SUPPLY AND DEMAND: A MODEL OF A COMPETITIVE MARKET

Market = a group of producers and consumers who exchange a good or service for payment.
Competitive market is a market in which there are many buyers and sellers of the same good or
service. More precisely, the key feature of a competitive market is that no individual’s actions have a
noticeable effect on the price.
The demand curve
A demand schedule is a table showing how much of a good or service, its graphical representation is
the demand curve, this reflects the inverse relationship between price and the quantity demanded.
The law of demand says that a higher price for a good or service, other things equal, leads people to
demand a smaller quantity of that good or service.

It’s crucial to make the distinction between such shifts of the demand curve and movements along the
demand curve, changes in the quantity demanded of a good arising from a change in that good’s price
(a movement from a point A to a point B).
When economists talk about an increase in demand, they mean a rightward shift of the demand curve.
When they talk about a decrease in demand, they mean a leftward. There are five principal factors that
shift the demand curve (when we say “other things equal we mean that they don’t change):
Factors affecting shifts in demand:
Prices of related goods:
 Substitutes: Goods replacing each other (e.g., tea and coffee).
 Complements: Goods consumed together (e.g., milk and cereal).
Income:
 Normal Goods: Demand increases with income.
 Inferior Goods: Demand decreases with income.
Tastes, Population, Advertising, Expectations: Each can shift the demand curve right (increase) or
left (decrease).
The supply curve
The quantity supplied is the actual amount of a good or service people are willing to sell at some
specific price. A supply schedule shows how much of a good or service would be supplied at different
prices and a supply curve is its representation.
A shift of the supply curve is a
change in the quantity supplied of
a good or service at any given
price. It is represented by the
change of the original supply curve
to a new position, denoted by a
new supply curve.

There are two basic ways in which

supply curves can shift. When economists talk about an “increase in supply,” they mean a rightward
shift, when about a “decrease in supply,” they mean a leftward shift.
Shifts in the supply curve are influenced by several factors:
1. Input Prices: Higher costs reduce supply; lower costs increase it.
2. Technology: Innovations make production more efficient, increasing supply.
3. Profitability of Other Goods: Resources shift to more profitable goods, reducing supply for
less profitable ones.
4. Joint Supply: Changes in related goods’ prices affect supply.
5. Natural/Social Factors: Weather, disasters, or social trends impact supply positively or
negatively.
6. Producer Expectations: Anticipated price changes affect current supply levels.
7. Number of Sellers: More sellers increase supply; fewer sellers decrease it.
8. Government Policies: Taxes reduce supply, while subsidies increase it.
9. Regulations: Stricter rules decrease supply; relaxed regulations increase it.
10. Related Costs: Higher costs like transportation reduce supply, while lower costs increase it.
The market equilibrium, which includes the equilibrium price and equilibrium quantity
The general principle is that markets move toward equilibrium, a situation in which no individual
would be better off taking a different action.
A competitive market is in equilibrium when
price has moved to a level at which the quantity
of a good or service demanded equals the
quantity of that good or service supplied. This is
what we call the market price.
There is a surplus of a good or service when the
quantity supplied exceeds the quantity demanded.
There is a shortage of a good or service when the quantity demanded exceeds the quantity supplied.
What Happens When the Demand Curve Shifts?
An increase in demand is indicated by a
rightward shift from D1 to D2. At the original
market price P1, this market is no longer in
equilibrium: a shortage occurs because the
quantity demanded exceeds the quantity
supplied. A new equilibrium is established at
point E2, with a higher equilibrium price, P2,
and higher equilibrium quantity, Q2. When
demand for a good or service increases, the
equilibrium price and the equilibrium
quantity of the good or service both rise.
What Happens When the Supply Curve
Shifts?
Supply increases and S1 shifts rightward to
S2. At the original price P1, a surplus of
natural there is no longer the equilibrium.
The surplus causes a fall in price and an
increase in the quantity demanded. The new
equilibrium is at E2, with an equilibrium
price P2 and an equilibrium quantity Q2.
When supply of a good or service increases,
the equilibrium price of the good or service
falls and the equilibrium quantity of the
good or service rises.
Sometimes, it can happen that the two curves
shift both.

ELASTICITY AND ITS APPLICATIONS

Elasticity measures the percentage change in one variable in response to a percentage change in
another variable.
Price Elasticity of Demand
Definition: The price elasticity of demand measures the responsiveness of quantity demanded to a
change in price.
 Elastic Demand: Quantity demanded changes significantly when price changes.
 Inelastic Demand: Quantity demanded changes only slightly with price changes.
 Unit Elastic Demand: Percentage change in quantity demanded equals the percentage change
in price.
Determinants of Price Elasticity of Demand
1. Availability of Close Substitutes: Goods with more substitutes are more elastic (e.g., butter
vs. margarine).
2. Necessities vs. Luxuries: Necessities (e.g., food) are less elastic, while luxuries (e.g., designer
bags) are more elastic.
3. Market Definition: Narrowly defined markets (e.g., vanilla ice cream) are more elastic than
broadly defined ones (e.g., ice cream or food).
4. Proportion of Income: Goods taking a larger share of income (e.g., cars) have higher elasticity
than small expenditures (e.g., chewing gum).
5. Time Horizon: Demand becomes more elastic over time as consumers adjust behaviour.
Measuring Price Elasticity of Demand

Midpoint Method: Used to calculate elasticity between two points, avoiding direction-based
inconsistencies.
The total amount paid by buyers, and received as
expenditure by sellers, equals the area of the box under
the demand curve, P × Q.

 When demand is inelastic (a price elasticity less

than 1), price and total expenditure move in the
same direction.
 When demand is elastic (a price elasticity greater than 1), price and total expenditure move in
opposite directions.
 If demand is unit elastic (a price elasticity exactly equal to 1), total expenditure remains
constant when the price changes.

Income Elasticity of Demand

Measures the responsiveness of quantity demanded to change in consumer income.

 Normal Goods: Positive elasticity. Necessities have low elasticity, while luxuries have high
elasticity.
 Inferior Goods: Negative elasticity (e.g., bus rides when income rises).

The Cross-Price Elasticity of Demand

The cross-price elasticity of demand measures how the quantity demanded of one good changes as the
price of another good changes.

Whether the cross-price elasticity is a positive or negative number depends on whether the two goods
are substitutes or complements.
 Substitutes: Positive elasticity (e.g., butter and margarine).
 Complements: Negative elasticity (e.g., coffee and sugar).
Price Elasticity of Supply
The price elasticity of supply measures how responsive quantity supplied is to price changes.
 Elastic Supply: Quantity supplied responds significantly to price changes.
 Inelastic Supply: Quantity supplied responds only slightly to price changes.
Determinants of Price Elasticity of Supply
1. Time Period:
o Short Run: Supply is less elastic due to fixed capacity.

o Long Run: Supply becomes more elastic as firms adjust production capabilities.

2. Productive Capacity: Firms operating near full capacity have less elastic supply.
3. Mobility of Factors: High mobility of resources between uses increases elasticity.
4. Inventory: Goods that can be stored easily have more elastic supply.
5. Size of Firms/Industry: Smaller firms or industries often have more elastic supply than
larger ones.
Total Revenue and the Price Elasticity of Supply
When studying changes in supply in a market we are often interested in the resulting changes in the
total revenue received by producers. In any market, total revenue received by sellers is P × Q.
With an inelastic supply curve, an increase in the price leads to an increase in quantity supplied that is
proportionately smaller. Therefore, total revenue (the product of price and quantity) increases.

With an elastic supply curve, an increase in the price leads to an increase in quantity supplied that is
proportionately larger. Therefore, total revenue (the product of price and quantity) increases.
CONSUMER SURPLUS AND THE DEMAND CURVE
A consumer’s willingness to pay for a good is the maximum price
at which he or she would buy that good. It can be represented in a
graph:
Individual consumer surplus is the net gain to an individual buyer
from the purchase of a good. It is equal to the difference between
the buyer’s willingness to pay and the price paid. The sum of the
individual consumer surpluses is called Total consumer surplus.

PRODUCER SURPLUS AND THE SUPPLY CURVE

Total producer surplus is the sum of the individual producer
surpluses of all the sellers of a good in a market, it can be
represented graphically as the area above the supply curve but
below that price. Economists use the term producer surplus to
refer both to individual and to total producer surplus.

CONSUMER SURPLUS, PRODUCER SURPLUS AND THE GAINS FROM TRADE

The total surplus generated in a market is the

total net gain to consumers and producers from
trading in the market.
Thus, both consumers and sellers gain, there are
gains from trade.
At quantities less than the equilibrium quantity, the value to buyers exceeds the cost to sellers. At
quantities greater than the equilibrium quantity, the cost to sellers exceeds the value to buyers.
Therefore, the market equilibrium maximizes the sum of producer and consumer surplus.
A market is efficient if it maximizes total surplus. Efficiency occurs when:
1. Goods are produced by sellers with the lowest costs.
2. Goods are consumed by buyers who value them most.
3. The quantity of goods produced and consumed maximizes the sum of consumer and producer
surplus.
Pareto efficiency = When trades take place, the consumer gains some benefit and so does the
producer and this is referred to as a Pareto improvement. A Pareto improvement occurs when an
action makes at least one economic agent better off without harming another economic agent.
Efficiency focuses on maximizing the total surplus.
Equity concerns the fairness of the distribution of resources.
While free markets are efficient, they may not lead to equitable outcomes. Policymakers must balance
efficiency with equity when designing economic policies.
Situations where markets may fail to allocate resources efficiently, such as:
Externalities: Costs or benefits of a transaction affecting third parties.
Market Power: Monopolies or oligopolies distorting prices and output.
Information Asymmetry: Inefficient outcomes due to unequal access to information.

CONTROLS ON PRICES
 price ceiling a legal maximum on the price at which a good can be sold
 price floor a legal minimum on the price at which a good can be sold

Non-Binding Ceiling: If the price ceiling is set above the equilibrium price, it has no effect.
Binding Ceiling: If the price ceiling is below the equilibrium price, it creates a shortage. For example,
rent controls can lead to a housing shortage and lower-quality housing, as landlords reduce
investments.

Non-Binding Floor: If the price floor is set below the equilibrium price, it has no effect.
Binding Floor: If the price floor is above the equilibrium price, it creates a surplus. For instance, a
minimum wage can lead to unemployment as labour supply exceeds demand.
TAXES
Taxes are levied to generate revenue and influence market behaviour. They create a wedge between
the price buyers pay and the price sellers receive, shrinking market size. Direct taxes a tax levied on
income and wealth. Indirect tax a tax levied on the sale of goods and services. specific tax is a set
amount per unit of expenditure, for example, €0.75 per litre of petrol or €2.50 on a bottle of whisky.
An ad valorem tax is expressed as a percentage, for example a 10 per cent tax or a 20 percent tax.
Economists use the term tax incidence to refer to the distribution of a tax burden.
A Specific Tax on Sellers
When a tax of €0.50 is levied on sellers, the
supply curve shifts to the left by €0.50 at every
price from S1 to S2. The equilibrium quantity
falls from 100 to 90 million litres. The price that
buyers pay rises from €1.00 to €1.30 per litre. The
price that sellers receive (after paying the tax)
falls from €1.00 to €0.80. Even though the tax is
levied on sellers, buyers and sellers share the
burden of the tax.

An Ad Valorem Tax on Sellers

The impact of the tax is again on the sellers. The
quantity of training shoes demanded at any given
price is the same; thus, the demand curve does
not change. The seller again faces an increase in
the cost of production but this time the effective
increase in cost varies at each price.

How the Burden of a Tax Is Divided

In panel (a), the supply curve is elastic and the demand curve is inelastic. In this case, the price
received by sellers falls only slightly, while the price paid by buyers rises substantially. Thus, buyers
bear most of the burden of the tax. In panel (b) the supply curve is inelastic, and the demand curve is
elastic. In this case, the price received by sellers falls substantially, while the price paid by buyers
rises only slightly. Thus, sellers bear most of the burden of the tax.

Any reduction in total surplus in the market outcome when

taxes are levied compared to a free-market outcome is
called the deadweight loss.
A tax on a good reduces consumer surplus (by the area B +
C) and producer surplus (by the area D + E). Because the
fall in producer and consumer surplus exceeds tax revenue
(area B + D), the tax is said to impose a deadweight loss
(area C + E). The area C + E shows the fall in total surplus
and is the deadweight loss of the tax.
The magnitude of deadweight loss depends on the elasticities of supply and demand:
 Elastic Supply or Demand: Larger deadweight loss as participants adjust behaviour significantly.
 Inelastic Supply or Demand: Smaller deadweight loss as participants’ behaviour is less responsive

When the government imposes a tax

on a good, the quantity sold falls
from Q1 to Q2. As a result, some of
the potential gains from trade among
buyers and sellers do not get
realized. These lost gains from trade
create the deadweight loss.

How Deadweight Loss and Tax

Revenue Vary with the Size of a Tax
Panel (a) shows that, as the size of a tax grows larger, the deadweight loss grows larger. Panel (b)
shows that tax revenue first rises, then falls. This relationship is sometimes called the Laffer curve.

Complying with tax laws incurs costs, including record-keeping, form-filling, and hiring tax experts.
Complex tax codes increase these burdens and create inefficiencies. Simplifying tax systems can
reduce administrative costs but may face political resistance.
Adam Smith's Four Canons of Taxation:
1. Equality: Taxes should be based on the taxpayer’s ability to pay.
2. Certainty: Taxpayers should know their liabilities clearly.
3. Convenience: Tax systems should be easy to comply with.
4. Economy: Administrative costs should be minimal relative to tax revenue.
When discussing the efficiency and equity of income or direct taxes, economists distinguish between
two notions of the tax rate: the average and the marginal. The average tax rate (ATR) is total taxes
paid divided by total income and can be expressed by the formula:

The marginal tax rate (MTR) is the extra taxes paid on an additional unit of income expressed by the
formula:

Everyone owes the same amount, regardless of earnings or any actions that a person might take. Such
a tax is called a lump-sum tax.
One principle of taxation, called the benefits principle, states that people should pay taxes based on
the benefits they receive from government services.
Ability-to-Pay Principle: Taxes should depend on a person’s capacity to bear the burden.
 Vertical Equity: Higher-income individuals pay more taxes.
 Horizontal Equity: Individuals with similar incomes pay similar taxes.
The division of the tax burden between buyers and sellers. Flypaper Theory: The assumption that
taxes stick where they are imposed is often incorrect. Example: Corporate taxes may ultimately
burden workers or consumers.
SUBSIDIES
Subsidies are payments made by governments to buyers or sellers to reduce costs or encourage
consumption/production.
Subsidies shift the supply curve downward (or
to the right), lowering prices for buyers and
increasing the equilibrium quantity. Both
buyers and sellers share the benefits, depending
on elasticities.
Benefits: Encourage production/consumption
of socially desirable goods, reduce road
congestion (transport subsidies), or support
farmers.
Costs: Require taxpayer funding, risk
overproduction, and may distort global trade.