Flagship Course

Module 1 Overview

The Basics of Market

Three Fundamental Questions

• What goods and services should be produced

and how?

• How much of each type of good and service

should be produced?

• How should these goods and services be

distributed among members in society?

Three Fundamental Questions

• What goods and services should be produced

and how?

• How much of each type of good and service

should be produced?

• How should these goods and services be

distributed among members in society?

MARKET

Market

Under certain conditionsUnder certain conditions markets can lead to

a:

• Technically

• Cost-effectively and

• Allocatively

Efficient allocation of resources.

PricesPrices Ensure That:

• On the production sideOn the production side resources are

used in their most productive way

• On the consumption sideOn the consumption side goods go to

those who value them most

Efficiency-equity Relationship

Individual ability and willingness to pay

Market-based resource allocation

Income and wealth distribution EquityEquity

EfficiencyEfficiency

Conditions for a Well-functioning Market1- Production Side

• Many producers

• Free entry and exit of producers

• Low fixed cost

• No production externality

Conditions for a Well-functioning Market2- Consumption Side

• Informational symmetry

• No consumption externality

• No dominant consumer

Externality

• Production externalityProduction externality

Social cost = Private cost + E

• Consumption externalityConsumption externality

Social benefit = Private benefit ± E

Determinants of Supply

• Price

• Production cost

production continues to increase to the point

where marginal costmarginal cost equals marginal revenuemarginal revenue

Determinants of Demand

• Price

• Tastes, preferences and needs

• Income

• Price of complementary/substitute goods

Demand Schedule

Quantity

Price

P1

P2

Q2Q1Q’2 Q’1

Price elasticityof demand

Demand Schedule

Quantity

Price

P1

P2

Q2Q1

Vertical height ofdemand schedule

Supply Schedule

Quantity

Price

P1

P2

Q2Q1

Price elasticityof supply

Supply Schedule

Quantity

Price

P1

P2

Q2 Q1

Vertical height ofsupply schedule

Interaction of Demand and Supply Schedule

Quantity

Price

PE

P0

Q0s QE

Q0d

S D

Externality

• Production externalityProduction externality

Social cost = Private cost + E

• Consumption externalityConsumption externality

Social benefit = Private benefit ± E

Efficiency of the MarketMSC = Marginal Social CostMPC = Marginal Private CostP = PriceMPB = Marginal Private BenefitMSB = Marginal Social Benefit

MSC = MPC = P = MPB = MSBMSC = MPC = P = MPB = MSB

Efficiency of the Market

• Consumers’ surplus:

Consumers’ value – Price

• Producers’ surplus:

Price – Actual production cost

Efficiency = Maximizing SurplusEfficiency = Maximizing Surplus

Surplus

a

b

c

Surplus = (a + c) + (b – c) = a + b

S = MSC

D = MSBQ

P

Surplus

a

b

cd

e

Surplus = (a + c - e) + (b – c - d) = (a + b) – (d + e)

S = MSC

D = MSBQ

P

Efficiency of the Market

a

b

Surplus = a + b

S = MSC

D = MSBQE

PE

Market FailureMSC = MPC = P = MPB = MSBMSC = MPC = P = MPB = MSB

Examples:• Water contamination by pesticides

MSC > MPCMSC > MPC

• Inability of consumers to judge the true value of a good (automobile)P > MPBP > MPB

• MonopolyMPC < PMPC < P

Government Role in Market Failure

FailureFailure Government RoleGovernment Role

Water contamination by pesticides

Taxation

Inability of consumers to judge the true value of a good

• Public education• Regulatory approach

Monopoly Anti-trust regulations

Major Features of Health Care

• Uncertainty and risk

• Informational asymmetries

– Supplier-induced demand

• Derived demand

• Externality

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