Market economies work through forces of supply and demand. When supply equals demand that's when you have equilibrium so no shortages or surpluses (extra goods or services).
Buyers cause demand by their willingness and ability to pay for goods and services whereas sellers cause supply by their willingness and ability to accept payment for goods and services at a particular price. Demand is determined by market price, consumer income, prices of related goods, tastes and expectations.
Law of demand: the higher (lower) the price the lower (higher) the quantity demanded.
Demand schedule is a table that shows how the price of a good relates to the quantity demanded.
Demand curve is the curve (actually a straight line) that shows the graphical relationship between price on the y-axis and quantity on the x-axis of a particular good or service. It is usually a downward sloping straight line because the rate at which price decreases relative to an increase in quantity demanded is constant.
Ceteris paribus is latin for assume everything apart from the variables you're studying are equal. Eg. economic laws such as the law of demand are valid as long as everything else is equal.
Demand curve is not always a straight line because relationship can be quite complicated. However we can often estimate the relationship between price and quantity demanded as a straight line.
Market demand is the sum of individual demands at any given price.
Demand curve can shift either left or right depending on prices of other goods, income, tastes, information or credit availability. If other goods are cheaper demand curve will shift to left because demand will decrease, if income increases (decreases) demand curve will shift to right (left), if tastes for the good increase (decrease) demand curve will shift to the right (left).
Substitutes are goods that can be bought instead of each other because an increase in price of one would increase demand in the other. Eg. iPads and Amazon Kindles are substitutes because an increase in price of one would increase demand for the other. Other substitutes are Playstations and Xboxes, margarine and butter, coke and pepsi, vegemite and marmite, Nintendo Wii and Microsoft Kinect etc.
Complements are goods whose change in prices affect each other. Good A and good B are complements if an increase in the price of good A decreases the demand for good B. Complements are usually goods that you have to purchase together such as DVDs and DVD players. If the price of DVDs increases then the demand for DVD players decreases because, since people don't want DVDs as much as before, they don't need DVD players. Other complements include, shoes and socks, USB drives and computers, bread and butter.
Supply
Quantity supplied is the amount of goods that a seller is willing and able to sell at a particular price.
Law of supply: the higher (lower) the price the higher (lower) the quantity supplied. Obviously as the price of a good increases sellers are willing to sell more so there is a positive relationship here.
Things that determine supply include market price, input prices, technology, expectations and the number of producers.
Supply schedule is like a demand schedule except instead of quantity demanded it's quantity supplied.
Supply curve slopes up (unlike the demand curve) because as the price of a good increases sellers or suppliers are willing to increase the quantity of goods that they are willing to sell.
Market supply is like market demand except it's supply instead of demand.
Movement along the supply curve (change in quantity supplied) is only caused by a change in price whereas factors apart from price can cause the supply curve to shift. These factors include: price of inputs, technology used to produce the good, expectation and availability of credit.
Eg. as the price of building materials increases the supply of buildings decreases because buildings become more expensive to build. Genetic engineering increases the supply of grain because more of it can be produced in the same area.
Supply and Demand
So far we've looked at demand and supply separately but in order to understand how market economies work we have to look at them together.
Equilibrium price is the price at which supply equals demand or where the supply curve meets the demand curve
Equilibrium quantity is the quantity at which supply equals demand or where the supply curve meets the demand curve.
When markets are allowed to function freely without government interference the market price eventually becomes the equilibrium price (supply equals demand) so there would no shortages or surpluses. Buyers are always wanting to buy more for less but sellers want to sell more for more so all this bidding between them causes the market to clear to equilibrium and efficiently balance itself out.
However, this isn't always the case because of government interference in the free market and regulations. Governments sometimes stipulate a maximum price or quantity or minimum price or quantity instead of letting buyers and sellers negotiate between themselves. This causes a disequilibrium which is inefficient. We sometimes get shortages when there is more demand than supply or surpluses when there is more supply than demand.
When the government stipulates a minimum price of, say grain, that is higher than the equilibrium price then we get a surplus of grain because buyers aren't willing to pay more than the equilibrium price. This results in extra grain that can't be sold unless sellers lower the price to equilibrium. Minimum wages are another example of government interference causing surpluses. If the minimum wage is higher than the equilibrium wage then employers aren't as willing to pay more than the equilibrium wage. Since they're not allowed to pay less than the minimum wage this results in a surplus of labour supplied because of the difference between the minimum wage and the equilibrium wage. This causes unemployment because there are some extra people who are willing and able to work but can't because they're not as worth as the minimum wage.
Shortages work just like surpluses except, instead of an excess of supply, there is an excess of demand due to, for example, a maximum price. Rent control is a good example of what can cause shortages. If the maximum rent is below the market rent then landlords are not as willing and able to supply as much accommodation. Tenants demand more property than landlords are willing to provide so we get a shortage. Without rent control tenants and landlords can negotiate between themselves their own rents etc so there is no shortage or surplus and the market is efficient. If tenants think the rent is too high they will look for somewhere cheaper. If landlords are finding it hard to attract tenants then they will lower the rent. The point is that price controls cause the market to be inefficient because they result in either surpluses or shortages. The best solution is to leave buyers and seller alone to freely negotiate themselves their own prices and quantities that they are willing to buy and sell so the market can eventually allocate resources efficiently.
As shown on the above graph, the consumer surplus can be found by measuring the area of the triangle above the equilibrium price and below the demand curve.
