Econ 160, Vardanyan 1Chapter 4Demand, Supply, and Market Equilibrium In the previous chapter we showed why specialization and exchange made people better off. We also mentioned that this exchange happens in the markets, where the equilibrium prices are being determined. In this chapter we will investigate the mechanics of markets. We will assume that themarkets are perfectly competitive, i.e. characterized by a very large number of firms, each of which produces the same standardized product in amounts so small that no individual firm can affect the price. The Demand CurveThe main question concerning the demand side of the market, where consumers buy products from firms, is: How much of a particular product are the consumers willing to buy during a particular period? Let’s start with the discussion of the demand by an individual consumer (Al in our example). There are several variables that can affect a consumer’s willingness to buy, say, a pizza. They are: •The price of pizza •The consumer’s income level •The prices of substitute goods, such as sandwiches and tacos •The prices of complementary goods, such as beer or soda •The consumer’s taste for pizza •The consumer’s expectations about future prices All these variables together determine how much pizza the consumer will be willing to buy, i.e. his/her quantity demanded. We first investigate the relationship between the price of pizza and quantity demanded. Demand schedule is a table of numbers that shows the relationship between price and quantity demanded, ceteris paribus(i.e. “everything else held constant”). The individual demand curve is a curve showing the relationship between price and quantity demanded, ceteris paribus, or a graphical representation of the demand schedule(Fig 4.1). The demand curve is negatively sloped, because of the law of demand – the higher the price, the smaller the quantity demanded, ceteris paribus. For example, if the price of pizza changes from $6 to $4, the consumer increases the quantity demanded from 7 to 10 pizzas per month, provided there is no change in any of the other relevant variables, such as the consumers income, prices of substitute goods, etc. We move from point cto point don the demand curve. This is called a change in the quantity demanded – a change in the quantity the consumer is willing to buy when the price changes, represented graphically by movement along the demand curve. What is the logic behind the law of demand? Does it make sense? There are two reasons why the law of demand holds: 1.Substitution effect, i.e. the change in consumption resulting from a change in the price of one good relative to the price of another good. In other words, if the price of pizza falls, it will become cheaper relative to tacos, so the consumer will be willing to buy more pizza.
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