IB Economics/Microeconomics/Markets

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2.1 Markets[edit | edit source]

It is a place where buyers and sellers meet and agree on a price of goods or services.

  • PRICE is important as a signal and as an incentive in terms of resource allocation in a correctly-functioning market economy
  • A market is a meeting of buyers and sellers who do not have to physically meet
  • Markets cannot exist unless both buyer and sellers are involved
  • Markets include those for wheat, fruit, stocks and bonds and foreign exchange:
  • Wheat produced in one place can be sold anywhere in the world
  • Between the London stock exchange, the New York stock exchange and the Tokyo exchange, it is now possible to trade certain stocks 24 hours a day - markets are not limited to certain intervals of time
  • Foreign exchange markets are located in the international telephone networks and computer hookups
  • In some rural markets, fruits, vegetables and fish may be quite expensive in the morning but be marked down drastically toward the end of the day, particularly if there is no refrigerated storage available
  • Non market sectors include non-governmental organizations (NGOs) such as charities/volunteer organizations which raise money from the public to pay for goods and services
  • The bulk of non market production is accounted for by government and NGOs:
  • Money is provided by tax revenue and donations, and the non market goods and services are distributed to households and firms

Different types of industries

  • Perfect Competition: industry structure in which there are many firms, none large enough to influence the industry, producing homogeneous products = price takers
  • No/few barriers to entry or barriers to exit
  • Everyone - both buyers and sellers - have perfect information about the product
  • Examples include the agricultural market and stock market

  • Monopolistic Competition: industry structure in which there are many firms, producing slightly differentiated products
  • There are close substitutes for the product of any given firm - competitors have slight control over price
  • There are relatively insignificant barriers to entry or exit and success invites new competitors into the industry
  • Examples include home builders and restaurants

  • Oligopoly: industry structure in which there are a few firms producing products that range from slightly differentiated to highly differentiated
  • Each firm is large enough to influence this industry
  • Barriers to entry and exit are difficult, but exist
  • Examples include aircraft manufacturers, tire manufacturers, camera/electronics manufacturers, car manufacturers, supermarkets

  • Monopoly: industry structure where a single firm produces a product for which there are no close substitutes
  • Monopolists can set price = price makers - but are constrained by market discipline
  • Barriers to entry and exit exist and in order to ensure profits, a monopoly will attempt to maintain them
  • Examples include Microsoft's (former? current?) virtual monopoly over the global PC operating system market and historical examples of AT&T and Standard Oil (US)
  • Antitrust legislation used to break up monopolies who abuse monopoly power via price gouging and lack of responding to consumer concerns

Demand[edit | edit source]

Quantity of a commodity that consumers are willing and able to purchase at a given period of time at a given price - what consumers are willing and able to buy at a price affects the demand for that good

  • Effective demand is a want backed by money and the willingness to pay
  • Function of demand: Qn= f [Pn, Y, (P1....Pn-1), T]

Law of demand states that as a price of good or service rises, the quantity demanded will fall; concurrently, if the price of a good or service falls, the quantity demanded will increase

  • The law of demand states that a higher quantity will be demanded at a lower price assuming other factors such as the price of substitutes are unchanged
  • Quantity demanded refers to a continuous flow of purchases per period of time
  • A single point on the demand curve reflects the quantity demanded at that price
  • The demand curve shows the quantity of a good that consumers want at each price, assuming they have the effective purchasing power (income) to pay
  • Price and quantity demanded are negatively related:
  • Demand is downward sloping: each increment in consumption leads to less and less satisfaction, and the consumer will buy more only for a lower price
  • As price rises, the quantity demanded of the good or service tends to fall
  • It becomes an increasingly expensive way to satisfy the need or want associated with the good or service
  • People switch in part to some other goods or services to satisfy the same need, and less will be purchased of the good that has gone up in price
  • As the price of the good falls, it becomes relatively cheaper and more of it will be purchased and less of substitute goods
  • Fundamental distinction between a movement along the demand curve and a shift of the demand curve
  • Price of a good: A change in the price of a good causes a movement along the demand curve
  • Movements along the demand curve (own price effect) lead to changes in quantity demanded
  • A movement along the demand curve is caused by a change in price; however, a shift of the demand curve means that more is demanded at each price - this is caused by a change in any of the determinants of demand (with the exception of price)
  • The demand curve is downsloping for several reasons, including the law of diminishing marginal utility - extra utility gained from the consumption of a good falls
  • Therefore, the price must be lower for a person to purchase extra units of a given good
  • The income effect states that as prices fall, real income increases
  • Consumers can therefore afford to consume a greater quantity, providing a second reasons for the downsloping curve
  • A third reason is the substitution effect, whereby the falling price of a good makes that good cheaper in relation to other goods (substitutes)

Determinants of demand/Shifts in the demand curve

  • Income, tastes/preferences, price of other/related goods, advertising
  • The demand curve will shift out if more is demanded at each price and is caused by changes in factors other than the price of the good itself:
  • Substitutes: Goods that can be used in place of one another/different goods that satisfy the same needs
  • If the price of a substitute rises, demand for the good will increase
  • If the price of coffee falls, many people will shift from drinking tea to drinking coffee and the demand curve for tea shifts in to the left
  • Complements: These are goods which tend to be used jointly
  • If the price of a complement rises, demand will decrease.
  • If the price of gasoline rises people are motivated to use their car less, and the demand for cars shifts to the left
  • Real income: when income rises, more people can afford to buy cars and the demand curve for cars shifts to the right for normal goods and a decrease in demand for inferior goods
  • Population: if the population grows/changes composition (old/young) there are more consumers and demand will shift out to the right
  • Tastes and preferences: more people may want the product or service (a product becomes 'fashionable') and demand shifts out
  • Advertising: the more effective the advertising the greater the demand, unless the government uses negative advertising for things such as the dangers to health from cigarette smoking
  • Other macro factors:
  • Legislation
  • Access to credit: more credit means it is easier to borrow for durable goods like cars and demand shifts right

Exceptions to the law of Demand (HL) (role of expectations)

  • Veblen (ostentatious) goods: named after the economist Veblen and link with his theory of conspicuous consumption
  • If price for a status good rises, then demand for that good also rises
  • People want to be seen buying more expensive goods – goods with ‘snob’ appeal
  • If the price rises, people will buy more because they are more expensive
  • Giffen goods: goods which are absolutely vital for a person
  • All Giffen goods are inferior goods: as income rises, less is purchased
  • The income effect is more powerful than the substitution effect, and less is bought as the price falls; the demand curve is positively sloped
  • This usually refers to staple crops such as rice in some parts of China and potatoes during the Irish potato famine
  • As price for the good increases, individuals will be able to buy little of anything else and instead spend their income purchasing staple crops
  • During the Irish famine, families spent 80% of their income on potatoes - as potato prices fell, real income rose and money was spent on milk and meat instead; quantity demanded for potatoes fell as prices fell
  • Perhaps rice in some areas today could be considered a Giffen good; other than that, you'll never find one!
  • Speculative goods: As share prices increases, so does the quantity demanded of shares, as individuals predict further price increases

Supply[edit | edit source]

Willingness and ability for producers to produce a good at a given price over a given period of time

Law of supply: a higher quantity of a good will be supplied at a higher price

  • Producers can afford to supply extra units at a higher price because it allows them to produce more before AC is greater than MC

Movements along the supply curve (change in P)

  • The supply curve shows the quantity producers are willing to supply at each price
  • Law of Supply states that higher quantities will be supplied at higher prices,all other things unchanged:
  • This leads to a movement along the supply curve
  • As the extra cost of producing a unit increases, producers need a higher price to produce the product
  • A movement along the supply curve is a change in quantity supplied resulting from a change in the good price
  • All other determinants of supply will change the supply and so will shift the entire supply curve
  • Quantity supplied is a flow of goods or services per unit of time

Shift of the supply curve

  • Changes in supply refer to shifts of the whole supply curve

Factors (determinants) causing shifts in the supply curve:

  • Increase in number of producers in an industry (new firms entering a market): leads to an increase in supply
  • Prices of factors of production are:
  • If there are increases, less is supplied at each price (less profit is being made), and the supply curve shifts left
  • If factor prices fall, the supply curve shifts right
  • Technological changes: always leads to a rightward shift in supply
  • Weather: improvements can increase the supply of agricultural products
  • Taxes and subsidies (government intervention): increases in taxes lead to a fall in supply, increases in subsidies leads to an increase in supply
  • Changes in the prices of other (jointly produced) goods:
  • Sometimes goods are produced jointly such as wool and mutton: if the price of wool falls dramatically and farmers switch to producing something else, the price of mutton rises dramatically
  • Alternatively, if you could produce two goods from the same factory and the demand for one rises dramatically:
  • Production will switch to that good and its supply will shift out (rightward)
  • Production of the second good will fall and it's supply will shift in (leftward)

Effect of taxes and subsidies:

  • An increase in corporate taxes increases input costs for the supplier. Less is produced at each price – the supply curve shifts leftwards
  • A subsidy, or corporate tax credit, reduces input costs for the supplier. More is produced at each price level. The supply curve shifts rightwards.

Interaction of Supply and Demand[edit | edit source]

Example: When a good is placed on a market, it suddenly does not begin to sell at its equilibrium price. What follows is a game of trial and error. Say a new pair of jeans comes out on the market at CHF20.00 and it instantly becomes a success selling out everywhere. Producers decide to produce more and charge it at CHF30.00. Now they are not selling enough and have a surplus of stock. They reduce the price to CHF25 and they sell as much as they make.

YOU must be able to make a diagrammatic analysis of changes in demand and supply to show adjustment of a new equilibrium

Market Equilibrium

  • Occurs when quantity demanded equals quantity supplied
  • Market clearing price, where supply equals demand
  • Only at a price of $8,000 (in diagram at right) does quantity demanded equal quantity supplied

Price below equilibrium (shortage): households will desire more but firms will not be prepared to offer as much leading to excess demand

  • Inventories will be falling, and sellers can charge a higher price
  • The price will edge back up to $8,000 (equilibrium) where the quantity supplied and demanded will be equal to each other again

Price above equilibrium (surplus): people will want fewer cars while firms will be only too happy to supply more leading to excess supply:

  • Inventories will be rising and firms will lower prices to clear the carlots
  • Households will be happy to buy cars at lower prices

No equilibrium: where supply is everywhere above demand, nothing will be produced because the higher price consumers are prepared to pay is less than the minimum price producers need to supply (e.g., spaceships)

Goods or services with no price:

  • In most countries, roads are available free of charge and people will use them out to the point where demand intersects the horizontal axis leading to excess demand
  • Rationing does not take place: there is overcrowding (tragedy of the commons)
  • In some countries medicine is free and again there is excess demand which is likely to get worse as populations age
  • Rationing takes place through queuing (typically the government issues coupons to stop hoarding)

Four Laws of Demand & Supply:

1. A rise in demand: excess demand, inventories fall, price and quantity increase:

  • The rise in price acts as a rationing device to lower demand but encourages existing firms to produce more and for other firms to join the industry, thus moving resources into the industry to respond to the increase in demand

2. A fall in demand: excess supply, inventories rise, price and quantity decrease

3. A rise in supply: excess supply, inventories rise, price falls and quantity rises

4. A fall in supply: excess demand, inventories fall, price rises and quantity falls

Price Controls[edit | edit source]

  • Maximum Price/price ceiling: a maximum price that sellers may charge for a good or service - usually set by the government
  • To be effective, the maximum price (or price ceiling) must be set BELOW the market clearing price
  • E.g., rent control and concert tickets may have maximum prices
  • If price is held below equilibrium, there will be excess demand, shortages, and parallel or black markets often spring up
  • Black marketers buy at the low price and resell to the highest bidder ($100 in diagram at right)
  • The profit is represented by the difference between the two prices ($100 - $50) times the quantity they buy and resell
  • Black markets: can exist because purchasers who have the money are willing to pay more than the ceiling price for the limited amounts of the good available
  • In most economies black markets are illegal, and buyers have to wait for hours to get into stores, only to find that supplies are exhausted before they can be served (a particular problem in centrally planned economies, where the government has a high degree of involvement in the economy)
  • Governments can ration the commodity by issuing only enough ration coupons to match the available supply and then distribute the coupons to purchasers who must present both the money and the coupons in order to get the goods (many economies have done this is times of war/natural disaster)
  • Rationing is often considered fairer than the black market
  • Grey markets: where a product is bought and sold outside of the manufacturer's authorized trading channels
  • Applies to price ceilings, as e.g., renters may pay the ceiling price (lower than market value) for rent, but then have to pay much higher prices for furniture for the apartment, totalling market value for the apartment, and thereby skirting the around the price control

  • Minimum Price/price floor a minimum price that sellers may charge for a good or service - usually set by the government
  • To be effective, it must be set ABOVE the market clearing price
  • If price is held above equilibrium, there will be excess supply
  • Either inventories build up or the govt. purchases the surplus and stores it or sells it cheap on the international market
  • Minimum wage: the excess supply results in people not being able to find work, and the government supports the surplus by providing welfare support
  • Those who do find jobs are better off because their wages are higher than they would normally have been in a free market
  • Farmers who sell their crops at floor prices are better off, but the government traditionally purchases the surplus and stores it; if the crops are later sold at a loss, it is taxpayers that pay the costs

  • Buffer stock scheme: government tries to regulate the price level of a good or service by buying the good up when demand is too low or selling off any surplus when demand is too high (in a free market, commodities tend to fluctuate in price)
  • Buffer stock schemes tend to be very expensive, as there are storage costs, the goods in question might be perishable, and there is an opportunity cost made by the government in implementing them
  • Other options: pay not to plant (leave fields fallow)

  • Commodity agreements: agreements between countries to attempt to stabilise commodity prices
  • This may be done by a buffer stock scheme or placing a tariff on foreign goods
  • OPEC is a good example of such an agreement

  • Quantity controls: Quotas
  • Government cannot force the quota to be above the equilibrium quantity, people cannot be forced to consume what they do not want
  • Thus quotas usually restrict the quantity below what would have been the case with a free market

  • Subsidies
  • Payments by the government to a producer to lower costs of production - these lowered costs can be passed along to consumers

Why do governments intervene in agricultural markets?

  • There has been a downward trend in agricultural markets: thanks to more efficient technology, there has been an increase in supply, resulting in lower prices (as demand has increased only slightly). Moreover, the income elasticity of demand for food is inelastic. Someone does not buy more apples because he has more money.
  • Agricultural prices are subject to fluctuations because of harvests, time lags in supply, and the price elasticity of demand is very low (many substitutes available; e.g., if the price of beef goes up, individuals will switch to chicken)
  • Governments may wish to subsidize to prevent cheap imports from abroad in an effort to protect domestic jobs
  • National security concerns and ability of a country to feed itself
  • Preserve a traditional 'way of life'
  • Governments may wish to intervene by using buffer stocks, subsidies, high fixed prices, or some combination of all of these