Economics for CED

1. Economics for CED Noémi GiszpencSpring 2004Lecture 4: Micro: Supply and Demand March 16, 2004

2. What’s demand again? • Back in lecture 2, we learned where effective demand comes from: individuals equating the marginal utility of goods to the market price of goods • In general, a change in prices affected quantity demanded, depending on • Good being normal or inferior • Elasticity • Income • Substitutability of other goods • Durability of good (time factor) Economics for CED: Lecture 3, Noémi Giszpenc

3. How does demand add up? • In a population, if there are many different people with demand, all of these individual demands add up to one Market Demand. • Additional demand will tend to make Market Demand more elastic--the bigger the market, the more elastic. Economics for CED: Lecture 3, Noémi Giszpenc

4. 20 10 15 10 5 5 0 9 7 5 3 1 21 19 17 15 13 11 0 9 7 5 3 1 21 19 17 15 13 11 A simple demonstration Individual demands… to market demands. Economics for CED: Lecture 3, Noémi Giszpenc

5. OK, so what’s supply again? • Firms’ willingness to sell depends a lot on the firms’ costs. • In general, firms will wish to maximize profit, which they do by producing at the point where marginal revenue (which for price-takers works out to be market price) equals marginal cost. • (As long as the price is above the average cost of production.) Economics for CED: Lecture 3, Noémi Giszpenc

6. What happens when they meet? • Equilibrium! • Buyers demand a certain quantity at a certain price • Sellers provide that quantity at that price • Such a price allows supply to match demand • No one who would like to make a mutually beneficial trade is left out • Many who would have paid more or sold for less get a bargain (this is called consumer and producer surplus) • When this happens in many markets (for many goods), it is called general market equilibrium Economics for CED: Lecture 3, Noémi Giszpenc

7. Here is what it looks like: Price Consumer surplus Supply(willingness to sell) Peq Demand (willingness to buy) Producersurplus Qeq Quantity Economics for CED: Lecture 3, Noémi Giszpenc

8. Is market equilibrium efficient? • The satisfaction buyers derive from the last dollar’s worth of each good equals the last dollar’s worth bought of every other good • The goods are sold at marginal cost, meaning the last dollar spent producing each good brings the same return as the last dollar spent producing the other goods. • Land, labor and capital are put to uses that most efficiently satisfy customers’ preferences Economics for CED: Lecture 3, Noémi Giszpenc

9. Fundamental principle of microeconomics • IF all goods, services and resources are paid for by those who benefit from them • AND the payment is at P-competitive equilibrium prices (more on this later) • THEN output quantities are efficient • Externalities or lack of competition undermine these assumptions • Also, efficiency may not be society’s goal Economics for CED: Lecture 3, Noémi Giszpenc

10. “…to the extent that the markets work efficiently, producers supply the effective demands that arise from the distribution of spending power. That use of the available resources can only be as good, socially speaking, as you believe the distribution of spending power to be.” --Hugh Stretton, Economics: A New Introduction, p. 486 Economics for CED: Lecture 3, Noémi Giszpenc

11. How do we know it’s equilibrium? • If the price is below Peq, there is excess demand. • Buyers will compete against each other and bid up the price • If the price is above Peq, there is excess supply. • Sellers will compete to sell by lowering price Economics for CED: Lecture 3, Noémi Giszpenc

12. How does the price move? • There can be movements along a supply or demand curve • A change in quantity leads to a change in price, or a change in price leads to a change in quantity • There can be shifts in the supply or demand curves • Think of these as movements right or left, not up or down • Caused by changes in tastes, technology, costs (prices of inputs, natural conditions), income, population, expectations, prices of other goods… Economics for CED: Lecture 3, Noémi Giszpenc

13. The carrot example • People grow fonder of carrots • Demand curve shifts right, causing movement along supply curve to reach new equilibrium in short run • Genetic super-carrots grow faster • Farmers’ costs fall--they increase volume and drop prices until price=MC: a shift right in the supply curve • People get bored again of carrots Economics for CED: Lecture 3, Noémi Giszpenc

14. A graph of the carrot example S1 S2 price of carrots E1 E2 E0 D2 E3 D1 bushels of carrots Economics for CED: Lecture 3, Noémi Giszpenc

15. What usually happens when demand increases • Producers, wholesalers and retailers meet the increased demand by running down inventories, without price changes • If new capacity is ready when stores run out, demand continues to be met; otherwise prices rise to ration existing product or attract imports • When new capacity ready, if unit costs are same, prices return to former levels, or fall further if there are new economies of scale Economics for CED: Lecture 3, Noémi Giszpenc

16. Is market equilibrium real? • Depends on the market. • Some markets clear very rapidly • (e.g. international currency exchanges) • Others have big lags and imbalances • (e.g. software engineering labor) • Adjustment time is a huge potential factor Economics for CED: Lecture 3, Noémi Giszpenc

17. “interference” in the market: tax • What happens to supply and demand when a tax is imposed? • Say, a per-quantity (excise) tax Price that buyer “sees” tax S p } p’ Price that seller “sees” D D’ Economics for CED: Lecture 3, Noémi Giszpenc

18. Loss of efficiency / well-being • In the tax example, assuming all costs were being accounted for, society lost something: “dead-weight loss.” C.S. S p p’ P.S. D governmentrevenue from tax D’ Economics for CED: Lecture 3, Noémi Giszpenc

19. “interference” in the market: subsidy • A subsidy is a payment to the producer per unit of production--it works exactly like the excise tax but in reverse Price that seller “sees” subsidy S p } S’ p’ Price that buyer “sees” D Economics for CED: Lecture 3, Noémi Giszpenc

20. What’s wrong with this picture? • Can you spot the extra cost to society? Cost to government of subsidy S p S’ p’ D Economics for CED: Lecture 3, Noémi Giszpenc

21. Then why taxes or subsidies? • Remember that quantities produced are efficient only if there are no (positive or negative) externalities. • Taxes reduce quantities--may be a way to “internalize” negative externalities • Subsidies increase quantities--may be a way to “internalize” positive externalities • If taxes are for revenue generation, better to impose them on goods with inelastic demand • Minimizes the amount that quantities are shifted Economics for CED: Lecture 3, Noémi Giszpenc

22. Conditions for perfect competition • Generally speaking, there are many alternatives available and known about • Specifically, the four conditions are • Many buyers and sellers • A homogenous (undifferentiated) product (e.g. wheat, steel) • Sufficient knowledge (more on this next week!) • Free entry of new firms • From legal point of view and • From cost point of view Economics for CED: Lecture 3, Noémi Giszpenc

23. P-competition • The P stands for perfect or pure, but also for “price.” • Remember that to achieve equilibrium, either excess buyers must bid up price or excess sellers must cut price • This competition assumes that all costs are included in calculation • Very unusual to have all features exist • But it is usual for most firms to be “price-takers” • They cannot affect market price; to them the demand curves are flat and perfectly elastic Economics for CED: Lecture 3, Noémi Giszpenc

24. Conditions of limited competition • For example, • Only one seller or buyer • Sellers or buyers collude not to compete • Price is fixed by law • Prices are not a good method of comparison (information problems) • buyers or sellers don’t know who else buys or sells item • buyers unsure of quality of item offered Economics for CED: Lecture 3, Noémi Giszpenc

25. 4 types of industries • Perfect/pure/price-competition • Monopoly (one seller) • Oligopoly (few sellers) • Monopolistic competition (differentiated products) • Latter three described in terms of how they deviate from the first, “ideal” industry Economics for CED: Lecture 3, Noémi Giszpenc

26. Features of P-competition • As mentioned above, firms in a p-competitive industry face a horizontal demand curve • In the short run, it may be possible to make economic profits, but with free entry, in the long run, economic profits always come back down to zero Economics for CED: Lecture 3, Noémi Giszpenc

27. Where monopolies come from • Patents and other intellectual property • Control of an input resource • Created by the government • Decreasing costs with scale (“natural monopoly”) • Crime Economics for CED: Lecture 3, Noémi Giszpenc

28. What does a monopoly do? • Maximize profits, of course. • Since it faces entire market demand, it is not a price-taker: its output decisions affect the price. Marginal revenue, in this case, is not simply the given price. • Profit = revenue - costsπ = pxQ - C(Q) = demand(Q)xQ - C(Q)to max. π, choose Q so dπ/dQ = 0same as saying so marg’l rev. = marg’l cost Economics for CED: Lecture 3, Noémi Giszpenc

29. What a monopolist’s decision looks like (Analysis does not depend on shape of MC curve) P PM MC Peq Demand P = 5 - 0.4Q QM Qeq Q Marginal revenue Economics for CED: Lecture 3, Noémi Giszpenc

30. Results of monopoly decisions Compared to a competitive equilibrium, • Quantity produced is less • Price is higher • There is inefficiency (“deadweight loss”) Economies of scale and “natural monopolies” may make p-competition more difficult, but people have been creative in creating competition Economics for CED: Lecture 3, Noémi Giszpenc

31. What’s an oligopoly? • From Greek, meaning “a few” sellers • “A few” means between 1 and many • The fewer, the more powerful Economics for CED: Lecture 3, Noémi Giszpenc

32. Four possible theories about oligopolist pricing • Total collusion among few oligopolists allows them to charge full monopoly price • All-out competition and distrust erodes economic profits down to 0, as in p-competition • Somewhere in between • Indeterminate--cannot be predicted Economics for CED: Lecture 3, Noémi Giszpenc

33. So what do oligopolists do? • Short answer: nobody knows for sure. • Difficult to predict theoretically, since behavior is strategic (takes into account predictions about others’ behavior) • Can be modeled using game theory • But are there repeat interactions? Collusion? How are payoffs structured? Economics for CED: Lecture 3, Noémi Giszpenc

34. What is monopolistic competition? • Deviates from p-competition only in that the industry’s products are not homogenous--they are differentiated. • the products may be (more or less) good substitutes, but they are not perfect substitutes • Competition occurs on features other than price--advertising is important Economics for CED: Lecture 3, Noémi Giszpenc

35. Industries may combine features • Oligopolists may engage in monopolistic competition • Examples: cars, breakfast cereals • See next slides for looooong list of questions to ask about an industry Economics for CED: Lecture 3, Noémi Giszpenc

36. The nature of the product • How durable or perishable is it? • How easy or difficult to store? • How cheap or dear to transport? • What home or foreign trade regulations apply to it? • From first four, is it tradeable or nontradeable? • Is it homogenous or differentiable (e.g. soap)? • Can buyers judge quality before buying, or get help? • What regulation (e.g. quality, safety, labeling) does the nature of the product attract? Economics for CED: Lecture 3, Noémi Giszpenc

37. The method of production • How long and/or complex is network of producers who contribute to production of the product? • What market strength do they have? • For what purposes do strong ones use strength? • Are there lead times affecting suppliers’ adjustment to demand? • Can producers be informed or communicate at the start of the lead time to regulate supply? • Is there fit or misfit between suppliers’ and buyers’ lead times? Economics for CED: Lecture 3, Noémi Giszpenc

38. The method of production (cont.) • Are there economies or diseconomies of scale? • Do these tend to produce large/small firms, monopolies, oligopolies? • Is there market power through means other than economies of scale? To what use is it put? • What regulations (e.g. safety, industrial relations, environmental care) does the method of production attract? • Are suppliers affected by anti-trust or fair-trading regulations? Economics for CED: Lecture 3, Noémi Giszpenc

39. Pricing and marketing • (repeat): is product homogenous or is there differentiation? • How do suppliers price it? Is there monopoly pricing anywhere in chain? • Is advertising worthwhile? How much does it add to price? • Is marketing affected by public consumer protection or price control? Economics for CED: Lecture 3, Noémi Giszpenc

40. The buyers • Where in spectrum between necessities and luxuries is the product? What alternatives are available? • Are buyers susceptible to advertising? • Can they judge quality and value of product? Can they, and do they, get expert help? • Does buying depend on credit? If so how much is available to them? • How much money do they have to spend? • Whose money do they spend? • For whose benefit do they spend it? • Do they have market strength, and do they use it? Economics for CED: Lecture 3, Noémi Giszpenc