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1 Markets Chapter 3 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 2 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 3 Examples of Markets Markets are where people make comparisons. Buyers and sellers interact with the goal of an exchange taking place. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 4 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 5 Willingness to Pay and Consumer Benefits A demand curve identifies the maximum amount consumers are willing to pay for any given amount of a good. The difference between the amount consumers are willing to pay and the amount they have to pay is called consumer surplus. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 6 Demand and Quantity Demanded A movement from A to B on demand curve D is referred to as an increase in the quantity demanded. A B A shift in the demand curve from D to D1 is referred to as an increase in demand. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. D1 7 Demand Shifters Information: learning that the consumption of macaroons increases the risk of heart attack, shifts the demand curve from D1 to D2. Income or wealth: if an increase in income shifts the demand for macaroons from D1 to D2 we say macaroons are an inferior good. Prices of related goods: if the price of a substitute for macaroons decreases, the Demand for macaroons will shift from D1 to D2. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 8 From Individual to Market Demand The market demand curve is the horizontal summation of all the demand curves of individual consumers. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 9 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10 The Profit Motive and the Gains to Producers The supply curve shows the minimum price that sellers will accept for various quantities of a good. The difference between the minimum price they will accept and the price they receive is referred to as the producer surplus. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 11 Supply and Quantity Supplied The movement from A to B on supply curve, S is referred to as an increase in the quantity supplied. B A A shift in the supply curve from S to S1 is referred to as an increase in supply. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. S1 12 From Individual to Market Supply The horizontal sum of the individual seller’s supply curves is the market supply. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 13 Market Equilibrium When a market comes to rest and there are no additional mutually acceptable trades to be made, we say the market has reached an equilibrium. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 14 Market Equilibrium - Example (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 15 Market Equilibrium - Example Given the market demand and an initial endowment of the good, 3 for Ahmed, 3 for Becky, 2 for Carl, 1 for Deb and 0 for Enzo, a market equilibrium price of $4 will emerge from trading between the parties. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 16 Changes in Equilibrium – An Increase in Demand Suppose that Deb experiences an increase in demand. The market demand will increase to D’ and the equilibrium price will rise to $5. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 17 Changes in Equilibrium – A Decrease in Supply Suppose two units of the good were destroyed, decreasing the supply to S’. This would increase the equilibrium price still further to $6. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 18 Comparing Equilibria Consider the initial equilibrium between supply (S) and demand (D) with a price of $13 and quantity of 12.5. Suppose there is a decrease in the price of an input of $4 so the supply curve shifts down by $4 to S’. What happens to the equilibrium price? As shown in the diagram, equilibrium price falls, but not by $4. It only falls by $2.50, to $10.50. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 19 Why Equilibrium Matters – A Price Ceiling Here we see what happens when we try to circumvent the equilibrium by imposing a price ceiling of $11.00. At the ceiling price we see that a shortage of the good will exist. The amount consumers wish to purchase at the ceiling price exceeds the amount sellers wish to sell. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 20 Why Equilibrium Matters – A Price Floor Here we see what happens when we try to circumvent the market by imposing a price floor of $15.00. At the floor price we see that a surplus will exist. The amount that sellers wish to sell at the floor price exceed the amount consumers wish to buy. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 21 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 22 Recycling Paper Will recycling paper save forests? Many people believe that the answer is yes. But, the supply and demand model suggest otherwise. Here is the supply (S) and demand (D) For pulpwood before recycling. The equilibrium price is $70 per cord with 100 million cords exchanged. Recycling reduces the demand for pulpwood to D’ reducing the price and quantity exchanged. Recycling paper reduces the need for trees for the production of paper, but will the trees be cut to clear space for agricultural or commercial or residential use instead? (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 23 Who Benefits from a Price Ceiling? Here is the market for loans, with the given supply and demand curve, $800 billion would be saved and borrowed at an interest rate of 8% If regulations set a ceiling on the interest rate banks could pay depositors at 4%, then depositors would only want to deposit $400 billion. The rate that banks could then charge to ration the available funds would be 12%. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 24 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 25 Elasticity of Demand Price elasticity of demand is the responsiveness of quantity demanded to changes in the price of a good. For two points on the demand curve that are close together, we can express price elasticity as: (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 26 Elasticity of Demand Value Name Effect of lower price on spending ED < 1 Inelastic Raises ED = 1 Unit Elastic Constant ED > 1 Elastic Lowers (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 27 Elasticity of Demand The more and better the substitutes for a good, the higher the elasticity of demand will be. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 28 Some Other Elasticities – Income Elasticity Income elasticity is the responsiveness of quantity demanded to changes in income. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 29 Some Other Elasticities – Cross Elasticity The cross elasticity of demand for good X is the responsiveness of the quantity of X demanded to changes in the price of good Y. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 30 Some Other Elasticities – Elasticity of Supply The elasticity of supply is the responsiveness of the quantity supplied to changes in price. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 31 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 32 How Prices Convey Information – Adam Smith In the Wealth of Nations, Adam Smith provides a clear example of the extent of the coordination problem needed to produce something as common as a woolen coat. The shepherd, the sorter of the wool, the wool-comber or carder, the dyer, the scribbler, the spinner, the weaver, the fuller, the dresser, with many others, must all join their different arts in order to complete even this homely production. And this is only the start of it! (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 33 How Prices Convey Information – After the Epizootic Take Adam Smith’s story a little further and imagine that an epizootic suddenly cuts the sheep population in half. Thousands of adjustments ensue, not the least of which is that the price of woolen coats will increase. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 34 How Prices Convey Information – Dispersed Knowledge and Informative Prices Market prices solve the planning problem by decentralizing decisions into the hands of people who know only the particulars of their individual situations. They need not know about the epizootic at all to respond to the price changes that result from it. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 35 The Present and the Future – Trading With Yourself How can an individual best allocate a good between the present and the future if information about the future is uncertain or unknown? Because most potatoes are harvested at the end of the summer, consumers cannot rely on growers to deliver a steady stream of them to market every week over the year. Some of the harvest must be stored and decisions made daily on how much to release from storage for consumption over the year. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 36 The Present and the Future – Trading With Yourself Buying the stockpile is costly and holding it is risky. If you are skilled at investing, the potatoes tie up funds that have earning power in investments elsewhere. If you do not acquire information about potatoes while you hold them, you might make mistakes that a potato expert would not. The more commodities you must treat like potatoes, the more severe your information problems. Self-sufficiency in potatoes carries high transaction costs and risks you might rather pay someone else to bear. Fortunately, intermediaries are available. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 37 The Present and the Future Speculators Here is what happens both with and without speculation. Consider a commodity whose peak harvest occurs in October while smaller amounts come to market in other months. Without speculation, all of each month’s production is immediately sold and consumed. Speculators will buy when it is abundant and hold it in expectation of gains from being able to resell it later for more money, which will reduce the price fluctuations. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 38 The Present and the Future Information and Revision of Prices The market price is affected by information besides that in weather forecasts. For instance, an expert on grocery markets expects that a continuing trend for low-carbohydrate diets will decrease the economy’s demand for wheat. An expert on foreign policy hears from informed sources that the government will soon initiate policies to raise wheat exports. Some people believe the information of the grocery researcher or foreign policy expert will move prices, and so begin to trade accordingly. Price changes as different people trade on the basis of information that others do not know and beliefs that others do not hold. There is simply no imaginable way to centralize all of this knowledge in, say, a government agency. Yet the market incorporates it into prices through the actions of dispersed individuals. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 39 The Present and the Future Derivatives and Derivatives Markets Our commodity markets have so far offered their participants a range of choices that are far smaller than exist in reality. For example, people might enter into forward contracts that fix the price today for delivery of a good at some date in the future. Because its value depends on the price of the underlying commodity, the forward contract is an example of a derivative or a derivative asset. A futures contract is a standardized forward contract, traded on a futures exchange. Like a forward contract, it sets a price today for future delivery. The contract is valuable to both producers and large consumers of gas as a hedge that lessens the risks associated with the highly unstable (“volatile”) spot price. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.