Markets and Market Participants (Supply and Demand) Chapter-3

In This Chapter… Market Participants, their Goals, and Interactions in the Market Place 3.2. The Representation (Characterization) of Market Participants Supply and demand  Individual and Market 3.3. The formation of Market Signals that guide us in Allocating the Scarce Resources

3.1. Identifying Markets, Market Participants and their Behavior  Who?  Millions of people (domestic or foreign), firms, and government institutions participate directly or indirectly in the market (a given country’s economy).  We can identify three broad groups of market participants

3.1. Identifying Markets, Market Participants and their Behavior  Consumers (Households): Those economic agents who go to the marketplace to buy goods and services and satisfy their needs (wants) from their limited resources.  Producers (Businesses or firms): Economic agents who go to the marketplace to sell goods and services so as to make profits from their limited outputs (services)  Government (Government Institutions): Serve the public needs interest by using the available resources

3.1. Identifying Markets, Market Participants and their Behavior  The Purpose (Goal) of Market Participants?  Consumers (Households): maximize their utility (satisfaction) given limited resources.  Producers (Businesses): maximize profits by using resources efficiently in producing goods.  Government Institutions: maximize general welfare of the society. Maximizing Behavior

3.1. Identifying Markets, Market Participants and their Behavior  Maximizing Behavior The basic goals of utility maximization, profit maximization, and welfare maximization thus explain most market activity. How do Markets enable Participants to Achieve the goal Maximization?

3.1. Identifying Markets, Market Participants and their Behavior  Economic interactions …the opportunity for specialization and exchange.  Our economic interactions with others in the market place is necessitated by two constraints: 1.Our absolute inability as individuals to do (produce) all the things we need or desire. 2.The limited amount of time, energy, and resources we have producing those things we could make for ourselves…scarcity

3.1. Identifying Markets, Market Participants and their Behavior  Markets thus refer to a place where consumers and producers come together and where exchange takes place.  Although identifiable and peculiar in some cases, there is no specific place where markets are located (they could be virtual)  A market exists wherever and whenever an exchange takes place.  Based on the items for exchange, however, we can identify TWO MAIN types of markets

3.1. Identifying Markets, Market Participants and their Behavior 1. Factor Markets: … are any place where factors of production (e.g., land, labor, capital) are bought and sold. 2.Product Markets: …are any place where finished (final) goods and services (products) are bought and sold.

3.1. Interaction in the Market Place International participants Consumers (Households) International participants Producers (Firms) Governments Product Markets Factors Markets Factors of production supplied Goods and services demanded Factors of production demanded The Circular Flow Goods and services supplied

Dollars and Exchange  Every market transaction involves an exchange of dollars for goods (in product markets) or resources (in factor markets).

3.1. Interaction in the Market Place International participants Consumers (Households) International participants Producers (Firms) Governments Product Markets Factor Markets Household Expenses Costs of Production The Circular Flow Revenue IncomesFactors of production demanded Factors of production supplied Goods and services demanded Goods and services supplied

3.2. Characterization of the Activities of Market Participants  Market is a place that brings together Consumers (Buyers) and Producers (Sellers).  For every market transaction, there must be a buyer and a seller. The sellers represent the supply side of the market. The buyers represent the demand side of the market.

3. 2. Supply and Demand Demand

3. 2. Supply and Demand  What is Demand ? is the ability and willingness of consumers (buyers) to buy specific quantities of a good at alternative prices in a given time period, ceteris paribus.ceteris paribus. Quantity Demanded:  The amount of a good that a consumer is willing and able to buy at given time and price level, ceteris paribus

Ceteris Paribus  Ceteris paribus is the assumption of nothing else changing (keeping all other unchanged).  To simplify their models, economists focus on only one or two forces at a time and assume nothing else changes.

3.2. Supply and Demand  A demand exists only if someone is willing and able to pay for a good. Thus…  “Demand” is an expression of consumer buying intentions – of a willingness and ability to buy – not a statement of actual purchases.

Individual Demand  Three different ways to present demand: 1.Using A table (Demand Schedule) 2.Using A graph (Demand Curve) 3.Using A Mathematical Equation (Demand Function)

Individual Demand  Demand schedule: is a table showing the quantities of a good a consumer is willing and able to buy at alternative prices in a given time period, ceteris paribus.

Individual Demand  Demand curve: is a curve (graph) describing the quantities of a good a consumer is willing and able to buy at alternative prices in a given time period, ceteris paribus.

Demand Schedule and Curve Quantity of Tutoring Demanded (hours) PRICE $ A B C D E F G H I

Individual Demand  Demand Function: an algebraic representation of the quantities of a good a given consumer is willing and able to buy at alternative prices in a given time period, ceteris paribus.

Individual Demand  The Law of demand: The quantity of a good demanded in a given time period increases as its price falls, ceteris paribus.

Determinants of Demand  Determinants of market demand include: Tastes — desire for the particular good under consideration and other goods. Income — of the consumer. Income — of the consumer. Other goods — their availability and price. Other goods — their availability and price. Expectations — for income, prices, tastes. Number of buyers.

Other Goods Substitute goods: Goods that can be used to serve the same purpose (Substitute for each other). E.g., Pepsi and Coke When the price of good x rises, the demand for good y increases, ceteris paribus. Complementary goods: Goods that are frequently consumed in combination (E.g., Burger and Cheese). When the price of good x rises, the demand for good y falls, ceteris paribus.

Income Normal goods: Goods the consumption of which increases as our income level increases, and falls as income level falls (E.g., …..) Inferior goods: Goods the consumption of which increases as income level falls and decreases as the income level rises (E.g., …..).

Types of Demand  We can identify two types of demand:  Individual demand  Market demand : is the total quantities of a good or service people are willing and able to buy at alternative prices in a given time period.  It is the sum of individual demands.

Market Demand  Market demand is determined by the number of potential buyers and their respective tastes, incomes, other goods and expectations.

The Market Demand Curve  Market demand represents the combined demands of all market participants.  The separate demands of individual consumers is added up to determine the total quantity demanded at any given price.

Construction of the Market Demand Curve ++= Morke’s demand curve $50 Price + Stacy’s demand curve Leah’s demand curve Negassa’s demand curve Price Quantity Demanded

Construction of the Market Demand Curve A B C D E F G I $ The market demand curve Price Quantity Demanded H =

Shifts in Demand Vs Movements along the Demand Curve  The determinants of demand can and do change.  A Change in demand is indicated by a shift in the demand curve. Represents a change in the quantity demanded at every given price level. Results from changes in one or more factors in the determinants of demand (due to changes in tastes, income, other goods, or expectations), except own price of the good

Shifts in Demand Vs Movements along the Demand Curve Changes in quantity demanded : Is indicated by movements along a demand curve, and it results only as a response to changes in the price of the good itself.

Changes in Demand Change in Demand is indicted by a shift in the Demand Curve An increase in demand shifts the demand curve to the right when: A decrease in demand shifts the demand curve to the left when: The good is normal and income increases The good is normal and income decreases The good is inferior and income decreases The good is inferior and income increases The price of a substitute good increases The price of a substitute good decreases The price of a complementary good decreases The price of a complementary good increases

Market Effects of Changes in Demand Changes in Demand Shift the Demand Curve An increase in demand shifts the demand curve to the right when: A decrease in demand shifts the demand curve to the left when: Population increasesPopulation decreases Consumer tastes shift in favor of the product Consumer tastes shift away from the product Consumers expect a higher price in the future Consumers expect a lower price in the future

Market Effects of Changes in Demand Changes in Demand Shift the Demand Curve An increase in demand shifts the demand curve to the right when: A decrease in demand shifts the demand curve to the left when: Population increasesPopulation decreases Consumer tastes shift in favor of the product Consumer tastes shift away from the product Consumers expect a higher price in the future Consumers expect a lower price in the future

Movements vs. Shifts PRICE $ Quantity D1D1 initial demand d1d1 Movement along curve g1g1 Shift in demand D2D2 increased demand d2d2

Pizza and Politics: Quiz (True or False)  At the Clinton White House whenever a political crisis erupted, the demand for pizza increased.  …we can represent this by a shift in demand curve for pizza (at the White House) not by movement along the same demand curve.  True

3. 2. Supply and Demand Supply

3.2. Supply and Demand  What is Supply? is the ability and willingness of a producer (supplier) to sell specific quantities of a good at alternative prices in a given time period, ceteris paribus. Quantity Supplied  The quantity of a given good that the producer is willing and able to supply at a given price and time, ceteris paribus

Supply  Supply is the total quantities of a good that sellers are willing and able to sell at alternative prices in a given time period, ceteris paribus.

Law of Supply  Larger quantities will be offered for sale at higher prices.  Law of supply, the quantity of a good supplied in a given time period increases as its price increases, ceteris paribus.  Supply curves are thus upward-sloping to the right.

Market Supply

Erin’s Supply Hussein’s Supply Miranda’s Supply

Market Supply

Determinants of Supply  The determinants of market supply include: –Factor costs –Technology –Other goods –Taxes and subsidies –Expectations –Number of sellers

Market Supply  The market supply curve is just a summary of the supply intentions of all producers.  Market supply is an expression of sellers’ intentions (willingness and ability)– an offer to sell – not a statement of actual sales.

Movements and Shifts of Supply  Changes in the quantity supplied — movements along the supply curve.  Changes in supply — shifts in the supply curve.

Equilibrium Market Price

Equilibrium  Equilibrium price is the price at which the quantity of a good demanded in a given time period equals the quantity supplied.  Equilibrium Quantity The quantity of the good purchased and sold at the equilibrium price

Equilibrium Price

Market demand Equilibrium price Market supply $ At equilibrium price, quantity demanded equals quantity supplied Quantity39 Price

….Equilibrium Price is a Market Clearing Price  Everyone may not be happy with the prevailing price or quantity at equilibrium.  However, it is unique in that the outcome at market equilibrium is efficient. Resources are put to their best possible use

The Invisible Hand  Adam Smith characterized this market mechanism as the invisible hand.  The market mechanism is the use of market prices and sales to signal desired outputs (or resource allocations).

Deviation from the Equilibrium

Market Surplus  A market surplus is the amount by which the quantity supplied exceeds the quantity demanded at a given price – excess supply.  A market surplus is created when the market prices are too high.

Market Shortage  A market shortage is the amount by which the quantity demanded exceeds the quantity supplied at a given price – excess demand.  A market shortage is created when the market prices are too low.

Surplus and Shortage Market demand Market supply $ Quantity39 Price Shortage y x Surplus

Self-Adjusting Prices  A market surplus will emerge when the market price is above the equilibrium price.  A market shortage will emerge when the market price is below the equilibrium price.

Self-Adjusting Prices  Buyers and sellers will change their behavior to overcome a surplus or shortage.  Only at the equilibrium price will no further adjustments be required.

Surplus and Shortage Market demand Equilibrium price Market supply $ Quantity39 Price Shortage y x Surplus

Changes in Equilibrium  No equilibrium price is permanent.  The equilibrium price will change whenever the supply or demand curve shifts.  Changes in supply and demand occur when the determinants of supply and demand change.

Changes in Equilibrium  Should the demand curve shift, the result will be a change in equilibrium price and quantity. Should the demand curve shift, the result will be a change in equilibrium price and quantity.  Should the supply curve shift, the result will be a change in equilibrium price and quantity. Should the supply curve shift, the result will be a change in equilibrium price and quantity.

Changes in Equilibrium Changes in Equilibrium Demand Shift Quantity Price $ E1E1 Initial demand Market supply New demand E2E2

Changes in Equilibrium Supply Shift Quantity Price $ E3E3 E1E1 Initial demand Market supply

Implications---Outcomes  In a free market economy, the market mechanism resolves the basic economic questions of WHAT, HOW, and FOR WHOM.

Market Outcomes  WHAT we produce is determined by the equilibrium of the markets.  HOW we produce is determined by profit seeking behavior and using resources efficiently.  FOR WHOM we produce is determined by those willing and able to pay the equilibrium price

 Does the Market Outcome Satisfy Everybody?  Is it Perfect?  Is it Optimal?

Optimal, Not Perfect!!  Not everyone is happy with market outcomes.  But we are given the opportunity to maximize our own satisfaction.  Thus although the outcomes of the marketplace are not perfect, they are often optimal.  Because Everyone has done the best possible given their incomes and talents

Real Life Examples…  People are often upset with the market outcome.  In a market-driven economy of the U.S.A.(California), electricity prices are set by the forces of supply and demand.

Real Life Examples…  In 2000, Electricity prices increased in California because of two reasons: an increase in demand (The demand curve shifted rightward) and a decrease in supply (The supply curve shifted leftward). Sharp Increase in Electricity Price..

Price Ceilings Create Shortages Quantity Of Electricity (megawatts per hour) Price Of Electricity (cent per kilowatt-hour) D1D1 D2D2 S1S1 S2S2 E1E1 E2E2 P1 P2

Real Life Examples…  This led to Government Intervention in Electricity pricing …. The California legislature put a price ceiling on retail electricity prices. A price ceiling is the upper limit imposed on the price of a good.

Price Ceilings Create Shortages Quantity Of Electricity (megawatts per hour) Price Of Electricity (cent per kilowatt-hour) D1D1 D2D2 S1S1 S2S2 E1E1 E2E2 P1 P2 Price ceiling

Consequences of Price Ceilings  Price ceilings have three predictable effects: Increase the quantity demanded. Decrease the quantity supplied. Create a market shortage.

Price Ceilings Create Shortages Quantity Of Electricity (megawatts per hour) Price Of Electricity (cent per kilowatt-hour) shortage shift in supply D 1 Old demand shift in demand D 2 New demand S 1 Old supply S 2 New supply qs c qd c qe 2 Price ceiling E1E1 E2E2

Price Ceilings Create Shortages  Letting prices rise would have: –Reduced the quantity demanded. –Increased the quantity supplied. –Alleviated the market shortage.