Markets

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Markets
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Outline.

• Basic supply and demand analysis
• Equilibrium quantity and price.
• Rationing and allocative functions of price
• Determinants of demand and supply.
• Predicting and explaining changes in price and
  quantity
• Example impact of taxes
• Example the market for apartments

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Outline.

• Basic supply and demand analysis

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Basic supply and demand analysis

• A market, consists of the buyers and sellers of a
  good or service.
• It can be very local or might be such that
  participants never meet (e.g. stock exchange).
• Definition can be wide or narrow. Identical
  product at different time and place might
  considered a different good. Classical example
  umbrella by sunny or rainy days.
• Example market for lobsters on a given place and
  a given day.
• Objective explain price and quantity traded.

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Demand curve

• First step study the demand curve. It is a
  relationship that tells how many lobsters will be
  bought at a various possible price.
• To plot it, ask for a given price, how many
  lobsters would find someone to buy them.
• Represented graphically with real price on the
  vertical axis and quantity on the horizontal one.

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Ex Demand curve for lobsters, in Hyannis Mass,
July 20, 2006.
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• General pattern downward sloping (not need to be
  linear though)
• i.e. as price rises, quantity demanded decreases
  (or quantity demanded rises when price falls).
• Law of demand (empirical observation that when
  the price of a product falls, people demand
  larger quantities of it).
• Why?
• If the good is too expensive, people try to find
  cheaper substitute
• People run out of money (income constraint).

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• It results from the various cost-benefit
  calculations made by the buyers to each
  individual wondering whether to buy, the cost is
  given by the price and the benefit by the
  satisfaction it will give him.
• The negative sloped curve says that for a more
  expensive price, less individuals will find that
  consuming lobster give sufficient satisfaction to
  be worth its price.

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Supply schedules

• In the same way, quantity offered by sellers can
  be related to the (minimum) price at which they
  are ready to offer it.
• The supply schedule is the set of price-quantity
  pairs for which sellers are satisfied, i.e. for
  each pair, at the given price, they are better
  off selling the corresponding quantity than
  either more or less.

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The supply curve for lobsters, same place same
day.
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• Quantity supplied rises when prices rises
• Law of supply (empirical observation that when
  the price of a product rises, firms offer more of
  it for sale).
• A supplier is willing to sell only if the price
  covers the marginal cost of producing or
  acquiring it.

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Outline.

• Basic supply and demand analysis
• Equilibrium quantity and price.

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Equilibrium quantity and price.

• With the demand and supply schedules , the
  price-quantity pair at which both seller and
  buyer are satisfied can be found i.e. sellers
  are selling as much as they want at that price
  and buyers are buying the amount they wish given
  the price.
• This gives the equilibrium

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Equilibrium in the lobster market.
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Adjustment to equilibrium

• If the price is greater than the equilibrium
  price, dissatisfied sellers will have incentives
  to cut their price down to attract buyers.
• This will go on until the price reaches its
  equilibrium level.
• If the price is lower than the equilibrium price,
  the existence of dissatisfied buyers will induce
  sellers to realize that they can increase the
  price and still sell as much as they want.
• This will happen until equilibrium price is
  reached.

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Some welfare properties of equilibrium

• If price and quantity take anything other than
  their equilibrium values, it will always be
  possible to reallocate so as to make at least
  some people better off without harming others .
• A Pareto improvement is a way to make some people
  better off without making anybody else worse off.
  If an allocation is such that no Pareto
  improvements are possible, it is called Pareto
  efficient

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• This doesnt imply that equilibrium outcomes are
  desirable in any absolute sense.
• Poor people, might do the best possible given
  their income, but this might not allow them to
  purchase the bare necessities of life.
• Concern for the poor led some governments to
  implement price control for some prime
  necessities.
• Microeconomics theory has it that it is always
  more beneficial to the poor to be given the
  equivalent amount in cash than in kind.

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Outline.

• Basic supply and demand analysis
• Equilibrium quantity and price.
• Rationing and allocative functions of price

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Rent control
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Price support
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Rationing and allocative functions of price

• Rationing function of price the process whereby
  price directs existing supplies of a product to
  the users who value it most highly.
• Allocative function of price the process whereby
  price acts as a signal that guides resources away
  from the production of goods whose price lies
  below cost toward the production of goods whose
  price exceed cost.
• Price control (either though ceiling or floor)
  prevents the price mechanism to play this role.

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Outline.

• Basic supply and demand analysis
• Equilibrium quantity and price.
• Rationing and allocative functions of price
• Determinants of demand and supply.

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Determinants of demand and supply.

• Determinants of demand
• Incomes for normal goods (most goods), demand
  increases with income. Inferior goods are those
  whose demand decreases when income increases.
• Tastes
• Prices of substitutes and complements an
  increase in the price of complements (egg and
  bacon) decrease the demand while an increase in
  the price of close substitutes (coffee and tea)
  increases it.
• Expectations expectations of high future income
  will increase demand, as will expectations of
  rising prices.
• Population the larger the market, the more of
  each good is sold (pretty obvious!)

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• Determinants of supply
• Technology if change in technology reduce the
  production cost, the supply curve will shift to
  the right.
• Factor prices if they increase, production cost
  increase, and hence supply decrease.
• The number of suppliers
• Expectations expectations of higher future
  prices could decrease the current supply while
  stock are held in waiting for these future higher
  prices.
• Weather for agricultural product. Bad weather
  conditions shift the supply schedule to the left.

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Vocabulary

• Change in demand means a shift of the entire
  demand curve
• Change in the quantity demanded refers to
  movement along the demand curve.
• The fall in price will induce an increase in the
  quantity demanded, not an increase in demand.
• The same applies to change in supply vs. change
  in the quantity supplied.

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Outline.

• Basic supply and demand analysis
• Equilibrium quantity and price.
• Rationing and allocative functions of price
• Determinants of demand and supply.
• Predicting and explaining changes in price and
  quantity

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Predicting and explaining changes in price and
quantity

• An increase in demand will lead to an increase in
  both the equilibrium price and quantity
• A decrease in demand will lead to a decrease in
  both the equilibrium price and quantity
• An increase in supply will lead to a decrease in
  the equilibrium price and an increase in the
  equilibrium quantity
• A decrease in supply will lead to an increase in
  the equilibrium price and a decrease in the
  equilibrium quantity.

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Examples
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If soybeans are one of the ingredients in cattle
feed, how does a price support program in the
soybean market affect the equilibrium price and
quantity of beef?
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Simple algebra

• Supply schedule
• Demand schedule
• Equilibrium quantity
• Hence, equilibrium price

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Outline.

• Basic supply and demand analysis
• Equilibrium quantity and price.
• Rationing and allocative functions of price
• Determinants of demand and supply.
• Predicting and explaining changes in price and
  quantity
• Example impact of taxes

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Example impact of taxes

• A common public policy question is the impact of
  taxation on equilibrium prices and quantities?
• This can be studied with the basic tools provided
  by supply and demand analysis.
• Lets consider a tax levied on each unit sold by
  producers. It can be levied either on the sellers
  or collected directly from the buyer.

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First case a tax T10 is levied on the sellers.
Supply curve shifts leftward.
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The demand curve is not affected, but quantity
demanded falls
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• The sellers share of the tax is the reduction in
  the price he receives, divided by the tax
• The buyers share is the increase in price
  divided by the tax

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• In general, the way the burden of the tax is
  shared between buyers and sellers need not be
  equal. It depends on the shapes of the supply and
  demand schedules.
• If supply is unresponsive to changes in price,
  suppliers will bear most of the burden of the tax
• The reverse holds true if demand is unresponsive
  to changes in price.

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Second case the tax T10 is collected from the
buyer. Demand curve shifts downward.
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Example PQs, P10-Qd and T2
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Outline.

• Basic supply and demand analysis
• Equilibrium quantity and price.
• Rationing and allocative functions of price
• Determinants of demand and supply.
• Predicting and explaining changes in price and
  quantity
• Example impact of taxes
• Example the market for apartments

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The market for apartments

• We consider here a town with an inner ring close
  to the jobs and an outer ring, further away.
• Apartments are all identical, except their
  location. Inner ring apartments are more
  desirable than outer ring ones.
• We focus on the market for apartments in the
  inner ring. Price of apartments in the outer ring
  are considered as given.

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• Since arguably each individual will rent only one
  flat, it is easy to see the relation between
  demand curve and reservation price
• Each point of the demand curve represent in
  decreasing order the reservation price of one
  individual in the population.
• Hence at a given price p, the number of
  apartments rented is exactly equal to the number
  of people whose reservation price is greater or
  equal to p.
• The demand curve represents the number of flats
  that would be rented at any particular price.

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• On the supply side, since all apartments are
  identical and if renters are fully informed about
  prices charged by owners, the price of all
  apartments in the inner-ring must be equal
  (competitive market).
• In the short run, the number of available
  apartments is given.
• Hence the supply curve is vertical at any price,
  the number of apartments rented will be the same,
  i.e. all those available at that time.

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• The equilibrium is given by the intersection of
  the two curves. At this point, neither owners nor
  renters have any reason to change their
  behaviour.
• Everyone willing to pay p finds an apartment in
  the inner-ring, other get a flat in the
  outer-ring. The assignment of apartment to
  renters is hence determined by their willingness
  to pay for it.

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Comparative statics

• If supply of apartments is increased,
  equilibrium price falls.
• If now, some apartments are sold to their
  occupants, what happens to the equilibrium price
  of rented flats?
• The supply of flats for rent has decreased
• But the demand as well.
• If all those who bought a flat were previously
  living in the inner-ring, supply and demand will
  have decreased of exactly the same amount, and
  there is no impact on the equilibrium price.
• If all the buyers come from outside, then supply
  decrease and demand doesn't change, so that
  equilibrium price increases.

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• Creation of a tax on each apartment, levied on
  the landlord.
• What happens to the equilibrium price in this
  market?
• Nothing! In fact, since the supply curve is
  vertical, it is not affected by the tax. Nor is
  the demand curve.
• Here, the landlords pay the entire amount of the
  tax

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Other ways to allocate apartments

• The previous description is that of a competitive
  market.
• Other possibilities exist
• The discriminating monopolist one owner for all
  the apartments, he charges each one his
  reservation price exactly the same people will
  get a flat in the inner-ring than in the market
  solution. The price paid differs.
• The ordinary monopolist What if the monopolist
  is forced to rent every apartment at the same
  price? He faces a trade-off between renting more
  apartments at a cheaper price or less at a higher
  price. He will choose the solution that maximizes
  his revenue (here, we assume there is no cost for
  renting flats), given by pD(p).

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• The third possibility is the rent control already
  mentioned. In this case there is excess demand,
  and it is not possible without additional
  information to know who will get the apartments
  in the inner-ring. It might depend on whether
  renters have time to look around, know the
  previous tenant or one of the owners etc.
• It is unlikely to be the same people as in the
  market solution.

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• Which is the best way to allocate the apartments?
• For owners being a discriminating monopolist is
  clearly the most favourable case, while rent
  control is the worse.
• For renters on average in the case of a
  discriminating monopolist, they are worse off
  since they would be paying more than the
  equilibrium price. Under rent control, some would
  be better off and other worse off.
• The criterion of Pareto-efficiency is used to
  compare different outcomes.

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• In the market for apartments, if anyone in the
  outer-ring has a higher reservation price for
  inner-ring flats that anyone who has an apartment
  in the inner-ring, they will both benefit from
  trading their respective apartments.
• Thus if there are S apartments to be rented, the
  S people with the highest reservation prices
  end-up getting inner-ring apartments.
• This is a Pareto efficient allocation. Anything
  else is not.
• Hence, competitive market and discriminating
  monopolist both allow to reach an efficient
  allocation of flats,
• While ordinary monopolist and rent control do
  not.

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