1. Markets - Bringing Demand and Supply Together -

3. What is a Market ?
In economic theory, a market is where buyers and sellers of goods and services (or resources) are come together to carry out an exchange/transaction.
In addition to the physical places, markets also includes non-physical places where buyers and sellers can come together through
Internet/online, phone, fax, etc.
Markets can be local (buyers and sellers in the local region e.g. local grocery), national (within the country), and international (anywhere in the world e.g. oil)
types:
Goods and services (product markets)
Resources (factor markets eg labor market)
Financial markets where international currencies, securities and stocks (ownership of companies) are bought and sold
 and underlying all markets is the concept of Demand and Supply

5. Market Analysis
A market is analyzed by combining and the concepts of demand and supply and considering their interaction
Each curve separately shows the quantities consumers and producers are willing and able to buy and sell at each price
But the analysis did NOT tell us anything about how much quantities the consumer and producer actually demand and supply NOR the actual price they pay and sell for, respectively.

6. Market Mechanism
How is the final (actual) market price and quantity demanded and supplied determined?
This is through the interaction, negotiation, bargaining between the demand and supply of the good and services
Assume the objective/goal of the consumers and producers
Maximize utility given their limited income
Maximize profit given the cost of production
 there is a clash of interest!

7. Interaction process… Disequilibrium situations
Suppose market price is initially at $5 (next slide or graoh on handout Page 3)
Excess Supply (surplus) of units Qd < Qs  stocks of unsold goods pile up  discounts P will go down and as it falls Qd increases while Qs falls
_____________________________________________
Or if P= $2  Excess Demand (shortage) of thousand units Qd > Qs
“empty shelves” and “queues”  P moves up and
and as it increases Qd falls while Qs rises equilibrium
Notice that as Price changes there is a MOVEMENT along each curve in response

10. Equilibrium Definition: occurs when the market “clears” 1) Qd = Qs
2) No excess demand or excess supply
3) All plans are fulfilled
consequently
4) If in equilibrium, ………………………….
5) If in disequilibrium, will …………………….
Though may take time through a COBWEB

11. Graphing the equilibrium (Page 3 of H/0)
Need to be able to find the equilibrium
a) graphically b) algebraically
How much do consumers spend?
How much REVENUE do producers earn?.

12. Consumer Surplus Consumer surplus is defined as
…….the highest price the consumers are willing to pay for a good minus the price actually paid.
It represents the difference between total benefits (satisfaction or utility) consumers receive from buying a good and the price paid to receive them
It is the bargain and gain you get through buying an item you wanted but for a price lower than you were willing to pay!

13. Graphically,
Consumer surplus is indicated by the area between the demand curve (your marginal benefit and utility) and the market price for the units of goods consumed

14. Producer Surplus
Producer surplus is defined as the price received by firms minus the lowest price that they are willing to accept to produce the good.
It is the excess earnings producers receive from given quantity of output, over and above the (minimum) amount they were prepared to accept
It is the “profit”, return, and $$$ that they wanted!

15. Graphically,
It is the area above the firms’ supply curve and below the price received by firms (determined by the market)

16. consumer and producer surplus together= community (social) surplus
What can you say about the CS and PS at the market equilibrium?
Suppose P = P3 instead?  Pages 7 and 8 of H/O

17.  COMMUNITY (social) SURPLUS
= consumer surplus + producer surplus
It is often referred to as the social welfare or well being of society.
Where is it maximized?
CALCULATE on graph (can ignore units)
 concept of WELFARE LOSS
(or DEADWEIGHT LOSS)

18. So to sum, The final decision on how to
allocate our scarce resources efficiently
can be evaluated through looking at the satisfaction or welfare of the people running this economy (market) consumers and producers
Consumer surplus
Producer surplus

19. The Social (community) surplus is MAXIMIZED at the EQUILIBRIUM, which is therefore the OPTIMUM

20. Allocative Efficiency ( Pareto Optimality)
Allocative efficiency refers to producing the combination of the goods mostly wanted by society.
It is THE allocation of scarce resources that “best” satisfies the unlimited wants…it is the “optimal” choice made for the society given their scarce resources
And the finding above shows that free and perfectly competitive markets can achieve Allocative Efficiency at the equilibrium

21. Explanation
The demand curve represents the interests of the consumers while the supply curve represents the interests of the producers
We can assume that D = MU/MB (marginal utility/benefit) while S = MC (marginal cost)
Then we can (re)interpret the market equilibrium as a point where MB = MC
This equality tells us that the extra benefit to society of getting one more unit of the good is equal to the extra cost to society of producing one more unit of the good… this implies that the society’s scarce resources are being used to produce the “right” quantity  two interests in balance, equilibrium
That is, society has allocated the “right” amount of resources to the production of the good and producing the quantity of the good that is mostly wanted by the society

22. To understand this better,
Consider that if MB > MC, then society would be placing a greater value on the last unit of the good produced than it costs to produce it and so more of it should be produced (disequilibrium of excess D)
Consider that if MB < MC, then it would be costing society more to produce the last unit of the good produced than the value society puts on it, so less should be produced (disequilibrium of excess S)
Thus allocation where MB = MC is the optimum for society

23. Suppose disequilibrium due to shift in…..
Demand
Supply
Income (normal and inferior good)
Taste and Preferences
Price of related goods (substitutes and complements)
Population size
Age structure
Government policy
Seasonal change
 these things are constantly changing in the real world
Factors of production and cost
Technology
Price of related goods (competitive and joint supply)
Producer expectation
Government policies
Number of firms
Shocks and natural disasters

24. Δ in market equilibrium due to a shift in D or S
Shift in Demand to the right (e.g. due to……….)
 excess demand=
 ………..pressure on prices
 incentive for producers to increase Qs
And signal to consumers to decrease Qd
The price rise also RATIONS the good to consumers willing to pay the higher prices
+examples on pages 4-6

25. What happens to the market equilibrium when there is a shift in D or S?
Case 2: Shift in Supply to the right
(e.g. new technology or more resources found)

26. PRICES (the PRICE MECHANISM) (
Act as
SIGNALS….. prices communicate information to the decision makers.
INCENTIVES prices motivate decision makers (who want utility or profits) to respond to the information
In order to reallocate resources and RATION scarce resources
In other words act as an INVISIBLE HAND
 ALLOCATIVE EFFICIENCY

27. the Price Mechanism The process is called the Market Mechanism and/or
Introduced and founded by the Father of Economics called Adam Smith
What is the significance or essence of this?

28. Market Mechanism and Price Mechanism
The what to produce question of resource allocation is answered because firms produce only those goods consumers are willing and able to buy, while consumers buy only those goods producers are willing and able to supply
 power to the people! (Consumer Sovereignty)
The how to produce question of resource allocation is answered because firms use those resources and technologies they are willing and able to pay for (in the resource market)
But what about the third question……
does allocative efficiency= equity?

29. In other words…
So free (and competitive market) “best” answers the fundamental economic questions of:
What to produce – allocative efficiency refers to producing what the consumers mostly want
How to produce – productive efficiency means producing with the fewest possible resources
BUT it falls short and fails to answer
For whom to produce – only the most efficient and productive (or competitive) individuals benefit, equity or fairness is not ensured
This leads and justifies the need of governments

30. Adam Smith stated….
that the invisible hand working through the market mechanism and prices succeeds in coordinating the buying and selling decisions of thousands and millions of individuals without any central authority (government). At the equilibrium, the buying and selling choices of all buyers and sellers are satisfied and in balance
THE END

31. Calculating the Market Equilibrium (Review)
Do Section (e) of Page 3 of H/O
Using the demand and supply functions for the chocolate bars:
Qd = 14 – 2P
Qs = 2 + 2P
Market equilibrium price and quantity are values where
Qd = Qs
Therefore, the equilibrium price is $3 and equilibrium quantity is 8,000 chocolate bars
You can check your calculation by inserting P = 3 into the demand or supply equations and see whether you obtain Qd = Qs = 8

32. Assumptions and implications
1. Assume a free market (free interaction between D and S) to determine the final equilibrium outcome
2. Assume a competitive market
Notice: 3. The shift in the demand or supply curve is not equal to (usually more than) the change in the equilibrium quantity
This is due to the subsequent price changes and the price mechanism which cause the movement along the curves
4. the magnitude of the change in equilibrium price and quantity depends on:
the slope (elasticity) of the D and/or S curves (next topic)

33. We have learned that when markets operate under competitive conditions, composed of numerous individuals, the market determines an equilibrium P and Q
At the equilibrium, the buying and selling choices of all buyers and sellers are satisfied and in balance
This market mechanism, working through prices (which provide SIGNALS and INCENTIVES), is known as the invisible hand of the market which RATIONS the scarce resources
Do rest of Page 3 (e)
Also look at Page 6 for examples of correct diagrams and writing.

34. Mr. Adam Smith concluded…
Free market or perfectly competitive market is the best system that maximizes the welfare of the society… allocation where no one can be better off without making others worse off..
called the Allocative Efficiency or Pareto Optimality
But is it really??? Realistic assumptions? Survival of the fittest… equitable (fair)?

35. STOP HERE Market Equilibrium
Equilibrium is defined as a state of balance between different forces such that there is no tendency to change
Market equilibrium – state where the forces of demand and supply are in balance and there is no tendency for the price to change. There is no excess supply/surplus nor excess demand/shortage.
The price in market equilibrium is the equilibrium price and the quantity is the equilibrium quantity.
At this price, the quantity consumers are willing and able to buy is exactly equal to the quantity firms are willing and able to sell. And for this reason, this price is called the market clearing price or simply market price
Excess demand or excess supply is referred to as the market disequilibrium and it cannot last as there is a tendency, force, and incentives for the price to change which consequently changes the Qd and Qs in accordance to its definition (downward sloping D curve and upward sloping S curve)

36. Excess Demand (Shortage of Supply)
Now, say the market price is at $1, at this price, the producers are willing and able to produce only 4,000 bars whereas consumers will be willing and able to buy 12,000 bars. There is therefore a shortage of supply
With a high demand for their product as they are quickly sold out, producers will see this as an opportunity/ incentive to raise price to earn more profits
As they raise prices, the quantity supplied increases (can produce more with more revenue) with a movement along the supply curve and the quantity demanded falls with a movement down the demand curve
And again the prices will continue to rise until the point where Qd = Qs where there is no more opportunity/ incentives for producers to raise the price as there is no more excess demand to profit from

37. Excess Supply (Surplus of Supply)
At price of $5, producers will be willing and able to produce 12,000 bars but consumers would only be willing and able to buy 4,000 bars. There is therefore a surplus or excess supply
With unsold quantity of 8,000 bars, producers will lose money and waste their product (less profit) unless they somehow sell this excess supply
In order to do so, there is an incentive for producers to lower the price of the chocolate bars to encourage consumers to purchase more
Now, as the price of the chocolate falls, in accordance to the definition of demand and supply, there will be a movement along the demand curve to the right (quantity demanded increases) and along the supply curve to the left (quantity supplied decreases)
And the prices will fall until the point where Qd = Qs where there is no more incentives or reasons for producers to lower the price as there is no more excess supply