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Markets & Prices (c) R.D. Weaver Penn State
Using Economics to Analyze Prices
Intuition and concepts review
Single market model of price determination
What is a product?
Think of bananas……..
What is the price of a banana?
what is a banana !?@#$%$*&
We all have an idea of: the general concept of a banana
So we could say what – in general – the price is.
But specifically, we need to add detail to specification of what we mean by a banana!
Markets & Prices (c) R.D. Weaver Penn State
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Categories, groups, and products
Define a product category If a group of products can be thought of as composed of close substitutes and consumers typically allocate budget to that group, versus other groups, we label that product group as a product category.
Examples: Fresh fruit, beef, cars, sports equipment
Markets & Prices (c) R.D. Weaver Penn State
Product category vs. product types
Within a product category, it is useful to define
product groups or “types” in which products are nearly perfect substitutes, so consumers buy only one product type in each group.
Typically, only one product type is chosen from a product category.
Examples: Bananas, apples,….pick-up trucksMarkets & Prices (c) R.D. Weaver Penn State
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Consumer choice as nested choice
Budget is allocated through a nested series of product categories…
Markets & Prices (c) R.D. Weaver Penn State
Total income
DiscretionaryNon-
Discretionary
Housing Food CommTrans SavingEducEntertTravel
Consumer choice as nested choice….it keeps branching down to greater detail and eventual purchase
Markets & Prices (c) R.D. Weaver Penn State
Food budget
DiscretionaryNon-
Discretionary
Meat Carbs FruitVegs SavingUpgradesSnacks
This makes sense since consumer preferences reflect this type of independence across trade-offs. You think about travel vs. education, transportation vs. housing, etc. Then within each product category, the trade-offs are independent of your decisions in other categories….
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Consumer’s nested choices also result in picking the product’s market position across market dimensions
Markets & Prices (c) R.D. Weaver Penn State
Fruit
FrozenFresh
Bananas Oranges KiwiApples
Grocery i Grocery jBackyard
…where…when....exactly what
horizontal
…stage of processing (vertical)
Producers do the same in choosing what to produce…..nested choice
Markets & Prices (c) R.D. Weaver Penn State
Fruit
FrozenFresh
Bananas Oranges KiwiApples
Grocery i Grocery jBackyard
…where…when....exactly what
horizontal
…stage of processing (vertical)
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Markets & Prices (c) R.D. Weaver Penn State
So, in the real world……….multiple markets…..considerable complexity within each dimension! Over time
Over geography (space)
Over vertical position of the product
Over horizontal position of the product
Let’s shift now to the market level
Conceptually, at the market level consumers and producers come together to buy and sell a product.
The aggregation of those transactions result in what we can call “aggregate demand” and “aggregate supply”
In each case, “aggregate” means the summation across all purchases, or all sales.
We can think of these aggregates as defining a “quantity flow” from sellers to buyers.
Markets & Prices (c) R.D. Weaver Penn State
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Markets & Prices (c) R.D. Weaver Penn State
Price & quantity flows are determined by simultaneous adjustment across all those markets!
Quantity flow:
At the micro-level,the product quantity that is transacted between a buyer and a seller.
At the market-level, the aggregate quantity sold = aggregate quantity bought.
quantity flows decomposed
Markets & Prices (c) R.D. Weaver Penn State
As we will see, when we step away from the single isolate market in basic economics, we see need to consider the spectrum of interacting markets for a product. To do so, we need to generalize our concept of demand and supply, e.g.
Total demand components
Current demand for use (maybe many types)
Demand for exports (spatial)
Demand for carry-out, closing stocks ..ending inventory
Total supply components
Current supply just produced (maybe many forms)
Supply from imports
Supply from carry-in, opening stocks…..opening inventory
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Composition of demand and supply
Market Dimension Demand Component Supply Component
Intertemporal(at time t)
Current demandInventory demand
Current supplyInventory supply
Spatial (at location s) Demand for export Supply from imports
Vertical (at stage v) Demand derived from next stage of processing
Supply to next stage of processing
Horizontal (at product type i)
Demand for product variation Supply to product variation
Market aggregate(t, s, v, i )
Total demand Total supply
Markets & Prices (c) R.D. Weaver Penn State
Price is determined in competitive markets by equilibirum between total demand and supply.
Total demand = YD (Pt, s, v, i ) = YS (Pt, s, v, i ) = Total supply
Price determination
How is price determined? Producers have to set prices, BUT…….
If they set price > market price, their sales 0
If they set price < market price, they would loose $
So they need to set their price at market price.
Market price is not always observable! But, in principle
it adjusts such that
YD (Pt, s, v, i ) = YS (Pt, s, v, i )
Markets & Prices (c) R.D. Weaver Penn State
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Quantity flows & structure of a market To understand price, we need to understand what
dimensions of the market are important….and what are the drivers affecting those dimensions.
We need to break down Total demand and Total supply
We can learn about the structure of the market by considering quantity flow data.
For many products, not all market dimensions are relevant!
Markets & Prices (c) R.D. Weaver Penn State
Quantity flow data
Markets & Prices (c) R.D. Weaver Penn State
the key to understanding the structure of a market …if it is available!
Wheat: Supply and Disappearance, 1996 - 2009
ERS/USDA Data - Wheat Data: Yearbook Tables
It can be considered at Product Category, product group or type, or specific product level!
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Vast data is available on prices and quantity flows
Section: FEEDSTOCKSWheat: Supply and Disappearance, 1996-2009
(million bushels)
Year (beginning
September 1)
Supply Disappearance
Ending stocks May 31
Beginning stocks Production Importsa Total
Domestic use
Food Seed Feedb Total Exportsa
Total disappear
ance1996 376 2,277 92 2,746 891 102 308 1,301 1,002 2302 4441997 444 2,481 95 3,020 914 92 251 1,257 1,040 2,298 7221998 722 2,547 103 3,373 909 81 391 1,381 1,046 2,427 9461999 946 2,296 95 3,336 929 92 279 1,300 1,086 2,386 9502000 950 2,228 90 3,268 950 79 300 1,330 1,062 2,392 8762001 876 1,947 108 2,931 926 83 182 1,192 962 2,154 7772002 777 1,606 77 2,460 919 84 116 1,119 850 1,969 4912003 491 2,344 63 2,899 912 80 203 1,194 1,158 2,353 5462004 546 2,157 71 2,774 910 78 181 1,168 1,066 2,234 5402005 540 2,103 81 2,725 917 77 157 1,151 1,003 2,154 5712006 571 1,808 122 2,501 938 82 117 1,137 908 2,045 4562007 456 2,051 113 2,620 947 88 115 1,050 1,264 2,314 3062008 306 2,499 127 2,932 927 78 255 1,260 1,015 2,275 657
2009 c 657 2,216 119 2,991 917 70 149 1,137 881 2,018 973
Source:U.S. Department of Agriculture, 2010 Agricultural Statistics, Table 1-7, and previous annual editions,http://www.nass.usda.gov/Publications/Ag_Statistics/index.asp
a Imports and exports include flour and other products expressed in wheat equivalent.b Approximates feed and residual use and includes negligible quantities used for distilled spirits.c Preliminary. Totals may not add due to independent rounding.
Markets & Prices (c) R.D. Weaver Penn State
Data shows
Extent of specific sources of supplyBeginning stocks, imports, current production
Extent of specific types of use – illustrates relevance of particular dimensions of the market Where and when is it consumed
Current consumption
Vertical downstream processing
Exports
Markets & Prices (c) R.D. Weaver Penn State
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By the end of the course
You will need to understand The quantity flows that are relevant for you product
The drivers of each component of total demand and of total supply.
You will need to be able to find data on quantity flows and drivers.
You will be begin to think about how the drivers affect change quantity flows and price!
Markets & Prices (c) R.D. Weaver Penn State
Markets & Prices (c) R.D. Weaver Penn State
But……lets start with a single market………
Recall we noted prices exhibit substantial systematic variation
What is the system?
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Markets & Prices (c) R.D. Weaver Penn State
System concept
System
Drivers = Zt
Outcome
We want to break open this “ black box “ to
1) identify the drivers
2) Understand how the drivers affect price
Markets & Prices (c) R.D. Weaver Penn State
Economic system concept
Product Market
Drivers = Zt
exogenous variables
Pt
We want to break open this “ black box “ to
1) identify the drivers
2) Understand how the drivers affect price
What are the nuts & bolts of this
system?
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Markets & Prices (c) R.D. Weaver Penn State
Economic system concept
Product Market
Demand Drivers = ZDt
Pt
Pt = P(ZDt ZS
t ) + et
Three aspects of the market system
Demand drivers demand(price)
Supply drivers supply(price)
Equilibrium demand(price) = supply(price) price (drivers)+error
Supply Drivers = ZSt
Markets & Prices (c) R.D. Weaver Penn State
Economic system concept
Product Market
Demand Drivers = ZDt
Pt
Pt = P(ZDt ZS
t ) + et
Three aspects of the market system
Demand drivers demand(price)
Supply drivers supply(price)
Equilibrium demand(price) = supply(price) price (drivers)+error
Supply Drivers = ZSt
Structural form
Reduced form
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Markets & Prices (c) R.D. Weaver Penn State
what we will cover in this section
Single Market Model of Price Determination Intuition
Algebraic
Back-of-the-envelop
Using a single market model Setting up data
Tracking Change
Reduced-form price models
Markets & Prices (c) R.D. Weaver Penn State
The single market model - remember the parts?
P1
Y1
P1*
Y1*
Notation: P for price Y for quantity
* means “the equilibrium value”$/apple
Lbs apples
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Markets & Prices (c) R.D. Weaver Penn State
To understand price, we need to understand drivers or determinants of demand, supply, and how equilibrium occurs
P1
Y1
P1*
Y1*
Demand is a function of own price and other
stuff
Supply is a function of own price and other
stuff
Markets & Prices (c) R.D. Weaver Penn State
What are the drivers of demand or of supply?
P1
Y1
P1*
Y1*
What is the theory of demand?
What is the theory of supply?
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What is so magic about the X? Why is P* determined at the intersection?
P1
Y1
P1*
Y1*
What is the theory of
equilibrium?
Markets & Prices (c) R.D. Weaver Penn State
Single Market Model: Intuition
Review at home……..
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Markets & Prices (c) R.D. Weaver Penn State
We use three theories to motivate our ideas of how price is determined
Consider textbook case
Consumer demand
Producer supply
Equilibrium: how price is determined
(Later we will consider producer demand for inputs…)
Markets & Prices (c) R.D. Weaver Penn State
System involves three subsystems
Demand determinants
Consumer Demand
Competitive Equil
Producer Supply
Supply determinants PriceQuantity Traded
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Markets & Prices (c) R.D. Weaver Penn State
note
In this single market, we do not consider
1) Markets over time (inventories)
2) Markets over space (imports, exports)
3) Markets linked vertically (stages of processing)
4) Horizontal markets for close substitutes
We are starting with a simple model!
Markets & Prices (c) R.D. Weaver Penn State
1) Theory of Consumer Demand(quick review of AGBM 101, 102, 302)
Schematic
Prices
IncomePreferences
Over Y1 vs. Y2
Demand
Let’s look at it graphically
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Markets & Prices (c) R.D. Weaver Penn State
Summarizing demand Demand:
Yd1 = Yd1(P1,Ps,Pc,Inc)
Yd1 is demand quantity of good 1P1 is own price, the price of good 1Ps is price of a substitute (or a set of prices….)Pc is the price of a complement (s)Inc is income
Example: Yd1 = a0 + a1 P1 + a2 Ps + a3 Pc + a4 Inc
Inverse demand: To graph the demand curve, we want price on the vertical axis, so we
use what is called the inverse demand curve….P1= P1d( Y1, Ps, Pc, Inc)
Example P1d = [Yd1 – (a0 + a2 Ps + a3 Pc + a4 Inc )]/a1
We call the a’s parameters
Markets & Prices (c) R.D. Weaver Penn State
2) Theory of Supply(quick review of AGBM 101, 102, 302)
Schematic
Prices (output & input)
Fixed Inputs
Preferences (profits)
Subject to
Technology
Supply
Input demands
Objective
Reality constraint!
Let’s look at it graphically
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Summarizing supply
Supply for good 1: Ys1 = Ys1(P1,R, K)
Ys1 is quantity supplied for good 1P1 is price of good 1R is a set of input prices for inputs used in producing good 1K is capital or quantity of fixed goods and services used in
producing good 1Example: Ys1 = b0 + b1 P1 + b2 R + a3 K
Inverse demand: P1= P1s( Y1, R,K) Example: P1s = [Ys1 – (b0 + b2 R + a3 K )]/b1
Markets & Prices (c) R.D. Weaver Penn State
3) Theory of how price is determined
Roulette wheel?
Bureaucratically (think California electricity!)
Competition (what do we mean by this???)
A game among a small set of agents
By a dominant firm….
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Markets & Prices (c) R.D. Weaver Penn State
Graphing the inverse demand and supply curves……
P1
Y1
P1*
Y1*
We note equilibrium occurs when Quantity demanded = Quantity supplied
or quivalentlyDemand price = supply price
Markets & Prices (c) R.D. Weaver Penn State
How can you graph the demand function?
P1
Y1
You first have to set values for Ps, Pc, & Inc….why?
Demand: Yd1 = Yd1(P1,Ps,Pc,Inc)
Inverse demand: Pd1= P1d( Yd1, Ps’ , Pc’, Inc’)
If you change those values,
you would get a different graph, why?
Yd1 ‘
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Markets & Prices (c) R.D. Weaver Penn State
How can you graph the demand function?
P1
Y1
You first have to set values for Ps, Pc, & Inc….why?
Demand: Yd1 = Yd1(P1,Ps,Pc,Inc)
Inverse demand: Pd1= P1d( Yd1, Ps’ , Pc’, Inc’)
Yd1 ‘
Yd1 ‘”
Suppose income decreased from Inc’ to Inc”
Markets & Prices (c) R.D. Weaver Penn State
How can you graph the demand function?
P1
Y1
You first have to set values for Ps, Pc, & Inc….why?
Demand: Yd1 = Yd1(P1,Ps,Pc,Inc)
Inverse demand: Pd1= P1d( Yd1, Ps’ , Pc’, Inc’)
Yd1 +
Yd1 ‘
Suppose income increased from Inc’ to Inc+
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Drivers except own price are called “demand shifters”Why?
P1
Y1
Demand: Yd1 = Yd1(P1,Ps,Pc,Inc)
Inverse demand: Pd1= P1d( Yd1, Ps’ , Pc’, Inc’)
Yd1 +
Yd1 ‘
Suppose income increased from Inc’ to Inc+
Markets & Prices (c) R.D. Weaver Penn State
What determines the slope of the demand curve?
P1
Y1
Preferences………..why? Think of organic vs. conventional preferences….
Yd1
Yd1
Person with “green” preferences will be less price responsive (sensitive) than conventional preferences
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What determines position and slope of the supply curve? Review
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Summarizing………..for particular values for drivers preferences and technology
we can graph demand and supplyP1
Y1
P1*
Y1*
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But….what causes equilibrium………..??P1d P1s Y1dY1s
P1
Y1
P1*
Y1*
Supply: Ys1 = Ys1(P1,R, K)
Inverse demand: P1= P1s( Y1,R,K)
Demand: Yd1 = Yd1(P1,Ps,Pc,Inc)
Inverse demand: P1= P1d( Y1, Ps, Pc, Inc)
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Competitive Equilibrium
At the market level, we assume
1) Free entry and exit
2) Products and goods are “private goods”
a) Exclusive
b) Exhaustive consumption
Why does that matter?
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Price is determined where Yd1=Ys1
P1
Y1
P1*
Y1*
Demand: Yd1 = Yd1(P1,Ps,Pc,Inc) = Ys1 = Ys1(P1,R, K) = Supply
If we had actual functions, and values for Ps, Pc, Inc, R, K,
we could solve for P1!
Markets & Prices (c) R.D. Weaver Penn State
Start with bureaucratic prices how would they work?
Friday afternoon after a long and IMPORTANT meeting, 12 people decide what the price of a bushel of soybeans should be:
Pbt = $8.10/ unit
Demand YDt = YD (Pb
t )
Supply YSt = YS (Pb
t )
We could have two possible outcomes
Excess demand = YD (Pbt ) - YS (Pb
t ) ) ≥ 0 ? or
Excess supply = YD (Pbt ) - YS (Pb
t ) ) ≤ 0 ?
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Why bureaucrats fail1) Bureaucratic pricing is not likely to clear the market!
P1
Y1
P1*
Y1*
P1b
P1 b
Who cares! Why is it important that prices clear markets????
Why would anyone expect a
bureaucrat to have special
knowledge?
Markets & Prices (c) R.D. Weaver Penn State
Why bureaucrats fail2) Bureaucratic pricing determines who gets the product, leaving buyers and sellers disappointed!
P1
Y1
P1*
Y1*
P1b
P1 b
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Examples of bureaucratic prices Pa electricity Milk prices? License plates Bridge tolls Parking tickets Tickets to your favorite band’s concert (football
game)(Price = $/seat + pain and effort to get a ticket!)
The price of public educationWhat’s wrong with this picture?
Markets & Prices (c) R.D. Weaver Penn State
What else??????
Interest rates (Fed tries to influence them! )
Exchange rates
(Govs & Feds try to influence them! )
Available credit
(Govs & Feds try to influence them! )
Price of health care
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Competitive markets - how would they work? Consider “ short-run” first….Key assumptions
Buyers and sellers take the price, they can adjust their demand and supply as price changes….but do not “set price”.
Private good characteristics imply people have to compete for the right to consume a product
(remember long lines for whatever “ must have “ you didn’t have! )
Free entry implies that if there is excess demand, someone will enter and expand supply………
Markets & Prices (c) R.D. Weaver Penn State
The price adjustment story – suppose price is too highIf price were too high, supply at that price would exceeed demand, producers
could not sell what they produced. Soon, those with more to sell would reduce their price and market price would fall…..until the market clears…
P1
Y1
P1*
Y1*
P1 b
Y1D
Y1S
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Markets & Prices (c) R.D. Weaver Penn State
The price adjustment story – suppose price is too lowIf price were too low, demand at that price would exceed supply, consumers
would not be able to find all they wanted to buy. Soon, some would offer to pay more increasing the price and market price would increase…..until the market clears…
P1
Y1
P1*
Y1*
P1 b
Y1D
Y1S
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Bottom line
Competitive market determines Price that signals
Cost of resources
Consumer willingness to pay for the product
Quantity that exactly equals demand and supply
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What happens if P* results in profits?
In the long-run, we assume free entry and exit.
If P* results in profits, more people will enter the industry, expanding supply, driving price down and profits to zero.
If P* results in some people losing money (neg. profits), people will close businesses, decreasing supply, driving price up, and profits to zero.
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Implications of competitive markets in the long-run Resources move into or out of the market to adjust
supply such that profits are driven to zero
That implies!.........
P* is driven to equal average cost of production (AC)
P* = average cost of production
And that means………..prices have social value!
P* reflects cost and preferences! Leads to max social welfare (societal standard of living given available resources!)
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We need to use a concept - functions
A function “processes” a value of a variable x
into another value or new variable, call it y
We can write a function symbolically as f( )
And if it transforms every value of x into a value of y
We can write it as:
y = f(x)
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Example functions in economics?
Cost of production
For value of output y, there is an associated cost C
C = C(y)
That cost might be influenced by the values of other variables, e.g. capacity K C= C(y, K)
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Example cost function
Cost
Y1Y1*
TC1
For each value of Y output, there is a unique value for cost
Total cost could be broken down to variable and fixed cost.
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Cost of production and profits
Define “ variable cost of production” as the sum of all costs that can be varied in the short-run.
Define the cost function C=C(YS|Θ) it measures the variable cost of producing each level of output YS that is feasible given available fixed resources Θ.
Note: this cost reflects how technology can combine and transform inputs into the output.
Example???
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If some resources are fixed, the position of cost curve will change when we change the level of those resources.
Cost
Y1Y1*
C(Y|Θ”)
C(Y|Θ’)
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Average cost of production and profits
If we divide variable cost by quantity of output, we get average cost of producing that quantity of output!
AC1(YS | Θ) = C(YS |Θ)/YS
Define profits as π = P YS - C(YS |Θ)
that is, the left-over revenue after you pay all your variable costs!
note,……this is a return you have left to pay for use of your fixed resources Θ
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Profits, zero profits and prices
If entry and exit drive profits to zero, what does that mean for price?
as π = P YS - C(YS |Θ) 0
divide both sides by YS
P YS - C(YS |Θ) = 0 P - AC = 0
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The long-run story
P1
Y1
P1*
Y1*
Y1D
Y1S
AC1
Here, P* exceeds AC, profits are positive. New firms would enter and expand supply, shifting supply outward, driving price down until profits=0
Can you calc profits?
AC(Y*1 )
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Markets & Prices (c) R.D. Weaver Penn State
The long-run story
P1
Y1
P1*
Y1*
Y1D
Y1S
AC1
Here, P* exceeds AC, profits are positive. New firms would enter and expand supply, shifting supply outward, driving price down until profits=0
1) Supply shifts outward as more firms enter
2) But, AC shifts up as costs increase for new entrants
3) Over time, innovation reduces costs (not shown here!)
P1**
Two effects make this happen
Conclusions – what makes a market work? Price and quantity adjusts in response to profit
opportunities
If price exceeds average cost, profits entice increased supply, driving price down, average cost up….until profit 0
AND at that price (P*) Demand = supply !
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Why does the competitive mechanism work?
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Markets naturally emerge
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Review again?
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Ingredients necessary for competitive markets to work Human initiative …….a.k.a. “hedonism”
Institutional infrastructure Legal system
Currency
Physical infrastructure
Market technologies: Information, data, analysis,……
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System involves three subsystems
Demand determinants (drivers)
Consumer Demand
Competitive Equil
Producer Supply
Supply determinants (drivers) Price &Quantity Traded
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Implications
Three subsystems
Consumer choicesDemand
Producer choices Supply
Equilibrium
price
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Important implication
For consumer, price is predetermined
For producer, price is predetermined
At the market level, price is determined
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Boiling it down……we need three theories……….
Demand determinants
Consumer Demand
Competitive Equil
Producer Supply
Supply determinants Price &Quantity Traded
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Think of it as a balanced system
Newton’s which law??? For every action there is an accompanying reaction….
Demand
YD1(P1)
Supply
YS1 (P1)
Change in supply driver increase supply
Price has to change to rebalance the system
P
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Think of it as a balanced system
Demand
YD1(P1)
Supply
YS1 (P1)
Change in Determinants
Price has to change to rebalance the system
Price
Price has to fall when supply increases
Price is the pivot!
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Home Thoughts….
Think of your product
Can you identify three key determinants of demand for that product?
Can you identify three key determinants of supply of that product?
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