Economics for Management

GSB728

Topic 2:

Markets and Prices

1

Note: This lecture note was prepared based on the teaching material provided

by the publisher of the textbook Principles of Economics.

2

Learning Objectives1. Economic systems – How do countries differ in the

way their economies are organised?

2. Demand and Supply – How much will people buy and offer of any item?

3. The free market economy – How well does it serves us?

4. The determination of price – How much of any item will actually be bought and sold, and at what price?

5. Price elasticity of demand – How responsive is demand to a change in price?

3

Learning Objectives (contd.)

6. Price elasticity of demand & total consumer expenditure – How much do we spend on a good at a given price?

7. Price elasticity of supply – How responsive is supply to a change in price?

8. Other elasticities – How does demand respond to changes in income and to changes in the price of other goods?

9. Markets and adjustment over time – How do markets respond in the longer term to a change in demand or supply?

10. Government fixes prices – Markets where prices are controlled – What happens if the government fixes prices?

4

• How do countries differ in the way their economies are organised?

• Types of economy:

– Classification by degree of government control:

• Command economies.

• Free-market economies.

• Mixed economies.

Economic Systems

5

Totallyplannedeconomy

Totallyfree-marketeconomy

N. KoreaCuba Poland France UK

USA

1980s

China HongKong

Australia

Economic Systems (contd.)

6

Source: Sloman et al. (2014).

AustraliaTotallyplannedeconomy

Totallyfree-marketeconomy

N. Korea

N. Korea

Cuba

China

Poland

Poland France

France UK

UK USA

USA

1980s

2000s

China HongKong

CubaChina(HongKong)

Australia

Economic Systems (contd.)

7

Source: Sloman et al. (2014).

The Free Market Economy

8

– Free decision making by individuals:• Firms seek to maximise profits.

• Consumers seek value for money from purchases.

• Workers seek to maximise wages.

– The price mechanism:• Shortages and surpluses.

– Shortage price rises.– Surplus price falls.

• Equilibrium price:– Where demand equals supply.

• Equilibrium:– A position of balance.

– Effects of changes in demand and supply:• A change in demand.• A change in supply.

– Interdependence of markets:• Effects of a rise in demand.

– In the goods market.

The Free Market Economy (contd.)

9

Goods Market:

Dg ­ Shortage(Dg > Sg)

Pg ­Sg ­

Dg ¯until Dg = Sg

The Price Mechanism: Effect of a Rise in Demand

10

Source: Sloman et al. (2014).

– Effects of changes in demand and supply:• A change in demand.• A change in supply.

– Interdependence of markets:• Effects of a rise in demand.

– In the goods market.– In the factor market.

The Free Market Economy (contd.)

11

Goods Market:

Dg ­ Shortage(Dg > Sg)

Pg ­Sg ­

Dg¯until Dg = Sg

Factor Market:

Sg ­

Sf ­

Df ¯

until Df = Sf­Df Shortage(Df > Sf)

Pf ­

The Price Mechanism: Effect of a Rise in Demand (contd.)

12

Source: Sloman et al. (2014).

– Competitive markets:• Perfectly competitive markets.

• Everyone is a price taker.

• Why study perfect markets?

The Free Market Economy (contd.)

13

Demand and Supply

The Demand Curve

14

Demand

• The relationship between demand and price:– Law of demand.– Income effect.– Substitution effect.

• The demand curve:– Assumptions (all other things (determinants) equal).– The axes.– Illustrates how much would be demanded at each

price.

15

16

Price

($ per kg)

Tracey's Demand

(kg)

Darren's Demand

(kg)

Total Market Demand

(tonnes: 000s)

A 0.40 28 16 700

B 0.80 15 11 500

C 1.20 5 9 350

D 1.60 1 7 200

E 2.00 0 6 100

The Demand Curve:The Demand for Potatoes (Monthly)

Source: Sloman et al. (2014).

0 50 100 150 200 250 300 350 400 450 500 550 600 650 700 750 8000

0.4

0.8

1.2

1.6

2

Quantity (tonnes: ‘000s)

Price($ per kg)

0.40

Market Demand(tonnes 000s)

700A

Point

Demand

A

Pri

ce (

$ p

er

kg)

Source: Sloman et al. (2014). 17

Market Demand for Potatoes (Monthly) (contd.)

Market Demand for Potatoes (Monthly) (contd.)

0 50 100 150 200 250 300 350 400 450 500 550 600 650 700 750 8000

0.4

0.8

1.2

1.6

2

Quantity (tonnes: ‘000s)

Price($ per kg)

0.40

Market Demand(tonnes 000s)

700A

Point

Demand

APri

ce (

$ p

er

kg)

B 0.80 500

B

C 1.20 350C

D

D 1.60 200

E

E 2.00 100

18Source: Sloman et al. (2014).

Demand and Supply

Shifts in Demand

19

• Other determinants of demand:– Tastes.– Number and price of substitute goods.– Number and price of complementary goods.– Income.– Distribution of income.– Expectations of future price changes.

• Movements along and shifts in the demand curve.

Demand

20

D1

P

O Q0 Q1 Quantity

D0

Increase in Demand

Source: Sloman et al. (2014). 21

Price

D0

P

OQ1 Q0 Quantity

D1

Decrease in Demand

22Source: Sloman et al. (2014).

Price

Demand and Supply

The Supply Curve

23

Supply• Supply and price:

– As price rises, firms supply more.• It is worth incurring the extra unit costs.• They switch from less profitable goods.• In the long run, new firms will be encouraged to enter

the market.

• The supply curve:– Assumptions (all other determinants are constant).– The axes.– Illustrates how much would be supplied at each price.

24

25

The Supply Curve: The Supply for Potatoes (Monthly)

Price of Potatoes ($ per kg)

Farmer X's Supply (tonnes)

Total Market Supply

(tonnes: 000s)

a 0.40 50 100

b 0.80 70 200

c 1.20 100 350

d 1.60 120 530

e 2.00 130 700

Source: Sloman et al. (2014).

0 25

50

75

100

125

150

175

200

225

250

275

300

325

350

375

400

425

450

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500

525

550

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700

725

750

775

800

0

0.4

0.8

1.2

1.6

2 Supply

a

P

0.40

Q

100a

Quantity (tonnes: 000s)

Pric

e ($

per

kg)

Market Supply for Potatoes (Monthly) (contd.)

Source: Sloman et al. (2014). 26

0 25

50

75

100

125

150

175

200

225

250

275

300

325

350

375

400

425

450

475

500

525

550

575

600

625

650

675

700

725

750

775

800

0

0.4

0.8

1.2

1.6

2 Supply

a

P

0.40

Q

100a

Quantity (tonnes: 000s)

Pric

e ($

per

kg)

b

b 0.80 200c

c 1.20 350

d

d 1.60 530

e

e 2.00 700

27Source: Sloman et al. (2014).

Market Supply for Potatoes (Monthly) (contd.)

Demand and Supply

Shifts in Supply

28

• Other determinants of supply:– Profitability of alternative products.– Profitability of goods in joint supply.– Nature, random shocks and other unpredictable

events.– Aims of producers.– Expectations of future price changes.– The number of suppliers.

• Movements along and shifts in the supply curve.

Supply

29

P

QO

S0

Shifts in The Supply Curve

S1S2

Increase in supply

Decrease in supply

Source: Sloman et al. (2014). 30

Determination of Price

• Equilibrium price and output:• Response to shortages and surpluses.

• Market clearing.

• Significance of ‘equilibrium’.

– Demand and supply curves.

31

32

Equilibrium Price and Output:Market Demand and Supply of Potatoes (Monthly)

Price of Potatoes ($ per kilo)

Total Market Demand (Tonnes: 000s)

Total Market Supply (Tonnes: 000s)

0.40 700 (A) 100 (a)

0.80 500 (B) 200 (b)

1.20 350 (C) 350 (c)

1.60 200 (D) 530 (d)

2.00 100 (E) 700 (e)

Source: Sloman et al. (2014).

0 25

52

75

100

125

150

175

200

225

250

275

300

325

350

375

400

425

450

475

500

525

550

575

600

625

650

675

700

725

750

775

800

E

D

C

Aa

c

d

eSupply

Demand

Bb

2.00

1.60

1.20

0.80

0.40

Quantity (tonnes: 000s)

Determination of Market EquilibriumP

rice

($ p

er k

g)

Source: Sloman et al. (2014). 33

• Equilibrium price and output:• Response to shortages and surpluses.

• Market clearing.

• Significance of ‘equilibrium’.

– Demand and supply curves.– Effect of price being above equilibrium.

• Surplus price falls

Determination of Price (contd.)

34

0 25

52

75

100

125

150

175

200

225

250

275

300

325

350

375

400

425

450

475

500

525

550

575

600

625

650

675

700

725

750

775

800

E

C

B

Aa

b

c

e Supply

Demand

D dSURPLUS

(330 000)

2.00

1.60

1.20

0.80

0.40

Quantity (tonnes: 000s)

Determination of Market Equilibrium (contd.)P

rice

($ p

er k

g)

Source: Sloman et al. (2014). 35

• Equilibrium price and output:• Response to shortages and surpluses.

• Market clearing.

• Significance of ‘equilibrium’.

– Demand and supply curves.

– Effect of price being above equilibrium.• Surplus price falls.

– Effect of price being below equilibrium.• Shortage price rises.

Determination of Price (contd.)

36

0 25

52

75

100

125

150

175

200

225

250

275

300

325

350

375

400

425

450

475

500

525

550

575

600

625

650

675

700

725

750

775

800

E

D

C

B

Aa

b

c

d

e Supply

Demand

SHORTAGE(300 000)

2.00

1.60

1.20

0.80

0.40

Quantity (tonnes: 000s)

Pric

e ($

per

kg)

Source: Sloman et al. (2014).

Determination of Market Equilibrium (contd.)

37

Demand and Supply

Market Equilibrium

38

• Equilibrium price and output:• Response to shortages and surpluses.

• Market clearing.

• Significance of ‘equilibrium’.

– Demand and supply curves.– Effect of price being above equilibrium.

• Surplus price falls.

– Effect of price being below equilibrium.• Shortage price rises.

– Equilibrium: where D = S.

Determination of Price (contd.)

39

0 25

52

75

100

125

150

175

200

225

250

275

300

325

350

375

400

425

450

475

500

525

550

575

600

625

650

675

700

725

750

775

800

D d

Qe

E

B

Aa

b

eSupply

Demand

2.00

1.60

1.20

0.80

0.40

Quantity (tonnes: 000s)

Pric

e ($

per

kg)

Source: Sloman et al. (2014).

Determination of Market Equilibrium (contd.)

40

• Movement to a new equilibrium:

– Effects of shifts in the demand curve:

• Movement along S curve and new D curve.

• Rise in demand (rightward shift) P rises.

• Fall in demand (leftward shift) P falls.

41

Determination of Price (contd.)

Demand and Supply

Effect of a Shift in the Demand Curve

42

P

QO

Pe1

Qe1

S

g h

D1

D2

Pe2

Qe2

i

Effect of a Shift in the Demand Curve

Source: Sloman et al. (2014). 43

Demand and Supply

Effect of a Shift in the Supply Curve

44

P

QO

Pe1

Qe3Qe1

D

S1

S2

j g

kPe2

45

Effect of a Shift in the Supply Curve

Source: Sloman et al. (2014).

Markets, Demand and Supply

Economic Systems

46

The Free-Market Economy

• Advantages of a free-market economy:• Transmits information between buyers and sellers.

• No need for costly bureaucracy.

• Incentives to be efficient.

• Competitive markets respond to consumer wishes.

• Problems with a free-market economy:• Competition may be limited.

• Inequality.

• Environment and social goals may be ignored.

47

The Mixed Economy

– Types of intervention:• Use of taxes, subsidies and benefits.

• Legislation and regulation.

• Direct provision by the government.

48

Elasticities

Elasticities of Supply and Demand

49

Price Elasticity of Demand

• Defining price elasticity of demand (PeD):– Responsiveness of quantity demanded to a change

in price.

50

Pric

e

OQ3Q1 Q2

P2

P1

P3

c

S1

S2

D

D’

b

a

Quantity

Market Supply and Demand

Source: Sloman et al. (2014). 51

Price Elasticity of Demand

• Measuring price elasticity of demand:

%QD / %P

– Percentage measure.

– Negative sign.

– Value: greater or less than 1 (in absolute value).

52

Price Elasticity of Demand (contd.)

– PeD­>1:­Elastic demand

– PeD­<1:­Inelastic demand

– P ­e D­=1:­Unit elastic demand

53

Elasticity

Measuring Elasticity

54

0 10 20 30 40 500

2

4

6

8

10

Demand

m

n

Measuring Elasticity

Quantity

Pric

e

55Source: Sloman et al. (2014).

0 10 20 30 40 500

2

4

6

8

10

= -7/3 = -2.33

DQ DPmid Q mid P¸ Ped =

Demand

m

nMid P7

Mid Q15

Measuring Elasticity (contd.)

Q = 10

P = –2

Pric

e

Quantity

10 -2 15 7

=

= 10/15 x -7/2

= -70/30

¸

Source: Sloman et al. (2014). 56

• Determinants of price elasticity of demand:

– Number and closeness of substitute goods.

– Proportion of income spent on the good.

– Time period.

57

Price Elasticity of Demand (contd.)

Price Elasticity of Demand andTotal Consumer Expenditure

• Defining total consumer expenditure:

– TE = P × Q

• Next slide illustrates TE graphically…

58

D

0 1 2 3 4 50

1

2

3

4

Total ExpenditureP

rice

Quantity

Consumers’ total expenditure

=firms’ total revenue

=$2 x 3m = $6m

59Source: Sloman et al. (2014).

• Effects of a price change: Elastic demand.

– P rises: TE falls.

– P falls: TE rises.

Price Elasticity of Demand andTotal Consumer Expenditure (contd.)

60

Effect of Advertising on Demand Curve

61

Source: Sloman et al. (2014).

Elasticity

Elastic and Inelastic Demand

62

0

aD4

20

b

Elastic Demand Between Two PointsP

rice

Quantity10

5

Total expenditure fallsas price rises from $4 to $5:

($4 x 20) > ($5 x 10)

Source: Sloman et al. (2014). 63

• Effects of a price change: Inelastic demand.

– P rises: TE rises

– P falls: TE falls

64

Price Elasticity of Demand andTotal Consumer Expenditure (contd.)

a4

200

D

Total expenditure rises as price

rises from $4 to $8:

($4 x 20) < ($8 x 15)c

Inelastic Demand Between Two PointsP

rice

Quantity

8

15Source: Sloman et al. (2014).

Different Elasticities Along a Demand Curve

66

Source: Sloman et al. (2014).

• Special cases:– PeD = 0 : Totally inelastic demand

– PeD = - : Infinitely elastic demand

– PeD = –1 : Unit elastic demand

67

Price Elasticity of Demand andTotal Consumer Expenditure (contd.)

OQ1

P1

D

b

a

Totally Inelastic Demand (PÎD = 0)

Pric

e

Quantity

P2

Source: Sloman et al. (2014). 68

Q2O Q1

P1 Da b

Infinitely Elastic Demand (PÎD = ¥)

Pric

e

QuantitySource: Sloman et al. (2014). 69

O 40

20

D

a

Unit Elastic Demand (PÎD = -1)

b

Pric

e

Quantity

Total expenditure remains unchanged as price falls

from $20 to $8:

($20 x 40) = ($8 x 100)

8

8070Source: Sloman et al. (2014).

Elasticity

Elastic and Inelastic Supply

71

Price Elasticity of Supply• The elasticity of supply determine how

responsive is the quantity supplied to changes in prices.

• Measuring price elasticity of supply:

%QS / %P

– Positive sign.

– Elastic and inelastic supply, >1 and <1 respectively.

72

O

P2

Q3

P1

Q1 Q2

S2

S1

Supply Curves with Differing Price ElasticityP

rice

Quantity73Source: Sloman et al. (2014).

• Determinants of price elasticity of supply:

– Amount that costs rise as output increases:• Spare capacity.

• Access to raw materials.

• Ability to switch away from alternative products.

• Avoidance of the need to pay overtime.

– Time period:• Immediate: Highly inelastic.

• Short run: Some responsiveness.

• Long run: Highly elastic.74

Price Elasticity of Supply (contd.)

Elasticity

Markets and Adjustment Over Time

75

Markets and Adjustment Over Time

• Short-run and long-run adjustment:

– Short-run and long-run supply curves.

– Short-run and long-run demand curves.

76

D

S long-run

P1

P3

P2

Q1 Q2 Q3O

bc

S short-run

a

Pric

e

Quantity

D1

Response of Supply to an Increase in Demand

Source: Sloman et al. (2014). 77

D short-run

D long-run

P1

P3

P2

Q1 Q2 Q3O

a

b

c

Pric

e

Quantity

S

S1

78Source: Sloman et al. (2014).

Response of Demand to an Increase in Supply

Speculation

Stabilising Speculation

79

Suppliers and/or demanders believe that a change in price is only temporary.

P1

P2

O

S1

D1

D2

a

b

c

Stabilising Speculation: Initial Price Rise and Then Fall

Pric

e

Quantity

D3

S2

P3

Q1 Q3 Q2

80Source: Sloman et al. (2014).

S2

D3

P1

P2

O

D2

a

b

c

S1

D1

Stabilising Speculation: Initial Price Fall and Then Rise

Pric

e

Quantity

P3

Q2 Q3 Q1

81Source: Sloman et al. (2014).

Speculation

Destabilising Speculation

82

Suppliers and/or demanders believe that a change in price heralds similar changes to come.

P1

P2

O

P3

S1

S2

D1

D2

a

b

c

Destabilising Speculation: Price RiseP

rice

Quantity

D3

Q1 Q2,3Source: Sloman et al. (2014). 83

P1

P2

O

S1

S2

D1

D2

a

b

D3

c

Destabilising Speculation: Price FallP

rice

Quantity

P3

Q2,3 Q1

Source: Sloman et al. (2014). 84

Markets and Adjustment Over Time

• Dealing with uncertainty and risk:

– Defining risk and uncertainty.

– Reducing risks by holding stocks and diversification.

– Market information.

85

Elasticity

Other Elasticities

86

Income Elasticity of Demand

• Income elasticity of demand.– Measurement:

%QD / %Y

– Determinants:• Degree of necessity.• Level of income.

– Type of good:• Normal goods.• Inferior goods.

87

• Cross-price elasticity of demand.– Measurement:

%QD of good A / %P of good B

– Determinants:• Closeness of substitute goods.• Closeness of complement goods.

88

Cross-Price Elasticity of Demand

Effect of Imposing Tax on Goods

89

Source: Sloman et al. (2014).

Price Controls

Minimum (High) Price: Price Floor

90

O

Pe

Minimum Price

Qd Qs

S

D

Surplus

Minimum Price: Price FloorP

rice

QuantityQe

Pmin

Source: Sloman et al. (2014).

Consequences of Price Floor

– Consequences:• Dealing with resulting surpluses.• Inefficiency.• Discourage production of more efficient alternative

products.• Higher prices for consumers.

– Examples: Common Agricultural Policy (EU).

92

Price Controls

Maximum (Low) Price: Price Ceiling

93

O

Pe

S

D

Qs

Maximum Price

Shortage

Maximum Price: Price CeilingP

rice

QuantityQd

Pmax

Source: Sloman et al. (2014). 94

– Consequences:• Dealing with resulting shortages.

• Preferential treatment to particular customers (firms or government decide who can buy the product and volume).

• Rationing.

• Black markets.

95

Consequences of Price Ceiling

References

Morales, L. E., Simons, P. and Valle de Souza, S. (2014). GSB728: Economics for Management [Topic Notes]. Armidale, Australia: University of New England, Graduate School of Business.

Sloman, J., Norris, K and Garratt, D. (2014). Principles of Economics (4th ed.). French Forest, Australia: Pearson.

96