Download HOW MARKETS WORK

HOW MARKETS WORK
• Market exchange is a process through
which people buy and sell commodities.
• Chapter three examines the workings of
perfectly competitive markets.
• A large number of buyers and a large
number of sellers participate. No one
party sets the price.
RELATIVE PRICE
• Markets establish a price. The price is a sum of money you pay for
the good.
• Economists are concerned about the opportunity cost of a good.
– Suppose a pack of cigarettes costs $10.00 and taxi cab fare is $5.00.
Buying cigarettes costs two taxi cab trips. If you walk back and forth to
the University for one day and give up taking a cab each way, you can
pay for the pack of cigarettes.
• In talking about markets were call the opportunity cost of goods the
relative price. We are concerned about the change in the price of
one good relative to the changes in prices of other goods.
• During a period of inflation the prices of all goods may be rising. If
the price of one good, such as cigarettes rises by less than the price
of other goods, than its relative price has fallen.
– For example if taxi cab fares rose from $5.00 to $10.00 and the price of
cigarettes rose from $10.00 to $15.00, the relative price of cigarettes
has fallen. A pack now costs 1.5 taxi cab rides instead of two taxi cab
rides.
LAW OF DEMAND
• The higher the price, the lower
the quantity demanded, c.p.
– c.p. -- other things being the same
Individual and Market Demand
Goods
• A market demand curve is the horizontal
sum of all individual demand curves.
– This is determined by adding the individual
demand curves of all the consumers
(“demanders”).
Individual and Market Demand
Goods
• In reality, the sellers do not add up
individual demand curves.
• They estimate total market demand for
their product which becomes smooth and
downward sloping curve.
From Individual Demands
to a Market, Fig. 4-4 (a and b), p 88
A $.0.50
B 1.00
C 1.50
D 2.00
E 2.50
F 3.00
G 3.50
H 4.00
9
8
7
6
5
4
3
2
6
5
4
3
2
1
0
0
1
1
0
0
0
0
0
0
16
14
11
9
7
5
3
2
$4.00
Price per cassette (in dollars)
(1)
(2)
(3)
(2)
(3)
Price per Marie’s Pierre’s Cathy’s Market
cassette demand demand demand demand
3.50
G
F
3.00
E
2.50
D
2.00
C
1.50
B
1.00
0.50
Cathy
0
2 4
A
Pierre Marie Market demand
6 8 10 12 14 16
Quantity of cassettes demanded per week
From a Demand Table to a
Demand Curve
• The demand curve graphically conveys
the same information that is on the
demand table.
• The curve represents the maximum price
that you will pay for various quantities of a
good—you will happily pay less.
From a Demand Table to a
Demand Curve, Fig. 4-3 (a and b), p 87
A Demand Table
A
B
C
D
E
$0.50
1.00
2.00
3.00
4.00
9
8
6
4
2
Price per cassette (in dollars)
Price per Cassette rentals
cassette demanded per
week
A Demand Curve
$6.00
5.00
4.00
3.50
3.00
E
D
G
2.00
C
1.00
.50
0
F
Demand for
cassettes
B
A
1 2 3 4 5 6 7 8 9 10 11 12 13
Quantity of cassettes demanded (per week)
Individual and Market Demand
Goods
• The demand curve is downward sloping
for the following reasons:
– At lower prices, existing consumers buy
more.
– At lower prices, new consumers enter the
market.
SUBSTITUTION EFFECT
• As the price of one good rises c.p. the
opportunity cost of the good relative to
substitutes increases. People buy less of
the good and more of its substitutes
• If the price of pizza rises people buy more
Big Macs or subway sandwiches.
INCOME EFFECT
• As the price of one good rises, c.p. the
price rises relative to buyers’ incomes.
People must buy fewer goods and they will
buy fewer of the good whose price has
risen
• Even if pizza had no substitutes, at high
prices people would buy fewer because of
budget constraints
DETERMINANTS OF DEMAND
1. PRICE OF THE GOOD
2. PRICE OF RELATED GOODS
– COMPLEMENTS
– SUBSTITUTES
3. INCOME
– NORMAL GOODS
– INFERIOR GOODS
4. POPULATION
5. EXPECTED FUTURE PRICES
6. PREFERENCES
Demand for Pizzas
QUANTITY
PRICE
0
$ 30.00
100
$ 25.00
200
$ 20.00
300
$ 15.00
400
$ 10.00
500
$
5.00
Demand Curve
DEMAND FOR PIZZA
$40.00
$35.00
PRICE OF ONE PIZZA
• As the price rises,
people are willing to
buy fewer pizzas.
• As the price of pizza
changes, move along
the demand curve
$30.00
$25.00
$20.00
$15.00
$10.00
$5.00
$0
100 200 300 400 500 600
QUANTITY PIZZAS PER WEEK
Change in price of a complement
PRICE OF PIZZA
DEMAND
$35.00
$30.00
$25.00
$20.00
$15.00
$10.00
Beer = $3
Beer = $7
$5.00
$0.00
0
200
400
QUANTITY OF PIZZA
600
Change in price of a substitute
PRICE OF PIZZA
DEMAND
$40.00
$35.00
$30.00
$25.00
$20.00
$15.00
$10.00
$5.00
$0.00
Steak = $10
Steak = $20
0
200
400
QUANTITY OF PIZZA
600
Change in Income
PRICE OF PIZZA
DEMAND
$40.00
$35.00
$30.00
$25.00
$20.00
$15.00
$10.00
$5.00
$0.00
Income = $250
Income = $350
0
200
400
QUANTITY OF PIZZA
600
LAW OF SUPPLY
• The higher the price, the larger the
quantity supplied, other things being equal
• When the price of a good rises, c.p. It
rises relative to the opportunity cost of
producing it, so firms are willing to produce
more of the good.
Individual and Market Supply of
Goods
• A market supply curve is the horizontal
sum of all individual supply curves.
– This is determined by adding the individual
supply curves of all the firms (“supplers”).
Supply of Pizza
Quantity
Price
0
$5.00
100
$10.00
200
$15.00
300
$20.00
400
$25.00
500
$30.00
600
$35.00
SUPPLY
SUPPLY
PRICE OF PIZZA
• At a higher price the
firm is willing to
supply more pizza.
• As price of pizza
changes, move along
the supply curve
$40.00
$35.00
$30.00
$25.00
$20.00
$15.00
$10.00
$5.00
$0.00
0
100
200
300
400
500
QUANTITY OF PIZZA
600
700
DETERMINANTS OF SUPPLY
• PRICE OF THE GOOD
• PRICE OF FACTORS OF PRODUCTION
• PRICES OF RELATED GOODS
– RAW MATERIALS
– SUBSTITUTES IN PRODUCTION
– COMPLEMENTS IN PRODUCTION
• NUMBER OF SUPPLIERS
• EXPECTED FUTURE PRICES
• TECHNOLOGY
Rise in Cost of a Factor of
Production
PRICE OF PIZZA
SUPPLY
$40.00
$35.00
$30.00
$25.00
$20.00
$15.00
$10.00
$5.00
$0.00
0
100
200
300
400
500
600
QUANTITY OF PIZZA
Wage = 6.50
Wage = 7.50
700
Rise in price of raw material
PRICE OF PIZZA
SUPPLY
$40.00
$35.00
$30.00
$25.00
$20.00
$15.00
$10.00
$5.00
$0.00
0
100
200
300
400
500
600
QUANTITY OF PIZZA
Cheese = 5.50/lb
Cheese = 7.00/lb
700
Rise in Price of Substitute in
Production
SUPPLY
PRICE OF PIZZA
• The diagram tells the following
story. When the price of a
donair is $5.50, a firm will
produce 200 pizzas only if it
receives a price of at least
$15.00. A firm will produce 300
pizzas only if it receives a price
of at least $20.00. When the
donair rises in price to $7.00,
the opportunity cost of
producing pizza rises. The firm
is giving up the opportunity of
producing donairs instead of
pizzas. As a result it requires a
higher price to produce a given
number of pizzas. A firm now
requires a price of at least
$18.00 to produce 200 pizzas
and a price of $23 to produce
300 pizzas.
$40.00
$35.00
$30.00
$25.00
$20.00
$15.00
$10.00
$5.00
$0.00
0
100 200 300 400 500 600 700
QUANTITY OF PIZZA
Donair = $5.50
Donair = $7.00
Rise in Price of a Complement in
Production
SUPPLY
PRICE OF BEEF
• The diagram tells the following
story. When the price of a beef
hide is $5.50, a firm will
produce 200 units of beef only
if it receives a price of at least
$15.00 per unit. A firm will
produce 300 units of beef only
if it receives a price of at least
$20.00 per unit. When the
hides rise in price to $7.00, the
return to producing beef rises.
The firm receives the price of
beef plus the price of the hide
each time it slaughters an
animal, so when the price of a
hide rises, the total return to
producing beef goes up. A firm
now requires a price of at least
$11.00 to produce 200 units of
beef and a price of $16 to
produce 300 units of beef.
$40.00
$35.00
$30.00
$25.00
$20.00
$15.00
$10.00
$5.00
$0.00
0
100 200 300 400 500 600 700
QUANTITY OF BEEF
HIDES = $5.50
HIDES = $7.00
Equilibrium Price and Quantity
• At low prices, people will want
to buy more than people want
to sell.
• Competition to buy will drive
prices up.
• At high prices, people will want
to sell more than people will
want to buy
• Competition to sell will drive
prices down
• Only when the quantity people
want to sell equals the quantity
people want to buy will price
stop changing– be in
equilibrium.
PRICE
SUPPLY
DEMAND
$0.00
0
500
$5.00
0
400
$10.00
100
300
$15.00
200
200
$20.00
300
100
$25.00
400
0
$30.00
500
0
Equilibrium price and quantity
MARKET FOR PIZZAS
$30.00
PRICE OF PIZZA
• At low prices, people will want
to buy more than people want
to sell.
• Competition to buy will drive
prices up.
• At high prices, people will want
to sell more than people will
want to buy
• Competition to sell will drive
prices down
• Only when the quantity people
want to sell equals the quantity
people want to buy will price
stop changing – be in
equilibrium.
$25.00
$20.00
SUPPLY
$15.00
DEMAND
$10.00
$5.00
$0.00
0
100 200 300 400 500
QUANTITY OF PIZZA
Market for Pizza
MARKET FOR PIZZAS
PRICE OF PIZZA
$30.00
$25.00
$20.00
SUPPLY
$15.00
DEMAND
$10.00
$5.00
$0.00
0
100 200 300 400 500
QUANTITY OF PIZZA