TOPIC 3: MarketsDemand and supplyMarket failure: Price mechanism takes into account private benefits and costs of production to consumers Law of demand

Terminologyo Law of Demand: Inverse relationship b/wn

price and demand, assuming ceteris paribus (All other affecting factors remain the same)

o Individual demand: Demand of an individual consumer for a particular good or service at a particular price

o Market demand: Demand by all consumer for a particular good or service

Factors influencing demand

Priceo Necessities: Goods necessary to survival, bought regardless of price

changeso Luxury goods: Goods that are higher in quality, ↑ P = ↓ D

Incomeo High: Increased purchasing power, increased demand for g/s

(mostly luxury) o Low: Decreased purchasing power decreased demand for g/s (for

luxury. inferior) Shift in YDistribution Altered demand for goods and services

o Expected future income affects demand for certain types of goods

Populationo Size: Affects total quantity of goods demanded

Small population Small QD of goods Large population Large QD of goods

o Age distribution: Affects type of goods demanded Ageing population = ↑ Demand for nursing homes/hospitals

Tasteso Demand for particular goods will change over time

Fashion industry Clothes in fashion = high demand Clothes out of fashion = low demand

o Innovation and technological progress New/better products > Old products Mp3 players in comparison to music CDs

Prices of substituteso Definition: Goods bought in place of another

Price increase of substitute Demand increase of good Price decrease of substitute Demand decrease of good

o Examples: Coke and Pepsi, tea and coffee, butter and margarine Price of complements

o Definition: Goods bought in conjunction with another Price increase of complement = Demand decrease of good Price decrease of complement = Demand increase of good

o Examples: Printers and cartridges, cars and petrol, milk and cereal

TOPIC 3: Markets Future expectations of price

o Price increase in near future Current demand increases (e.g. Tax)o Price decrease in near future Current demand decreases

Movements and shifts of the demand curve

Movements (Only price-related changes: ceteris paribus)

o Contraction: An increase in price (0P1 to 0P2) causes the quantity demanded to fall (0Q1 to 0Q2)

o Expansion: A decrease in price of a (0P1 to 0P2) causes the quantity demanded to rise (0Q1 to 0Q3)

Shifts (caused by factors other than price)

o Increases in demand: Consumers are willing and able to buy more of the product at each possible price

Shift of demand curve to the right (D1 D2)

Increase in quantity demanded (0Q1 to 0Q2) at the same price (P1)

Willing to pay higher price (0P2 instead of 0P1) to buy the same quantity of goods (Q1)

o Decreases in demand: Consumers are willing and able to buy less of the product at each possible price

Shift of demand curve to the left (D1 D2)

Decrease in quantity demanded (0Q1 to 0Q2) at the same price (P1)

Willing to pay lower price (0P1 instead of 0P2) to buy the same quantity of goods (Q2)

TOPIC 3: MarketsSupplyLaw of supply

Terminologyo Law of Supply: As the price of a certain product rises, the quantity

supplied will rise More profitable, attract new firms to the industry

o Individual supply: Supplies of individual producers at various price levels

o Market supply: Total supply of all producers for a particular product

Factors influencing supply

Market priceo Influences producer’s ability and willingness to supply the g/so Too low = Producers may not be able to cover production costs

Costs of factors of productiono Decrease: Allows firms to supply more of a particular goodo Increase: Difficult for firms to maintain present supply, leads to

decrease in supply Large production companies sharply increase movies that

small cinemas buy Forces smaller, less profitable cinemas out of business Lower market supply of movies to consumers (fewer

places) Price of other goods/services

o PX unchanged, PY increasedo Firms less willing to supply Good X, more willing to start

producing/suppling Good Y More profitable (Business goal)

Future expectations of priceo Increase in near future Current supply increases (possibility of

increased profits)o Decrease in near future Current supply decreases

Number of supplierso Increase in suppliers = Increase in supplyo Decrease in suppliers = Decrease in supply

TOPIC 3: Markets Improvements in technology

o Lower production costs, allow more firms to supply more goods at a given price

Automated production-line techniques in motor vehicle industry

o Adjust production runs (accommodate changing demand patterns)

Movements along and shifts of the supply curve

Movements (Only price-related changes: ceteris paribus)

o Expansion: An increase in price (0P1 to 0P3) causes the quantity supplied to fall (0Q1 to 0Q3)

o Contraction: A decrease in price of a (0P1 to 0P2) causes the quantity supplied to fall (0Q1 to 0Q2)

Shifts (caused by factors other than price)

o Increases in supply: Firms are willing and able to supply more of the product at each possible price

Shift of demand curve to the right (S1 S2)

Increase in supplied (0Q1 to 0Q2) at the same price (P1)

Willing to supply given quantity (0P2) at a lower price (0P2 instead of P1)

o Decreases in supply: Firms are willing and able to supply less of a good at each price level than before

Shift of supply curve to the left (S1 S2)

Decrease in quantity supplied (0Q1 to 0Q2) at the same price (P1)

TOPIC 3: Markets Only willing and able to supply given quantity (0Q2) at 0P2

instead of 0P1

TOPIC 3: MarketsPrice elasticity of demandPrice elasticity and the outlay method

PED: The responsiveness of quantity demanded to changes in price%∆QD%∆ P

Elastic: Strong response to a change in price%∆QD > %∆ P, PED>1

Inelastic: Weak response to a change in price%∆QD < %∆ P, PED<1

Unitary elastic: Proportional response to a change in price%∆QD = %∆ P, PED=1

Perfectly elastic: Consumers demand an infinite quantity at a certain price, e.g. fruit/veg

o No individual seller would be able to charge a higher price (lose customers)

o Farmer selling apples: Higher price = No consumers, Lower price = less revenue

Perfectly inelastic: Consumers willing to pay any price to obtain a certain quantity of goods

o Life-threatening disease: Particular drug required to treat it Calculation of elasticity using outlay method

o Effect of changes in price on total revenue earned by the producer $5-$6: Increase in total outlay Relatively inelastic $7-$8: Total outlay remains the same Unit elastic $9-$10: Decrease in total outlay Relatively elastic

Price ($) Quantity Demanded Total Outlay (Price x Quantity)

Elasticity

5 50 250 Inelastic6 45 270 Inelastic7 40 280

Unit Elastic8 35 2809 30 270 Elastic

10 25 250 Elastic

Significance of PED – Market research Businesses: Deciding on the optimal pricing strategy for the good/s they

produceo Types

Relatively elastic: Low price More sales More revenue Relatively inelastic: High price More sales More revenue

o Statistical market research: Determine consumer preferences Governments

o Pricing g/s that it provides for the community Public transport fares

o Predict effects of changes in indirect taxes (predict how much revenue raised)

TOPIC 3: Markets Sales taxes: Alcohol, tobacco Excise duties/special levies: Petrol

o Example: Excise duty on inelastic good: weak response to price,

increasing revenue Excise duty on elastic good: strong response to price,

reducing revenueFactors affecting elasticity of demand

Type of goodo Necessities: Essential for daily life, relatively inelastic PED e.g.

bread and milko Luxuries: Not essential for survival, relatively elastic PED, e.g.

expensive dining out Existence of close substitutes

o Close substitutes: Highly elastic demand, e.g. brands of cerealo Few/No substitutes: Inelastic demand, e.g. water supply

Proportion of income spent on the goodo Small proportion: Inelastic demand, e.g. disposable lighters and

chewing gumo Large proportion: Elastic demand, e.g. holidays and new cars

Length of time since a price changeo Price increase/decrease

Short-run: Inelastic demand (takes time to become aware of and adjust to ∆price)

Long-run: Elastic demand (sought out alternatives/substitutes)

o Durability Elastic demand, would decline over time, e.g. replacing or

repairing cars Habit-forming/Addictive

o Cigarettes and alcohol: Relatively inelastic demand

Special cases involving PED

Perfectly Elastico Consumers will demand an

infinite quantity of the goodo Below/above the price: Not willing

to demand any quantityo Can be witnessed in fresh fruit

markets (example of competitive markets)

Lower price = Loss of profit Higher price = Loss of

customers (lower price elsewhere)

TOPIC 3: Markets Perfectly Inelastic

o Consumers are willing to pay any price in order to obtain a given quantity of a good, represented by a vertical demand curve

Life-threatening disease Medicine

Concert tickets Limited supply

TOPIC 3: MarketsPrice elasticity of supplyTerminology

PES: The responsiveness of quantity supplied to changes in price%∆QS%∆ P

Elastic: Strong response (more than proportional) to a change in price%∆QS > %∆ P, PES>1

Inelastic: Weak response (less than proportional) to a change in price%∆QS < %∆ P, PES<1

Special cases involving PES

Perfectly Elastic:o At price 0P, suppliers would supply an infinite

quantity of the goodo Below/above the price: Not willing to supply

any quantityo Highly unlikely scenario

Perfectly inelastic: Quantity supplied is fixed at 0Q regardless of the price

o Examples Unique piece of art Ticket prices to a concert

Factors affecting elasticity of supply

Time lags after a price changeo Price Increase

Right after: Perfectly inelastic (suppliers can’t increase supply immediately)

Short run: Inelastic supply (Increase of resources allocated to existing production capital, e.g. raw materials/additional workers)

Long run: Elastic supply (Increase in inputs, e.g. size of production plant/amount of machinery ∴ greater increase in production)

o Price Decrease Right after: Perfectly inelastic (suppliers can’t decrease

supply immediately) Short run: Inelastic supply (Decrease of resources allocated

to existing production capital, e.g. raw materials/additional workers)

Long run: Elastic supply (Decrease in inputs, e.g. size of production plant/amount of machinery ∴ greater decrease in production)

The ability to hold and store stocko Perishable goods: Relatively inelastic (Cannot store when in

economic downturn)o Durable goods: Relatively elastic (Can put into storage when in

economic downturn)

TOPIC 3: Markets Inventory: Total stock of g/s held by a firm at a particular

time, intended for sale to consumers Excess capacity

o Definition: A firm not using its existing resources to their full capacity

o Existence: Elastic (Using existing resources more intensively)o Absence: Inelastic (Hard to increase resources in a short amount of

time)

Market priceTerminology

Price Mechanism: The process by which the forces of supply and demand interact to determine the market price at which g/s are sold and the quantity produced

Market Equilibrium: At a certain price level, the quantity supplied and the quantity demanded of a particular commodity are equal (No excess D/S), no tendency for ∆P/D

Movement to equilibrium

Excess demando At price 0P1, the quantity

demanded (0Q2) exceeds the quantity supplied (0Q1)

o Competition for limited goods Consumers will start bidding up the price

o Rise in price: Expansion in supply, contraction in demand (Movement along curves)

o Movement will occur as long as there is excess demand

o Movement will stop at the intersection of the supply and demand curves (0PE/0QE)

o Market clears at the price 0PE: No excess demand/supply

Excess supplyo At price 0P2, the quantity supplied

(0Q2) exceeds the quantity demanded (0Q1)

o Sellers will offer to sell at a lower price (remove excess supply)

TOPIC 3: Marketso Fall in price: Expansion in demand, contraction in supply (Movement

along curves)o Movement will occur as long as there is excess supplyo Movement will stop at the intersection of the supply and demand

curves (0PE/0QE)o Market clears at the price 0PE: No excess demand/supply

TOPIC 3: MarketsEffects of changes in supply and/or demand on equilibrium market price and quantity

Increase in demand: o Demand curve shifts to the right (from D1D1 to D2D2)o Consumers demand more goods at the old equilibrium price (0PE1)o Quantity demanded (0Qx) exceeds quantity

supplied (0QE1)o Competition among buyers for the limited

quantity of goods will force the price upo Expansion in supply (Movement along the

supply curve to the right)o Market clears at new equilibrium price (0PE2)

and quantity (0QE2)o Leads to a raise in both equilibrium price and equilibrium quantity

Decrease in demando Demand curve shifts to the left (from D1D1 to D2D2) o Consumers demand less goods at the old equilibrium price (0PE1)o Quantity supplied (0Qx) exceeds quantity demanded (0QE1)o Sellers will offer to sell at a lower price

(remove excess supply)o Contraction in supply (Movement along the

supply curve to the left)o Market clears at new equilibrium price (0PE2)

and quantity (0QE2)o Leads to a decrease in both equilibrium price

and equilibrium quantity Increase in supply

o Supply curve shifts to the right (from S1S1 to S2S2) o Sellers provide more goods at the old equilibrium price (0PE1)o Quantity supplied (0Qx) exceeds quantity demanded (0QE1)o Sellers will offer to sell at a lower price (remove excess supply)o Expansion in demand (Movement along the

demand curve to the right)o Market clears at new equilibrium price (0PE2)

and quantity (0QE2)o Leads to a decrease in equilibrium price and

a rise in equilibrium quantity Decrease in supply

o Supply curve shifts to the left (from S1S1 to S2S2)

o Sellers provide less goods at the old equilibrium price (0PE1) o Quantity demanded (0Qx) exceeds quantity supplied (0QE1)o Competition among buyers for the limited

quantity of goods will force the price upo Contraction in demand (Movement along the

demand curve to the left)o Market clears at new equilibrium price (0PE2)

and quantity (0QE2)o Leads to a raise in equilibrium price and a

decrease in equilibrium quantity

TOPIC 3: MarketsRole of the Market

Product Market: The interaction of demand for and supply of production outputs, i.e. g/s

o Interaction of demand and supply determines a price and quantity that best satisfies individual wants with the limited resources available to firms, giving a solution to the economic problem

o Producers will only produce g/s for which there is consumer demand Higher opportunity cost in producing other goods when price

of product X rises Factor Market: The market for any input into the production process, aka

CELLo Individuals who possess resources (including skills) or produce

goods and services that are scarce and in high demand will command higher incomes and a greater proportion of total output

Allocative efficiency: Economy’s ability to allocate resources to satisfy consumer wants

o Demand curve: Indication of the value that consumers place on a certain good

o Supply Curve: Indication of producers’ costs in supplying that product

Competition among producers: Responsive to consumer demand, attempt to minimise costs of production in order to remain competitive, maintain profitability

Alternatives to market solutions – the role of government Market Failure - Price Intervention

Market failure: Price mechanism takes into account private benefits and costs of production to consumers and producers, but does not take into account indirect costs (social costs)

Price ceilings: Maximum price that can be charged for a particular commodity, e.g. bread

o Distributes money from sellers to buyers

o PE: Excessively high, Govt. imposes price ceiling at Pmax

o Producers willing to produce 0QP, consumers demand 0QCo Disequilibrium, with excess demand for bread of QPQC

Price floors: The minimum price that can be charged for a particular good, e.g. wheat/milk

o Distributes money from buyers to sellers

o PE: Excessively low, Govt. imposes price floor at Pmin

TOPIC 3: Marketso Producers willing to produce 0QP, consumers demand 0QCo Disequilibrium, with excess supply for wheat/milk of QCQP

TOPIC 3: MarketsMarket failure – Quantity Intervention

Producers only consider private costs (labour, raw resources), but not social costs (pollution/environmental damage)

o Taxes: Increases production costs, reduce production levelso Laws: Issuing pollution emission permits

Individual consumer do not consider social benefits of some g/so Merit goods: Goods that are not produced in sufficient quantity

(Individuals do not place sufficient value on these goods), e.g. Education and Health Care

o Subsidies (C/P): Lowers price and increases competition Public goods: Good that private firms are willing to supply, as

usage/benefits cannot be restricted to those who are paying for them, e.g. National defence, police, public roads

o Government intervenes to supply these items, finances them with its tax revenue

Variations in competitionMarket structures

Pure competitiono Many small buyers, none of them are sufficiently large to be able to

affect the market price, e.g. bulk-buyingo Homogeneous products (same), Buyers and sellers are aware of

prices at which the product is offered for sale throughout the market

o Buyers do not incur any cost for moving from one supplier to another

o No barriers to entry of new firms/exiting of existing firmso Sellers can sell as much of their product at market priceo Price takers: Market price determined but forces of supply and

demand Monopolistic competition

o Large number of relatively small firms in the industryo Products are similar, not identical (product differentiation:

packaging/presenting)o Firms have some degree of price-setting powero Small barriers to entry for new firms (loyal customers, brand loyalty)o Advertising: Attracts new customers, Maintains existing ones

Oligopolieso A few relatively large firms have a significant share of the marketo Products are similar, but differentiatedo Significant barriers to entry: Only a few firmso Firms constantly monitors behaviour of other rival firms, must

consider reactions of competitors when changing its pricing/output policies

o Tend to compete through advertising campaignso Supermarkets: Woolworths, Coleso Banks: Commonwealth, NAB, Westpac, ANZo Airlines: Qantas, Virgin Australia

TOPIC 3: Markets Monopolies

o Only one firm selling the product, no market competitiono Product sold has no close substituteso Significant barriers to entry, prevents any potential competitors

from enteringo Monopolist is a price setter, sets price in order to maximise profito As level of competition within a market increases, prices are likely

to fall and output increase