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 (next slide)

Excess Supply (surplus) of …………….. Qd < Qs ??____________________________________________• 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 (or DEADWEIGHT LOSS)

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 groupsAlso look at Page 6 for examples of correct diagrams and writing.

Disequilibria result from shiftsDemand 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