Chapter 5 Market Equilibrium

2 Tanker service industry : Frontline  Frontline: a large independent crude carrier  Market conditions during the financial crises  Demand for oil transportation fell  Declining freight rates  Falling utilization

3  Decisions  Entire company  Continue in business or shut down  If continue, scale of operation  For each ship  Operate or sell ships  The demand for oil transportation and the supply for tanker services Tanker service industry : Frontline

4 Learning objectives  Appreciate the impact of excess supply on the market price.  Appreciate the impact of excess demand on the market price.  Apply the price elasticities of demand and supply to predict the impact of shifts in supply on market price and production.  Apply the price elasticities of demand and supply to predict the impact of shifts in demand on market price and production.

5 Outline  Perfect competition  Market equilibrium  Supply shift  Demand shift

6 Perfect competition  Homogeneous product  All firms sell an identical good.  Many buyers and sellers  Buyers and sellers can’t individually influence the market price  Free entry and exit  No entry and exit barriers  Equal (symmetric) information  Buyers and sellers have all the relevant information about the market, e.g., price, quality.

7 Perfect competition  In market where products are differentiated, competition is not as keen as that in a market where products are homogeneous.  Compare  mineral water – differentiated  gold – pure commodity

8 Perfect competition  Many small buyers  Many small sellers  Buyer/seller with market power can influence demand/supply

9 Perfect competition  Free entry and exit  entry barriers to potential competitors  absolute cost advantage ; e.g., better technology, patent.  economies of scale; large capital expenditures e.g., semiconductor, TFT LCD, steel, etc. hard to raise capital, large potential loss  exit barriers to existing sellers  commitment to regulator; e.g., telephone service provider

10 Perfect competition  Information about market conditions, e.g., price, available substitutes, technologies.  When buyers and sellers have symmetric information, then competition is more intense.  Compare  Photocopying service  Medical treatment  sellers (doctors) vs buyers (patients)  Legal service

The behavior of a single firm  Profit maximization 11

12 Outline  Perfect competition  Market equilibrium  Supply shift  Demand shift

13 Market equilibrium  Definition: Price at which quantity demanded equals quantity supplied  When market out of equilibrium, market forces push price towards equilibrium

14 Market equilibrium

15 Market equilibrium  Excess supply = excess of quantity supplied over quantity demanded  Triggers price decrease  Business implication: (Short run) Shrink production and (long run) exit  Excess demand = excess of quantity demanded over quantity supplied  Triggers price increase  Business opportunity: (Short run) Increase production and (long run) enter the industry

16 Outline  Perfect competition  Market equilibrium  Supply shift  Demand shift

17 Supply shift  Supply shift (cost): down/up  Represents change in cost at all quantities of production  Supply shift (quantity): right/left  Represents change in quantity of production at all prices  New equilibrium depends on elasticities of demand and supply

18 Supply shift (cost)

19 Supply shift (cost): Price elasticities of demand and supply

20 Supply shift (cost)  Price change no more than dollar amount of the supply shift  Price change greater if  Demand is more inelastic  Supply is more elastic

21 French products: Foie gras vis-à-vis butter  Two major French agricultural exports  foie gras  French butter

French products: Foie gras vis-à-vis butter 22  If Euro becomes 10% more expensive, compare the effect on prices of  foie gras  French butter  The demand for foie gras is less elastic (fewer substitutes)

23 Outline  Introduction  Perfect competition  Market equilibrium  Supply shift  Demand shift

24 Demand shift  Demand shift (willingness to pay): down/up  Represents change in willingness to pay (marginal benefit) at all quantities of consumption  Demand shift (quantity): right/left  Represents change in quantity demanded at all prices  New equilibrium depends on elasticities of demand and supply

25 Demand shift (quantity)

26 Demand shift (quantity)  Price change no more than dollar amount of the demand shift  Price change greater if  Demand is more inelastic  Supply is more inelastic

27 Valentine’s Day  Price of roses always rises much more than the price of greeting cards. Why?  Which one is more elastic in supply?  Greeting cards can be stored, but roses are perishable

28 Key takeaways  If the market price exceeds equilibrium, there will be excess supply and the price will tend to fall.  If the market price falls below equilibrium, there will be excess demand and the price will tend to rise.  A shift in supply will affect the market price and quantity to an extent that depends on the elasticities of both demand and supply.  A shift in demand will affect the market price and quantity to an extent that depends on the elasticities of both demand and supply.  A shift in demand will lead to a larger change in price in the short run than long run.  A shift in demand will lead to a smaller change in production in the short run than long run.