Download AS 3.3 unit 1 File

9
Market Forces
1
MARKET FORCES (3.3)
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MARKET FORCES (3.3)
BEFORE you start this unit (in pencil) ...
•write the key idea of this unit in the centre of the page
•write what you know about this idea around it and draw lines to them.
•try and group the ideas together
mind-map
Mind-maps are very good revision tools. Our minds learn by
making patterns. Mind-maps help you to make these patterns
and so makes the content easier to learn and remember.
1
AFTER you finish this unit (in pencil) ...
•remove anything that doesn’t belong to this unit
•ensure that things are grouped together appropriately. Move stuff around if needed
•add any extra ideas that you think are missing
MARKET
MARKET FORCES
FORCES (3.3)
(3.3)
unit over
view
may the forces be with you !!
The more that you read about business and economics, the more you will hear
references to the price mechanism and market forces.
Both of these phrases refer to how supply (firms) and demand (consumers) interact
in markets to use society’s scarce resources to produce what consumers demand.
This unit introduces the idea of market forces and how they achieve
allocative efficiency through or between different markets in the economy.
By the end of the unit, you should be able to...
o explain how demand curves are derived from marginal utility
o explain how supply curves are derived from marginal cost
o explain how market forces allocate resources between markets
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MARKET FORCES (3.3)
MARKET FORCES (3.3)
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just one more ...
If you like it, buy it. That’s the general reason for consumers demanding goods
and services. If the benefit you get from something equals or exceeds the price
you pay ... then buy it.
This unit looks at how the extra benefit or marginal utility we get from
consuming a good or service determines how much or many we will buy, i.e. our demand for that good or service.
by the end of this topic, you should be able to...
o describe marginal utility
o describe the law of diminishing marginal utility
o describe the optimal purchase rule
o explain the law of demand
o identify and describe consumer equilibrium
remember - try the exercises and then read the notes to learn what you don’t know ...
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MARKET FORCES (3.3)
Tom loves tomatoes.
Read the information below and answer the questions.
1. Complete the table below to show the utility Tom gets from consuming tomatoes.
2. Use the information from the table to draw Tom’s monthly demand for tomatoes on the axes.
Price
($/kg)
TOM’S UTILITY SCHEDULE FOR
TOMATOES
Tomatoes Total Utility
Marginal
(kg/month)
Utility
1
1.60
2
2.80
3
3.60
4
4.20
5
4.50
6
4.75
7
4.90
8
4.90
Quantity
(kg/month)
3. Tom’s total utility is the same whether he consumes 7 or 8 kilograms of tomatoes. Is this possible? Explain
your answer.
____________________________________________________________________________________________
____________________________________________________________________________________________
Marginal Utility
4. Is it possible for Tom’s total utility to go down as he consumes more of a good or service? Explain your
answer.
____________________________________________________________________________________________
____________________________________________________________________________________________
____________________________________________________________________________________________
5. With reference to the Law of Diminishing Marginal Utility, explain why Tom’s demand curve is downward
sloping.
____________________________________________________________________________________________
____________________________________________________________________________________________
Exercise 1.1
____________________________________________________________________________________________
____________________________________________________________________________________________
6. If the price of tomatoes is $0.60 per kg, what is Tom’s optimal purchase? Why?
optimal purchase: __________________ kg
Reason: ____________________________________________________________________________________
____________________________________________________________________________________
MARKET FORCES (3.3)
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Over the holidays, Tom likes to do three activities – going to the movies, playing golf
and wind-surfing. Based on his marginal utility for each product, Tom does one activity per day.
1. The table below shows the price of each activity and the marginal utility Tom derives from each
activity. Use this table and your understanding of consumer equilibrium to work out what Tom
will do each day, for the first ten days of his holiday.
Day 1: _____________________________
Day 2: _____________________________
Day 3: _____________________________
Day 4: _____________________________
Day 5: _____________________________
Day 6: _____________________________
Day 7: _____________________________
Day 8: _____________________________
Day 9: _____________________________
Day 10: _____________________________
1
TOM’S MARGINAL UTILITY SCHEDULE
(MU is measures in $)
(price = $10)
Movies
(price = $12)
Golf
Windsurfing
30
22
15
9
4
2
0
24
21
18
15
12
9
6
30
26
22
18
14
10
6
(price = $20)
2. The movies are the cheapest holiday activity. Why does Tom not always go to the movies?
____________________________________________________________________________________________
____________________________________________________________________________________________
____________________________________________________________________________________________
3. Tom’s sister, Maia, loves eating fresh strawberries over summer. Use Maia’s demand schedule below to draw
her demand curve for strawberries on the axis to the right. Label this curve D1.
($/punnet)
1
2
3
4
5
6
Marginal Utility
Price
Price
($/punnet)
Quantity
Demanded
(punnets / month)
5
4½
4
3
2
1
Quantity
(punnets/month)
4. The current market price for strawberries is $3. Show the market price as P1 and Maia’s resulting quantity
demanded as Q1.
5. This year, Maia’s marginal utility from eating bananas and oranges has increased. Show the impact of this on
the graph above. Label your changes appropriately.
Exercise 1.2
MAIA’S MONTHLY
DEMAND FOR
STRAWBERRIES
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MARKET FORCES (3.3)
Define the following terms.
Check that you can define each term and use it in an appropriate context.
ceteris paribus______________________________________________________________________
______________________________________________________________________
consumer equilibrium
______________________________________________________________________
______________________________________________________________________
law of diminishing marginal utility
_____________________________________________________________
______________________________________________________________________
marginal utility
______________________________________________________________________
______________________________________________________________________
optimal purchase rule
______________________________________________________________________
______________________________________________________________________
2. At a price of $3 for jellybeans and $4 for chocolates, William cannot decide which packet he should buy next.
Which of the following statements is most likely to be correct?
a. William receives the same total utility from jellybeans as he does from chocolate.
b. William receives the same marginal utility from jellybeans as he does from chocolate.
c. William considers that the marginal utility for jellybeans is greater than that for chocolate.
d. William considers that the marginal utility for jellybeans is less than that for chocolates.
Exercise 1.3
Marginal Utility
3.
When making purchases the consumers will always try to . . .
a. always buy the cheapest good.
b. spend the same amount on everything they buy.
c. maximise their total satisfaction.
d. buy until marginal utility is maximised.
4. The price of Commodity A is $4 and that of Commodity B is $10. If a consumer evaluates the marginal utility
of A to be 10 units then she is in equilibrium when the marginal utility of B is . . .
a. 4 units.
b. 10 units.
c. 25 units.
d. 40 units.
5.
A fall in the price of DVD’s leads to increased sales of DVD’s. As a result the . . .
a. marginal utility of DVD’s falls.
b. total utility obtained from DVD’s falls.
c. total and marginal utility obtained from DVD’s rise.
d. marginal utility of DVD’s rises.
6.
Diminishing marginal utility means . . .
a. as consumption of one product increases, holding all else constant, total utility begins to decrease.
b. as consumption of one product decreases, holding all else constant, total utility begins to increase.
c. there will be no demand for the product.
d. as consumption of one product increases, holding all else constant, total utility increases but at a decreasing
rate.
7. Explain why marginal utility falls as people consume more goods or services.
____________________________________________________________________________________________
____________________________________________________________________________________________
____________________________________________________________________________________________
MARKET FORCES (3.3)
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State the consumer equilibrium rule
(or formula) Noi should use to
ensure she maximises the total utility she receives from purchasing shoes and dresses.
1
____________________________________________________________________________________________
2. Use Table 1 below to determine the quantity of shoes and dresses Noi should purchase to maximise her total
utility. Assume each dress cost $200 and a pair of shoes costs $100.
a. Number of dresses Noi should purchase:
____________________________
b. Number of pairs of shoes Noi should purchase: ____________________________
Table 1: MARGINAL UTILITY NOI RECEIVES FROM
SHOE AND DRESS PURCHASES
Quantity of Dresses
Marginal Utility
Quantity of Shoes
Marginal Utility
1
2
3
4
800
400
200
100
1
2
3
4
300
200
150
75
($)
(pairs)
($)
3. Look at the changing values of marginal utility in Table 1 and state the law of economics they show.
____________________________________________________________________________________________
____________________________________________________________________________________________
____________________________________________________________________________________________
____________________________________________________________________________________________
____________________________________________________________________________________________
____________________________________________________________________________________________
____________________________________________________________________________________________
____________________________________________________________________________________________
____________________________________________________________________________________________
____________________________________________________________________________________________
Optmal Purchase Rule
4. Use the optimum purchase rule (P = MU) to explain why Noi would buy fewer dresses if their price increased.
Exercise 1.4
____________________________________________________________________________________________
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MARKET FORCES (3.3)
Marginal Utility
notes
The majority of our decisions are ‘marginal’ – i.e. they are concerned with one more. We tend to
think about economic (and non-economic) decisions in terms of “one more or not?”.
e.g. A firm will produce one more good if it produces a profit, i.e. its marginal revenue exceeds the
marginal cost. A consumer will buy one more good if the benefit is greater than the price she pays.
Many decisions that we make are marginal. Shall I buy one more hamburger? Will I buy a 80Gb
mp3 player rather than a 30Gb one? Shall I do one more hour’s homework? Decisions are easier
when you think of them in marginal terms.
Describe Marginal Utility
When you buy a good or service, you do it because you think you will get some benefit from it. For
example if you buy an ice cream, you will feel less hungry. Another word for this benefit is utility.
For the purposes of this analysis, we will measure benefit or utility in terms of dollars. This is
a reasonable assumption, as in everyday life we use money as a way of comparing the value of
different goods and services.
In economics we are concerned with individuals’ marginal utility. This is the extra benefit that
someone gets from buying one more good or service. Marginal utility helps us to work out how
much of a good or service an individual consumers will buy. Figure 1.1 illustrates this.
Marginal
Utility ($)
Figure 1.1 ... Marginal Utility
50
Marginal utility (MU) is the
extra utility or benefit that a
consumer gets from consuming
one more unit. As an individual
consumes more of a good, his
or her MU falls.
40
30
Measured in dollars, the MU
curve is also a consumer’s
demand curve.
20
10
MU = D
1
2
3
4
5
Quantity
Imagine you go shopping and see a shirt for sale. You decide you like it and are prepared to pay
$50 for it, i.e. you would get $50 worth of utility (benefit) from it. If the price is $50 or less you
will buy it.
Having bought one shirt, the question is “how much would you pay for a second one?” Typically
the extra benefit (marginal utility) you get from the second shirt will be less than the first – say $40.
If the price of the shirts is $40 or less, you will buy that one also.
And so this continues for the third and fourth shirts. You will continue to buy more shirts as long as
the marginal benefit is equal or greater than the price you have to pay.
This information can be used to work out how much of a good or service
an individual consumer is willing to buy at different prices. Assuming
the consumer has the money to buy the goods then this information
shows the consumer’s demand for a good or service. If you plot these
points with marginal utility on the vertical axis and quantity on the
horizontal axis, you get a downward sloping marginal utility curve.
As we will see later, the MU curve is also the consumer’s demand curve
- because it shows how much of a good that a consumer is willing and
able to buy at each price.
Marginal Utility:
The extra benefit gained from consuming one more good or (unit of) service.
MARKET FORCES (3.3)
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Describe the Law of Diminishing Marginal Utility
1
Figure 1.1 shows how marginal utility falls as the consumer buys extra shirts. This characteristic of
marginal utility is normal and is erferred to as ‘law of diminishing marginal utility’.
This is an important law of economic behaviour. When combined with the ‘optimal purchas rule’
it explains why consumers will only demand more if the price falls, i.e. the ‘law of demand’.
Law of Diminishing Marginal Utility: The extra benefit gained from consuming
one more good or (unit of) service falls as we increase consumption.
Describe the Optimal Purchase Rule
Marginal utility is important because it helps to explain consumer demand, i.e. how
much of a good or service consumers will choose to purchase.
The optimal purchase rule states that consumers will keep buying more of a good
or service up to the point where the price equals the marginal utility of a purchase.
Figure 1.2 ... Optimal Purchase Rule
Marginal
Utility ($)
If the market price is $20 then this consumer will
continue to buy goods until her MU is below that price.
50
In this example, she will buy the first good because her
MU exceeds the price. She will also buy the second
and third goods for the same reason.
40
30
price = $20
20
10
MU = D
1
2
3
4
5
She will buy the fourth good because MU = P, i.e. the
optimal purchase rule. But she will not buy the fifth
good as price exceeds her marginal utility.
Quantity
if the market price was $30 in
figure 1.2, how many shirts would the
consumer purchase? why?
The example in Figure 1.2 shows how based on this rule, we can work out how
much of a good or service, a consumer will buy at a given price.
In this example, the consumer will buy the first shirt because her marginal utility ($50) exceeds
to market price of $20. She will also buy a second and third shirt for the same reason. We also
assume that she will buy the fourth shirt because her extra benefit, or marginal utility, equals the
price. However she will not buy a fifth shirt as her marginal utility is only $10 ... less than the
current market price.
Based on the optimal purchase rule, we can therefore determine that at a market price of $20, this
consumer will purchase four shirts.
Optimal Purchase Rule:
Consumers will continue to buy more of a good or
service up to (and including) where the price equals
their marginal utility, i.e. P = MU..
Explain the Law of Demand
Together, the law of diminishing marginal utility and the optimal purchase rule explain the law of
demand ... i.e. why consumers will only buy more of a good if the price drops, and vice versa.
The optimal purchase rule states that consumers will buy up to the point where the price
equals their marginal utility. They won’t buy more because the extra value (MU) they
receive is less than the price they pay.
Because marginal utility falls as consumers purchase more (the law of diminishing
marginal utility), consumers will only buy more of a good or service if the price drops
to match their lower marginal utility. Hence the law of demand ... quantity demanded
increases when the price of a good or service falls, and decreases when its price rises.
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MARKET FORCES (3.3)
Identify and Describe Consumer Equilibrium
One problem with the above analysis is how do consumers choose what to buy when the price of
different goods and services vary so much? For instance, how does a consumer decide whether
they want a new computer, jandals or shirt? Consider the following table which compares the
marginal utility for Jack from consuming each of the products shown:
Quantity
Marginal Utility ($)
Computer
Jandals
Shirt
2 200
400
100
40
20
18
15
14
30
25
10
5
1
2
3
4
Looking at the marginal utility alone, Jack would be better to buy four computers and nothing else. But
common sense suggests this doesn’t make sense. We need to do is compare his marginal utility to its
price. Whichever product gives the highest relative marginal utility (i.e. MU/P) is what Jack will buy first.
Quantity
1
2
3
4
Marginal Utility ($)
Jandals
Shirt
(price = $1 000)
(price = $10)
(price = $20)
Computer
MU
MU/P
MU
MU/P
MU
MU/P
2 200
400
100
40
2.20
0.40
0.10
0.04
20
18
15
14
2.00
1.80
1.50
1.40
30
25
10
5
1.50
1.25
0.50
.25
MU 30
= 1.50
P
20
When we compare the marginal utility to price, we see that the first thing Jack will get the most
benefit from compared to its price is a computer but then the next thing he should buy is a pair of
jandals. He will then buy a second pair of jandals, before buying either a shirt or a third pair of
jandals.
Where the relative marginal utility of different goods is equal, Jack would choose either. This point
is called consumer equilibrium.
Consumer Equilibrium:
MUA
PA
=
Where the marginal utility compared to price is
the same for all goods or services.
MUB
PB
=
MUC
PC
MARKET
MARKETFORCES
FORCES (3.3)
(3.3)
2
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supply
productivity
If demand slope downwards to the right because of the law of diminishing
marginal utility and the optimal purchase rule ... why does supply slope upwards
to the right.
This topic looks at the law of diminishing marginal return (or the principle of
increasing costs) and how this explains the shape of the supply curve ... i.e.
why firms will only supply more if the price rises.
by the end of this topic, you should be able to...
o describe the law of diminishing returns (principle of increasing costs)
o explain the law of supply
remember - try the exercises and then read the notes to learn what you don’t know.
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MARKET FORCES (3.3)
Patchy Helicopters provides high quality attack helicopters
for New Zealand secondary schools. Below is a summary of their marginal costs of production
1. Assuming Patchy Helicopters lowest average cost of production (i.e. its shut-down point) is $40 000, use the information below
to complete Patchy Helicopters Supply Schedule.
PATCHY HELICOPTERS
Supply Schedule
PATCHY HELICOPTERS
Marginal Cost Schedule
Helicopters
Supplied
Marginal
Cost
Price
($)
0
----------
20 000
1
36 000
35 000
2
33 000
40 000
3
40 000
50 000
4
50 000
70 000
5
70 000
110 000
6
110 000
180 000
7
180 000
Quantity
Supplied
Supply Schedules and Curves
2. At what level of output does Patchy Helicopters start to face diminishing returns? __________________
3. Use the information in the table draw a supply curve for Patchy Helicopters on the graph alongside.
Patchy Helicopters
Supply of Attack Helicopters
Price
($000)
180
160
140
120
100
80
60
40
Exercise 1.5
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1
2
3
4
5
6
7
Q
4. Imagine New Zealand schools are prepared to pay up to $70,000 for their own helicopter, how many helicopters would Patchy Helicopters produce? _______________
5. Show your answer to question 4 on the graph above, indicating the price (P1) and quantity supplied (Q1).
MARKET FORCES (3.3)
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Norm’s Gnomes designs and creates designer garden
1
gnomes for Auckland homes.
1. Use the supply schedule below to draw Norm’s Gnomes supply curve.
NORM’S GNOMES
Supply Schedule
Price
($)
Quantity
Supplied
10
1
Price
15
2
90
25
3
80
40
4
70
60
5
85
6
______________
3. Show your answer to question 2 on the graph as P1 and Q1.
60
50
40
30
20
10
1
2
3
4
5
6
Q
4. On the graph, show the consequence (P2, Q2)
of the market price rising to $85.
5. With reference to Norm’s Gnomes as an example, explain they law of supply ... i.e. why do firms supply more if the price of a good or service rises?
____________________________________________________________________________________________
____________________________________________________________________________________________
____________________________________________________________________________________________
____________________________________________________________________________________________
____________________________________________________________________________________________
6. Norm’s costs of production rose by $15 per gnome produced. Show the impact of this on the graph above.
7. With the price of garden gnomes still at P2 , describe how Norm will respond to the increase in his costs of
production ... and explain why he does this.
Marginal Cost and Supply
2. If the market price for garden gnomes
in Auckland is $40, how many gnomes
will Norm supply?
NORM’S GNOMES
Supply of Garden Gnomes
____________________________________________________________________________________________
____________________________________________________________________________________________
____________________________________________________________________________________________
____________________________________________________________________________________________
____________________________________________________________________________________________
Exercise 1.6
____________________________________________________________________________________________
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MARKET FORCES (3.3)
Supply Analysis
notes
Describe The Law of Diminishing Marginal Returns
In Achievement Standard 3.2 we saw than in a perfectly competitive market, the marginal cost curve
is the firm’s supply curve, with the starting point depending on whether we are considering the
short-run or long-run. Figure 1.3 below shows the short-run supply curve for a perfectly competitive
Figure 1.3 ... A Perfectly Competitive Firm’s Short-run Supply Curve
Price
($)
A firm’s short-run supply curve is
the MC curve above the lowest
point on the AVC curve or ‘shutdown point’.
MC = SSHORT-RUN
AC
AVC
Q
But why does the marginal cost curve slope upwards to the right?
The answer is the Law of Diminishing Marginal Returns, otherwise known as the
Principle of Increasing Costs. This law describes a short-run situation where the output
of a business is limited by the availability of fixed resources.
In the short-run at least one resource (cost of production) is fixed. A firm can expand its
output by using more variable resources, but can’t change its fixed resources. Initially
adding more resources will improve the firm’s productivity (i.e. its output grows in
relation to its resources). For example the firm may employ extra staff who are able to
specialise and therefore work faster.
However, eventually the limited fixed resources will slow any growth in productivity. For example
the firm may employ extra staff but they can’t access the fixed resources. Output may continue
to grow, but at slower and slower rates, i.e. diminishing marginal returns occur. This is shown in
Figure 1.4 below.
Figure 1.4 ... The Law of Diminishing Marginal Returns
Imagine a small bakery. Assume it has one oven and employs staff on a casual basis, depending
on demand. The oven is a fixed resource (cost), while staff are a variable resource. The table
below shows how many loaves the bakery can produce as it employs more staff and the extra
output (or marginal physical product) achieved by employing one more staff member.
Number of
Staff
(loaves/hour)
Output
0
0
1
100
2
250
3
500
4
700
5
800
Extra Output
(Marginal Physical
Product)
100
150
250
200
100
As the firm employs more staff, its total output grows. The ‘extra output’ column shows the change in output resulting from
extra variable resources (staff) being added. For the first three workers, total output grows at faster and faster rates . . .
hence the bakery is said to be achieving ‘increasing returns’. This typically happens as employing more staff allows them
to specialise and increase productivity.
However, from the fourth worker on, while the total output is still growing, it does so at slower rates. The marginal physical
product starts to get smaller. This typically occurs as the limited number of fixed resources (e.g. the oven) hinders the
productivity of variable resources (e.g. the staff). After the third worker, the bakery is said to be facing diminishing returns.
MARKET FORCES (3.3)
The Law of Diminishing Returns can also be called the ‘Principle of Increasing Costs’, as shown
in Figure 1.5 below. This states that to increase output in regular amounts, the extra costs of
production eventually get higher and higher. This happens as the productivity of variable resources
(e.g. staff) are limited by the availability of fixed resources, e.g. space in a factory, machinery.
Figure 1.5 ... The Principle of Increasing Costs
The following table is exactly the same firm as in Figure 1.4 but rather than increasing
the number of staff in regular intervals, we show the output rising in regular amounts.
Output
Total Cost
0
0
100
300
200
450
300
555
400
640
500
700
600
780
700
900
800
1100
(loaves/hour)
($)
Extra Cost
(marginal cost of producing
100 more loaves)
300
150
105
85
60
80
120
200
Initially as the firm increases its output, the total cost of production rises . . . but in smaller and smaller amounts. This is
shown in the ‘extra cost’ or ‘marginal cost’ column. However, eventually the limited fixed resources will decrease productivity
of variable resources and so the total cost will rise in larger and larger amounts, i.e. marginal cost starts to rise.
Explain the Law of Supply
The law of supply states that firms will supply more, i.e. quantity supplied will increase, as the price
of a good or service rises. Why?
The answer is as follows:
• firms will supply a good or service if the price equals (or exceeds) the
cost of producing it
• the marginal cost of producing a good or service rises as output grows
due to the law of diminishing marginal returns
... THEREFORE ...
• firms will only supply more of a good or service if the price rises to cover
the extra (marginal) cost of producing it
This idea is shown in Figure 1.6 over the page.
Remember that when we refer to costs, we are talking about economic costs. Economic costs refer
to the daily running costs as well as a minimum accounting profit as good as the next best possible
income - i.e. the opportunity cost of running the business. So when the price equals the marginal
cost of production, this includes a minimum level of accounting profit.
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MARKET FORCES (3.3)
Figure 1.6 ... The Law of Supply
1
Useful Yachts produces made-to-order yachts. The left-hand table below shows the marginal
cost of producing more yachts. Notice that the marginal cost of producing more yachts
rises due to the law of diminishing marginal returns / principle of increasing costs.
USEFUL YACHTS
Cost Schedule
Yachts
Marginal
Supplied
Cost
USEFUL YACHTS
Supply Schedule
Quantity
Price
Supplied
3
20 000
20 000
3
4
23 000
23 000
4
5
28 000
28 000
5
6
35 000
35 000
6
7
49 000
49 000
7
8
65 000
65 000
8
Useful Yachts will supply more yachts if
the price covers the marginal (extra) cost
of producing the yacht.
For example, Useful Yachts will produce
a 5th yacht if its customers are willing
to pay the marginal cost of $28 000. It
will only produce a 6th yacht (i.e. increase
its quantity supplied) if customers pay
a higher price that covers the higher
marginal cost of $35 000.
Price
($000)
65
Based on this, we can derive the firm’s
supply schedule, i.e. how much will the
firm produce at various prices, and then
draw a supply curve.
49
The supply curve slopes upwards to the
right to reflect the law of diminishing
returns and that firms will only supply
more as the price rises to cover their
higher marginal cost.
28
Note:
This supply curve only starts at 3 yachts.
This occurs because this is a price above
the Useful Yacht’s average variable cost
curve, i.e. its shut-down point (see AS 3.2)
Useful Yachts
Supply of Luxury Yachts
Supply
35
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20
3
4
5
6
7
8
Q
MARKETFORCES
FORCES (3.3)
MARKET
(3.3)
3
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es &
c
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mark
e
w
t
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b
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alloca
we aim to please
This topic is arguably the most important of the first three achievement standards.
It identifies what Adam Smith refers to as the ‘invisible hand’, i.e. the interaction of
market forces to provide the goods and services demanded by consumers.
Market forces, or the ‘price mechanism’, are very good at causing firms to change
how they use scarce resources to produce what consumers want.
This topic describes how these market forces work to switch production from one
good or service ... to production of another.
by the end of this topic, you should be able to...
o explain how and why market forces allocate resources between markets
o explain how market forces achieve allocative efficiency across
an economy
remember - try the exercises and then read the notes to learn what you don’t know.
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1
MARKET FORCES (3.3)
Over half of the phones
sold around the world today are now smart phones. And this
percentage is growing as consumers’ preferences for smart phones grow.
1. The graphs below show the markets for smartphones and dumbphones. Show the impact of consumers’
growing preference for smart phones on the market for smart phones. Clearly label your changes.
Price
($)
Smart Phones
900
Dumb Phones
Price
($)
400
S
800
350
700
300
600
S
250
P1 500
200
400
P1 150
300
100
D
200
50
D
100
1
2
3
4
Q1
5
6
7
Q (million)
1
2
3
Q1
4
5
6
Q
(million)
2. Explain how the changes you made to the market for smart phones, will affect the supply of dumb phones.
Your answer should clearly refer to the concept of opporutnity cost
(note: assume ceteris paribus, i.e. no change to the demand for dumb phones)
____________________________________________________________________________________________
Smart vs Dumb Phones
____________________________________________________________________________________________
____________________________________________________________________________________________
____________________________________________________________________________________________
____________________________________________________________________________________________
____________________________________________________________________________________________
____________________________________________________________________________________________
3. Show the changes you have described in question 2 on the market for dumb phones.
4. Using smart phones and dumb phones as an example, explain how the price mechanism helps to achieve
allocative efficiency across markets.
____________________________________________________________________________________________
____________________________________________________________________________________________
Exercise 1.7
____________________________________________________________________________________________
____________________________________________________________________________________________
____________________________________________________________________________________________
____________________________________________________________________________________________
____________________________________________________________________________________________
____________________________________________________________________________________________
MARKET FORCES (3.3)
29
In the 2000’s
growth in the international demand for milk products alongside regulatory changes
relating to forestry, meant that the profitability of growing trees dropped significantly in comparison to farmers
producing milk.
1. The graphs below the markets for milk and timber. Show the current equilibrium price (P1)and quantity(Q1)
in both markets.
Price
($/M3)
Price
($/kg)
Timber
450
9.00
400
8.00
S
350
7.00
300
6.00
250
5.00
200
4.00
150
3.00
D
100
Milk
S
2.00
D
1.00
50
10
20
30
40
50
60
70
Q (m M3)
1
20
40
60
80
100
120 140
Q (m kg milksolids)
2. Show the impact of growing demand for milk on BOTH markets - ceteris paribus.
3. Clearly explain how an increase in demand in one market (milk) can affect the equilbrium price and quantity
in another market (timber).
____________________________________________________________________________________________
____________________________________________________________________________________________
____________________________________________________________________________________________
3. The allocation of resources from producing timber to producing milk took 2-3 years. With reference to the
concepts of short-term and long-term, explain why this change took so long.
____________________________________________________________________________________________
____________________________________________________________________________________________
____________________________________________________________________________________________
4. If the price of milk dropped dramatically tomorrow, explain why farmers would not immediately switch back
to growing timber.
____________________________________________________________________________________________
Timber and Dairy Products
____________________________________________________________________________________________
5. Using timber and dairy products as an example, explain why the ‘full mobility of resources’, a characteristic
of a perfectly competitive market, is so important for an economy to achieve allocative efficiency.
____________________________________________________________________________________________
____________________________________________________________________________________________
____________________________________________________________________________________________
____________________________________________________________________________________________
Exercise 1.8
____________________________________________________________________________________________
30
1
MARKET FORCES (3.3)
Another shift in technology
prefer smaller, more mobile technology.
Price
($)
Tablet Computers
is from laptop computers to tablet computers as consumers
1. Why does the supply curve for tablet computers
slope upwards to the right?
S
_______________________________________________
_______________________________________________
_______________________________________________
P1
_______________________________________________
_______________________________________________
D
Q1
_______________________________________________
Q
_______________________________________________
2. Why does the supply curve for tablet computers slope upwards to the right?
____________________________________________________________________________________________
____________________________________________________________________________________________
____________________________________________________________________________________________
3. Show the impact of growing demand for tablet computers on the graph above.
Exercise 1.7
Smart vs Dumb Phones
4. Show the impact of growing demand for tablet computers (ceteris paribus) on the market for laptop computers
shown below.
5. Explain, step by step, how the market for laptops shifts
from the old to new equilibrium price and quantity.
Laptop Computers
Price
($)
S
_______________________________________________
_______________________________________________
_______________________________________________
P1
_______________________________________________
_______________________________________________
D
_______________________________________________
_______________________________________________
Q1
Q
6. Adam Smith, a famous economist, coined the phrase “the
invisible hand” to refer to the price mechanism or market forces. Using one of the examples from exercises
1.5 to 1.7, explain how the ‘invisible hand’ or price mechanism benefits consumers AND producers.
____________________________________________________________________________________________
____________________________________________________________________________________________
____________________________________________________________________________________________
____________________________________________________________________________________________
____________________________________________________________________________________________
MARKET FORCES (3.3)
Market Forces and Resource Allocation
Between Markets
notes
1
Explain How and Why Market Forces Allocate Resources
Between Markets
Having seen how an individual market responds to changes in Achievement Standard 3.1, we now
need to examine how two or more markets operate together.
Few, if any markets are completely alone. Changes in one market such as increased demand for a
good, will affect other markets. Producers will respond to these changes by allocating resources away
from the production of one good to producing another. This happens as firms try to shift resources to
the most profitable goods and services.
Figure 1.7 shows how producers in two markets will respond to a change in one market (ceteris
paribus).
Figure 1.7 ... Allocation of Resources Between Markets
1. Both markets are in equilibrium.
MARKET FOR MOTOR BIKES
MARKET FOR CARS
S1
$
S1
$
P1
P1
D1
Q1
D1
Q
Q1
2. The demand for motorbikes falls.
. . . this causes D to shift to the left.
. . . this results in a surplus at P1.
MARKET FOR MOTOR BIKES
Q
MARKET FOR CARS
S1
$
S1
$
P1
P1
D2
Q2
Q1
D1
Q
surplus
continued over the page
D2
Q1
31
D1
Q
32
1
MARKET FORCES (3.3)
Figure 1.7 ... Allocation of Resources Between Markets (cont’d)
3. Motorbike producers will drop the price to shift stock that is not selling.
. . . as the price falls, QD will rise.
. . . the fall in price will cause QS to fall until it equals QD.
MARKET FOR MOTOR BIKES
MARKET FOR CARS
S1
$
S1
$
P1
P2
P1
D2
D1
D1
Q
Q2 Q3 Q1
Q1
Q
4. The price of cars (a related good) is now proportionally higher, making them relatively more profitable to produce. Firms will switch (some) resources from the production of motorbikes to producing cars.
MARKET FOR MOTOR BIKES
MARKET FOR CARS
S1
$
S1
$
S2
P1
P2
D2
D1
Q
Q3
Q1
Q
Q2
surplus
5. Faced with surplus stock in their showrooms that won’t sell at the current price, producers will drop the
price of cars until QS = QD
MARKET FOR MOTOR BIKES
MARKET FOR CARS
S1
$
S1
$
S2
P1
P2
P2
D2
Q3
Q
D1
Q1 Q3 Q2
Q
The net effect of these changes is that the price falls in both markets, the output of motor bikes has fallen and the output
of cars has risen. Firms have shifted some resources from producing motor bikes to producing cars.
MARKET FORCES (3.3)
In Figure 1.7 the price of motor bikes affects the market for cars because they are related goods. Car
producers could use their resources to also produce motor bikes. Assuming no other products, i.e.
ceteris paribus, selling motor bikes is the opportunity cost of producing cars. If the price of motor
bikes falls, the opportunity cost of selling cars falls.
Opportunity cost is part of firms’ economic costs. So if the opportunity cost of producing cars falls
then car manufacturers’ marginal cost of production falls . . . causing supply to shift down or to the
right.
This analysis can apply to a range of factors that will cause producers to respond to changes in the
market and so allocate resources to the goods and services most demanded by consumers. In this
way firms respond to changes in consumers’ demand and markets achieve allocative efficiency.
Explain How Market Forces Achieve Allocative Efficiency
Across an Economy
In Achievement Standard 3.1, we looked at how an individual market achieves allocative efficiency
... when consumer and producer surplus are maximised.
We also briefly looked at the idea of allocative efficiency across the economy, which is when all of an
economy’s resources are used to produce the goods and services that society (consumers) want. And
we used a production possibility frontier (PPF) graph to illustrate this.
The benefit of markets is that they are very good at responding to changes in consumer preferences.
Figure 1.8 shows the shift in production away from dumb phones to smart phones. This is a shift in
production due to changes in consumer demand, and occurs through market forces creating incentives
(i.e. more profit) for firms to reduce production of dumb phones and switch the use of these resources
to the use of smart phones.
Figure 1.8 ... Markets & Allocative Efficiency
Smart Phones
This PPF graph shows a change in an
economy’s use of resources.
Q4
B
A
Q3
Q2
Q1
As consumers’ preference for smart
phones increases, the profit from selling
them encourages firms to reduce
less dumb phones, and instead use
resources to produce smart phones.
This shift will occur through market
forces / the price mechanism.
Dumb Phones
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1
MARKET FORCES (3.3)
UNIT 1
Market Forces
Unit Content:
Understanding
1
(poor)
2
1.1 Demand and Marginal Utility
• Describe Marginal Utility
• Describe the Law of Diminishing Marginal Utility
• Describe the Optimal Purchase Rule
• Explain the Law of Demand
• Identify and Describe Consumer Equilibrium
1.2 Supply and Marginal Cost
• The Law of Diminishing Marginal Returns
• Explain the Law of Supply
1.3 Market Forces and Resource Allocation Between Markets
• Explain How and Why Market Forces Allocate Resources Between Markets
• Explain How Market Forces Achieve Allocative Efficiency Across an Economy
checklist:
I have ...
 done a mind-map of the main ideas (before and after I’ve done the work)
 tried (and marked) all of the exercises
 watched the online videos of this work
 read the notes and summarised the key ideas in the margins of the pages
 made (or downloaded from quizlet) flashcards of the key ideas and definitions
relevant current events and examples:
relevant events and examples for this unit are:
I didn’t really get the following parts of this unit ...
... and I’m going to ask ___________________ to help me with this
3
(good)