1. Markets and Price Determination
ECON 704
Module 2, Part 2

2. Agenda Describe characteristics of a competitive market
Understand the determinants of demand and supply in a market
Use demand and supply to determine market prices and changes therein
Understand the role of the price system in allocating resources

3. Prices and Markets
Oil – worldwide production more than its ever been…so why has price increased so much?
Platinum… $540/oz. May 2002 to $1296/oz Sept 2007
If red wine is discovered to be healthier, what would happen to the price of beer?
What will happen in the market your business is in? The market for your labor?

4. Assumption: Competitive Market
A market is buyers and sellers of a good or service
A market is perfectly competitive when
many buyers and many sellers
free entry and exit
individually no power to influence prices (price takers)
product is undifferentiated
participants have complete information

5. Competitive Markets, cont.
Close Examples:
agricultural grains; some precious metals
Non-competitive markets:
monopolies: single seller
oligopoly: few sellers with substantial pricing interdependence
monopolistic competition: many sellers of similar but differentiated products

6. Buyers and Sellers
Buyers demand the product and consume it or use it as input into further production
Buyers DEMAND a good or service; is a function of perceived benefit. The quantity demanded depends on price and other determinants.
Sellers produce the product using inputs and sell it to the buyer
Sellers SUPPLY a good or service; is a function of costs of production

7. Demand
Quantity Demanded (QD) is the amount buyers are willing and able to buy, and falls as price increases (Law of Demand).
Demand is the relationship between P and QD
If price changes, Demand does not change!! Qty demanded changes along given demand
Other determinants disturb the P/ QD relationship and change demand

8. A demand curve
Price of pencils
$0.30
0.25
0.20
0.15
0.10
0.05
Quantity of Pencils (in hundreds 1 2 3 4 5 6 7 8 9 10 11 12

9. Demand Determinants Income Tastes Expectations Prices of Related Goods
Normal vs. Inferior goods
Tastes
Expectations
Prices of Related Goods
Substitutes vs. Complements
Number of Buyers
Demand curve shifts left (decrease) or right (increase)

10. Changes in Demand D2 D1 D3 Increase in demand Decrease in demand Price
Quantity

11. Supply and Quantity Supplied
Positive relationship between Price and Quantity Supplied (QS)
Supply curves slope up
Other Determinants
Price of Inputs
Technology/Productivity
Number of Producers
Expectations

12. Price Determination
Surpluses (QS > QD) and Shortages (QD > QS) cause prices to change
Equilibrium price where QS = QD

13. Surplus Equilibrium Shortage Supply Phigh $.15 Plow Demand 600
Price of Pencils
Supply
Surplus
Demand
Equilibrium
Phigh
$.15
Plow
Shortage
Quantity of Pencils
600

14. Changes in Equilibrium
An Event Happens!
Analytical Steps:
What determinant is affected? Is it a determinant of Demand or Supply? or both?
Do the curve(s) shift left or right?
What happens to equilibrium price and quantity?
Draw your curves and see the shifts!
Do what model says, do not assume the result

15. Healthier Red Wine Supply D2 D1 Price of Red Wine
1. Greater “tastes” increases
the demand for red wine... D2
Supply
final price P1
New equilibrium
initial price P0
2. ...resulting
in a higher
price...
Initial
equilibrium D1 Q0 Q1
Quantity of
Red Wine
3. ...and a higher
quantity sold.

16. Wine and the Beer market
How would healthier red wine affect market for beer?
“Common” Sense (i.e., the usual answer): demand for beer falls, which would mean less beer being sold at a lower price, but this is jumping to conclusions…
Model says: price of beer substitute has increased; demand for beer should increase, and more beer sold at a higher price

17. Fossil Fuels Oil supply has increased, but not as much as demand
Cheap oil as a deterrent to research into alternative energy sources
Paying the full cost of producing and using fossil fuels?

18. Water Pricing
Half of China’s 600 largest cities are running short of water ~ on 2 hours/day
Annual rainfall normal, with some flooding
Massive government water projects to move water
Problem: no or very low pricing
common issue with utilities in poorer countries, and some rich ones too!
creates chronic shortages; lack of revenues impedes investment
markets are not very sensitive to equity, but societies are

19. Intellectual Piracy
Movie Studios and Record Labels putting huge sums into digital protection
Motive: cheaper digital recording technology has eaten into sales?
substitute goods (the copies) now less expensive

20. Why the Price System?
Allocates resources to most highly valued uses as firms seek to provide that which consumers value
Signals relative scarcity of resources
Provides incentive to increase efficiency of resource use as firms try to minimize costs
Helps consumers to allocate their scarce income in satisfying their wants

21. Conclusion
Next Time: Elasticity concepts in demand and supply applications