Markets, Demand, and Supply: Fundamental Economic Questions

What, How, and For Whom to Produce

Sabrina Auci
University of PalermoWhat, How, and For whom to produce (I)
· All societies face some fundamental economic questions:
· What to produce?
· Which goods to produce? How much of each good to produce?
· How to produce?
· With what resources? With what technology? Which and how many
inputs to use?
· For whom to produce?
. How to distribute the goods produced? By income or by need? By price
or by government decisions?
Sports Economics - Markets, demand, and supply
2What, How, and For whom to produce (II)

• Two approaches:
• Planned economy:
• Resource allocation is decided by a political and administrative apparatus
  that gathers information on technology, available resources and final demand
  for goods and services.
• Market structure:
• Physical or imaginary place where all buyers and sellers of a good meet.
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The Market: Agents' Choices and Price Mechanism

Agents' Choices

The market: Agents' choices
· Agents make decisions based on utilitarian considerations:
· Firms (producers): seek to maximise thier profit as the difference between revenues and
costs
· Households (consumers): seek to obtain the greatest possible satisfaction from the
goods they purchase.
· As a result of agents' choices, it is possible to define supply and demand
curves that interact in the market to achive price equilibrium.
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Price Mechanism

The market: Price mechanism
· The price rule is very simple:
. Prices rise in situations of scarcity and fall in situations of abundance.
An example:

1. If consumers want more of a good, demand will exceed supply and the price
   will rise.
2. The increase will induce producers to increase supply and consumers to stop
   increasing (or reducing) demand.
3. Prices will rise to the point where the scarcity is eliminated and there is an
   equilibrium between supply and demand.
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Market Equilibrium and Variation

Equilibrium Conditions

The market: Equilibium
· This price adjustment mechanism applies not only to consumer goods, but
also to factors of production such as labour.
· An economic system is in equilibrium when two conditions are met:

1. Each economic agent has no reason to change his choice ("subjective"
   conditionality)
2. The choices of the various agents are compatible with each other
   ("objective" condition).
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Variation of Equilibrium

The market: variation of equilibrium
· When supply or demand changes from the initial equilibrium, prices change.
· An increase in demand leads to an increase in prices
· An increase in supply leads to a fall in prices
. We can now go on to analyse the price mechanism in more detail from the
point of view of both supply and demand.
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Demand Curve Analysis

Demand Curve Definition

Demand curve
· Demand for a good is the quantity individuals are willing (and able) to
purchase at a given price.
p
24
16
10
q
6
9
20
· Demand has a negative
relationship (or slope) between
quantity and price.
· Consumers buy larger quantities at
lower prices and smaller quantities
at higher prices.
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Law of Demand

Law of Demand
· The term 'Law of Demand' refers to the phenomenon that when the price of a
good rises, the quantity demanded falls.
. This is due to two factors:

1. Income effect
   · Individuals become poorer as the price increases.
2. Substitution effect
   · Individuals tend to replace the good that has become more expensive with alternative,
   relatively cheaper goods.
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Factors Influencing Demand

Factors that influence the demand
· The other factors, apart from price, that determine the quantity demanded are

1. Tastes
2. Substitutes (number and price)
3. Complementary goods (number and price)
4. Income
5. Future price expectations
   · Differences in income and consumer preferences can lead to variations in the
   prices they are willing to pay.
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Buyer Reserve Price

Reserve price of a buyer
· Based on cost-benefit analysis, the consumers reserve price is the
highest price that buyers are willing to pay for a single unit of
goods.
· The demand curve has a negative slope because the reserve price
of the marginal consumer decreases as the quantity purchased
increases.
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Movement and Shifts in Demand Curve

Movement along the curve and shifts in the
demand curve
· When price changes, there
is a movement along the
demand curve
P
D
D
P2
P
I
I
I
I
I
Q0
Q1
Q2
Q
· When one of the other
determinants changes,
there is a shift of the entire
demand curve.
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Individual and Market Demand

Individual and market demand
· Starting from the demand of an individual consumer, one can obtain the
market demand
· Market demand is the orizontal sum of the quantities of a given good
demanded by consumers at each possible price level
P
P
P
PA
P.
1
P.
1
d'
D.
0
q 0
b
0
q
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Supply Curve Analysis

Supply Curve Definition

Supply curve
· The Supply curve describes the quantity of a good or service that producers
are willing and able to offer for sale at a given price
p
18
12
8
q
6
10
20
· When the price of a good
increases, the quantity offered
also increases (as shown by the
upward curve).
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Factors Influencing Supply

Factors that influence the supply
· The other factors, apart from price, that determine the quantity demanded are

1. The costs of production.
2. The profitability of alternative and joint products.
3. Shocks
4. Producers' Objectives
5. Future Price Expectations
   · Differences in income and seller preferences can lead to variations in the
   prices they are willing to offer
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Seller Reserve Price

Reserve price of a seller
· The sellers reserve price is the minimum price at which a seller is
willing to sell an additional unit of the good or service or in other
words, it is the lowest price a seller is willing to accept for a good or
service
. Generally, it is equal to the marginal cost, and this explains why the
supply curve has a positive slope.
· Producing additional goods means more costs.
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Movement and Shifts in Supply Curve

Movement along the curve and shifts in the
supply curve
· When the price changes, there is
a movement along the supply
curve
· When one of the other
determinants changes, there is
a shift of the entire supply curve
P
S
S'
-
P
P.
Q
Q1
Q2
Q
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Equilibrium Price and Market Mechanism

Equilibrium Price and Quantity

Price and quantity of equilibrium
· The price at which demand
equals supply is known as the
equilibrium price.
. In this equilibrium solution, the
independent decisions of
producers and consumers are
compatible.
Price
S
P0
I
D
-
Quantity
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Market Mechanism Characteristics

Market mechanism
· In addition to whether an equilibrium solution exists, we are interested in
whether the price-quantity combination determined in the market is a stable
equilibrium, i.e. a situation towards which the market tends.
· Characteristics of the equilibrium:
. QD = Qs
· Zero excess demand
· Zero excess supply
· No pressure to change price
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Market with Oversupply Example

Oversupply Scenario (I)

Example: The Market with Oversupply (I)
Price
S
Oversupply
If the price is higher than
the equilibrium price:
P
P0
1) Qs > Qp Oversupply
2) The price falls to the
market-clearing price
D
QD
Q
Qs Quantity
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Oversupply Consequences (II)

Example: The Market with Oversupply (II)
· The market price is currently above the equilibrium price,
indicating an oversupply.
. This has two main consequences:

1. Producers will reduce prices, and
2. The quantity demanded will increase while the quantity offered
   decreases.
   . The market adjusts until the equilibrium price is reached.
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Oversupply Resolution (III)

Example: The Market with Oversupply (III)
P
S
Oversupply
P.
P0
D
I
QD
Q0
Qs
Q
Qs > Qd
1) The oversupply is the
difference between Qs and QD.
2) Producers will reduce the
price of the good
3) The offered quantity will
reduce and the demanded
quantity will increase
4) The equilibrium will be
reached in P0Q0
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Demand and Supply Shocks

Demand Shock

Demand shock
. If there is a change in any of the determinants of demand other than price.
p
S
p2
p1
D1
D
q1
q2
q
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Supply Shock

Supply shock
. If there is a change in any of the determinants of supply other than price.
p
S
S1
p1
p2
D
q1
q2
q
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