When the economy is growing and incomes are rising, the demand for normal products will rise, while the demand for inferior products will fall. By contrast, when the economy is in recession and incomes are falling, the demand for normal products will fall, while the demand for inferior products will rise.

Misperceptions caused by Inflation

• If we want to examine the effect of a particular price increase, we must first abstract from the effects of a general increase in prices.

• Example: If the price of gasoline rose 50% during a period in which the general price level rose 100%, economic theory would predict an increase in the quantity of gasoline demanded (gasoline gets cheaper “in real terms”).

Changes in Demand and Quantity Demanded

• Change in Demand – a shift in the entire demand curve.

• Change in Quantity Demanded – a movement along the same demand curve in response to a change in its price.

Demand Curve Shifters

• Change in the number of consumers• Demographic changes• Change in tastes and preferences• Change in income (normal vs. inferior goods)• Change in the price of substitutes• Change in the price of a complementary good• Change in the expected price of a good

Price Elasticity of DemandElasticity (= Responsiveness) to price changes is influenced by several factors:

•TIME It takes time to find out and begin to use substitutes

•AVAILABILITY AND CLOSENESS OF SUBSTITUTESCup of coffee, Tacos…can be substituted with Tea, Burgers…Demand for such goods is relatively elastic. Gasoline, Electricity… have few close substitutes. Demand for such goods is relatively inelastic.

•PROPORTION OF ONE’S BUDGET SPENT ON A GOODSalt, Toothpicks, Matches…relatively inelastic. (Low benefits of economizing – ‘low involvement’)Furniture…relatively elastic

•BUYER’S PRIOR COMMITMENTSCars (spare parts), Software (Upgrades) – whenever there is such a ‘lock-in’, demand is less elastic.

The elasticity of demand helps a company decide how raising or lowering prices will affect total revenue.

Producer Choice and the Law of Supply

Refresher on Opportunity Cost:

• The cost of an action is the value of the next-best alternative opportunity sacrificed

• A decision for something is always a decision against something else

• “De-cidere” = to cut off

Question for Thought

• Why do poor people travel between cities by bus, while wealthy people are more likely to travel by air?

• Answer: The higher one’s income, the higher the opportunity cost of time

Costs are tied to Actions, not to Things

• Confusion between price and costs (Common sense tells us that things have “real costs”)

• Costs are always tied to actions, decisions and choices – COSTS TO WHOM?

• To see the true cost of things, recognize that only actions have cost, and that actions can entail different costs for different people

• Things cannot have a cost, only actions have a cost, and these are the cost to the actor

Opportunity Costs of Production• Producers purchase resources and use them to produce

output.• Producers will incur costs as they bid resources away

from their alternative uses.• Opportunity cost of production:

The sum of the producer’s costs of employing each resource required to produce the good.

• Firms will not stay in business for long unless they are able to cover the cost of all resources employed, including the opportunity cost of the resources owned by the firm.

Opportunity Costs of Production• The resource that most clearly illustrates the opportunity

cost concept is land:

– Land can be used for residential, commercial, or industrial purposes

– The cost you pay for land will be determined by the alternative opportunities that people perceive for its use

Question for Thought:

Why is there no potato field in the center of Prague?

Law of Supply

• Law of Supply: there is a positive relationship between the price of a product and the amount of it that will be supplied.• As the price of a product rises, producers will

be willing to supply a larger quantity.

Cellular phone service price(avg. monthly

bill)

Cellular phone

subscribers(millions) 120

100

80

40

0 20 30 40 50

60

60 7010

140

Supply$ 60 5.0 $ 73 11.0$ 80 15.1 $ 91 18.2 $ 107 21.0 $ 120 22.5

Market Supply SchedulePrice(monthly bill)


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Supply

Price(monthly bill)

Market Supply Schedule

• Notice how the law of supply is reflected by the shape of the supply curve.

• As the price of a good rises … producers supply more.


The Irrelevance of Sunk Costs• When making cost calculations do not look at the past, for the past

is filled with sunk cost (irretrievable cost)

• Sunk costs are irrelevant to economic decisions because the represent no opportunity for choice

• The proper stance is to look forward to opportunity cost, which always lie in the future

• Most people have difficulty putting this idea into practice. The SUNK COST FALLACY is manifested when we have a greater tendency to continue an endeavor once an investment in money, effort or time has been made. (“Bounded Rationality”)

The Irrelevance of Sunk CostsExamples:

A common mistake made by investors is reluctance to sell securities at a loss. It does not matter what you paid for shares, if the market price has fallen you have already made that loss. It is a sunk cost and should be forgotten about. What matters is whether the shares are worth holding or not at the current market price. A key question is whether the shares would still be worth buying at current prices. If not, they are probably not worth holding.

Colloquially, this is known as "throwing good money after bad".

The Irrelevance of Sunk Costs

If you have purchased a nonrefundable ticket to a concert, and you are feeling ill, you might attend the concert anyway because you do not want the ticket to go to waste. However, the money spent to buy the ticket is sunk, and the cost of the ticket is entirely irrelevant, whether it cost $5 or $100. The only relevant consideration is whether you would derive more pleasure from attending the concert or staying home on the evening of the concert.

The Irrelevance of Sunk Costs• Sunk costs have a tendency to add up• Example: Wrong career path? Cut your losses at time!

Changes in Supply and Quantity Supplied

• Change in Supply – a shift in the entire supply curve.

• Change in Quantity Supplied – movement along the same supply curve in response to a change in its price.

Supply Curve ShiftersThe following will cause a change in supply

(a shift in the entire curve):

• Technology changes• Prices of substitutes• Change in expected price (Hoarding)• Change in overall number of suppliers• Changes in taxes

Price Elasticity of Supply• (1) Spare production capacity• If there is plenty of spare capacity then a business should be

able to increase its output without a rise in costs and therefore supply will be elastic in response to a change in demand. The supply of goods and services is often most elastic in a recession, when there is plenty of spare labor and capital resources available to step up output as the economy recovers.

• (2) Stocks of finished products and components• If stocks of raw materials and finished products are at a high

level then a firm is able to respond to a change in demand quickly by supplying these stocks onto the market - supply will be elastic. Conversely when stocks are low, dwindling supplies force prices higher and unless stocks can be replenished, supply will be inelastic in response to a change in demand.

Price Elasticity of Supply• (3) The ease and cost of factor substitution• If both capital and labor resources are occupationally

mobile then the elasticity of supply for a product is higher than if capital and labor cannot easily and quickly be switched

• (4) Time period involved in the production process• Supply is more price elastic the longer the time period that a

firm is allowed to adjust its production levels. In some agricultural markets for example, the momentary supply is fixed and is determined mainly by planting decisions made months before, and also climatic conditions, which affect the overall production yield.

Market Equilibrium• This table & graph indicate demand & supply

conditions of the market for calculators.• Equilibrium will occur where the quantity demanded

equals the quantity supplied. If the price in the market differs from the equilibrium level, market forces will guide it to equilibrium.

• A price of $12 in this market will result in a quantity demanded of 450 … and a quantity supplied of 600 …resulting in an excess supply.

With an excess supply present, there will be downward pressure on price to clear the market.

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Quantity demanded = 450

Quantity supplied= 600

Price ($)

450 500 550 600 650

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Excess supply Downwar

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Price(dollars)

Quantitysupplied(per day)

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(per day)

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Market Equilibrium

• A price of $8 in this market will result in a quantity supplied of 500 …and quantity demanded of 650 … resulting in an excess demand.

• With an excess demand present, there will be upward pressure on price to clear the market.


Quantity demanded= 650

Excess demand Upwar

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• A price of $10 in this market results in quantity supplied of 550 …

• With market balance present, there will be an equilibrium present and the market will clear.

and a quantity demanded of 550 … resulting in market balance.

Quantity demanded= 550

MarketBalance Equilibriu

m=


Excess supply

Excess demand

Equilibrium price

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Market Equilibrium

• At every price above market equilibrium there is excess supply and there will be downward pressure on the price level.

• At every price below market equilibrium there is excess demand and there will be upward pressure on the price level.

• At the equilibrium price, quantity demanded and quantity supplied are in balance.

Equilibrium

Upward

Downward

Outstanding EconomistAlfred Marshall (1842 – 1924)

• British economist Alfred Marshall was one of the most influential economists of his era. Many concepts and tools that form the core of modern microeconomics originated with Marshall in his famous Principles of Economics, first published in 1890. Marshall introduced the concepts of supply and demand, equilibrium, elasticity, and the idea of distinguishing between short-run and long-run changes.

Recommended Reading• Strategic Market Management

David A. Aaker, Damien McLoughlin; John Wiley & Sons, 2010

HISTORY OF POLITICAL AND ECONOMIC THOUGHT

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supply and demand - how markets work

Economy & Finance