Markets & Marginal Analysis Lesson 2

MARKETS & MARGINAL ANALYSIS A.)Demand: Considerations and Semantics Consumers’ demand can be defined as “the relationship between prices and quantities that consumers are able and willing to buy”. For most output and consumers, this relationship can be aptly described by the law of demand...

MARKETS & MARGINAL ANALYSIS A.)Demand: Considerations and Semantics Consumers’ demand can be defined as “the relationship between prices and quantities that consumers are able and willing to buy”. For most output and consumers, this relationship can be aptly described by the law of demand which manifest into a negative or inverse relationship between prices and quantities demanded (i.e. at higher prices lower quantity demanded and with lower prices, higher quantity demanded). This can be illustrated with the use of the following graphs. Prices Prices A B A B Quantities demanded Quantities demanded For both graphs, point A represents higher prices and lower quantity demanded while point B represents lower prices with higher demand quantities. This relationship between prices and quantities demanded (in both graphs) illustrates the typical law of demand. Example (demand with a linear relationship) The demand for an output can be represented as Q d = 200 – 1/5P with P representing price in pesos while Qd is the quantity demanded in units. Using this [linear] functional relationship between prices and quantities demanded will result in the values summarized in the table. Prices Quantity demanded 5 199 15 197 20 196 There are four main factors influencing any demand for an output: consumers’ income (I)+, consumer taste and preferences (+), price of substitutes (Ps)+, price of complements (Pc)- and the number of consumers (+)---with signs following each factor representing a (+) positive or (-) negative relationship between demand for an output and the specified factor influencing demand. A complement is another output that is normally consumed together with the output while a substitute is another output which can replace consumption of the output). Any changes in these factors (besides the price of an output) will be represented by a shift in the demand rather than a change within the demand itself.  In the following two graphs, it can be noticed that there is an upward shift in the demand. This upward shift in the demand can result from the following: a higher income of consumers, more preferences for the output, higher prices of substitutes, lower prices of complements or a higher number of consumers. The upward shift in the demand can be evidenced by the higher quantity demanded despite the same price levels at points A and B. Prices Prices A B A B Quantities demanded Quantities demanded The next set of two demand curves graphs represents either a lower income of consumers, less preferences of consumers, lower price of substitutes and a higher price of complement and a lower number of consumers. In this instance, there is a lower quantity demanded despite the price remaining the same. Prices Prices B A B A Quantities demanded Quantities demanded B.)Supply: Considerations and Semantics Supply represents the quantities of an output that sellers are able and willing to provide in the market. Selling prices and supply quantities are positively or directly related (termed as the law of supply) for vendors are induced to provide more with higher prices. Both graphs representing the supply of an output are positively sloped to reflect the law of supply. This positive or direct relationship Prices Prices B B A A Quantities Quantities between prices and supply quantities are represented by a movement from points A to B in both graphs. Such movements along the same supply line or curve is termed as a change in the supply (quantities) --- due to a change in prices. Example (Supply) The supply of an output is represented by the function Q s = 100 + 5P with Qs representing supply quantities while P is the price. Values portrayed in the following table were generated using the supply function provided in this example. Qs P 125 5 150 10 175 15 Notice that the supply function provided in this example has an intercept term of 100. This intercept value can be equally considered as the part of supply quantities that are not influenced by prices or the minimum supply quantities. The slope of 5 can be interpreted as the change in supply quantities for every change in the price. Any consideration of supply should likewise recognize the relevance of price elasticity. In the context of supply, price elasticity will reflect the responsiveness or sensitivity of sellers to any change in selling prices. The extreme case of an infinitely price elastic supply reflects a market situation of perfect competition or small size of sellers. In this context, sellers have to consider that prices are determined in the market. Alternatively, sellers in the market can expect to sell every unit of output produced as long as the output is sold at the market price level. For the perfectly price inelastic supply, the situation can be used to depict that sellers cannot respond to any change in prices. This non-responsiveness could be a direct result of either a need to expand productive capacities or resource constraints or both. There are six major factors affecting supply of an output: the number of sellers +, technology+, productive capacities+(; i.e. how much output can be feasibly produced), prices of inputs -, prices of complements- and prices of substitutes+. The signs for each cited factor represent the expected relationship between supply quantities and a specific factor. Notice that changes in each of these factors will be likewise graphically represented by shifts in the supply(line or curve). The following graphs both represent a shift to the right or downwards in the supply. Alternatively, these graphs represent a situation in which suppliers are able and willing to provide greater quantities at the same price (consider the two points A and B in the two sets of graphs for illustration). Such a situation can represent greater number of sellers in the market, lower prices of inputs, the use of better production technologies, an expansion of productive capacities and lower (higher) prices of complements (substitutes). Prices Prices A B A B Quantities Quantities In the next pair of graphs, a shift in the opposite direction is being depicted (again, consider points A and B in which the direction for consideration has been reversed). Both pair of graphs demonstrate a supply shift to the left or upwards. The supply situation has changed such that suppliers are able and willing to provide lower quantities even at the same price. In these graphs, the situation has resulted from a lower number of sellers in the market, higher prices of inputs, a reduction in productive capacities, using poorer technologies and a higher (lower) prices of complements (substitutes). prices prices B A B A quantities quantities  C.) Market equilibrium Market equilibrium is a situation in which demand is exactly equal to supply. Graphically, such a situation can be represented by the point of intersection involving the demand and supply (line or curve). The market equilibrium can be changed by a shift in both the demand and the supply. In the following graphs, some dynamics in the market equilibrium is presented—while the first graph shows an upward shift in the demand, the next graph illustrates an upward shift in the supply situation. Notice that in both graphs, equilibrium prices will be increased by the upward shift in the demand curve and supply line. The effects of these same shifts will however result in different equilibrium quantities. While the upward shift in the demand will increase equilibrium quantities, the upward shift in the supply will result in lower quantities. prices prices S’ S S D’ D D quantities quantities Example (market equilibrium) In a market, demand is represented by the equation Q d = 2,000 -5P while supply by the equation Qs = 1,000 + 5P. Applying the definition provided for market equilibrium (in which demand is equal to supply or Qd = Qs) will result in 2,000 -5P = 1,000 + 5P. The resulting equilibrium price will be P e equal to 100. Substituting this equilibrium price into both demand and supply equations will indicate equilibrium quantities Qe of 1,500 units of output. The demand, supply and equilibrium prices and quantities are presented in the following graph. prices 400 s S:Q = 1,000 + 5P 100 d D:Q = 2,000 – 5P quantities 1,500 -200  The concept of market equilibrium in this example can be extended. For instance, consider a price greater than equilibrium price Pe such as P equal to 150. At this price, supply quantity Q s is equal to 1,750 (i.e. Qs = 1,000 + 5) while demand quantities Qd will be equal to 1,250(Qd = 2,000 -5 = 1,250). Since, Qs > Qd, a market price that is greater than equilibrium price will result in a market surplus or excess quantities of output available in the market. A shortage [i.e. inadequate quantities of output] will result in this market if the market price becomes lower than the equilibrium price. For instance, a market price equal to 75 will result in Q s equal to (i.e. Qs = 1,000 +5 ) 1,375 while Qd will be (i.e. Qd = 2,000 +-5) of 1,625. Since in this instance, quantity demanded Qd is greater than supply quantities Qs, there will be a shortage in the quantities of output in the market. S D Qs Qe Qd Extensions made in the example demonstrate a key concept regarding market equilibrium. That is, market equilibrium can be considered most stable –in the sense that markets tend to settle at equilibrium price and quantity levels. To demonstrate the stability of market equilibrium, consider the following graph in which there is an existing shortage (the price level is initially at P’). This shortage will push the price to move upwards towards equilibrium price Pe since demand quantities is greater than supply quantities. The stability of market equilibrium can be likewise demonstrated in the case of a market surplus. In the following graph, the existence of a surplus will compel to sellers to accept a lower price. This lowering of asking price for the output will likewise move the price level towards the equilibrium price level. S D Qd Qe Qs  A last point regarding market equilibrium can be made: a market that is in equilibrium does not represent equity or fairness to all market agents. This observation regarding market equilibrium follows from the use of the following graph. Notice that in this graph, the market has already settled at its equilibrium levels Pe and Qe. For the supply side, there are sellers who will not be able to continue selling once the price has settled at the equilibrium level. In this graph, these sellers are located in the upper portion of the supply (red upward sloping line; yellow colored arrow) above the equilibrium price level. On the demand side, there are consumers which can not avail of the output for their “bid” price or the price these consumers are willing to pay are at a level below the equilibrium price. These consumers are located in the lower portion of the demand (blue colored downward sloping line; green colored arrow). S Pe D Qe D.)Markets and Marginal Analysis Previously, it was stated that there exists a negative or inverse relationship between prices and demand quantities. The need for lower prices to induce higher demand quantities reflect the decreasing incremental or marginal benefits consumers received from additional units of output. Marginal benefit is the change in the total benefits (received by consumers) for every change in the quantity of output. This is the reason why demand can be considered as the marginal benefit of consumers. A related economic concept into considering demand as marginal benefits is consumer surplus. Consumer surplus is the area underneath the demand but above the market price. This area representing consumer surplus is widely considered in Economics to represent consumers' total benefits. A reason for this consideration of consumer surplus is the reasoning that there are consumers who are able and willing to pay a higher price but are going to pay the lower market price. These are the consumers whose prices and quantities are located in the upper (meaning, higher than the market price) parts of the demand. The graphical representation of consumer surplus is labeled as CS in the following graph. Another use of consumer surplus is its use as an indicator of consumers' willingness to pay. This alternative use of consumer surplus as an indicator of consumers' willingness to pay can be validated by equating the consumers' the total valuation of total benefits received by consumers to the entire area of the consumer surplus.  For sellers/producers, there is a positive or direct relationship between prices and supply quantities. This type of relations reflects that higher prices will induce sellers/producers to provide greater quantities in the market and indicates the rising costs of producing each additional unit of output. The rise or change in the production costs for every additional unit of output provided in the market is referred to as the marginal costs in Economics. Therefore, the supply is alternatively considered as the marginal costs of sellers into providing each additional unit of output in the market. There is a related concept into this consideration of supply being the same as marginal costs. This concept is referred to as producer surplus. Producer surplus is the area above the supply (or marginal costs) but below the market price. In the following graph, the producer surplus is labeled as PS. In Economics, producer surplus is widely used to indicate the total benefits of sellers/producers. An alternate consideration for the area of the producer surplus is a measure of the "rewards or returns" into selling or producing output considering the costs incurred into providing the output. Usually, a marginal analysis involves a consideration of increments or changes in benefits relative to the same increments or changes in costs. In a market, this will involve a consideration of the marginal benefits of consumers (that is, the demand) relative to the marginal costs of sellers (that is, the supply. A marginal analysis involving both sides of a market is likewise represented in the following graph. prices S = marginal costs CS CS = consumer surplus Pe PS = producer surplus PS D = marginal benefits quantities Q’ Qe Q” In an earlier discussion of market equilibrium (the equality between demand and supply or [graphically] the point of intersection between demand and supply), this concept was determined to be the most stable point in a market. Notice that in the preceding graph, at market equilibrium there is equality between marginal benefits of consumers to the marginal costs of sellers. Moreover (as can be observed in the previous graph, the total benefits of consumers (that is, consumer surplus CS) and the total benefits of sellers (that is, producer surplus PS) gets to be maximized. For demonstration, consider a quantity level such that marginal benefits are greater than marginal costs. In the graph, these are quantity levels less than equilibrium (represented by Q’). Any application of marginal analysis implies that quantities will be increased until marginal benefits become just equal to marginal costs. At quantities greater than equilibrium (represented by Q”), marginal costs will be greater than marginal benefits. For this situation, quantity levels will be reduced by the greater costs considering benefits to be had from the output.  Usually, application of marginal analysis is undertaken for assessing market efficiencies. A market is considered most efficient when the total benefits of consumers (consumer surplus) and the total benefits of sellers (producer surplus) are at a maximum. This maximization of total benefits (or market efficiency) can only occur at market equilibrium (without any changes in the market attributed to market dynamics or any form of market intervention) as earlier observed in the preceding graph. The importance of maximizing market efficiencies at market equilibrium is: "the market allocation has resulted into the optimal use of resources into generating maximum total benefits for both consumers and sellers." In instances when maximum market efficiencies are not realized, the situation is depicted as the existence of deadweight losses or a failure to realize total benefits from market allocation. Example (market efficiencies and marginal analysis) Demand in a market is represented by the function P = 5,000 -5Qd = MB while the supply by the function P = 1,000 + 5Qs = MC. The price P in this market is measured in pesos while Q represents quantity of output (measured in physical units). Following the marginal analysis discussed in the text, demand is considered equal to marginal benefit (MB) while supply is equal to marginal cost (MC). The market equilibrium quantities (where D = S) can be determined as 400 units (with D = S; 5,000 -5Qd = 1,000 + 5Qs will result in 4,000 = 10Q and Qe = 4,000/10 = 400 units). Equilibrium price Pe can be determined using the equilibrium quantity Q e into either demand or supply equations; that is, Pe = 5,000 -5(400) = 1,000 + 5(400) = 3,000 pesos. The demand equation and supply equation, and equilibrium price and quantity levels are likewise represented in the following graph. pesos consumer surplus = 400,000 S = MC = P = 1,000 +5Qs 5,000 3,000 producer surplus = 400,000 D = MB = P = 5,000 -5Qd 1,000 quantities 400 In this graph, consumer surplus CSe (the total benefits of consumers) at market equilibrium was determined as ½(2,000*400) = 400,000 pesos. At market equilibrium, producer surplus PSe (the total benefits of sellers) was determined as ½(2,000*400) = 400,000 pesos. Combining both consumer and producer surpluses at market equilibrium will result in the net market surplus at market equilibrium NMSe = CSe + PSe = 400,000 + 400,000 = 800,000 pesos. This net market surplus at market equilibrium represents the maximum for both market agents barring any changes in market conditions.