Transcript Lecture_3

Lecture 3
The Market Mechanism
The Market Mechanism
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Readings:
Chapters 3
The Market Mechanism
Between 1900 and 2000, productivity grew
faster in agriculture than in any other sector
of the economy.
 Over the same period, productivity has only
grown very slowly in the service sector.
Q: Why has agricultural output hardly
increased while the service sector has
grown faster than any other sector?
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The Market Mechanism
Services
PPF: 1900
PPF: 2000
Agriculture
The Market Mechanism
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As the PPF diagram on the last page shows it
is possible for the technologically innovative
sector to shrink and the low productivity
sector to grow.
Technological innovation in farming allowed
resources to be released from farming and
re-employed in services without much impact
on farm output.
Farm technology made possible the growth of
the urban service sector.
The Market Mechanism
Q: It made it possible, but why did it happen?
 Agriculture has stagnated while services have
grown because agricultural prices have fallen
relative to other goods. Falling agricultural
prices have caused massive social change:
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Productive resources moved out of agriculture into
more profitable manufacturing and services.
People have followed causing a mass migration from
the countryside to the city
A new urban centered economy has emerged.
Urban consumers consume much more meat and
fruit than their farming ancestors.
The Market Mechanism
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Farmers have organized politically to resist these
changes. While they have succeeded in forcing
government to adopt subsidies and price controls to
“stabilize” farm prices, they have failed slow the
pace of change.
The moral of this story is that understanding
technology does not get you very far in
understanding human society.
Technology and politics may be powerful social
forces, but the market forces that determine and
alter relative prices are more powerful still.
The Market Mechanism
Q: So what are these powerful market
forces?
 Demand and Supply
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The forces of Demand and Supply combine to
generate prices that automatically cause the
economy to move to a particular point on the
PPF.
Changes to Demand and Supply will change
relative prices and hence change where on the
PPF society will find itself.
The Market Mechanism
Q: What is demand?
 For economists it is the relationship between price
(independent variable) and the quantity of goods
demanded (dependent variable) in a market.
Q: What is a market?
 Any place where people meet to communicate for
the purpose of voluntary exchange.
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Newspaper
Mall
Internet
Telephone Network
The Market Mechanism
Q: What is fundamental to demand?
 All demand relationships are governed by the
Law of Demand which says that an increase
in the relative price of a good causes the
quantity demanded to fall.
 Another way of putting this is to say that price
and quantity demanded are inversely related.
 The law does not specify the sensitivity of the
quantity demanded to price changes, as this
will vary from commodity to commodity.
The Market Mechanism
Q: What is behind the Law of Demand?
If the relative price of a commodity rises, then
ceteris-paribus:
Consumers will begin to substitute a cheaper alternative
good in their shopping basket. This is called the
substitution effect.
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For example, if the price of butter goes up people buy less butter
and more margarine (a butter substitute).
Consumers will feel poorer and generally consume fewer
of most normal goods. This is called the income effect.
2.
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For example, rising energy prices reduces disposable income,
causing a reduction in restaurant purchases and all sorts of other
unrelated products.
The Market Mechanism
Q: How do we measure demand and its
social impact?
Unfortunately demand is difficult to observe
or measure. To deal with this problem, Alfred
Marshall developed a model of demand that:
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Can be applied to many commodities
Allows general market principles to be understood
Supports the task of observing and measuring
demand by providing a framework for the
statistical examination of market data to estimate
the demand relationship in different markets
The Market Mechanism
Q: What is Marshall’s model of demand?
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Demand Equation: The most basic model is the linear
demand equation which represents the demand for each
commodity using a simple equation:
Qd = a - b•P
Each commodity can be expected to have different
values for “a” and “b”
Empirical economists (econometricians) can estimate “a”
and “b” using market data.
For example, if an econometrician estimated that for
potatoes, a=2500 and b=0.1, then the demand for
potatoes can be represented by: Qd = 2500 - 0.1•P
The Market Mechanism
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Frequently the relationship is represented by a
graph of the equation called the Demand Curve.
Price
$9
$5
Demand
325
700
Quantity
The Market Mechanism
Q: What extreme simplification was used in
constructing the demand equation and its
graph (the demand curve)?
 It was assumed that the relationship is linear,
which is unlikely to be strictly true.
 Despite this simplification it can be a useful
model because it may be approximately true
over certain intervals of the graph.
 More complex models can be estimated
using market data which yield non-linear
graphs.
The Market Mechanism
Q: What is strange about the Marshallian
Demand curve?
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The independent variable is on the vertical axis, while the
dependent variable is on the horizontal axis.
This is opposite to the convention in physics and
chemistry.
Graphing developed in Economics at about the same time
as in the physical sciences. Alfred Marshall’s choice to
put the independent variable on the vertical axis has
become a convention in economics for demand and
supply relations.
Other economic relationships are graphed with the
independent variable on the horizontal axis.
The Market Mechanism
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This creates difficulties for students drawing the
graph of a demand equation.
To avoid this problem, rewrite the linear demand
equation:
Qd = a - b•P
b•P = a - Qd
P = (a/b) - (1/b)•Qd
This inverse demand equation has the:
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intercept of the vertical price axis = (a/b)
intercept of the horizontal quantity axis = a
slope is -(1/b).With a little thought you can see that
intercept of the horizontal axis is “a”.
The Market Mechanism
A model of demand cannot explain market
outcomes, as it just describes the response of
consumers to changes in market prices.
Q: What is missing from our model of
market behaviour?
 A model of how sellers (or producers)
respond to market prices.
 Alfred Marshall’s model of these social forces
is called Supply.
The Market Mechanism
Q: What is Supply?
 For economists it is the relationship between
price (P, the independent variable) and the
quantity of goods supplied (QS, the
dependent variable) to a market.
 Q: What is fundamental to Supply?
 The Law of Supply: an increase in the relative
price of a good causes the quantity supplied
to rise (P and QS are directly related).
The Market Mechanism
Q: What is Marshall’s model of supply?
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Supply Equation: The most basic model is the linear
supply relationship which can be represented by:
Qs = c + d•P
Each commodity can be expected to have a
different value for “c” and “d”
Econometricians can go out and estimate “c” and “d”
using market data.
If an econometrician estimates that c=1000 and
d=0.05 for potatoes, then the supply equation for
potatoes is:
Qs = 1000 + 0.05•P
The Market Mechanism
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The graph of the supply equation is called the
Supply Curve:
Supply
Price
$13
$8
200
500
Quantity
The Market Mechanism
Q: How do consumers and producers interact in
the marketplace?
Q: Where do market prices come from, and what
causes them to change?
Q: What determines the amount of each
commodity produced and sold in the marketplace, and what causes this to change?
Q: Can we predict how change will affect market
prices and quantities?
To answer each of these questions, simply put our
models of Demand and Supply together.
The Market Mechanism
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Market Surplus  Price will fall
Supply
Price
Demand
Qd
Qs
Quantity
The Market Mechanism
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Market Shortage  Price will rise
Supply
Price
Demand
Qs
Qd
Quantity
The Market Mechanism
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We now have an answer for why prices
change.
Whenever the Quantity Supplied is larger than
the Quantity Demanded (Qs > Qd) there is a
market surplus and prices will adjust down.
Whenever the Quantity Supplied is smaller
than the Quantity Demanded (Qs < Qd) there is
a market shortage, and prices will adjust up.
The Market Mechanism
Q: Will prices ever stop changing?
 Prices will change predictably when there is a
shortage or a surplus. Whenever there is no
shortage or surplus, there is no social pressure
on prices to change.
 When there is no shortage or surplus (Qs =
Qd), the market is in equilibrium.
The Market Mechanism
Q: How do we find the market equilibrium?
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Equilibrium occurs where the demand and supply
curves intersect one another.
Supply
Price
Demand
Qs=Qd
Quantity
The Market Mechanism
How do you find market equilibrium using
demand and supply equations?
Class Exercise: Find the market equilibrium if
Qs = 1000 + 0.05•P and Qd = 2500 - 0.1•P
The Market Mechanism
What will cause the market equilibrium price
and quantity to change?
 If demand or supply change, then the
equilibrium will change.
Does our model allow us to make qualitative
predictions concerning the impact of
Demand (D) and Supply (S) Changes?
 A Theory of Comparative Statics:
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D ↑  P ↑ and Q ↑, while D ↓  P ↓ and Q ↓
S ↑  P ↓ and Q ↑, while S ↓  P ↑and Q ↓
The Market Mechanism
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To prove this theory, we begin by defining what a
change in demand and supply means.
An increase in demand causes the quantity demanded
to increase at every price P. This is equivalent to
saying that:
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An increase in Demand (D) causes Demand to shift right.
By similar logic:
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A decrease in Demand (D) causes Demand to shift left.
An increase in Supply (S) causes Supply to shift right.
A decrease in Supply (S) causes Supply to shift left.
The Market Mechanism
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Example: D↑  demand curve shifts right 
P↑ and Q↑ to reach new equilibrium
Price
S
D
Quantity
D’
The Market Mechanism
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Example: S↑  supply curve shifts right  P↓ and
Q↑ to reach new equilibrium
Price
S’
S
D
Quantity
The Market Mechanism
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As an exercise use the graphical model of
demand and supply to determine the impact on
P and Q of :
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1.
2.
3.
4.
5.
6.
Decrease in Supply
Decrease in Demand
Increase in D combined with an increase in S
Decrease in D combined with a decrease in S
Increase in D combined with decrease in S
Decrease in D combined with an increase in S
Note that in 3 and 4, there is a predictable
impact on Q but unpredictable impact on P,
while the reverse is true for 5 and 6.
The Market Mechanism
What causes demand to change?
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Demand will change if:
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5.
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Price of a complement changes.
Price of substitute changes.
Income changes. (Normal and Inferior goods)
Expectations about the future price changes.
Population changes.
Preferences change from new information.
If any of these things change, then the demand
curve will shift and a new equilibrium emerges.
The Market Mechanism
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Example: What happens to the Kraft Dinner (KD) market if
the price of milk rises?
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Milk is a complement to KD in consumption. A rise in the price
of an important complement will reduce demand for KD
Equilibrium P and Q fall.
Price
S
D’
Quantity
D
The Market Mechanism
Example: What happens to the KD market if a recession
causes student incomes to fall?
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Price
KD is an inferior good. Decreasing income means that will
cause D↑ which causes P↑ and Q↑.
S
D
Quantity
D’
The Market Mechanism
What happens to the gasoline market if
consumers hear a rumour that gas prices
will go up next week?
 Consumers will increase their demand for gas
this week which in turn will immediate cause
prices to rise - making the belief a self fulfilling
expectation.
 This shows how important expectations are to
the operation of markets.
 Exercise: Draw a diagram showing how the
increase in Demand drives both P and Q up.
The Market Mechanism
What happens to the rental housing market in
London if the University grows by 2,000
students?
 D↑  P↑ and Q↑ (exercise: draw diagram)
What happens to the butter market if the price
of margarine falls?
 Margarine is a substitute of butter so a
decrease in the price of margarine causes
butter consumers to substitute out of butter into
margarine. This causes D↓  P↓ and Q↓ in
the butter market.
The Market Mechanism
New research indicates that the red colour of tomato
products are important anti-cancer agents. This
new information will do what to the tomato market?
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D↑  P↑ and Q↑
The economic boom from 1994-2008 lifted incomes.
What was the impact of these changes on the
market for SUV’s?
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SUV’s are normal goods, therefore:
income↑  D↑  P↑ and Q↑
The current recession has caused incomes to fall and
has caused the price of gasoline to fall, what will
be the impact of these changes on the market for
SUV’s?
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Exercise
The Market Mechanism
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It is essential to
distinguish
between a Change
in the Quantity
Demanded Versus
a Change in
Demand
The Market Mechanism
A
Movement along
the Demand Curve
When the price of the
good changes and
everything else
remains the same, the
quantity demanded
changes and there is a
movement along the
demand curve.
The Market Mechanism
A
Shift of the Demand
Curve
If the price remains the
same but one of the
other influences on
buyers’ plans changes,
demand changes and
the demand curve shifts.
The Market Mechanism
What causes Supply to change?
 Supply will change if there are changes to:
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Prices for factors of production (wages, interest, etc.)
Prices of complements in production.
Expected future prices.
Number of firms supplying the marketplace.
Technology.
Weather
If any of these things change, then the supply
curve will shift.
The Market Mechanism
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Example: What happens to the automobile market
if autoworker wages rise?
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Higher wages causes supply to decline (shift left), which
in turn drives prices up and quantity down.
Price
S’
S
D
Quantity
The Market Mechanism
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Example: A housing boom is expected to cause
the demand for leather furniture to increase,
which will in turn cause the price of leather to
rise. What is the likely impact of these changes
on the Beef market?
Beef and leather are complements in
production. Therefore a rise in the price of
leather (ceteris paribus) will increase the
production of cattle, and hence increase the
supply of beef. An increase in the supply of beef
will cause the price to fall as the quantity
purchased rises.
The Market Mechanism
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Example: A frost in California destroyed 40% of
the orange crop in 1998  S↓  P↑, Q↓
Example: A new computer manufacturer enters
the computer market  S↑  P↓, Q↑
Example: OPEC reduced its supply of oil
causing the price of crude oil to rise. The
gasoline market is effected because crude oil is
a key factor input. Rising factor prices  Sgas↓
 Pgas↑ and Qgas↓
The Market Mechanism
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Exercise: More Canadians are going to
university than ever before. Ceteris Paribus,
what will this do to the wages of University
graduates?
The Market Mechanism
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It is essential to
understand the
difference between a
Change in the
Quantity Supplied
Versus a Change in
Supply
Figure 3.6 illustrates
the distinction between
a change in supply
and a change in the
quantity supplied.
The Market Mechanism
A
Movement Along
the Supply Curve
When the price of the
good changes and other
influences on sellers’
plans remain the same,
the quantity supplied
changes and there is a
movement along the
supply curve.
The Market Mechanism
A
Shift of the Supply
Curve
If the price remains
the same but some
other influence on
sellers’ plans changes,
supply changes and
the supply curve shifts.
The Market Mechanism
If the demand for computers has risen over the last 20 years,
why has the price for computing power fallen?
 Because supply grew even faster.
Price
S
D
Quantity
D’
The Market Mechanism
How good is the Demand and Supply model?
It is very useful for a simple model, but it can be
imprecise. To be more precise we need to
consider extending the model in important
ways:
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1.From Partial Equilibrium to General Equilibrium
2.From Short-Run Equilibrium to Long-Run
Equilibrium
3.From comparative statics to market dynamics
The Market Mechanism
1. From Partial to General Equilibrium
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The Demand-Supply model considers only one
market in isolation (partial equilibrium analysis).
Change effecting one market is likely to
spillover into other markets, which can have
great social importance.
We need to develop a model that looks at both
the immediate impact of change and the
subsequent spillover into other markets
(general equilibrium analysis).
The Market Mechanism
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Example: Orange crop failure in California. Higher
orange prices cause people to substitute into apple
consumption, driving up apple prices.
Orange Market
Price
Apple Market
S’
S
Price
S
D’
D
Quantity
D
Quantity
The Market Mechanism
2. From Short-Run to Long-Run Equilibrium
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The supply curve shows the relationship between price
and quantity supplied.
This relationship is often different in the short-run than
in the long-run.
In the short-run, many producers are only able to
increase their output by a little bit if prices rise.
In the long-run, producers usually have more flexibility
to respond to changes in prices.
The Market Mechanism
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Example: Suppose that in July, the Canadian
Wheat-Board finds a foreign buyer willing to pay
a higher price than producers expected.
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In the short-run, farmers cannot respond quickly
because their crop is in the ground.
Over the long-run, farmers can seed larger
acreages to take advantage of the higher prices.
The Market Mechanism
From Short-Run Equilibrium to Long-Run Equilibrium
Ssr
Ssr’
SLR
Price
D
D’
Quantity
The Market Mechanism
3. From comparative statics to market dynamics
 In our partial equilibrium model of demand and supply,
we assumed that the market quickly adjusts from one
equilibrium to another.
Q: Is this true in all markets?
 There is substantial evidence that labour markets have
difficulties in adjusting from one equilibrium to another.
For example, recessions drive the demand for labour
down, but wages appear to be sticky, causing
unemployment to rise.
The Market Mechanism
From comparative statics to market dynamics
S
W
w
D’
Qd
Qs
L
D
The Market Mechanism
Next Lecture: Elasticity (Chapter 4)