Lecture 3 The Market Mechanism The Market Mechanism

Lecture 3 The Market Mechanism

The Market Mechanism l l Readings: Chapters 3

The Market Mechanism Between 1900 and 2000, productivity grew faster in agriculture than in any other sector of the economy. l Over the same period, productivity has only grown very slowly in the service sector. Q: Why has agricultural output hardly increased while the service sector has grown faster than any other sector? l

The Market Mechanism Services PPF: 1900 PPF: 2000 Agriculture

The Market Mechanism l l l As the PPF diagram on the last page shows it is possible for the technologically innovative sector to shrink and the low productivity sector to grow. Technological innovation in farming allowed resources to be released from farming and re -employed in services without much impact on farm output. Farm technology made possible the growth of the urban service sector.

The Market Mechanism Q: It made it possible, but why did it happen? l Agriculture has stagnated while services have grown because agricultural prices have fallen relative to other goods. Falling agricultural prices have caused massive social change: l l Productive resources moved out of agriculture into more profitable manufacturing and services. People have followed causing a mass migration from the countryside to the city A new urban centered economy has emerged. Urban consumers consume much more meat and fruit than their farming ancestors.

The Market Mechanism l l l Farmers have organized politically to resist these changes. While they have succeeded in forcing government to adopt subsidies and price controls to “stabilize” farm prices, they have failed slow the pace of change. The moral of this story is that understanding technology does not get you very far in understanding human society. Technology and politics may be powerful social forces, but the market forces that determine and alter relative prices are more powerful still.

The Market Mechanism Q: So what are these powerful market forces? l Demand Supply l l The forces of Demand Supply combine to generate prices that automatically cause the economy to move to a particular point on the PPF. Changes to Demand Supply will change relative prices and hence change where on the PPF society will find itself.

The Market Mechanism Q: What is demand? l For economists it is the relationship between price (independent variable) and the quantity of goods demanded (dependent variable) in a market. Q: What is a market? l Any place where people meet to communicate for the purpose of voluntary exchange. l l Newspaper Mall Internet Telephone Network

The Market Mechanism Q: What is fundamental to demand? l All demand relationships are governed by the Law of Demand which says that an increase in the relative price of a good causes the quantity demanded to fall. l Another way of putting this is to say that price and quantity demanded are inversely related. l The law does not specify the sensitivity of the quantity demanded to price changes, as this will vary from commodity to commodity.

The Market Mechanism Q: What is behind the Law of Demand? If the relative price of a commodity rises, then ceteris -paribus: Consumers will begin to substitute a cheaper alternative good in their shopping basket. This is called the substitution effect. 1. l For example, if the price of butter goes up people buy less butter and more margarine (a butter substitute). Consumers will feel poorer and generally consume fewer of most normal goods. This is called the income effect. 2. l For example, rising energy prices reduces disposable income, causing a reduction in restaurant purchases and all sorts of other unrelated products.

The Market Mechanism Q: How do we measure demand its social impact? Unfortunately demand is difficult to observe or measure. To deal with this problem, Alfred Marshall developed a model of demand that: l l l Can be applied to many commodities Allows general market principles to be understood Supports the task of observing and measuring demand by providing a framework for the statistical examination of market data to estimate the demand relationship in different markets

The Market Mechanism Q: What is Marshall’s model of demand? l l Demand Equation: The most basic model is the linear demand equation which represents the demand for each commodity using a simple equation: Qd = a - b • P Each commodity can be expected to have different values for “a” and “b” Empirical economists (econometricians) can estimate “a” and “b” using market data. For example, if an econometrician estimated that for potatoes, a=2500 and b=0. 1, then the demand for potatoes can be represented by: Qd = 2500 - 0. 1 • P

The Market Mechanism l Frequently the relationship is represented by a graph of the equation called the Demand Curve.

The Market Mechanism Q: What extreme simplification was used in constructing the demand equation and its graph (the demand curve)? l It was assumed that the relationship is linear, which is unlikely to be strictly true. l Despite this simplification it can be a useful model because it may be approximately true over certain intervals of the graph. l More complex models can be estimated using market data which yield non-linear graphs.

The Market Mechanism Q: What is strange about the Marshallian Demand curve? l l The independent variable is on the vertical axis, while the dependent variable is on the horizontal axis. This is opposite to the convention in physics and chemistry. Graphing developed in Economics at about the same time as in the physical sciences. Alfred Marshall’s choice to put the independent variable on the vertical axis has become a convention in economics for demand supply relations. Other economic relationships are graphed with the independent variable on the horizontal axis.

The Market Mechanism l l l This creates difficulties for students drawing the graph of a demand equation. To avoid this problem, rewrite the linear demand equation: Qd = a - b • P = a - Qd P = (a/b) - (1/b) • Qd This inverse demand equation has the: l l l intercept of the vertical price axis = (a/b) intercept of the horizontal quantity axis = a slope is -(1/b). With a little thought you can see that intercept of the horizontal axis is “a”.

The Market Mechanism A model of demand cannot explain market outcomes, as it just describes the response of consumers to changes in market prices. Q: What is missing from our model of market behaviour? l A model of how sellers (or producers) respond to market prices. l Alfred Marshall’s model of these social forces is called Supply.

The Market Mechanism Q: What is Supply? l For economists it is the relationship between price (P, the independent variable) and the quantity of goods supplied (QS, the dependent variable) to a market. l Q: What is fundamental to Supply? l The Law of Supply: an increase in the relative price of a good causes the quantity supplied to rise (P and QS are directly related).

The Market Mechanism Q: What is Marshall’s model of supply? l l Supply Equation: The most basic model is the linear supply relationship which can be represented by: Qs = c + d • P Each commodity can be expected to have a different value for “c” and “d” Econometricians can go out and estimate “c” and “d” using market data. If an econometrician estimates that c=1000 and d=0. 05 for potatoes, then the supply equation for potatoes is: Qs = 1000 + 0. 05 • P

The Market Mechanism l The graph of the supply equation is called the Supply Curve:

The Market Mechanism Q: How do consumers and producers interact in the marketplace? Q: Where do market prices come from, and what causes them to change? Q: What determines the amount of each commodity produced and sold in the marketplace, and what causes this to change? Q: Can we predict how change will affect market prices and quantities? To answer each of these questions, simply put our models of Demand Supply together.

The Market Mechanism l Market Surplus Price will fall

The Market Mechanism l Market Shortage Price will rise

The Market Mechanism l l l We now have an answer for why prices change. Whenever the Quantity Supplied is larger than the Quantity Demanded (Qs > Qd) there is a market surplus and prices will adjust down. Whenever the Quantity Supplied is smaller than the Quantity Demanded (Qs < Qd) there is a market shortage, and prices will adjust up.

The Market Mechanism Q: Will prices ever stop changing? l Prices will change predictably when there is a shortage or a surplus. Whenever there is no shortage or surplus, there is no social pressure on prices to change. l When there is no shortage or surplus (Qs = Qd), the market is in equilibrium.

The Market Mechanism Q: How do we find the market equilibrium? l Equilibrium occurs where the demand supply curves intersect one another.

The Market Mechanism How do you find market equilibrium using demand supply equations? Class Exercise: Find the market equilibrium if Qs = 1000 + 0. 05 • P and Qd = 2500 - 0. 1 • P

The Market Mechanism What will cause the market equilibrium price and quantity to change? l If demand or supply change, then the equilibrium will change. Does our model allow us to make qualitative predictions concerning the impact of Demand (D) and Supply (S) Changes? l A Theory of Comparative Statics: l l D ↑ P ↑ and Q ↑, while D ↓ P ↓ and Q ↓ S ↑ P ↓ and Q ↑, while S ↓ P ↑and Q ↓

The Market Mechanism l l To prove this theory, we begin by defining what a change in demand supply means. An increase in demand causes the quantity demanded to increase at every price P. This is equivalent to saying that: l l An increase in Demand (D) causes Demand to shift right. By similar logic: l l l A decrease in Demand (D) causes Demand to shift left. An increase in Supply (S) causes Supply to shift right. A decrease in Supply (S) causes Supply to shift left.

The Market Mechanism l Example: D↑ demand curve shifts right P↑ and Q↑ to reach new equilibrium

The Market Mechanism l Example: S↑ supply curve shifts right P↓ and Q↑ to reach new equilibrium

The Market Mechanism l As an exercise use the graphical model of demand supply to determine the impact on P and Q of : l l l l 1. 2. 3. 4. 5. 6. Decrease in Supply Decrease in Demand Increase in D combined with an increase in S Decrease in D combined with a decrease in S Increase in D combined with decrease in S Decrease in D combined with an increase in S Note that in 3 and 4, there is a predictable impact on Q but unpredictable impact on P, while the reverse is true for 5 and 6.

The Market Mechanism What causes demand to change? l Demand will change if: l l l l 1. 2. 3. 4. 5. 6. Price of a complement changes. Price of substitute changes. Income changes. (Normal and Inferior goods) Expectations about the future price changes. Population changes. Preferences change from new information. If any of these things change, then the demand curve will shift and a new equilibrium emerges.

The Market Mechanism l Example: What happens to the Kraft Dinner (KD) market if the price of milk rises? l Milk is a complement to KD in consumption. A rise in the price of an important complement will reduce demand for KD Equilibrium P and Q fall.

The Market Mechanism Example: What happens to the KD market if a recession causes student incomes to fall? l KD is an inferior good. Decreasing income means that will cause D↑ which causes P↑ and Q↑.

The Market Mechanism What happens to the gasoline market if consumers hear a rumour that gas prices will go up next week? l Consumers will increase their demand for gas this week which in turn will immediate cause prices to rise - making the belief a self fulfilling expectation. l This shows how important expectations are to the operation of markets. l Exercise: Draw a diagram showing how the increase in Demand drives both P and Q up.

The Market Mechanism What happens to the rental housing market in London if the University grows by 2, 000 students? l D↑ P↑ and Q↑ (exercise: draw diagram) What happens to the butter market if the price of margarine falls? l Margarine is a substitute of butter so a decrease in the price of margarine causes butter consumers to substitute out of butter into margarine. This causes D↓ P↓ and Q↓ in the butter market.

The Market Mechanism New research indicates that the red colour of tomato products are important anti-cancer agents. This new information will do what to the tomato market? l D↑ P↑ and Q↑ The economic boom from 1994 -2008 lifted incomes. What was the impact of these changes on the market for SUV’s? l SUV’s are normal goods, therefore: income↑ D↑ P↑ and Q↑ The current recession has caused incomes to fall and has caused the price of gasoline to fall, what will be the impact of these changes on the market for SUV’s? l Exercise

The Market Mechanism l It is essential to distinguish between a Change in the Quantity Demanded Versus a Change in Demand

The Market Mechanism l. A Movement along the Demand Curve l. When the price of the good changes and everything else remains the same, the quantity demanded changes and there is a movement along the demand curve.

The Market Mechanism l. A Shift of the Demand Curve l. If the price remains the same but one of the other influences on buyers’ plans changes, demand changes and the demand curve shifts.

The Market Mechanism What causes Supply to change? l Supply will change if there are changes to: l l l l Prices for factors of production (wages, interest, etc. ) Prices of complements in production. Expected future prices. Number of firms supplying the marketplace. Technology. Weather If any of these things change, then the supply curve will shift.

The Market Mechanism l Example: What happens to the automobile market if autoworker wages rise? l Higher wages causes supply to decline (shift left), which in turn drives prices up and quantity down.

The Market Mechanism l l Example: A housing boom is expected to cause the demand for leather furniture to increase, which will in turn cause the price of leather to rise. What is the likely impact of these changes on the Beef market? Beef and leather are complements in production. Therefore a rise in the price of leather (ceteris paribus) will increase the production of cattle, and hence increase the supply of beef. An increase in the supply of beef will cause the price to fall as the quantity purchased rises.

The Market Mechanism l l l Example: A frost in California destroyed 40% of the orange crop in 1998 S↓ P↑, Q↓ Example: A new computer manufacturer enters the computer market S↑ P↓, Q↑ Example: OPEC reduced its supply of oil causing the price of crude oil to rise. The gasoline market is effected because crude oil is a key factor input. Rising factor prices Sgas↓ Pgas↑ and Qgas↓

The Market Mechanism l Exercise: More Canadians are going to university than ever before. Ceteris Paribus, what will this do to the wages of University graduates?

The Market Mechanism l l It is essential to understand the difference between a Change in the Quantity Supplied Versus a Change in Supply Figure 3. 6 illustrates the distinction between a change in supply and a change in the quantity supplied.

The Market Mechanism l. A Movement Along the Supply Curve l. When the price of the good changes and other influences on sellers’ plans remain the same, the quantity supplied changes and there is a movement along the supply curve.

The Market Mechanism l. A Shift of the Supply Curve l. If the price remains the same but some other influence on sellers’ plans changes, supply changes and the supply curve shifts.

The Market Mechanism If the demand for computers has risen over the last 20 years, why has the price for computing power fallen? l Because supply grew even faster.

The Market Mechanism How good is the Demand Supply model? It is very useful for a simple model, but it can be imprecise. To be more precise we need to consider extending the model in important ways: l l l 1. From Partial Equilibrium to General Equilibrium 2. From Short-Run Equilibrium to Long-Run Equilibrium 3. From comparative statics to market dynamics

The Market Mechanism 1. From Partial to General Equilibrium l l l The Demand-Supply model considers only one market in isolation (partial equilibrium analysis). Change effecting one market is likely to spillover into other markets, which can have great social importance. We need to develop a model that looks at both the immediate impact of change and the subsequent spillover into other markets (general equilibrium analysis).

The Market Mechanism l Example: Orange crop failure in California. Higher orange prices cause people to substitute into apple consumption, driving up apple prices.

The Market Mechanism 2. From Short-Run to Long-Run Equilibrium l l The supply curve shows the relationship between price and quantity supplied. This relationship is often different in the short-run than in the long-run. In the short-run, many producers are only able to increase their output by a little bit if prices rise. In the long-run, producers usually have more flexibility to respond to changes in prices.

The Market Mechanism l Example: Suppose that in July, the Canadian Wheat-Board finds a foreign buyer willing to pay a higher price than producers expected. l l In the short-run, farmers cannot respond quickly because their crop is in the ground. Over the long-run, farmers can seed larger acreages to take advantage of the higher prices.

The Market Mechanism From Short-Run Equilibrium to Long-Run Equilibrium

The Market Mechanism 3. From comparative statics to market dynamics l In our partial equilibrium model of demand supply, we assumed that the market quickly adjusts from one equilibrium to another. Q: Is this true in all markets? l There is substantial evidence that labour markets have difficulties in adjusting from one equilibrium to another. For example, recessions drive the demand for labour down, but wages appear to be sticky, causing unemployment to rise.

The Market Mechanism From comparative statics to market dynamics

The Market Mechanism Next Lecture: Elasticity (Chapter 4)