fundamentals of markets © 2011 d. kirschen and the university of washington 1

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Fundamentals of Markets

© 2011 D. Kirschen and the University of Washington

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Let us go to the market...

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• Opportunity for buyers and sellers to:

– compare prices

– estimate demand

– estimate supply

• Achieve an equilibrium between supply and demand

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How much do I value apples?

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Price

Quantity

One apple for my break

Take some back for lunch

Enough for every meal

Home-made apple pie

Home-made cider?

Consumers spend until the price is equal to their marginal utility

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Demand curve

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• Aggregation of the individual demand of all consumers

• Demand function:

• Inverse demand function:

Price

Quantity

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Elasticity of the demand

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• 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

Price

Quantity

Low elasticity good

High elasticity good

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Elasticity of the demand

• Mathematical definition:

• Dimensionless quantity

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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

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How much does the next one costs?

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Cost of producing a widget

Total Quantity

Normal production procedure

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How much does the next one costs?

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Cost of producing a widget

Total Quantity

Use older machines

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How much does the next one costs?

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Cost of producing a widget

Total Quantity

Second shift production

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How much does the next one costs?

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Cost of producing a widget

Total Quantity

Third shift production

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How much does the next one costs?

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Cost of producing a widget

Total Quantity

Extra maintenance costs

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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:

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Price or marginal cost

Quantity

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Market equilibrium

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Price

Quantity

Supply curveWillingness to sell

Demand curveWillingness to buy

marketclearingprice

volumetransacted

market equilibrium

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Supply and Demand

© 2011 D. Kirschen and the University of Washington

Price

Quantity

supply

demand

equilibrium point

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Market equilibrium

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• Sellers have no incentive to sell for less

• Buyers have no incentive to buy for more

marketclearingprice

Quantityvolumetransacted

Price supply

demand

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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

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Price

Quantity

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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

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Extra-marginal

Infra-marginal

Marginal producer

Price

Quantity

supply

demand

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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

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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

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Examples• Efficient markets:

– Open air food market– Chicago mercantile exchange

• Inefficient markets:– Used cars

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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¢

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Price

Quantity

Total cost

Consumer’s surplus15¢

10¢

5

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Economic Profit of Suppliers

• Cost includes only the variable cost of production• Economic profit covers fixed costs and shareholders’

returns

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Quantity

Pricesupply

demand

π

RevenueQuantity

Price

supply

demand

Cost

Profit

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Social or Global Welfare

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Suppliers’ profit

Quantity

Price

supply

demand

Consumers’ surplus

+

= Social welfare

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Market equilibrium and social welfare

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Q

π

supply

demand

Market equilibrium Artificially high price:• larger supplier profit• smaller consumer surplus• smaller social welfare

Q

π

supply

demand

Welfare loss

Operating point

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Market equilibrium and social welfare

© 2011 D. Kirschen and the University of Washington

Q

π

supply

demand

Q

π

supply

demand

Market equilibrium Artificially low price:• smaller supplier profit• higher consumer surplus• smaller social welfare

Welfare loss

Operating point

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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

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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

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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

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Concepts from the Theory of the Firm

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Production function

• y: output• x1 , x2: factors of production

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y

x1

x2 fixed

x2

x1 fixedy

Law of diminishing marginal products

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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

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Input-output function

Example: amount of fuel required to produce a certain amount of power with a given plant

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fixed

The inverse of the production function is the input-output function

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Short run cost function

• w1, w2: unit cost of factors of production x1, x2

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Short run marginal cost function

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Convex due to lawof marginal returns

Non-decreasing function

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Optimal production

• Production that maximizes profit:

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Only if the price π does not depend on y perfect competition

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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

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Production cost [$]

Quantity

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Average cost

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Quantity

Average cost [$/unit]Production cost [$]

Quantity

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Marginal vs. average cost

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MC AC$/unit

Production

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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 > Q1 because of fixed costs

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Marginal cost [$/unit]

Average cost [$/unit]

π

Q1 Q3 Q4Q2

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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

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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© 2011 D. Kirschen and the University of Washington