Market Fundamentals

1
Market Fundamentals

• Frederick University
• 2012

2
Main Economic Problems

• Questions
• What and how much
• How
• For Whom

• Problems
• Efficiency in allocation
• Efficiency in motivation
• Efficiency in distribution

3
Types of Economic Systems

• Traditional economy
• Market Economy
• Command Economy

4
Market Functions

• Allocation of scarce resources
• Motivation for efficiency
• Distribution of goods and services

5
The Demand for chocolates Milka
6
The Demand for chocolates Milka
A
P
B
C
D
E
Q
The demand curve
7
Demand

• Demand buyers behavior
• The Demand for a good the quantities buyers are
  willing and able to buy at every different price
• The law of Demand the decrease in the price of
  the good raises the quantity of the good
  demanded, other factors held equal

8
FACTORS DETERMINING DEMAND

• Buyers income
• Prices of the other goods
• Buyers expectations Buyers taste and
  preferences
• Market size
• Institutions

• P

D
Q
Demand rises the demand curve shifts rightwards
Demand falls the demand curve shifts leftwards
9
Supply of Chocolate Milka
S
P
S
Q
10
Supply

• Supply sellers behavior
• The Supply of a good quantities of the good
  that sellers are willing to sell at different
  price levels
• The Law of Supply as the price of the good
  rises, sellers are willing to sell greater
  quantities of the good, ceteris paribus.

11
FACTORS DETERMINING SUPPLY

• Sellers expectations
• Cost of production
• Technological changes
• Market size
• Institutions

• P

S
Q
Supply rises the supply curve shifts rightwards
Supply falls the supply curve shifts leftwards
12
Market Equilibrium
D
S
P
E
Pe
Q
Qe
The market is in equilibrium when the quantity
supplied equals the quantity demanded at the same
price
13
Market Equilibrium

• P

• Market equilibrium
• quantity supplied equals quantity demanded
• Pe equilibrium price
• Qe equilibrium quantity

S
D
E
Pe
Q
Qe
14
The Dynamics of Market Equilibrium
D
Qd gt Qs Qd Qs shortage

• P

D
E
P
P rises and Qs increases
E
Pe
P rises and Qd falls
S
Qd
Q
Qe
Q
The Equilibrium is restored at E
15
The Dynamics of Market Equilibrium

• P

S
Qd lt Qs Qs Qd surplus
S
D
E
P falls and Qd increases
Pe
P falls and Qs decreases
E
The Equilibrium is restored at E
Qs
Qe
Q
The equilibrium price clears all shortages and
surpluses Pe market clearing price
16
Price Ceiling
Shortage (Qd-Qs) x Pc

• P

D
Pb.m.
Profits of the blackmarketeers (Pb.m. Pc) x Qs
Pe
Pc
S
shortage
Q
Qs
Qd
Qe
17
Arbitrage and speculation
Zo widget market
Oz widget market
P

• P

S
POz
D
PZo
D
S
Q
Q
QOz
QZo
Supply shifts to Oz market
Demand shifts to Zo market
exports
imports
Shifts in Supply and Demand until price
differences are eliminated
18
Arbitrage and speculation

• Arbitrage the process by which individuals seek
  to make a profit by taking advantage of
  discrepancies among prices prevailing
  simultaneously in different markets
• Speculation a way to make a profit by taking a
  deliberately risky position

19
Quantifying Market Responses Elasticity

• TR P x Q
• Price Elasticity of Demand buyers
  responsiveness to the price changes
• Ep change in Quantity Demanded change in
  Price

20
Classifying Price Elasticity of Demand

• ? lt 1 inelastic demand
• E gt 1 elastic demand
• E 1 unit elastic demand
• E 0 perfectly inelastic demand
• E 8 perfectly elastic demand

21
Calculating Price Elasticity of Demand

• Ep change in Quantity Demanded change in
  Price
• change in Quantity Demanded
• (Q2 Q1) (Q2 Q1)/2
• change in Price
• (P2 P1) (P2 P1)/2

22
Price Elasticity of Demand and Total Revenue

• TR P x Q
• The Law of Demand - If P rises, Q falls
• If the percentage change in price is greater than
  the percentage change in quantity, the demand is
  inelastic
• If the price falls, the change in quantity
  demanded does not compensate for the price
  reduction and TR falls
• If the price rises, TR will increase

23
Price Elasticity of Demand and Total Revenue



Q
TR
P
E lt 1
If the price rises, TR increases
E gt 1
If the price rises, TR falls

• If E 1, TR does not change

24
E change in Q change in P
change in Quantity Demanded (Q2 Q1)
(Q2 Q1)/2
P Q
10 1 A
9 2 B
8 3 C
7 4 D
6 5 F
5 6 G
4 7 H
3 8 I
2 9 J
1 10 K
change in Price (P2 P1) (P2 P1)/2
change in Q (10-9) (910)/2 0.10
change in P (1-2) (21)/2 - 0.67
E - 0.14 - 0.14 lt 1
E lt 1
J
2
K
1
10
9
25
change in P (5-6) (56)/2 - 1.18
change in Q (6-5) (65)/2 1.18
P Q
10 1 A
9 2 B
8 3 C
7 4 D
6 5 F
5 6 G
4 7 H
3 8 I
2 9 J
1 10 K
Egt1
F
E 1
6
5
G
E lt 1
5
6
E 1.18 - 1.18 -1 - 1 1
26
A
P
Egt1
10
9
B
P Q
10 1 A
9 2 B
8 3 C
change in Q (2-1) (21)/2 0.67
change in P (9-10) (910)/2 - 0.10
E 0.67 - 0.10 - 670 -670 gt 1
E change in Q change in P
change in Quantity Demanded (Q2 Q1)
(Q2 Q1)/2
change in Price (P2 P1) (P2 P1)/2
Q
2
1
27
FACTORS AFFECTING PRICE ELASTICITY OF DEMAND

• Availability of substitutes/Definition of market
• Time horizon
• Income
• Traditions

28
Price Elasticity of Supply

• Price elasticity of supply sellers
  responsiveness to the price changes
• Ep change in Quantity Supplied change in
  Price

29
Price Elasticity of Supply
E lt 1

• P

E 1
E gt 1
Q
30
Price Elasticity of Supply

• P

E 0
E 8
Q
31
FACTORS AFFECTING PRICE ELASTICITY OF SUPPLY

• Time horizon
• Availability of production factors
• Mobility of production factors
• Inventory levels
• Competitiveness of the market structure
• Institutions

32
Applications of Price ElasticityEconomics of
Agriculture

• P

S2
S1
P1
change in P gt change in Q
E lt 1
P falls and TR falls
Farmers have lower income
P2
D
Q1
Q2
Q
33
Applications of Price ElasticityEconomics of
Agriculture

• P

Solution 1 government pays the difference P1
P0 to the farmers
S
P1
Government will lose (P1 P0) x Q
P0
D
Q
Q
34
Applications of Price ElasticityEconomics of
Agriculture

• P

Solution 2 government buys all Q from farmers at
P1 and sells it. However, buyers will buy less at
P1
S
P1
Government cannot sell Q Q1 and will lose (Q
Q1) x P1
The loss under solution 1 is (P1 P0) x Q The
loss under solution 2 is (Q Q1) x P1
P0
Since demand is inelastic, (P1 P0) x Q gt (Q
Q1) x P1
D
Q1
Q
Q
Solution 2 is preferable because the loss is
smaller.
35
The Tax Incidence
Case 1 perfectly inelastic demand

• P

S2
Government imposes an excise tax t
D
Sellers will be willing to sell the same Q if
only someone else would pay the tax Supply shifts
to S2
S1
P2 P1 t
t
Since demand is perfectly inelastic, buyers will
not change the quantity demanded
P1
Buyers pay the tax
Q
Q
36
The Tax Incidence
Case 2 inelastic demand and elastic supply

• P

D
Government imposes an excise tax t
Sellers will be willing to sell the same Q if
only someone else would pay the tax Supply shifts
to S2
S2
S1
P2
t
P3
Demand is not perfectly inelastic And buyers
will not want to buy Q1 at the higher price P2
P1
Buyers are willing to buy Q2 lt Q1
Q
Q1
Q2
The shortage Q2 Q1 will push the Price down to
a new equilibrium
Q3
Tax P2 P1. Buyers pay (P3 P1) - this is the
greater part of the tax. The rest (P2 P3) is
paid by sellers
37
The Tax Incidence
S2
Case 2 elastic demand and inelastic supply

• P

D
Government imposes an excise tax t
P2
S1
Sellers will be willing to sell the same Q if
only someone else would pay the tax Supply shifts
to S2
t
P3
Demand is elastic And buyers will not want to
buy Q1 at the higher price P2
P1
Buyers are willing to buy Q2 lt Q1
The shortage Q2 Q1 will push the Price down to
a new equilibrium
Q
Q2
Q3
Q1
Tax P2 P1. Buyers pay (P3 P1) - this is the
smaller part of the tax. The rest (P2 P3) is
paid by sellers