Unit 1 Competitive Market Equilibrium
Demand
Demand Definition
Demand refers to the willingness and ability of consumers to purchase goods and services at different prices in a given market during a specific time period.
The Law of Demand
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Negative Causal Relationship: As the price of a good increases, the quantity demanded decreases, and vice versa, ceteris paribus (all other factors being constant).
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Individual vs. Market Demand: The market demand is the sum of all individual demands for a particular good or service.
The Demand Curve
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Explanation: A demand curve represents the relationship between the price of a product and the quantity demanded, holding other factors constant.
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Diagram: Draw a downward-sloping curve from left to right, indicating that lower prices lead to higher quantities demanded.
Movements Along the Demand Curve
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Movements Along: Caused by a change in the price of the good itself.
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Increase in price (P1 to P2) causes a decrease in demand (Q1 to Q2), movement from point A to C.
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Decrease in price (P1 to P3) causes a decrease in demand (Q1 to Q3), movement from point A to B.
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Demand Curve: Plot the quantity demanded on the x-axis and price on the y-axis.
The Non-Price Determinants of Demand
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Preferences: Changes in consumer tastes and preferences can increase or decrease demand.
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Prices of Related Goods:
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Substitutes: An increase in the price of one leads to an increase in demand for the other.
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Complements: An increase in the price of one leads to a decrease in demand for the other.
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Demographic Changes: Changes in population size and composition affect demand.
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Income Changes:
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Normal Goods: Demand increases as income rises.
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Inferior Goods: Demand decreases as income rises.
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- Advertising: Brands can influence demand through marketing strategies.
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Taxes: Taxes on income will increase the cost of purchasing goods, which can decrease demand.
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Preferences and Tastes: Changes in consumer preferences can increase or decrease demand. Example: A shift towards healthier eating habits can increase demand for organic food.
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Expectations of Future Prices: If consumers expect prices to rise in the future, they are likely to buy more now, increasing current demand. Example: Anticipated increases in housing prices can lead to more purchases now.
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Consumer Confidence: If consumers are optimistic about the economy, they are more likely to spend, increasing demand. Example: High consumer confidence can lead to increased demand for luxury items.
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Substitutes: An increase in the price of a substitute good can increase demand for the original good. Example: If the price of Pepsi increases, the demand for Coca-Cola may increase.
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Complementary Goods: An increase in the price of a complementary good can decrease demand for the original good. Example: If the price of printers increases, the demand for printer ink may decrease
DIATPECS: Demographics, Income, Advertising, Taxes, Preferences, Expectations of future prices, Complementary goods prices, Substitute goods prices.
Shifts along the Demand Curve
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Shifts: Caused by changes in non-price determinants (DIATPECS).
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Show shifts to the right (increase in demand) or left (decrease in demand).
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Shifts: Illustrate how changes in determinants (e.g., increase in income, introduction of a new substitute) shift the demand curve left (decrease) or right (increase).
Linear Demand Functions (HL ONLY)
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Demand Function: Qd = a - bP
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Plotting the Curve: Use the equation to plot points and draw the demand curve.
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Slope Identification: The slope is -b, the coefficient of P.
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Shifts of the Demand Curve: Changes in the "a" term shift the curve.
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Steepness Changes: Changes in "b" affect the steepness of the curve (elasticity, to be discussed in later chapter).
The concept of "demand" was first analyzed by economist Alfred Marshall in the publication "Principles of Economics" (1890).
Fun Fact
Demand refers to consumers' willingness and ability to purchase goods at various prices, with quantity demanded inversely related to price.
Key Concept
Supply
Definition
Supply refers to the willingness and ability of producers to offer goods and services for sale at various prices in a market during a specific time period.
The Law of Supply
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Positive Causal Relationship: As the price of a good increases, the quantity supplied increases, and vice versa, ceteris paribus. This positive relationship between price and quantity supplied is due to the potential for higher profits at higher prices.
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Individual vs. Market Supply: The market supply is the sum of all individual supplies for a particular good or service.
The Supply Curve
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Explanation: A supply curve represents the relationship between the price of a product and the quantity supplied, holding other factors constant.
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Diagram: Draw an upward-sloping curve from left to right, indicating that higher prices lead to higher quantities supplied.
Movement Along the Supply Curve
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Movements Along: Caused by a change in price, will affect quantity of the good supplied.
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Suppliers will want to supply more product if the price is higher, because they will earn/profit more.
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Increase in price (P1 to P2) causes a decrease in demand (Q1 to Q2), movement from point A to C.
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Decrease in price (P1 to P3) causes a decrease in demand (Q1 to Q3), movement from point A to B.
The Non-Price Determinants of Supply
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Subsidies: Financial assistance provided by the government to reduce costs and encourage production.
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Expected future prices: Anticipated changes in prices that can influence current supply decisions by producers.
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Cost of essential inputs: The prices of key materials and resources needed for production, affecting the overall supply.
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Production shocks (a.k.a. supply shocks): Unexpected events that disrupt production, such as natural disasters or strikes, impacting supply levels.
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Type of competition (perfect, imperfect, monopolistic, oligopoly): The market structure and level of competition which influence how supply is managed and priced.
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Advancements in technology: Innovations and improvements in technology that enhance production efficiency and increase supply.
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Legal and tax changes: Modifications in laws and taxation policies that affect production costs and supply strategies.
SCEPTAL: Subsidies, Cost of essential inputs, Expected future prices, Production shocks (a.k.a supply shocks), Type of competition (perfect, imperfect, monopolistic, oligopoly), Advancements in technology, Legal and tax changes
Shifts of the Supply Curve
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Shifts: Caused by changes in non-price determinants (costs of production, technology, taxes/subsidies, etc.).
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Show shifts to the right (increase in supply) or left (decrease in supply).
Linear Supply Functions (HL ONLY)
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Supply Function: Qs = c + dP
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Plotting the Curve: Use the equation to plot points and draw the supply curve.
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Slope Identification: The slope is d, the coefficient of P.
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Shifts of the Supply Curve: Changes in the "c" term shift the curve.
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Steepness Changes: Changes in "d" affect the steepness of the curve.
The first recorded use of the supply curve in economic analysis was in the late 19th century, and it has since become a fundamental tool in economic theory.
Fun Fact
Supply refers to producers' willingness and ability to offer goods for sale at various prices, with quantity supplied directly related to price.
Key Concept
Competitive market equilibrium occurs where the quantity demanded equals the quantity supplied, ensuring no surplus or shortage and maximizing total surplus.
Key Concept
Competitive Market Equilibrium
Definition
A competitive market equilibrium occurs where the quantity demanded by consumers equals the quantity supplied by producers, resulting in no tendency for the market price to change. This is the point of market efficiency, where social benefits (MSB) equal social costs (MSC).
Key Concepts in Market Equilibrium
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Market Efficiency:
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Marginal Social Benefit (MSB): The additional benefit to society from consuming one more unit of a good.
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Marginal Social Cost (MSC): The additional cost to society from producing one more unit of a good.
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At equilibrium, MSB equals MSC, indicating allocative efficiency where resources are optimally distributed.
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Equilibrium and Changes to Equilibrium
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Market Equilibrium: The point where quantity demanded equals quantity supplied.
Consumer Surplus (CS)
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Definition: The difference between what consumers are willing to pay for a good and what they actually pay at the equilibrium price.
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Explanation: Consumer surplus represents the benefit to consumers who would have been willing to pay more than the equilibrium price but are able to purchase the good at the lower equilibrium price.
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Example: If consumers are willing to pay up to $10 for a coffee but the equilibrium price is $6, the consumer surplus is $4 per coffee.
Producer Surplus (PS)
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Definition: The difference between what producers are willing to accept for a good and what they actually receive at the equilibrium price.
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Explanation: Producer surplus represents the benefit to producers who would have been willing to sell at lower prices but are able to sell at the higher equilibrium price.
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Example: If producers are willing to accept $4 for a coffee but the equilibrium price is $6, the producer surplus is $2 per coffee.
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In IB examinations, they may ask you to calculate the consumer/producer surplus. Simply use basic area of a triangle formula.
Combined Surplus and Market Efficiency
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Total Surplus: The sum of consumer surplus (CS) and producer surplus (PS). This is maximized at the competitive market equilibrium, indicating the highest level of social welfare.
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Efficiency: At equilibrium, resources are allocated in the most efficient manner, maximizing total surplus. Any deviation from this equilibrium would result in a loss of total surplus, known as deadweight loss.
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Market Definition: A market is a place or situation where buyers and sellers interact to exchange goods and services for money.
Equilibrium and Changes to Equilibrium
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Diagrams: Show how demand and supply interact to produce equilibrium.
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Excess Demand and Supply: Diagrams showing how changes in determinants of demand and supply create new equilibrium points.
Calculating and Illustrating Equilibrium Using Linear Equations (HL ONLY)
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Calculating Equilibrium: Set Qd = Qs to find equilibrium price and quantity.
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Plotting Curves: Use linear equations to plot demand and supply curves and identify equilibrium.
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Excess Demand/Supply: State the quantity of excess demand or supply in diagrams.
Resource Allocation
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Scarcity and Choice: Scarcity necessitates choices about what to produce, leading to opportunity costs.
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Price as a Signal and Incentive: Price changes signal where resources are needed and incentivize reallocation of resources.
Allocative Efficiency
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Definition: The best allocation of resources from society's point of view is at competitive market equilibrium, where total surplus (consumer surplus + producer surplus) is maximized.
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Diagram Explanation: Show how marginal benefit equals marginal cost at equilibrium.
The Engel curve is named after Ernst Engel, a 19th-century German statistician who observed that as household income rises, the proportion of income spent on food falls, even if actual expenditure on food rises.
Fun Fact
Engel Curve
The Engel curve illustrates the relationship between a consumer's income and the quantity of a good demanded:
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Low Income: Consumers may not afford to buy many goods.
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Example: At low income levels, demand for McDonald's burgers is low because they can't afford many.
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Middle Income: As income rises, consumers can afford more goods.
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Example: At middle income levels, demand for McDonald's burgers increases as they become affordable.
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High Income: With further income increases, consumers may shift to higher-quality alternatives, and the good becomes an inferior good.
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Example: At high income levels, demand for McDonald's burgers may decrease as consumers prefer higher-quality dining options.
DEED Framework
Use the DEED framework for structured economic analysis.
Definition: Clearly define economic terms and concepts.
Explain: Explain how the concept operates or the factors involved.
Example/Evaluate: Provide real-world examples or evaluate the impact of the concept.
Diagram: Include diagrams to illustrate concepts visually.
DERDER Framework
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Definition: Start by clearly defining the key terms or concepts in the question.
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Explain: Provide a detailed explanation of how concepts operate, and the factors involved.
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Real world example: refer to a real micro or macroeconomics case, to answer the question.
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Diagram: Diagram the real world example, and explain it further.
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Evaluate: Highlight at least 3 advantages and disadvantages with a certain policy. Assess the overall situation, weighing the pros and cons, and provide a balanced analysis.
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Recommend: Conclude with a recommendation based on the evaluation and examples provided. What policy is best?
Use the DEED framework when answering data response questions. Use DERDER for extended response questions.
Exam Tip
Unit 1 Practice Questions
Section A: Short-Answer Questions
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Define demand and explain the law of demand.
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Describe three factors that can cause a shift in the demand curve for a product. Provide an example for each.
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Explain how a change in consumer income affects the demand for normal and inferior goods. Include examples in your explanation.
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Define supply and explain the law of supply.
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Illustrate with a diagram how an increase in the cost of production affects the supply curve of a product.
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Describe the effect of an indirect tax on the supply curve of a product. Include a diagram in your explanation.
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Explain the concept of market equilibrium using a supply and demand diagram.
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Define consumer surplus and explain how it is represented on a demand and supply diagram.
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Define producer surplus and explain how it is represented on a demand and supply diagram.
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Explain how the expectations of future prices can affect the current supply of a good.
Section B: Data Response Questions
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Consider a market for electric cars. Explain how an increase in government subsidies for electric car production would affect the supply curve. Illustrate your answer with a diagram.
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Analyze the impact of a technological innovation in the production process on the supply curve of smartphones. Include a diagram in your explanation.
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Suppose the government imposes a tax on sugary drinks. Illustrate and explain the effect of this tax on the market equilibrium for sugary drinks.
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Using the concept of the Engel curve, explain how the demand for fast food might change as consumer income increases from low to high.
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Consider a market where the price of a substitute good has increased. Explain how this affects the demand curve for the original good, using a diagram.
Section C: Extended Response Questions
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Evaluate the impact of an increase in consumer confidence on the market for luxury goods. Include diagrams and real-world examples in your answer.
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Discuss how a natural disaster, such as a hurricane, might affect the supply and market equilibrium of agricultural products in the affected region. Use diagrams to support your explanation.
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Analyze the effects of a government-imposed price floor on a product such as wheat. Include diagrams and discuss the potential consequences for both consumers and producers.
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Evaluate the impact of an increase in the price of oil on the supply of goods that rely heavily on oil for their production. Use diagrams and real-world examples to support your answer.
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Discuss how the introduction of a new competitor in the market for a popular consumer electronic product, such as smartphones, might affect market equilibrium. Include diagrams and real-world examples in your explanation.