HOW MARKETS WORK Why are airfares more expensive during the summer? Why are tickets to a National Basketball Association (NBA) playoff game more expensive than a regular season game? Why are gas prices higher when there is instability in the Middle East? The answer to these questions can be found through supply and demand analysis. Supply and demand are the forces that make market economies work. They determine the quantity of each good produced and the price at which it is sold. This chapter will introduce the theory of supply and demand, as well as the concept of elasticity, a measure of how much buyers and sellers respond to changes in market conditions. A market is a group of buyers and sellers of a particular good or service. With this definition in mind, let’s begin our study of markets by analyzing the behavior of both buyers and sellers. DEMAND (Principles of Economics 5th ed. pages 67–73/6th ed. pages 67–73) Buyers demand the goods and services produced and sold by sellers in various markets. What determines buyer demand? This section will provide you with the answer to this question. Let’s start with an example using the ice cream market. When the price of ice cream is high, the quantity of ice cream people are willing to buy is smaller. Conversely, when the price of ice cream is low, the quantity of ice cream people are willing to buy is greater. The economic concept here that captures this behavioral dynamic is the law of demand, which states that other things equal, the quantity demanded of a good falls when the price of the good rises. The quantity demanded is the amount of a good that buyers are willing and able to purchase. Suppose that ice cream cones cost $3.00. At that price, I am unwilling to buy an ice cream cone, but at the price of $2.50, I am willing to buy 2 ice cream cones, which means that the quantity demanded increases from 1 to 2 when the price of ice cream decreases from $3.00 to $2.50. The figure below shows my demand schedule for 79 80N❖NChapter 2 ice cream, a table that shows the relationship between the price of a good and the quantity demanded, for ice cream cones. Based on the above ice cream demand schedule, we can plot the market demand curve, a graph of the relationships between the price of a good and the quantity demanded, as in this figure below. The demand curve for ice cream slopes downward since a lower price increases both consumers’ willingness and ability to buy an ice cream cone. The demand curve in the figure above only represents my demand for ice cream. Since our goal is to analyze how markets work, we need to look at the market demand for ice cream, which is the sum of the demand curves of everyone who is willing and able to buy an ice cream cone. The market demand curve for ice cream follows the law of demand and, therefore, is also a downward sloping curve, as in this graph below. How Markets Work ❖N81 There are many variables that can shift the demand curve. Here are the most common variables that can shift the demand curve: INCOME–Holding other things constant, if your income increases, you will have more to spend. Assuming that ice cream is a normal good, a good for which, other things equal, an increase in income leads to an increase in demand, an increase in income will lead to an increase in the demand for ice cream. If ice cream is instead an inferior good, a good for which, other things equal, an increase in income leads to a decrease in demand, an increase in income will lead to a decrease in the demand for ice cream. PRICE OF RELATED GOODS–The price of goods related to ice cream may affect our decision to buy ice cream. For example, suppose the price of frozen yogurt falls. You will likely buy frozen yogurt instead of ice cream since frozen yogurt and ice cream are substitutes, two goods for which an increase in the price of one leads to an increase in the demand for the other. Alternatively, suppose that the price of ice cream cones fall. You will likely buy more ice cream because ice cream and ice cream cones are often consumed together and are therefore complements, two goods for which an increase in the price of one leads to a decrease in demand for the other. TASTES–Obviously, if you like ice cream, you will likely buy ice cream and vice versa. Market demand can change when tastes change. Applying this to our example, when more people decide that they now like ice cream, the demand for ice cream will increase. EXPECTATIONS–If you expect a pay raise, then you may be more likely to buy ice cream. Alternatively, if you expect the price of a good to change in the future, you may buy more or less of a good depending on the direction of the price change. For example, if you expect the price of ice cream to fall during the winter, you may choose to wait and buy your ice cream in the winter. 82N❖NChapter 2 NUMBER OF BUYERS–If the number of ice cream buyers increase, the demand for ice cream also increases. Similarly, if the number of ice cream buyers decline, the demand for ice cream also declines. The baby-boomer generation is an interesting example of this—as baby boomers have aged through time, the demand for the goods that they buy increases. AP Tip A helpful pneumonic to remember these demand determinants is S-E-P-T-I-C: Substitutes, Expectations, Population, Tastes, Income, Complements. Any change in market demand due to changes in any of the above mentioned variables leads to a shift in the demand curve. Refer to the following demand curves below for a better understanding of how to show a demand shift. Note that, when the price of ice cream changes, the demand curve does not shift. When the price of ice cream changes, there is a movement along the existing demand curve, meaning that there is a change in the quantity demanded (represented by a movement along the curve), not a change in demand (represented by a shift of the curve). The table below provides a good summary of the effects of the variables that influence buyers and market demand. How Markets Work ❖N83 AP Tip The AP will test whether you know the difference between a change in the quantity demanded versus a change in demand. A change in the quantity demanded is represented by a movement along the demand curve whereas a change in demand is represented by a shift of the demand curve. The graphs here illustrate this difference graphically. SUPPLY (Principles of Economics 5th ed. pages 73–76/6th ed. pages 73–76) We now look at the behavior of sellers in the market for ice cream. When the price of ice cream is high, producers are willing to sell more ice cream because the revenue potential is higher. Conversely, when the price of ice cream is low, ice cream producers are willing to sell less ice cream. This tells us that, as prices rise, the quantity supplied of ice cream will increase. The economic concept here that captures this behavioral dynamic is the law of supply, which states that other things equal, the quantity supplied of a good rises when the price of the good rises. The quantity supplied is the amount of a good that sellers are willing and able to sell. The law of supply is true because suppliers face increasing opportunity costs, just as in the PPF model discussed in Chapter 1. The following table and graph show the supply schedule and supply curve. 84N❖NChapter 2 As in our demand analysis, the market supply curve consists of the sum of all individual supply curves of everyone who is willing and able to sell ice cream cones. Contrary to the demand curve, however, the market supply curve is upward sloping. The suppliers who were willing to sell at $1 are also happy to take $2 and may even provide additional units, which is one of the reasons why the quantity supplied increases as the market price increases. The following graph shows the market supply curve. There are many variables that can shift the market supply curve. Here are the most common variables that can affect supply: INPUT PRICES–Sellers use factors of production, or inputs, to produce goods and services. To produce ice cream, sellers may use inputs such as sugar, cream, machines, and workers. If the price of any of these inputs rises, it becomes less profitable for a seller to produce ice cream. TECHNOLOGY–The use of technology in the production process may help to increase the overall productivity of the supplier. In our example, if the ice cream producing firm uses machinery to make ice cream, ice cream producing firms can produce and supply more ice cream to the market. EXPECTATIONS–The amount of ice cream supplied today may depend on suppliers’ expectations about the future. For example, if there is an expectation that ice cream prices will increase, ice cream producers may choose to put ice cream into storage to sell at a later date. NUMBER OF SELLERS–Market supply depends on the number of sellers. If the number of ice cream sellers increase, the supply of ice cream also increases.