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Week 2 lecture demand & supply fall 2012

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Ali Madridista
Ali Madridista

The document discusses key concepts related to markets and demand, including: 1) It defines different economic systems such as capitalism, communism, socialism, and mixed economies. 2) It explains how a market works as a place where buyers and sellers voluntarily exchange goods and services at an agreed upon price, creating mutual benefits. 3) It introduces the demand and supply model and how the interaction between buyers and sellers determines price and quantity. It also outlines key determinants of demand such as price, income, and expectations. 4) It illustrates the inverse relationship between price and quantity demanded via a demand curve and how marginal revenue can be used to find the price that maximizes total revenue for a firm.

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Markets Gregory Chase ACK
Economic Systems Capitalism means of production are privately owned; distribution of goods and services is determined by the market (Market economy: laissez-faire) Communism common ownership of the means of production; equal distribution Socialism many definitions & variants. Think of it as growing from a concern with problems associated with the market economy and a focus on social outcomes Mixed economy both state and private sector direct the economy
Market Economy A market is any place where buyers and sellers come together for the purpose of exchange Characteristics of a market Voluntary exchange An agreed price Mutual benefits Spontaneous (not centrally directed)
A Simple Market Model Think about how many goods and services are bought and sold every day. How does the market economy coordinate the production and distribution of so many goods and services? This is a problem we can examine using economic modeling (identify a problem, develop a model, test the model)
Demand and Supply Model Depicts the interaction of buyers (demand) and sellers (supply) in a marketplace How this interaction determines price and quantity traded Assumes both parties are pursuing their own self- interest Buyers allocate scarce income (make choices) among a range of goods and services in order to maximise utility Sellers allocate scarce resources (make investment decisions) and sell goods and services in order to maximising profits
Determinant of Demand In the previous lecture we examined the demand for housing Now lets consider a more generalised depiction of demand What are some of the key determinants of demand? Do these variables have a positive (direct) or negative (inverse) relationship with demand?
Determinants of Demand Variable Price Price of related goods substitutes, complements Income Tastes and preferences Population (number of buyers) Expectations of future (consumer sentiment) Interest ratesetc.
Determinants of Demand Variable Relationship Explanation Price Inverse If the price of a good or service increases, we expect demand to fall Is this always the case? Can you think of an example when a fall in price might not lead to an increase in demand? Price of related goods Substitutes Complements Direct Inverse If the price of a substitute falls, this makes it cheaper relative to this good or service and demand will fall. Consumed in bundles. If the price of a complementary good increases, demand decreases. Examples? Income Normal good Inferior good Positive Inverse Demand increases as income increases Demand falls as income increases Expectations Positive Inverse If optimistic about future If pessimistic about future Population Direct
The Demand Curve Simplifying assumption of ceteris paribus Enables economists to construct models that explore how a change in one variable affects another, other things remaining constant Lets assume all the determinants of demand - except price - are constant, so we can isolate and observe the relationship between these two variables
The Demand Curve Quantity Price 1 $2.50 2 $2.40 3 $2.15 4 $1.95 5 $1.80 6 $1.60 7 $1.40 8 $1.20 9 $0.95 10 $0.70 Price Quantity At $2.50 we could sell 1 unit; at $2.10 we could sell 3 units; at $1.50 we could sell 7 units We can think of the price each individual is willing to pay as the marginal value placed on the good (or marginal utility derived from consuming the good) $2.50 $2.40 $2.15 $1.95 $1.80 $1.60 $1.40 $1.20 $0.95 $0.70 $0.00 $0.50 $1.00 $1.50 $2.00 $2.50 $3.00 0 2 4 6 8 10 12
Maximising Revenue If we had several cans of coke to sell - at what price would we maximise revenue? Total revenue (TR) is simply price (P) multiplied by quantity (Q) Short-hand: TR = P*Q
Maximising Revenue We can sell one can at $2.50. If we charge a price of $2.40 we would be able to sell 2 units, increasing revenue from $2.50 to $4.80. If we lower price to $1.40 we could sell 7 units and generate a TR of $9.80 Note: when we lower price from $2.50 to $2.40 we add $2.30 to total revenue. Why is the additional revenue lower than the selling price? Quantity Price Revenue 1 $2.50 $2.50 2 $2.40 $4.80 3 $2.15 $6.45 4 $1.95 $7.80 5 $1.80 $9.00 6 $1.60 $9.60 7 $1.40 $9.80 8 $1.20 $9.60 9 $0.95 $8.55 10 $0.70 $7.00 $2.50 $4.80 $6.45 $7.80 $9.00 $9.60 $9.80 $9.60 $8.55 $7.00 $0.00 $2.00 $4.00 $6.00 $8.00 $10.00 $12.00 1 2 3 4 5 6 7 8 9 10 Revenue Revenue
Activity Starting at a price of $2.50 calculate the marginal revenue of each additional unit sold, as we progressively lower the price Marginal analysis refers to a process of examining the incremental effect of small changes in one variable on other variables. Marginal revenue the additional revenue gained from selling one more unit.
Marginal Revenue Quantity Price Revenue Marginal Revenue 1 $2.50 $2.50 2 $2.40 $4.80 $2.30 3 $2.15 $6.45 $1.65 4 $1.95 $7.80 $1.35 5 $1.80 $9.00 $1.20 6 $1.60 $9.60 $0.60 7 $1.40 $9.80 $0.20 8 $1.20 $9.60 ($0.20) 9 $0.95 $8.55 ($1.05) 10 $0.70 $7.00 ($1.55) $2.30 $1.65 $1.35 $1.20 $0.60 $0.20 ($0.20) ($1.05) ($1.55) -2 -1.5 -1 -0.5 0 0.5 1 1.5 2 2.5 1 2 3 4 5 6 7 8 9 10 Marginal Revenue Diminishing Marginal Revenue
Demand, Price and Revenue There is an inverse relationship between price and quantity demanded. Lowering price means we can sell more units. Initially as we reduce price and increase sales, total revenue increases. At some price, further reductions in price reduces total revenue. We can use marginal analysis to help us understand this. Lets look at TR and MR together.
$2.50 $4.80 $6.45 $7.80 $9.00 $9.60 $9.80 $9.60 $8.55 $7.00 $0.00 $2.00 $4.00 $6.00 $8.00 $10.00 $12.00 1 2 3 4 5 6 7 8 9 10 Revenue $2.30 $1.65 $1.35 $1.20 $0.60 $0.20 ($0.20) ($1.05) ($1.55)-2 -1.5 -1 -0.5 0 0.5 1 1.5 2 2.5 1 2 3 4 5 6 7 8 9 10 Marginal Revenue When we reduce price from $2.40 to $2.15, marginal revenue falls from $2.30 to $1.65 Selling one more unit adds $1.65 to total revenue, which increases from $4.80 to $6.45 Lets take another example If we reduce price from $1.40 to $1.20, marginal revenue is -$0.20 That is, increasing sales by one unit would lower total revenue by $0.20 If our aim was to maximise revenue we would not lower price beyond $1.40 It would not be rational in an economic sense to produce and sell at a price when MR is negative. Remember: optimisation firms maximise profit; consumers maximise utility
Responsiveness of Demand TR = P*Q P and Q are inversely related If we lower price, quantity demanded increases Question: if we lower price by 10% and quantity goes up by 20%, would you expect TR to rise or fall? P( 10%) x Q ( 20%) = TR If the % increase in demand is greater than the % fall in price, then TR will increase Whether TR rises or falls, depends on the responsiveness of demand to a change in price Economists refer to this as the price elasticity of demand
Quantity Price Revenue Marginal Revenue % Change in Quantity % Change in Price 1 $2.50 $2.50 2 $2.40 $4.80 $2.30 3 $2.15 $6.45 $1.65 +50% -10% 4 $1.95 $7.80 $1.35 5 $1.80 $9.00 $1.20 6 $1.60 $9.60 $0.60 7 $1.40 $9.80 $0.20 8 $1.20 $9.60 ($0.20) 9 $0.95 $8.55 ($1.05) +13% -21% 10 $0.70 $7.00 ($1.55) Elastic Inelastic Lets consider two examples
Price elasticity & total revenue 19 TR1 = P*Q = $30x10,000 = $30,000 If price is lowered to $20 TR2 = $20x30,000 = $60,000 Loss of TR Gain in TR
Variations along a straight-line demand curve 20 Notice how TR reflects the variation in elasticity along the demand curve.
Mutual benefits Market: buyers and sellers come together voluntarily for the purpose of exchange Buyer values the product or service more than the price s/he pays Seller values the price received more than the product/service exchanged Both parties to the transaction are therefore optimising/maximising How can we measure these benefits?
Utility (Satisfaction) The highest price any consumer is willing to pay is $2.50: this is the marginal value placed on the good A market price of $1.50 means that this consumer has a surplus of $1.00: money they would have spent to acquire the good but did not have to. This consumer surplus is the benefit received. If it costs the seller $0.50 to produce the product they receive a producer surplus of $1.00 per unit The individual that places a marginal value of $1.40 or $1.20 will not give up $1.50 the market price to acquire the good. Now, imagine the quantities on the horizontal axis were measuring millions of units. What would be the producer surplus if price was $1.95? $2.50 $2.40 $2.15 $1.95 $1.80 $1.60 $1.40 $1.20 $0.95 $0.70 $0.00 $0.50 $1.00 $1.50 $2.00 $2.50 $3.00 0 2 4 6 8 10 12 P = Using marginal analysis to explain the mutual gains from market transactions Price Quantity $1 $0.65 Cost per unit $1
23 An individual demand curve The demand curve has a negative/inverse slope.
24 An individual demand curve The demand curve has a negative/inverse slope. At the higher price consumers will consume less units. At a lower price they will consume more units.
25 Individual demand curves Line up the price levels so Y-axis is the same scale.
26 Market demand Market demand is the horizontal summation of individual demand schedules.
27 WHEN price changes When price changes, quantity demanded changes. There is a movement along the demand curve.
Non-price determinants of demand Changes in demand occurs when the following non-price determinants of demand change: number of buyers in the market tastes and preferences income expectations of buyers prices of related goods 28
29 WHEN non-price factors change Change in demand Demand curve shifts
30 Summary: Demand Price Changes: Increase: decrease in the quantity demanded leftward movement up the demand curve Decrease: increase in the quantity demanded rightward movement down the demand curve Changes in a non-price factors: Favourable: an increase in demand - a rightward shift of the whole curve Unfavourable: a decrease in demand a leftward shift of the whole curve
31 Supply A direct relationship between the price of a good and the number of units sellers are willing to offer for sale in a defined time period, ceteris paribus. The supply schedule (table) shows the quantity of a good or service that firms are willing and able to offer for sale at different prices. The supply curve shows this relationship.
32 An individual sellers supply curve for DVDs Note that the supply curve has a positive slope.
33 A positive relationship At a higher price, sellers will offer more units for sale. It is more profitable for sellers to supply more at higher prices.
34 Individual supply curves Line up the price levels so Y-axis is the same scale.
35 Market supply Market supply is the horizontal summation of individual supply schedules in the market.
36 Changes in quantity supplied If the price changes, quantity supplied changes. This is a movement along the supply curve.
Non-price determinants of supply 37 Changes in supply occur when the following NON- PRICE determinants of supply change: number of sellers in the market available technology input prices taxes and subsidies expectations of producers prices of other goods the firm could produce
38 Changes in supply A change in non-price factors is known as a change in supply; i.e. the supply curve shifts. Rightward shift indicates supply increasing.
39 Impacts of changes in non-price determinants
The Price Mechanism Price acts as a coordination mechanism that rations goods and services among consumers How does it do this? Lets develop a simple economic model to help explain the operation of a market.
41 Market supply and demand A market exists where interaction amongst buyers and sellers determines the price and quantity of goods and services exchanged. This is often called the price mechanism or price system the forces of supply and demand create market equilibrium.
42 Equilibrium A market condition that occurs at any price for which the quantity demanded and the quantity supplied are equal. Equilibrium is the point of balance between demand and supply in the market.
Supply and demand for jeans 43
44 Market forces bring change At any price other than the equilibrium price, market forces act to bring the market into balance. In a surplus there is excess supply: sellers compete for buyers by cutting their selling price. In a shortage there is excess demand: potential customers try to attain the available goods by paying a higher price.
What to Produce? One of the fundamental economic problems How the price mechanism help to coordinate the allocation of scarce resources among the hundreds of thousands of goods and services we can produce in any given period? Lets consider what would happen, for example, if there was a change in consumer preferences that caused many to shift away from cars to bicycles.
The Market for Cars Fewer people buy cars Demand decreases (demand curve shifts to the left) This creates a surplus at current prices Prices fall to remove the surplus Lower prices cause supply fall As supply falls fewer resources are drawn into this sector of the economy
The Market for Bicycles More people buy bicycles Demand increases (demand curve shifts to the right) This creates a shortage at current prices Prices rise in response to the shortage Higher prices cause supply to increase As supply increases more resources are drawn into this sector of the economy
The Price Signal Price is a signal to producers/ entrepreneurs about the relative value that consumers place on goods and services If consumers demand more of a product, price will rise and this will cause production to increase thereby drawing more resources into this sector of the economy On the supply side, if a product (or resources required to product that product) becomes scarce, it will become more expensive. This will lead to an increase in price We can think of price as rationing goods and services among the population If a consumers marginal valuation for a product is equal to (or greater than) the price and they have the income they can acquire the product If their marginal valuation is below price and/or their income is too low they will not be able to acquire the product Price therefore acts as a mechanism that rations our limited goods and services among consumers Only when consumers are willing and able to buy a product will they do so
Water-Diamond Paradox Why are diamonds more expensive than water, when it is water that is necessary to sustain life? Economists refer to this as the paradox of value The answer is scarcity If we have an abundance of water, then we would generally not value it very highly How quickly would you trade diamonds for water if you were stranded in the desert?

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Week 2 lecture demand & supply fall 2012

  • 2. Economic Systems Capitalism means of production are privately owned; distribution of goods and services is determined by the market (Market economy: laissez-faire) Communism common ownership of the means of production; equal distribution Socialism many definitions & variants. Think of it as growing from a concern with problems associated with the market economy and a focus on social outcomes Mixed economy both state and private sector direct the economy
  • 3. Market Economy A market is any place where buyers and sellers come together for the purpose of exchange Characteristics of a market Voluntary exchange An agreed price Mutual benefits Spontaneous (not centrally directed)
  • 4. A Simple Market Model Think about how many goods and services are bought and sold every day. How does the market economy coordinate the production and distribution of so many goods and services? This is a problem we can examine using economic modeling (identify a problem, develop a model, test the model)
  • 5. Demand and Supply Model Depicts the interaction of buyers (demand) and sellers (supply) in a marketplace How this interaction determines price and quantity traded Assumes both parties are pursuing their own self- interest Buyers allocate scarce income (make choices) among a range of goods and services in order to maximise utility Sellers allocate scarce resources (make investment decisions) and sell goods and services in order to maximising profits
  • 6. Determinant of Demand In the previous lecture we examined the demand for housing Now lets consider a more generalised depiction of demand What are some of the key determinants of demand? Do these variables have a positive (direct) or negative (inverse) relationship with demand?
  • 7. Determinants of Demand Variable Price Price of related goods substitutes, complements Income Tastes and preferences Population (number of buyers) Expectations of future (consumer sentiment) Interest ratesetc.
  • 8. Determinants of Demand Variable Relationship Explanation Price Inverse If the price of a good or service increases, we expect demand to fall Is this always the case? Can you think of an example when a fall in price might not lead to an increase in demand? Price of related goods Substitutes Complements Direct Inverse If the price of a substitute falls, this makes it cheaper relative to this good or service and demand will fall. Consumed in bundles. If the price of a complementary good increases, demand decreases. Examples? Income Normal good Inferior good Positive Inverse Demand increases as income increases Demand falls as income increases Expectations Positive Inverse If optimistic about future If pessimistic about future Population Direct
  • 9. The Demand Curve Simplifying assumption of ceteris paribus Enables economists to construct models that explore how a change in one variable affects another, other things remaining constant Lets assume all the determinants of demand - except price - are constant, so we can isolate and observe the relationship between these two variables
  • 10. The Demand Curve Quantity Price 1 $2.50 2 $2.40 3 $2.15 4 $1.95 5 $1.80 6 $1.60 7 $1.40 8 $1.20 9 $0.95 10 $0.70 Price Quantity At $2.50 we could sell 1 unit; at $2.10 we could sell 3 units; at $1.50 we could sell 7 units We can think of the price each individual is willing to pay as the marginal value placed on the good (or marginal utility derived from consuming the good) $2.50 $2.40 $2.15 $1.95 $1.80 $1.60 $1.40 $1.20 $0.95 $0.70 $0.00 $0.50 $1.00 $1.50 $2.00 $2.50 $3.00 0 2 4 6 8 10 12
  • 11. Maximising Revenue If we had several cans of coke to sell - at what price would we maximise revenue? Total revenue (TR) is simply price (P) multiplied by quantity (Q) Short-hand: TR = P*Q
  • 12. Maximising Revenue We can sell one can at $2.50. If we charge a price of $2.40 we would be able to sell 2 units, increasing revenue from $2.50 to $4.80. If we lower price to $1.40 we could sell 7 units and generate a TR of $9.80 Note: when we lower price from $2.50 to $2.40 we add $2.30 to total revenue. Why is the additional revenue lower than the selling price? Quantity Price Revenue 1 $2.50 $2.50 2 $2.40 $4.80 3 $2.15 $6.45 4 $1.95 $7.80 5 $1.80 $9.00 6 $1.60 $9.60 7 $1.40 $9.80 8 $1.20 $9.60 9 $0.95 $8.55 10 $0.70 $7.00 $2.50 $4.80 $6.45 $7.80 $9.00 $9.60 $9.80 $9.60 $8.55 $7.00 $0.00 $2.00 $4.00 $6.00 $8.00 $10.00 $12.00 1 2 3 4 5 6 7 8 9 10 Revenue Revenue
  • 13. Activity Starting at a price of $2.50 calculate the marginal revenue of each additional unit sold, as we progressively lower the price Marginal analysis refers to a process of examining the incremental effect of small changes in one variable on other variables. Marginal revenue the additional revenue gained from selling one more unit.
  • 14. Marginal Revenue Quantity Price Revenue Marginal Revenue 1 $2.50 $2.50 2 $2.40 $4.80 $2.30 3 $2.15 $6.45 $1.65 4 $1.95 $7.80 $1.35 5 $1.80 $9.00 $1.20 6 $1.60 $9.60 $0.60 7 $1.40 $9.80 $0.20 8 $1.20 $9.60 ($0.20) 9 $0.95 $8.55 ($1.05) 10 $0.70 $7.00 ($1.55) $2.30 $1.65 $1.35 $1.20 $0.60 $0.20 ($0.20) ($1.05) ($1.55) -2 -1.5 -1 -0.5 0 0.5 1 1.5 2 2.5 1 2 3 4 5 6 7 8 9 10 Marginal Revenue Diminishing Marginal Revenue
  • 15. Demand, Price and Revenue There is an inverse relationship between price and quantity demanded. Lowering price means we can sell more units. Initially as we reduce price and increase sales, total revenue increases. At some price, further reductions in price reduces total revenue. We can use marginal analysis to help us understand this. Lets look at TR and MR together.
  • 16. $2.50 $4.80 $6.45 $7.80 $9.00 $9.60 $9.80 $9.60 $8.55 $7.00 $0.00 $2.00 $4.00 $6.00 $8.00 $10.00 $12.00 1 2 3 4 5 6 7 8 9 10 Revenue $2.30 $1.65 $1.35 $1.20 $0.60 $0.20 ($0.20) ($1.05) ($1.55)-2 -1.5 -1 -0.5 0 0.5 1 1.5 2 2.5 1 2 3 4 5 6 7 8 9 10 Marginal Revenue When we reduce price from $2.40 to $2.15, marginal revenue falls from $2.30 to $1.65 Selling one more unit adds $1.65 to total revenue, which increases from $4.80 to $6.45 Lets take another example If we reduce price from $1.40 to $1.20, marginal revenue is -$0.20 That is, increasing sales by one unit would lower total revenue by $0.20 If our aim was to maximise revenue we would not lower price beyond $1.40 It would not be rational in an economic sense to produce and sell at a price when MR is negative. Remember: optimisation firms maximise profit; consumers maximise utility
  • 17. Responsiveness of Demand TR = P*Q P and Q are inversely related If we lower price, quantity demanded increases Question: if we lower price by 10% and quantity goes up by 20%, would you expect TR to rise or fall? P( 10%) x Q ( 20%) = TR If the % increase in demand is greater than the % fall in price, then TR will increase Whether TR rises or falls, depends on the responsiveness of demand to a change in price Economists refer to this as the price elasticity of demand
  • 18. Quantity Price Revenue Marginal Revenue % Change in Quantity % Change in Price 1 $2.50 $2.50 2 $2.40 $4.80 $2.30 3 $2.15 $6.45 $1.65 +50% -10% 4 $1.95 $7.80 $1.35 5 $1.80 $9.00 $1.20 6 $1.60 $9.60 $0.60 7 $1.40 $9.80 $0.20 8 $1.20 $9.60 ($0.20) 9 $0.95 $8.55 ($1.05) +13% -21% 10 $0.70 $7.00 ($1.55) Elastic Inelastic Lets consider two examples
  • 19. Price elasticity & total revenue 19 TR1 = P*Q = $30x10,000 = $30,000 If price is lowered to $20 TR2 = $20x30,000 = $60,000 Loss of TR Gain in TR
  • 20. Variations along a straight-line demand curve 20 Notice how TR reflects the variation in elasticity along the demand curve.
  • 21. Mutual benefits Market: buyers and sellers come together voluntarily for the purpose of exchange Buyer values the product or service more than the price s/he pays Seller values the price received more than the product/service exchanged Both parties to the transaction are therefore optimising/maximising How can we measure these benefits?
  • 22. Utility (Satisfaction) The highest price any consumer is willing to pay is $2.50: this is the marginal value placed on the good A market price of $1.50 means that this consumer has a surplus of $1.00: money they would have spent to acquire the good but did not have to. This consumer surplus is the benefit received. If it costs the seller $0.50 to produce the product they receive a producer surplus of $1.00 per unit The individual that places a marginal value of $1.40 or $1.20 will not give up $1.50 the market price to acquire the good. Now, imagine the quantities on the horizontal axis were measuring millions of units. What would be the producer surplus if price was $1.95? $2.50 $2.40 $2.15 $1.95 $1.80 $1.60 $1.40 $1.20 $0.95 $0.70 $0.00 $0.50 $1.00 $1.50 $2.00 $2.50 $3.00 0 2 4 6 8 10 12 P = Using marginal analysis to explain the mutual gains from market transactions Price Quantity $1 $0.65 Cost per unit $1
  • 23. 23 An individual demand curve The demand curve has a negative/inverse slope.
  • 24. 24 An individual demand curve The demand curve has a negative/inverse slope. At the higher price consumers will consume less units. At a lower price they will consume more units.
  • 25. 25 Individual demand curves Line up the price levels so Y-axis is the same scale.
  • 26. 26 Market demand Market demand is the horizontal summation of individual demand schedules.
  • 28. Non-price determinants of demand Changes in demand occurs when the following non-price determinants of demand change: number of buyers in the market tastes and preferences income expectations of buyers prices of related goods 28
  • 29. 29 WHEN non-price factors change Change in demand Demand curve shifts
  • 30. 30 Summary: Demand Price Changes: Increase: decrease in the quantity demanded leftward movement up the demand curve Decrease: increase in the quantity demanded rightward movement down the demand curve Changes in a non-price factors: Favourable: an increase in demand - a rightward shift of the whole curve Unfavourable: a decrease in demand a leftward shift of the whole curve
  • 31. 31 Supply A direct relationship between the price of a good and the number of units sellers are willing to offer for sale in a defined time period, ceteris paribus. The supply schedule (table) shows the quantity of a good or service that firms are willing and able to offer for sale at different prices. The supply curve shows this relationship.
  • 32. 32 An individual sellers supply curve for DVDs Note that the supply curve has a positive slope.
  • 33. 33 A positive relationship At a higher price, sellers will offer more units for sale. It is more profitable for sellers to supply more at higher prices.
  • 34. 34 Individual supply curves Line up the price levels so Y-axis is the same scale.
  • 35. 35 Market supply Market supply is the horizontal summation of individual supply schedules in the market.
  • 36. 36 Changes in quantity supplied If the price changes, quantity supplied changes. This is a movement along the supply curve.
  • 37. Non-price determinants of supply 37 Changes in supply occur when the following NON- PRICE determinants of supply change: number of sellers in the market available technology input prices taxes and subsidies expectations of producers prices of other goods the firm could produce
  • 38. 38 Changes in supply A change in non-price factors is known as a change in supply; i.e. the supply curve shifts. Rightward shift indicates supply increasing.
  • 39. 39 Impacts of changes in non-price determinants
  • 40. The Price Mechanism Price acts as a coordination mechanism that rations goods and services among consumers How does it do this? Lets develop a simple economic model to help explain the operation of a market.
  • 41. 41 Market supply and demand A market exists where interaction amongst buyers and sellers determines the price and quantity of goods and services exchanged. This is often called the price mechanism or price system the forces of supply and demand create market equilibrium.
  • 42. 42 Equilibrium A market condition that occurs at any price for which the quantity demanded and the quantity supplied are equal. Equilibrium is the point of balance between demand and supply in the market.
  • 43. Supply and demand for jeans 43
  • 44. 44 Market forces bring change At any price other than the equilibrium price, market forces act to bring the market into balance. In a surplus there is excess supply: sellers compete for buyers by cutting their selling price. In a shortage there is excess demand: potential customers try to attain the available goods by paying a higher price.
  • 45. What to Produce? One of the fundamental economic problems How the price mechanism help to coordinate the allocation of scarce resources among the hundreds of thousands of goods and services we can produce in any given period? Lets consider what would happen, for example, if there was a change in consumer preferences that caused many to shift away from cars to bicycles.
  • 46. The Market for Cars Fewer people buy cars Demand decreases (demand curve shifts to the left) This creates a surplus at current prices Prices fall to remove the surplus Lower prices cause supply fall As supply falls fewer resources are drawn into this sector of the economy
  • 47. The Market for Bicycles More people buy bicycles Demand increases (demand curve shifts to the right) This creates a shortage at current prices Prices rise in response to the shortage Higher prices cause supply to increase As supply increases more resources are drawn into this sector of the economy
  • 48. The Price Signal Price is a signal to producers/ entrepreneurs about the relative value that consumers place on goods and services If consumers demand more of a product, price will rise and this will cause production to increase thereby drawing more resources into this sector of the economy On the supply side, if a product (or resources required to product that product) becomes scarce, it will become more expensive. This will lead to an increase in price We can think of price as rationing goods and services among the population If a consumers marginal valuation for a product is equal to (or greater than) the price and they have the income they can acquire the product If their marginal valuation is below price and/or their income is too low they will not be able to acquire the product Price therefore acts as a mechanism that rations our limited goods and services among consumers Only when consumers are willing and able to buy a product will they do so
  • 49. Water-Diamond Paradox Why are diamonds more expensive than water, when it is water that is necessary to sustain life? Economists refer to this as the paradox of value The answer is scarcity If we have an abundance of water, then we would generally not value it very highly How quickly would you trade diamonds for water if you were stranded in the desert?