HOW MARKETS WORK

Market exchange is a process through which people buy and sell commodities. Chapter three examines the workings of perfectly competitive markets. A large number of buyers and a large number of sellers participate. No one party sets the price.

RELATIVE PRICE Markets establish a price. The price is a sum of money you pay for the good. Economists are concerned about the opportunity cost of a good. –Suppose a pack of cigarettes costs $10.00 and taxi cab fare is $5.00. Buying cigarettes costs two taxi cab trips. If you walk back and forth to the University for one day and give up taking a cab each way, you can pay for the pack of cigarettes. In talking about markets were call the opportunity cost of goods the relative price. We are concerned about the change in the price of one good relative to the changes in prices of other goods. During a period of inflation the prices of all goods may be rising. If the price of one good, such as cigarettes rises by less than the price of other goods, than its relative price has fallen. –For example if taxi cab fares rose from $5.00 to $10.00 and the price of cigarettes rose from $10.00 to $15.00, the relative price of cigarettes has fallen. A pack now costs 1.5 taxi cab rides instead of two taxi cab rides.

LAW OF DEMAND The higher the price, the lower the quantity demanded, c.p. –c.p. -- other things being the same

Individual and Market Demand Goods A market demand curve is the horizontal sum of all individual demand curves. –This is determined by adding the individual demand curves of all the consumers (“demanders”).

Individual and Market Demand Goods In reality, the sellers do not add up individual demand curves. They estimate total market demand for their product which becomes smooth and downward sloping curve.

From Individual Demands to a Market, Fig. 4-4 (a and b), p 88 (1) Price per cassette $ (2) Marie’s demand (3) Pierre’s demand (2) Cathy’s demand (3) Market demand ABCDEFGHABCDEFGH Quantity of cassettes demanded per week 2 Cathy Pierre Marie D A C E F G $ Price per cassette (in dollars) B Market demand

From a Demand Table to a Demand Curve The demand curve graphically conveys the same information that is on the demand table. The curve represents the maximum price that you will pay for various quantities of a good—you will happily pay less.

Price per cassette (in dollars) A Demand Curve Quantity of cassettes demanded (per week) $ E D C BF A From a Demand Table to a Demand Curve, Fig. 4-3 (a and b), p 87 Price per cassette ABCDEABCDE A Demand Table Cassette rentals demanded per week $ Demand for cassettes G

Individual and Market Demand Goods The demand curve is downward sloping for the following reasons: –At lower prices, existing consumers buy more. –At lower prices, new consumers enter the market.

SUBSTITUTION EFFECT As the price of one good rises c.p. the opportunity cost of the good relative to substitutes increases. People buy less of the good and more of its substitutes If the price of pizza rises people buy more Big Macs or subway sandwiches.

INCOME EFFECT As the price of one good rises, c.p. the price rises relative to buyers’ incomes. People must buy fewer goods and they will buy fewer of the good whose price has risen Even if pizza had no substitutes, at high prices people would buy fewer because of budget constraints

DETERMINANTS OF DEMAND 1.PRICE OF THE GOOD 2.PRICE OF RELATED GOODS –COMPLEMENTS –SUBSTITUTES 3.INCOME –NORMAL GOODS –INFERIOR GOODS 4.POPULATION 5.EXPECTED FUTURE PRICES 6.PREFERENCES

Demand for Pizzas QUANTITYPRICE 0 $ $ $ $ $ $ 5.00

Demand Curve As the price rises, people are willing to buy fewer pizzas. As the price of pizza changes, move along the demand curve

Change in price of a complement

Change in price of a substitute

Change in Income

LAW OF SUPPLY The higher the price, the larger the quantity supplied, other things being equal When the price of a good rises, c.p. It rises relative to the opportunity cost of producing it, so firms are willing to produce more of the good.

A market supply curve is the horizontal sum of all individual supply curves. –This is determined by adding the individual supply curves of all the firms (“supplers”). Individual and Market Supply of Goods

Supply of Pizza QuantityPrice 0$ $ $ $ $ $ $35.00

SUPPLY At a higher price the firm is willing to supply more pizza. As price of pizza changes, move along the supply curve

DETERMINANTS OF SUPPLY PRICE OF THE GOOD PRICE OF FACTORS OF PRODUCTION PRICES OF RELATED GOODS –RAW MATERIALS –SUBSTITUTES IN PRODUCTION –COMPLEMENTS IN PRODUCTION NUMBER OF SUPPLIERS EXPECTED FUTURE PRICES TECHNOLOGY

Rise in Cost of a Factor of Production

Rise in price of raw material

Rise in Price of Substitute in Production The diagram tells the following story. When the price of a donair is $5.50, a firm will produce 200 pizzas only if it receives a price of at least $ A firm will produce 300 pizzas only if it receives a price of at least $ When the donair rises in price to $7.00, the opportunity cost of producing pizza rises. The firm is giving up the opportunity of producing donairs instead of pizzas. As a result it requires a higher price to produce a given number of pizzas. A firm now requires a price of at least $18.00 to produce 200 pizzas and a price of $23 to produce 300 pizzas.

Rise in Price of a Complement in Production The diagram tells the following story. When the price of a beef hide is $5.50, a firm will produce 200 units of beef only if it receives a price of at least $15.00 per unit. A firm will produce 300 units of beef only if it receives a price of at least $20.00 per unit. When the hides rise in price to $7.00, the return to producing beef rises. The firm receives the price of beef plus the price of the hide each time it slaughters an animal, so when the price of a hide rises, the total return to producing beef goes up. A firm now requires a price of at least $11.00 to produce 200 units of beef and a price of $16 to produce 300 units of beef.

Equilibrium Price and Quantity At low prices, people will want to buy more than people want to sell. Competition to buy will drive prices up. At high prices, people will want to sell more than people will want to buy Competition to sell will drive prices down Only when the quantity people want to sell equals the quantity people want to buy will price stop changing– be in equilibrium. PRICESUPPLYDEMAND $ $ $ $ $ $ $

Equilibrium price and quantity At low prices, people will want to buy more than people want to sell. Competition to buy will drive prices up. At high prices, people will want to sell more than people will want to buy Competition to sell will drive prices down Only when the quantity people want to sell equals the quantity people want to buy will price stop changing – be in equilibrium.

Market for Pizza