Markets
- Bringing Demand and Supply Together -
What is a Market ???
• In economic theory, market include any kind of arrangement
where buyers and sellers of goods and services (or resources) are
come together to carry out an exchange/transaction.
• In addition to the physical places, markets also includes non-physical
places where buyers and sellers can come together through
– Internet/online, phone, fax, etc.
• Markets can be local (buyers and sellers in the local region e.g. local
grocery), national (within the country), and international (anywhere in
the world e.g. oil)
• types:
– Goods and services (product markets)
– Resources (factor markets) and one more…..
– Financial markets where international currencies, securities and
stocks (ownership of companies) are bought and sold
•  and underlying all markets is the concept of Demand and Supply
Market Analysis
• In the field of economics, a market is studied/
analyzed through combining and interacting the
concepts of demand and supply together
• Recall that until now, demand and supply were
studied separately. It illustrated the quantities
consumers and producers are willing and able to
buy and sell at each price
• But it did NOT tell us anything about how much
quantities the consumer and producer actually
demand and supply NOR the actual price they
pay and sell for, respectively.
Market Mechanism
• How is the final (actual) market price and
quantity demanded and supplied determined?
• This is through the interaction, negotiation,
bargaining between the demand and supply of
the good and services
• Assume the objective/goal of the consumers and
producers
– Maximize utility given their limited income
– Maximize profit given the cost of production
–  different perspectives towards the role of price of
goods/services (consumers want P to be low while
producers want P to be high to earn profits)
–  there is a clash of interest!
Interaction process… Disequilibrium
situations
• Suppose price of the market is initially at $5
 Excess Supply (surplus) of ……………..
Qd < Qs ??
(next slide)
____________________________________________
• Or if P= $2 (two slides on)
 Excess Demand (shortage)
• ………………. Qd > Qs
• ???
_______________________________________________
• Notice that as Price changes there is a MOVEMENT along
each curve in response
Equilibrium
• Definition: occurs when the market “clears”
•
1)
Qd = Qs
•
2) No excess demand or excess supply
•
3) All plans are fulfilled
• consequently
• 5) If in equilibrium, ………………………….
• 6) If in disequilibrium, will …………………….
• Though may take time through a COBWEB
Graphing (Page 3 of H/0)
• Need to be able to find
• a) graphically
b) algebraically
• How much do consumers spend?
• How much REVENUE do producers earn?.
Group III Tuesday
Consumer Surplus
• Consumer surplus is defined as the highest price
the consumers are willing to pay for a good minus
the price actually paid.
• It represents the difference between total
benefits, satisfaction or utility consumers receive
from buying a good and the price/cost paid to
receive them
• It is the bargain and gain you get through
shopping an item you wanted but for a price
lower than you were willing to pay!
Graphically,
• Consumer surplus is indicated by the area between
the demand curve (your marginal benefit and utility)
and the market price for the units of goods
consumed
Producer Surplus
• Producer surplus is defined as the price
received by firms for selling their good minus
the lowest price that they are willing to accept
to produce the good.
• It is the excess earnings producers receive
from given quantity of output, over and above
the (minimum) amount they were prepared to
accept
• It is the profit, return, and $$$ that they
wanted!
Graphically,
• It is the area above the firms’ supply curve and
below the price received by firms (determined by the
market)
Let’s then put consumer and producer
surplus together!
• What can you say about the CS and PS at the market
equilibrium? What if we were to produce Qd with P3
instead?
 COMMUNITY (social) SURPLUS
• = consumer surplus + producer surplus
• It is often referred to as the social welfare or well
being of society.
• (Look at last two pages of H/O or next slide or Word document)
• Where is it maximized?
• CALCULATE on graph (can ignore units)
•  concept of WELFARE LOSS
DEADWEIGHT LOSS)
(or
So to sum,
• The final decision on how to allocate our
scarce resources can be evaluated through
looking at the satisfaction or welfare of the
people running this economy (market)
consumers and producers
– Consumer surplus
– Producer surplus
Consumer Surplus and Producer Surplus
1
Calculating the Market Equilibrium
(Review)
• Using the demand and supply functions for the chocolate
bars:
Qd = 14 – 2P
Qs = 2 + 2P
• Market equilibrium price and quantity are values where
•
Qd = Qs
• Therefore, the equilibrium price is $3 and equilibrium
quantity is 8,000 chocolate bars
– You can check your calculation by inserting P = 3 into the
demand or supply equations and see whether you obtain
Qd = Qs = 8
Do rest of Page 3 and pp4/5 of H/O in groups
Also look at Page 6 for examples of correct diagrams and
writing.
Disequilibria result from shifts
Demand
Supply
- Income (normal and inferior
good)
- Taste and Preferences
- Price of related goods
(substitutes and complements)
- Population size
- Age structure
- Government policy
- Seasonal change
-  these things are constantly
changing in the real world!
- Factors of production and cost
- Technology
- Price of related goods
(competitive and joint supply)
- Producer expectation
- Government policies
- Number of firms
- Shocks and natural disasters
What happens to the market equilibrium
when there is a shift in D or S?
• Case 1: Shift in Demand to the right (e.g. increase
in income and product is a normal good)
What happens to the market equilibrium
when there is a shift in D or S?
• Case 2: Shift in Supply to the right (e.g. new
technology or more resources found)
Assumptions and implications
• 1. We assume a free market (free interaction between
D and S) to determine the final equilibrium outcome
• 2. The shift in the demand or supply curve is not equal
to (usually less than) the change in the equilibrium
quantity
– This is due to the subsequent price changes and the price
mechanism which cause the movement along the curves
• 3. the magnitude of the change in equilibrium price
and quantity depends on:
– 1. the magnitude of the change in D and/or S
– 2. the slope (elasticity) of the D and/or S curves (next
topic)
• The mechanism we have described is called
the Market Mechanism and/or the Price
Mechanism
– Introduced and founded by the Father of
Economics called Adam Smith
• What is the significance or essence of this?
Market Mechanism and Price Mechanism
• The what to produce question of resource allocation
is answered because firms product only those goods
consumers are willing and able to buy, while
consumers buy only those goods producers are
willing and able to supply
 power to the people! (Consumer Sovereignty)
• The how to produce question of resource allocation
is answered because firms use those resources and
technologies they are willing and able to pay for (in
the resource market)
Adam Smith stated…
• that the invisible hand working through the
market mechanism and prices succeeds in
coordinating the buying and selling decisions of
thousands and millions of individuals without any
central authority
• The market mechanism determined the one P
and Q to settle, the equilibrium, where the
buying and selling choices of all buyers and
sellers are satisfied and in balance
Allocative Efficiency and Pareto Optimality
• Allocative efficiency or Pareto Optimality refers to
producing the combination of the goods mostly wanted by
society. It is achieved when the economy allocates its
resources so that no one can become better off (in terms of
increasing benefits and utility) without someone else
becoming worse off.
• In other words, it best answers the very purpose and
definition of economics and exemplifies an equilibrium
• It is THE allocation of scarce resources that “best” and
“maximally” satisfies the unlimited wants…it is the “best”
and “optimal” choice and decision made for the society
given their scarce resources
• And the finding above shows that free or perfectly
competitive markets (under their many assumptions)
achieves Allocative Efficiency and Pareto Optimality
Let’s look at AE a bit more…
• So we now the demand curve represents the interest of the
consumers while the supply curve represents the interest of
the producers
• We learned that D = MU/MB (marginal utility/benefit) while
S = MC (marginal cost)
• Then we can (re)interpret the market equilibrium as a point
where MB = MC
• This equality tells us that the extra benefit to society of
getting one more unit of the good is equal to the extra cost to
society of producing one more unit of the good… this implies
that the society’s scarce resources are being used to produce
the “right” quantity  two interests in balance, equilibrium
• That is, society has allocated the “right” amount of resources
to the production of the good and producing the quantity of
the good that is mostly wanted by the society
To understand this better,
• Consider that MB > MC, then society would be placing
a greater value on the last unit of the good produced
than its costs to produce it and so more of it should be
produced (disequilibrium of excess D)
• Consider that MB < MC, then it would be costing
society more to produce the last unit of the good
produced than the value society pts on it, so less
should be produced (disequilibrium of excess S)
• In both case, you can reallocate the resources to make
some consumers better off without making others
worse off and thus allocation where MB = MC is the
“right” and “best” for society
To sum,
• Under the market mechanism or price
mechanism, they key to market’s ability to
allocate resources can be found in the role of
prices as signals (consumer sovereignty) and
price as incentives (higher utility and profits).
As signals, prices communicated information
to the decision makers. As incentives prices,
motivate decision makers to respond to the
information
In other words…
• So free or perfectly competitive market “best”
answers the fundamental economic questions of:
– What to produce – allocative efficiency refers to
producing what the consumer mostly want
– How to produce – productive efficiency means
producing with the fewest possible resources
• BUT it falls short and fails to answer
– For whom to produce – only the most efficient and
productive (or competitive) individuals benefits,
equity or fairness is not ensured
– This leads and justifies the need of governments
Mr. Adam Smith concluded…
• Free market or perfectly competitive market is
the best system that maximizes the welfare of
the society… allocation where no one can be
better off without making others worse off..
– called the Allocative Efficiency or Pareto
Optimality
• But is it really??? Realist assumptions?
Survival of the fittest… fair? Let’s keep
thinking about it… and applying it to the real
world (your life long project!)
STOP HERE Market Equilibrium
• Equilibrium is defined as a state of balance between
different forces such that there is no tendency to change
• Market equilibrium – state where the forces of demand
and supply are in balance and there is no tendency for the
price to change. There is no excess supply/surplus nor
excess demand/shortage.
– The price in market equilibrium is the equilibrium price and the
quantity is the equilibrium quantity.
– At this price, the quantity consumers are willing and able to buy
is exactly equal to the quantity firms are willing and able to sell.
And for this reason, this price is called the market clearing price
or simply market price
– Excess demand or excess supply is referred to as the market
disequilibrium and it cannot last as there is a tendency, force,
and incentives for the price to change which consequently
changes the Qd and Qs in accordance to its definition
(downward sloping D curve and upward sloping S curve)
Excess Demand (Shortage of Supply)
• Now, say the market price is at $1, at this price, the
producers are willing and able to produce only 4,000 bars
whereas consumers will be willing and able to buy 12,000
bars. There is therefore a shortage of supply
• With a high demand for their product as they are quickly
sold out, producers will see this as an opportunity/
incentive to raise price to earn more profits
• As they raise prices, the quantity supplied increases (can
produce more with more revenue) with a movement
along the supply curve and the quantity demanded falls
with a movement down the demand curve
• And again the prices will continue to rise until the point
where Qd = Qs where there is no more opportunity/
incentives for producers to raise the price as there is no
more excess demand to profit from
Excess Supply (Surplus of Supply)
• At price of $5, producers will be willing and able to produce
12,000 bars but consumers would only be willing and able
to buy 4,000 bars. There is therefore a surplus or excess
supply
• With unsold quantity of 8,000 bars, producers will lose
money and waste their product (less profit) unless they
somehow sell this excess supply
• In order to do so, there is an incentive for producers to
lower the price of the chocolate bars to encourage
consumers to purchase more
• Now, as the price of the chocolate falls, in accordance to
the definition of demand and supply, there will be a
movement along the demand curve to the right (quantity
demanded increases) and along the supply curve to the
left (quantity supplied decreases)
• And the prices will fall until the point where Qd = Qs where
there is no more incentives or reasons for producers to
lower the price as there is no more excess supply
Plotting Demand and Supply Curves Together
• Finally, you can plot the demand and supply functions on
the same graph and indicate the market equilibrium price
and quantity found at the point of intersection of the two
curves