IB STUDY

1.1 Competitive markets: Demand and supply

 

Markets

 

These are some key words and definitions which must be learnt as in the exams you must define the terms that you use to demonstrate you true understanding. 

 

Scarcity: the condition of having unlimited wants/desires and limited resources (or distribution /dissemination of them)

 

Market: a place where buyers and sellers meet and agree on a price of goods or services.

 

Opportunity cost: the cost of any activity measured in terms of the value of the next best alternative foregone

 

Demand 

 

Demand: the willingness and ability of the consumer to consume a good or service in a given amount of time.

 

The law of demand: as the price of a product falls, the quantity demanded of the product will usually increase, ceteris paribus.

 

The market demand gives the total quantity demanded by all consumers. The individual demand is the demand of one individual or firm.

 

The demand curve represents the relationship between the price and the quantity demanded of a product.

 

The change in the price of a good causes a movement along the demand curve. For instance, as price falls from P to P1 the demand moves down the demand curve, which increase the quantity demanded from Q to Q1. 

 

The non-price determinants of demand 

 

A change in the non-price determinants shift the demand curve because the quantity demanded at the price has changed.

 

Substitutes: Goods that can be used in place of one another as they satisfy the same needs

 

If the price of a substitute rises, demand for the good will increase

 

If the price of coffee falls, many people will shift from drinking tea to drinking coffee and the demand curve for tea shifts in to the left

 

Complements: Goods which tend to be used jointly

 

If the price of a complement rises, demand will decrease.

 

If the price of petrol rises people are motivated to use their car less, and the demand for cars shifts to the left.

 

Population: if the population grows/changes composition (old/young) there are more consumers and demand will shift out to the right

 

Tastes and preferences: more people may want the product or service (a product becomes 'fashionable') and demand shifts out

 

Real income: when income rises, more people can afford to buy cars and the demand curve for cars shifts to the right for normal goods and a decrease in demand for inferior goods. (Don't worry too much about this definition, it will become clearer once you have studied income elasticity, just remember real income affects demand) 

 

Advertising: the more effective the advertising the greater the demand, unless the government uses negative advertising for things such as the dangers to health from cigarette smoking

 

So just remember SCRIPTA for this (substitutes, complements, real income, population,  tastes, advertising) 

 

Linear demand functions (equations), demand schedules and graphs (HL)

 

Demand function: Qd = a – bP

 

 

 

 

 

 

 

 

 

 

 

 

 

 

‘A’ causes a shift in the demand curve because a= the quantity demanded when the price is 0, so, if a decreases the curve will shift to the left (non-price factors)

 

The slope will depend on '–b' (negative because the relation QD=P is inverse)   that is the responsiveness of the consumer to a change in price. It can depend on the number of substitutes. So if it becomes less responsive to substitutes the steepness of the curve will increase

 

Supply

 

Supply: the total amount of goods and services that producers are willing and able to purchase at a given

 

The law of supply: as the price of a product rises, the quantity supplied of the product will usually increase, ceteris paribus.

 

The market supply gives the total quantity supplied by all individual producers.

 

The supply curve represents the relationship between the price and the quantity supplied of a product, ceteris paribus.

 

The change in the price of a good causes a movement along the supply curve. For instance, as price increases from P to P1 the supply moves up the supply curve, which increases the quantity supplies from Q to Q1.

 

Non-price determinants of supply

 

Factors of production: changes in costs of factors of production, including land, labour, capital and entrepreneurship (human capital or intellectual capital).

 

If these costs increase, then supply shifts to the left.

 

If the government suddenly increased the minimum wage then this could greatly increase the costs of labour to a shoe making factory, this would cause a shift in supply to the left.

 

Subsidy: effectively reduces the firm’s costs of production, so supply shifts outwards.

A change in the non-price determinants shift the supply curve because the quantity supplied at the price has changed

 

Indirect tax: effectively increases the firm’s variable costs, so supply shifts inwards.

 

Expectations: If demand for a product is likely to rise, for example due to a successful advertisement campaign or celebrity endorsements, supply increases.

 

Price of relating product: if producer could produce another product with higher profitability, due to limited resources, the quantity supplied of the original product would decrease.

 

Number of firms in the market: more firms producing shifts supply to the right as more is being supplied at each price

 

Transportation and infrastructure: if these improve then supply shifts outwards because the firm’s average costs are lowered. 

 

State of technology: If technology improves then supply shifts to the left. As the firm can become more efficient with the same amount of costs so increase output.

 

So just remember PERSISTT for this (production, expectations, related, size, infrastructure, subsidy, tax and technology)

 

Linear supply functions, equations and graphs (HL)

 

Supply function: Qs = c + dP

 

 

 

 

 

 

 

 

 

 

 

 

 

‘C’ causes a shift in the supply curve because c = the quantity supplied when the price is 0, so, if c decreases the curve will shift to the left (non-price factors)

 

The slope will depend on d (positive because the relation QD=P is)   that is the responsiveness of the producer to a change in price. It can depend on the number of factors of production.

 

Market equilibrium and changes in equilibrium

 

Market equilibrium: where the quantity supplied equals the quantity demanded

 

 

 

 

 

 

 

 

 

Excess supply: more is being supplied than demanded at P1, in order to eliminate the surplus, producer must lower the price

 

Excess demand: more is being demanded than supplied at P2, in order to eliminate the surplus, producer must raise the price

 

 

 

 

 

 

 

When there is a change in determinants of demand/supply other than the price of the product, it would lead to a shift of a curve.

 

When demand shifts to D1, Qe is the quantity supplied, but Q2 is the quantity demanded, there is excess demand.

 

The price will rise until P1, where the new equilibrium quantity, is both demanded and supplied.

 

 

 

 

Calculating and illustrating equilibrium using linear equations (HL)

 

The graph shows that the equilibrium price and quantity are Pe, which is between $6 and $7, and Qe, which is between 10 and 20 units. However, to get more exact values calculations can be used.

 

 

 

 

 

 

 

 

 

 

 

 

This shows how to calculate the equilibrium price and quantity. At the equilibrium Qs = Qd.

 

 

 

 

 

 

This graph now shows that at new higher price P1, there is an excess supply of Q1 to Q2.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

The role of the price mechanism

 

The price mechanism moves the market into equilibrium, so that the scarce resources are reallocated.

 

Opportunity cost: is the next best alternative forgone. When a choice is made, there is an opportunity cost.

 

Rationing function: Prices serve to ration scarce resources when demand in a market outstrips supply.

 

Signalling function: prices rise and fall to reflect surpluses and scarcities, which shows where resources are required.

 

If prices of bikes are rising because of high demand from consumers, this is a signal to suppliers to expand production to meet the higher demand.

 

If there is excess supply in the market the price mechanism will help to eliminate a surplus of a good by allowing the market price to fall.

 

An increase in market supply causes a fall in the relative prices of laptops and prompts an expansion along the market demand curve.

 

When there is a shortage, the price is bid up – leaving only those with the willingness and ability to pay to purchase the product. The market price acts a rationing device to equate demand with supply.

 

Transmission of preferences: through their choices consumers send information to producers about the changing nature of needs and wants.

 

Higher prices act as an incentive to raise output because the supplier stands to make a better profit.

 

When demand is weaker in a recession then supply contracts as producers cut back on output.

 

Market efficiency

 

Consumer surplus: the extra satisfaction a consumer gains from paying a price less than they were prepared to pay.

 

Producer surplus: the excess of actual earnings that a producer makes from a given quantity of output, over and above the amount the producer would be prepared to accept for that output.

 

When a market is allocatively efficient, the social (community) surplus is maximised, this is made up of the consumer and producer surplus. This means that the marginal social benefit = the marginal social cost.

 

Allocative efficiency happens when competitive market is in equilibrium, where resources are allocated in the most efficient way from society’s point of view.