Ch 04
What’s a Market?
Markets connect competition between buyers, competition between sellers, and cooperation between buyers and sellers. Government guarantees of property rights allow markets to function.
Market — the interactions between buyers and sellers.
Markets mix
Competition — between buyers, between sellers
Cooperation — between buyers and sellers
When the market price turns out to be too high...
surplus, or excess supply — quantity supplied exceeds quantity demanded.
surpluses create pressure for prices to fall.
falling prices provide signals and incentives for businesses to decrease quantity supplied and for consumers to increase quantity demanded, eliminating the surplus.
Price Elasticity of Demand
Elasticity of Demand: measures how responsive quantity demanded is to a change in price.
Perfectly inelastic/elastic demand
Perfectly inelastic supply — price elasticity of supply equals zero; quantity supplied does not respond to a change in price.
Perfectly elastic supply — price elasticity of supply equals infinity; quantity supplied has infinite response to a change in price.
Rent controls have unintended and undesirable consequences:
create housing shortages, giving landlords the upper hand over tenants.
subsidize well-off tenants willing and able to pay market-clearing rents.
inefficiency, reducing total surplus below market-clearing amounts.
Why does an exchange between a buyer and seller happen only when both sides end up better off?
Buyers are better off when businesses supply products or services that provide satisfaction (marginal benefit) that is at least as great as the price paid.
Sellers are better off when the price received is at least as great as marginal opportunity costs.
When Prices Sit Still...
The price that coordinates the smart choices of consumers and businesses has two names:
market-clearing price — the price that equalizes quantity demanded and quantity supplied.
equilibrium price — the price that balances forces of competition and cooperation, so that there is no tendency for change.
Perfectly inelastic/elastic demand
Elasticity of supply of a product or service is influenced by:
availability of additional inputs — more available inputs means more elastic supply.
time production takes — less time means more elastic supply.
Minimum wage laws:
Unintended consequences of minimum wage above market-clearing wage
Minimum wage laws: example of price floor — minimum price set by government, making it illegal to pay a lower price.
The quantity of labour supplied by households will be greater than the quantity of labour demanded by businesses, creating unemployment.
Inefficiency, reducing total surplus.
Property rights:
Property rights — legally enforceable guarantees of ownership of physical, financial, and intellectual property. It is essential for this mix of competition, cooperation, and voluntary exchange
Government sets rules of the game, defining and enforcing property rights necessary for free and voluntary exchange
What Happens When Demand and Supply Change?
(reference photos)
The price elasticity of demand of a product or service is influenced by:
available substitutes — more substitutes mean more elastic demand.
time to adjust — longer time to adjust means more elastic demand.
proportion of income spent — greater proportion of income spent on a product or service means more elastic demand.
Cross elasticity of demand
Income elasticity of demand
Cross elasticity of demand — measures the responsiveness of the demand for a product or service to a change in the price of a substitute or complement.
Income elasticity of demand — measures the responsiveness of the demand for a product or service to a change in income.
Alternative policies to help the working poor that do not sacrifice market flexibility are:
training programs to help unskilled workers get higher-paying jobs
wage supplements
Where Do Prices Come From?
Define prices.
Prices: Prices are signals that coordinate the smart decisions of consumers and businesses.
Consumers compare prices and marginal benefits (buy if the marginal benefit is greater than the price)
Businesses compare prices and marginal opportunity costs (sell if the price is greater than the marginal opportunity costs)
► Note: Prices come from the interaction of demand and supply, in markets with appropriate property rights. They are the outcome of a market process of competing bids (from buyers) and offers (from sellers).
Define: Consumer Surplus, Producer Surplus, Total Surplus and an Efficient Market Outcome
consumer surplus — the difference between the amount a consumer is willing and able to pay, and the price actually paid. The area under the marginal benefit curve but above the market price.
producer surplus — the difference between the amount a producer is willing to accept, and the price actually received. The area below the market price but above the marginal cost curve.
Efficient market outcome — coordinates smart choices of businesses and consumers so
Total revenue
Total revenue — all money a business receives from sales, equal to price per unit (P) multiplied by quantity sold (Q).
When price is fixed below market-clearing:
When price is fixed above market-clearing:
Note: When price is fixed below market-clearing:
shortages develop (quantity demanded greater than quantity supplied) and consumers are frustrated.
quantity sold = quantity supplied only
Note: When price is fixed above market-clearing:
surpluses develop (quantity supplied greater than quantity demanded) and businesses are frustrated.
quantity sold = quantity demanded only
When Markets Work Well, Are They Fair? Trade-Offs between Efficiency and Equity
Well-functioning markets are efficient, but not always equitable. Government may smartly choose policies that create more equitable outcomes, even though the trade-off is less efficiency.
When the market price turns out to be too low...
shortage, or excess demand — quantity demanded exceeds quantity supplied.
shortages create pressure for prices to rise.
rising prices provide signals and incentives for businesses to increase quantity supplied and for consumers to decrease quantity demanded, eliminating the shortage.
Tax incidence
Tax incidence — the division of a tax between buyers and sellers; depends on elasticities of demand and supply
Demand
Perfectly inelastic – vertical – you will pay anything you need to
Perfectly elastic – horizontal – you will not pay anymore, so a seller has to pay the tax
Supply
Perfectly inelastic – suppliers will accept any price all the way down to zero
Perfectly elastic – the willingness of businesses to supply is a single price, so they're not going to supply anything if the price is lower
Elasticity of supply
Elasticity of supply measures by how much quantity supplied responds to a change in price.
Inelastic — For inelastic supply, small response in quantity supplied when price rises. Difficult and expensive to increase production.
Elastic — For elastic supply, large response in quantity supplied when price rises. Easy and inexpensive to increase production.
Rent controls
Benefits:
Alternative policies to help the homeless that do not sacrifice market flexibility are:
Rent controls: example of price ceiling — maximum price set by government, making it illegal to charge higher price.
- Policy view
- Equity
government subsidies to help those who are poor pay rent.
government-supplied housing.
Equal outcomes:
Equal opportunities:
Equal outcomes — at the end, everyone gets the same amount.
Equal opportunities — at the start, everyone has the same opportunities, but the outcomes can be different.