Fundamentals of Markets © 2011 D. Kirschen and the University of Washington 1

Let us go to the market... © 2011 D. Kirschen and the University of Washington 2 Opportunity for buyers and sellers to: – compare prices – estimate demand – estimate supply Achieve an equilibrium between supply and demand

How much do I value apples? © 2011 D. Kirschen and the University of Washington 3 Price Quantity One apple for my break Take some back for lunch Enough for every meal Home-made apple pie Home-made cider? Consumers spend until the price is equal to their marginal utility

Demand curve © 2011 D. Kirschen and the University of Washington 4 Aggregation of the individual demand of all consumers Demand function: Inverse demand function: Price Quantity

Elasticity of the demand © 2011 D. Kirschen and the University of Washington 5 Slope is an indication of the elasticity of the demand High elasticity – Non-essential good – Easy substitution Low elasticity – Essential good – No substitutes Electrical energy has a very low elasticity in the short term Price Quantity Price Quantity Low elasticity good High elasticity good

Elasticity of the demand Mathematical definition: Dimensionless quantity © 2011 D. Kirschen and the University of Washington 6

Supply side How many widgets shall I produce? – Goal: make a profit on each widget sold – Produce one more widget if and only if the cost of producing it is less than the market price Need to know the cost of producing the next widget Considers only the variable costs Ignores the fixed costs – Investments in production plants and machines © 2011 D. Kirschen and the University of Washington 7

How much does the next one costs? © 2011 D. Kirschen and the University of Washington 8 Cost of producing a widget Total Quantity Normal production procedure

How much does the next one costs? © 2011 D. Kirschen and the University of Washington 9 Cost of producing a widget Total Quantity Use older machines

How much does the next one costs? © 2011 D. Kirschen and the University of Washington 10 Cost of producing a widget Total Quantity Second shift production

How much does the next one costs? © 2011 D. Kirschen and the University of Washington 11 Cost of producing a widget Total Quantity Third shift production

How much does the next one costs? © 2011 D. Kirschen and the University of Washington 12 Cost of producing a widget Total Quantity Extra maintenance costs

Supply curve Aggregation of marginal cost curves of all suppliers Considers only variable operating costs Does not take cost of investments into account Supply function: Inverse supply function: © 2011 D. Kirschen and the University of Washington13 Price or marginal cost Quantity

Market equilibrium © 2011 D. Kirschen and the University of Washington14 Price Quantity Supply curve Willingness to sell Demand curve Willingness to buy market clearing price volume transacted market equilibrium

Supply and Demand © 2011 D. Kirschen and the University of Washington 15 Price Quantity supply demand equilibrium point

Market equilibrium © 2011 D. Kirschen and the University of Washington 16 Sellers have no incentive to sell for less Buyers have no incentive to buy for more market clearing price Quantity volume transacted Price supply demand

Centralized auction Producers enter their bids: quantity and price – Bids are stacked up to construct the supply curve Consumers enter their offers: quantity and price – Offers are stacked up to construct the demand curve Intersection determines the market equilibrium: – Market clearing price – Transacted quantity © 2011 D. Kirschen and the University of Washington17 Price Quantity

Centralized auction Everything is sold at the market clearing price Price is set by the “ last ” unit sold Marginal producer: – Sells this last unit – Gets exactly its bid Infra-marginal producers: – Get paid more than their bid – Collect economic profit Extra-marginal producers: – Sell nothing © 2011 D. Kirschen and the University of Washington18 Extra-marginal Infra- marginal Marginal producer Price Quantity supply demand

Bilateral transactions Producers and consumers trade directly and independently Consumers “ shop around ” for the best deal Producers check the competition ’ s prices An efficient market “ discovers ” the equilibrium price © 2011 D. Kirschen and the University of Washington 19

Efficient market All buyers and sellers have access to sufficient information about prices, supply and demand Factors favouring an efficient market – number of participants – Standard definition of commodities – Good information exchange mechanisms © 2011 D. Kirschen and the University of Washington 20

Examples Efficient markets: – Open air food market – Chicago mercantile exchange Inefficient markets: – Used cars © 2011 D. Kirschen and the University of Washington 21

Consumer ’ s Surplus Buy 5 apples at 10¢ Total cost = 50¢ At that price I am getting apples for which I would have been ready to pay more Surplus: 12.5¢ © 2011 D. Kirschen and the University of Washington22 Price Quantity Total cost Consumer’s surplus 15¢ 10¢ 5

Economic Profit of Suppliers Cost includes only the variable cost of production Economic profit covers fixed costs and shareholders ’ returns © 2011 D. Kirschen and the University of Washington 23 Quantity Price supply demand π Revenue Quantity Price supply demand Cost Profit

Social or Global Welfare © 2011 D. Kirschen and the University of Washington 24 Suppliers’ profit Quantity Price supply demand Consumers’ surplus + = Social welfare

Market equilibrium and social welfare © 2011 D. Kirschen and the University of Washington 25 Q π supply demand Market equilibrium Artificially high price: larger supplier profit smaller consumer surplus smaller social welfare Q π supply demand Welfare loss Operating point

Market equilibrium and social welfare © 2011 D. Kirschen and the University of Washington 26 Q π supply demand Q π supply demand Market equilibriumArtificially low price: smaller supplier profit higher consumer surplus smaller social welfare Welfare loss Operating point

What’s “the price”? Price = marginal revenue of supplier = marginal cost of supplier = marginal cost of consumer = marginal utility to consumer Market price varies with offer and demand: – If demand increases Price increases beyond utility for some consumers Demand decreases Market settles at a new equilibrium © 2011 D. Kirschen and the University of Washington 27

What’s “the price”? – If demand decreases Price decreases Some producers leave the market Market settles at a new equilibrium In theory, there should never be a shortage © 2011 D. Kirschen and the University of Washington 28

Price vs. Tariff Tariff: fixed price for a commodity Assume tariff = average of market price Period of high demand – Tariff < marginal utility and marginal cost – Consumers continue buying the commodity rather than switch to another commodity Period of low demand – Tariff > marginal utility and marginal cost – Consumers do not switch from other commodities © 2011 D. Kirschen and the University of Washington 29

Concepts from the Theory of the Firm © 2011 D. Kirschen and the University of Washington 30

Production function y: output x 1, x 2 : factors of production © 2011 D. Kirschen and the University of Washington 31 y x1x1 x 2 fixed x2x2 x 1 fixed y Law of diminishing marginal products

Long run and short run Some factors of production can be adjusted faster than others – Example: fertilizer vs. planting more trees Long run: all factors can be changed Short run: some factors cannot be changed No general rule separates long and short run © 2011 D. Kirschen and the University of Washington 32

Input-output function Example: amount of fuel required to produce a certain amount of power with a given plant © 2011 D. Kirschen and the University of Washington 33 fixed The inverse of the production function is the input-output function

Short run cost function w 1, w 2 : unit cost of factors of production x 1, x 2 © 2011 D. Kirschen and the University of Washington 34

Short run marginal cost function © 2011 D. Kirschen and the University of Washington 35 Convex due to law of marginal returns Non-decreasing function

Optimal production Production that maximizes profit: © 2011 D. Kirschen and the University of Washington 36 Only if the price π does not depend on y  perfect competition

Costs: Accountant ’ s perspective In the short run, some costs are variable and others are fixed Variable costs: – labour – materials – fuel – transportation Fixed costs (amortized): – equipments – land – Overheads Quasi-fixed costs – Startup cost of power plant Sunk costs vs. recoverable costs © 2011 D. Kirschen and the University of Washington37 Production cost [$] Quantity

Average cost © 2011 D. Kirschen and the University of Washington 38 Quantity Average cost [$/unit] Production cost [$] Quantity

Marginal vs. average cost © 2011 D. Kirschen and the University of Washington 39 MC AC $/unit Production

When should I stop producing? Marginal cost = cost of producing one more unit If MC > π next unit costs more than it returns If MC < π next unit returns more than it costs Profitable only if Q 4 > Q 1 because of fixed costs © 2011 D. Kirschen and the University of Washington 40 Marginal cost [$/unit] Average cost [$/unit] π Q1Q1 Q3Q3 Q4Q4 Q2Q2

Opportunity cost Use money to grow apples or to grow cherries? If profit from growing cherries is larger than the profit from growing apples, growing apples has an opportunity cost Use money to grow apples or put it in the bank where it earns interests? Profit from growing apples must be larger than bank interest because putting money in the bank has a lower risk Profit from a business must be compared against the “normal profit”, i.e. what putting money in the bank would bring © 2011 D. Kirschen and the University of Washington 41

Costs: Economist ’ s perspective Opportunity cost: – What would be the best use of the money spent to make the product ? – Not taking the opportunity to sell at a higher price represents a cost Examples: – Use the money to grow apples or put it in the bank where it earns interests? – Growing apples or growing kiwis? Comparisons should be made against a “ normal profit ” –What putting money in the bank would bring Selling “ at cost ” means making a “normal profit” – Usually not good enough because it does not compensate for the risk involved in the business © 2011 D. Kirschen and the University of Washington 42