Markets

Gregory ChaseACK

Economic Systems• Capitalism – means of production are privately owned;

distribution of goods and services is determined by the market (Market economy: laissez-faire)

• Communism – common ownership of the means of production; equal distribution

• Socialism – many definitions & variants. Think of it as growing from a concern with problems associated with the market economy and a focus on social outcomes

• Mixed economy – both state and private sector direct the economy

Market Economy• A market is any place where buyers and sellers

come together for the purpose of exchange

• Characteristics of a marketVoluntary exchangeAn agreed priceMutual benefitsSpontaneous (not centrally directed)

A Simple Market Model• Think about how many goods and services are

bought and sold every day. • How does the market economy coordinate the

production and distribution of so many goods and services?

• This is a “problem” we can examine using economic modeling (identify a problem, develop a model, test the model)

Demand and Supply Model• Depicts the interaction of buyers (demand) and sellers

(supply) in a marketplace• How this interaction determines price and quantity traded• Assumes both parties are pursuing their own self-interest • Buyers – allocate scarce income (make choices) among a

range of goods and services in order to maximise utility• Sellers – allocate scarce resources (make investment

decisions) and sell goods and services in order to maximising profits

Determinant of Demand

• In the previous lecture we examined the demand for housing

• Now let’s consider a more generalised depiction of demand

• What are some of the key determinants of demand?

• Do these variables have a positive (direct) or negative (inverse) relationship with demand?

Determinants of DemandVariable

Price

Price of related goods – substitutes, complements

Income

Tastes and preferences

Population (number of buyers)

Expectations of future (consumer sentiment)

Interest rates…etc.

Determinants of DemandVariable Relationship Explanation

Price Inverse •If the price of a good or service increases, we expect demand to fall•Is this always the case? Can you think of an example when a fall in price might not lead to an increase in demand?

Price of related goods•Substitutes

•Complements

Direct

Inverse

•If the price of a substitute falls, this makes it cheaper relative to this good or service and demand will fall. •Consumed in “bundles”. If the price of a complementary good increases, demand decreases. Examples?

Income•Normal good•Inferior good

PositiveInverse

•Demand increases as income increases•Demand falls as income increases

Expectations PositiveInverse

•If optimistic about future•If pessimistic about future

Population Direct

The Demand Curve

• Simplifying assumption of ceteris paribus• Enables economists to construct models that

explore how a change in one variable affects another, other things remaining constant

• Let’s assume all the determinants of demand - except price - are constant, so we can isolate and observe the relationship between these two variables

The Demand CurveQuantity Price

1 $2.50 2 $2.40 3 $2.15 4 $1.95 5 $1.80 6 $1.60 7 $1.40 8 $1.20 9 $0.95

10 $0.70

Price

Quantity

•At $2.50 we could sell 1 unit; at $2.10 we could sell 3 units; at $1.50 we could sell 7 units•We can think of the price each individual is willing to pay as the marginal value placed on the good (or marginal utility derived from consuming the good)

0 2 4 6 8 10 12$0.00

$0.50

$1.00

$1.50

$2.00

$2.50

$3.00

$2.50 $2.40

$2.15 $1.95

$1.80 $1.60

$1.40 $1.20

$0.95

$0.70

Maximising Revenue• If we had several cans of coke to sell - at what

price would we maximise revenue?• Total revenue (TR) is simply price (P)

multiplied by quantity (Q)• Short-hand: TR = P*Q

Maximising Revenue• We can sell one can at $2.50. If we charge a price of $2.40 we would be able to sell 2 units,

increasing revenue from $2.50 to $4.80.• If we lower price to $1.40 we could sell 7 units and generate a TR of $9.80• Note: when we lower price from $2.50 to $2.40 we add $2.30 to total revenue. Why is the

additional revenue lower than the selling price?Quantity Price Revenue

1 $2.50 $2.50 2 $2.40 $4.80 3 $2.15 $6.45 4 $1.95 $7.80 5 $1.80 $9.00 6 $1.60 $9.60 7 $1.40 $9.80 8 $1.20 $9.60 9 $0.95 $8.55

10 $0.70 $7.00 1 2 3 4 5 6 7 8 9 10

$0.00

$2.00

$4.00

$6.00

$8.00

$10.00

$12.00

$2.50

$4.80

$6.45

$7.80

$9.00 $9.60 $9.80 $9.60

$8.55

$7.00

Revenue

Revenue

Activity• Starting at a price of $2.50 calculate the

marginal revenue of each additional unit sold, as we progressively lower the price

• Marginal analysis refers to a process of examining the incremental effect of small changes in one variable on other variables.

• Marginal revenue – the additional revenue gained from selling one more unit.

Marginal Revenue

Quantity Price RevenueMarginal Revenue

1 $2.50 $2.50

2 $2.40 $4.80 $2.30

3 $2.15 $6.45 $1.65

4 $1.95 $7.80 $1.35

5 $1.80 $9.00 $1.20

6 $1.60 $9.60 $0.60

7 $1.40 $9.80 $0.20

8 $1.20 $9.60 ($0.20)

9 $0.95 $8.55 ($1.05)

10 $0.70 $7.00 ($1.55)

1 2 3 4 5 6 7 8 9

-2

-1.5

-1

-0.5

0

0.5

1

1.5

2

2.5

3

$2.30

$1.65 $1.35

$1.20

$0.60

$0.20 ($0.20)

($1.05)

($1.55)

Marginal Revenue

Diminishing Marginal Revenue

Demand, Price and Revenue

• There is an inverse relationship between price and quantity demanded.

• Lowering price means we can sell more units.• Initially as we reduce price and increase sales,

total revenue increases.• At some price, further reductions in price reduces

total revenue.• We can use marginal analysis to help us

understand this. Let’s look at TR and MR together.

1 2 3 4 5 6 7 8 9 10$0.00

$2.00

$4.00

$6.00

$8.00

$10.00

$12.00

$2.50

$4.80

$6.45

$7.80

$9.00 $9.60 $9.80

$9.60 $8.55

$7.00

Revenue

1 2 3 4 5 6 7 8 9

-2

-1.5

-1

-0.5

0

0.5

1

1.5

2

2.5

3

$2.30

$1.65 $1.35

$1.20

$0.60 $0.20

($0.20)

($1.05)

($1.55)

Marginal Revenue

• When we reduce price from $2.40 to $2.15, marginal revenue falls from $2.30 to $1.65

• Selling one more unit adds $1.65 to total revenue, which increases from $4.80 to $6.45

• Let’s take another example• If we reduce price from $1.40 to $1.20,

marginal revenue is -$0.20• That is, increasing sales by one unit would

lower total revenue by $0.20• If our aim was to maximise revenue – we

would not lower price beyond $1.40• It would not be rational – in an economic

sense – to produce and sell at a price when MR is negative.

• Remember: optimisation – firms maximise profit; consumers maximise utility

Responsiveness of Demand• TR = P*Q• P and Q are inversely related• If we lower price, quantity demanded increases

• Question: if we lower price by 10% and quantity goes up by 20%, would you expect TR to rise or fall?

• P( 10%) x Q ( 20%) = TR • If the % increase in demand is greater than the % fall in price,

then TR will increase• Whether TR rises or falls, depends on the responsiveness of

demand to a change in price• Economists refer to this as the price elasticity of demand

Quantity Price RevenueMarginal Revenue

% Change in Quantity

% Change in Price

1 $2.50 $2.50 2 $2.40 $4.80 $2.30 3 $2.15 $6.45 $1.65 +50% -10%4 $1.95 $7.80 $1.35 5 $1.80 $9.00 $1.20 6 $1.60 $9.60 $0.60 7 $1.40 $9.80 $0.20 8 $1.20 $9.60 ($0.20)9 $0.95 $8.55 ($1.05) +13% -21%

10 $0.70 $7.00 ($1.55)

Elastic

Inelastic

Let’s consider two examples

Price elasticity & total revenue

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TR1 = P*Q = $30x10,000 = $30,000

If price is lowered to $20 TR2 = $20x30,000 = $60,000

Loss of TR

Gain in TR

Variations along a straight-line demand curve

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Notice how TR reflects the variation in elasticity along the demand curve.

Mutual benefits• Market: buyers and sellers come together

voluntarily for the purpose of exchange• Buyer values the product or service more than

the price s/he pays• Seller values the price received more than the

product/service exchanged• Both parties to the transaction are therefore

optimising/maximising• How can we measure these benefits?

Utility (Satisfaction)• The highest price any consumer is willing

to pay is $2.50: this is the marginal value placed on the good

• A market price of $1.50 means that this consumer has a “surplus” of $1.00: money they would have spent to acquire the good but did not have to.

• This consumer surplus is the benefit received.

• If it costs the seller $0.50 to produce the product – they receive a producer surplus of $1.00 per unit

• The individual that places a marginal value of $1.40 or $1.20 will not give up $1.50 – the market price – to acquire the good.

• Now, imagine the quantities on the horizontal axis were measuring millions of units. What would be the producer surplus if price was $1.95?

0 2 4 6 8 10 12$0.00

$0.50

$1.00

$1.50

$2.00

$2.50

$3.00

$2.50 $2.40

$2.15 $1.95

$1.80 $1.60

$1.40 $1.20

$0.95

$0.70

P =

Using marginal analysis to explain the mutual gains from market transactions

Price

Quantity

$1

$0.65

Cost per unit

$1

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An individual demand curve

The demand curve has a negative/inverse slope.

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An individual demand curve

The demand curve has a negative/inverse slope.At the higher price consumers will consume less units.At a lower price they will consume more units.

25

Individual demand curves

Line up the price levels so Y-axis is the same scale.

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Market demand

Market demand is the horizontal summation of individual demand schedules.

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WHEN price changes

When price

changes, quantity

demanded changes.

There is a movement along the demand curve.

Non-price determinants of demand

Changes in demand occurs when the following non-price determinants of demand change:

• number of buyers in the market• tastes and preferences • income • expectations of buyers• prices of related goods.

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29

WHEN non-price factors change

Change in demand

Demand curve shifts

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Summary: Demand

Price Changes:

• Increase:• decrease in the quantity

demanded • leftward movement up

the demand curve• Decrease:

• increase in the quantity demanded

• rightward movement down the demand curve

Changes in a non-price factors:

• Favourable:• an increase in demand -

a rightward shift of the whole curve

• Unfavourable:• a decrease in demand –

a leftward shift of the whole curve

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Supply• A direct relationship between the price of a

good and the number of units sellers are willing to offer for sale in a defined time period, ceteris paribus.

• The supply schedule (table) shows the quantity of a good or service that firms are willing and able to offer for sale at different prices.

• The supply curve shows this relationship.

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An individual seller’s supply curve for DVDs

Note that the supply curve has a positive slope.

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A positive relationship

At a higher price, sellers will offer more units for sale.It is more profitable for sellers to supply more at higher prices.

34

Individual supply curves

Line up the price levels so Y-axis is the same scale.

35

Market supply

Market supply is the horizontal summation of individual supply schedules in the market.

36

Changes in quantity supplied

If the price changes,

quantity supplied changes.

This is a movement along the

supply curve.

Non-price determinants of supply

37

Changes in supply occur when the following NON-PRICE determinants of supply change:

• number of sellers in the market• available technology• input prices• taxes and subsidies• expectations of producers• prices of other goods the firm could produce.

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Changes in supply

A change in non-price factors is

known as a change in

supply; i.e. the supply

curve shifts.

Rightward shift indicates

supply increasing.

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Impacts of changes in non-price determinants

The Price Mechanism• Price acts as a coordination mechanism that

rations goods and services among consumers• How does it do this? Let’s develop a simple

economic model to help explain the operation of a market.

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Market supply and demand

• A market exists where interaction amongst buyers and sellers determines the price and quantity of goods and services exchanged.

• This is often called the price mechanism or price system – the forces of supply and demand create market equilibrium.

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Equilibrium

• A market condition that occurs at any price for which the quantity demanded and the quantity supplied are equal.

• Equilibrium is the point of balance between demand and supply in the market.

Supply and demand for jeans

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Market forces bring change• At any price other than the equilibrium price,

market forces act to bring the market into balance.

• In a surplus there is excess supply: sellers compete for buyers by cutting their selling price.

• In a shortage there is excess demand: potential customers try to attain the available goods by paying a higher price.

What to Produce?

• One of the fundamental economic problems• How the price mechanism help to coordinate

the allocation of scarce resources among the hundreds of thousands of goods and services we can produce in any given period?

• Let’s consider what would happen, for example, if there was a change in consumer preferences that caused many to shift away from cars to bicycles.

The Market for Cars

• Fewer people buy cars• Demand decreases (demand curve shifts to the

left)• This creates a surplus at current prices• Prices fall to remove the surplus• Lower prices cause supply fall • As supply falls fewer resources are drawn into

this sector of the economy

The Market for Bicycles

• More people buy bicycles• Demand increases (demand curve shifts to the

right)• This creates a shortage at current prices• Prices rise in response to the shortage• Higher prices cause supply to increase • As supply increases more resources are drawn

into this sector of the economy

The Price Signal• Price is a signal to producers/ entrepreneurs about the relative value that

consumers place on goods and services• If consumers demand more of a product, price will rise and this will cause

production to increase – thereby drawing more resources into this sector of the economy

• On the supply side, if a product (or resources required to product that product) becomes scarce, it will become more expensive. This will lead to an increase in price

• We can think of price as rationing goods and services among the population• If a consumers marginal valuation for a product is equal to (or greater than) the

price – and they have the income – they can acquire the product• If their marginal valuation is below price – and/or their income is too low – they

will not be able to acquire the product• Price therefore acts as a mechanism that rations our limited goods and services

among consumers• Only when consumers are willing and able to buy a product will they do so

Water-Diamond Paradox

• Why are diamonds more expensive than water, when it is water that is necessary to sustain life?

• Economists refer to this as the paradox of value • The answer is scarcity• If we have an abundance of water, then we

would generally not value it very highly• How quickly would you trade diamonds for

water if you were stranded in the desert?