Economics for Educators

Transcription

1 Economics for Educators Lesson 6 and 5E Model Revised Edition Robert F. Hodgin, Ph.D.

2 ii Economics for Educators, Revised Copyright 2012 All Rights Reserved

3 30 Economics for Educators, Revised Lesson 6: How Markets Coordinate Exchange Exchange Creates Wealth People trade because when they do, the wealth of both buyer and seller increases. Some regard that statement skeptically because trade carries a poor connotation. Should trade between two people not be an exchange of equals? Some people are wedded to the idea that only material things like property, cars, or gold constitute wealth. Neither sentiment is correct to an economist. Wealth gets confused with material well-being as opposed to perceived value, the preferred and far more useful economic idea. Consider that no object is wealth unless someone values it. An object s value is entirely subjective, and it depends solely on the willingness of admirers to sacrifice something to acquire it. Once that idea about value is accepted, it becomes clear that exchange occurs when there is a tradable difference in a good s value providing an increase in wealth to each party in the transaction. Information also is a good that has value. Because economic actions are undertaken based on expectations about the future and the future is never certain. A used car purchase, for example, may look superficially worthy. Once acquired, latent defects could surface to reduce or destroy the value anticipated by the buyer prior to the exchange. Buyer and seller possess unequal amounts of information, and the seller often holds the favored position. Acquiring additional information has an economic value as well as a cost. This difference in information between buyer and seller may affect negotiating power and the outcome of the exchange. Market Price as a Signal Much like the two cutting blades on a pair of scissors, price in the market place is determined by the interplay between supply and demand. Market actors buyers and sellers can efficiently exchange private goods because market price serves as a signal, telling those wanting the good the size of the sacrifice opportunity cost others have paid to acquire it. A market exists anywhere a transaction between buyer and seller occurs. Free and competitive markets efficiently allocate goods and services through an anonymously determined market price reflecting substitutes available to buyers and the expectations of sellers, at a particular moment. Market equilibrium price works as a beacon, coordinating the choices of buyer and seller by providing at least one measure of a good s current worth the market s value. That value turns away those buyers seeking less expensive options and those sellers whose production costs are too high, while attracting others who may be more able to find a favorable price for the exchange. The more open, competitive and informed the market s bargaining processes, the more efficient is the allocation of relatively scarce private goods. In economics, efficiency implies several things. Most fundamentally, it means that goods are sold at a price equal to opportunity cost. Efficiency also means that goods flow to their most highly valued use.

4 31 Economics for Educators, Revised The lower the transaction costs costs of arranging transactions between buyer and seller the more efficient is the market. The clearer and more accepted the property rights what belongs to whom under what circumstances the more efficient is the market. You can see how the efficiency mantra pervades all aspects of production, exchange and distribution in economics. Choices and Trade-offs at the Margin To the untrained eye, market processes can appear chaotic and directionless. Using economics fundamental division, buyers versus sellers, then separating time into current and future periods, allows market dynamics to make sense. In the chart below, market demand (in blue) slopes down to the right and market supply (in green) slopes up to the right, the two lines cross at a quantity of 5 units. To the right of their intersection, both curves are dotted to suggest that no transactions can occur there. The only area where transactions can logically occur is in the reddish-silver triangular area bounded by the solid blue upper range of the demand curve and the solid red lower range of the supply curve up to their intersection. Why is this so? The reddish-silver triangular area is the only place where a potentially negotiable price is both below the maximum demand price for some buyers and above the minimum opportunity supply cost for some sellers. Buyers know their maximum value price for a good and wish to pay that price or less. Sellers know the minimum opportunity costs of bringing the good to market and wish to get that price or more.

5 32 Economics for Educators, Revised The intersection of the demand and supply schedules reveals the market equilibrium price, where the quantity demanded just equals the quantity supplied. While competitive market exchanges tend toward an equilibrating price that will clear the market of goods, not all prices negotiated between buyers and sellers will be at the equilibrium amount. Any transaction completed in the reddish-silver triangular area will be for a price no higher than some buyer s maximum value and no lower than some supplier s minimum cost. Higher equilibrium prices indicate that sellers held the stronger bargaining position and lower equilibrium prices indicate that buyers held the stronger position in the market. Now look once more at the point of equilibrium in the graph where the demand and supply curves meet. At that point it can be said that the price of the good reflects the opportunity value of the last purchaser and, at the same instant, the opportunity cost of the last seller in that market. Someone did purchase the 5 th unit of the good at the equilibrium price. For that buyer the sacrifice was just worth the exchange. Also as clearly, some producer sold the good at the market equilibrium price. For that producer the sale just covered all production opportunity costs including a minimum profit. For all units of the good sold at that particular equilibrium, and at that time, market value just equaled the opportunity cost value to the last buyer and to the last seller. Other buyers in the market place held different and higher values for the good. Other sellers in the market place held different and lower opportunity costs of production for the good. Some buyers could have paid less than market equilibrium price and reaped the extra value. Some sellers could have sold for more than market equilibrium price and reaped the extra profits. Equilibrium Responses to Non-price Changes So far this discussion has focused on the short run time period where current market price reflects the quantity demanded and the quantity supplied. What happens to equilibrium price when non-price market forces cause demand or supply to shift? Three steps to assess equilibrium effects of market change Determine if the force affects the demand or the supply curve Decide the direction the curve shifts increase (rightward) or decrease (leftward) Note the change in equilibrium price and quantity from the original demand and supply curve intersection to the resulting demand and supply equilibrium. From the facts given in a situation, the first step means to determine if the market force pertains to buyers the demand side, or to producers the supply side. Next, reason through which particular force is at work for that side of the market, then note its direction. Shift the demand or supply curve in the appropriate direction increases to the right or decreases to the left. Finally, compared to the original equilibrium price and quantity, note the position of the new equilibrium price and quantity.

6 33 Economics for Educators, Revised Inspect the chart above. See how the current market demand schedule (in blue) and the current market supply schedule (in green) together determine the market equilibrium Price (= $5) and quantity (= 5 units) for a good. Now suppose that buyers believe the future market price of the good will increase, and that sellers perceive the same thing to be true. What will happen to market equilibrium price and why? Step 1: How to shift demand? Recall when buyers believe prices will rise in the future they tend to buy more now, at all current prices. That is an INcrease in demand, a shift to the right from the blue demand to the dotted blue demand curve, labeled B. Step 2: How to shift supply? Suppliers will want to restrict current supply (if the good is not perishable) and sell later at the higher expected price. That is a DEcrease in supply, a shift to the left from the green supply to the dotted green supply curve labeled A. Step 3: What is the effect on equilibrium price and quantity? The blue demand has increased to the now higher demand (more units are demanded at each price) labeled B. The green supply has decreased to the now lower supply (fewer units are supplied at each price) labeled A. The increased demand and decreased supply together raise the market equilibrium price to $7 and lower the equilibrium quantity to 4.5 units. When both demand and supply shift, it is necessary to work through the logic to correctly determine the effect on the resulting equilibrium price and quantity in the market.

7 34 Economics for Educators, Revised In Sum Trade creates wealth because both parties perceive a gain in a voluntary exchange. An economic good provides wealth only to someone who values it. A market exists anywhere an exchange transaction occurs. The forces of supply and demand working together efficiently determine market equilibrium price when: o Competitive markets tend toward an equilibrium price one that clears the market, and o Many buyers and sellers exist to bargain freely when market information and mobility costs are low o Property rights what belongs to whom under what conditions are known and respected o Transactions costs the costs of completing a transaction are low Efficient markets in economics means: o Goods are produced at their opportunity cost and exchanged for their perceived value o Goods flow to their highest valued use o Market exchanges occur when the buyer s maximum willing price exceeds the seller s minimum offer price. o Market equilibrium is a tendency where the exchange price for the last buyer and last seller in that market are equal. Non-price market forces shift either the demand or supply curve and alter the market equilibrium price and quantity. Starting from a given demand and supply intersection with a given equilibrium price and quantity, the following are true: o Increased demand (supply constant) a rightward shift, increases both equilibrium price and quantity. o Decreased demand (supply constant) a leftward shift, decreases both equilibrium price and quantity. o Increased supply (demand constant) a rightward shift, decreases equilibrium price and increases equilibrium quantity. o o Decreased supply (demand constant) a leftward shift, increases equilibrium price and decreases equilibrium quantity. Mixed movements in demand and supply must be determined using the facts in the problem statement. Equilibrium price and quantity can rise, fall or stay the same.

8 35 Economics for Educators, Revised Lesson 7: Competition, Market Power and Economic Efficiency Market Power and the Structure of Industry The economics of industry is about market power the power to set product price, gain market share and improve profits. The study of economic welfare, where the social goal is to efficiently solve the economic problem for all citizens prefers competitive markets above all others. For it is only purely competitive producers, due to their individual powerlessness to affect price, that offer society the most output at no more than the opportunity cost to produce it as firms pursue profit maximization. In stark contrast, monopolistic markets permit the ruling firm to restrict output and raise the price for their production as they search for the price, above opportunity cost, that maximizes their profit. Between the polar market structures of competition and monopoly lie two others: monopolistic competition a blend of competitive extremes; and oligopoly a peculiarly postured industry where a few large firms strategically spar for market share in game-like fashion. Competition s Efficiency Promise Perfect competition is a fiction, though a highly useful one. It serves as an ideal against which to compare diversions from the economically desirable position of maximum efficiency and output. Much of competition s value rests in its ability to show just how far from the ideal other market solutions may lie. Many public policies also can be judged against their progress toward reaching selected competitive criteria. Since perfect competition resides only in the economist s mind, what does it look like and what is its logic? The industry characteristics that create this idealized market structure include the following: very many buyers and sellers; identical products; costless entry into and exit from the market; perfect market information and costless market mobility. These characteristics combine to form a market where no one actor buyer or seller or small group of actors can influence market equilibrium results. Competitors have no price-setting power. The market for selling and buying corn comes close to these requirements. Fast, faceless and efficient exchanges work through market demand and supply to achieve an equilibrium price that clears the market. So powerless is each competitive seller to affect market price that they can only accept the established equilibrium price as the per unit revenue they will receive for selling their product. Effectively, their demand curve is horizontal (completely elastic). The result is that the only decision a producer needs to make for a current cycle is to choose the level of production.

9 Engage Demand Lesson 6: How Markets Coordinate Exchange, page What is a product you really wish to purchase but lack the funding? 2. What are the characteristics you seek in the product? 3. What would you really like to pay? 4. What is a realistic price do you want to pay and why? Page 20 Supply 5. You are a supplier of that product. What characteristics would you provide at various prices? Why? 6. What would you REALLY like to charge for the product? As a seller what price would be a fair one for your business investments that would attract buyers? The answers will vary. The answers will vary, but be sure to stress that suppliers want to charge higher prices to increase their profits and that there are prices that are too low to accept when costs are not covered. Explore View the graph below to answer the next three questions. Where does your #3 price from questions above fall? Where does your #6 price from questions above fall? What is the equilibrium price that will allow the buyer and seller to come to an agreement? (#4 and # 7 from questions above) #3 Willing buyers but no sellers. #6 Willing sellers but no buyers. #4 and #7 will meet at the big equilibrium point at $5 market price and 5 quantity bought and sold. This is sometimes called the marriage of supply and demand Allen Parkway * Houston, TX * (713) * Fax: (713) tcee@economicstexas.org *

10 Explain In viewing the graph, describe the four quadrants and explain why the buyers and sellers react the way that they do. Top area: The price is too high for buyers but would reap greater profit for the seller OR the opportunity to spend more on factors of production. Page 21 Right area: The price is too low for sellers to make a profit or too high for the buyers to pay for the true value of the product. Bottom area: The price is very low and would be pleasing to the buyer but the seller cannot cover expenses. Left area: The middle area of the left area represents a price that a buyer would consider fair and the seller would be able to justify. Extend Choose a product that you buy on a regular basis. What market forces would cause you to buy more or less of the item? What market forces would cause the seller to supply the product at a lower price than their equilibrium price? Higher price? As a buyer the product may have gone on sale or the perceived future price has increased. A new product with improved, better and/or newer features has entered the market or will soon. Buyers may reduce their demand for the current product and suppliers may restrict their production. Technology for production of the product has become more economical so the supplier can supply more at a lower price. The supplier could restrict the quantity of goods on the market to maintain a higher price Allen Parkway * Houston, TX * (713) * Fax: (713) tcee@economicstexas.org *

11 Evaluate Choose a product you would like to produce. Research the cost of the factors of production. Develop a budget and a projected price you feel is fair for you and for the buyer. Create a PowerPoint show with slides that show your product, the cost of factors of production and your source for information, a budget, supply and demand chart showing equilibrium, and a marketing slide to convince consumers that yours is the best product for the best price on the market. Page 22 Rubric: 10 points Creativity of PowerPoint 10 points Prototype of product 30 points Cost of Factors of Production 10 points Sources 20 points Graph showing equilibrium and explanation 20 points Marketing 1801 Allen Parkway * Houston, TX * (713) * Fax: (713) tcee@economicstexas.org *

12 The (TCEE) thanks the Council for Economic Education and the Department of Education Office of Innovation and Improvement for awarding the Replication of Best Practices Program grant that allowed Economics for Educators, Revised Edition to be written and published. The also thanks six of its major partners whose support allows TCEE to provide the staff development that utilizes content and skills provided in Economics for Educators.

13 Helping young people learn to think & make better economic & financial choices in a global economy. economicstexas.org 1801 Allen Parkway Houston, Texas Telephone Fax info@economicstexas.org