Market and demand Markets • Definition: In economic theory a market is where buyers and sellers come together to carry out an economic transaction. • Product markets, factor markets, financial markets: • Product market: goods and services are bought and sold • Factor markets: e.g. labour market, factors of production are bought and sold • Financial market: e.g. foreign exchange market, where international currencies are traded, and stock markets, where shares in companies are bought and sold. Demand • Definition: Demand is the quantity of a good or service that consumers are willing and able to purchase at a given price in a given period of time. • Effective demand: Consumers must have the financial means to buy the product, the ability to buy, this is known as effective demand. The law of demand Three explanations for the law of demand • The income effect Real income refers to income that is adjusted for price changes and implies the actual buying power of a consumer. As P decreases, Qd (quantity demanded) increases because consumers now have more real income to spend • The substitution effect As P drops, consumers switch from other substitute goods to this good because its P is comparatively lower. The law of diminishing marginal utility This law states that as we consume additional units of something, the satisfaction (utility) we drive for each additional unit (marginal unit) grows smaller (diminishes). Changes in demand vs changes in quantity • A change in price leads to a change in the quantity demanded • A change in demand is caused by a change in a non-price determinant Non-price determinants: (TOESIS) • Taste/preferences Diet revolutions Price of other related goods, substitution effect: pizza and burgers; Coke and Pepsi • Complements computers and computer software • Expectations If income is expected to rise, demand will increase • • • Income effect: demand for a normal good, positively related; demand for inferior good, negatively related The size of the market/buyers: the number of buyers increase thus demand increase Special circumstances: weather, natural disasters Exceptions to the law of demand: • Giffen good A Giffen good is a good for which an increase in price results in an increase in demand for the good. It is an extreme inferior good and will have a perverse (upward sloping) demand curve. • Veblen good A Veblen good is a good that has an upward-sloping demand curve. People buy more of the good because it is more expensive and therefore demand is higher when the price is higher. Three explanations for the law of supply: • The short run At least one FOP fixed. ALL PRODUCTION, SR All FOP variable, the state of tech fixed. ALL PLANNING, LR When a firm is producing, some of its FOP will be fixed in the SR If a firm is not able to increase the quantity of certain factors quickly, even if the price goes up and the producer wishes to produce more. • The law of diminishing returns Increasing marginal cost - The law of supply The quantity supplied of any good is the amount that sellers are willing and able to sell. Law of supply: the claim that the quantity supplied of a good rises when the price of the good rises, other things equal. Why the supply curve slopes upwards from left to right? Answer: The more it costs to produce a G&S, then the less producers are willing and able to supply the product. Less profitable. Why does the supply for a product require producers to be willing and able to produce the product at each given price? Answer: It needs to process financial and production facilities to do as sometimes this is not possible. Supply curve shifters: subsidies and indirect taxes • An increase tax is a payment to the government by firms per unit of output produced, whereas a subsidy is a payment to firms by government per unit of output produced to reduce costs of products. Indirect tax- shifts S to the left Subsidy- shifts S to the right • Technology Technology determines how much inputs are required to produce a unit of product. A cost-saving technological improvement has the same effect as a fall input in prices, shifts S curve to the right • Productivity Productivity is defined as output per unit of input, so labor productivity would be output per worker. Experienced Better trained Healthier Firms will be willing to offer more units at each price, increasing supply and shifting the S curve to the right • Prices of other related goods Goods in competitive supply In the case of two goods, refers to production of one or the other by a firm; in other words, the two goods compete with each other for the same resources Joint supply Refers to the production of two goods or more goods are derived from a single product, so that it is not possible to produce more of one without producing more of the other. Example: mutton and wool If the price of mutton increases in the market this firm will have an incentive to increase the quantity supplied of mutton, but at the same time the supply of wool will increase, thus shifting S curve to the right. • Resources cost input prices A fall in input prices makes production more profitable at each output price, so firms supply a larger quantity at each price, and the S curve shifts to the right. Examples: some raw materials • Expectations • Size of market An increase in the number of sellers increases the quantity supplied at each price, shifting S curve to the right • Supply shock - Refers to an unexpected event that changes the supply of a product or commodity, resulting in a sudden change in its price They can be negative or positive Almost always negative and rarely positive The vertical supply curve: the supply is not changing there is no possibility of ever producing more of it, or there is no time to produce more of it because it is more expensive and therefore demand is higher when the price is higher. Three explanations for the law of supply: • The short run At least one FOP fixed. ALL PRODUCTION, SR All FOP variable, the state of tech fixed. ALL PLANNING, LR When a firm is producing, some of its FOP will be fixed in the SR If a firm is not able to increase the quantity of certain factors quickly, even if the price goes up and the producer wishes to produce more. • The law of diminishing returns Increased variable FOP added to the production process, when at least one FOP is fixed, will at some point result in falling marginal output. By employing more workers we should see total output start to rise. We might even see the rate at which output grows by increase. We should continue to employ more workers for as long as output continues to increase and before output starts to fall. • Increasing marginal cost Marginal cost is the increase in total cost of producing an extra unit of output. The law of supply: To increase output, we need to add more units of a variable factor to fixed factors. Eventually, output from each extra unit of the variable factor falls, as inefficiency sets in [law of diminishing returns] Logically, the cost of producing more output, MC, will go up. So, firms will only produce more if prices rise to cover the increased MC. Thus, the supply curve will slope upwards. The Market Equilibrium Equilibrium: P has reached the level where quantity supplied equals quantity demanded. Equilibrium price: the price that equates quantity supplied with equilibrium quantity Equilibrium quantity: the quantity supplied and demanded at the equilibrium price. Surplus: when quantity supplied is greater than quantity demanded. When facing surplus, sellers try to increase sales by cutting price. This causes QD to rise and QS to fall. Prices continue to fall until market reaches equilibrium. Shortage: When quantity demanded is greater than quantity supplied. Facing a shortage, sellers will raise the price, causing QD to fall and QS to rise. Prices continue to rise until market reaches equilibrium. - Three steps the analyzing changes in equilibrium market 1. To determine the effects of any event: • Decide whether the event shifts S curve, D curve, or both. • Decide in which direction curve shifts • Use supply-demand diagram to see how the shift changes equilibrium P and Q 2. Example explanation: • A shift in demand An increase/decrease (D1 to D2)… …causes excess demand at P1 (Q1 Q3) …and this forces up the market price …leading suppliers to quantity supplied (Q1 to Q2) • A shift in supply An increase in supply (S1 to S2)… … causes excess supply at P1 (Q1 Q3) … and this forces down the market price (P1 to P2) …leading to an increase in quantity demanded (Q1 to Q2) 3. Analysis: Cause—consequences Price mechanism Signalling function • In a market economy, prices perform a signalling function, prices adjust to show where resources are required and where they are not. Incentive function • Prices also perform an incentive function. • As prices rise or fall, this provides an incentive for producers to increase/reduce supply ( as profitability of the good changes) and an incentive for consumers to purchase less/more (as the benefit they receive rises/falls) Rationing function • If a market is free when whoever is willing and able to pay the market-determined price will end up with the good. Market efficiency Willingness to pay: A buyer's willingness to pay for a good is the maximum amount the buyer will pay for that good. WTP measures how much the buyer values to good. Consumer surplus: Definition: the amount a buyer is willing to pay minus the amount the buyer actually pays CS and the demand curve The lesson: total CS equals the area under the demand curve above the price from 0 to Q How a higher price reduces CS Two reasons: • Some buyers leave the market. • Existing consumers who are willing to purchase pay higher prices. Cost and the supply curve Cost is the value of everything a seller must give up to produce a good. Includes cost of all resources used to produce good, including value of the seller's time. A seller will produce and sell the good/service only if the price exceeds their cost. Producer surplus (PS) : the amount a seller is paid for a good minus the seller's cost PS=P- cost Total PS equals the area above the supply curve under the price from 0 to Q. Two reasons for the fall in PS Sellers leaving the market Remaining seller getting lower P CS = (value to buyers) - (amount paid by buyers) = buyers' gain from participating in the market PS = (amount received by sellers) - (cost to sellers) = sellers' gain from participating in the market Total surplus = CS + PS Total surplus is used as a measurement of society's well-being, and we consider whether the market is efficient. Efficiency Total surplus = (value to buyers) - (cost to sellers) All allocation of resources is efficient if it maximizes total surplus. Efficiency means: The goods are consumed by the buyers who value them most highly. The goods are produced by the producers with the lowest cost. Raising or lowering the quantity of a good would not increases total surplus. Does eq'm Q maximize total surplus? The market eq'm quantity maximizes total surplus: at any other quantity, can increase total surplus by moving toward the market eq'm quantity. When a market is in equilibrium, resources are efficiently allocated. • Demand = marginal social benefit (MSB) The demand for any good represents the benefits that society derives from the consumption of that good. Marginal benefits decrease at higher levels of output because additional units of a good bring benefits to fewer and fewer people the more of the good exists. • Supply = marginal social cost (MSC) - The supply of a good represents the cost to society of producing the good - For almost all goods, the greater the amount is produced, the more it costs to additional units of it. - Think of oil. As the world produces more and more oil, it becomes increasingly harder to produce, thus the marginal cost decreases. • Only when the MSB = MSC is society producing the right amount of any good. If output occurs at any other level, we must say that resources are misallocated towards the good. • Allocative efficiency - An allocation of resources that results in producing the combination and quantity of goods and services mostly preferred by consumers. - It is achieved when the economy allocates its resources so that no one become better off in terms of increasing their benefit from consumption without someone else becoming worse off. - The condition for allocative efficiency is given P=MC (Price is equal to marginal cost) Elasticity- PED PED • Explain the concept of elasticity • Define elasticity of demand • Define and calculate PED • Illustrate different values of PED using demand curves • Explain the determinants of PED Inquiry question: How does the change in quantity demanded for different goods and services respond differently to changes in price? Elasticity • Basic idea: elasticity measures how much one variable responds to changes in another variable. - One type of elasticity measures how much demand for your websites will fall if you raise your price • Definition: Elasticity is a numerical measure of the responsiveness of Qd or Qs to one of is determinants. - Price elasticity of demand measures how much Qd responds to a change in P • Price elasticity of demand = !"#$"%&'(" *+,-./ 0- 12 3/4*/-5,./ *+,-./ 0- 6 - It measures the sensitivity of buyers' demand Determinants of PED - Example sunscreen and cereals: Price elasticity is higher when close substitutes are available - Example blue jeans and clothing: Price elasticity is higher for narrowly defined goods than for broadly defined ones. - Example insulin and Caribbean cruises: Price elasticity is higher for luxuries than for necessities. - Example short run gasoline and long run gasoline: Price elasticity is higher in the long run than the short run - Example pen and summer holidays: Price elasticity is higher when a good costs larger the proportion of one's income. Learning objectives: • Examine the role of PED for firms in making decisions regarding price changes and their effect on total revenue. • Examine the significance of PED for government in relation to indirect taxes. • Explain why the PED for many primary commodities is relatively low and the PED for manufactured products is relatively high. • Explain why PED varies along a straight line demand curve and is not represented by the slope of the demand curve. Enquiry question: what is the role of PED for firms in making decisions regarding price changes and their effect on total revenue? • A price increase has two effects on revenue: - Higher P means more revenue on each unit you sell But you sell fewer units due to law of demand. If demand is elastic, then price elasticity of demand > 1 Percentage change in Q > percentage change in P - The fall in revenue from lower Q is greater than the increase in revenue from higher P so revenue falls. When D is elastic, a price increase causes revenue to fall, when D is inelastic, a price increase causes revenue to rise - • PED and indirect taxes The lower the price elasticity of demand for the taxed good, the greater the government tax revenues. Enquiry question: Why is the PED for primary commodities relatively low and the PED for manufactured products relatively high? Total revenue is at a maximum when the price is at the point where demand is unit elastic. Primary commodities: Any product that is produced in the primary sector, which includes agriculture, forestry, fishing and the extractive industries; also known as commodity. Shifts in the supply curve result in large price fluctuations when demand is inelastic, and much milder ones when demand is elastic. Large price fluctuations over short periods of time are referred to as price volatility (volatility means instability or high variability) PED primary commodities vs. manufactured products- application in agriculture Primary commodities: supply shifts with inelastic demand Manufactured products: supply shifts with elastic demand • • A poor crop: A poor crop due to poor weather conditions, which results in a fall in supply(S2), leads to higher prices and higher total revenue. A good crop: A good crop resulting in a supply increase, or S3, leads to lower prices and lower farmers' revenues. The problem of unstable farmer revenues is an important reason behind government intervention to support farmer incomes. YED Learning objectives: • Define and calculate income elasticity of demand • Explain the possible range of values for income elasticity of demand • Understand the importance of YED for firms and explaining the sectoral changes in the structure of the economy. Enquiry question: • What is income elasticity of demand and what determines the YED elasticity of a product or not? • What are the implications of YED for businesses and the economy as a whole? YED • Income elasticity of demand: measures the response of Qd to a change in consumer income. - 3/4*/-5,./ *+,-./ 0- 12 income 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 = 3/4*/-5,./ *+,-./ 0- 0-*78/ • • • Recall: an increase in income causes an increase in demand for a normal good Hence, for normal goods, income elasticity > 0 For inferior goods, income elasticity < 0 • An inferior good is one with a negative YED coefficient. This is a good that people will buy more of as income falls, and less of as income rises. A normal good is one with a positive YED coefficient. There is a direct relationship between income and demand. • Engel curve An Engle Curve showing the relationship between income and the demand for potatoes. YED for firms • Recession is a persistent fall in real GDP in an economy, where unemployment tends to increase. Two consecutive quarters of negative GDP growth is considered a recession. - Inferior good producer: increase in sales - Normal good producer: may avoid large reduction in sales - Superior good producer: suffer the largest fall in sales • Economic growth is defined as real GDP growth in a specific time period. It usually implies a growth in employment in the economy and therefore in people's incomes. - Inferior good producer: market contraction - Normal good producer: small increase in sales - Superior good producer: the largest potential market growth The lipstick effect: lipsticks can be defined as inferior goods as the quantity demanded increases when income decreases. YED and producers- The rate of expansion of industries Suppose that total income in an economy grows at an average rate of about 3% per year YED > 1, demand for superior goods and services that are income elastic grows as a higher rate than 3% YED < 1, demand for other goods and services that are income inelastic grows at a rate of less than 3% The higher the YED for a good or service, the greater the expansion of its market is likely to be in the future; the lower the YED, the smaller the expansion. YED and the economy • Primary sector YED < 1 As society's income grows over time, the demand for agriculture output grows more slowly than the growth in income. • Manufacturing sector YED > 1 As society's income grows, the demand for these products grows faster than income. • Services sector YED > 1 Many services have even higher YEDs, so the percentage increase in the demand for these is much larger. PES • • • • Define and calculate price elasticity of supply Explain the possible range of values for price elasticity of supply Illustrate different values of price elasticity of supply using supply curves Explain the determinants of price elasticity of supply • • Understanding some implications of elasticity information for business and governments Explain a problem for producers of primary commodities due to the low price elasticity of demand and supply Definition: Price elasticity of supply measures how much Qs responds to a change in P. (sellers' price sensitivity) Formula: !"#$"%&'(" $+'%(" 9% : !"#$"%&'(" $+'%(" 9% ; The variety of supply curves • The slope of the supply curve is closely related to price elasticity of supply • Rule of thumb: The flatter the curve, the bigger the elasticity. The steeper the curve, the smaller the elasticity. The determinants of supply elasticity The more easily sellers can change the quantity they produce, the greater the price elasticity of supply. • Time: immediate vs short run vs long run - For many goods, PES is greater in the long run than in the short run, because firms can build new factories, or new firms may be able to enter the market. • How much costs rise as output is increased • The ability to store stock Market intervention Objectives: price ceilings (maximum prices): rational, consequences and examples price floors: rational (minimum prices), consequences and examples How price ceilings affect market outcomes? The eq'm price (800$) is above the ceiling and therefore illegal. In the long run, supply and demand are more price-elastic. Consequences of a price ceiling? • Shortage - With a shortage, sellers must ration the goods among buyers. • Non-price rationing - A method of dividing up something among possible users - In a free market, it is achieved by the price system: those who are willing and able to pay for a good will do so, and the good is rationed among users according to who buys it. - First-come-first-served principle, favouritism Some rationing mechanisms: long lines, discrimination according to sellers' biases - These mechanisms are often unfair, and inefficient: the goods do not necessarily go to the buyers who value them most highly. In contrast, when prices are not controlled, the rationing mechanism is efficient and impersonal (and thus fair). Underground (parallel) market - Involve buying/selling transactions that are unrecorded, and are usually illegal. Under allocation of resources to the goods and allocative inefficiency - Society is worse off: Too few resources are allocated to the production of the good Underproduction relative to social optimum Under allocation of resources to the goods and allocative inefficiency Thus resulting in an economy that's worse off Negative welfare impact - A price ceiling creates a welfare loss, indicating that the price ceiling introduces allocative inefficiency due to an under allocation of resources to the production of the good. - MB > MC, indicating that society is not getting enough of the good Consumers Consumers partially gain and partially lose. They lose area b but gain area c from producers. Those consumers who are able to buy the good at the lower price are better off. However, some consumers remain unsatisfied as at the ceiling price there is not enough of the good to satisfy all demands. Producers Producers are worse off, because with the price ceiling they sell a smaller quantity of the good at a lower price; therefore their revenues drop from QePe to QsPc. Workers The fall in output means that some workers are likely to be fired, resulting in unemployment. - • • • • • • • Government There will be no gains or loses for the government budget, yet the government may gain in political popularity among the consumers who are better off due to the price ceiling. • How could government eliminate the shortage in supply? - Plan A subsidies - Govts produce the products - Release the stocks Paper 1 part (b) [15 marks] To what extent might the concept of YED and PED be of significant for business organisations? D: definition E: explanation E: example D: diagram S: synthesis and evaluation - Pros/cons - Stakeholder analysis - Short run and long run - Conclusion
