Data provided is atomistic data: for each person, the quantity given is the quantity demanded by that person, and the price given is the maximum that person is willing to pay. Students should be made aware that different people have different levels of “want”, and therefore are willing to pay different prices.
Points to emphasize to the student: 1. Total quantity demanded at each price consists of the sum of the quantity demanded of all individuals who are willing to pay that price or more. 2. The demand schedule considers the total quantity demanded at each price from highest price to lowest. This will aid the student when graphing the demand schedule, since demand curves are usually read from highest price to lowest price.
When drawing a demand curve, the instructor should plot the points determined in the demand schedule before drawing the curve connecting the points (seen here). Again, the instructor should emphasize that the total quantity demanded at each price consists of the quantity demanded of different people summed
It is important here to note that demand (and therefore, the demand curve) is a relationship between two variables. This will provide a context for later when variables are introduced which also affect quantity demanded, and will be used to shift the demand curve. If the math level of students makes it possible, the instructor could at this point describe demand as a function , and provide a more mathematically rigorous description of demand.
This slide is used to cement the demand concept in the mind of the student.
It is vital that the student recognizes the difference between quantity demanded and demand. The instructor should then use the demand curve to show that the demand relationship “tells” the student that at a specific price ($4, for example), a specific amount (2 units) will be the quantity demanded.
At this point, the instructor should emphasize again the nature of demand as a relationship, noting that demand describes not only the specific quantity demanded at a specific price, but also the effect of a change in price on the quantity demanded. This is shown above as the increase in quantity demanded from 2 to 4 units because of a decline in price from $4 to $2 (point I to point II). To explain this, the instructor could either use the raw data from previously and explain it as an increase in the number of people who are willing to buy the good, or introduce the concepts of income and substitution effects: a. income effect: a change in price causes a change in real income (or purchasing power), and therefore a change in the quantity demanded (more can be afforded), b. substitution effect: a change in price causes a change in a good’s relative price (the price of a good expressed in terms of an amount of another good), which affects the relative amounts of the two goods that will be demanded. For example, a decrease in the price of butter so that it is twice as expensive as margarine instead of three times as expensive will tend to make people substitute butter for margarine.
At this point, the instructor should introduce the other variables which affect quantity demanded, and therefore will cause shifts in the demand curve. The instructor should emphasize that these variables affect quantity demanded just as price does. In addition, the instructor should describe the appropriate subcategories of each variable: 1. Income: normal goods (a direct relationship between quantity demanded and income) and inferior goods (an inverse relationship between quantity demanded and income) 2. Related goods: substitutes (a direct relationship between the price of A and the quantity demanded of B) and complements (an inverse relationship between the price of A and the quantity demanded of B) The instructor should provide the students (and have the students determine some of their own) with examples of each of the above subcategories.
An increase in demand is described as “an increase in quantity demanded at each possible price”, thus the graphical representation of an increase in demand as a rightward shift. Some examples of this shift that can be used in class are: 1. An increase in the demand for computers over time due to an increase in consumer preferences for computers. 2. An increase in the demand for new cars as incomes increase and people can afford more cars (new cars are a normal good). 3. An increase in the demand for software due to less expensive computers increasing the quantity demanded of computers (computers and software are complementary goods). 4. An increase in the demand for beef due to more expensive chicken decreasing the quantity demanded of chicken (beef and chicken are substitute goods). 5. An increase in the demand for gasoline due to people’s expectations that the price of gasoline will be higher in the future than previously thought.
A decrease in demand is described as “a decrease in quantity demanded at each possible price”, thus the graphical representation of an decrease in demand as a leftward shift. Some examples of this shift that can be used in class are: 1. A decrease in the demand for fatty foods over time due to an decrease in consumer preferences for a more healthy lifestyle. 2. A decrease in the demand for used cars as incomes increase and people can afford more new cars (used cars are an inferior good). 3. A decrease in the demand for milk due to more expensive cereal decreasing the quantity demanded of cereal (milk and cereal are complementary goods). 4. A decrease in the demand for chicken due to less expensive beef increasing the quantity demanded of beef (beef and chicken are substitute goods). 5. A decrease in the demand for computers due to people’s expectations that the price of computers will be lower in the future than previously thought.
The instructor should not as yet introduce the specific contracts of the IEM, but rather use other, more commonly known, examples of the demand for an intangible good. This way, the instructor can discuss the concepts necessary using examples of which the students are already aware. Insurance is a particularly good example. The idea that people will pay someone a periodic amount(the ‘premium’) for the promise that if some future event occurs(car accident, illness, death) the insurance company will pay some amount is a good way to introduce the concept of the futures contract. Perhaps the instructor could have the class design their own intangible good. For example, students could issue ‘get out of an assignment free’ cards. A student could then ‘get out of an assignment’ by holding a card or reaching a certain score on an previous assignment. Students could then trade cards based on their expectation of whether they will need one or not.
At this point, the instructor should introduce some real world examples of events that a futures contract could be based upon. Once an event is introduced, the class should discuss how the contract would be set up and some of the variables which might affect the attractiveness (and therefore the bid price) of the contract. Note the example given of the stock price of Microsoft on the 3rd Friday of June, which mirrors the Microsoft Price Level market on the IEM. The instructor could at this point introduce some of the other types of events that could be the basis for a futures contract, especially political and financial markets.
The data for this exercise is available in an Excel spreadsheet. Alternatively, the instructor can simply describe the example and show the actual demand curve on the next slide.
As in the smaller examples, we see that more contracts are demanded at the lower prices. Depending on the course structure, the instructor may wish to use this example later to illustrate changes in price elasticity of demand over the range of prices.
In this example, the instructor should discuss the nba party thrown by Bill Bradley as a way to gain political popularity. Then the probable effect of the party, an increase in Bradley’s popularity and therefore probability of gaining the nomination, should be connected to the demand for the Bradley contract. The shift in the demand for the contract can be explained not only in terms of an increase in the preferences for the Bradley contract, but also in terms of buyers’ change in their expectation of the probability of the Bradley contract paying off.
Data given is atomistic: for each company to provide a single unit of the good, the minimum acceptable price is given. The instructor should introduce at this point the concept of cost and profitability: that the minimum acceptable price is based upon the marginal cost of the unit produced. For example, for company ADC, the marginal cost of producing a unit of the good is $3, therefore the company must receive a minimum of $3 to make that unit profitable.
The supply schedule shows at each price, the additional number of units that would be offered (quantity, second column) and the total number of units that would be offered (total quantity supplied, third column). The instructor should point out to the student that the supply schedule then shows, at each price, the total number of units that would be profitable to be offered.
The above graph shows the supply schedule from the previous slide. The instructor should note the following: 1. Price is listed on the independent axis, quantity supplied on the dependent axis. This could be explained by noting that a given price determines the quantity that is profitable, and therefore offered. 2. The instructor should use this to discuss the law of increasing costs: that as production increases, the additional (marginal) cost of production increases. 3. The instructor should connect the law of increasing costs to the slope of the supply curve.
The instructor should note that supply , a relationship between price and quantity supplied, only describes the effect of price changes on the quantity of a good offered. It should also noted here that there are other variables which would affect the profitability of production, and therefore other variables which affect quantity supplied. This will prepare the student for when shifts in supply are introduced later. A more rigorous mathematical treatment can be introduced here, with supply being described mathematically as an upward-sloping function.
The above is a graphical representation of the supply schedule data presented in slide 18. Point I above should be noted as a single point on the supply curve, showing that at a price of $2, 2 units of production are profitable and therefore will be offered.
A second point is added to the supply curve of the previous slide, showing the supply curve telling us that a change in price will affect the quantity that is profitable, and therefore will be offered. As price rises, more units are profitable (units 3 and 4 cost too much to be profitable at $2, but are profitable at $4), and the greater quantity will be supplied. The instructor should note the difference between supply, the relationship, and quantity supplied, the amount offered at a given price shown by the supply relationship.
At this point, the instructor can introduce the other variables which affect profitability (or expected profitability, in the case of expectations of future prices) and therefore also affect the quantity supplied of a good. The variables listed above should be discussed with the effect on profitability of each: 1. A change in costs from a change in resource prices will change the profitability of each unit of production. 2. Changes in technology (the available methods of production) will affect the amount of each resource used, and therefore the cost of producing a unit of output. 3. Changes in taxes, especially the sales tax, will affect the profitability of a unit at any given price. 4. Changes in the number of suppliers will change the amount available at various prices, especially in the short-run. 5. Changes in the expected future price will affect the business’ decision to offer or inventory production in the current period.
An increase in supply is described as “an increase in quantity supplied at each possible price”, thus the graphical representation of an increase in supply as a rightward shift. This can typically be attributed to an increase in profitability, making more units profitable at a given price. Some examples of this shift that can be used in class are: 1. A decline in labor costs reduces the cost of producing each unit of the good, so a greater quantity of units is profitable at each price. 2. An improvement in technology reduces the number of resources necessary for each unit, reducing the cost of producing each unit, increasing the number of units profitable at each price. 3. The sales tax is lowered on a good (for example, the sales tax on groceries in Iowa was removed many years ago), reducing the cost to the seller, increasing the profitability each each unit and therefore the quantity offered at each price. 4. If sellers believe the future price is now lower than previously, they may choose to offer units which were going to be put into inventory for the higher relative profitability now.
A decrease in supply is described as “a decrease in quantity supplied at each possible price”, thus the graphical representation of a decrease in supply as a leftward shift. This can typically be attributed to a decrease in profitability, making fewer units profitable at a given price. Some examples of this shift that can be used in class are: 1. An increase in labor costs increases the cost of producing each unit of the good, so a lesser quantity of units is profitable at each price. 2. A decline in technology increases the number of resources necessary for each unit, increasing the cost of producing each unit, decreasing the number of units profitable at each price. 3. The sales tax is raised on a good (for example,a local option sales tax is approved for a region), increasing the cost to the seller, decreasing the profitability each each unit and therefore the quantity offered at each price. 4. If sellers believe the future price is now higher than previously, they may choose to inventory some units rather than offering them now (a decrease in quantity supplied at each price), to gain the relatively higher future profit.
The instructor should discuss with the class the concept of differing expectations and views of the probability of certain events: this time, however, from the supplier point of view. The premiums for car insurance provide an excellent example for class discussions. Why insurance rates are higher for younger drivers, lower for married people, all cement the idea that sellers of insurance and other intangible goods have their own expectations of the amount paid out for claims (their “costs”) and therefore what price (premium) they are willing to accept for their “product” (promise to pay).
Using the example futures contract introduced in slide 14, it was discussed then how buyers might view such a contract. Now it is time to discuss the seller side. The specifics of the contract should be reviewed: holders of the contract receive $1 if Bradley is the nominee, $0 otherwise. If holders are not sure if Bradley will be the nominee, they may be willing to sell their contract. Holders would take into account the probability that Bradley will receive the nomination, and therefore the expected payout of the contract. The minimum price holders are willing to accept, their “cost”, could either be the expected payout or the price that was paid for the contract.
This is the actual supply curve for Bradley contracts from the IEM data. As before, the instructor may wish to have the students construct this graph from the raw data or merely use this as a real-life example.
In this example, suppose that a tax was placed on transactions occurring over the internet. Therefore, if a Bradley contract is sold, the seller would have to pay the tax to the government. This would have the effect of raising the “cost” to the seller, and would raise the price the seller would have to receive to make selling the contract “profitable”. Therefore, for each possible quantity of the Bradley contract, a higher price would be needed to make that quantity profitable of offered (a decrease in supply).
A market, then, would be described as the getting together of buyers and sellers to make exchanges seen as beneficial. This is shown graphically as the supply and demand curves “together” on the same graph. The instructor should note that 1. A market requires both buyers and sellers. 2. A unit will be exchanged if the exchange benefits both buyer and seller.
In the above example, we can see what would occur in a market at a price above equilibrium. At a price of $4, the quantity demanded is 2 units. In other words, at that price, only “two” people are willing to buy the good or only two units are seen as providing enough benefit for people to be willing to pay $4 for them. At $4, the quantity supplied is 4 units. In other words, that price is high enough for 4 units of the good to be profitable (the “cost” of each is less than or equal to $4). Only 2 units would be purchased in this case, as units 3 and 4 are not “worth” spending $4 on. Units 3 and 4 therefore become “excess quantity supplied”, or a surplus . They are units the seller(s) wish to sell, but will not.
In the case of a typical good, a surplus results in an undesired and unplanned increase in inventory levels. The seller, faced with a need to decrease both the amount offered and increase the quantity demanded, reacts by lowering the price until a surplus no longer occurs: at the price where quantity supplied equals quantity demanded. In the case of an IEM contract, since the buyer is willing to pay more ($4 for the second unit) than the seller is willing to accept ($2 for the second unit), that unit will be traded, and the trade price for the next unit (3rd) will be lower.
At a price of $2 (below equilibrium), the quantity supplied is 2 units (only the first 2 units have a “cost” low enough to be profitable at $2) and the quantity demanded is 4 units (at that price, 4 units provide the buyer with enough benefit to make them worthwhile). This results in units 3 and 4 being “excess quantity demanded”, or a shortage.
In today’s businesses, the need to satisfy customers is a primary issue. In this case, there is an excess quantity demanded. Rather than not provide customers with the product, sellers will typically pull units out of inventory to satisfy the customers. This will result in an undesired and unplanned decrease in inventory levels. Faced with the need to increase the amount they offer, and decrease the quantity demanded, sellers will react by raising price until the shortage no longer occurs (at the price where quantity demanded equals the quantity supplied).
At this price ($3), the quantity supplied (3 units) equals the quantity demanded (3 units). At this price, all 3 units will be exchanged. Since no surpluses or shortages occur, there is no pressure on price to change or the market to adjust. Since this situation has both of the following characteristics: 1. once a market reaches this point, there is a tendency to stay at this point, 2. when a market is not at this point, the resulting surplus or shortage will move the price toward this point, it is an equilibrium point . For a futures contract such as those on the IEM, the equilibrium can be described as the amount where the bid price equals the ask price.
Price ceilings : a government mandated maximum legal price for a product, effective only if placed at a price below the market equilibrium price; otherwise, the market will simply move to equilibrium. An effective price ceiling will therefore result in a perpetual excess quantity demanded. Since inventories cannot cover this indefinitely, the quantity exchanged will revert to the quantity supplied. The quantity sold being less than the quantity demanded will then require a new method of rationing the good. (Examples of other rationing methods include a lottery, queuing, and others.) Minimum wage is an example of a price floor: a government mandated minimum legal price for a product, effective only if placed at a price above the market equilibrium price; otherwise, the market will simply move to equilibrium. An effective minimum wage will result in the quantity purchased by buyers (employers) will be less than the quantity offered by workers. This excess quantity supplied in the labor market translates into underemployment or unemployment. The instructor could explore the effect on the shape of the labor supply curve by introducing the “backward L” shaped supply curve for labor.
In the Bradley market, by putting the supply and demand curves together, we can now explore the effect of supply and demand shifts on the price of the “good”. Assuming the market is initially in equilibrium (the last traded price on the IEM), the demand shift predicted as a result of the nba party would result in a “surplus” of the contract. This would be interpreted as for each contract, people are now willing to pay more since they see the probability that the Bradley contract will pay off $1 is higher. This will result in the next trade price to be higher (an increase in the equilibrium price). The effect of a tax shifting supply can also be analyzed. The higher “cost” of each contract will result in holders of that contract requiring a higher price (a decrease in the supply of the contract) for the contract to be profitable. This will result in the next trade price to be higher (an increase in the equilibrium price).
When a market is in equilibrium, then, the last price traded is the equilibrium price. Since only those units which benefits both buyers and sellers will be traded, all of the units to the “left” of the equilibrium point have already been exchanged. Therefore, in a futures market especially (which reach equilibrium very quickly), the bid prices of the buyers and the ask prices of the sellers that are “seen” (shouted out in a pit, listed on the IEM market screens)are those for trades that have not occurred; those to the “right” of the equilibrium point.
In this slide, we see a close-up of the “right” side of a market in the context of the IEM markets. The last trade price is shown as the equilibrium price; the next prices in the queues are for the next contract in the respective queues. The next lowest ask price in the supply queue is now the “best ask”, while the next highest bid price is now the “best bid”. Since the seller requires more than the buyer is willing to pay, this unit will not currently be traded.
The IEM is a real-time, real $ futures market at the University of Iowa. Here, buyers and sellers trade contracts based on political, economic and business events. The political markets have a strong reputation for accurately predicting the popular vote of U.S. Presidential elections. Since 1988, the IEM has been, on average, more accurate than the major polling organizations. For more details, the instructor can check out the IEM web site at the address on the slide.
This is an example of the type of information available to traders in the IEM markets. This particular screen mock-up was from 12/10/99. BRADLEY refers to the contract which pays $1 if Bill Bradley is the Democratic nominee for President in the 2000 election. It pays $0 otherwise. GORE refers to the contract which pays $1 if Al Gore is the Democratic nominee for President in the 2000 election. It pays $0 otherwise. The Last, Low, High and Average columns refer to the prices of executed trades since 12:01 am of the previous night. For this example, the data cover the time period from midnight on Friday, December 10, 1999 to three forty-five PM in the afternoon of the same day . Depending on the class, the instructor may want to discuss why the Bids add up to less than $1 and the Ask prices add up to more than $1. This would also be a good test question. The instructor may wish to show slide 39 again to reinforce the relationship between these data and the market demand and supply curves.
Depending on how the instructor is going to use the IEM in the future, non-political markets may be more appropriate for the students. With this assignment, the students get early exposure to the specifics of a currently-running IEM market. They apply their knowledge of supply and demand to understand how and why information changes the prices in the specific IEM market.
This slide is useful for instructors who wish to have their students actually trade in the markets. At this point, the instructor should guide the student through the process of placing limit orders. 1. The instructor should discuss the limit order section of the trading manual, available online from the IEM home page; follow the link to documents. 2. The instructor, if possible, should demonstrate placing bid and ask orders online through their own or a practice account. 3. If possible, the instructor should then supervise students practicing bid and ask orders in the IEM practice markets.
This slide is useful for instructors wishing to have their students trade in the IEM markets. A bundle of contracts consists on one of each of the contracts in the market. At the end of the market, one of these contracts will pay $1 while the others will pay $0. Therefore, the expected value of the set of all contracts is $1. A traders buy s a bundle of contracts in order to keep those contracts she believes will pay $1 and sell off those which she believes will pay $0. The instructor might want to discuss why traders will have different expectations of the same event, e.g. Presidential election, price of Microsoft stock on a given day, inflation rate or whether the Federal Reserve Open Market Committee (“the Fed”) will raise interest rates at its next meeting. Depending on the sophistication of the students, a discussion of the variance in beliefs on the prices in the markets is also interesting.
For the bottom-line oriented student, this is a key slide. Note that these prescriptions are easier to describe than execute!
Supply, Demand and Market Equilibrium By: Thomas Gruca - University of Iowa Mark Pelzer - Kirkwood Community College
Demand for an intangible good <ul><li>For example, a promise exchanged for money </li></ul><ul><li>Value of the promise depends on future events </li></ul><ul><li>Examples </li></ul><ul><ul><li>loans </li></ul></ul><ul><ul><li>insurance </li></ul></ul>
Demand for an intangible good <ul><li>Application: a futures contract </li></ul><ul><ul><li>value based on a future event </li></ul></ul><ul><ul><li>possible events </li></ul></ul><ul><ul><ul><li>price of a bushel of wheat in October </li></ul></ul></ul><ul><ul><ul><li>Microsoft stock price on 3rd Friday of June </li></ul></ul></ul><ul><ul><ul><li>value of the Euro in $ on February 1st </li></ul></ul></ul><ul><ul><ul><li>price of oil on April 21st </li></ul></ul></ul>
Assignment <ul><li>Political futures contract </li></ul><ul><ul><li>pays $1 if Bradley is the Democratic nominee for 2000 </li></ul></ul><ul><ul><li>pays $0 otherwise </li></ul></ul><ul><li>Price that someone is willing to pay is based on their own prediction of a particular outcome </li></ul><ul><li>Assignment: graphing a real demand curve </li></ul>
Change in quantity supplied due to a change in price I II S
Shifts in the Supply Curve <ul><li>prices of relevant resources </li></ul><ul><li>technology </li></ul><ul><li>taxes </li></ul><ul><li>number of sellers </li></ul><ul><li>expectations of future prices </li></ul>
Supply for an intangible good <ul><li>Simplified insurance example </li></ul><ul><li>Why would anyone supply car insurance? </li></ul><ul><li>Seller expects that you will not have an accident during the next year </li></ul><ul><li>If you do, they pay the bills. If not, they still keep the premium (price of policy) </li></ul><ul><li>Prices depend on how likely there will be a claim </li></ul>
Political Futures Contract <ul><li>Recall our example political futures contract </li></ul><ul><li>People holding this contract get $1 if Bradley is the Democratic nominee for 2000 and $0 otherwise </li></ul><ul><li>They may be willing to sell if they are not 100% sure that Bradley will be the nominee </li></ul><ul><li>Assignment 4: graphing a real supply curve </li></ul>
Government interventions: Price controls <ul><li>The government sets a maximum price </li></ul><ul><ul><li>Example: the price of basic commodities in many countries (milk, flour, bread, rice) </li></ul></ul><ul><ul><li>what happens to the availability of this good? </li></ul></ul><ul><li>The government sets a minimum price for wages </li></ul><ul><ul><li>Example: minimum wage </li></ul></ul><ul><ul><li>what happens to the supply of labor? </li></ul></ul>
Supply and demand information available in a real market Price Quantity S D Exchanges that already have occurred Offers to sell (ask price) Offers to buy (bid price) Market price (observed)
Supply and demand information available in a real market Price Quantity S D Eq.Q Eq.Q +1 Best Ask Best Bid Last Trade Note: Eq.Q. is equilibrium quantity
Iowa Electronic Market <ul><li>The market for Bradley contracts is run by the Iowa Electronic Market </li></ul><ul><ul><li>real $, real time futures market run by the Tippie Business School at the University of Iowa </li></ul></ul><ul><ul><li>web site: www.biz.uiowa.edu/iem </li></ul></ul>
IEM Prices: 12/10/99 <ul><li>Market Quotes: DCONV00 </li></ul><ul><li>(2000 Democratic National Convention Market) </li></ul><ul><li>Quotes current as of 15:45:05 CST, Friday, December 10, 1999 . </li></ul><ul><li>Symbol Bid Ask Last Low High Average </li></ul><ul><li>BRADLEY 0.310 0.324 0.311 0.311 0.323 0.314 </li></ul><ul><li>GORE 0.682 0.694 0.682 0.681 0.698 0.682 </li></ul><ul><li>DCROF 0.002 0.003 0.002 0.002 0.002 0.002 </li></ul><ul><li>DCROF is a contract for candidates other than Gore and Bradley </li></ul>
Assignment 7 <ul><li>Choose one of the current markets running at the IEM </li></ul><ul><ul><ul><li>Read the prospectus to make sure you understand how the contracts work </li></ul></ul></ul><ul><ul><ul><li>Using various news sources, try to determine what events will affect prices in the IEM for two-weeks </li></ul></ul></ul><ul><ul><ul><li>Using your understanding of supply and demand, predict how prices should change </li></ul></ul></ul><ul><ul><ul><li>Determine if your predictions were correct and reconcile any discrepancies </li></ul></ul></ul>
How do bid,ask prices happen? <ul><li>The bid and ask prices you see on the IEM trading screen are offers to buy and sell posted by traders in the market. </li></ul><ul><li>Other information available includes: </li></ul><ul><ul><li>last traded price </li></ul></ul><ul><ul><li>volume of trades </li></ul></ul><ul><ul><li>historical prices </li></ul></ul>
How do you get contracts to sell? <ul><li>There are two ways to buy contracts </li></ul><ul><ul><li>Buy a bundle of contracts from the market </li></ul></ul><ul><ul><ul><li>each market has a set of contracts </li></ul></ul></ul><ul><ul><ul><li>only one will pay $1, all others pay 0$ </li></ul></ul></ul><ul><ul><ul><li>keep the contracts that you think will pay off and sell the others </li></ul></ul></ul><ul><ul><li>Buy from another trader </li></ul></ul>
How do you make $ in the IEM markets? <ul><li>Buy and hold those contracts which eventually pay $1 </li></ul><ul><li>Buy contracts at a low price and sell them when the prices rise </li></ul><ul><li>Sell one of each contract when sum of all bid prices is greater than $1 (Why?) </li></ul>