Markets and Price Determination ECON 704 Module 2, Part 2

Agenda Describe characteristics of a competitive market Understand the determinants of demand and supply in a market Use demand and supply to determine market prices and changes therein Understand the role of the price system in allocating resources

Prices and Markets Oil – worldwide production more than its ever been…so why has price increased so much? Platinum… $540/oz. May 2002 to $1296/oz Sept 2007 If red wine is discovered to be healthier, what would happen to the price of beer? What will happen in the market your business is in? The market for your labor?

Assumption: Competitive Market A market is buyers and sellers of a good or service A market is perfectly competitive when many buyers and many sellers free entry and exit individually no power to influence prices (price takers) product is undifferentiated participants have complete information

Competitive Markets, cont. Close Examples: agricultural grains; some precious metals Non-competitive markets: monopolies: single seller oligopoly: few sellers with substantial pricing interdependence monopolistic competition: many sellers of similar but differentiated products

Buyers and Sellers Buyers demand the product and consume it or use it as input into further production Buyers DEMAND a good or service; is a function of perceived benefit. The quantity demanded depends on price and other determinants. Sellers produce the product using inputs and sell it to the buyer Sellers SUPPLY a good or service; is a function of costs of production

Demand Quantity Demanded (QD) is the amount buyers are willing and able to buy, and falls as price increases (Law of Demand). Demand is the relationship between P and QD If price changes, Demand does not change!! Qty demanded changes along given demand Other determinants disturb the P/ QD relationship and change demand

A demand curve Price of pencils $0.30 0.25 0.20 0.15 0.10 0.05 Quantity of Pencils (in hundreds 1 2 3 4 5 6 7 8 9 10 11 12

Demand Determinants Income Tastes Expectations Prices of Related Goods Normal vs. Inferior goods Tastes Expectations Prices of Related Goods Substitutes vs. Complements Number of Buyers Demand curve shifts left (decrease) or right (increase)

Changes in Demand D2 D1 D3 Increase in demand Decrease in demand Price Quantity

Supply and Quantity Supplied Positive relationship between Price and Quantity Supplied (QS) Supply curves slope up Other Determinants Price of Inputs Technology/Productivity Number of Producers Expectations

Price Determination Surpluses (QS > QD) and Shortages (QD > QS) cause prices to change Equilibrium price where QS = QD

Surplus Equilibrium Shortage Supply Phigh $.15 Plow Demand 600 Price of Pencils Supply Surplus Demand Equilibrium Phigh $.15 Plow Shortage Quantity of Pencils 600

Changes in Equilibrium An Event Happens! Analytical Steps: What determinant is affected? Is it a determinant of Demand or Supply? or both? Do the curve(s) shift left or right? What happens to equilibrium price and quantity? Draw your curves and see the shifts! Do what model says, do not assume the result

Healthier Red Wine Supply D2 D1 Price of Red Wine 1. Greater “tastes” increases the demand for red wine... D2 Supply final price P1 New equilibrium initial price P0 2. ...resulting in a higher price... Initial equilibrium D1 Q0 Q1 Quantity of Red Wine 3. ...and a higher quantity sold.

Wine and the Beer market How would healthier red wine affect market for beer? “Common” Sense (i.e., the usual answer): demand for beer falls, which would mean less beer being sold at a lower price, but this is jumping to conclusions… Model says: price of beer substitute has increased; demand for beer should increase, and more beer sold at a higher price

Fossil Fuels Oil supply has increased, but not as much as demand Cheap oil as a deterrent to research into alternative energy sources Paying the full cost of producing and using fossil fuels?

Water Pricing Half of China’s 600 largest cities are running short of water ~ on 2 hours/day Annual rainfall normal, with some flooding Massive government water projects to move water Problem: no or very low pricing common issue with utilities in poorer countries, and some rich ones too! creates chronic shortages; lack of revenues impedes investment markets are not very sensitive to equity, but societies are

Intellectual Piracy Movie Studios and Record Labels putting huge sums into digital protection Motive: cheaper digital recording technology has eaten into sales? substitute goods (the copies) now less expensive

Why the Price System? Allocates resources to most highly valued uses as firms seek to provide that which consumers value Signals relative scarcity of resources Provides incentive to increase efficiency of resource use as firms try to minimize costs Helps consumers to allocate their scarce income in satisfying their wants

Conclusion Next Time: Elasticity concepts in demand and supply applications