What you need to know

A market is any arrangement that brings buyers and sellers together. Demand is the quantity of a good or service consumers are willing and able to buy at each price over a period of time. The law of demand says that, other things being equal (ceteris paribus), as price rises the quantity demanded falls, so the demand curve slopes downwards. Supply is the quantity producers are willing and able to sell at each price. The law of supply says that as price rises the quantity supplied rises, because higher prices make production more profitable, so the supply curve slopes upwards. A change in the good's own price causes a movement along the curve; a change in anything else causes the whole curve to shift.

• Demand shifts right (increases) when: consumer income rises (for a normal good); the price of a substitute rises; the price of a complement falls; tastes move towards the product; the population or number of buyers grows; consumers expect prices to rise in future.
• Demand shifts left (decreases) when: the opposite of each of the above occurs, for example income rises for an inferior good.

• Supply shifts right (increases) when: the cost of inputs such as wages or raw materials falls; technology improves; more firms enter the market; the government lowers taxes or pays a subsidy; favourable weather or seasons (for agricultural goods); producers expect lower future prices.
• Supply shifts left (decreases) when: input costs rise, firms leave the market, taxes rise, drought or disruption reduces output.

The price mechanism is the way prices coordinate the decisions of millions of buyers and sellers without a central planner. Prices perform a signalling function (a rising price tells producers that consumers want more), a rationing function (scarce goods go to those willing and able to pay) and an allocating function (resources move towards goods whose prices are rising and away from those whose prices are falling). This is how a market economy answers the questions of what, how and for whom to produce.

Check yourself

1. State the law of demand.
2. A rise in the price of petrol reduces the demand for large cars. Are petrol and large cars substitutes or complements?
3. Using the schedule in this guide, what is the size of the surplus at $10?
4. Demand is Qd = 100 − 5P and supply is Qs = 20 + 3P. Find the equilibrium price and quantity.
5. A new technology lowers production costs. Which curve shifts, and in which direction?
6. A price floor is set above the equilibrium price. Does it cause a shortage or a surplus?

Answers: 1. Other things being equal, as the price of a good rises the quantity demanded falls (and vice versa). 2. Complements (they are used together). 3. 100 − 20 = 80 units. 4. 100 − 5P = 20 + 3P, so 80 = 8P and P = $10; Q = 20 + 30 = 50 units (check: 100 − 50 = 50). 5. Supply shifts to the right (increases). 6. A surplus, because quantity supplied exceeds quantity demanded at the higher price.