September 26, 2011 Lecture Notes

Size: px
Start display at page:

Download "September 26, 2011 Lecture Notes"


1 September 26, 2011 Lecture Notes The Market System: Basics Market Definition Price rationing device: information and incentive for econ decisions. "Invisible Hand" Property Rights Money Role of Government Circular Flow model Two kinds of decision makers, two kinds of markets "Real" and "Money" flows connect econ decision makers through markets where Prices are set Answers to the what, how, for whom questions are determined. Zero-sum game: one person's win is someone's loose. In an economic system, all parties have to benefit. What is a Market? A Market it any arrangement that allows buyers and sellers to communicate (exchange information) and then trade. A market can be a physical location A market can also be world-wide as long as there's still communication between the buyers and sellers. The Price The price is the outcome of all the information that is shared amongst the buyers and sellers. It summarizes all the information that is brought by the buyers and sellers. Itself provides information and incentives to decision makers. The rationing criteria Provides answers to the what/how/whom questions. Adam Smith's Invisible Hand: The markets will automatically operate such as to provide the best (productive and allocative efficiency) answrs to the what/how/whom questions. Property Rights are an essential ingredient: These are laws that govern the ownership and disposal of factors of production and goods /services. Defines theft and consequences of theft. The government is important in the market system as it's role is securing property rights. What is money? Money is a medium of exchange. Facilitates exhange Removes the need for Barter. "Limited" Role of Government We have a mixed market system, referring to it is not laissez-faire, but rather we have some government involvement. The Market system by itself pays no attention to equity of distribution of income.

2 In order to prevent this kind of poverty, there must be some kind of government involvement. Circular Flow Model We have assumptions: Two groups of decision makers, households and firms. We will not consider govnerment as part of this model right away. Also assume they are rational decision makers. Two kinds of Markets: Goods & Services Resource Markets. Decision makers make different decisions in each market. Households are buyers in Goods&Services, sellers in Resource Markets Assume Households are the ultimate owners of all resources (factors of production, inputs). This Model is called the circular flow model. Consists of the following 4 pieces: Revenues Good Market Firms Goods/Service s Resources Goods/Ser vices Households. $ Factor Market Income How are these linked? Households: Households have consumer soveriegnty -> The flow starts with consumers. They are willing to purchase things from the goods market. Those dollars go to firms as revenues. Firms then use that money to buy resources from the factor market The money from the factor market goes to households as income. Firms also provide goods and services from the goods market On the outside, we have money flows. In inside we have the real flow. Firms make buying/selling decisions to be rational.

3 September 28, 2011 Lecture Outline Circular Flow Model Two kinds of decision makers; two kinds of markets, "real" and "money" flows connect econ decision makers Prices are set Answers to the "what", "how", "for whom" questions are determined. Theory of Demand, Supply, and Price Demand Definition Law of Demand Shft factors Shift vs. Movement along Supply Definition Law of Supply Shift factors Shift vs. Movement along Households Buyers, Consumers/Demanders of goods and services Sellers/Owners/Suppliers of resources Rational Decision makers Self-interest is to maxize income and other personal goals for satisfaction. This model assumes house-holds are the ultimate owners of the factors of production. Firms/Producers Sellers/Supplers of goods and services Buyers/Demanders of resources. Rational decision makers Self-interest = Maximize profit. In the Market; producers make the things consumers want. Firms will produce those things that consumers value the most --> looking after their own selfinterest. How? Producers are interested in making the profit; how they are going to do things depends on how much they have to pay for resources. Thus, they are going to choose a method that uses the least costly way to produce goods. For whom? Prices recused by the households when they sell resources -> income, what can be bought by households. The way this is answered isn't great: some people have resources not valuable. What about those people? These people find themselves with nothing.

4 How to demand and supply interact together to set a price? The relationship between the amounts of a good that people are willing to purchase and the sacrifices or prices they are willing and able to make to get them. Ceteris Paribus: For a given time, everything else is held constant. You must balance Marginal Costs, and Marginal benefits. When we have to make a sacrifice, we moderate our desires. September 30, 2011 Lecture Outline Demand Shift vs. Movement along Supply Definition Law of Supply Shift Factors Shift vs. Movement along. Market equilibrium Price and quantity Shortages, surpluses Equilibrium Changes in market equilibrium price and quantity.

5 Demand P Quantity Shifts/changes in demand When a non price determinant of demand changes. Something in the ceteris paribus envelope) Then, Demand shifts or changes it's position. Anything that is not price shifts the demand schedule. -> refers to the prices and quantities along the demand. We have to be careful with a demand shift (different demand schedule) vs a change in demand on the same schedule. Quantity change is in response to a price change only. Consider the following example: Health Canada has released the latest results from a study conducted on carbonated beverages. These drinks pose a health hazard to those prone to... The decimation of information causes a change in ceteris paribus, which will shift the demand schedule. -> Change in tastes/preferences changes the demand schedule. This detrimental information shifts the demand schedule. A demand shift to the left causes a given price to sell fewer quantities for the same price in comparison to the orignal demand schedule. A demand shift to the right causes a given price to sell more quantities for the same price in comparison to the original demand schedule. A change in demand means a demand shift (of the curve). Changing the quantity demanded is simply moving along the demand schedule. Example: Reducing smoking. We can reduce the demand for cigarettes through policy, by educating people, shifting the demand curve to the left. We can also raise prices, following the demand curve upwards on the curve, reducing the quantity demanded. Example: Car trips into downtown. We could shift the curve by lowering the price of substitutes (such as the price of transit). Lower transit prices => fewer trips. We could also raise the price of compliments. Higher parking costs downtown -> fewer trips. We can simply raise the price of the activity, such as London's congestion charge.

6 Supply. A schedule showing the relationship between the quantities of a good or service that firms are willing and able to pay and the prices that people are willing and able to pay. This is a decision made by producers. This is a relationship between the price of the good and the quantity of the good supplied. The supplier is making a choice between the Marginal benefits (Product price) and Marginal Costs of production. This choice is made to maximize profit Profit: Total Revenue Total cost Total Revenue is Price x quantity. The costs are the reason why there is a direct relationship between price and quantity Costs = Opportunity Cost. When we are looking at costs, we need to look at how many do we need, how much to pay. Then we have to look at how much technology is available. Revenue is determined by price, costs are the things above. Law of Supply: Based on an increase of opportunity cost. As more and more resources are transfeered (PPF) the costs of production increase. Market Supply: The summation of the quantity supplied by each of the suppliers in the market at each price. If any of these change, the supply curve shifts Cost of inputs (price in factor markets for factors of production) Technology and Productivity Taxes and Subsidies Price Expectations Number of Firms in the Industry. The non price determinants of supply are above ^^ the things we hold constant. The supply schedule shifts It shifts up and down.

7 Price Quantity If we produce more, we need to have a higher price. Shifting of the Supply Schedule When the supply decreases the quantity supplied is less at each price. Employees form a union, negotiate higher wages (costs) When the supply increases, the quantity supplied is greater at each price Producer is able to use cheaper materials due to a technological change. Technological change that does not reduce opportunity cost is not worth talking about. Market Equilibrium Price and Quantity Prices tend toward market equilibirum through the continuous interaction od demanders and suppliers. These demand and supply forces emerge due to scarcity in a market where exhange takes place. You want to have specialization if you have scaricty Therefore, you want markets. In a market we bring supply and demand forces together to interact. Example: If your friend has something that you want and you offer to buy it from him or her. As a buyer, you're going to offer them the lowest price that they might accept. The seller wants to try and charge the highest price that they can get. Perfectly Competitive Market This is where the interaction begins. If you're only willing to pay a dollar, and she wants $5, nothing will happen. If both parties really want an exchange to take place, both parties will negotiate together to an equlibirum price. Buyers and sellers numerous enough that no single buyer/seller can influence the price; no market participant has any power. Buyers and Sellers are free to enter or exit the market at any time. Each party to the exchange has full information. DONOT SAY At equlibrium supply is equal to demand. At equilibrium price, the quantity demanded is equal to the quantity of supply. Market clearing happens at equilibirum.

8 Lecture Outline October 3, 2011 Theory of Demand, Supply, and price Shortages, surpluses Equilibirum Changes in market equilibrium price and quantity Single and Double shfts determinant and indeterminant outcomes. The price adjusts until price is such that the quantity demanded is equal to the quantity supplied. No dissatisfied buyers or sellers, nothing is "left over", market equilibirum is reached. The market clears and a single price prevails. The price ensures that the suppliers than can actually supply the products for minimum opportunity costs are the ones that will supply the products, and ensures that people who can pay and value the products the most will actually get them. How is the market affected when the assumptions are changed? Decide: is demand of supply effected? Decide: in which direction will the affected Demand/Supply move? Use Demand and Supply to determine the new market equilibrium. Can you spot the errors: "An increase in demand causes an increase in price. But an increase in price causes a decrease in demand. Increases in demend, therefore largely cancel themselves out". First mistake: Does the increase in the price in the demand schedule? NO! An increase in the price causes in increase in the quantity demanded. Therefore, there is an incorrect conclusion drawn! There is no cancelling out, the price increases. Government Policy Price Ceiling / Price Floor Price Ceiling: Affects on market outcomes Example: Rent Control "black market" Price floor Affects on Market outcomes Example: Minimum wage Example: Agriculture

9 Policy: Government takes some kind of action to change the market for the reason that a government wishes to pursue goals. A Government may choose to make a price control = fixing the price. There are two ways the govnerment can fix the price. Ceiling: the price cannot rise higher than x Floor: price cannot go lower than x This suspends the price system. If we stop this interaction by mandating "this is the price", prices cannot be a rationing criteria -> problems (think about that bonus mark exercise). Examples of price controls Minimum wage (price floor) In war times, sometimes there are price controls on food items (alledgedly to give more people access). Midterm: