THE NATURE OF MARKETS
A market is any arrangement that allows buyers and sellers of goods and services and resources to be linked together and exchange things.
A market is a place where sellers and buyers gather together to trade money for goods or services. They do not necessarily get together face to face. Products may be purchased by consumers and offered by suppliers at online marketplaces like Amazon and eBay. The amount paid to the supplier by the consumer in return for a product is known as the price. There are different markets associated with each of four factors of production. For instance, there exists a market for a workforce (laborers). The workforce is required by manufacturers to produce goods. The manufacturers are the purchasers of labour and individuals are the sellers of their own personal labour.
Markets are diverse. Buyers and sellers may decide to meet face-to-face to make an exchange, such as customers exchanging money for goods in a supermarket. Markets may be virtual such as Amazon's marketplace and consumers and suppliers are never likely to meet. Markets can be local, national and international. Product markets facilitate the exchange of goods and serves.
Factor markets or resource markets are where the factors of production are exchanged.In IB Economics, competition is a rivalry between businesses trying to sell products to consumers in market, and to consumers trying to purchase goods and services in that same market.
Competitive markets are markets composed of large numbers of sellers and buyers acting independently, so that no one individual seller or small group of sellers has the ability to control the price of the product sold. Here market prices are determined by the forces of supply and demand, which is what we turn our attention to next.
What is a market?
The free market
The RELATIONSHIP BETWEEN PRICE AND QUANTITY DEMANDED
Quantity demanded is the amount of a good or service that a consumer is willing and able to purchase at a given price within a certain period of time. Demand implies that consumers must not merely wish to purchase the product, but also possess sufficient funds to be in a position to purchase it, and that the amount demanded is calculated over a certain time period (e.g., daily, monthly and yearly). Effective demand is the amount of a good people are willing to buy at given prices over a given period of time backed by the ability to pay.
The law of demand says that as the price of a good or service increases, the quantity demanded decreases, and vice versa for a decrease in price, assuming ceteris paribus. There is an inverse or negative association between price and quantity demanded.
Ceteris Paribis: "Other things being equal"; used as a reminder that all variables other than the ones being studied are assumed to be constant.
The law of demand explained
law of demand ASSUMPTION I: substitution AND INCOME effects HL
substitution and income effects
There is an inverse or negative association between price and quantity demanded. The two main effects on quantity demanded of price changes that describe the negative relationship: the substitution effect and the income effect.
The substitution effect: If can of Coke increases in price, then a can of Pepsi becomes relatively less expensive. A substitute is a product you can use instead of a different product. If the price of a product declines it would be less expensive compared to the alternate product resulting in some customers deciding to purchase the product instead of the substitute. When the price of a product increases, it would be comparatively more costly compared to the alternate product resulting in some customers purchasing the alternate good. Changing the price consequently results in a change in the amount demanded.
The income effect: As the price declines, the amount of the product which can be purchased using the same money rises. Consequently, when the price declines quantity demanded also increases. If the price rises, the amount of the product which can be purchased using the same money declines. Hence, when the price goes up, quantity demanded drops.
INCOME AND SUBSTITUTION EFFECT
income effect explained
substitution EFFECT EXPLAINEd
Essential statement: The law of demand is explained by the substitution and income effects. The inverse relationship between price and quantity demanded arises because price changes trigger substitution and income effects and change the quantity demanded of a good or service.
LAW OF DEMAND ASSUMPTION II: law of Diminishing marginal utility HL
Most consumer choices involve marginal analysis, which means comparing the benefits and costs of choosing a little more or a little less of a good.
People desire goods and services for the satisfaction or utility those goods and services provide. Utility is subjective but that does not make it less real.
Key point: Economists typically assume that the more of some good one consumes (for example, slices of pizza), the more utility one obtains.
At the same time, the utility a person receives from consuming the first unit of a good is typically more than the utility received from consuming the fifth or the tenth unit of that same good.
When Annabel chooses between burgers and bus tickets, for example, the first few bus rides that she chooses might provide her with a great deal of utility – perhaps they help her get to a job interview or a doctor’s appointment. But later bus rides might provide much less utility – they may only serve to kill time on a rainy day. Similarly, the first burger that Annabel chooses to buy may be on a day when she missed breakfast and is ravenously hungry. However, if Annabel has a burger every single day, the last few burgers may taste pretty boring.
MARGINAL UTILITY EXPLAINED
Utility in Microeconomics means the satisfaction or benefit a consumer gains from the consumption of goods and services.
Marginal utility is the satisfaction or benefit gained from an additional unit of consumption.
Total utility is the satisfaction or benefit gained from all units of consumption of a good or service.
We can distinguish between total and marginal utility by thinking of pizza slice consumption. How much satisfaction has the consumer gained by eating four slices of pizza – total utility? How much additional satisfaction was gained by eating the fourth slice of pizza after having already consumed three slices – marginal utility?
DIMINISHING MARGINAL UTILITY
The general pattern that consumption of the first few units of any good tends to bring a higher level of utility to a person than consumption of later units is a common pattern. Economists refer to this pattern as the law of diminishing marginal utility, which means that as a person receives more of a good, the additional (or marginal) utility from each additional unit of the good declines. In other words, the first slice of pizza brings more satisfaction than the sixth.
The law of diminishing marginal utility explains why people and societies rarely make all-or-nothing choices. You would not say, “My favorite food is ice cream, so I will eat nothing but ice cream from now on.” Instead, even if you get a very high level of utility from your favorite food, if you ate it exclusively, the additional or marginal utility from those last few servings would not be very high.
Similarly, most workers do not say: “I enjoy leisure, so I’ll never work.” Instead, workers recognize that even though some leisure is very nice, a combination of all leisure and no income is not so attractive.
The budget constraint framework suggests that when people make choices in a world of scarcity, they will use marginal analysis and think about whether they would prefer a little more or a little less.
LAW OF DIMINISHING MARGINAL UTILITY
Annabel wishes to choose the combination that will provide her with the greatest utility, which is the term economists use to describe a person’s level of satisfaction or happiness with his or her choices.
Let’s begin with an assumption, which will be discussed in more detail later, that Annabel can measure her own utility with something called utils – a subjective measure of the satisfaction gained from consumption. The table, right, shows how Annabel's utility is connected with her consumption of burgers or bus rides.
The first column of the table shows the quantity of burgers consumed.
The second column shows the total utility, or total amount of satisfaction, that Annabel receives from consuming that number of burgers.
The most common pattern of total utility, as shown here, is that consuming additional goods leads to greater total utility, but at a decreasing rate.
The third column shows marginal utility, which is the additional utility provided by one additional unit of consumption. This equation for marginal utility is:
DONUTS AND DIMINISHING MU!
MU OF BURGER CONSUMPTION
Notice that marginal utility diminishes as additional units are consumed, which means that each subsequent unit of a good consumed provides less additional utility. For example, the first burger Annabeleats is her favorite and it gives her an addition of 300 utils. The fourth burger is pretty boring (she's already eaten 3!) and yields only 100 additional utils. This is an example of the law of diminishing marginal utility, which holds that the additional utility decreases with each unit added.
The rest of the table above shows the quantity of burgers that Annabel eats, and her total and marginal utility from eating each burger.
Notice that total utility is also the sum of the marginal utilities.
Key point: The marginal utility a consumer gets from consuming a good will influence their willingness to pay for that good. If there are diminishing marginal returns, then people’s willingness to pay will also decline. Hence the individual demand curve will be downward-sloping. Price and quantity demanded for goods and services will be inversely related.
INDIVIDUAL CONSUMER DEMAND AND MARKET DEMAND
A demand schedule is a table that lists the quantity of a good a consumer is willing and able to buy at a range of different prices. This information can then be used to construct an individual's demand curve.
Assume five consumers make a market. Table 1 shows the quantities demanded by the five consumes at a range of different prices. Market demand is the sum of all individual consumer demand in the market for a good or service.
THE DEMAND CURVE
A demand curve represents the relationship between price and quantity demanded, ceteris paribus.
Ceteris paribus means "Other things being equal" and it is used as a reminder that all variables other than the ones being studied are assumed to be constant.
The quantity demanded at each price is shown in the demand schedule. Changes in the price of a good or services result in changes in the quantity demanded.
The quantity demanded of a good or service at each price is shown in the demand schedule (see table 2). One of the determinants of demand is price. Changes in price lead to changes in the quantity demanded.
The demand curve is a graph of the relationship between the price of a good and the quantity demanded, ceteris paribus, see Figure 1. It is constructed by using the price and quantity information found in the demand schedule. Price and quantity demanded information are plotted on a graph where price is always on the X axis and quantity demanded on the Y axis.
Introduction to demand curves
Demand curve and marginal utility HL
The Demand curve explained
A CHANGE IN DEMAND VS A CHANGE IN QUANTITY DEMANDED
A price change results in a movement along the demand curve
Changes in the price of a good or service results in a change in the quantity demanded and results in a movement along the demand curve (see figure 2, below). A rise in price brings about a decrease in quantity demanded as well as an upward movement along the demand curve. A drop in price triggers an increase in quantity demanded along with a downward movement along the demand curve. It is only a price change that results in a movement along the demand curve.
Essential statement: Ceteris paribus is all other things are assumed to be constant. Thus, to isolate the effects of a price change on the quantity demanded, all of the other determinants of demand are held constant.
FACTORS AFFECTING DEMAND
QUANTITY DEMANDED VS DEMAND
Non-price determinants of demand
The non-price factors that will determine demand and can cause a shift of the demand curve
The demand curve itself can shift left (decreased demand) or shift right (increased demand). See figure 3 below. The five factors that determine demand, and thus, increase or decrease demand are:
Essential statement: A change in quantity demanded is only caused by a change in the price of a good or service, and is shown by a movement along the demand curve. A change in demand shifts the demand curve up (an increase) and right or down and left (a decrease) and is only caused by a change in one or more of the factors that determine demand.
Tastes and preferences
As goods and services become more desirable demand grows. The demand curve moves up and right to indicate that quantity demanded also increases at each price, and when it gets to be less desirable, demand declines. The demand curve shifts down and left to indicate that less is demanded at each price.
For example, as Apple’s iPhone became preferred by a large segment of consumers, demand for it increased (the demand curve shifted right). Conversely, as Blackberry phones fell out of favour, demand for their phones decreased (the demand curve shifted left).
The price of related goods
Substitutes are products you can use instead of a different good or service (e.g., Coke and Pepsi are substitutes, so too are petrol and public bus rides.
A rise in the price of petrol results in a rise in quantity demanded of bus rides at each price and the demand curve for bus rides moves up and right.
Complements are products that are used and consumed with each other (e.g., smartphones and apps). Once the cost of smartphones falls the quantity demanded of this good increases. Extra apps are then sold. Demand for apps increases as the price of smartphones decreases. Additional apps are required at each fall in the price of smartphones, and the demand curve for apps moves up and right.
What is a substitute good?
What is a complement good?
Normal goods are goods and services for which demand increases as consumers' income increases and for which demand goes down when income is lower. Examples include new cars and holidays.
Demand for normal goods will increase as consumers’ income increases. The demand curve shifts up and right to illustrate that more of the good or service is required at each price.
Inferior goods are those goods and services for which demand tends to fall when income rises. Examples would include used cars and cheaper cuts of meat. Demand for inferior goods decreases when income increases. The demand curve moves down and left to indicate less is required at each price.
Every buyer responds in different ways to an adjustment in income. A good or service that is considered ‘inferior’ for one individual might not be for another.
What is a normal good?
What is an inferior good?
changing numbers of consumers
Demographic changes. These are variations in the attributes of the population (size, age, proportion of women in the workforce). As the population grows quantity demand for the majority of products rises at each price and the demand curve shift up and right. For example, as the population of New Zealand grew from 3.5 million in 1991 to 5 million in 2020, the extra 1.5 million consumers increased the demand for almost all goods and services in the market.
Changes in the composition of the population.The proportion of elderly citizens in the United States population is rising. It rose from 9.8% in 1970 to 12.6% in 2000, and will be a projected (by the U.S. Census Bureau) 20% of the population by 2030. A society with relatively more children, like the United States in the 1960s, will have greater demand for goods and services like tricycles and day care facilities. A society with relatively more elderly persons, as the United States is projected to have by 2030, has a higher demand for nursing homes and hearing aids. Similarly, changes in the size of the population can affect the demand for housing and many other goods. Each of these changes in demand will be shown as a shift in the demand curve.
Future price expectations
The decision to purchase a good today depends on expectations of future prices. Buyers seek to purchase a good at the lowest possible price. If they expect the price to rise in the future, they are inclined to buy more now. If buyers expect the price to decline in the future, they are inclined to buy less now.
Looking to the future. Buyers make buying decisions based on a comparison of current and future prices. They are motivated to purchase the good at the lowest price possible. If that lowest price is the one existing today, then they will buy today. If that lowest price is expected to occur in the future, then they will wait until later to buy.
Consider the example of Wacky Willy Stuffed Amigos, a cute and cuddly line of stuffed creatures. Buyers decide how many Stuffed Amigos to buy, at a given current price, based on their expectations of future prices.
Price going higher: Suppose that news media throughout the country report on the prospects of a worldwide shortage of stuffing, the same sort of stuffing used to stuff Wacky Willy Stuffed Amigos. Every expert interviewed projects that the higher stuffing prices will most assuredly cause an increase in the price of Stuffed Amigos. The price increase has not yet occurred, but it most assuredly will occur. Everyone expects it to occur. With this news, anyone pondering the purchase of Wacky Willy Stuffed Amigos will be inclined to make their purchase now, without delay. As such, the current demand increases.
Price going lower: Alternatively, suppose that The Wacky Willy Company, the firm that produces Wacky Willy Stuffed Amigos announces that it has developed a new production technique, that when implemented will allow them to sell Stuffed Amigos at half their current price. This news is greeted enthusiastically by Stuffed Amigos collectors. They expect to purchase Stuffed Amigos at a lower price in the near future. With this news, anyone pondering the purchase of Wacky Willy Stuffed Amigos today will likely postpone their purchase until later, at the lower price. As such, the current demand decreases.
IB Economics 2.1 Demand
IB Economics: 2.1 Demand teaching and learning PowerPoint notes for HL and SL IB Economics.
PROGRESS CHECK - TEST YOUR UNDERSTANDING BY COMPLETING THE ACTIVITIES BELOW
You have below, a range of practice activities, flash cards, exam practice questions and an online interactive self test to ensure you have complete mastery of the IB Economics requirements for the 2.1 Demand topic.
USE THE FLASHCARDS IN ALL THREE STUDY MODES
IB Economics interactive QUIZZES AND TWO CLASSROOM GAMES
Test how well you know the IB Economics Supply and demand: 2.1 Demand topic with the interactive self-assessment quizzes below. Each interactive quiz selects 30 questions at random from a much larger question bank so keep on practicing! Aim for a score of at least 80 per cent