Chapter 2: How Markets Work? Market Forces and Equilibrium

Introduction

Two main players in markets are consumers (households), who are the consuming units in a market and also in an economy, and producers (firms), which the organizations that transform inputs into outputs.

As the decisions of these actors interact in complex patterns, focusing on demand and supply, which are two essential mechanisms in economy, simplifies this complex interaction.

Market Forces and Competition

A market is either a physical or an online place where consumers and producers meet to carry out an economic transaction.

Markets can be divided into two broad categories as product markets and factor markets. While all sorts of goods and services are bought and sold in product markets, factor markets refer to factors of production such as land, labor and capital.

Shares of companies are bought or sold in stock markets; whereas, international currencies are traded in foreign exchange markets.

Market competition affects how markets work. Consumers compete to buy a particular good and producers compete to sell it.

There are two types of markets in terms of the intensity of competitive forces: perfectly competitive and imperfectly competitive markets.

Perfect competition refers to a competitive market in which there are many buyers and sellers so that the effect of each one on market price is negligible. This is a hypothetical market in which:

• The good or service being exchanged is the same across all sellers,
• There is a high number of potential buyers and sellers of this good; and all act independently from each other,
• Entry of new sellers into the market is not restricted at all,
• Buyers and sellers readily and freely have access to information related to the prices at which other buyers and sellers are exchanging the good.

Imperfect competition, on the other hand, refers to imperfectly competitive markets. Monopoly and monopsony are extreme cases of such markets.

A monopoly is a market where there is only one seller of the product and this seller sets the price alone. However, in monopsonist markets, there is only one buyer even though there are many sellers.

Demand and Demand Curve

The quantity of a product or service that consumers are willing and able to buy at a given price in a given time period at any given market is called demand. The desire alone is not sufficient; consumers must have the financial means to buy the product for demand to occur, which is known as effective demand and a demand curve shows such demands.

A demand curve is a graph that illustrates how much of a specific good an individual or household would be willing to buy at different prices.

In addition, a demand schedule is a table that shows the relationship between the price and quantity demanded of a product.

Demand would become meaningless if desired goods and services were free of charge, or resources were unlimited.

Frequently observed regularities are often called as “law” by economists. According to the law of demand, there is a negative, or inverse, relationship between the price of a good and the quantity of that good demanded under the assumption of ceteris paribus.

Ceteris Paribus is a Latin phrase, which means “other things being equal.” It is used in economics to state that all variables other than the one studied are assumed to be constant or fixed.

The amount of good that the buyers are willing and able to buy is called the quantity demanded.

Market demand is the sum of all the quantities of a product demanded per period by all the buyers in the market.

Income effect and substitution effect shape consumer responses to price change, which then affects the slope and the curvature of the demand curve. Income effect refers to the increase in people’s purchasing power or real income when the price of a product falls. On the other hand, substitution effect refers to the fact that a fall in the price of a product makes it relatively more attractive compared to other products with unchanged prices.

Moreover, the positioning of the demand curve on the Quantity-Price plane is also influenced by such factors as tastes and preferences, income, prices of related goods, population, seasons and expectations.

Tastes and preferences shape the demand in markets. The positive shift in consumer preferences means higher market prices which, in turn, provide incentives for new sellers to enter the market. This will eventually lead to an increase the quantity supplied as well.

If income of the society increases, the demand for most products also goes up. When a change in income affects the demand for a good positively or in the same direction, that good is called a normal good. The exceptions are called inferior goods. In other words, a product is said to be inferior if the demand for that product goes down when the income of the consumers increases.

Decisions on consumptions entail tradeoffs and choices among various goods whose prices also affect the decision-making process.

Substitute goods serve as replacements for one another. If two products are substitutes for each other, a change in the price of one product will change the demand for the other product in the opposite direction. On the contrary, complements are the goods that go together. If products are complements to each other, then a rise in the price of one of the products will decrease the demand for the other product.

Another factor that affects demand is expectations because when consumers expect that the price of a product will increase in the near future, their current demand curve shifts upwards.

Furthermore, number of buyers influences demand. With the increase of the number of buyers, the market demand curve shifts to the right, which indicates an increase in demand.

A change in demand is not the same as a change in the quantity demanded. However, a change in the price of a good causes a change in the quantity demanded. A movement along the demand curve occurs when the price of the good changes because a change in price causes quantity demanded to change in opposite direction. Moreover, a change or shift of a demand curve occurs when the other factors, other than the price, such as the income changes, happens. Any change that increases the quantity that buyers wish to buy at a given price causes a shift of the demand curve to the right.

Supply and Supply Curve

Supply can be defined as the willingness and the ability of producers to produce a quantity of a good or a service at a given price in a given time period. Similar to demand, it is not enough for producers to be willing to produce a good or a service; they must also be able to produce it.

In perfectly competitive firms, the curvature and the slope of the supply curve follow the marginal cost (MC) curve of the producers. Marginal cost refers to the additional cost that the producers have to incur when they increase the production of a certain product by one unit. What is more, a perfectly competitive firm stops increasing the production when the MC gets equal to price.

How much of a good a firm is willing to sell at different prices is illustrated on a graph called supply curve.

As producers intend to make profit despite technological and market demand constraints, they have to consider their unit cost as well as the price at which they can sell. Therefore, their supply curve depends on all the factors affecting the costs, technology and the market demand constraints.

The difference between total revenue and the total cost determines profit.

The quantities that the producers are willing and able to supply at every given prices are called quantity supplied.

According to law of supply, there is a positive relationship between the price and the quantity supplied of a good, which implies that the supply curves normally slope upwards meaning that that when the price of a good goes up, the sellers’ quantity supplied also goes up, and viceversa.

A shift of the supply curve to either the right or the left occurs depending on such determinants as:

• input prices,
• technology,
• expectations, and
• number of sellers.

Market Equilibrium: Demand and Supply

Equilibrium, which is a central concept in economics, means a state of rest. That is, equilibrium is a situation in which the supply and demand equals to each other. Unless there is an external intervention or shock, it will not be disturbed by itself.

According to economists, the price level at which demand and supply curves meet is market equilibrium. In a competitive market, equilibrium prices and quantities characterize the so-called Pareto-efficient matching which represents the best outcome for both buyers and sellers under the relevant constraints they face.

Changes in Market Equilibrium

Several factors affect demand and supply curves, a shift in which may disturb the existing equilibrium and move the market to a new equilibrium.

Any outside disturbance may cause a change in one of the determinants of demand or supply, which would lead to a shift of either one of the curves. When the demand curve shifts to the right, an excess demand arises at the initial price. A change in demand causes both the equilibrium price and the equilibrium quantity to increase.

Since each curve can shift either to the right or to the left, four different combinations of simultaneous shifts exist. The effects of these shifts on the prices and quantities at new market equilibrium points may be determinate or indeterminate.

Prices and Allocation of Resources

Scarce resources are allocated efficiently as market prices adjust to various changes which affect demand and/or supply. Since changes in demand and supply affect relative scarcity of resources, prices respond accordingly.

Producers allocate more resources to the production of the goods that consumers wish to buy in great amounts because the main goal of producers is to maximize their profit.