Market Fundamentals

1. Market Fundamentals Frederick University 2012

2. Questions What and how much How For Whom Problems Efficiency in allocation Efficiency in motivation Efficiency in distribution Main Economic Problems

3. Types of Economic Systems • Traditional economy • Market Economy • Command Economy

4. Market Functions • Allocation of scarce resources • Motivation for efficiency • Distribution of goods and services

5. The Demand for chocolates“Milka”

6. The Demand for chocolates “Milka” A P B C D E Q The demand curve

7. Demand Demand – buyers’ behavior The Demand for a good – the quantities buyers are willing and able to buy at every different price The law of Demand – the decrease in the price of the good raises the quantity of the good demanded, other factors held equal

8. Buyers’ income Prices of the other goods Buyers’ expectations Buyers’ taste and preferences Market size Institutions P FACTORS DETERMINING DEMAND D Q Demand rises = the demand curve shifts rightwards Demand falls = the demand curve shifts leftwards

9. Supply of Chocolate“Milka” S P S Q

10. Supply Supply – sellers’ behavior The Supply of a good – quantities of the good that sellers are willing to sell at different price levels The Law of Supply – as the price of the good rises, sellers are willing to sell greater quantities of the good, ceteris paribus.

11. Sellers’ expectations Cost of production Technological changes Market size Institutions P FACTORS DETERMINING SUPPLY S Q Supply rises – the supply curve shifts rightwards Supply falls – the supply curve shifts leftwards

12. Market Equilibrium D S P E Pe Qe Q The market is in equilibrium when the quantity supplied equals the quantity demanded at the same price

13. P Market equilibrium quantity supplied equals quantity demanded Pe – equilibrium price Qe – equilibrium quantity Market Equilibrium S D E Pe Q Qe

14. The Dynamics of Market Equilibrium D’ Qd > Qs Qd – Qs = shortage P D E’ P’ P rises and Qs increases E Pe P rises and Qd falls S Qd Q Qe Q’ The Equilibrium is restored at E’

15. The Dynamics of Market Equilibrium P Qd < Qs Qs – Qd = surplus S S’ D E P falls and Qd increases Pe P falls and Qs decreases E’ The Equilibrium is restored at E’ Qs Qe Q The equilibrium price clears all shortages and surpluses Pe = market clearing price

16. Price Ceiling Shortage = (Qd-Qs) x Pc P D Pb.m. Profits of the blackmarketeers = (Pb.m. – Pc) x Qs Pe Pc S shortage Qs Qd Q Qe

17. Arbitrage and speculation Zo widget market Oz widget market P P S POz PZo D D S Q QOz Q QZo Supply shifts to Oz market Demand shifts to Zo market exports imports Shifts in Supply and Demand until price differences are eliminated

18. Arbitrage and speculation • Arbitrage – the process by which individuals seek to make a profit by taking advantage of discrepancies among prices prevailing simultaneously in different markets • Speculation – a way to make a profit by taking a deliberately risky position

19. Quantifying Market Responses Elasticity • TR = P x Q • Price Elasticity of Demand – buyers’ responsiveness to the price changes • Ep = % change in Quantity Demanded : % change in Price

20. Classifying Price Elasticity of Demand |Е| < 1inelastic demand |E| > 1 elastic demand |E| = 1 unit elastic demand |E| = 0 perfectly inelastic demand |E| =∞ perfectly elastic demand

21. Calculating Price Elasticity of Demand Ep = % change in Quantity Demanded : % change in Price % change in Quantity Demanded = = (Q2 – Q1) : (Q2 + Q1)/2 % change in Price = = (P2 – P1) : (P2 + P1)/2

22. Price Elasticity of Demand and Total Revenue • TR = P x Q • The Law of Demand - If P rises, Q falls • If the percentage change in price is greater than the percentage change in quantity, the demand is inelastic • If the price falls, the change in quantity demanded does not compensate for the price reduction and TR falls • If the price rises, TR will increase

23. Price Elasticity of Demand and Total Revenue Q TR P |E| < 1 If the price rises, TR increases If |E| = 1, TR does not change |E| > 1 If the price rises, TR falls

24. E = % change in Q : % change in P % change in Quantity Demanded = = (Q2 – Q1) : (Q2 + Q1)/2 % change in Price = = (P2 – P1) : (P2 + P1)/2 % change in Q = =(10-9) : (9+10)/2 = 0.10 % change in P = = (1-2) : (2+1)/2 = - 0.67 E =- 0.14 |- 0.14| < 1 |E| < 1 J 2 K 1 10 9

25. % change in P = (5-6) : (5+6)/2 = - 1.18 % change in Q = (6-5) : (6+5)/2 = = 1.18 |E|>1 F |E|= 1 6 5 G |E| < 1 5 6 E = 1.18 : - 1.18 = -1 |- 1| = 1

26. A P |E|>1 10 9 B % change in Q = = (2-1) : (2+1)/2 = 0.67 % change in P = =(9-10) : (9+10)/2 = - 0.10 E = 0.67 : - 0.10 = - 670 |-670| > 1 E = % change in Q : % change in P % change in Quantity Demanded = = (Q2 – Q1) : (Q2 + Q1)/2 % change in Price = = (P2 – P1) : (P2 + P1)/2 Q 2 1

27. FACTORS AFFECTING PRICE ELASTICITY OF DEMAND • Availability of substitutes/Definition of market • Time horizon • Income • Traditions

28. Price Elasticity of Supply • Price elasticity of supply – sellers’ responsiveness to the price changes • Ep = % change in Quantity Supplied : % change in Price

29. Price Elasticity of Supply E < 1 P E = 1 E > 1 Q

30. Price Elasticity of Supply P E = 0 E = ∞ Q

31. FACTORS AFFECTING PRICE ELASTICITY OF SUPPLY • Time horizon • Availability of production factors • Mobility of production factors • Inventory levels • Competitiveness of the market structure • Institutions

32. Applications of Price ElasticityEconomics of Agriculture P S2 S1 P1 % change in P > % change in Q E < 1 P falls and TR falls Farmers have lower income P2 D Q1 Q2 Q

33. Applications of Price ElasticityEconomics of Agriculture P Solution 1: government pays the difference P1 – P0 to the farmers S P1 Government will lose (P1 – P0) x Q P0 D Q Q

34. Applications of Price ElasticityEconomics of Agriculture P Solution 2: government buys all Q from farmers at P1 and sells it. However, buyers will buy less at P1 S P1 Government cannot sell Q – Q1 and will lose (Q – Q1) x P1 The loss under solution 1 is (P1 – P0) x Q The loss under solution 2 is (Q – Q1) x P1 P0 Since demand is inelastic, (P1 – P0) x Q > (Q – Q1) x P1 D Q1 Q Q Solution 2 is preferable because the loss is smaller.

35. The Tax Incidence Case 1: perfectly inelastic demand P S2 Government imposes an excise tax = t D Sellers will be willing to sell the same Q if only someone else would pay the tax Supply shifts to S2 S1 P2 = P1 + t t Since demand is perfectly inelastic, buyers will not change the quantity demanded P1 Buyers pay the tax Q Q

36. The Tax Incidence Case 2: inelastic demand and elastic supply P D Government imposes an excise tax = t S2 Sellers will be willing to sell the same Q if only someone else would pay the tax Supply shifts to S2 S1 P2 t P3 Demand is not perfectly inelastic And buyers will not want to buy Q1 at the higher price P2 P1 Buyers are willing to buy Q2 < Q1 Q Q1 Q2 The shortage Q2 – Q1 will push the Price down to a new equilibrium Q3 Tax = P2 – P1. Buyers pay (P3 – P1) - this is the greater part of the tax. The rest (P2 – P3) is paid by sellers

37. The Tax Incidence S2 Case 2: elastic demand and inelastic supply P D Government imposes an excise tax = t P2 S1 Sellers will be willing to sell the same Q if only someone else would pay the tax Supply shifts to S2 t P3 Demand is elastic And buyers will not want to buy Q1 at the higher price P2 P1 Buyers are willing to buy Q2 < Q1 The shortage Q2 – Q1 will push the Price down to a new equilibrium Q2 Q3 Q Q1 Tax = P2 – P1. Buyers pay (P3 – P1) - this is the smaller part of the tax. The rest (P2 – P3) is paid by sellers