Principle 6: Markets work well with competition, the rule of law, information, property rights, and incentives.
Objectives:
State and explain the Law of Demand
State and explain the Law of Supply
Use the concept of competition to explain how prices are determined
Use the concept of elasticity to identify the strength of the response of one variable to a change in another variable
Why do you want to learn this? The price of gasoline fluctuates dramatically in short periods and you wonder why. The minimum wage doesn’t go up and you wonder why. You get a loan to buy a car and the interest rate has gone up since last week and you wonder why. You travel to a foreign country, you get fewer pesos for your dollar during the week that you are there, and you wonder why. All these mysteries can be solved if you understand how prices are determined. So pay attention. This and the next summary lay the foundation for much that follows.
So now we are about to tell you something you already know. The Law of Demand states that an increase in the price of a product, with no other changes, will cause buyers to buy less of it. If the price goes down, people will buy more of it. No surprise. You have witnessed people rushing to retail stores during certain times of the holiday season, literally fighting off other buyers to get to the products whose prices have been slashed. While this is an extreme example, the point is that prices are a disincentive to buy. The lower the price, the lower the disincentive, the more people will buy. The absolute extreme is a price of zero. When we want to get rid of something, my wife and I put it out front by the road with a sign with the hated “free” word on it and we have NEVER failed to find it gone after about two hours. People who say they have had trouble selling their house really mean that they have had trouble selling their house at a price acceptable to them. They can sell their house; they simply have to lower the price. When some people think that sellers can charge any price they want, you should explain the Law of Demand to them. Higher prices mean that fewer buyers will be willing and able to buy the product. There will be a price that is so high that no one will be willing and able to buy the product.
Buyers will buy products as long as the marginal benefit that they expect to gain from a product outweighs the marginal cost, as represented by the price. It’s AM and a student is on his way to school. He stops by the doughnut shop and buys a doughnut which costs $.75. It is really good. He decides to buy another one which costs $.75. It is good too, but not as good as the first one. He is thinking about a third but decides that the pleasure he will get from the third is not worth $.75. Economists call this “pleasure” that consumers derive from goods and services utility and say that the utility derived from greater amounts of a particular good or service declines with consumption of additional units of the product.
As a result, the doughnut eater would only continue eating doughnuts if the price he had to pay declined. Remember the Principle of Exchange. He would not pay a price that was greater than the marginal utility he expected to receive from each doughnut. People don’t usually pay prices greater than their expected utility from consuming a good or service. The law of demand (Price and quantity demanded move in opposite directions) is based on diminishing marginal utility.
You may think that sellers can set any price they want and sell all of the products they want at that price. But, clearly, they can’t charge a million dollars for a bunch of bananas, even if they are very good bananas. How about one thousand dollars? Following the logic, it becomes clear that sellers must always beware of setting a price that is so high that it drives buyers away. If substitutes for the product exist (and there are very few products that do not have substitutes), a higher price for one product will cause buyers to search for those substitutes. If the price of pork is “too high” some buyers will look for beef or chicken.
The amount that sellers are willing and able to supply is determined by the opportunity cost of all resources involved in production. As production increases, marginal opportunity costs increase. Higher prices compensate suppliers for their increased costs. Higher prices provide incentives for sellers to supply more; lower prices provide incentives to supply less. The Law of Supply states that price and quantity supplied move in the same direction.
So marginal opportunity cost of producing goods and services increases as production increases and marginal utility decreases as consumption increases. The proper amount of resources is allocated to the production of any good or service when the marginal opportunity cost of producing it is equal to the marginal utility of consuming it. If fewer resources are devoted to the product, the marginal utility is greater than the marginal cost and society will gain additional benefit from “another round.” If greater resources are devoted to the product beyond the optimal, the marginal cost is greater than the marginal utility and society will gain by cutting back.
Supply represents marginal opportunity cost and demand represents marginal utility. For any product, the optimal point of production and consumption of that product for society is the point of allocative efficiency. To know how many resources should be devoted to the production of bananas, tires, clocks, shoes, or any other product, simply look at the output that a competitive market would produce and there you have it. When all of the necessary conditions of an efficient market exist (competition, rule of law, incentives, property rights, and information), the market will attain allocative efficiency. No resources are being wasted in this market. Buyers who participate in the market are getting the quantity for which they are willing and able to pay. Sellers who can compete in the market are selling all that that they can produce at the equilibrium price. Given the fact that all scarce resources have an alternative use, the competitive market allocates just the correct amount in relation to society’s demand for the product. Resources are allocated efficiently.
Price | Quantity Demanded |
$10 | 0 |
9 | 0 |
8 | 1 |
7 | 2 |
6 | 3 |
5 | 4 |
4 | 5 |
3 | 6 |
2 | 7 |
1 | 8 |
The table to the right illustrates a possible demand schedule, which is a relationship between a set of prices and quantities demanded. The schedule is often simply called demand.
What the table shows is that buyers will demand less of the product at highe prices and more of the product at lower prices, given the buyers’ characteristics, constraints, and considerations. At a price of $10, no buyers are interested. At $9, no buyers are interested. If the price falls to $8, one of these products will be purchased. Then, if the price falls further, buyers become more and more interested. The table illustrates the Law of Demand.
Now let’s turn to sellers. The Law of Supply states that an increase in the price of a product, with no other changes, will cause sellers to supply more of it. If the price goes down, sellers will supply less of it. No surprise. Price is the incentive for sellers to supply their products. Assume that your parents have told you that they want you to clean the yard. They want you to pull all of the weeds, rake them, bag them, and haul them to the curb for trash pickup. The job will take two full days and you had other plans for the weekend. If you can get some friends to help it will go much more quickly. So you offer 50 cents per hour and you look for folks who will be willing to help you. But you have no takers. You think about it and decide that maybe your pay is a little low. You raise it to $20 per hour and you ask again. The result to your surprise is that ten people are willing and able to supply their labor for $20 per hour. You hire three of them, go to work, and the job is done in 4 hours. You are happy, they are happy, your folks are happy, the law of supply has worked for you.
Producers of products react to the increased incentives the same way as your friends do. A higher price is an incentive for sellers to supply more of the product, a lower price lowers the incentive to produce resulting in less of the product. Changes in prices will cause suppliers to cut back on their offerings if price falls, and squeeze a bit more out of available resources if prices rise. Suppliers respond to incentives and price is a powerful incentive. In the very short run suppliers are stuck with the amount they have brought to the market, and higher prices won’t impact the quantity that they supply. Given a bit more response time, however, suppliers will do what they can to respond to price changes. A change in quantity supplied is the short run response of suppliers to price changes. The Law of Supply states that a higher price will cause an increase in the quantity supplied and a lower price will cause a decrease in the quantity supplied.
Sellers respond to incentives in a predictable manner. Given all of their characteristics, constraints, and considerations, a higher price for a product will bring forth a greater quantity from the supplier. Supply is the relationship between the price of a product and the quantity supplied, assuming nothing else changes in the market, including the characteristics, constraints, and considerations of both buyers and sellers.
The table below illustrates a possible supply schedule which is a relationship between prices and
Price | Quantity Supplied |
$10 | 5 |
9 | 4 |
8 | 3 |
7 | 2 |
6 | 1 |
5 | 0 |
4 | 0 |
3 | 0 |
2 | 0 |
1 | 0 |
quantities supplied. It is often simply called supply. The schedule illustrates the law of supply, showing that these suppliers will supply more at a higher price than at a lower price, given the characteristics, constraints, and considerations. This concept of supply does not tell us anything about what quantity will actually be supplied; it is not a specific quantity like 3 tons of steel. It is a relationship that lists quantities that would be supplied at different prices. Supply is a relationship between prices and quantities supplied; it is NOT a specific quantity. The table to the right tells us that no suppliers are interested at a price of $1. Not until the price reaches $6 are any suppliers interested. If the rises to $7, there is more interest (2). As the price rises further, suppliers become more interested. Higher prices attract a greater quantity supplied. Following the logic of the law of supply, one way to increase the amount of water supplied is to increase the price of water. If society wants a greater supply of water or oil or green energy, an increase in the price will help make that happen. If there is a shortage of nurses or teachers, an increase in their wages will make that happen. The law of supply applies to both product and labor markets.
Elasticities: the strength of buyers’ and sellers’ response to price changes
The laws of demand and supply state that quantities demanded and supplied respond to changes in the price of the product. But by how much do they respond? The fact that they respond is not news, but the strength of their response is extremely important for businesses and for policy makers.
Price elasticity of demand is the measure of the strength of buyers’ responses to price changes; it tells us how great the responses of quantities demanded and supplied will be in response to a price change. If demand for the product within a particular price range is very elastic, buyers will respond strongly to a change in the price of the product. If demand is inelastic, buyers will respond, but not by much. Similarly for supply, an elastic supply tells us that suppliers will respond strongly to price changes; inelastic supply tells us that they will not respond by much, or maybe not at all.
Businesses want to know what will happen if they raise or lower their prices. They do know that an increase in price will drive away some customers but they don’t know how many customers they will lose. If only a few customers respond, the price increase may increase their revenue (the price of the product multiplied by the number of products they sell). If customers leave in large numbers (demand is elastic) they are likely to lose revenue.
Policymakers are also interested in elasticities. If they award subsidies to green energy producers in order to increase the production of wind, water, and solar energy, they have to know the strength of suppliers’ response to the subsidy. If they impose a tax on cigarettes in order to reduce smoking, they have to know the strength of smokers’ response to a price increase.
Buyers and sellers come together
Buyers want the lowest price possible and sellers want the highest price possible. But there is one goal that they have in common; they both want to make a deal. So how do they achieve that mutual goal? Given the supply and demand schedules above, what will the price be and what quantity will be exchanged? If we combine the two tables above, we can see how supply and demand interact. In addition, we can identify the market price and the quantity exchanged.
Price | Quantity Supplied | Quantity Demanded |
$10 | 5 | 0 |
$9 | 4 | 0 |
$8 | 3 | 1 |
$7 | 2 | 2 |
$6 | 1 | 3 |
$5 | 0 | 4 |
$4 | 0 | 5 |
$3 | 0 | 6 |
$2 | 0 | 7 |
$1 | 0 | 8 |
At a price of $7, the quantity supplied and the quantity demanded are the same. At any other price, sellers want to sell a different amount than buyers want to buy. At $7, sellers are willing and able to supply 2 of the product and buyers are willing and able to buy 2 of the product. In this market, the equilibrium price is $7 and the quantity exchanged is 2. The equilibrium price is the price at which the quantity supplied and the quantity demanded are the same. All buyers who are willing and able to pay the price will receive the product; all sellers who are willing and able to supply the product at that price will sell their products. There are no surprises, the market “clears.” There are no leftover products on the shelves and there are no disappointed buyers who can’t get the product at the equilibrium price.
The principle of exchange states that people will only exchange if they expect to gain more than they give. In a market a seller must cover the opportunity cost of all resources involved in the production of the good or service. If the price is not high enough, supplying the product is simply not worth it. Offering a car salesperson $2,000 for a new car is not likely to encourage her to supply a new car. There is some price, below which she will not sell the car. A buyer’s goal is to discover that price. Similarly, asking $500 at a garage sale for a used, battered and bruised garden hoe is not likely to encourage buyers. There is some price above which a prospective customer will not make a purchase. A seller’s goal is to discover that price. A buyer expects to gain a certain amount of pleasure from a product. If the price is higher than the utility expected, the buyer won’t buy the product.
Bottom Line
The Law of Demand states that an increase in the price of a product, with no other changes, will cause buyers to buy less of it. If the price goes down, people will buy more of it.
The Law of Supply states that an increase in the price of a product, with no other changes, will cause sellers to supply more of it. If the price goes down, sellers will supply less of it.
Price elasticities of demand and supply measure the strength of buyers’ and sellers’ responses to price changes. In general, an elasticity measures the strength of one variable’s response to a change in another variable.
The equilibrium price is the price at which the quantity supplied and the quantity demanded are the same. That quantity is the quantity exchanged. This price is determined by buyers competing against other buyers, which drives the price up, and sellers competing against other sellers, which drives the price down.
1. In a competitive market, prices are determined by the competition of:
a. Buyers against sellers
b. Buyers against buyers
c. Sellers against sellers
d. Both b and c
2. Which of the following statements is true?
a. Buyers want the highest price possible.
b. Sellers want the lowest price possible.
c. Both buyers and sellers want to make an exchange.
d. All of the above statements are true.
3. Which of the following is true if the price of skateboards increases?
a. The quantity demanded will increase.
b. The quantity supplied will decrease.
c. The price elasticity of demand will decrease.
d. None of the above are true.
4. Which of the following is true if the price of hamburgers decreases?
a. The quantity demanded will increase.
b. The quantity supplied will increase
c. The price elasticity of supply will increase
d. None of the above
It is claimed that an increase in the minimum wage will reduce the incentive for some people to work. Assume that it does, in fact, do so. What important information will the elasticity of the change in the quantity supplied of labor to the minimum wage provide? How would this affect your support of an increase in the minimum wage?