Market Fundamentals Frederick University 2012

Main Economic Problems Questions What and how much How For Whom Problems Efficiency in allocation Efficiency in motivation Efficiency in distribution

Types of Economic Systems Traditional economy Market Economy Command Economy

Market Functions Allocation of scarce resources Motivation for efficiency Distribution of goods and services

The Demand for chocolates “Milka”

P Q A B C D E The demand curve

Demand Demand – buyers’ behavior The Demand for a good – the quantities buyers are willing and able to buy at every different price The law of Demand – the decrease in the price of the good raises the quantity of the good demanded, other factors held equal

FACTORS DETERMINING DEMAND Buyers’ income Prices of the other goods Buyers’ expectations Buyers’ taste and preferences Market size Institutions P Q Demand rises = the demand curve shifts rightwards Demand falls = the demand curve shifts leftwards D

Supply of Chocolate “Milka ” P Q S S

Supply Supply – sellers’ behavior The Supply of a good – quantities of the good that sellers are willing to sell at different price levels The Law of Supply – as the price of the good rises, sellers are willing to sell greater quantities of the good, ceteris paribus.

FACTORS DETERMINING SUPPLY Sellers’ expectations Cost of production Technological changes Market size Institutions P Q S Supply rises – the supply curve shifts rightwards Supply falls – the supply curve shifts leftwards

Market Equilibrium P Q DS E The market is in equilibrium when the quantity supplied equals the quantity demanded at the same price PePe QeQe

Market Equilibrium P Market equilibrium quantity supplied equals quantity demanded P e – equilibrium price Q e – equilibrium quantity Q D S PePe QeQe E

The Dynamics of Market Equilibrium P Q D S E D’ PePe QeQe QdQd Q d > Q s Q d – Q s = shortage P rises and Q s increases P rises and Q d falls The Equilibrium is restored at E’ P’ Q’ E’

The Dynamics of Market Equilibrium P Q D S E PePe QeQe S’ QsQs Q d < Q s Q s – Q d = surplus P falls and Qs decreases P falls and Q d increases E’ The Equilibrium is restored at E’ The equilibrium price clears all shortages and surpluses P e = market clearing price

Price Ceiling P Q D S PePe Qe PcPc QsQs QdQd shortage P b.m. Shortage = (Q d -Q s ) x P c Profits of the blackmarketeers = (P b.m. – P c ) x Q s

Arbitrage and speculation P Q Oz widget market D S P Oz Q Oz P Q Zo widget market D S P Zo Q Zo Demand shifts to Zo market Supply shifts to Oz market Shifts in Supply and Demand until price differences are eliminated exports imports

Arbitrage and speculation Arbitrage – the process by which individuals seek to make a profit by taking advantage of discrepancies among prices prevailing simultaneously in different markets Speculation – a way to make a profit by taking a deliberately risky position

Quantifying Market Responses Elasticity TR = P x Q Price Elasticity of Demand – buyers’ responsiveness to the price changes E p = % change in Quantity Demanded : % change in Price

Classifying Price Elasticity of Demand |Е| < 1 inelastic demand |E| > 1 elastic demand |E| = 1 unit elastic demand |E| = 0 perfectly inelastic demand |E| =∞ perfectly elastic demand

Calculating Price Elasticity of Demand E p = % change in Quantity Demanded : % change in Price % change in Quantity Demanded = = (Q 2 – Q 1 ) : (Q 2 + Q 1 )/2 % change in Price = = (P 2 – P 1 ) : (P 2 + P 1 )/2

Price Elasticity of Demand and Total Revenue TR = P x Q The Law of Demand - If P rises, Q falls If the percentage change in price is greater than the percentage change in quantity, the demand is inelastic If the price falls, the change in quantity demanded does not compensate for the price reduction and TR falls If the price rises, TR will increase

Price Elasticity of Demand and Total Revenue P QTR |E| > 1 If the price rises, TR increases If the price rises, TR falls If |E| = 1, TR does not change |E| < 1

PQ 101A 92B 83C 74D 65F 56G 47H 38I 29J 1 K |E| < E = % change in Q : % change in P % change in Quantity Demanded = = (Q2 – Q1) : (Q2 + Q1)/2 % change in Price = = (P2 – P1) : (P2 + P1)/2 % change in Q = =(10-9) : (9+10)/2 = 0.10 % change in P = = (1-2) : (2+1)/2 = E = |- 0.14| < 1 J K

|E|>1 |E| < 1 |E|= 1 % change in Q = (6-5) : (6+5)/2 = = 1.18 % change in P = (5-6) : (5+6)/2 = PQ 101A 92B 83C 74D 65F 56G 47H 38I 29J 1 K F G E = 1.18 : = -1 |- 1| = 1

PQ 101A 92B 83C |E|>1 % change in Q = = (2-1) : (2+1)/2 = 0.67 % change in P = =(9-10) : (9+10)/2 = A B P Q E = % change in Q : % change in P E = 0.67 : = |-670| > 1 % change in Quantity Demanded = = (Q2 – Q1) : (Q2 + Q1)/2 % change in Price = = (P2 – P1) : (P2 + P1)/2

FACTORS AFFECTING PRICE ELASTICITY OF DEMAND Availability of substitutes/Definition of market Time horizon Income Traditions

Price Elasticity of Supply Price elasticity of supply – sellers’ responsiveness to the price changes E p = % change in Quantity Supplied : % change in Price

Price Elasticity of Supply P Q E < 1 E > 1 E = 1

Price Elasticity of Supply P Q E = 0 E = ∞

FACTORS AFFECTING PRICE ELASTICITY OF SUPPLY Time horizon Availability of production factors Mobility of production factors Inventory levels Competitiveness of the market structure Institutions

Applications of Price Elasticity Economics of Agriculture P Q S1S1 S2S2 D Q1Q1 P1P1 P2P2 Q2Q2 % change in P > % change in Q E < 1 P falls and TR falls Farmers have lower income

Applications of Price Elasticity Economics of Agriculture P Q S D P1P1 P0P0 Q Solution 1: government pays the difference P 1 – P 0 to the farmers Government will lose (P 1 – P 0 ) x Q

Applications of Price Elasticity Economics of Agriculture P Q S D Q1Q1 P1P1 P0P0 Q Solution 2: government buys all Q from farmers at P 1 and sells it. However, buyers will buy less at P 1 Government cannot sell Q – Q 1 and will lose (Q – Q 1 ) x P 1 Solution 2 is preferable because the loss is smaller. The loss under solution 1 is (P 1 – P 0 ) x Q The loss under solution 2 is (Q – Q 1 ) x P 1 Since demand is inelastic, (P 1 – P 0 ) x Q > (Q – Q 1 ) x P 1

The Tax Incidence P Q D S1S1 Case 1: perfectly inelastic demand Government imposes an excise tax = t Sellers will be willing to sell the same Q if only someone else would pay the tax Supply shifts to S 2 Q P1P1 Since demand is perfectly inelastic, buyers will not change the quantity demanded t S2S2 P 2 = P 1 + t Buyers pay the tax

The Tax Incidence P Case 2: inelastic demand and elastic supply Q D S1S1 Government imposes an excise tax = t Sellers will be willing to sell the same Q if only someone else would pay the tax Supply shifts to S 2 Demand is not perfectly inelastic And buyers will not want to buy Q 1 at the higher price P 2 Q1Q1 P1P1 S2S2 P2P2 Buyers are willing to buy Q 2 < Q 1 Q2Q2 The shortage Q 2 – Q 1 will push the Price down to a new equilibrium P3P3 t Q3Q3 Tax = P 2 – P 1. Buyers pay (P 3 – P 1 ) - this is the greater part of the tax. The rest (P 2 – P 3 ) is paid by sellers

The Tax Incidence P Case 2: elastic demand and inelastic supply Q D S1S1 Government imposes an excise tax = t Sellers will be willing to sell the same Q if only someone else would pay the tax Supply shifts to S 2 Demand is elastic And buyers will not want to buy Q 1 at the higher price P 2 Q1Q1 P1P1 S2S2 P2P2 Buyers are willing to buy Q 2 < Q 1 Q2Q2 The shortage Q 2 – Q 1 will push the Price down to a new equilibrium P3P3 t Q3Q3 Tax = P 2 – P 1. Buyers pay (P 3 – P 1 ) - this is the smaller part of the tax. The rest (P 2 – P 3 ) is paid by sellers