unit 2 review
Supply and demand form the backbone of market economics, explaining how prices are determined and resources allocated. This unit explores the interplay between producers' willingness to sell and consumers' desire to buy, introducing key concepts like equilibrium, elasticity, and market efficiency.
Understanding supply and demand is crucial for analyzing real-world economic phenomena. From housing markets to labor dynamics, these principles help explain price fluctuations, shortages, surpluses, and the impact of government interventions on various industries and sectors.
Key Concepts and Definitions
- Supply refers to the quantity of a good or service that producers are willing and able to offer for sale at various prices
- Demand represents the quantity of a good or service that consumers are willing and able to purchase at different prices
- Equilibrium occurs when the quantity supplied equals the quantity demanded resulting in a stable market price
- Price elasticity measures the responsiveness of supply or demand to changes in price (elastic, inelastic, or unit elastic)
- Shortage happens when the quantity demanded exceeds the quantity supplied at a given price
- Surplus arises when the quantity supplied exceeds the quantity demanded at a given price
- Market efficiency is achieved when resources are allocated optimally and social welfare is maximized
Supply and Demand Curves
- Supply curve is an upward-sloping line that shows the relationship between price and quantity supplied
- As price increases, producers are willing to supply more of a good or service (law of supply)
- Demand curve is a downward-sloping line that illustrates the relationship between price and quantity demanded
- As price decreases, consumers are willing to purchase more of a good or service (law of demand)
- Shifts in supply or demand curves occur when factors other than price change (non-price determinants)
- Shifts in supply curve can be caused by changes in input prices, technology, or government policies
- Shifts in demand curve can result from changes in income, preferences, or prices of related goods
- Movements along the supply or demand curve happen when only the price changes ceteris paribus (all else being equal)
Market Equilibrium
- Equilibrium price is the price at which the quantity supplied equals the quantity demanded
- Also known as the market-clearing price because it "clears" the market of any shortages or surpluses
- Equilibrium quantity is the quantity bought and sold at the equilibrium price
- Disequilibrium occurs when the market price is not at the equilibrium level resulting in a shortage or surplus
- A price below equilibrium leads to a shortage as quantity demanded exceeds quantity supplied
- A price above equilibrium results in a surplus as quantity supplied exceeds quantity demanded
- Market forces (price mechanism) drive the market towards equilibrium by adjusting prices in response to shortages or surpluses
Factors Affecting Supply and Demand
- Supply can be influenced by various factors such as input prices, technology, taxes or subsidies, and expectations
- An increase in input prices (labor, raw materials) shifts the supply curve to the left (decreases supply)
- Technological advancements that improve productivity shift the supply curve to the right (increases supply)
- Demand can be affected by factors like income, preferences, prices of related goods, and expectations
- An increase in consumer income shifts the demand curve to the right for normal goods (increases demand)
- Changes in tastes or preferences can shift the demand curve either to the left or right
- Government interventions (price ceilings, price floors, taxes, subsidies) can also impact supply and demand
- A price ceiling set below the equilibrium price leads to a shortage (rent control)
- A price floor set above the equilibrium price results in a surplus (minimum wage)
Elasticity of Supply and Demand
- Price elasticity of supply (PES) measures the responsiveness of quantity supplied to a change in price
- Elastic supply (PES > 1) means a small change in price leads to a large change in quantity supplied
- Inelastic supply (PES < 1) indicates a large change in price results in a small change in quantity supplied
- Price elasticity of demand (PED) measures the responsiveness of quantity demanded to a change in price
- Elastic demand (PED > 1) implies a small change in price leads to a large change in quantity demanded
- Inelastic demand (PED < 1) means a large change in price results in a small change in quantity demanded
- Factors affecting PES include time horizon, availability of inputs, and storage capacity
- Factors influencing PED include availability of substitutes, proportion of income spent, and necessity vs. luxury
Price Mechanisms and Market Efficiency
- Price mechanism refers to the role of prices in coordinating the decisions of buyers and sellers in a market
- Rising prices signal producers to increase supply and consumers to decrease demand
- Falling prices encourage producers to decrease supply and consumers to increase demand
- Invisible hand concept suggests that individuals acting in their own self-interest can lead to socially beneficial outcomes
- Market efficiency is achieved when resources are allocated optimally and social welfare is maximized
- Allocative efficiency occurs when the marginal benefit equals the marginal cost (P = MB = MC)
- Productive efficiency is reached when goods or services are produced at the lowest possible cost
- Market failures (externalities, public goods, information asymmetry) can lead to inefficient outcomes requiring government intervention
Real-World Applications and Examples
- Housing market demonstrates the interaction of supply and demand (location, amenities, and economic conditions)
- Gentrification can shift the demand curve to the right leading to higher rental prices
- Labor market illustrates the supply of workers and the demand for labor by employers
- Minimum wage laws can create a surplus of labor (unemployment) if set above the equilibrium wage
- Agricultural markets are affected by factors such as weather, subsidies, and international trade policies
- Droughts can shift the supply curve to the left resulting in higher prices for crops
- Energy markets (oil, gas, electricity) are influenced by geopolitical events, technological advancements, and environmental regulations
- Increasing popularity of electric vehicles can shift the demand curve for gasoline to the left
Common Misconceptions and FAQs
- Misconception: Higher prices always lead to lower demand
- Clarification: For some goods (Veblen or Giffen goods), higher prices can increase quantity demanded
- Misconception: Equilibrium is always desirable or efficient
- Clarification: Market failures can result in equilibrium outcomes that are not socially optimal
- FAQ: What causes a shift in the supply or demand curve?
- Answer: Non-price determinants such as income, preferences, input prices, or technology can shift the curves
- FAQ: How do you calculate equilibrium price and quantity?
- Answer: Set the supply and demand functions equal to each other and solve for price (P) and quantity (Q)
- Misconception: Price ceilings and floors always benefit consumers or producers
- Clarification: Price controls can lead to shortages, surpluses, or inefficiencies that harm market participants
- FAQ: What is the difference between a change in quantity supplied/demanded and a change in supply/demand?
- Answer: A change in quantity supplied/demanded is a movement along the curve due to a price change, while a change in supply/demand is a shift of the curve due to non-price factors