Week 3 markets in action

Markets in Action

Gregory ChaseACK

Changes in market equilibrium• Supply and demand analysis explains many of

the events that occur in the real world.

• Changes in prices and quantities sold in markets primarily occur because of:– changes in demand– changes in supply

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Changes in demand

From Chapter 3 Changes in demand occur as a result of changes in:

number of buyers in the market

tastes and preferences

levels of disposable income

expectations of consumers

prices of related goods.

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Changes to demandIf one of these factors causes a decrease in

demand, the result will be:

a decrease in prices

a decrease in quantity supplied.

If one of these factors causes an increase in demand, the

result will be:

an increase in prices

an increase in quantity supplied.

Change in Demand• Consider the demand for New Zealand (NZ)

holidays• Movie Lord of the Rings was filmed in NZ• This caused a change in consumer tastes and

preferences – increasing demand for NZ holidays

• As demand increases we expect price to rise, as well as the quantity of holidays traded

An increase in demand

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• High Fuel Consumption Autos• Causes

Recent events: appreciation of Australian DollarPast events: failure of local manufacturers to

respond to changes in consumer demand for smaller cars as petrol prices increased (complementary product)

Improved safety features in small cars• Result: decrease in demand for cars with large

engines in preference for fuel efficient cars

A decrease in Demand

A decrease in demand

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Review: Market supply

•Assumed market supply is directly related to price.•Based on assumption of “increasing costs”•As production increases, the cost of each additional unit of output increases (increasing marginal cost)•If a firm faces increasing marginal cost, then they would only be willing to increase supply if they receive a higher price•The result is an upward sloping supply curve•But is this always the case?

Constant Cost, supply and price• In reality, firms can often respond to increased demand without

increasing price• Wood-oven pizza restaurant factors of production:

• Pizza oven, one pizza maker, wood, pizza ingredients etc.• Production = 20 pizzas per hour• What is the additional cost of producing the 10th, 11th or 12th pizza? • In this situation, the producer does not experience increasing marginal

cost• Price does not need to increase as demand increases from 10 to 11 or

from 11 to 12 pizzas.• As production increases, the cost of each additional unit of output

remains the same (constant marginal cost)• Flat (elastic) supply curve in this range of production

Constant Cost and Supply

SC

What if we had considerable excess capacity in both airline seats and hotel rooms?

Constant costs could mean no increase in price until seats and rooms started to become scarce

Changes in supply

From Chapter 3 Changes in supply occur as a result of changes in:

technology

number of sellers in the market

resource prices

taxes and subsidies

expectations of producers.

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Changes in supplyIf one of these factors causes an increase in

supply, the result will be:

a decrease in prices

an increase in quantity

demanded.

If one of these factors causes a decrease in

supply, the result will be:

an increase in prices

a decrease in quantity

demanded.

Change in Supply• Each choice has an opportunity cost: consider the

following scenario• An entrepreneur presently has $1 million invested in a

machinery hire business: 6% return on investment (ROI)• Suit hire business: ROI = 12%• Profit maximising entrepreneur decides to shift their

investment into the suit hire business• Supply will increase in the suit hire sector (and decrease in

machinery hire)

An increase in supply

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Analysis• Market entry causes surplus at original price• Price falls and quantity traded increases until

equilibrium is restored • As price falls, the ROI (profit) will fall • As the ROI falls, so too does opportunity cost• Resources stop shifting into this market• If resources were free to move between markets

– the ROI (profit) would be equalised in all industries

• In reality, barriers to entry and exit

A Decrease in Supply• Timber is a natural resource • It is a renewable resource – plantation timber• But also finite – old growth forests such as the Amazon• Scientific evidence: logging of old growth forests is

creating considerable environmental cost, often beyond the countries in which logging is taking place (Amazon rainforest produces 20% of earths oxygen supply)

• Government regulation introduced to restrict logging

A decrease in supply

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Analysis• A reduction in supply causes a shortage at the

original price• This excess demand causes price to increase and

quantity traded to fall• This continues until the price consumers are

willing to pay equals the price at which producers are willing to sell

• Price acts to “ration” scarce goods and services towards those that value them most highly (marginal value) and have the ability to pay

Crude oil supply

Organisation of Petroleum Exporting Countries

12 countries with about 80% of world oil reserves

Rather than competing, these countries coordinate supply to increase revenue (export earnings) and profits

With few substitutes, demand is not very responsive to changes in price (demand is price inelastic)

By reducing supply, price will rise and quantity traded will fall

However, total revenue will increase since demand is price inelastic

OPEC

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Profit maximisingPrice of Oil

1.2m

$60

S1

Quantity of Oil

S2

D

$130

1m

•TR = P x Q•TR1 = $60 x 1.2m = $72 million (Area A + B)•TR2 = $130 x 1m = $130 million(Area B + C)•Area A = loss of TR•Area C = gain in TR •Area C > A so TR increases

AB

C

E1

E2

Government intervention

• Governments intervene in the operations of the market system for several reasons, including:EfficiencyEquity

• We now consider some examples:Price Floor and Price CeilingMarket FailureExternalitiesPublic Goods

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Price ceilings• A price ceiling is a legally established

maximum price a seller can charge.

• Governments impose these to ensure that the wider community can access the product/service sold.

• It can cause an excess of quantity demanded over quantity supplied at the ceiling price.

The Market for Social Housing

• Social housing: government provided housing to low-income individuals or families

• Market rents can be unaffordable for some individuals and families

• In a free market – this would cause homelessness

• Improve affordability by setting a price below the market rent

• Justification for government provision is equity

Price ceilings

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Price ceilings (cont.)• Rent ceilings help people on low incomes by

keeping prices lower than the equilibrium.

• They can be counterproductive if they cause:– excessive shortages– illegal markets– less maintenance– discrimination

Price floors

• A price floor is a legally established minimum price a seller can be paid.

• Governments can create these in order to lower the consumption of a good, or ensure some employees are not disadvantaged.

• It can result in an excess of quantity supplied over quantity demanded at the floor price.

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Minimum Wage• The market for labour• Individuals supply labour - Firms demand labour• Wage rate determined by the interaction of

demand and supply• What if the wage rate is so low that you can’t

afford the essentials of life? • Australia has a minimum wage to improve equity • Minimum wages USA

Price

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Examples of price floors• Price floor examples are minimum wages and

agricultural price support schemes.

• These can also have unintended consequences:– unemployment– overproduction and waste of resources.

Trade-off: The pursuit of equity can create inefficiency

Policy Making is often requires balancing the twin goals of equity and efficiency

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Market failure• The price system may not always operate

efficiently, as society fails to achieve some goals.• The market mechanism does not achieve

desirable results.

Four

examples

•Lack of competition

•Third party effects (externalities)

•Public goods

•Income inequality

Market failure: lack of competition

• Consumer sovereignty is replaced by ‘producer sovereignty’.

• Firms without competitors tend to restrict supply, which raises prices and profits, and reduces community well-being by wasting resources and retarding innovation.

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CartelPrice of Oil

1.2m

$60

S1

Quantity of Oil

S2

Demand

$130

1m

•Competitive price is $60 and 1.2 million barrels produced per day•Cartel restricts supply and pushes price to $130 per barrel•This results in a transfer of income from consumers to producers•Area C was consumer surplus and is now producer surplus• Deadweight loss = area A + D

AB

CD

Review: price elasticity & TR

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TR1 = P*Q = $30x10,000 = $30,000

If price is lowered to $20 TR2 = $20x30,000 = $60,000

Loss of TR

Gain in TR

Variations along a straight-line demand curve

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Notice how TR reflects the variation in elasticity along the demand curve.

Public goods

•users collectively consume benefits

•no-one can be excluded.

Goods that have two

properties:

Public goods are goods that are consumed by everyone regardless of

whether they pay or not.

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Categories of goods

Excludable Non-excludable

Rivalry Private Goods(Cars, cloths, food)

Common Goods(fish, timber, rivers)

Non-Rivalry Club Goods(satellite TV)

Public Goods(Air, national defence, free to air TV)

Criteria•Rivalry: consumption by one person precludes consumption by another person (resource depletion)

•Exclusion: it is possible to exclude a person from consumption of the good (user pays)

Public goods

• The characteristics of a public good – particularly non-excludability - means that firms will not produce them

• Consider National Defense – who benefits?

• If you can benefit (consume) without paying, why would you pay for it?

• Free riding – leads to under-production or no production

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Market Failure: Externalities

• Market transaction: buyers and sellers come together voluntarily for the purpose of exchange

• Mutual gains from trade

• An externality is a cost or benefit imposed on third parties (people other than the buyers and sellers of the good).

• Spill-over effect

• Externalities can be:– positive (beneficial spill overs)– negative (harmful spill overs).

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Negative externalities

• Those that are detrimental to third parties:– a neighbour’s consumption of loud music may

reduce your ability to study– noise pollution caused by aircraft– smoke from a factory.

• Approaches to solving these ‘failures’ are:– taxes (e.g. pollution taxes)– regulations (to limit pollution).

Case Study: Carbon Tax• Air (the atmosphere) is a public good• Carbon and other pollutants released into the

atmosphere • External costs imposed locally (ill-health from air

pollution) and internationally (global warming)• External costs not reflected in the market price

and quantity traded• How do we internalise these external costs?• How does carbon pricing work? Part 1 and Part 2

Negative externalities

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Economists prefer a tax-based solution because it is more efficient.

Positive externalities• Externalities that are beneficial to third

parties, for example:

– government expenditure in schooling benefits the whole of society, not just students

– vaccinations provide a direct benefit to the patient and a spill-over benefit to other people (less chance of contracting the disease).

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Positive externalities

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Society encourages positive spillovers

• There are government subsidies for attending school and being vaccinated against disease.

• Regulations push the demand curve for positive spillover type commodities to the right, for example:– laws about immunisation of infants– laws about attending school.

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Income inequality

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•Economics: what, How and for Whom

•For whom is about income distribution

•Income depends on education, skills and experience

•How much income would your earn in a pure market economy if you were unemployed?

•Income inequality is a major part of the incentive structure inherent in a market system

•This market imperfection is addressed via

• government regulation (subsidised training)

• Tax-transfer system (unemployment benefits)