markets and market participants (supply and demand) chapter-3

Markets and Market Participants

(Supply and Demand)

Chapter-3

In This Chapter….

3.1. Market Participants, their Goals, and Interactions in the Market Place

3.2. The Representation (Characterization) of Market Participants Supply and demand

Individual and Market

3.3. The formation of Market Signals that guide us in Allocating the Scarce Resources

3.1. Identifying Markets, Market Participants and their Behavior

Who? Millions of people (domestic or

foreign), firms, and government institutions participate directly or indirectly in the market (a given country’s economy).

We can identify three broad groups of market participants

3.1. Identifying Markets, Market Participants and their Behavior Consumers (Households):

Those economic agents who go to the marketplace to buy goods and services and satisfy their needs (wants) from their limited resources.

Producers (Businesses or firms): Economic agents who go to the marketplace to

sell goods and services so as to make profits from their limited outputs (services)

Government (Government Institutions): Serve the public needs interest by using the

available resources

3.1. Identifying Markets, Market Participants and their Behavior

The Purpose (Goal) of Market Participants? Consumers (Households):

maximize their utility (satisfaction) given limited resources.

Producers (Businesses): maximize profits by using resources efficiently in

producing goods. Government Institutions:

maximize general welfare of the society.

Maximizing Behavior

3.1. Identifying Markets, Market Participants and their Behavior

Maximizing Behavior The basic goals of utility maximization,

profit maximization, and welfare maximization thus explain most market activity.

How do Markets enable Participants to Achieve the goal Maximization?

3.1. Identifying Markets, Market Participants and their Behavior Economic interactions …the opportunity for

specialization and exchange. Our economic interactions with others in

the market place is necessitated by two constraints:1. Our absolute inability as individuals to do

(produce) all the things we need or desire.

2. The limited amount of time, energy, and resources we have producing those things we could make for ourselves…scarcity

3.1. Identifying Markets, Market Participants and their Behavior Markets thus refer to a place where consumers

and producers come together and where exchange takes place.

Although identifiable and peculiar in some cases, there is no specific place where markets are located (they could be virtual)

A market exists wherever and whenever an exchange takes place.

Based on the items for exchange, however, we can identify TWO MAIN types of markets

3.1. Identifying Markets, Market Participants and their Behavior

1. Factor Markets:… are any place where factors of production (e.g., land, labor, capital) are bought and sold.

2. Product Markets: … are any place where finished (final)

goods and services (products) are bought and sold.

3.1. Interaction in the Market Place

Internationalparticipants

Consumers(Households)

Internationalparticipants

Producers (Firms)

Governments

ProductMarkets

FactorsMarkets

Factors ofproduction supplied

Goods and servicesdemanded

Factors ofproduction demanded

The Circular Flow

Goods and servicessupplied

Dollars and Exchange

Every market transaction involves an exchange of dollars for goods (in product markets) or resources (in factor markets).

3.1. Interaction in the Market Place

Internationalparticipants

Consumers(Households)

Internationalparticipants

Producers (Firms)

Governments

ProductMarkets

FactorMarkets

Household Expenses

Costs of Production

The Circular Flow

Revenue

Incomes Factors ofproduction demanded

Factors ofproduction supplied

Goods and servicesdemanded Goods and services

supplied

3.2. Characterization of the Activities of Market Participants

Market is a place that brings together Consumers (Buyers) and Producers (Sellers).

For every market transaction, there must be a buyer and a seller.

The sellers represent the supply side of the market.

The buyers represent the demand side of the market.

3. 2. Supply and Demand

Demand

3. 2. Supply and Demand

What is Demand ? is the ability and willingness of

consumers (buyers) to buy specific quantities of a good at alternative prices in a given time period, ceteris paribus.

Quantity Demanded: The amount of a good that a consumer is

willing and able to buy at given time and price level, ceteris paribus

3.2. Supply and Demand

A demand exists only if someone is willing and able to pay for a good. Thus…

“Demand” is an expression of consumer buying intentions – of a willingness and ability to buy – not a statement of actual purchases.

Individual Demand

Three different ways to present demand:

1. Using A table (Demand Schedule)2. Using A graph (Demand Curve)3. Using A Mathematical Equation (Demand

Function)

Individual Demand

Demand schedule: is a table showing the quantities of a

good a consumer is willing and able to buy at alternative prices in a given time period, ceteris paribus.

Individual Demand

Demand curve:

is a curve (graph) describing the quantities of a good a consumer is willing and able to buy at alternative prices in a given time period, ceteris paribus.

Demand Schedule and Curve

2 4 6 8 10 12 14 16 18 20Quantity of Tutoring Demanded (hours)

PRICE$5045403530252015105

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A

B

CD

E

F

GH

I

Individual Demand

Demand Function:

an algebraic representation of the quantities of a good a given consumer is willing and able to buy at alternative prices in a given time period, ceteris paribus.

)P(fQd=

Individual Demand

The Law of demand:

The quantity of a good demanded in a given time period increases as its price falls, ceteris paribus.

Determinants of Demand

Determinants of market demand include: Tastes — desire for the particular good

under consideration and other goods. Income — of the consumer. Other goods — their availability and price. Expectations — for income, prices,

tastes. Number of buyers.

Types of Demand

We can identify two types of demand:

Individual demand Market demand :

is the total quantities of a good or service people are willing and able to buy at alternative prices in a given time period.

It is the sum of individual demands.

Market Demand

Market demand is determined by the number of potential buyers and their respective tastes, incomes, other goods and expectations.

The Market Demand Curve

Market demand represents the combined demands of all market participants.

The separate demands of individual consumers is added up to determine the total quantity demanded at any given price.

Construction of the Market Demand Curve

+ + =

Morke’s demand curve

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$50

Price

+

Stacy’s demand curve

0 4 8 12 16 20 24 28

Leah’s demand

curve

0 4 8 12

Negassa’s demand

curve

0 4 8 12

Price

Quantity Demanded

Construction of the Market Demand Curve

ABC

DE

FG

I

$50

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The market demand curve

Pric

e

Quantity Demanded

H

=

Shifts in Demand Vs Movements along the Demand Curve The determinants of demand can and do

change.

A Change in demand is indicated by a shift in the demand curve.

Represents a change in the quantity demanded at every given price level.

Results from changes in one or more factors in the determinants of demand (due to changes in tastes, income, other goods, or expectations), except own price of the good

Shifts in Demand Vs Movements along the Demand Curve

Changes in quantity demanded :

Is indicated by movements along a demand curve, and it results only as a response to changes in the price of the good itself.

Changes in Demand

Change in Demand is indicted by a shift in the Demand Curve

An increase in demand shifts the demand curve to the right when:

A decrease in demand shifts the demand curve to the left when:

The good is normal and income increases

The good is normal and income decreases

The good is inferior and income decreases

The good is inferior and income increases

The price of a substitute good increases

The price of a substitute good decreases

The price of a complementary good decreases

The price of a complementary good increases

Market Effects ofChanges in Demand

Changes in Demand Shift the Demand Curve

An increase in demand shifts the demand curve to the right when:

A decrease in demand shifts the demand curve to the left when:

Population increases Population decreases

Consumer tastes shift in favor of the product

Consumer tastes shift away from the product

Consumers expect a higher price in the future

Consumers expect a lower price in the future

Movements vs. Shifts

PRICE

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3530252015

1050

$45

2 4 6 8 10 12 14 16 18 20 22 Quantity

D1initial demand

d1

Movement along curve

g1

Shift in demand

D2 increased demand

d2

Pizza and Politics: Quiz (True or False)

At the Clinton White House whenever a political crisis erupted, the demand for pizza increased.

…we can represent this by a shift in demand curve for pizza (at the White House) not by movement along the same demand curve.

True

3. 2. Supply and Demand

Supply

3.2. Supply and Demand

What is Supply? is the ability and willingness of a

producer (supplier) to sell specific quantities of a good at alternative prices in a given time period, ceteris paribus.

Quantity Supplied The quantity of a given good that the

producer is willing and able to supply at a given price and time, ceteris paribus

Supply

Supply is the total quantities of a good that sellers are willing and able to sell at alternative prices in a given time period, ceteris paribus.

Law of Supply Larger quantities will be offered for sale at

higher prices.

Law of supply, the quantity of a good supplied in a given time period increases as its price increases, ceteris paribus.

Supply curves are thus upward-sloping to the right.

Market Supply

Quantity Supplied By:

Price Erin + Hussein + Miranda = Market

j $50 94 35 19 148

i 45 93 33 14 140

h 40 90 30 10 130

g 35 86 28 0 114

f 30 78 12 0 90

e 25 53 9 0 62

d 20 32 7 0 39

c 15 20 0 0 20

b 10 10 0 0 10

Market Supply

Erin’sSupply

Hussein’sSupply

Miranda’sSupply

Market Supply

Determinants of Supply

The determinants of market supply include:

– Factor costs

– Technology

– Other goods

– Taxes and subsidies

– Expectations

– Number of sellers

Market Supply

The market supply curve is just a summary of the supply intentions of all producers.

Market supply is an expression of sellers’ intentions (willingness and ability)– an offer to sell – not a statement of actual sales.

Movements and Shifts of Supply

Changes in the quantity supplied — movements along the supply curve.

Changes in supply — shifts in the supply curve.

Equilibrium Market Price

Equilibrium

Equilibrium price is the price at which the quantity of a

good demanded in a given time period equals the quantity supplied.

Equilibrium Quantity The quantity of the good purchased and

sold at the equilibrium price

Price Quantity Supplied Quantity Demanded $50 148 surplus 5

45 140 surplus 8 40 130 surplus 11 35 114 surplus 16 30 90 surplus 22 25 62 surplus 30 20 39 equilibrium 39 15 20 shortage 47 10 10 shortage 57

Equilibrium Price

Equilibrium Price

Market demand

Equilibrium price

Market supply$504540353025201510

5

0 25 50 75

At equilibrium price, quantity demanded equals quantity supplied

100 125 Quantity39

Price

….Equilibrium Price is a Market Clearing Price

Everyone may not be happy with the prevailing price or quantity at equilibrium.

However, it is unique in that the outcome at market equilibrium is efficient. Resources are put to their best possible

use

The Invisible Hand

Adam Smith characterized this market mechanism as the invisible hand.

The market mechanism is the use of market prices and sales to signal desired outputs (or resource allocations).

Price Quantity Supplied Quantity Demanded $50 148 surplus 5

45 140 surplus 8 40 130 surplus 11 35 114 surplus 16 30 90 surplus 22 25 62 surplus 30 20 39 equilibrium 39 15 20 shortage 47 10 10 shortage 57

Deviation from the Equilibrium

Market Surplus

A market surplus is the amount by which the quantity supplied exceeds the quantity demanded at a given price – excess supply.

A market surplus is created when the market prices are too high.

Market Shortage

A market shortage is the amount by which the quantity demanded exceeds the quantity supplied at a given price – excess demand.

A market shortage is created when the market prices are too low.

Surplus and Shortage

Market demand Market supply$504540353025201510

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0 25 50 75 100 125 Quantity39

Price

Shortage

yx

Surplus

Self-Adjusting Prices

A market surplus will emerge when the market price is above the equilibrium price.

A market shortage will emerge when the market price is below the equilibrium price.

Self-Adjusting Prices

Buyers and sellers will change their behavior to overcome a surplus or shortage.

Only at the equilibrium price will no further adjustments be required.

Surplus and Shortage

Market demand

Equilibrium price

Market supply$504540353025201510

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0 25 50 75 100 125 Quantity39

Price

Shortage

yx

Surplus

Changes in Equilibrium

No equilibrium price is permanent. The equilibrium price will change

whenever the supply or demand curve shifts.

Changes in supply and demand occur when the determinants of supply and demand change.

Changes in Equilibrium

Should the demand curve shift, the result will be a change in equilibrium price and quantity.

Should the supply curve shift, the result will be a change in equilibrium price and quantity.

Changes in Equilibrium Demand Shift

25 50 75 100 Quantity

Price

$50

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E1

Initial demand

Market supply

New demand

E2

Changes in Equilibrium Supply Shift

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Price

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E3

E1

Initial demand

Market supply

Implications---Outcomes

In a free market economy, the market mechanism resolves the basic economic questions of WHAT, HOW, and FOR WHOM.

Market Outcomes

WHAT we produce is determined by the equilibrium of the markets.

HOW we produce is determined by profit seeking behavior and using resources efficiently.

FOR WHOM we produce is determined by those willing and able to pay the equilibrium price

Does the Market Outcome Satisfy Everybody?

Is it Perfect?

Is it Optimal?

Optimal, Not Perfect!!

Not everyone is happy with market outcomes.

But we are given the opportunity to maximize our own satisfaction.

Thus although the outcomes of the marketplace are not perfect, they are often optimal.

Because Everyone has done the best possible given their incomes and talents

Real Life Examples…

People are often upset with the market outcome.

In a market-driven economy of the U.S.A.(California), electricity prices are set by the forces of supply and demand.

Real Life Examples…

In 2000, Electricity prices increased in California because of two reasons:

an increase in demand (The demand curve shifted rightward)

and a decrease in supply (The supply curve shifted leftward).

Sharp Increase in Electricity Price..

Price Ceilings Create Shortages

Quantity Of Electricity(megawatts per hour)

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E1

E2

P1

P2

Real Life Examples…

This led to Government Intervention in Electricity pricing ….

The California legislature put a price ceiling on retail electricity prices.

A price ceiling is the upper limit imposed on the price of a good.

Price Ceilings Create Shortages

Quantity Of Electricity(megawatts per hour)

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Price ceiling

Consequences of Price Ceilings

Price ceilings have three predictable effects: Increase the quantity demanded. Decrease the quantity supplied. Create a market shortage.

Price Ceilings Create Shortages

Letting prices rise would have:

– Reduced the quantity demanded.– Increased the quantity supplied.– Alleviated the market shortage.