Markets Chapter 3 1 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website,

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MarketsChapter 3

(c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole

or in part.

(c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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BUYERS, SELLERS, GOODS, AND INFORMATION


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Examples of Markets

Markets are where people make comparisons. Buyers and sellers interact withthe goal of an exchange taking place.


4

Demand


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Willingness to Pay and Consumer Benefits

A demand curve identifies the maximum amount consumers are

willing to pay for any given amountof a good.

The difference between the amountconsumers are willing to pay and

the amount they have to pay is calledconsumer surplus.


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Demand and Quantity Demanded

D1

B

A

A movement from A to B on demandcurve D is referred to as an increase

in the quantity demanded.

A shift in the demand curve fromD to D1 is referred to as an increase

in demand.


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Demand ShiftersInformation: learning that the

consumption of macaroonsincreases the risk of heart attack,

shifts the demand curve fromD1 to D2.

Income or wealth: if an increasein income shifts the demand formacaroons from D1 to D2 we saymacaroons are an inferior good.

Prices of related goods: if the price of a substitute for macaroons decreases, theDemand for macaroons will shift from D1 to D2.


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From Individual to Market Demand

The market demand curve is the horizontal summation of all the demand curves ofindividual consumers.


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Supply


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The Profit Motive and the Gains to Producers

The supply curve shows the minimum price that sellers

will accept forvarious quantities of a good.

The difference between theminimum price they will accept

and the price they receive isreferred to as the producer

surplus.


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Supply and Quantity Supplied

S1

A

B

The movement from A to B on supply curve, S is referred to as an increase

in the quantity supplied.

A shift in the supply curve from Sto S1 is referred to as an increase

in supply.


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From Individual to Market Supply

The horizontal sum of the individual seller’s supply curves is the market supply.


13

Market Equilibrium

When a market comes to rest and there are no additional mutually

acceptabletrades to be made, we say the market has reached

an equilibrium.


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Market Equilibrium - Example


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Market Equilibrium - Example

Given the market demand and an initial endowment of the good, 3 for Ahmed,3 for Becky, 2 for Carl, 1 for Deb and 0 for Enzo, a market equilibrium price

of $4 will emerge from trading between the parties.


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Changes in Equilibrium – An Increase in Demand

Suppose that Deb experiences an increase in demand. The market demandwill increase to D’ and the equilibrium price will rise to $5.


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Changes in Equilibrium – A Decrease in Supply

Suppose two units of the good were destroyed, decreasing the supply toS’. This would increase the equilibrium price still further to $6.


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Comparing EquilibriaConsider the initial equilibrium betweensupply (S) and demand (D) with a priceof $13 and quantity of 12.5. Suppose

there is a decrease in the price of an inputof $4 so the supply curve shifts down by

$4 to S’. What happens to the equilibriumprice?

As shown in the diagram, equilibrium pricefalls, but not by $4. It only falls by $2.50,

to $10.50.


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Why Equilibrium Matters – A Price Ceiling

Here we see what happens when we try to circumvent the

equilibrium by imposing a price ceiling of $11.00. At the

ceiling price we see that a shortage of the good will exist.

The amount consumerswish to purchase at the ceiling

priceexceeds the amount sellers

wish to sell.


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Why Equilibrium Matters – A Price Floor

Here we see what happens when we try tocircumvent the market by imposing a pricefloor of $15.00. At the floor price we seethat a surplus will exist. The amount that

sellers wish to sell at the floor price exceedthe amount consumers wish to buy.


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Using Supply and Demand

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Recycling Paper


Will recycling paper save forests? Manypeople believe that the answer is yes. But,

the supply and demand model suggestotherwise. Here is the supply (S) and

demand (D) For pulpwood beforerecycling. The equilibrium price is $70

per cord with 100 million cords exchanged.

Recycling reduces the demand for pulpwood

to D’ reducing the price and quantityexchanged. Recycling paper reduces the need for trees for the production of paper, but will the trees be cut to

clear space foragricultural or commercial or

residentialuse instead?


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Who Benefits from a Price Ceiling?

Here is the market for loans, with thegiven supply and demand curve, $800 billion would be saved and borrowed

at an interest rate of 8%

If regulations set a ceiling on the interestrate banks could pay depositors at 4%,

then depositors would only want todeposit $400 billion. The rate that

banks could then charge to ration theavailable funds would be 12%.


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Elasticity


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Elasticity of Demand

Price elasticity of demand is the responsiveness of quantity demanded tochanges in the price of a good.

For two points on the demand curve that are close together, we can expressprice elasticity as:


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Value Name

Effect of lower price on

spending

ED < 1 Inelastic Raises

ED = 1 Unit Elastic Constant

ED > 1 Elastic Lowers


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The more and better the substitutes for a good, the higher the elasticity

of demand will be.


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Some Other Elasticities – Income Elasticity

Income elasticity is the responsiveness of quantity demanded to changes in income.


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Some Other Elasticities – Cross Elasticity

The cross elasticity of demand for good X is the responsiveness of the quantity of X demanded

to changes in the price of good Y.


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Some Other Elasticities – Elasticity of Supply

The elasticity of supply is the responsivenessof the quantity supplied to changes in price.


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Information and Markets


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How Prices Convey Information – Adam Smith

In the Wealth of Nations, Adam Smith provides a clearexample of the extent of the coordination problem needed

to produce something as common as a woolen coat.

The shepherd, the sorter of the wool, the wool-comber or carder,the dyer, the scribbler, the spinner, the weaver, the fuller, the dresser,

with many others, must all join their different arts in order to completeeven this homely production.

And this is only the start of it!


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How Prices Convey Information – After the Epizootic

Take Adam Smith’s story a little further and imagine that an epizootic suddenly cuts the sheep

population in half. Thousands of adjustments ensue, not the least of which is that the price of

woolen coats will increase.


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How Prices Convey Information – Dispersed Knowledge and Informative Prices

Market prices solve the planning problem by decentralizing decisions into the hands of people who know only the

particularsof their individual situations. They need

not know about the epizootic at all to respond to the price changes that result

from it.

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The Present and the Future – Trading With Yourself


How can an individual best allocate a good between the present

and the future if information about the future is uncertain or unknown? Because most potatoes are

harvested at the end of the summer, consumers cannot rely on growers to deliver a steady stream of them to market every week over the year. Some of the harvest must be stored and decisions made daily on how much to release from storage for consumption over the year.


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The Present and the Future – Trading With Yourself

Buying the stockpile is costly and holding it is risky. If you are skilled at investing, the potatoes tie up funds that have earning power in investments elsewhere. If you do not acquire information about potatoes while

you hold them, you might make mistakes that a potato expert would not. The more commodities you must

treat like potatoes, the more severe your information problems. Self-sufficiency in potatoes carries high transaction costs and risks you might rather pay

someone else to bear. Fortunately, intermediaries are available.


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The Present and the Future - Speculators

Here is what happens both with and without speculation.

Consider a commodity whose peak harvest occurs in October while smaller amounts come to

market in other months. Without speculation, all of each month’s production is immediately sold and consumed. Speculators will

buywhen it is abundant and hold it

in expectation of gains from being able to resell it later for more money, which will reduce

the price fluctuations.


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The Present and the Future - Information and Revision of Prices

The market price is affected by information besides that in weather forecasts. For instance, an expert on grocery markets expects that a continuing trend for low-carbohydrate diets will

decrease the economy’s demand for wheat. An expert on foreign policy hears from informed sources that the

government will soon initiate policies to raise wheat exports. Some people believe the information of the grocery researcher or foreign policy expert will move prices, and so begin to trade

accordingly. Price changes as different people trade on the basis of information that others do not know and beliefs that

others do not hold. There is simply no imaginable way to centralize all of this knowledge in, say, a government agency. Yet the market incorporates it into prices through the actions

of dispersed individuals.


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The Present and the Future - Derivatives and Derivatives Markets

Our commodity markets have so far offered their participants a range of choices that are far smaller than

exist in reality. For example, people might enter into forward contracts that fix the price today for delivery of a

good at some date in the future. Because its value depends on the price of the underlying commodity, the

forward contract is an example of a derivative or a derivative asset. A futures contract is a standardized

forward contract, traded on a futures exchange. Like a forward contract, it sets a price today for future delivery.

The contract is valuable to both producers and large consumers of gas as a hedge that lessens the risks

associated with the highly unstable (“volatile”) spot price.

Documents

Markets Chapter 3 1 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website,