2. Demand and Supply in a Market Economy
• Demand: The willingness and ability of buyers to
purchase a product (a good or a service).
• Demand curve: How much product will be demanded (bought)
at different prices.
• Supply: The willingness and ability of producers to
offer a good or service for sale.
• Supply curve: How much product will be supplied (offered
for sale) at different prices.
• Market price (equilibrium price): The price at which the
quantity of goods demanded and the quantity of goods
supplied are equal.
The demand and supply schedule explains the relationships among different levels of demand and supply at different price levels. These relationships are obtained from marketing research, historical data and other market studies.
We briefly mentioned earlier that demand and supply intersect in the market.
The demand curve shows graphically how much product will be demanded or purchased at different price levels.
The supply curve depicts how much of the product will be supplied, or offered for sale, at different price levels.
The market price or equilibrium price is the price at which the quantity of good demanded equals the quantity of good supplied. Graphically, we will see how the market price is shown at the intersection of the demand and supply curves.
Let’s see how this looks.
Here we can look at the demand curve for pizza.
When the price of pizza is high, fewer people are willing to pay for it. But as the price decreases, more people are willing to buy pizza. Or, in other words, more people “demand” the pizza at a lower price.
This is the demand curve for pizza.
Teaching Tips:
What price would you be willing to pay for the best piece of pizza you have ever eaten?
Listen to the student answers and point out on the graph where their demand fits.
In the first graph on the left you can see that when the price of pizza is low, more people are willing to buy it. But pizza makers don’t have the money to invest in making pizza, so they make fewer pizzas. When this happens, the supply of pizza is limited and the price of pizza will rise. Only when the price of pizza rises will the pizza makers be willing and able to increase the supply. This is the supply curve for pizza.
The second graph shows the equilibrium price of market price for pizza. The supply curve, or blue line, rises as the price of the pizza rises. The demand curve, or red line, falls as the price of pizza falls. At the point where the two lines cross—at approximately $10 and at a quantity of 1,000 pizzas, the supply and demand curves cross. This is the point at which the price that suppliers can charge is equal to the price that a maximum number of customers are willing to pay. This is the profit maximizing quantity for the pizza makers and it is also the equilibrium price, where demand for pizza and the supply of pizza meet.
Teaching Tips:
Look at the second graph. What is the market price for pizza?
$10
Let’s explore supply and demand, which are key to the economics of market systems. Demand can be defined as the willingness and ability of buyers to purchase a good or service. For example, the demand for oil has increased over the past 25 years.
Supply can be defined as the willingness and ability of producers to offer a good or service for sale. Think about the market for gasoline in the United States and China. The U.S. has moved away from its production of domestic oil, so the supply has decreased. The U.S. has had to rely more on foreign oil, and foreign oil producers can offer oil or gas at whatever price they believe the market will bear.
The laws of supply and demand are at play in the market system. Producers will offer, or supply, more of a product for sale as its price increases. They will offer less of the product as its price drops. Buyers will purchase or demand more of a product as its price drops. They will demand less of the product as its price increases. Therefore, demand and supply are interconnected, as we will see from the demand and supply curves.
Teaching Tips:
Please form teams of two students. Each team will write down three examples of a product or service that is in high demand by consumers today. Your team will also write down what would happen if the price 1) increases for that product and 2) decreases for the same product or service. Each team will then share their favorite example with the class.
Answers will vary based on the good or service chosen. Apply the definitions as each team reports to the class on their examples.
When we examine supply and demand we also need to consider surplus and shortage.
A surplus exists when the quantity supplied of a product is greater than the quantity demanded by consumers. This situation can cause losses because the business may have to sell its inventory at a lower price than the cost of manufacturing the product.
A shortage exists when the quantity demanded of a product is greater than the quantity supplied by the manufacturer. This situation also causes losses because the opportunity existed for additional sales if production could have been increased. This situation also invited increased competition, since the current manufacturer cannot produce what the consumers have demanded. This leaves a gap in the market that can be filled by a competitor.
Teaching Tips:
Think back to our pizza example. What happens when our pizza maker at a restaurant five miles down the road makes too many pizzas on a snowy Friday night?
He has to throw them away because not enough people come in to eat them. He loses money.
What if our pizza maker only provides pizza by delivery on a snowy Friday night and he makes the normal number of pizzas?
He doesn’t have enough because everyone wants to stay in and have pizza delivered. When the pizza doesn’t arrive within an hour, customers will call the pizza place across the street, which made enough pizzas after listening to the weather forecast!
Now we will look more at perfect competition. In perfect competition, prices are determined only by supply and demand, because no one company is powerful enough to influence the price of its product. In perfect competition all organizations in the industry are small and the number of firms in the industry is large.
The principles of perfect competition include the following:
Buyers or consumers see all products offered as identical. There are no differences perceived between your new healthy fruit juice and tea drink and your competitors’ similar product.
Buyers and sellers know the prices that consumers and suppliers are paying and receiving in the marketplace. For example, in many developing nations all the banana sellers will set up stands in the same area of the road. They all charge the same price and get their bananas from the same source. They all pay the same amount for their bananas.
It is easy for firms or banana stands to enter or leave the market. The banana seller can come with his or her supply of bananas, set up a stand in minutes, or take it down and leave and not come back.
Prices are set exclusively by supply and demand, and these prices are accepted by both sellers and buyers. In our banana stand example, this means that all the sellers on a particular stretch of highway know the price the buyer is willing to pay, and both they and the consumer accepts the price.
Teaching Tips:
Would a series of children’s lemonade stands be an example of perfect competition? Why or why not?
Let’s look at the principles of perfect competition. Buyers certainly view all the products as identical. However the children may not, thinking they have a better flavor of lemonade, don’t use sugar, etc. The second principle holds true, since every child on the block can see what the prices are for all the lemonade stands and the buyers know the same as well. The third principle holds true, since the child can easily take down or put up his or her lemonade stand. In looking at the fourth principle, it also holds true, since people are only going to pay what is charged and the children all set the price similarly, but one could argue that the children could set different prices.
Now let’s examine monopolistic competition. Within monopolistic competition there are also four principles we need to review:
There are numerous sellers trying to differentiate their products from those of competitors so as to have some control over the price.
There are many sellers, though fewer than in pure competition.
Sellers can enter or leave the market easily.
The large number of buyers in relation to the number of sellers applies potential upper limits to prices.
So, if we look at our lemonade stand idea from earlier, this model may apply more specifically to these young sales people and their stands. Why is this the case? Because as we discussed, each child may try to offer a different flavor of lemonade or offer it with or without sugar. This is an application of the first principle of monopolistic competition. There are still lots of lemonade stands on our street, but far fewer than the banana stands in Latin America. This is an example of the second principle. The sellers can still leave or enter the market easily, as we discussed. However, when we look at the fourth principle, we may have more neighbors or commuters who want to buy the lemonade and fewer stands, so the price may be higher.
Teaching Tips:
Please join with another class member. In your team, please come up with two examples of monopolistic competition and explain how the four principles apply.
Answers will vary. In order to determine if the idea of each student team is monopolistic competition, assist them by reviewing each of the four principles and ask them to explain if the principle can clearly be applied or not.
Now we are going to examine another form of competition called oligopoly. There are five key principles that apply to an oligopoly:
An oligopoly operates in an industry with only a few large sellers or suppliers. For example, let’s discuss the gasoline market in the United States. Certainly there are maybe five to ten key providers of gasoline, with many different gas stations supplying the same or competing brands.
Entry by new competitors, or new gasoline companies, is hard because a large investment of capital is needed to open a new gas company or even build a new gas station.
The actions of one gasoline company can significantly affect the sales of every other firm in the industry. Certainly, when one gasoline company lowers or raises its prices, all the others respond accordingly.
The prices of comparable products, such as regular or super gasoline, etc., are usually similar.
As the trend toward globalization continues, most experts believe that oligopolies will become increasingly prevalent.
Teaching Tips:
Let’s examine this last principle in more detail. Please write down one industry in which oligopolies will become increasingly prevalent and explain the reason to your student partner. Then let’s share some of our thoughts with the class.
The answers will vary. However, as in the last slide, have the students refer to the five principles when reviewing their examples. Some examples could include the cellular phone industry, the provision of broadband internet services and “hypermarkets.”
The concept of a true monopoly applies when an industry or market has only one producer or is dominated by one producer so completely that other firms cannot compete with it. This sole supplier enjoys complete control over the prices of its products and the only real constraint it faces is a decrease in consumer demand due to increased prices.
There are also natural monopolies. These monopolies occur in industries in which one firm can most efficiently supply all the needed goods and services. These types of monopolies are typically allowed and regulated by government agencies or legislated acts. An example of this type of monopoly is the local electric company. Rate increases have to be voted on by state boards or governments.
Teaching Tips:
Please take a minute now to talk to your student partner and think of another example of a monopoly. Then let’s share these with the class.
Answers could include cable TV, internet service, natural gas and others. Again, have each student team defend their choice by applying the key principles of a monopoly.
Let’s discuss two important economic indicators:
The first is the Gross Domestic Product, or GDP, as it is most frequently referred to. The GDP is an aggregate output measure of the total value of all goods and services produced within a given time period by a national economy through its domestic factors of production. What does this mean? In general, the news media will monitor the growth of or decline in the GDP against the previous year. If the GDP is going up, the output of the entire domestic economy is going up. If the GDP is going up it means the nation is experiencing economic growth. If the GDP shows a decline, as it did in the last part of 2008, it means the economy is declining.
The second economic indicator is the Gross National Product, or the GNP, as it is usually called. The GNP reflects the total value of all goods and services produced by a national economy within a given period of time, regardless of where the factors of production are located.
Teaching Tips:
What is the difference between the GDP and the GNP?
The GDP measures growth based on the total value of all goods and services produced through domestic factors of production.
The GNP measures this same growth but includes the total value of all goods and services produced regardless of where the factors of production are located.
The difference is in the location of the factors of production.
There are two more key terms regarding economic growth that we will discuss.
The first is stability. Stability is a condition in which the amount of money available in an economic system and the quantity of goods and services produced in the same system are growing at about the same rate.
The second is inflation. Inflation occurs when the amount of money injected into an economy exceeds the increase in actual output or production of goods and services. This results in price increases that exceed increases in purchasing power. We measure inflation with the Inflation Rate. The Inflation Rate is the percentage change in a price index such as the Consumer Price Index.
Teaching Tips:
What is the difference between stability and inflation in terms of economic growth?
In stability, money available in the economy and production of goods and services grow at the same rate.
With inflation, more money is injected into the economy by the government than the actual increase in output of goods and services. This results in price increases that exceed purchasing power increases.
As we discussed a few minutes ago, the Consumer Price Index is another important economic indicator. It is a measure of the prices of typical products purchased by consumers living in urban areas.
The current index is compared against a base period, which is an arbitrarily selected time period against which other time periods are compared.
Teaching Tips:
What are some typical products that might be included in the Consumer Price Index?
According to the U.S. Department of Labor statistics, typical products could include food and beverages, housing, apparel, transportation, medical care, recreation and other personal services such as cigarettes and even funeral services.
Is the Consumer Price Index a good measure of inflation?
Again, according to the U.S. Bureau of Labor statistics, the CPI measures the rate of inflation in the day-to-day lives of consumers.
Unemployment, another factor in economic growth, is the level of joblessness among people actively seeking work in an economic system. For example, at the end of 2008 there were many people who became unemployed through forced layoffs by major auto makers and other industries due to the economic slow down.
Low unemployment occurs when there is a shortage of labor for businesses to hire. This results in higher wages. Higher wages reduce hiring, which increases unemployment. This in turn results in lower wages.
During the last quarter of 2008, Cyclical Unemployment occurred. Cyclical Unemployment occurs when businesses continue to eliminate jobs during a business cycle downturn. This causes a further reduction in revenues and further job losses.
Teaching Tips:
Why does an economic downturn result in unemployment, based on the information we’ve discussed in this chapter?
When economic growth slows, consumers no longer have confidence and begin to slow their purchases of goods and services. They may put off making a purchase such as a home or a car if the economy slows. This in turn reduces the need for the amount of goods and services produced, and fewer people are needed to produce the goods and services that are demanded by the consumers. Unemployment and layoffs result.
Finally, we need to discuss negative economic growth, first by discussing Recession. A Recession is a period during which the aggregate output, as measured by real GDP, declines. Many times, we will see that Monetary Policy is used to try to hold off a recession in the U.S. economy.
A Depression is a prolonged and deep recession. In the United States there was a Great Depression after the stock market crash of 1929. This Depression was turned around after Franklin D. Roosevelt was elected President. He implemented his New Deal program, which created public works programs.
Teaching Tips:
In your opinion, what is the state of the U.S. economy at the present moment?
Answers will vary based on the month and year this chapter is taught. You may want to reflect back to the market crash of fall 2008, the bank bailouts, the increase of FDIC insurance for bank accounts to $250,000, and any other changes that take place after the publishing of this book.
