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Chapter 3: The Market Forces of Supply and Demand The assumptions of the competitive market model Market; a group of buyers and sellers of a particular good or service. The competitive model of supply and demand which leads to this ‘efficient’ outcome is based on the following assumptions: There ar...

Chapter 3: The Market Forces of Supply and Demand The assumptions of the competitive market model Market; a group of buyers and sellers of a particular good or service. The competitive model of supply and demand which leads to this ‘efficient’ outcome is based on the following assumptions: There are many buyers and sellers in the market. No individual buyer and seller is big enough or has the power to be able to influence price. There is freedom of entry and exit to and from the market. Goods produced are homogenous (identical). Buyers and sellers act independently and only consider their own position in making decisions. There are clearly defined property rights which mean that producers and consumers consider all costs and benefits when making decisions. Competitive market (‘perfectly competitive market’ or ‘perfect competition’); a market in which there are many buyers and sellers so that each has a negligible impact on the market price. Demand Quantity demanded; the amount of a good that buyers are willing and able to purchase at different prices. Law of demand; the claim that, other things being equal (ceteris paribus), the quantity demanded of a good falls when the price of the good rises. Demand schedule; a table that shows the relationship between the price of a good and the quantity demanded. Demand curve; a graph of the relationship between the price of a good and the quantity demanded. Reasons for movement along the demand curve: The income effect: how an increase in income can change the quantity of goods that consumers will demand.  The substitution effect: the decrease in sales for a product that can be attributed to consumers switching to cheaper alternatives when its price rises. Shift versus movements along the demand curve The main factors affecting demand, changes in which cause a shift in the demand curve: Prices of Other (Related) Goods Substitutes; two goods for which an increase in the price of one leads to an increase in the demand for the other (and vice versa). Complements; two goods for which an increase in the price of one leads to a decrease in the demand for the other. Income Normal good; a good for which, ceteris paribus, an increase in income leads to an increase in demand (and vice versa). Inferior good; a good for which, ceteris paribus, an increase in income leads to a decrease in demand (and vice versa). Tastes The Size and Structure of the Population Advertising Expectations of Consumers Supply Quantity supplied; the amount of a good that sellers are willing and able to sell at different prices. Law of supply; the claim that, ceteris paribus, the quantity supplied of a good rises when the price of a good rises. Supply schedule; a table that shows the relationship between the price of a good and the quantity supplied. Supply curve; a graph of the relationship between the price of a good and the quantity supplied. Factors affecting supply other than price: Profitability of Other Goods in Production and Prices of Goods in Joint Supply Technology Natural/Social Factors Input Prices: The Prices of Factors and Production Expectations of Producers Number of Sellers Supply and demand together Equilibrium or market price; the price where the quantity demanded is the same as the quantity supplied. Equilibrium quantity; the quantity bought and sold at the equilibrium price. Surplus; a situation in which the quantity supplied is greater than the quantity demanded at the going market price Shortage; a situation in which. quantity demanded is greater than quantity supplied at the going market price. Comparative statics; the comparison of one initial static equilibrium with another Law of supply and demand; the claim that the price of any good adjusts to bring the quantity supplied and the quantity demanded for that good into balance. Price as signals The main function of price in a competitive market is to act as a signal to both buyers and sellers. For buyers, price tells them something about what they must give up (usually an amount of money) to acquire the benefits that having the good will confer on them. For sellers, price acts as a signal in relation to the profitability of production. Rising prices to a seller means that there is a shortage and thus acts as a signal to expand production. For buyers, a rising price changes the nature of the trade-off they face. Rising prices act as a signal that more will have to be given up to acquire the good. Analyzing changes in equilibrium Comparative static analysis in three steps: We decide whether the event in question shifts the supply curve, the demand curve or, in some cases, both. We decide whether the curve shifts to the right or to the left. We use the supply and demand diagram to compare the initial and the new equilibrium, which shows how the shift affects the equilibrium price and quantity bought and sold. Elasticity Elasticity; a measure of the responsiveness of quantity demanded or quantity supplied to one of its determinants. The price of elasticity of demand Price of elasticity of demand; a measure of how much the quantity demanded of a good responds to a change in the price of that good, computed as the percentage change in quantity demanded divided by the percentage change in price. $$Price\ elasticity\ of\ demand - \ \frac{\text{Percentage\ change\ in\ quantity\ demanded}}{\text{Percentage\ change\ in\ price}}$$ Elasticity can have a value which lies between 0 and infinity: Between 0 and 1, elasticity is said to be price inelastic, that is the percentage change in quantity demanded is less than the percentage change in price. If elasticity is greater than 1 it said to be price elastic – the percentage change in quantity demanded is greater than the percentage change in price. If the percentage change in quantity demanded is the same as the percentage change in price then the price elasticity is equal to 1 and is called unit or unitary elasticity. General rules what determines the price elasticity of demand: Availability of Close Substitutes Necessities versus Luxuries Definition of the Market Proportion of Income Devoted to the Product Time Horizon Using the Midpoint (Arc Elasticity of Demand) Method $$Price\ elasticity\ of\ demand = \ \frac{(Q_{2} - Q_{1})/\lbrack\frac{{(Q}_{2} + Q_{1})}{2}\rbrack}{(P_{2} - P_{1})/\lbrack\frac{{(P}_{2} + P_{1})}{2}\rbrack}$$ Using the Point Elasticity of Demand Method $Price\ elasticity\ of\ demand = \ \frac{\%\mathrm{\Delta}Qd}{\%\mathrm{\Delta}P}$ Total expenditure; the amount paid by buyers, computed as the price of the good times the quantity purchased. How total expenditure changes when price changes: When demand is price inelastic (a price elasticity less than 1), price and total expenditure move in the same direction. When demand is price elastic (a price elasticity greater than 1), price and total expenditure move in opposite directions. If demand is unit price elastic (a price elasticity exactly equal to 1), total expenditure remains constant when the price changes. Other demand elasticities Income elasticity of demand; a measure of how much quantity demanded of a good responds to a change in consumers’ income, computed as the percentage change in quantity demanded divided by the percentage change in income. $$Income\ elasticity\ of\ demand = \ \frac{\text{Percentage\ change\ in\ quantity\ demanded}}{\text{Percentage\ change\ in\ income}}$$ Cross-price elasticity of demand; a measure of how much the quantity demanded of one good responds to a change in the price of another good, computed as the percentage change in quantity demanded of the first good divided by the percentage change in the price of the second good. $$Cross - price\ elasticity\ of\ demand = \ \frac{Percentage\ change\ in\ quantity\ demanded\ of\ good\ 1}{Percentage\ change\ in\ the\ price\ of\ good\ 2}$$ Price elasticity of supply Price elasticity of supply; a measure of how much the quantity supplied of a good responds to a change in the price of that good, computed as the percentage change in quantity supplied divided by the percentage change in price. $$Price\ elasticity\ of\ supply = \ \frac{\text{Percentage\ change\ in\ quantity\ supplied}}{\text{Percentage\ change\ in\ price}}$$ The key determinants of the price elasticity of supply: The Time Period Productive Capacity The Size of the Firm/Industry The Mobility of Factors of Production Ease of Storing Stock/Inventory The Midpoint (Arc) Method of Calculating the Elasticity of Supply $$Price\ elasticity\ of\ supply = \ \frac{(Q_{2} - Q_{1})/\lbrack\frac{{(Q}_{2} + Q_{1})}{2}\rbrack}{(P_{2} - P_{1})/\lbrack\frac{{(P}_{2} + P_{1})}{2}\rbrack}$$ Point Elasticity of Supply Method $$Price\ elasticity\ of\ supply = \ \frac{P}{\text{Qs}}\text{\ x\ }\frac{1}{\frac{\mathrm{\Delta}P}{\mathrm{\Delta}Qs}}$$ Total revenue; the amount received by sellers of a good, computed as the price of the good times the quantity sold. For price inelastic demand curves, total revenue rises as price rises. For price elastic demand curves, total revenue falls as price rises. Chapter 11: Market Structures I: Monopoly Imperfect competition Imperfect competition; exists where firms can differentiate their product in some way and so have some influence over price. Market share; the proportion of total sales in a market accounted for by a particular firm. Why monopolies arise Monopoly; a firm that is the sole seller of a product without close substitutes Barriers to entry; anything which prevents a firm from entering a market or industry. Barriers to entry have four main sources: A key resource is owned by a single firm. The government gives a single firm the exclusive right to produce some good or service. Patent; the right conferred on the owner to prevent anyone else making or using an invention or manufacturing process without permission. Copyright; the right of an individual or organization to own things they create in the same way as a physical object, to prevent others from copying or reproducing the creation. The costs of production make a single producer more efficient than a large number of producers. Natural monopoly; a monopoly that arises because a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms. A firm is able to gain control of other firms in the market and thus grow in size. How monopolies make production and pricing decisions Demand curves for monopoly firms Because a monopoly firm is the sole producer in its market, it faces the downwards sloping market demand curve. As a result, the monopoly must accept a lower price if it wants to sell more output (marginal revenue is always below the price of its goods). When a monopoly increases the amount it sells, it has two effects on total revenue: The output effect. More output is sold, so Q is higher, which tends to increase total revenue. The price effect. The price falls, so P is lower, which tends to decrease total revenue. Profit maximization for a monopoly A monopoly maximizes profit by choosing the quantity at which marginal revenue equals marginal cost. It then uses the demand curve to find the price that will induce consumers to buy that quantity (so its price exceeds marginal cost). A monopoly’s profit: π = (P−ATC) x Q The welfare cost of monopoly The efficient level of output Total surplus in the market would be maximized at the level of output where the demand curve and marginal cost curve intersect. Below this level, the value of the good of the marginal buyer exceeds the marginal cost of making the good. Above this level, the value to the marginal buyer is less than marginal cost. The inefficiency of monopoly Because a monopoly charges a price above marginal cost, not all consumers who value the good at more than its cost buy it. Thus, the quantity produced and sold by a monopoly is below the socially efficient level. This is the deadweight loss. Price discrimination Price discrimination; the business practice of selling the same good at different prices to differenct customers. There are three lessons to be learned about price discrimination: Price discrimination is a rational strategy for a profit-maximizing monopolist. Price discrimination requires the ability to separate customers according to their willingness to pay. Certain markets forces can prevent firms from price discriminating. Arbitrage; the process of buying a good in one market at a low price and selling it in another market at a higher price to profit from the price difference. Price discrimination can raise economic welfare. Perfect price discrimination; a situation in which the monopolist knows exactly the willingness to pay of each customer and can charge each customer a different price. Examples of price discrimination: Cinema Tickets Airline Prices Discount Coupons Quantity Discounts Public policy towards monopolies Policymakers in the government can respond to the problem of monopoly in a variety of ways, by: Trying to make monopolized industries more competitive. Regulating the behavior of the monopolies. Turning some private monopolies into public enterprises. Doing nothing at all. Competition legislation covers three main areas: Acting against cartels and cases where businesses engage in restrictive business practices which prevent free trade. Banning pricing strategies which are anti-competitive such as price fixing, predatory pricing, price gouging and so on; as well as through behavior which might lead to a restriction in competition, such as the sharing of information or carving up markets between different firms, rigging bids in tender processes or deliberately restricting production to reduce competition. Monitoring and supervising acquisitions and joint ventures. Synergies; where the perceived benefits of the combined operations of a merged organization are greater than those which would arise if the firms stayed separate. Chapter 12: Market Structures II: Monopolistic competition Monopolistic competition; a market structure in which many firms sell products that are similar but not identical. Monopolistic competition describes a market with the following attributes: Many sellers Product differentiation Free entry Competition with differentiated products A monopolistic competitor in the short run Monopolistic competitors, like monopolists, maximize profit by producing the quantity at which marginal revenue equals marginal cost. A monopolistic competitor in the long run In a monopolistically competitive market, if firms are making profits, new firms enter and the demand curves for the incumbent firms shift to the left. Similarly, if firms are making losses, old firms exit, and the demand curves of the remaining firms shift to the right. Because of these shifts in demand, a monopolistically competitive firm eventually finds itself in the long-run equilibrium. In this long-run equilibrium, price equals average total cost, and the firm earn zero profit. Two characteristics describe the long-run equilibrium in a monopolistically competitive market: As in a monopoly market, price exceeds marginal cost. This conclusion arises because profit maximization requires marginal revenue to equal marginal cost and because the downwards sloping demand curve makes marginal revenue less than the price. As in a competitive market, price equals average total cost. This conclusion arises because free entry and exit drive economic profit to zero. There are two noteworthy differences between monopolistic and perfect competition – excess capacity and the mark-up. In addition, the number of firms (and thus the variety of products) can be too large or too small. In practice, the ability of policymakers to correct these inefficiencies is limited. Advertising and branding The critique of advertising; critics of advertising argue that firms advertise to manipulate people tastes. Much advertising is psychological rather than informational. Critics also argue that advertising impedes competition. The defense of advertising; defenders of advertising argue that firms use advertising to provide information to customers. Defenders also argue that advertising fosters competition. Branding; the means by which a business creates an identity for itself and highlights the way in which it differs from its rivals.