The market place and the law of demand

Main idea: In a market economy buyers and sellers set prices. The law of demand states that as price goes up, quantity demanded goes down, and vice versa.

 

When you buy something, do you ever wonder why it sells at the particular price you paid? People do not usually think that individual consumers have any influence over the price of an item. In a market economy, however, consumers collectively have a great deal of influence on the prices of all goods and services. To understand this, let’s look first at how people in the marketplace decide what to buy and at what price. This is demand.

What is the marketplace? A marketrepresents the freely chosen actions between buyers and sellers of goods and services. A market for a particular item or service can be local, national, international, or a combination of these. In a market economy, individuals decide for themselves the answers to the WHAT?, HOW?, and FOR WHOM? economic questions.  

The basis of activity in a market economy is the principle of voluntary exchange. A buyer and a seller exercise their economic freedom by working toward satisfactory terms of an exchange of goods or services. For example, the seller of an automobile sets a certain price based on his or her view of market conditions. The buyer, through the act of buying, agrees to the product and the price.

In a market economy, buyers have many choices about how to spend their income, and sellers have many choices about how to sell their products. With voluntary exchange, the seller’s problem of what to charge and the buyer’s problem of how much to pay is solved voluntarily in the market. Supply and demand analysisis a model of how buyers and sellers operate in the marketplace.

Demand, in economic terms, represents all of the different quantities of a good or service that consumers will purchase at various prices. It includes both the willingness and the ability to pay. A person may say he or she wants a new DVD. Until that person is both willing and able to buy it, however, no demand for DVDs has been created by that individual.

The law of demandexplains how people react to changing prices in terms of the quantities demanded of a good or service. There is an inverse, or opposite, relationship between quantity demanded and price. For example, if the price of a DVD is $15 many people will buy it. If the price went up to $20 fewer people would buy it, but many people who wanted the DVD would still buy it. Only a few people would buy the DVD if the price went up to $75.

Several factors explain the inverse relation between price and quantity demanded, or how much people will buy of any item at a particular price. These factors include real income, possible substitutes, and diminishing marginal utility.

     Real Income Effect   No one—not even the wealthiest person in the world—will ever be able to buy everything he or she might possibly want. People’s incomes limit the amount they are able to spend. Individuals cannot keep buying the same

quantity of a good if its price rises while their income stays the same. This concept is known as the real income effecton demand. It forces consumers to make trade-offs.

Suppose that you normally fill your car’s gas tank twice a month, spending $40 each time. If the price of gasoline rises, you may have to spend $50 each time. If the price continues to rise while your income does not, eventually you will not be able to fill the gas tank twice per month because your real income, or purchasing power, has dropped. To keep buying the same amount of gasoline, you would need to cut back on buying other things. The real income effect forces you to make a trade-off in your gasoline purchases.

Substitution Effect Suppose there are two items that are not exactly the same but which satisfy basically the same need. Their cost is about the same. If the price of one falls, people will most likely buy it instead of the other, now higher-priced, good. If the price of one rises in relation to the price of the other, people will buy the now lower-priced good. This principle is called the substitution effect.

Suppose, for example, that you listen to both CDs and downloaded music. If the price of CDs rises dramatically, you will probably buy more music downloads and fewer CDs. Alternately, if the price of music downloads increases, you will probably buy more CDs.

     Diminishing Marginal Utility Almost everything that people like, desire, use, or think they would like to use, gives satisfaction. The term that economists use for satisfaction is utility. Utilityis defined as the power that a good or service has to satisfy a want. Based on utility, people decide what to buy and how much they are willing and able to pay at any given time.

Consider the utility that can be derived from buying a cold soft drink at a  baseball game on a hot day. At $4 per cup, how many will you buy? That decision depends on the additional utility, or satisfaction, you expect to receive from each additional soft drink. Your total satisfaction will rise with each one bought. The amount of additional satisfaction, or marginal utility, however, will lessen with each additional cup bought. This example illustrates the law of diminishing marginal utility.

At some point, you will stop buying soft drinks. Maybe you don’t want to wait in line, or perhaps you are no longer thirsty. At that point, the satisfaction you get from the drink is less than the value you place on its cost. In general, people stop buying an item when the satisfaction from the next unit of the same item becomes less than the price they must pay for it.

 

Unit 6

THE LAW OF SUPPLY

Main idea: Сonsumers demand products and services at the lowest possible prices.

The law of supply is geared toward making profits.   It states that as price goes up, quantity supplied goes up, and vice versa.

 

Profits and the Law of Supply To understand how prices are determined, you have to look at both demand and supply—the willingness and ability of producers to provide goods and services at different prices in the marketplace. The law of supplystates that as the price of a good rises, the quantity supplied generally rises; as the price falls, the quantity supplied also falls.

You may recall that with demand, price and quantity demanded move in opposite directions. With supply, a direct relationship exists between the price and quantity supplied. A direct relationship means that when prices rise, quantity supplied will rise, too. When prices fall, quantity supplied by sellers will also fall. Thus, a larger quantity will generally be supplied at higher prices than at lower prices. A smaller quantity will generally be supplied at lower prices than at higher prices.

The profit incentiveis one of the factors that motivate people in a market economy. In the case of supply, the higher the price of a good, the greater the incentive is for a producer to produce more. The higher price not only returns higher revenues from sales but also covers the additional costs of producing more. This concept is the basis of the law of supply.

The Determinants of Supply Many factors can affect the supply of a specific product. Four of the major determinants of supply (not quantity supplied) are the price of inputs, the number of firms in the industry, taxes, and technology.

     Price of Inputs   If the price of the inputs needed to make a product—raw   materials, wages, and so on—drops, a producer can supply more at a lower production cost. This causes the entire supply curve to shift to the right.    In contrast, if the cost of inputs increases, then the cost of production also  increases, and suppliers will offer fewer goods for sale at every possible price.

     Number of Firms in the Industry As more firms enter an industry, greater quantities of their product or service are supplied at every price, and the supply curve shifts to the right. The larger the number of suppliers, the greater the market supply. Consider DVD rentals, for example. If profits from movie and game rentals increase, the number of DVD rental stores supplying these items will increase as well. As more DVD rental stores enter the market, the supply curve for DVD rentals shifts to the right.

Conversely, if some suppliers leave the market, fewer quantities of their product or service are supplied at every price, and the supply curve shifts to the left. Sellers in a free-market economy are entering and leaving the market all the time.

Taxes   If the government imposes more taxes on the production of certain items, businesses will not be willing to supply as much as before because the cost of production will rise. The supply curve for products will shift to the left, indicating a decrease in supply. For example, if taxes on the production of silk scarves increased, businesses that sell silk scarves would supply fewer quantities at each and every price.

Technology The use of science to develop new products and new methods for producing and distributing goods and services is called technology. Any improvement in technology will increase supply. This is because new technology usually allows suppliers to make more goods for a lower cost. The entire cost of production is cut, and the supply curve shifts to the right.

The Law of Diminishing Returns Imagine that you own a business, and you want to expand production. Assume you have 10 machines and employ 10 workers, and you hire an 11th worker. Now, production increases by 1,000 units per week. When you hire a 12th worker, however, production increases by only 900 per week. If you continue to hire more workers, production will continue to increase, but the rate of increase will fall. Maybe there are not enough machines to go around, and perhaps the workers are getting in each other’s way. If you continue to hire still more workers, your overall output will eventually decrease.

This example illustrates the law of diminshing returns, which says that adding units of one factor of production increases total output. After a certain point, however, the extra output for each additional unit hired will begin to decrease.

Equilibrium price In the real world, demand and supply operate together. As

the price of a good goes down, the quantity demanded rises and the quantity supplied falls. As the price goes up, the quantity demanded falls and the quantity supplied rises.

Is there a price at which the quantity demanded and the quantity supplied meet? Yes. This level is called the equilibrium price. At this price, the quantity supplied by sellers is the same as the quantity demanded by buyers.

 

Unit 7

PERFECT COMPETITION

    Main idea: Businesses are categorized by market structure – or by the amount of competition they face. There are perfect and imperfect market structures.

 

Market Structure and Perfect Competition     All businesses must engage in some form of competition as long as other businesses produce similar goods or services. When a market includes so many sellers of a particular good or service that each seller accounts for a small part of the total market, a special situation exists. Economists term it perfect competition.For perfect competition, also known as pure competition, to take place, five conditions must be met:

(1) A Large Market:  Numerous buyers and sellers must exist for the product.

(2) A Nearly Identical Product: The goods or services being sold must be nearly

the same.

(3) Easy Entry and Exit: Sellers already in the market cannot prevent competition,

or entrance into the market. In addition, the initial costs of investment are small, and the good or service is easy to learn to produce.

(4) Easily Obtainable Information: Information about prices, quality, and sources of supply is easy for both buyers and sellers to obtain.

(5) Independence: The possibility of sellers or buyers working together to control the price is almost nonexistent.

No Control Over Price When the above five conditions are met, the workings of supply and demand, rather than a single seller or buyer, control the price. On the supply side, perfect competition requires a large number of suppliers of a nearly identical product. On the demand side, perfect competition requires a large number of buyers who know exactly what the market price is for the good or service.

In a perfectly competitive market, the market price is the equilibrium price. Total supply and total demand are allowed to interact to reach the equilibrium price—the only price at which quantity demanded equals quantity supplied. In a world of perfect competition, each individual seller would accept that price. Because so many buyers and sellers exist, one person attempting to charge a

higher or lower price would not affect the market price.

Perfect competition is an idealized type of market structure. Most industries in the market economy, in contrast, represent some form of imperfect competition. Economists classify these types of imperfect market structures as monopoly, oligopoly, or monopolistic competition. They differ on the basis of how much competition and control over price the seller has.

  Monopoly The most extreme form of imperfect competition is a pure monopoly, in which a single seller controls the supply of the good or service and thus  determines its price. A few such markets do exist in the real world. For example, some local electric utility companies are the sole providers for a community.

  In a pure monopoly, the supplier can raise prices without fear of losing  business, because buyers have nowhere else to go to buy the good or service. A monopolist, however, cannot charge outrageous prices, as the law of demand is still operating. As the price of a good or service rises, consumers buy less.

If a monopoly is collecting all the profits in a particular industry, why don’t other businesses rush in to get a share of those profits? A monopoly is protected by barriers to entry— obstacles that prevent others from entering the market. State

laws that prevent competing utility companies from entering the market are one example of a barrier to entry. Another barrier to entry is the cost of getting started.

  Oligopoly Unlike a monopoly with just one supplier, an oligopolyis an industry dominatedby several suppliers who exercise some control over price. Oligopolies are not considered as harmful to consumers as monopolies. Consumers may pay more than if they were buying in a perfectly competitive market, but oligopolistic markets tend to have generally stable prices. They also offer consumers a wider variety of products than would a perfectly competitive industry.

Product Differentiation Oligopolists engage in nonprice competition. What does this mean? Let’s use automobiles as an example. Several large auto manufacturers have an oligopoly on the domestic car market. They all make cars, trucks, and sport utility vehicles. They spend millions, if not billions, of advertising dollars per year to differentiate their products in your mind—and to win your consumer dollars.

The price you pay for brand names is not just based on supply and demand.  Rather, it is based on product differentiation—the real or perceived differences in the good or service that make it more valuable in consumers’ eyes.

Interdependent Behavior With so few firms in an oligopoly, whatever one does, the others are sure to follow. When one domestic airline cuts its airfares to gain market share, for example, the other major domestic airlines lower theirs even more. Although this type of price war is initially good for consumers in the form of lower prices, it may force an airline out of business if prices drop too much. Fewer airlines leads to less competition, which may raise prices in the long run.

Monopolistic competition The most common form of market structure in the United States is monopolistic competition,in which a relatively large number of sellers offer similar but slightly different products or services. Obvious examples are brand-name items such as toothpaste, cosmetics, and designer clothes.

Many of the characteristics of monopolistic competition are the same as those of an oligopoly. The major difference is in the number of sellers of a product. As you recall, in an oligopoly a few companies dominate an industry, and control over price is interdependent. In contrast, monopolistic competition has many firms, no real interdependence, and some slight difference among products.

 

Unit 8