The Market Structure Markets are any place where transactions take place. It is an arrangement between buyers and sellers in order to exchange. Millions of people participate directly or indirectly in the U.S. economy. Consistent with rational decision making, the following assumptions apply to market participants. Consumers try to maximize their utility (satisfaction) given limited resources. Businesses try to maximize profits by using resources efficiently in producing goods. Government try to maximizes general welfare of society. Demand represents the behavior of utility maximizing consumers. Supply represents the behavior of profit maximizing producers. Demand is the amount of a good that consumers are able and willing to buy at alternative prices in a given time period, holding all else constant. It is the relationship between the possible prices of a good and the amount consumers are willing to buy. Other factors that influence buying decisions, for example income and prices of related goods, are held constant. To simplify their models, economists focus on only one force at a time and assume all else is constant. Ceteris paribus is the assumption of nothing else changing. According to law of demand, there is an inverse relationship between prices and the amount of the good consumers are willing to buy, ceteris paribus. As price increases, people buy less. When a good’s price rises, people tend to substitute less expensive goods, the principle of substitution. A demand curve is a curve describing the quantities of a good a consumer is willing and able to buy at alternative prices in a given time period, ceteris paribus. The law of demand is represented by the downward slope of the curve. At lower prices, higher quantities are demanded. Price $/q $5 $3 Demand 10 15 Quantity units At a price of $5 per unit, the consumer is willing to purchase 10 units. As price changes, we move along the demand curve. A decrease in price to $3 per unit leads to and increase in consumer purchases to 15 units. This change in price led to a change in quantity demanded. There has not been a change in demand, the curve did not change. Other factors other than price that influence buying decisions are the determinants of demand. These are the variables being held constant in the ceteris paribus assumption. Determinants of market demand include: ◦ Income — of the consumer. ◦ Price of related goods — substitutes & complements. ◦ Expectations — future prices, in particular. ◦ Number of buyers – market size. ◦ Tastes — desire for this and other goods. Demand can either increase or decrease with a determinant change. An increase in demand means that consumers are willing to buy more than before at a specific price. Demand shifts to the right. A decrease in demand is the opposite, consumers purchase less than before at a specific price. Demand shifts to the left. Demand increases from D1 to D2. Demand shifts to the right. Price $/q $5 D2 D1 10 17 Quantity units The quantity increases, 10 to 17, at the price of $5 per unit. Income – an increase in income usually increases demand. These goods are called normal goods. For some goods, inferior goods, an increase in income causes a decrease in demand, e.g., store brand can vegetables. Related goods – either substitutes or complements. As the price of a substitute increases, demand will increase. As the price of Coke increases, the demand for Pepsi increases. Complementary goods, such as peanut butter and jelly, go together. As the price of peanut butter increases, the quantity demanded for peanut butter falls, causing a decrease in the demand for jelly. Expectations – if consumers believe the price of a good is going to increase, demand will rise beforehand. For example, if gasoline prices are expected to increase tomorrow, people fill up their cars today. Changes in quantity demanded are portrayed Changes in demand are portrayed as shifts as movements along a demand curve which result from a price change of a good, ceteris paribus. of the demand curve due to changes in demand determinants, such as tastes, income, other goods’ prices, or expectations, violating the ceteris paribus assumption. PRICE $45 40 35 30 25 20 15 10 5 0 Shift in demand d2 d1 Movement along curve g1 D2 increased demand D1 initial demand 2 4 6 8 10 12 14 16 18 20 22 Quantity Market demand is the total quantities of a It is the sum of individual demands. good or service people are willing and able to buy at alternative prices in a given time period. Supply is the amount of a good sellers are able and willing to sell at alternative prices in a given time period, ceteris paribus. Notice that the definition of supply parallels the one for demand. The distinction between changes in quantity supplied and changes in supply are similar. According to the law of supply, the quantity of a good supplied in a given time period increases as its price increases, ceteris paribus. Supply curves are upward sloping. Price $/q Supply $7 $5 10 12 Quantity units At a price of $5 per unit, the seller is willing to sell 10 units. As price changes, we move along the supply curve. A increase in price to $7 per unit leads to and increase in seller sales to 12 units. This change in price led to a change in quantity supplied. There has not been a change in supply, the curve did not change. Other factors other than price that influence selling decisions are the determinants of supply. These are the variables being held constant in the ceteris paribus assumption. Determinants of market supply include: ◦ Price of inputs – changes costs of production ◦ Technology– changes costs of production ◦ Taxes– changes costs ◦ Expectations- future prices ◦ Number of sellers – market size Supply can either increase or decrease with a determinant change. An increase in supply means that sellers are willing to sell more than before at a specific price. Supply shifts to the right. A decrease in supply is the opposite, sellers sell less than before at a specific price. Supply shifts to the left. As supply increases from S1 to S2 the quantity increases from 10 to 13 at the price of $5. S1 Price $/q S2 $5 10 13 Quantity units A decrease in supply would be a shift from S2 to S1. Increases in the cost of production, either due to increase prices of inputs, decrease in technology, or taxes, decreases supply. Expectations of future price changes also effects sellers, but in the opposite direction. If price is expected to go up tomorrow, supply decreases today in order to sell more tomorrow. Changes in the quantity supplied — movements along the supply curve resulting from price changes. Changes in supply — shifts in the supply curve resulting from changing determinants. Buyers and sellers are brought together in order to exchange Market price adjusts to bring the market into an equilibrium If price is too high, sellers will want to sell more than buyers want to buy. If price is too low, buyers will want to buy more than sellers want to sell. Exchange requires both buyers and sellers, the lesser of quantity demanded or supplied will determine the amount transacted between the two. The equilibrium price is the price at which the quantity of a good demanded in a given time period equals the quantity supplied. This represents the point where demand and supply are the same, leaving no excess want or production. The equilibrium price is not determined by any single individual. Price $50 45 40 35 30 25 20 15 10 5 0 Market demand Market supply At equilibrium price, quantity demanded equals quantity supplied Equilibrium price 25 39 50 75 100 125 Quantity A market surplus is the amount by which the quantity supplied exceeds the quantity demanded at a given price – excess supply. A market surplus is created when the seller’s asking prices are too high. A market shortage is the amount by which the quantity demanded exceeds the quantity supplied at a given price – excess demand. A market shortage is created when the seller’s asking prices are too low. Price $50 45 40 35 30 25 20 15 10 5 0 Market demand Market supply Surplus x y Shortage 25 39 50 75 100 125 Quantity To overcome a surplus or shortage, buyers and sellers will change their behavior. Only at the equilibrium price will no further adjustments be required. Price $50 Market supply 40 E2 30 New demand E1 20 10 0 Initial demand 25 50 75 100 Quantity Price $50 Market supply 40 E3 30 E1 20 10 0 Initial demand 25 50 75 100 Quantity WHAT we produce is determined by the equilibrium quantities of various markets. HOW we produce is determined by profit seeking behavior and using resources efficiently. FOR WHOM we produce is determined by those willing and able to pay the equilibrium price. Although the outcomes of the marketplace are not perfect, they are often optimal. Everyone has done the best possible given their incomes and talents.