Week 3 markets in action


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Week 3 markets in action

  1. 1. Markets in Action Gregory Chase ACK
  2. 2. Changes in market equilibrium • Supply and demand analysis explains many of the events that occur in the real world. • Changes in prices and quantities sold in markets primarily occur because of: – changes in demand – changes in supply 2
  3. 3. Changes in demand From Last Week Changes in demand occur as a result of changes in: number of buyers in the market tastes and preferences levels of disposable income expectations of consumers prices of related goods 3
  4. 4. 4 Changes to demand If one of these factors causes a decrease in demand, the result will be: a decrease in prices a decrease in quantity supplied. If one of these factors causes an increase in demand, the result will be: an increase in prices an increase in quantity supplied.
  5. 5. Change in Demand • Consider the demand for New Zealand (NZ) holidays • Movie Lord of the Rings was filmed in NZ • This caused a change in consumer tastes and preferences – increasing demand for NZ holidays • As demand increases we expect price to rise, as well as the quantity of holidays traded
  6. 6. An increase in demand 6
  7. 7. • High Fuel Consumption Autos • Causes Recent events: appreciation of Australian Dollar Past events: failure of local manufacturers to respond to changes in consumer demand for smaller cars as petrol prices increased (complementary product) Improved safety features in small cars • Result: decrease in demand for cars with large engines in preference for fuel efficient cars A decrease in Demand
  8. 8. A decrease in demand 8
  9. 9. 9 Review: Market supply •Assumed market supply is directly related to price. •Based on assumption of “increasing costs” •As production increases, the cost of each additional unit of output increases (increasing marginal cost) •If a firm faces increasing marginal cost, then they would only be willing to increase supply if they receive a higher price •The result is an upward sloping supply curve •But is this always the case?
  10. 10. Constant Cost, supply and price • In reality, firms can often respond to increased demand without increasing price • Wood-oven pizza restaurant factors of production: • Pizza oven, one pizza maker, wood, pizza ingredients etc. • Production = 20 pizzas per hour • What is the additional cost of producing the 10th, 11th or 12th pizza? • In this situation, the producer does not experience increasing marginal cost • Price does not need to increase as demand increases from 10 to 11 or from 11 to 12 pizzas. • As production increases, the cost of each additional unit of output remains the same (constant marginal cost) • Flat (elastic) supply curve in this range of production
  11. 11. Constant Cost and Supply SC What if we had considerable excess capacity in both airline seats and hotel rooms? Constant costs could mean no increase in price until seats and rooms started to become scarce
  12. 12. Changes in supply From Last Week Changes in supply occur as a result of changes in: technology number of sellers in the market resource prices taxes and subsidies expectations of producers. 12
  13. 13. 13 Changes in supply If one of these factors causes an increase in supply, the result will be: a decrease in prices an increase in quantity demanded. If one of these factors causes a decrease in supply, the result will be: an increase in prices a decrease in quantity demanded.
  14. 14. Change in Supply • Each choice has an opportunity cost: consider the following scenario • An entrepreneur presently has $1 million invested in a machinery hire business: 6% return on investment (ROI) • Suit hire business: ROI = 12% • Profit maximising entrepreneur decides to shift their investment into the suit hire business • Supply will increase in the suit hire sector (and decrease in machinery hire)
  15. 15. An increase in supply 15 40 30 20 10
  16. 16. Analysis • Market entry causes surplus at original price • Price falls and quantity traded increases until equilibrium is restored • As price falls, the ROI (profit) will fall • As the ROI falls, so too does opportunity cost • Resources stop shifting into this market • If resources were free to move between markets – the ROI (profit) would be equalised in all industries • In reality, barriers to entry and exit
  17. 17. A Decrease in Supply • Timber is a natural resource • It is a renewable resource – plantation timber • But also finite – old growth forests such as the Amazon • Scientific evidence: logging of old growth forests is creating considerable environmental cost, often beyond the countries in which logging is taking place (Amazon rainforest produces 20% of earths oxygen supply) • Government regulation introduced to restrict logging
  18. 18. A decrease in supply 18
  19. 19. Analysis • A reduction in supply causes a shortage at the original price • This excess demand causes price to increase and quantity traded to fall • This continues until the price consumers are willing to pay equals the price at which producers are willing to sell • Price acts to “ration” scarce goods and services towards those that value them most highly (marginal value) and have the ability to pay
  20. 20. Crude oil supply  Organisation of Petroleum Exporting Countries  12 countries with about 80% of world oil reserves  Rather than competing, these countries coordinate supply to increase revenue (export earnings) and profits  With few substitutes, demand is not very responsive to changes in price (demand is price inelastic)  By reducing supply, price will rise and quantity traded will fall  However, total revenue will increase since demand is price inelastic OPEC 20
  21. 21. Profit maximising Price of Oil 1.2m $60 S1 Quantity of Oil S2 D $130 1m •TR = P x Q •TR1 = $60 x 1.2m = $72 million (Area A + B) •TR2 = $130 x 1m = $130 million(Area B + C) •Area A = loss of TR •Area C = gain in TR •Area C > A so TR increases AB C E1 E2
  22. 22. Government intervention • Governments intervene in the operations of the market system for several reasons, including: Efficiency Equity • We now consider some examples: Price Floor and Price Ceiling Market Failure Externalities Public Goods
  23. 23. 23 Price ceilings • A price ceiling is a legally established maximum price a seller can charge. • Governments impose these to ensure that the wider community can access the product/service sold. • It can cause an excess of quantity demanded over quantity supplied at the ceiling price.
  24. 24. The Market for Social Housing • Social housing: government provided housing to low-income individuals or families • Market rents can be unaffordable for some individuals and families • In a free market – this would cause homelessness • Improve affordability by setting a price below the market rent • Justification for government provision is equity
  25. 25. Price ceilings 25
  26. 26. 26 Price ceilings (cont.) • Rent ceilings help people on low incomes by keeping prices lower than the equilibrium. • They can be counterproductive if they cause: – excessive shortages – illegal markets – less maintenance – discrimination
  27. 27. Price floors • A price floor is a legally established minimum price a seller can be paid. • Governments can create these in order to lower the consumption of a good, or ensure some employees are not disadvantaged. • It can result in an excess of quantity supplied over quantity demanded at the floor price. 27
  28. 28. Minimum Wage • The market for labour • Individuals supply labour - Firms demand labour • Wage rate determined by the interaction of demand and supply • What if the wage rate is so low that you can’t afford the essentials of life? • Australia has a minimum wage to improve equity • Minimum wages USA
  29. 29. Price 29
  30. 30. 30 Examples of price floors • Price floor examples are minimum wages and agricultural price support schemes. • These can also have unintended consequences: – unemployment – overproduction and waste of resources. Trade-off: The pursuit of equity can create inefficiency Policy Making is often requires balancing the twin goals of equity and efficiency
  31. 31. 31 Market failure • The price system may not always operate efficiently, as society fails to achieve some goals. • The market mechanism does not achieve desirable results. Four examples • Lack of competition • Third party effects (externalities) • Public goods • Income inequality
  32. 32. Market failure: lack of competition • Consumer sovereignty is replaced by ‘producer sovereignty’. • Firms without competitors tend to restrict supply, which raises prices and profits, and reduces community well-being by wasting resources and retarding innovation. 32
  33. 33. Cartel Price of Oil 1.2m $60 S1 Quantity of Oil S2 Demand $130 1m •Competitive price is $60 and 1.2 million barrels produced per day •Cartel restricts supply and pushes price to $130 per barrel •This results in a transfer of income from consumers to producers •Area C was consumer surplus and is now producer surplus • Deadweight loss = area A + D AB C D
  34. 34. Review: price elasticity & TR 34 TR1 = P*Q = $30x10,000 = $30,000 If price is lowered to $20 TR2 = $20x30,000 = $60,000 Loss of TR Gain in TR
  35. 35. Variations along a straight-line demand curve 35 Notice how TR reflects the variation in elasticity along the demand curve.
  36. 36. Public goods • users collectively consume benefits • no-one can be excluded Goods that have two properties: Public goods are goods that are consumed by everyone regardless of whether they pay or not. 36
  37. 37. Categories of goods Excludable Non-excludable Rivalry Private Goods (Cars, cloths, food) Common Goods (fish, timber, rivers) Non-Rivalry Club Goods (satellite TV) Public Goods (Air, national defence, free to air TV) Criteria •Rivalry: consumption by one person precludes consumption by another person (resource depletion) •Exclusion: it is possible to exclude a person from consumption of the good (user pays)
  38. 38. Public goods • The characteristics of a public good – particularly non-excludability - means that firms will not produce them • Consider National Defense – who benefits? • If you can benefit (consume) without paying, why would you pay for it? • Free riding – leads to under-production or no production 38
  39. 39. Market Failure: Externalities • Market transaction: buyers and sellers come together voluntarily for the purpose of exchange • Mutual gains from trade • An externality is a cost or benefit imposed on third parties (people other than the buyers and sellers of the good). • Spill-over effect • Externalities can be: – positive (beneficial spill overs) – negative (harmful spill overs). 39
  40. 40. 40 Negative externalities • Those that are detrimental to third parties: – a neighbour’s consumption of loud music may reduce your ability to study – noise pollution caused by aircraft – smoke from a factory. • Approaches to solving these ‘failures’ are: – taxes (e.g. pollution taxes) – regulations (to limit pollution).
  41. 41. Case Study: Carbon Tax • Air (the atmosphere) is a public good • Carbon and other pollutants released into the atmosphere • External costs imposed locally (ill-health from air pollution) and internationally (global warming) • External costs not reflected in the market price and quantity traded • How do we internalise these external costs? • How does carbon pricing work? Part 1 and Part 2
  42. 42. Negative externalities 42 Economists prefer a tax-based solution because it is more efficient.
  43. 43. Positive externalities • Externalities that are beneficial to third parties, for example: – government expenditure in schooling benefits the whole of society, not just students – vaccinations provide a direct benefit to the patient and a spill-over benefit to other people (less chance of contracting the disease). 43
  44. 44. Positive externalities 44
  45. 45. Society encourages positive spillovers • There are government subsidies for attending school and being vaccinated against disease. • Regulations push the demand curve for positive spillover type commodities to the right, for example: – laws about immunisation of infants – laws about attending school. 45
  46. 46. Income inequality 46 •Economics: what, How and for Whom •For whom is about income distribution •Income depends on education, skills and experience •How much income would your earn in a pure market economy if you were unemployed? •Income inequality is a major part of the incentive structure inherent in a market system •This market imperfection is addressed via • government regulation (subsidised training) •Tax-transfer system (unemployment benefits)