Syllabus Content

• Markets - the nature of markets
• Demand - the law of demand; the demand curve; The non-price determinants of demand (factors that change demand or shift the demand curve); Movements along and shifts of the demand curve & Linear demand functions (equations), demand schedules and graphs (HL only)
• Supply - the law of supply; the supply curve; The non-price determinants of supply (factors that change supply or shift the supply curve); movements along and shifts of the supply curve & Linear supply functions, equations and graphs (HL only)
• Market equilibrium - equilibrium and changes to equilibrium; Calculating and illustrating equilibrium using linear equations (HL only)
• The role of the price mechanism - resource allocation
• Market efficiency - consumer surplus, producer surplus & allocative efficiency
• Linear Functions - Linear demand functions (equations), demand schedules and graphs; Linear supply functions, equations and graphs; Calculating and illustrating equilibrium using linear equations

Triple A Learning - Competitive Markets

Triple A Learning - Competitive markets questions

Triple A Learning - Competitive Markets simulations & activities

Competitive markets: Demand and Supply

The relationship between price and quantity demanded is the starting point for building a model of consumer behaviour. Measuring the relationship between price and quantity demanded provides information, which is used to create a demand schedule, from which a demand curve can be derived. Once a demand curve has been created, other determinants can be added to the model.

Task 1: (a) What is a market?

(b) Suggest examples of local, national and international markets

(c) What characteristics of a market does the medical cannabis industry exhibit?

Demand curves generally have a negative gradient indicating the inverse relationship between quantity demanded and price.

There are at least three accepted explanations of why demand curves slope downwards:

1. The law of diminishing marginal utility

2. The income effect

3. The substitution effect

Diminishing marginal utility

One of the earliest explanations of the inverse relationship between price and quantity demanded is the law of diminishing marginal utility. This law suggests that as more of a product is consumed the marginal (additional) benefit to the consumer falls, hence consumers are prepared to pay less. This can be explained as follows:

Most benefit is generated by the first unit of a good consumed because it satisfies all or a large part of the immediate need or desire.

A second unit consumed would generate less utility - perhaps even zero, given that the consumer now has less need or less desire.

With less benefit derived, the rational consumer is prepared to pay rather less for the second, and subsequent, units, because the marginal utility falls.

Consider the following figures for utility derived by an individual when consuming bars of chocolate. While total utility continues to rise from extra consumption, the additional (marginal) utility from each bar falls. If marginal utility is expressed in a monetary form, the greater the quantity consumed the less the marginal utility and the less value derived - hence the rational consumer would be prepared to pay less for that unit.

The income effect

The income and substitution effect can also be used to explain why the demand curve slopes downwards. If we assume that money income is fixed, the income effect suggests that, as the price of a good falls, real income - that is, what consumers can buy with their money income - rises and consumers increase their quantity demanded.

The substitution effect

In addition, as the price of one good falls, it becomes relatively less expensive. Therefore, assuming other alternative products stay at the same price, at lower prices the good appears cheaper, and consumers will switch from the expensive alternative to the relatively cheaper one.

Consumer Demand and Income

Consumer income (Y) is a key determinant of consumer demand (Qd). The relationship between income and demand can be both direct and inverse.

Inferior goods

In the case of inferior goods income and demand are inversely related, which means that an increase in income leads to a decrease in demand and a decrease in income leads to an increase in demand. For example, necessities like bread are often inferior goods.

It should be noted that ‘normal’ and ‘inferior’ are purely relative concepts. Any good or service could be an inferior one under certain circumstances. Even luxury goods can become inferior over time. DVD players were once luxuries, but as incomes have risen consumers have switched to online streaming.

Shifts in Demand

The position of the demand curve will shift to the left or right following a change in an underlying determinant of demand.

Increases in demand are shown by a shift to the right in the demand curve. This could be caused by a number of factors, including a rise in income, a rise in the price of a substitute or a fall in the price of a complement.

Demand schedule

A shift in demand to the right means an increase in the quantity demanded at every price. For example, if drinking cola becomes more fashionable demand will increase at every price.

Decreases in demand

Conversely, demand can decrease and cause a shift to the left of the demand curve for a number of reasons, including a fall in income, assuming a good is a normal good, a fall in the price of a substitute and a rise in the price of a complement.

Demand schedule

For example, if the price of a substitute, such as fizzy orange, falls,then less cola is demanded at each price, as consumers switch to the substitute.

Task 2: (a) Define the term ‘demand’

(b) What is the law of demand

(c) Explain whether the law of demand shows a negative or positive relationship

(d) Show the law of demand in a diagram

(e) Describe the relationship between an individual consumer’s demand and market demand.

(f) Distinguish between a ‘change in demand’ and a ‘change in quantity demanded’ and explain the cause or causes of each.

(g) How would you show the difference between a movement along the demand curve and a shift of the demand curve in a diagram?

Task 3: Using diagrams, show the impact of each of the following on the demand curve for product A.

(a) The number of consumers in the market for product A increases

(b) Consumer income increases and product A is an inferior good

(c) Consumer income decreases and product A is a normal good

(d) A news report claims that use of product A has harmful effects on health

(e) The price of substitute good B falls

(f) The price of complementary good B increases

Source: Tragakes, E. (2012) Economics for the IB Diploma, 2^nd edition, Cambridge University Press, Cambridge, UK, pp 20-25

Task 4: In the market for scooters, several events occur, one at a time.

a) Explain the influence of each event on the quantity demanded of scooters.

b) Illustrate the effects of each event by either a movement along the demand curve or a shift in the demand curve for scooters.

1. The price of a scooter falls

2. The price of a bicycle falls

3. Citing rising injury rates, cities and towns ban scooters from sidewalks

4. Average income increases

5. Rumuor has it that the price of a scooter will rise next month

6. The number of buyers increases

Source: Bade, Robin & Parkin, Michael (2002) Foundations of Microeconomics, Addison Wesley, p. 87

Supply

Production is the process of turning inputs of scarce resources into an output of goods or services. The role of a firm is to organise scarce resources to satisfy consumer demand in a profitable way.

Supply is defined as the willingness and ability of firms to produce a given quantity of output in a given period of time, or at a given point in time, and take it to market. Not all output is taken to market, and some output may be stored and released onto the market in the future.

Law of Supply

The law of supply states that, other things equal, the quantity supplied of a good rises when the price of the good rises.

Supply can be measured for a single factor of production, for a single firm, for an industry and for the whole economy.

Supply Curve

The supply curve is the graph of the relationship between the price of a good and the quantity supplied.

Why do supply curves slope upwards?

There are a number of explanations of this relationship, including the law of diminishing marginal returns.

The Law of diminishing returns

The law of diminishing marginal returns explains what happens to the output of products when a firm uses more variable inputs while keeping a least one factor of production fixed. Real capital, such as buildings, machinery, and equipment, is usually the factor kept fixed when demonstrating this principle.

Economic theory predicts that, when employing these extra variable factors, such as labour, the marginal returns (additional output) from each extra unit of input will eventually diminish.

Take, for example, a hypothetical firm that has a factory in which computers are assembled. The machinery is fixed, and extra workers can be hired to increase the output of assembled computers. At first, the addition of extra workers creates a significant benefit because it becomes possible to divide up the labour, and for workers to specialise in undertaking one task. Initially, there are increasing marginal returns to each additional worker.

However, marginal returns will eventually fall because the opportunity to divide labour and to specialise must eventually ‘dry up’. Gradually, each additional worker contributes less than the one before so that total output of computers continues to rise, but at a decreasing rate. The falling marginal returns from each successive worker leads to a rise in the cost of using them.

Diminishing returns and increasing costs

Firms need to sell their extra output at a higher price so that they can pay the higher marginal cost of production. Hence, decisions to supply are largely determined by the marginal cost of production. The supply curve slopes upward, reflecting the higher price needed to cover the higher marginal cost of production. The higher marginal cost arises because of diminishing marginal returns to the variable factors.

Determinants of Supply

Non-price factors

As well as price, there are several other underlying non-price determinants of supply, including:

The availability of factors of production

The availability of factors of production, such as labour or raw materials, can affect the amount that can be produced and supplied. For example, if a firm producing motor vehicles experiences a shortage of steel for its body panels, then its ability to produce vehicles will be reduced.

Cost of factors

Changes in costs will alter a firm’s calculation of how much to supply at a given price. For example, if the same motor manufacturer experiences an increase in labour costs due to an increase in the wage rate, the cost of producing each vehicle will rise. This means that the price the manufacturer expects to receive will increase. If the price does not increase, less will be produced, ceteris paribus.

New firms entering the market

In terms of total supply to a market, the number of firms in the market will affect the total supply. New firms in a market will increase market supply and firms leaving will reduce supply. New firms may be attracted into a market because of the expectation of profits and existing firms may leave because they cannot cover their costs, and make losses. They may also leave because they cannot cover their opportunity cost, meaning that leaving becomes the best alternative.

Weather and other natural factors

Changes in the weather can have a considerable impact on the ability to produce certain products, like farm produce andcommodities. This tends to affect the primary sector more than manufacturing.

Taxes on products

Taxes on products, such as Value Added Tax (VAT), have a direct effect on supply. An indirect tax imposed on a product has an effect similar to that of a cost. which means that increased taxes affect a producer’s decision to supply, and how much to supply.

Subsidies

Subsidies are funds given to firms to enable them to increase their supply or to reduce the price of their product to the consumer. Subsidies can alter the firm’s willingness and ability to produce and supply.

Shifts in Supply

The position of a supply curve will change following a change in one or more of the underlying determinants of supply. For example, a change in costs, such as a change in labour or raw material costs, will shift the position of the supply curve.

Any change in an underlying determinant of supply, such as a change in the availability of factors, or changes in weather, taxes, and subsidies, will shift the supply curve to the left or right.

Task 5: (a) Define the term ‘supply’

(b) What is the law of supply?

(c) Explain whether there is a negative or positive relationship between price and quantity supplied

(d) Show the law of supply in a diagram

(e) Describe the relationship between an individual producer’s supply and market supply.

(f) Distinguish between a ‘change in supply’ and a ‘change in quantity supplied’ and explain the cause or causes of each.

(g) How would you show the difference between a movement along the supply curve and a shift of the supply curve in a diagram?

Task 6: In the market for timber beams, several events occur one at a time.

a) Explain the influence of each event on the quantity supplied of timber beams and the supply of timber beams.

b) Illustrate the effects of each event by either a movement along the supply curve or a shift of the supply curve of timber beams.

The events are:

i. The wage rate of sawmill workers rises

ii. The price of a timber beam rises

iii. The price of a timber beam is expected to rise next year

iv. Environmentalists convince the national parliament to introduce a new law that reduces the amount of forest that can be cut for timber products

v. A new technology lowers the cost of producing timber beams

Task 7: In the market for SUVs, several events occur one at a time.

a) Explain the influence of each event on the quantity supplied of SUVs and the supply of SUVs.

b) Illustrate the effects of each event by either a movement along the supply curve or a shift of the supply curve of SUVs

The events are:

i. The price of a truck rises

ii. The price of a SUV falls

iii. The price of an SUV is expected to fall next year

iv. An SUV engine defect requires a huge and costly manufacturer’s recall to replace the defective engines

v. A new robot technology lowers the cost of producing SUVs

Source: Bade, Robin & Parkin, Michael (2002) Foundations of Microeconomics, Addison Wesley, p. 94

Market Equilibrium

Consumers and producers react differently to price changes. Higher prices tend to reduce demand while encouraging supply, and lower prices increase demand while discouraging supply.

Economic theory suggests that, in a free market there will be a single price, which brings demand and supply into balance, called equilibrium price. Both parties require the scarce resource that the other has and hence there is a considerable incentive to engage in an exchange.

Price discovery

In its simplest form, the constant interaction of buyers and sellers enables a price to emerge over time. It is often difficult to appreciate this process because the retail prices of most manufactured goods are set by the seller. The buyer either accepts the price. or does not make the purchase. While an individual consumer in a shopping mall might haggle over the price, this is unlikely to work, and they will believe they have no influence over price. However, if all potential buyers haggled, and none accepted the set price, then the seller would be quick to reduce price. In this way, collectively, buyers have influence over market price. Eventually a price is found which enables an exchange to take place. A rational seller would take this a step further, and gather as much market information as possible in an attempt to set a price which achieves a given number of sales at the outset. For markets to work, an effective flow of information between buyer and seller is essential.

Market clearing

Equilibrium price is also called market clearing price because at this price the exact quantity that producers take to market will be bought by consumers, and there will be nothing ‘left over’. This is efficient because there is neither an excess of supply and wasted output, nor a shortage – the market clears efficiently. This is a central feature of the price mechanism, and one of its significant benefits.

How is equilibrium established?

Excess Supply

At a price higher than equilibrium, quantity demanded will be less than 7 ice-cream cones, but quantity supplied will be more than 7 ice-cream cones and there will be an excess of supply in the short run.

Demand contracts because at the higher price, the income effect and substitution effect combine to discourage demand, and demand extends at lower prices because the income and substitution effect combine to encourage demand.

In terms of supply, higher prices encourage supply, given the supplier's expectation of higher revenue and profits, and hence higher prices reduce the opportunity cost of supplying more. Lower prices discourage supply because of the increased opportunity cost of supplying more. The opportunity cost of supply relates to the possible alternative of the factors of production. In the case of a college canteen, which supplies cola, other drinks or other products become more or less attractive to supply whenever the price of cola changes. Changes in demand and supply in response to changes in price are referred to as the signalling and incentive effects of price changes.

If the market is working effectively, with information passing quickly between buyer and seller (in this case, between Ben and Catherine), the market will quickly readjust, and the excess demand and supply will be eliminated. In the case of excess supply, sellers will be left holding excess stocks, and price will adjust downwards and quantity supplied will be reduced.

Excess demand

At a price higher than equilibrium, quantity demanded will be more than 7 ice-cream cones, but quantity supplied will be less than 7 ice-cream cones and there will be an excess of demand in the short run.

Changes in equilibrium

Graphically, changes in the underlying factors that affect demand and supply will cause shifts in the position of the demand or supply curve at every price.

Whenever this happens, the original equilibrium price will no longer equate demand with supply, and price will adjust to bring about a return to equilibrium.

Three steps in analysing changes in equilibrium

• Decide whether the event shifts the supply or demand curve (or both).

• Decide whether the curve(s) shift(s) to the left or to the right.

• Use the supply-and-demand diagram to see how the shift affects equilibrium price and quantity.

Changes in equilibrium

For example, if there is a particularly hot summer, students may prefer to drink more soft drinks at all prices, as indicated in the new demand schedule, QD₁

There are four basic causes of a price change:

Example: The entry and exit of firms

In a competitive market, firms may enter or leave with little difficulty. Firms may be attracted into a market for a number of reasons, but particularly because of the expectation of profit. This causes the market supply curve to shift to the right. Rising prices may provide a sufficient incentive and provide a signal to potential entrants to enter the market.

There is a chain reaction, starting with an increase in demand, from D to D1. This raises price to P1, which provides the incentive for existing firms to supply more, from Q to Q1. The higher price also provides the incentive for new firms to enter, and as they do the supply curve shifts from S to S1.

• Recap over the difference between a change in the curve and a movement along the curve

Task 9: Is the price of rare earth metals likely to rise in the future. Assess movements in the market from both the demand side and supply-side.

Task 10: Questions on Market Equilibrium

1: Suppose we have the following market demand and supply schedules for bicycles:

2: Consider the market for minivans. For each of the events listed here, identify which of the determinants of demand or supply is affected. Also indicate whether demand or supply is increased or decreased. Then show the effect on the price and quantity of minivans.

(a) People decide to have more children

(b) A strike by steelworkers raises steel prices

(c) Engineers develop new automated machinery for the production of minivans

(d) The price of station wagons rises

(e) A stock-market crash lowers people’s wealth.

(3) Suppose that market forces determine the price of football tickets at your college. Currently, the demand and supply schedules are as follows:

The role of the Price Mechanism

The interaction of buyers and sellers in free markets enables goods, services, and resources to be allocated prices. Relative prices, and changes in price, reflect the forces of demand and supply and help solve the economic problem. Resources move towards where they are in the shortest supply, relative to demand, and away from where they are least demanded.

The rationing function of the price mechanism

Whenever resources are particularly scarce, demand exceeds supply and prices are driven up. The effect of such a price rise is to discourage demand and conserve resources. The greater the scarcity, the higher the price and the more the resource is rationed. This can be seen in the market for oil. As oil slowly runs out, its price will rise, and this discourages demand and leads to more oil being conserved than at lower prices. The rationing function of a price rise is associated with a contraction of demand along the demand curve.

The signalling function of the price mechanism

Price changes send contrasting messages to consumers and producers about whether to enter or leave a market. Rising prices give a signal to consumers to reduce demand or withdraw from a market completely, and they give a signal to potential producers to enter a market. Conversely, falling prices give a positive message to consumers to enter a market while sending a negative signal to producers to leave a market. For example, a rise in the market price of 'smart' phones sends a signal to potential manufacturers to enter this market, and perhaps leave another one. Similarly, the provision of 'free' healthcare may signal to 'consumers' that they can pay a visit to their doctor for any minor ailment, while potential private healthcare providers will be deterred from entering the market. In terms of the labour market, a rise in the wage rate, which is the price of labour, provides a signal to the unemployed to join the labour market. The signalling function is associated with shifts in demand and supply curves.

The incentive function of the price mechanism

An incentive is something that motivates a producer or consumer to follow a course of action or to change behaviour. Higher prices provide an incentive to existing producers to supply more because they provide the possibility or more revenue and increased profits. The incentive function of a price rise is associated with an extension of supply along the existing supply curve.

Diagrammatic explanation

In conclusion, the price mechanism is said to work effectively through a combination of rationing, incentives and signals.

Task 11: Consider the market for market for corn, and the market for biofuels. What change in the market would explain the change in each respective market i.e. corn (change in quantity) and biofuels (change in price)

Task 12: Market changes in energy markets

(a) Graphic 1: What change in energy sectors would account for the change in the Levelized Cost of Energy (LCOE) in Solar energy and Wind energy?

(b) Graphic 2: Consider the level of investment in the oil & gas sector in 2016. What would you expect to happen to the price of oil and natural gas ceteris paribus?

Task 13: Market for neodymium oxide and US gasoline

(a) Graphic 3 - What reasons could have caused the price for neodymium oxide to rise significantly in 2011 yet experience a downtrend thereafter until 2016?

(b) In graphic 4, it states that 'geopolitical jitters drive up US gasoline prices'. What are geopolitical jitters and are they more likely to affect the demand for or supply of oil (of which gasoline is derived from)?

Task 14: North American Electricity Consumption (2006 and 2016)

(a) What is the most likely reason for the change in energy consumption?

(b) Is this trend likely to continue? What factors could affect this trend?

Task 15: (a) Graphic 1: How does a policy of energy investment for sustainable development differ to that of a 'Business as usual' (new policies)?

(b) Graphic 2: Does the change in investment in nuclear power plants reflect a 'Business as usual' (new policies) or sustainable development viewpoint?

Market Efficiency

Consumer Surplus

Consumer surplus is derived whenever the price a consumer actually pays is less than they are prepared to pay. A demand curve indicates what price consumers are prepared to pay for a hypothetical quantity of a good, based on their expectation of private benefit.

For example, at price P, the total private benefit in terms of utility derived by consumers from consuming quantity, Q is shown as the area ABQC in the diagram.

Declining consumer surplus

Consumer surplus generally declines with consumption. One explanation for this is the law of diminishing marginal utility, which suggests that the first unit of a good or service consumed generates much greater utility than the second, which generates greater utility than the third and subsequent units. A very thirsty consumer will be prepared to pay a relatively high price for their first soft drink, but, as they drink more, less utility is derived and the price they would be prepared to pay falls. Therefore, in the above diagram, as consumption rises from zero, at C, to Q, marginal utility falls. As utility falls, the price that consumers are prepared to pay declines, causing the demand curve to slope down from A to B.

Some firms can capture this consumer surplus by charging the highest price that consumers would be prepared to pay, rather than charge price P for all units consumed.

Producer surplus

Producer surplus is the additional private benefit to producers, in terms of profit, gained when the price they receive in the market is more than the minimum they would be prepared to supply for. In other words they received a reward that more than covers their costs of production.

Economic welfare

Economic welfare is the total benefit available to society from an economic transaction or situation.

In market analysis economic welfare at equilibrium can be calculated by adding consumer and producer surplus.

Welfare analysis considers whether economic decisions by individuals, organisations, and the government increase or decrease economic welfare.

Three Insights Concerning Market Outcomes

• Free markets allocate the supply of goods to the buyers who value them most highly, as measured by their willingness to pay.

• Free markets allocate the demand for goods to the sellers who can produce them at least cost.

• Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus (economic surplus/community surplus).

Task 16: Questions on Market Efficiency

1. Determine the amount of consumer surplus generated in each of the following situations.

a. Leon goes to the clothing store to buy a new T-shirt, for which he is willing to pay up to $10. He picks out one he likes with a price tag of exactly $10. When he Is paying for it, he learns that the T-shirt has been discounted by 50%.

b. Alberto goes to the CD store hoping to find a used copy of Nirvana’s Greatest Hits for up to $10. The store has one copy selling for $10, which he purchases.

c. After soccer practice, Stacey is willing to pay $2 for a bottle of mineral water. The 7-Eleven sells mineral water for $2.25 per bottle, so she declines to purchase it.

2. Determine the amount of producer surplus generated in each of the following situations.

a. Gordon lists his old Lionel electric trains on eBay. He sets a minimum acceptable price, known as his reserve price, of $75. After five days of bidding, the final high bid is exactly $75. He accepts the bid.

b. So-Hee advertises her car for sale in the used-car section of the student newspaper for $2,000, but she is willing to sell the car for any price higher than $1,500. The best offer she gets is $1,200, which she declines.

c. Sanjay likes his job so much that he would be willing to do it for free. However, his annual salary is $80,000.

3. There are six potential consumers of computer games, each willing to buy only one game.

▪ Consumer I is willing to pay $40 for a computer game,

▪ Consumer 2 is willing to pay $35,

▪ Consumer 3 is willing to pay $30,

▪ Consumer 4 is willing to pay $25,

▪ Consumer 5 is willing to pay $20,

▪ Consumer 6 is willing to pay S15.

a. Suppose the market price is $29. What is the total consumer surplus?

b. The market price decreases to $19. What is the total consumer surplus now?

c. When the price fell from $29 to $19, how much did each consumer’s individual consumer surplus change? How does total consumer surplus change?

4: Suppose that in a competitive market there are three buyers (Linda, Sue and Pete) with the marginal benefit (MB) schedules below. If the price is $8, what will be the consumer surplus for each person? What is the consumer surplus for the market as a whole?

5: Suppose that in a competitive market there are three sellers (Max, Scott and Karen) with the marginal cost (MC) schedules below. If the price is $8, what will be the producer surplus for each person? What is the producer surplus for the market as a whole?

Introduction to Linear Functions:

• Download the document '1.1. Linear Functions' below
• Linear demand functions (equations), demand schedules and graphs - watch the video clips below and answers questions on Linear Demand in the handout

• Complete questions on Linear demand on pages 1 to 2 of handout
• Complete Test Your Understanding 2.5. on page 35 of the textbook
• Complete practice questions on Linear demand

• Linear supply functions (equations), supply schedules and graphs - watch the video clips below and answers questions on Linear Supply in the handout

• Complete questions on Linear supply on pages 5 to 6 of the handout
• Complete Test Your Understanding 2.6. on page 37-38 of the textbook
• Go over the responses to the practice questions on Linear Demand; the questions on Linear supply on pages 5 to 6 of the handout and Test Your Understanding 2.6.
• Complete the Practice Questions on Linear Supply in the handout (p. 9)

Introduction to market equilibrium in linear functions

• Go over the responses to Practice Questions on Linear Supply, and the market equilibrium
• Complete Test your Understanding 2.7 in the textbook and the summary exercise on pages 13-14
• Linear Demand & Linear Supply Practice Questions 1.1. to 1.7

Files to download