AS/A2 Applying economic theory The theory of markets and the real world With illustrations from the housing, energy and food retailing markets The theory of markets and the real world With illustrations from the housing, energy and food retailing markets

Efficiency of Markets Efficiency of Markets AS/A2 Applying economic theory

Efficiency of markets Responsiveness to consumer wishes –price elasticity of supply factor mobility flexibility of work practices time period Responsiveness to consumer wishes –price elasticity of supply factor mobility flexibility of work practices time period

Supply curves with different price elasticity of supply P Q O P0P0 Q0Q0 S1S1 S2S2 D0D0 D1D1 Q2Q2 Q1Q1 P2P2 P1P1

Efficiency of markets Responsiveness to consumer wishes –price elasticity of supply factor mobility flexibility of work practices time period –the case of housing Responsiveness to consumer wishes –price elasticity of supply factor mobility flexibility of work practices time period –the case of housing

House price Inflation

Efficiency of markets Responsiveness to consumer wishes –price elasticity of supply factor mobility flexibility of work practices time period –the case of housing Responsiveness to consumer wishes –price elasticity of supply factor mobility flexibility of work practices time period –the case of housing : shifts in demand income rates of interest availability of mortgages mortgage tax relief desire for home ownership return on investment in housing speculation about future house prices : shifts in demand income rates of interest availability of mortgages mortgage tax relief desire for home ownership return on investment in housing speculation about future house prices

Efficiency of markets Responsiveness to consumer wishes –price elasticity of supply Responsiveness to consumer wishes –price elasticity of supply Responsiveness to changes in supply –price elasticity of demand number and closeness of substitutes time period –the case of oil Responsiveness to changes in supply –price elasticity of demand number and closeness of substitutes time period –the case of oil

Demand curves with different price elasticity of demand P Q O P0P0 Q0Q0 S0S0 S1S1 D2D2 D1D1 Q1Q1 Q2Q2 P1P1 P2P2

Cease-fire in Iran-Iraq war Yom Kippur War: Arab oil embargo First oil from North Sea Revolution in Iran Iraq invades Iran Recession in Far East Iraq invades Kuwait New OPEC quotas World-wide recovery World-wide slowdown Impending war with Iraq OPECs first quotas Continuing worries about supply and rapid growth in demand from China and India Oil prices

Efficiency of markets Responsiveness to consumer wishes –price elasticity of supply Responsiveness to changes in supply –price elasticity of demand Responsiveness to consumer wishes –price elasticity of supply Responsiveness to changes in supply –price elasticity of demand Competition –survival of the fittest –new products –lower costs Minimum average cost in long run –lower prices Supernormal profits firms enter market price Competition –survival of the fittest –new products –lower costs Minimum average cost in long run –lower prices Supernormal profits firms enter market price

O £ Q LRAC Effect of competition on price and average cost P 1 = AR 1 P 2 = AR 2 Q1Q1 Q2Q2 QLQL Min. AC

Efficiency of markets Responsiveness to consumer wishes –price elasticity of supply Responsiveness to changes in supply –price elasticity of demand Competition –survival of the fittest –new products –lower costs and prices Responsiveness to consumer wishes –price elasticity of supply Responsiveness to changes in supply –price elasticity of demand Competition –survival of the fittest –new products –lower costs and prices Efficiency –productive –allocative Efficiency –productive –allocative

Allocative efficiency (under perfect competition with no externalities) MSB = P = MSC MSB > P buy more MSB < P buy less Until MSB = P MSC < P produce more MSC > P produce less Until MSC = P Thus in equilibrium MSB = MSC

Market failures Externalities –External costs of production –External benefits of production –External costs of consumption –External benefit of consumption Externalities –External costs of production –External benefits of production –External costs of consumption –External benefit of consumption

O MC = S D P MSC Costs and benefits Quantity External cost Q1Q1 Q2Q2 Social optimum External costs in production

Market failures Market power –Monopolies and oligopolies –Aim to make demand less elastic Restricting competition Product differentiation –The case of supermarkets Market power –Monopolies and oligopolies –Aim to make demand less elastic Restricting competition Product differentiation –The case of supermarkets

UK supermarket food market share (2006)

Market failures Market power: the case of supermarkets –Barriers to entry Buying up plots of land Exclusive deals with suppliers –Relationships with suppliers Makes it harder for convenience stores to compete –Lack of effective price competition Higher prices in areas where there is less competition Predatory prices where there is Market power: the case of supermarkets –Barriers to entry Buying up plots of land Exclusive deals with suppliers –Relationships with suppliers Makes it harder for convenience stores to compete –Lack of effective price competition Higher prices in areas where there is less competition Predatory prices where there is –Attempts to drive out competition Entry to convenience store market –Attempts to drive out competition Entry to convenience store market

£ Q O MC ( = supply under perfect competition) Q1Q1 MR P1P1 P2P2 Q2Q2 AR = D Comparison with Perfect competition Equilibrium of industry under perfect competition and monopoly: with the same MC curve