Introductory Economics Lecture 3: Demand & Supply

MN12217 Introductory Economics Lecture 3 Continuing Demand & Supply; Review of the Market Experiment; The impact of Dr Tim Taxes Wakeley [email protected] & Subsidies 1  The...

MN12217 Introductory Economics Lecture 3 Continuing Demand & Supply; Review of the Market Experiment; The impact of Dr Tim Taxes Wakeley [email protected] & Subsidies 1  The supply curve the market supply curve for a good or service is constructed from individual firms’ supply curves an individual firm’s supply curve is assumed to slope upwards from left to right because of the way short-run costs behave as quantity supplied is increased £ assumed Firm A’s supply curve P for its good/service constant (ceteris 1 paribus): input prices, P technology, 0 number of firms in the market... 0 q q q 0 1 2  The Supply Curve £ £ £ 6 6 6 + = 2 2 2 0 2 4 q 0 1 3 q 0 3 7 Q Firm A’s supply + Firm B’s = MARKET supply SUPPLY curve curve CURVE 3  The supply curve what happens to the market supply curve if any of the ceteris paribus conditions change? A: the supply curve will shift its position £ S0 S1 Example: the effect ‘there has of an P been a increase general in 0 increase in the supply’ number of firms 0 Q Q0 Q1 4  Supply, demand & the model of competitive equilibrium Price (£) supply curve (S) 100 equilibriu m price, 80 point of intersection P* (where demand = 60 supply) is an equilibrium (e) 50 40 equilibrium quantity, Q* 20 demand curve (D) 0 20 40 50 60 80 100 Quantity (Q) equilibrium » a state of the world where there is balance so there is no pressure to change the situation 5  Supply, demand & the model of competitive in the market, if the price is tooequilibrium high the quantity demanded will be too low relative to the quantity supplied » excess supplyPrice» a state of disequilibrium (£) EXCESS supply curve (S) curren SUPPLY t price 80 b a market forces P*=50 e cause the price to fall to the equilibrium price, P*=50 demand curve (D) 0 Quantity (Q) 20 Q*=50 80 6  Supply, demand & the model of competitive in the market, if the equilibrium price is too low the quantity demanded will be too high relative to the quantity supplied » excess demand » a state of disequilibrium Price (£) S market forces P*=50 e cause the price to rise to the c d equilibrium price, 20 P*=50 current price EXCESS D 0 DEMAND 20 Q*=50 80 Quantity (Q) 7  The Invisible Hand? NO! Self-interested human agency responding to market incentives 8  Supply, demand & the model of competitive Measuring equilibrium the benefits - welfare triangles (i) CONSUMER SURPLUS: “the price the buyer is willing to pay minus the amount the buyer actually pays (i.e. the market price)” example: if I am willing to pay £5 for a mug of coffee but I am actually charged £2.90 at the campus coffee shop, my consumer surplus is £5 - £2.90 = £2.10 (ii) PRODUCER SURPLUS: “the price sellers receive for each unit sold (i.e. the market price) minus the price they would be willing to supply each unit for (which is represented by the supply curve)” example: if the campus coffee shop is willing to supply one more mug of coffee as long as they receive a minimum price of £1.50, 9  Supply, demand & the model of competitive Measuring equilibrium the benefits - welfare triangles £ Both consumer and producer surplus can be thought of as the extra 1 benefits accruing to 09 S consumers and 8 producers as the result of 0 exchange When markets are fully 7 competitive the sum of C 6 S consumer surplus and 5 producer surplus is maximized 4 P The competitive 3 S equilibrium outcome is 2 ALLOCATIVELY 1 EFFICIENT D 0 1 2 3 4 5 6 7 8 9 10 0 Q (x100) 0 0 0 0 0 0 0 0 0 0  Prices and resource allocation excess supply indicates a surplus of production » too much is being produced » a waste of scarce resources excess demand indicates a shortfall in production » too little of what people want is being produced in each case the change in price (i.e. the move to equilibrium) enables the market to allocate scarce resources better » prices are the signals that guide the allocation of resources prices will adjust to ration demand for scarce resources so (in theory at least!) the people who get to 11  Prices and resource allocation This simple model is the basis for the belief that competitive markets are the best way to coordinate an economy’s use of resources – it emphasises that people make choices based upon their willingness to pay for things – “every dollar spent on a good or service is like placing a vote in favour of that SOUNDS PRETTY GOOD good or service.” DOESN’T IT? 12  What other things might cause markets to fail? We will return to this question in a later lecture 13  Using the model: an example What is the likely impact in the market for sausages if the UK’s National Farmer’s Union launches an intensive advertising campaign to encourage sausage consumption? Market for Sausages Price (£) S The demand for 0 sausages is likely P1 to increase (D0 to P0 D1) which will create excess D0 D1 demand at the 0 original price and Q0 Q1 Quantity (Q) cause a price rise (P0 to P1). 14 Review of the Market Experiment 15  The data describing your market (90 buyers and 90 sellers) No. of No. of Buyer buyers Seller sellers Value (£) with this Cost (£) with this value cost Prediciton: these 14 18 6 18 Prediciton: potential these buyers will 12 18 8 18 potential be unserved sellers will sell zero 10 18 10 18 8 18 12 18 6 18 14 18 16  Experimental Market – Demand & Supply Predicted Outcome (90 buyers & £ 90 sellers) Consumer 16 surplus Marke 14 t (108) 12 Supply Producer Predicted 1 ‘curve’ surplus 08 equilibriu Market (108) 6 m price 4 Deman 2 d ‘curve’ 0 18 36 54 72 90 Quanti Predicted ty equilibrium quantity 17  Summary of Actual Results PREDICTI Round Round Round ON 1 2 3 Average 10 9.55 9.65 9.91 Price Maximu 10 14.00 14.00 14.00 m Price Minimu 10 6.00 6.00 6.00 What’s m Price Standar 0 1.75 1.95 1.68 d Dev. Modal Price Consum 10 108 10.00 10.00 10.00 going on here? 116.5 107.91 101.25 er Surplus Produce 108 77.5 46.09 84.75 r Surplus Total 216 194 154 186 Surplus No. of 54 63 63 57 18 Trades The impact of taxes and subsidies 19  Overview Up to this point we have not said anything about government intervention in free business markets Governments impose taxes on goods and services – these are classified as indirect taxes (the tax is collected by an intermediary) SPECIFIC TAXES AD VALOREM TAXES a fixed amount per unit a percentage of the price e.g. Soft Drinks Industry of a good e.g. V.A.T. is Levy (‘sugar tax’) is 18p typically levied at a rate of per litre for drinks with 20% of the price of goods between 5g – 8g of sugar in the UK per 100ml  Overview Governments also grant subsidies – these are essentially ‘reverse’ taxes Subsidies are often applied to farming in the UK, along with other business activities the government wishes to encourage e.g. Electric Vehicle production… From October 2022 – March 2023, every UK household was granted a £400 subsidy to help pay for gas and electricity via the ‘Energy Bills Support Scheme’. Taxes & subsidies change outcomes in markets…  A tax on buyers A thought experiment… You are a potential buyer; imagine your valuation of a widget is £5 i.e. you are willing to buy one widget if the price Now, is £5 or less imagine that the government puts a specific tax on widgets of £2 per widget and tells buyers they are responsible for paying this (i.e. this is a tax on buyers) What does the introduction of the tax mean for you? the £5 you are willing to pay is broken down into two elements: £2 to the £3 to the widget government seller  A tax on buyers More generally, what does the introduction of the tax on buyers mean for the market demand curve? It implies that the market demand curve will move vertically downwards by the amount of the tax  A tax on buyers Implications for Market Equilibrium £ Impose specific tax of £2 per unit 10 9 S0 Equilibriu Price paid 8 m before by buyers 7 tax 6 5 Price 4 received 3 by sellers 2 1 D0-tax D0 0 1020 30405060708090100 Q (x100)  A tax on sellers Another thought experiment… You are a potential seller; imagine your cost to produce a widget is £5 i.e. you are willing to produce one widget if the price you receive is £5 or more Now, imagine that the government puts a specific tax on widgets of £2 per widget and tells sellers they are responsible for paying this (i.e. this is a tax on sellers) What does the introduction of the tax mean for you? You are prepared to make a widget for £5, but now you will add £2 tax on top of this  A tax on sellers More generally, what does the introduction of the tax on sellers mean for the market supply curve? It implies that the market supply curve will move vertically upwards by the amount of the tax  A tax on sellers Implications for Market Equilibrium £ Impose specific tax of £2 per unit S0 + tax on 1 sellers 09 S Price paid 8 0 Equilibriu by buyers 7 m before 6 tax 5 Price 4 received 3 by sellers 2 1 D 0 1 2 3 4 5 6 7 8 90 10 Q (x100) 0 0 0 0 0 0 0 0 0 0  Indirect Taxes What have we discovered? It does not matter who the law says is responsible for paying the tax to the government - the outcome, regardless of whether buyers are responsible or whether sellers are responsible, will be identical! In fact, we do not need to shift any curves to see the impact of a given amount of specific tax – instead, we can just insert a ‘tax wedge’…  Inserting a tax wedge… tax drives a wedge between the price buyers pay and the price sellers re £ Impose specific tax of £4 per unit 1 09 S Price paid by buyers 8 0 7 6 TAX WEDGE = £4 5 4 Price 3 received 2 by sellers 1 D 0 1 2 3 4 5 6 7 8 90 10 Q (x100) 0 0 0 0 0 0 0 0 0 0  Indirect Taxes What’s the welfare impact of imposing indirect taxes? £ Specific tax of £4 per unit Both consumer and 1 producer surplus are 09 reduced Price paid S by buyers 8 C 0 The government 7 S collects tax revenue C 6 S TA The tax creates a DW 5 X deadweight loss L 4 RE VP (DWL) - because the Price 3 S number of efficient received 2 P trades is reduced by sellers 1 S D 0 1 2 3 4 5 6 7 8 9 10 0 Q (x100) 0 0 0 0 0 0 0 0 0 0  Indirect Taxes Who bears the burden of the tax? The incidence of tax is the term used to define how the tax contributions from buyers and suppliers are divided between them If the tax imposed exactly matches the rise in price then buyers bear the full burden of the tax, but if the price paid by buyers does not change at all the suppliers bear the full burden of the tax. Tax incidence depends critically on the (relative) elasticity of demand and supply…  Indirect Taxes An ad valorem tax (50%) £ 1 S0 + ad 09 Price paid valorem tax by buyers 8 S 50% 7 0 Equilibriu 6 m before 5 tax 4 Price 3 50% received 2 by sellers 1 D 0 1 2 3 4 5 6 7 8 9 10 Q 0 0 0 0 0 0 0 0 0 0  Subsidies Recall, subsidies can be thought of as ‘reverse’ taxes Grant £ a subsidy of £2 per unit 1 S Price 09 received 0 8 S0 - by sellers 7 subsidy 6 5 Price paid 4 by buyers 3 2 1 D 0 1 2 3 4 5 6 7 8 9 010Q (x100) 0 0 0 0 0 0 0 0 0 0  Subsidies What’s the welfare impact of a subsidy? £ DWL because Marginal Gain in 1 S Social Cost > Marginal producer 0 Social Benefit i.e. there is surplus 9 0 too much trade taking 8 place 7 6 Subsidy wedge 5 Cost of the subsidy = £2 Gain in x 5000 = £10,000 = consume 4 r surplus 3 2 1 The relative share of the D benefits depends on 0 1 2 3 4 5 6 7 8 9 010Q (x100) relative elasticities of 0 0 0 0 0 0 0 0 0 0 supply and demand  Elasticity and relative benefit Price received Subsidy of £3 by sellers per unit £ Inelastic £ Elastic 1 demand 1 Price demand 09 09 received S by sellers S 8 8 7 7 6 6 5 5 D 4 4 3 3 Price paid 2 Price paid D 2 by buyers 1 by buyers 1 0 1 2 3 4 5 6 7 8 9 10 Q 0 1 2 3 4 5 6 7 8 9 10 Q 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 Buyers benefit more than Suppliers benefit more suppliers than buyers  Summary TAXES Imposition of taxes on goods and services generates revenue for the government Imposition of taxes on goods and services generates deadweight losses because some trades that could have taken place efficiently don’t happen The legal incidence of a tax is not the same as the economic incidence The tax burden (incidence of tax) is a function of elasticity of demand and supply  Summary SUBSIDIES Granting subsidies costs the government (tax- payers) money Granting subsidies generates deadweight losses because too many trades take place i.e. at trades to the right of the competitive equilibrium quantity the cost of the extra units exceeds the value demanders place on those The extradirect units legal recipient of the subsidy is not the same as the economic beneficiary of the subsidy The benefit of a subsidy is a function of elasticity of demand and supply The 5-forces model 38  Moving on… We need a way of working out what areas of economics can help managers (and others) understand the markets in which they operate One way of doing this is to use a Strategic Management framework which can then give structure to the microeconomics we look at in the unit. it’s something to keep in the back of your mind as the unit evolves 39  Given we want to understand markets, what we are looking for is a way to develop answers to questions like: How do I tell What are the What actions can how profitable a key factors a firm take to particular affecting enhance its industry is? profitability? profits? This is where Porter’s 5-forces framework comes into play… 40  Porter’s 5-forces Michael Porter (1979) ‘How Competitive Forces Shape Strategy’ Harvard Business Review (March-April) A more developed treatment was published in HBR (January issue) in 2008, ‘The Five Competitive Forces that Shape Strategy.’ So, what’s all the fuss about? Let’s start with some empirical observations… 41 Average Industry Profitability for UK manufacturing industries (1993-98) Rank Industry Rate of Gross Profit 1 Water 70.2 % 2 Cement 50.1 % 3 Pharmaceuticals 45.3 % 4 Publishing 43.9 % 5 Glass 42.1 % 6 Clothing 41.5 % 7 Footwear 39.1 % 8 Aerospace 38.3 % 9 Rubber and 37.9 % Plastic 10 Textile Manuf. 37.7 %  Profit margin for various consumer staple companies 2018 Company Imperial Brands 46.0% British American Tobacco 38.0% Coca Cola 26.7% Heineken 16.9% Starbucks 15.7% PepisiCo 15.6% General Mills 15.4% Nestle 15.1% Carlsberg 15.0% Mondelez 12.8% Fedex 6.5% Source: J Robert Branston, “Industry profits continue to drive the tobacco epidemic: A new endgame for tobacco control?”, Tob. Prev. Cessation 2021;7(June):45 https://doi.org/10.18332/tpc/138232  Porter’s 5-forces 1. Some industries are inherently more profitable than others Industry average profit rates are consistently higher in some markets than in others 2. Some firms are consistently more profitable than others because they operate in these favourable environments On average, firms that are playing in a “good game” enjoy higher profits than those that are engaged in less profitable industries The market environment matters!  Porter’s 5-forces 3. Firms with similar activities have widely different rates of profit Whatever the inherent profitability of the environment, some firms consistently outperform others. Taking advantage of your environment matters! 45  Porter’s 5-forces Many strategy frameworks we could examine The Value Net, SWOT analysis, PEST analysis etc… Porter's framework relates directly to the empirical observations above Origins in the economic S-C-P theory The framework consists of two parts: Industry Analysis Generic Strategy a tool that helps us Formulation identify the key forces offers strategic at work in a market prescriptions that are based on industry  Porter’s 5-forces Arriving at a sensible definition of the market /industry is an essential precursor to conducting industry analysis This can be a more difficult exercise than imagined By defining the market, you explore things like: a set of competing products; a geographical area; a set of competitors  Porter’s 5-forces Identifying market boundaries - potential pitfalls Too narrow a Too broad a focus focus Can lead to Can lead to ‘strategic myopia’ irrelevant analysis i.e. potential threats i.e. the firm may look are overlooked at non-existent sometimes using athreats of number alternative definitions can be a useful way of generating a range of strategic options and perspectives 48 The 5-forces framework addresses the question ‘What characteristics of a market significantly affect the performance potential of the firms operating within them?’ Threat of new entrants Bargaining Rivalry among Bargaining power of existing power of suppliers competit buyers ors Threat of substitute products or services 49  Porter’s 5-forces Porter identifies two fundamental routes to acquiring competitive advantage a LOW-COST a strategy DIFFERENTIATI ON strategy Firms should only try to pursue one of these strategies - otherwise they might “get stuck in the middle” 50 https://hbr.org/video/2226587624001/the-five-competitive-forces-that-s hape-strategy 51 The END 52