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A market is a way of organizing trading between sellers of a good and buyers
of that good. It gives
1. a procedure for finding potential trading partners
2. rules for interaction between buyers and sellers
3. possibly enforcement of contracts between buyers and sellers
Examples of markets:
market for wheat
- buyers and sellers meet at specific time and place, auctioneer sets prices
and arranges sales.
market for ice cream in some town.
-many sellers of ice cream at different locations in town.
-selling and buying takes place at any time buyer chooses.
- no auctioneer calls out price of ice cream.
Yet market for ice cream is organized. There are known locations where one
can get ice cream. The price is determined by competitive market forces.
In this class, we will focus on markets that are efficiently organized. Some
markets, like market for used bikes, are relatively disorganized. There is no
specific location where one can go to for sure to find a used bike – perhaps look
in newspaper advertisements or look for garage sales.
Ebay has made the markets for all kinds of used goods more organized. By
looking on Ebay, there is a good chance of a potential buyer finding what she
is looking for, and a good chance of a potential seller finding a buyer.
Markets for things or skills that are rare or in very low demand also tend
to be disorganized – where would you go to find a translator from Syriac into
Nahuatl? Or if you had that skill, where would you find an employer?
Competition
A competitive market is a market in which each individual buyer and
each individual seller has a negligible effect on the price.
Ice cream market is competitive: If one seller alone raises price, all buyers
will buy from another seller.
Similarly no individual buyer can cause price to fall or rise.
This chapter assumes markets perfectly competitive.
Two conditions: 1. No individual buyer or seller has any effect on price. 2.
All products in a market exactly identical.
Some real markets are nearly perfectly competitive. Wheat market and
other agricultural goods markets.
Most real-life markets not perfectly competitive.
Monopoly - one seller. e.g. local cable company
Oligopoly - several sellers have some price-setting power.
Monopolistic Competition
Demand
A buyer’s demand for a good is the amount of the good that the buyer is
willing and able to buy.
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Many things determine the demand for a good, among them price.
The demand curve for an buyer shows the amount of a good the buyer
would buy at different prices, with all other factors held constant.
Most demand curves are downward-sloping. The higher the price, the less a
buyer buys of the good with other factors held constant.
The market demand for a good is the sum of all individual buyers’ demands for the good. At each price, sum the quantities demanded over all
individual buyers.
This corresponds to summing the graphs of demand curves horizontally.
Supply
A seller’s supply of a good is the amount of the good the seller is willing to
sell.
Many factors determine supply of a good, among them price of the good.
The supply curve for a seller shows the amount of the good the buyer
would be willing to sell at different prices, with all other factors held constant.
Most supply curves are upward-sloping. The higher the price, the more a
seller would like to sell of the good with other factors held constant.
Note: The supply curve for labor could be downward-sloping for some people. For instance, if a person wants more leisure when they get more money.
The market supply for a good is the sum of all individual sellers’ supplies
of the good. At each price, sum the quantity supplied over all sellers.
This corresponds to summing the graphs of supply curves horizontally.
An equilibrium price of the good and an equilibrium amount supplied
and bought is determined by an intersection of the market demand curve and
the market supply curve.
(If the supply curve is upward-sloping and the demand curve is downward
sloping, there is only one equilibrium).
This is a quantity where amount demanded of the good equals amount supplied of the good.
The corresponding price is the price at which buyers are willing to buy that
total amount of the good and sellers are willing to sell that total amount of the
good.
When the economy is out of equilibrium (demand for a good at the price
offered does not equal supply of the good at that price) there are forces that
cause a change.
When the economy is in equilibrium, those forces are absent.
What forces cause change when the economy is out of equilibrium?
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Suppose there is excess supply – the quantity that sellers want to sell at the
given price is higher than the quantity that buyers want to buy at that price.
Then sellers notice that some units are not being sold. If the good is not
durable, they will lose the unsold items. They lower price to be able to sell more.
Suppose there is excess demand – the quantity that buyers want to buy at
the given price is higher than the quantity sellers are willing to sell at that price.
Sellers will notice this in some way, and they will raise their price to a price
at which they are willing to sell more.
When supply curve is upward-sloping and demand curve is downward-sloping,
these forces drive the economy to the equilibrium price and quantity.
Is the economy in equilibrium or is it just tending toward it?
Depends on how quickly prices adjust to changes in factors.
In some markets, like markets for financial assets (e.g. currency futures –
contracts to trade one currency for another at some future date), prices adjust
very fast.
The market for currency futures is essentially open all the time. In the stock
markets as well, prices adjust very fast.
In other markets, prices adjust more slowly. For instance the labor market.
(Day labor wages adjust fast, sometimes in auctions.) Long-term jobs’ salaries
specified by contract, which may be for 3 or more years. Other shocks may
occur in the meantime that the salary can’t adjust to.
Factors that cause shifts in the demand and supply curves.
There are other factors that influence demand for a good besides price.
When one of these factors changes, the demand curve shifts – the amount of
the good bought at any given price may be different.
A shift to the right of a demand curve (buyers would buy more at any given
price) is called an increase in demand. A shift to the left of a demand curve
(buyers would buy less at any given price) is called a decrease in demand.
Examples of these factors:
1. Income – For most goods, when a person’s income falls, their demand for
that good also falls. Such goods are called normal goods.
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However there are goods for which demand rises when income falls. Such
goods are called inferior goods. E.g. bus rides, low-quality substitutes for
higher-quality goods, used cars.
2. Prices of related goods – if the price of frozen yogurt falls, some consumers
of ice cream will buy more frozen yogurt and less ice cream. Frozen yogurt is a
substitute for ice cream. Good B is a substitute for good A if the demand for
good B falls when the price of good A falls.
If the price of computers falls, people will buy more software. Software is a
complement of computers. Good B is a complement of good A if the demand
for good B rises when the price of good A falls.
3. Tastes and needs– the tastes for any good can change, for example if a
consumer good goes in or out of style. Or, if scientific research concludes that a
food is very good for you, the tastes for that food will probably change, leading
to an increase in demand for that food.
Needs for a good also change depending on circumstances – a person who
falls sick will need medicine that she didn’t buy before.
4. Expectations of future prices/conditions – a person who expects to earn a
higher income next month may smooth that income increase by spending more
this month as well. The effect will be similar to an income increase now. More
of normal goods and less of inferior goods will be bought.
If a person expects the price of ice cream to fall tomorrow, they may wait
until tomorrow to buy ice cream and be less likely to buy it today.
If a buyer expects the price of a durable or nonperishable good to rise in the
future, they may buy more of it now. For instance, demand for oil increased
because of expectations of a future rise in price (and this caused price of oil to
rise).
5. government regulations – there could be price controls, a good could
become illegal, or restricted in the way it gets used. For instance, when alcohol
was banned in the USA in 1920’s it changed the demand for it and for different
qualities of alcohol.
The shape of the demand curve
Besides being downwards-sloping in general, there is no restriction on the
shape of the demand curve.
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The shifts due to the changes in factors mentioned above need not cause a
parallel shift in the demand curve – they may change its shape.
For instance, suppose a new substitute for ice cream becomes available at a
reasonable price.
People who would only buy ice cream at a very low price wouldn’t change
their consumption of ice cream due to the availability of substitute.
But people who were buying ice cream at high prices would probably change
to the substitute – their consumption of ice cream would decrease significantly.
There may be only a few who remain loyal to ice cream even at high prices.
So the new demand curve for ice cream could be curved and below the
original demand curve.
Ways to reduce the quantity of smoking demanded.
Suppose the government wants to reduce the amount of smoking. One way
to do this is to cause the demand curve for smoking to shift to the left. How
can this be achieved?
Cause people’s income to fall - not a very good method.
Lower the price of substitutes or increase the price of complements? What
are substitutes or complements of cigarettes?
Change tastes - public health announcements, prohibition of cigarette ads
on TV.
Another way to reduce the amount of smoking is to raise price of cigarettes.
This can be done with a tax on cigarettes – sellers will pass at least some of
the tax on to the buyers as a higher price.
Cigarettes are taxed at one of the highest rates of any good, at a rate of 100
percent. However, tobacco is subsidized by the government. This makes it hard
to figure out the true tax rate on cigarettes net of the subsidy on tobacco.
The tax raising the price of cigarettes causes a movement up along the demand curve.
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Policies to reduce demand cause a shift of the demand curve.
Economists have estimated how much amount of smoking responds to a
change in cigarette price, by looking at what happens when tax changes.
They found a 10 percent increase in cigarette price causes a 4 percent reduction in total quantity demanded. For teenagers, the reduction is 12 percent.
Opponents of cigarette taxes claim tobacco and marijuana are substitutes –
then an increase in cigarette price would increase marijuana consumption.
But most studies find that tobacco and marijuana are complements.
Supply shifters
There are other factors besides price that affect the amount of a good sellers
sell.
These factors shift the supply curve. The amount of the good sellers would
sell at any price changes.
When the quantity supplied rises at any price, it is called an increase in
supply. When the quantity supplied at any price decreases, it is called a decrease
in supply.
Examples of factors that shift the supply curve:
1. A change in the price of an input – suppose the price of sugar falls. Sugar
is an input for ice cream. Then the production of ice cream becomes more profitable at any price of ice cream. So sellers are willing to supply more ice cream
at any price.
Suppose the price of labor rises. Then each unit of ice cream sold becomes
less profitable, so the seller sells less at any given price.
2. A change in technology – when mechanized ice cream machines were invented, it lowered the labor cost required to produce a unit of ice cream. This
made each unit of ice cream more profitable, so sellers would sell more at any
given price.
3. Expectations of a change in conditions – If a firm expects the price of
ice cream to rise in the near future, it might put some ice cream in storage or
produce less today, so present supply declines.
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If a hurricane is expected to destroy many oil rigs in the Gulf of Mexico,
decreasing the supply of oil, other sellers may expect the price to rise in the
future. Then they may sell less oil now and save it for later when the price is
higher. So the supply decreases now due to the expectation of a supply decrease.
4. Number of sellers – when an additional seller enters the market for a good,
supply rises. When a seller exits the market, supply falls (at least temporarily).
Changes in Equilibrium
How do shifts in the demand and the supply curve change the equilibrium
price and quantity?
Suppose one summer the weather is very hot, and people’s tastes are such
that the hotter it is, the more ice cream they want at any given price.
Then the demand curve shifts to the right.
An increase in demand
P
S
C
P1
A
B
D1
D2
Q
The original price P 1 is now such that there is excess demand. Sellers will
raise the price until the new amount demanded equals amount supplied at that
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price.
Both price and amount bought and sold rise. Compare C to A on the graph.
Suppose in another summer a hurricane destroys part of the sugarcane crop
(or corn crop). This causes price of sugar to rise.
The rise in price of sugar, an input for ice cream, causes the supply curve
for ice cream to shift to the left – there is less supplied at any given price.
A decrease in supply
P
S2
S1
C
P1
B
A
D
Q
The original price P 1 is now such that there is excess demand. Sellers will
raise the price until the new amount demanded equals the amount supplied.
Equilibrium price rises and equilibrium quantity bought and sold decreases
due to the change. Compare C to A on the graph.
Now suppose that the heat wave and the hurricane occur simultaneously.
Both curves will shift simultaneously.
The demand curve will shift to the right, and the supply curve will shift to
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the left.
P
D1
S2
D2
S1
P1
Q
The price rises unambiguously, since both of the changes individually cause
price to rise.
Uncertain what happens to quantity – it depends on the relative sizes of the
shifts in demand and supply.
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