Microeconomics for Business - Part 2: Market Forces PDF

Microeconomics for Business Part 2: Market forces Chapter 3 Demand and supply Overview 3.1. The ideal market (p. 81-83) 3.2. Demand as an expression of willingness to pay (p. 83-91) 3.3. Supply as an expression of marginal costs (p. 91-98) 3.4. Pricing (p. 9...

Microeconomics for Business Part 2: Market forces Chapter 3 Demand and supply Overview 3.1. The ideal market (p. 81-83) 3.2. Demand as an expression of willingness to pay (p. 83-91) 3.3. Supply as an expression of marginal costs (p. 91-98) 3.4. Pricing (p. 98-103) 3.1 The ideal market The “market” is the total supply and demand for a particular product. But not every market functions the same way. For example, price formation on the market for the construction of passenger aircraft will be clearly different from price formation on the stock markets. We therefore distinguish different “market structures” depending on a number of characteristics. We use two basic characteristics to classify these market forms: o the number of competitors in the market o the type of product 3.1 The ideal market Characteristic 1: Number of competitors Number of competitors: o One supplier: monopoly o Two suppliers: duopoly o Few suppliers: oligopoly o A lot of suppliers: competition (perfect of monopolistic) The number of competitors is determined by barriers to entry (see further chapters) Characteristic 2: Type of product Homogeneous: the products from different providers are perceived by consumers as virtually identical. Example: gasoline, wheat Heterogeneous: the products of different providers are perceived by consumers as clearly different. Example: clothing, restaurants 3.1 The ideal market The ideal market requires three conditions: private goods: bất kì hàng hóa (1) buyers and sellers have no market power. hoặctranh dịch vụ nào có tính cạnh và có thể loại trừ (2) the goods and services are private goods and there are no externalities. tac dong ben ngoai (3) buyers and sellers have the same information about the goods and services (no asymmetric information) On a perfectly competitive market: o there are many buyers and suppliers (market atomism). ➔ Each supplier is so small compared to the market that he/she has negligible influence on the price (price takers). o a homogeneous good/service is supplied. ➔ Because the products are perceived as identical by the consumer, the consumer only looks at the price. 3.1 The ideal market o Example of (perfectly) competitive market: Market for milk in Europe. Each milk producer has little to no control over the price of milk because other sellers offer virtually identical milk (“price takers”). o Example of non-competitive market: Belgian telecom market. Small number of suppliers => each supplier is sufficiently large to influence the market price (“price makers”). How buyers and suppliers interact in a competitive market is the (theoretical) starting point in this course. Further in the course we will delve deeper into how buyers and suppliers act in other market forms (monopoly / oligopoly / monopolistic competition). 3.2 Demand as an expression of willingness to pay Introductory thought exercise Consider your own demand for going to the movies. 1) What is the maximum price you would pay for an entrance ticket? 2) Find 2 more elements besides the price that determine how often you go to the movies every month. 3.2 Demand as an expression of willingness to pay Demand for sandwiches The demand function for sandwiches describes how the total quantity of sandwiches demanded relates to their price.. Reservation price or critical price: maximum price that people are willing to pay for a product. If the price is higher than the reservation price, the individual in question will not buy a sandwich. Maximum willingness to pay may be different for different consumers (e.g. due to differences in preference, income). Tabel 1.2  3.2. Demand as an expression of willingness to pay Demand for sandwiches The (discrete) demand function Note: price (p) on vertical axis, quantity demanded (q) on horizontal axis. There is an inverse or negative relationship between price (p) and quantity demanded (q): LAW OF DEMAND. Most goods obey the law of demand, we call them ‘ordinary goods’. (exceptions = Giffen goods (see ch6)) (inverse) demand function (see hereafter) also indicates Tabel 1.2 maximum willingness to pay. 3.2. Demand as an expression of willingness to pay Demand for sandwiches The (discrete) demand function Total willingness to pay (WTP): - maximum WTP of all ‘demanders’ - area under the demand curve until the last sold unit. Individual consumer surplus (CS): difference between maximum WTP and paid market price. E.g. CS Ann = 6 euro – 3 euro = 3 euro Total consumer surplus = sum of all individual CS. Tabel 1.2 3.2. Demand as an expression of willingness to pay Demand for sandwiches Tabel 1.2 3.2. Demand as an expression of willingness to pay Demand for sandwiches The (continuous/smooth) demand function Total willingness to pay: OMDN Price paid (= total expenses): 0QDN Consumer surplus: QMD As more sandwiches are demanded, the willingness to pay for theTabel last 1.2 unit purchased decreases (LAW OF DEMAND).  EXTRA 3.2 Demand as an expression of willingness to pay Other example: Demand for chocolates p 5 Exercise: What is the equation of (10; 4.5) this demand function? (20; 4) 4 (40; 3) 3 (50; 2.5) 2 1 q 0 10 20 40 50 60 80 100  EXTRA 3.2 Demand as an expression of willingness to pay Other example: demand for chocolates p General linear demand function: qD = a – bp (a and b are unknowns) 5 (10; 4.5) Fill in 2 points and calculate: (20; 4) Eg.: point (qD = 0, p = 5) and 4 point (qD = 100, p = 0) (40; 3) 0 = a – 5b → a = 5b 3 100 = a – 0b → 100 = a (50; 2.5) 2 2 equations, 2 unknowns: a = 100, b = 20 1 THUS: qD = 100 – 20p q 0 10 20 40 50 60 80 100  EXTRA The linear demand curve: QD = a - bP Other example: 𝑄𝐷 = 60 − 2𝑃 Beware: in economics we draw the P inverse demand curve: 30 𝑥𝑣 = 𝑎 − 𝑏𝑝 𝑎 1 𝑃= − 𝑄𝐷 𝑥𝑣 = 60 − 2𝑝 𝑏 𝑏 25 e.g. P = 30 – 1/2QD -1/2 20 a/b: e.g. 60/2=30 = intercept = +1 price for which demanded 15 quantity = 0 -1/b: e.g. -1/2 = slope of inverse 10 demand curve 5 (a= 60 = intercept on horizontal axis) 0 Q 0 10 20 30 40 50 60 Demand Finding price and quantity using algebra Linear equation for a demand curve: Qd = 1800 – 30P What will the quantity demanded be if the price is €5 €20 If we know the quantity demanded is 1500 how much will the price then be? Exercise: Qd = -80p + 1600 Calculate Qd when the price is €10 and €15. Plot the demand curve. Demand Finding price and quantity using algebra Exercise: Qd = -80P + 1600 Calculate Qd when the price is €10 and €15. Plot the demand curve. P=10: Q = 800 P=15: Q = 400 Demand Finding price and quantity using algebra Exercise: Qd = -80P + 1600 P=10: Q = 800 P=15: Q = 400 Intercept vertical axis: Intercept horizontal axis: 3.2. Demand as an expression of willingness to pay Solution of utility maximization (see Chapter 6) gives rise to a DEMAND FUNCTION. o The general demand function describes the relationship between the total quantity demanded of a good or service and the factors that influence purchasing behavior (the price of the good, the price of other goods, the consumer's income and preferences, etc.). The general demand function for sandwiches: Dependent variable independent or explanatory variables yA, yB,…: incomes of different consumers tasteA, tasteB, …: tastes of different consumers 3.2 Demand as an expression of willingness to pay Partial demand function All else being equal / ceteris paribus hypothesis: o What is the influence of one explanatory variable (e.g. p) on the variable to be explained (q) under the assumption that all other explanatory variables (y, taste,...) do not change? o “Lab-experiment” to determine the influence of, for example, price or income changes on demand. o Different partial demand functions arise depending on which explanatory variable is considered. E.g. the influence of price on the demand for ice cream or the influence of temperature on the demand for ice cream. 3.2 Demand as an expression of willingness to pay Partial demand function Notation: variable fixed ◼ Or short notation: ◼ Note: ◼ Other variables are no longer visible, but they still determine the quantity demanded (they are no longer noted because they are kept constant, but they are not equal to zero!). 3.2 Demand as an expression of EXTRA willingness to pay Inverse demand function Normal demand function: o for a given price, how much does the consumer demand? o Read from vertical to horizontal axis. Inverse demand function: o given quantity, what price is the consumer willing to pay for one additional unit? o marginal willingness to pay curve (WTP) o Read from horizontal to vertical axis. p = D -1(q) Exercise: What is the equation of the inverse demand function for chocolates? (normal demand function: qD = 100 – 20p)  EXTRA 3.2 Demand as an expression of willingness to pay E.g.: demand for chocolates: normal demand vs. inverse demand p 5 4 inverse demand function p = D -1(q) 3 2 normal demand function 1 q = D(p) q 0 10 20 40 50 60 80 100 3.2 Demand as an expression of willingness to pay In this course we assume linear demand functions. Example: general demand function for sandwiches  EXTRA 3.2 Demand as an expression of willingness to pay Market demand Market demand is the sum of the individual demand functions of all consumers. Elements that determine market demand: o the same factors as those that determine individual demand. o The number of consumers. MDF = IDF x Number of consumer For identical consumers, the market demand function is the individual demand function times the number of consumers. In the example of the chocolates, we assume 1000 identical consumers, the mathematical equation of the market demand function then becomes: 1000*q = Q = 100 000 – 20 000 P The market demand is found graphically by making a horizontal summation of all individual demand functions.  EXTRA 3.2 Demand as an expression of willingness to pay Market demand The market demand is found graphically by making a horizontal summation of all individual demand functions. p p p 5 5 5 4 4 4 3 3 3 2 + 2 = 2 1 1 1 100 150 0 250 3.2 Demand as an expression of willingness to pay Movements on the demand curve vs. demand shocks General demand function: Shifts ALONG (or ON) the curve are caused by changes in the own price of the good. Shifts OF the curve are caused by changes in other explanatory variables ((so if we no longer work ceteris paribus). 3.2 Demand as an expression of willingness to pay Price of Ice- Cream An increase of price of ice- Cones cream cones results in a movement along the demand B curve. €2.00 A €1.00 D 0 4 8 Quantity of Ice-Cream Cones 3.2 Demand as an expression of willingness to pay Demand shocks: Example: market demand for sandwiches 3.2 Demand as an expression of EXTRA willingness to pay Example: Demand function for chocolates: consumers become richer (increased income), resulting in an additional demand of 20 000 at any price. p (€) prijs Price aanvankelijk Quantity initially gevraagde hoeveelheid Quantity demanded at (p) (p) gevraagde demanded hoeveelheid new incomeinkomen bij hoger 6 5 0 20.000 4 20.000 40.000 3 40.000 60.000 5 2 60.000 80.000 1 80.000 100.000 4 0 100.000 120.000 Exercise: What is the equation of the new demand function for chocolates? 3 2 D1 D0 q 1 (x 1000) 0 20 40 60 80 100 120  EXTRA 3.2 Demand as an expression of willingness to pay Note the direction of the shift POSITIVE or NEGATIVE shock? o POSITIVE as quantity demanded increases at a given price (D shifts upwards), o NEGATIVE as quantity demanded decreases at a given price (D shifts downwards).  EXTRA 3.2. Demand as an expression of willingness to pay Types of demand shocks: impact of prices of other goods Consumers experience a relation between the consumption of some goods. If the price of one good changes, this will impact the consumption of the other good. Substitutes: two goods for which an increase in the price for one good leads to an increase in the demand for the other good (and vice versa). = goods that you consume instead of each other Examples: chocolate paste & jam, different types of fruit,... Complements: two goods for which an increase in the price for one good leads to a decrease in the demand for the other good (and vice versa). = goods that you consume together Examples: pizza & beer, gasoline & cars, printers & cartridges  EXTRA 3.2 Demand as an expression of willingness to pay Types of demand shocks: impact of income As your income increases, you buy more chocolates. As your income decreases, you buy less chocolates. If the demand for a good increases when income increases, the good is called a normal good. Examples: chocolates, beer, travelling, … If the demand for a good falls when income increases, the good is called an inferior good. Examples: second hand furniture, …  EXTRA 3.2 Demand as an expression of willingness to pay Types of demand shocks: impact of… … preference : if you like chocolates, you will buy more of them … taste: if tastes change, demand will change … expectations : o if you expect an increase in income next month, you may save less and spend more now. o If you think chocolate prices will be lower next week, you may be less inclined to buy today. … advertising : if a company runs an advertising campaign for its product, demand for that product is likely to increase. Tastes: economists are not interested in tastes, but in what happens when tastes change Expectations  EXTRA 3.2 Demand as an expression of willingness to pay Other demand shocks: Cyclical: mang tính chu kỳ o Daily patterns: consumption of electricity o Weekly patterns: use of train traffic o Annual patterns: demand for toys o Perennial: demand for televisions (e.g. link with major sporting events) Social developments: o LPs / CDs / Downloads One-time events: o Moon landing, September 11, covid-19 pandemic, war, … 3.3 Supply as an expression of marginal costs Supply of sandwiches The supply function of sandwiches describes how the total quantity of sandwiches supplied relates to their price. Reservation price or critical price: minimum price at which a supplier is willing to offer the product. If the price is lower than the reservation price, the supplier in question will not offer a sandwich. Reservation price may be different for different suppliers (including due to differences in production costs). Tabel 1.2 3.3 Supply as an expression of marginal costs Supply of sandwiches The (discrete) supply function Note: price (p) on vertical axis, quantity supplied (q) on horizontal axis. There is a positive relationship between price (p) and quantity supplied (q): LAW OF SUPPLY. (inverse) supply function (see hereafter) also indicates marginal costs. Tabel 1.2 3.3 Supply as an expression of marginal costs Supply of sandwiches Tabel 1.2 3.3 Supply as an expression of marginal costs Supply of sandwiches The (discrete) supply function Total production costs: - sum of the marginal production cost of all supplied units. - surface below the supply function to the last unit supplied/sold. Individual producer surplus (PS): Difference between marginale cost and received market price. Eg. PS Apicius = €6 – €3 = €3 Total producer surplus = sum of all individual PS Tabel 1.2 3.3 Supply as an expression of marginal costs Supply of sandwiches Tabel 1.2 3.3 Supply as an expression of marginal costs Supply of sandwiches The (continuous/smooth) supply function Total production cost: OQDN Total revenues: 0MDN Producer surplus: QMD The minimum price that producers are willing to receive for putting extra sandwiches on the market increases as they produce more.. Tabel 1.2 3.3 Supply as an expression of marginal EXTRA costs Other example: supply of chocolates p 6 S continuous 5 function 4 (50; 3.5) Exercise: What is the equation of (40; 3) 3 the supply function ? (20; 2) 2 (10; 1.5) 1 q 0 20 40 60 80 100  EXTRA 3.3 Supply as an expression of marginal costs Other example: Supply of chocolates 6 S p continuous 5 function 4 linear supply function: (50; 3.5) qS = a + bp (a and b unknowns) (40; 3) 3 Fill in 2 points and compute: Eg.: point (qS = 0, p = 1) and point (qS = 20, p = 2) (20; 2) 2 0 = a + 1b → a = b 20 = a + 2b → a = 20 – 2b (10; 1.5) 2 equations, 2 unknowns: 1 a = -20, b = 20 THUS: qS = -20 + 20p q 0 20 40 60 80 100  𝑒. 𝑔. 𝑄𝑆 = −15 + 3𝑃 The linear supply curve Qs = c + dP Beware: in economics we draw the inverse supply curve: 𝑥𝑎 = 𝑐 + 𝑑𝑝 𝑐 1 P 𝑃 = − + 𝑄𝑠 25 𝑥𝑎 = −15 + 3𝑝 S 𝑑 𝑑 20 e.g. P = 5 + 1/3Qs 15 -c/d: e.g. –(-15/3)= 5 = intercept = price for which 10 supplied quantity = 0 5 1/d: e.g. 1/3 = slope of inverse 0 supply curve 0 10 20 30 40 50 60 Q (c= -15 = intercept on horizontal axis – not on graph) 3.3 Supply as an expression of marginal costs Solution to profit maximization (see Chapter 7) gives rise to a SUPPLY FUNCTION. o The general supply function describes the relationship between the total quantity supplied of a good or service and the factors that influence the cost of production (the price of the inputs, the price of other goods, etc.). The general supply function of supplier i: dependent indepentent or variable explanatory variable 3.3 Supply as an expression of marginal costs Partial supply function (ceteris paribus hypothesis) Notation: variable fixed ◼ Or short notation: ◼ Note: ◼ Other variables are no longer visible, but they still contribute to the quantity supplied (they are no longer noted because they are kept constant, but they are not equal to zero!).  EXTRA 3.3 Supply as an expression of marginal costs Inverse supply function Normal supply function: o for a given price, how much does the supplier supply? o Read from vertical to horizontal axis. Inverse supply function: o for a given quantity, what price does the supplier want as minimum compensation before he wants to supply one extra unit? o marginal cost curve (MC) o Read from horizontal to vertical axis. 3.3 Supply as an expression of marginal EXTRA costs Normal supply vs. inverse supply 6 p 5 inverse supply 4 function p = S -1(q) 3 2 Normal supply function 1 q = S(p) q 0 20 40 60 80 100  EXTRA 3.3 Supply as an expression of marginal costs Increasing marginal cost curve Marginal cost curve is upward sloping because of the law of diminishing marginal returns. o E.g. Allowing employees to work extra hours and/or hiring temporary workers increases output. o But the increase in output is slowing down because employees become tired and/or temporary workers have less experience. To produce one extra unit of output, you have to deploy more and more resources and incur costs: the marginal production costs increase. 3.3 Supply as an expression of marginal costs In this course we assume linear supply functions. Example: general supply function of sandwiches  EXTRA 3.3 Supply as an expression of marginal costs Market supply The market supply is the sum of the individual supply functions of all producers. Elements that determine the market supply: o The same factors as those that determine the individual supply. o The number of suppliers With identical producers, the market supply function is the individual supply function times the number of producers. In the example of the chocolates, we assume 1000 identical producers, the mathematical equation of the market supply function then becomes 1000*q = Q = -20 000 + 20 000P. The market supply is found graphically by making a horizontal summation of all individual supply functions. The market supply is flatter than the individual supply because much more is now supplied at the same price.  EXTRA 3.3 Supply as an expression of marginal costs Market supply: heterogeneous suppliers In many markets, producers are not homogeneous but are characterized by different cost structures. E.g. for all producers (technologies) of crude oil: o Production capacity (width of the bars) Global supply curve or o Production cost (height of the bars) marginal production cost curve Production cost ($/barrel) tar sands offshore deep (Nord Sea) offshore shallow (Gulf of Mexico) Siberia, Alaska Quantity Middle-East (barrels/day) 3.3 Supply as an expression of marginal costs Movements on the supply curve vs. supply shocks General supply function: Shifts ALONG (or ON) the curve are caused by changes in one's own price. Shifts OF the curve are caused by changes in other explanatory variables (so if we are no longer working ceteris paribus). 3.3 Supply as an expression of marginal costs Price of Ice- Cream S Cones C €3.00 A rise in the price of ice cream cones results in a movement along A the supply curve. €1.00 Quantity of Ice-Cream 0 1 5 Cones 3.3. Supply as an expression of marginal costs Note direction of shifts POSITIVE or NEGATIVE shock? o POSITIVE as quantity supplied increases at a given price (S shifts downwards = to the right), o NEGATIVE as quantity supplied decreases at a given price (S shifts upwards = to the left). 3.3 Supply as an expression of marginal costs Supply shocks Example: market supply of sandwiches  EXTRA 3.3 Supply as an expression of marginal costs Example: Improvement economic cycle The suppliers see a brighter future than before. This 6 p (€) leads to a greater willingness to supply or a positive supply shock. 5 They want to supply 20 000 more at any price. S0 S 1 4 price initial supply Supply quantity (p) quantity with improvement economic cycle 3 6 100,000 120,000 2 5 80,000 100,000 4 60,000 80,000 3 40,000 60,000 1 2 20,000 40,000 1 0 20,000 0 20 40 60 80 100 120  EXTRA 3.3 Supply as an expression of marginal costs Types of supply shocks : impact of … …profitability of other goods that can be produced: companies can possibly switch between different products. … technology: technological progress reduces production costs and increases supply. … natural / social factors: environmental factors help determine the supply. Weather conditions, changing social norms or social unrest can influence the supply. … input prices: labor costs or other input prices strongly determine costs and therefore supply. … expectations: the economic expectations of suppliers or their expectations about price evolution will partly determine their decisions about supply. Expectations 3.4 Pricing Equilibrium price: price at which the quantity demanded and quantity supplied are equal. Equilibrium quantity: quantity traded at the equilibrium price. Graphically: intersection of the supply and demand functions (point E).  EXTRA 3.4 Pricing Graphically: p (€) S 5 4 p* 3 E 2 1 q D (x 1000) 0 q* 20 40 60 80 100  EXTRA 3.4 Pricing Mathematically: o Set the demand function equal to the supply function and solve for the price o In the example of the market for chocolates: qD = qS 100 000 – 20 000p = -20 000 + 20 000p 120 000 = 40 000p p = 120 000/40 000 p=3 q =100 000 – 20 000*3 OR q = -20 000 + 20 000*3 q = 40 000 q* = 40 000, p* = € 3 3.4 Pricing Price dynamics If p > p* there is excess supply (= supply surplus): o downward pressure on price because producers allow discounts to p get rid of supply surplus. (€) o quantity demanded increases and quantity supplied decreases. S 5 Supply surplus 4 3 E 2 1 q D (x 1000) 0 20 40 60 80 100 3.4 Pricing Price dynamics If p < p* there is excess demand (demand surplus of supply shortage) o upward pressure on prices because consumers bid against each other to p acquire scarce goods (think of concert tickets). (€) o quantity demanded decreases and quantity supplied increases. S 5 4 3 E 2 1 q D excess demand (x 1000) 0 20 40 60 80 100  EXTRA 3.4 Pricing Signal function of prices In a competitive market, prices send signals to buyers and suppliers about the situation in the market. o Producers learn something about the profitability of their production. o Consumers learn something about what they have to give up in order to purchase a product. Rising prices indicate that there is a shortage in the market and learns: o producers that it pays to produce extra because the higher costs can now be recovered more easily. o consumers that they must be prepared to give up more to purchase the good and that they must therefore weigh this against the purchase of other goods. Falling prices indicate that there is a surplus in the market and learns: o producers that costs can be recovered less easily and it is recommended to scale back production. o consumers that they will have to give up less to purchase the good, which may persuade them to purchase the good (thinking at the margin).  EXTRA 3.4 Pricing Changes in the market equilibrium Three steps to analyze changes in equilibrium: 1. Find out whether the event affects the demand function or the supply function (or possibly both). 2. Find out which direction the function shifts 3. Use a graph to see how the equilibrium changes and determine the new equilibrium price and new equilibrium quantity. We use comparative statics for the analysis: o comparison of the market equilibrium before and after the shock. o no statement about trajectory between equilibria.  EXTRA 3.4 Pricing a. New market equilibrium in the event of a positive demand shock (due to increase in income) p (€) 6 5 S 4 E1 3.5 3 E0 2 D1 S D0 q 1 (x 1000) 0 20 40 50 60 80 100 120  EXTRA 3.4 Pricing Comments on new market equilibrium The quantity demanded in the new equilibrium has only increased by 10 000 units while the quantity demanded has increased by 20 000 (due to the rise in income) at each price. Why? ➔ The price increase leads to a number of buyers dropping out. Price rises and equilibrium quantity rises, doesn't that contradict the “law of demand”? ➔ No, because “ceteris paribus” or “all else being equal” no longer applies here.  EXTRA 3.4 Pricing Impact negative demand shock on producer revenues Since equilibrium price and equilibrium quantity move in the same direction, the impact on p producers’ revenues is unambiguous. D0 D1 S E0 Δp E1 0 q Δq  EXTRA 3.4 Pricing b. New market equilibrium in the event of a positive supply shock (due to cheaper labor) 6 p (€) 5 S0 4 S1 E0 3 2.5 E1 2 q 1 D0 (x 1000) 0 50 20 40 60 80 100 120  EXTRA 3.4 Pricing Comments on new market equilibrium The quantity supplied in the new equilibrium has only increased by 10 000 units while the quantity supplied has increased by 20 000 (due to the cheaper labor) at each price. Why? ➔ The price decrease is causing a number of suppliers to drop out. Price falls and equilibrium quantity rises, doesn't that contradict the “law of diminishing returns”? ➔ No, because “ceteris paribus” or “all else being equal” no longer applies here.  EXTRA 3.4 Pricing Impact positive supply shock on producer revenues p (€) Since equilibrium price and equilibrium quantity evolve in opposite 6 directions, the impact on producers' income is ambiguous. In the example, the producers sell more chocolates, but at a lower price. 5 S0 4 S1 E0 3 Δp 2,5 E1 2 q 1 D0 (x 1000) Δq 0 50 20 40 60 80 100 120  EXTRA 3.4 Pricing c. New market equilibrium in the event of a combination of a demand and supply shock If a market is simultaneously affected by both a supply and demand shock, the two changes must be considered together. Depending on the type of shifts, the conclusions regarding the new equilibrium price and the new equilibrium quantity will then be different. Consider the example of the chocolate market in which the following 2 shocks occur: o The holidays are coming, which means more people will want to eat chocolates. o Cocoa is becoming more expensive, which makes producing chocolates more expensive. ➔ What happens to price and quantity?  EXTRA 3.4 Pricing c. New market equilibrium in the event of a combination of a demand and supply shock p (€) o The holidays are coming, 6 which means more people will want to eat chocolates. 5 4 E1 3.5 3 E0 2 D1 S D0 q 1 (x 1000) 0 50 20 40 60 80 100 120  EXTRA 3.4 Pricing c. New market equilibrium in the event of a combination of a demand- and supply shock o Cocoa is becoming 6 p (€) more expensive, S1 which makes producing chocolates 5 more expensive. 4 E1 S0 E0 3 2.5 2 D0 q 1 (x 1000) 0 50 20 40 60 80 100 120 3.4 Pricing EXTRA c. New market equilibrium in the event of a combination of a demand and supply shock ➔ When both shocks are combined: What happens to price and quantity? ➔ 2 situations are possible: S1 Situation 1: p (€) Equilibrium price p* increases, Equilibrium quantity q* decreases E1 S0 E0 D1 D0 q (x 1000) 0 3.4 Pricing EXTRA c. New market equilibrium in the event of a combination of a demand and supply shock ➔ When both shocks are combined: What happens to price and quantity? ➔ 2 situations are possible: Situation 2: p (€) S1 Equilibrium price p* increases, Equilibrium quantity q* increases E1 S0 Depends on the magnitude E0 of the shocks! D1 D0 q (x 1000) 0  EXTRA 3.4 Pricing Price stability? In practice: o there are many shocks at the same time (both for supply and demand) o and the shocks follow each other in rapid succession. As a result, the price in a competitive market (price takers) can be very unstable. o E.g. stock prices and prices of agricultural products constantly change Non-competitive markets (price setters) are often characterized by greater price stability. o E.g. Car manufacturers do not easily increase the price after a positive demand shock (for example during a big car show), they are more likely to extend the delivery period. Some MCQs MCQ 1 MCQ 2 For use with Mankiw and Taylor, Economics 4th edition 9781473725331 © Cengage EMEA 2017 MCQ 3