Chapter_3 - Chapter 3: Where Prices come from? This is a...

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Chapter 3: Where Prices come from? This is a model of competitive markets using demand and supply. Buyers and sellers come together in a Market for the exchange of goods and services. Buyers who are willing and able to buy the good demand the good. Demand is about the value you attach to consuming a good. That is your reservation price , the highest you are willing to pay for a good. The amount of the good the buyers are willing and able to buy at a given price is quantity demanded . Price and quantity demanded are inversely related. Other things being equal, when the price of a good increases, it becomes more expensive compared subsititute goods. Substitute goods serve similar functions. They can be used instead of each other. For example, bud light and miller light are substitutes. They sell at $3/bottle. But next day, if the barman asks for $5 for a bottle of bud light, you simply don t buy it. Instead you get a bottle of miller light. The reason you purchased fewer bud lights is that it became more expensive compared to its close substitutes. This we call substitution effect . Another reason you buy fewer number of a good when price increases is related to your purchasing power. When the price increases the fixed income in your pocket can buy fewer goods. Suppose you live in a world in which there is only bud light god forbid. They sell for $3/bottle. You have $6. You buy 2 bud lights. Then price increases to $5/bottle. In that case, you buy only a bottle, because can only afford one simply. That is, the price increase reduced your purchasing power and that is why you are buying fewer goods. This we call income effect . According to both income and substitution effects, you buy fewer goods when the price increases. That is why we have an inverse relationship between the number of goods you demand and price. That is there is an inverse relationship between quantity demanded and price. This we call the law of demand . Demand curve shows the relationship between price and quantity demanded. It is downward sloping. Demand schedule is a table that shows the relationship between the price and quantity demanded of a good. If you sum up all individuals demands for a good, then you ll end up with the market demand for that good. To arrive at market demand you need to horizontally add up individuals demands. Show an example. Do not confuse quantity demanded with demand . Demand summarized your willingness and ability to buy a good. Quantity demanded is the amount of the good you are willing and able to buy. When I say the quantity demanded increases , it is definitely because of decrease in price. So when the price changes you experience a change in quantity demanded . When your willingness or ability to buy a good changes at all price levels, then you are experiencing a
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This note was uploaded on 08/21/2011 for the course ECON 2010 taught by Professor Roussel during the Spring '08 term at LSU.

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Chapter_3 - Chapter 3: Where Prices come from? This is a...

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