Chapter 4.1 Market Equilibrium

Market Equilibrium Market equilibrium is a situation that occurs in a market when the price is such that quantity that consumers wish to buy is exactly balanced by the quantity that firms wish to supply. In a free market, the forces of supply and demand interact to determine equilibrium quantity and equilibrium price.

The Interaction of Supply and Demand The English historian Thomas Carlyle once said: “Teach any parrot the words supply and demand and you’ve got an economist.”

Equilibrium Equilibrium price – the price toward which the invisible hand drives the market. Equilibrium quantity – the amount bought and sold at the equilibrium price.

What Equilibrium Isn’t Equilibrium isn’t a state of the world, it is a characteristic of a model. Equilibrium isn’t inherently good or bad, it is simply a state in which dynamic pressures offset each other. When the market is not in equilibrium, you get either excess supply or excess demand, and a tendency for price to change.

Excess Supply & Excess Demand Excess supply – a surplus, the quantity supplied is greater than quantity demanded Prices tend to fall. Excess demand – a shortage, the quantity demanded is greater than quantity supplied Prices tend to rise.

Price Adjusts The greater the difference between quantity supplied and quantity demanded, the more pressure there is for prices to rise or fall. When quantity demanded equals quantity supplied, prices have no tendency to change.

The Graphical Interaction of Supply and Demand

The Graphical Interaction of Supply and Demand $5.00 S 4.00 Excess supply 3.50 A 3.00 Price per DVD 2.50 E C 2.00 1.50 Excess demand D 1.00 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of DVDs supplied and demanded

The Graphical Interaction of Supply and Demand When price is $3.50 each, quantity supplied equals 7 and quantity demanded equals 3. The excess supply of 4 pushes price down.

The Graphical Interaction of Supply and Demand When price is $1.50 each, quantity supplied equals 3 and quantity demanded equals 7. The excess demand of 4 pushes price up.

The Graphical Interaction of Supply and Demand When price is $2.50 each, quantity supplied equals 5 and quantity demanded equals 5. There is no excess supply or excess demand, so price will not rise or fall.

Equilibrium (Graph)

Chapter 4.2 Examples of Markets

Examples of Markets Labor market – firms demand labor and employees supply labor. From a firms point of view the demand for labor is a derived demand. Firms want labor not for its own sake, but for the output that it produces.

Unemployment A higher wage rate encourages more people to offer themselves for work. Unemployment results when people seeking work at the going wage cannot find a job. underemployment classification includes those workers who are highly skilled but working in low skill jobs and part-time workers who would prefer to be full time.

The Foreign Exchange Market The exchange rate is the price at which two currencies exchange and it can be analyzed using demand and supply.

Money Market Demand for money is associated with the functions of money set out as a medium of exchange, store of value, unit of account and standard of deferred payment. Money supply is determined by the central bank.

Chapter 4.3 Comparative Statics

Comparative statics Comparative static analysis – examines the effect on equilibrium of a change in the external conditions affecting a market.

Elasticity: the sensitivity of demand and supply Chapter 4.4 Elasticity: the sensitivity of demand and supply

Elasticity: The demand Sensitivity of demand and supply Elasticity is a measure of the sensitivity of one variable to change in another variable. Price elasticity of demand (PED) is a measure of the sensitivity of quantity demanded to change in the price of a good or service.

Income Elasticity of Demand Income elasticity of demand (YED) measures the responsiveness of quantity demanded to changes in real income. YED = %Δ demand / %Δ in income Example: A rise in consumer real income of 7% leads to an 9.5% rise in demand for pizza deliveries. The income elasticity of demand: = 9.5/ 7 = +1.36 (ELASTIC)

Significance of Income Elasticity of Demand High Income Elasticity Demand is sensitive to changes in real incomes Demand is therefore cyclical – in an economic expansion, demand will grow strongly. In a recession demand may fall Can be difficult for businesses to accurately forecast demand and make capital investment decisions

Significance of Income Elasticity of Demand Low Income Elasticity Demand is more stable during fluctuations in the economic cycle than high YED Over time, the share of consumer spending on inferior goods and normal necessities tends to decline Long run – businesses need to invest in / focus on products with a higher income elasticity of demand if they want to increase total profits

Elasticity – the concept The responsiveness of one variable to changes in another When price rises, what happens to demand? Demand falls BUT! How much does demand fall?

Elasticity – the concept If price rises by 10% - what happens to demand? We know demand will fall By more than 10%? By less than 10%? Elasticity measures the extent to which demand will change

Elasticity 4 basic types used: Price elasticity of demand Price elasticity of supply Income elasticity of demand Cross elasticity

Elasticity Price Elasticity of Demand The responsiveness of demand to changes in price Where % change in demand is greater than % change in price – elastic Where % change in demand is less than % change in price - inelastic

Elasticity The Formula: % Change in Quantity Demanded ___________________________ Ped = % Change in Price If answer is between 0 and -1: the relationship is inelastic If the answer is between -1 and infinity: the relationship is elastic Note: PED has – sign in front of it; because as price rises demand falls and vice-versa (inverse relationship between price and demand)

Elasticity Price (£) Quantity Demanded The demand curve can be a range of shapes each of which is associated with a different relationship between price and the quantity demanded. Quantity Demanded

Elasticity Total Revenue Price £5 D 100 Quantity Demanded (000s) Total revenue is price x quantity sold. In this example, TR = £5 x 100,000 = £500,000. This value is represented by the grey shaded rectangle. The importance of elasticity is the information it provides on the effect on total revenue of changes in price. £5 Total Revenue D 100 Quantity Demanded (000s)

Elasticity Total Revenue D Price £5 £3 100 140 If the firm decides to decrease price to (say) £3, the degree of price elasticity of the demand curve would determine the extent of the increase in demand and the change therefore in total revenue. £5 £3 Total Revenue D 100 140 Quantity Demanded (000s)

Elasticity % Δ Price = -50% % Δ Quantity Demanded = +20% Producer decides to lower price to attract sales 10 % Δ Price = -50% % Δ Quantity Demanded = +20% Ped = -0.4 (Inelastic) Total Revenue would fall 5 Not a good move! D 5 6 Quantity Demanded

Elasticity Producer decides to reduce price to increase sales % Δ in Price = - 30% % Δ in Demand = + 300% Ped = - 10 (Elastic) Total Revenue rises 10 Good Move! 7 D 5 20 Quantity Demanded

Elasticity If demand is price elastic: Increasing price would reduce TR (%Δ Qd > % Δ P) Reducing price would increase TR (%Δ Qd > % Δ P) If demand is price inelastic: Increasing price would increase TR (%Δ Qd < % Δ P) Reducing price would reduce TR (%Δ Qd < % Δ P)

Elasticity Income Elasticity of Demand: The responsiveness of demand to changes in incomes Normal Good – demand rises as income rises and vice versa Inferior Good – demand falls as income rises and vice versa

Elasticity Income Elasticity of Demand: A positive sign denotes a normal good A negative sign denotes an inferior good

Elasticity Cross Elasticity: The responsiveness of demand of one good to changes in the price of a related good – either a substitute or a complement % Δ Qd of good t __________________ Xed = % Δ Price of good y

Elasticity Goods which are complements: Goods which are substitutes: Cross Elasticity will have negative sign (inverse relationship between the two) Goods which are substitutes: Cross Elasticity will have a positive sign (positive relationship between the two)

Elasticity Price Elasticity of Supply: The responsiveness of supply to changes in price If Pes is inelastic - it will be difficult for suppliers to react swiftly to changes in price If Pes is elastic – supply can react quickly to changes in price % Δ Quantity Supplied ____________________ Pes = % Δ Price

Determinants of Elasticity Time period – the longer the time under consideration the more elastic a good is likely to be Number and closeness of substitutes – the greater the number of substitutes, the more elastic The proportion of income taken up by the product – the smaller the proportion the more inelastic Luxury or Necessity - for example, addictive drugs

Importance of Elasticity Relationship between changes in price and total revenue Importance in determining what goods to tax (tax revenue) Importance in analysing time lags in production Influences the behaviour of a firm This slide also has an automatic response with ten second gaps in between each point. At this stage we have tried to keep things as simple as possible but to introduce issues that will be dealt with later in the course.