Fundamentals of Markets

1. Fundamentals of Markets

2. Opportunity for buyers and sellers to: compare prices estimate demand estimate supply Achieve an equilibrium between supply and demand Let us go to the market...

3. Price One apple for my break Take some back for lunch Enough for every meal Home-made apple pie Home-made cider? Quantity How much do I value apples? Consumers spend until the price is equal to their marginal utility

4. Aggregation of the individual demand of all consumers Demand function: Inverse demand function: Price Quantity Demand curve

5. Slope is an indication of the elasticity of the demand High elasticity Non-essential good Easy substitution Low elasticity Essential good No substitutes Electrical energy has a very low elasticity in the short term Price Quantity Elasticity of the demand Price High elasticity good Quantity Low elasticity good

6. Elasticity of the demand • Mathematical definition: • Dimensionless quantity

7. Supply side • How many widgets shall I produce? • Goal: make a profit on each widget sold • Produce one more widget if and only if the cost of producing it is less than the market price • Need to know the cost of producing the next widget • Considers only the variable costs • Ignores the fixed costs • Investments in production plants and machines

8. How much does the next one costs? Cost of producing a widget Total Quantity Normal production procedure

9. How much does the next one costs? Cost of producing a widget Total Quantity Use older machines

10. How much does the next one costs? Cost of producing a widget Total Quantity Second shift production

11. How much does the next one costs? Cost of producing a widget Total Quantity Third shift production

12. How much does the next one costs? Cost of producing a widget Total Quantity Extra maintenance costs

13. Price or marginal cost Quantity Supply curve • Aggregation of marginal cost curves of all suppliers • Considers only variable operating costs • Does not take cost of investments into account • Supply function: • Inverse supply function:

14. Price Supply curve Willingness to sell market equilibrium market clearing price Demand curve Willingness to buy Quantity volume transacted Market equilibrium

15. Supply and Demand Price supply equilibrium point demand Quantity

16. Sellers have no incentive to sell for less Buyers have no incentive to buy for more Price supply market clearing price demand Quantity volume transacted Market equilibrium

17. Price Quantity Centralized auction • Producers enter their bids: quantity and price • Bids are stacked up to construct the supply curve • Consumers enter their offers: quantity and price • Offers are stacked up to construct the demand curve • Intersection determines the market equilibrium: • Market clearing price • Transacted quantity

18. Price supply Extra-marginal demand Infra- marginal Quantity Marginal producer Centralized auction • Everything is sold at the market clearing price • Price is set by the “last” unit sold • Marginal producer: • Sells this last unit • Gets exactly its bid • Infra-marginal producers: • Get paid more than their bid • Collect economic profit • Extra-marginal producers: • Sell nothing

19. Bilateral transactions • Producers and consumers trade directly and independently • Consumers “shop around” for the best deal • Producers check the competition’s prices • An efficient market “discovers” the equilibrium price

20. Efficient market • All buyers and sellers have access to sufficient information about prices, supply and demand • Factors favouring an efficient market • number of participants • Standard definition of commodities • Good information exchange mechanisms

21. Examples • Efficient markets: • Open air food market • Chicago mercantile exchange • Inefficient markets: • Used cars

22. Price 15¢ Consumer’s surplus 10¢ Total cost 5 Quantity Consumer’s Surplus • Buy 5 apples at 10¢ • Total cost = 50¢ • At that price I am getting apples for which I would have been ready to pay more • Surplus: 12.5¢

23. Price Price supply supply π Profit demand demand Cost Quantity Quantity Revenue Economic Profit of Suppliers • Cost includes only the variable cost of production • Economic profit covers fixed costs and shareholders’ returns

24. Price supply demand Quantity Social or Global Welfare Consumers’ surplus + Suppliers’ profit = Social welfare

25. π supply demand Q Market equilibrium and social welfare Operating point π supply Welfare loss demand Q Market equilibrium • Artificially high price: • larger supplier profit • smaller consumer surplus • smaller social welfare

26. π supply demand Q Market equilibrium and social welfare Welfare loss π supply demand Operating point Q Market equilibrium • Artificially low price: • smaller supplier profit • higher consumer surplus • smaller social welfare

27. What’s “the price”? • Price = marginal revenue of supplier = marginal cost of supplier = marginal cost of consumer = marginal utility to consumer • Market price varies with offer and demand: • If demand increases • Price increases beyond utility for some consumers • Demand decreases • Market settles at a new equilibrium

28. What’s “the price”? • If demand decreases • Price decreases • Some producers leave the market • Market settles at a new equilibrium • In theory, there should never be a shortage

29. Price vs. Tariff • Tariff: fixed price for a commodity • Assume tariff = average of market price • Period of high demand • Tariff < marginal utility and marginal cost • Consumers continue buying the commodity rather than switch to another commodity • Period of low demand • Tariff > marginal utility and marginal cost • Consumers do not switch from other commodities

30. Concepts from the Theory of the Firm

31. y x2 fixed x1 fixed x1 x2 Production function • y: output • x1 , x2: factors of production y Law of diminishing marginal products

32. Long run and short run • Some factors of production can be adjusted faster than others • Example: fertilizer vs. planting more trees • Long run: all factors can be changed • Short run: some factors cannot be changed • No general rule separates long and short run

33. Input-output function fixed Example: amount of fuel required to produce a certain amount of power with a given plant The inverse of the production function is the input-output function

34. Short run cost function • w1, w2: unit cost of factors of production x1, x2

35. Short run marginal cost function Convex due to law of marginal returns Non-decreasing function

36. Optimal production • Production that maximizes profit: Only if the price πdoes not depend on yperfect competition

37. Production cost [$] Quantity Costs: Accountant’s perspective • In the short run, some costs are variable and others are fixed • Variable costs: • labour • materials • fuel • transportation • Fixed costs (amortized): • equipments • land • Overheads • Quasi-fixed costs • Startup cost of power plant • Sunk costs vs. recoverable costs

38. Average cost Production cost [$] Average cost [$/unit] Quantity Quantity

39. Marginal vs. average cost MC AC $/unit Production

40. When should I stop producing? • Marginal cost = cost of producing one more unit • If MC > π next unit costs more than it returns • If MC < π next unit returns more than it costs • Profitable only if Q4 > Q1because of fixed costs Average cost [$/unit] Marginal cost [$/unit] π Q1 Q3 Q2 Q4

41. Opportunity cost • Use money to grow apples or to grow cherries? • If profit from growing cherries is larger than the profit from growing apples, growing apples has an opportunity cost • Use money to grow apples or put it in the bank where it earns interests? • Profit from growing apples must be larger than bank interest because putting money in the bank has a lower risk • Profit from a business must be compared against the “normal profit”, i.e. what putting money in the bank would bring

42. Costs: Economist’s perspective • Opportunity cost: • What would be the best use of the money spent to make the product ? • Not taking the opportunity to sell at a higher price represents a cost • Examples: • Use the money to grow apples or put it in the bank where it earns interests? • Growing apples or growing kiwis? • Comparisons should be made against a “normal profit” • What putting money in the bank would bring • Selling “at cost”means making a “normal profit” • Usually not good enough because it does not compensate for the risk involved in the business