1. Markets
Gregory Chase
ACK

2. Economic Systems
• Capitalism – means of production are privately owned;
distribution of goods and services is determined by the
market (Market economy: laissez-faire)
• Communism – common ownership of the means of
production; equal distribution
• Socialism – many definitions & variants. Think of it as
growing from a concern with problems associated with
the market economy and a focus on social outcomes
• Mixed economy – both state and private sector direct
the economy

3. Market Economy
• A market is any place where buyers and sellers
come together for the purpose of exchange
• Characteristics of a market
Voluntary exchange
An agreed price
Mutual benefits
Spontaneous (not centrally directed)

4. A Simple Market Model
• Think about how many goods and services are
bought and sold every day.
• How does the market economy coordinate the
production and distribution of so many goods
and services?
• This is a “problem” we can examine using
economic modeling (identify a
problem, develop a model, test the model)

5. Demand and Supply Model
• Depicts the interaction of buyers (demand) and sellers
(supply) in a marketplace
• How this interaction determines price and quantity
traded
• Assumes both parties are pursuing their own self-
interest
• Buyers – allocate scarce income (make choices) among
a range of goods and services in order to maximise
utility
• Sellers – allocate scarce resources (make investment
decisions) and sell goods and services in order to
maximising profits

6. Determinant of Demand
• In the previous lecture we examined the
demand for housing
• Now let’s consider a more generalised
depiction of demand
• What are some of the key determinants of
demand?
• Do these variables have a positive (direct) or
negative (inverse) relationship with demand?

7. Determinants of Demand
Variable
Price
Price of related goods – substitutes, complements
Income
Tastes and preferences
Population (number of buyers)
Expectations of future (consumer sentiment)
Interest rates…etc.

8. Determinants of Demand
Variable Relationship Explanation
Price Inverse •If the price of a good or service increases, we expect
demand to fall
•Is this always the case? Can you think of an example when a
fall in price might not lead to an increase in demand?
Price of related goods
•Substitutes
•Complements
Direct
Inverse
•If the price of a substitute falls, this makes it cheaper
relative to this good or service and demand will fall.
•Consumed in “bundles”. If the price of a complementary
good increases, demand decreases. Examples?
Income
•Normal good
•Inferior good
Positive
Inverse
•Demand increases as income increases
•Demand falls as income increases
Expectations Positive
Inverse
•If optimistic about future
•If pessimistic about future
Population Direct

9. The Demand Curve
• Simplifying assumption of ceteris paribus
• Enables economists to construct models that
explore how a change in one variable affects
another, other things remaining constant
• Let’s assume all the determinants of demand -
except price - are constant, so we can isolate
and observe the relationship between these
two variables

10. The Demand Curve
Quantity Price
1 $2.50
2 $2.40
3 $2.15
4 $1.95
5 $1.80
6 $1.60
7 $1.40
8 $1.20
9 $0.95
10 $0.70
Price
Quantity
•At $2.50 we could sell 1 unit; at $2.10 we could sell 3 units; at $1.50 we could sell
7 units
•We can think of the price each individual is willing to pay as the marginal value
placed on the good (or marginal utility derived from consuming the good)
$2.50
$2.40
$2.15
$1.95
$1.80
$1.60
$1.40
$1.20
$0.95
$0.70
$0.00
$0.50
$1.00
$1.50
$2.00
$2.50
$3.00
0 2 4 6 8 10 12

11. Maximising Revenue
• If we had several cans of coke to sell - at what
price would we maximise revenue?
• Total revenue (TR) is simply price (P)
multiplied by quantity (Q)
• Short-hand: TR = P*Q

12. Maximising Revenue
• We can sell one can at $2.50. If we charge a price of $2.40 we would be able to sell
2 units, increasing revenue from $2.50 to $4.80.
• If we lower price to $1.40 we could sell 7 units and generate a TR of $9.80
• Note: when we lower price from $2.50 to $2.40 we add $2.30 to total revenue.
Why is the additional revenue lower than the selling price?
Quantity Price Revenue
1 $2.50 $2.50
2 $2.40 $4.80
3 $2.15 $6.45
4 $1.95 $7.80
5 $1.80 $9.00
6 $1.60 $9.60
7 $1.40 $9.80
8 $1.20 $9.60
9 $0.95 $8.55
10 $0.70 $7.00
$2.50
$4.80
$6.45
$7.80
$9.00
$9.60 $9.80
$9.60
$8.55
$7.00
$0.00
$2.00
$4.00
$6.00
$8.00
$10.00
$12.00
1 2 3 4 5 6 7 8 9 10
Revenue
Revenue

13. Activity
• Starting at a price of $2.50 calculate the
marginal revenue of each additional unit
sold, as we progressively lower the price
• Marginal analysis refers to a process of
examining the incremental effect of small
changes in one variable on other variables.
• Marginal revenue – the additional revenue
gained from selling one more unit.

14. Marginal Revenue
Quantity Price Revenue
Marginal
Revenue
1 $2.50 $2.50
2 $2.40 $4.80 $2.30
3 $2.15 $6.45 $1.65
4 $1.95 $7.80 $1.35
5 $1.80 $9.00 $1.20
6 $1.60 $9.60 $0.60
7 $1.40 $9.80 $0.20
8 $1.20 $9.60 ($0.20)
9 $0.95 $8.55 ($1.05)
10 $0.70 $7.00 ($1.55)
$2.30
$1.65
$1.35
$1.20
$0.60
$0.20
($0.20)
($1.05)
($1.55)
-2
-1.5
-1
-0.5
0
0.5
1
1.5
2
2.5
1 2 3 4 5 6 7 8 9 10
Marginal Revenue
Diminishing Marginal Revenue

15. Demand, Price and Revenue
• There is an inverse relationship between price
and quantity demanded.
• Lowering price means we can sell more units.
• Initially as we reduce price and increase
sales, total revenue increases.
• At some price, further reductions in price reduces
total revenue.
• We can use marginal analysis to help us
understand this. Let’s look at TR and MR together.

16. $2.50
$4.80
$6.45
$7.80
$9.00
$9.60 $9.80
$9.60
$8.55
$7.00
$0.00
$2.00
$4.00
$6.00
$8.00
$10.00
$12.00
1 2 3 4 5 6 7 8 9 10
Revenue
$2.30
$1.65
$1.35
$1.20
$0.60
$0.20
($0.20)
($1.05)
($1.55)-2
-1.5
-1
-0.5
0
0.5
1
1.5
2
2.5
1 2 3 4 5 6 7 8 9 10
Marginal Revenue
• When we reduce price from $2.40 to
$2.15, marginal revenue falls from $2.30
to $1.65
• Selling one more unit adds $1.65 to total
revenue, which increases from $4.80 to
$6.45
• Let’s take another example
• If we reduce price from $1.40 to
$1.20, marginal revenue is -$0.20
• That is, increasing sales by one unit
would lower total revenue by $0.20
• If our aim was to maximise revenue – we
would not lower price beyond $1.40
• It would not be rational – in an economic
sense – to produce and sell at a price
when MR is negative.
• Remember: optimisation – firms
maximise profit; consumers maximise
utility

17. Responsiveness of Demand
• TR = P*Q
• P and Q are inversely related
• If we lower price, quantity demanded increases
• Question: if we lower price by 10% and quantity goes up by
20%, would you expect TR to rise or fall?
• P( 10%) x Q ( 20%) = TR
• If the % increase in demand is greater than the % fall in
price, then TR will increase
• Whether TR rises or falls, depends on the responsiveness of
demand to a change in price
• Economists refer to this as the price elasticity of demand

18. Quantity Price Revenue
Marginal
Revenue
% Change in
Quantity
% Change in
Price
1 $2.50 $2.50
2 $2.40 $4.80 $2.30
3 $2.15 $6.45 $1.65 +50% -10%
4 $1.95 $7.80 $1.35
5 $1.80 $9.00 $1.20
6 $1.60 $9.60 $0.60
7 $1.40 $9.80 $0.20
8 $1.20 $9.60 ($0.20)
9 $0.95 $8.55 ($1.05) +13% -21%
10 $0.70 $7.00 ($1.55)
Elastic
Inelastic
Let’s consider two examples

19. Price elasticity & total revenue
19
TR1 = P*Q = $30x10,000 = $30,000
If price is lowered to $20
TR2 = $20x30,000 = $60,000
Loss of TR
Gain in TR

20. Variations along a straight-line
demand curve
20
Notice how TR reflects the variation in elasticity along
the demand curve.

21. Mutual benefits
• Market: buyers and sellers come together
voluntarily for the purpose of exchange
• Buyer values the product or service more than
the price s/he pays
• Seller values the price received more than the
product/service exchanged
• Both parties to the transaction are therefore
optimising/maximising
• How can we measure these benefits?

22. Utility (Satisfaction)
• The highest price any consumer is
willing to pay is $2.50: this is the
marginal value placed on the good
• A market price of $1.50 means that
this consumer has a “surplus” of
$1.00: money they would have spent
to acquire the good but did not have
to.
• This consumer surplus is the benefit
received.
• If it costs the seller $0.50 to produce
the product – they receive a producer
surplus of $1.00 per unit
• The individual that places a marginal
value of $1.40 or $1.20 will not give
up $1.50 – the market price – to
acquire the good.
• Now, imagine the quantities on the
horizontal axis were measuring
millions of units. What would be the
producer surplus if price was $1.95?
$2.50
$2.40
$2.15
$1.95
$1.80
$1.60
$1.40
$1.20
$0.95
$0.70
$0.00
$0.50
$1.00
$1.50
$2.00
$2.50
$3.00
0 2 4 6 8 10 12
P =
Using marginal analysis to explain the
mutual gains from market transactions
Price
Quantity
$1
$0.65
Cost per unit
$1

23. 23
An individual demand curve
The demand curve has a negative/inverse slope.

24. 24
An individual demand curve
The demand curve has a negative/inverse slope.
At the higher price consumers will consume less units.
At a lower price they will consume more units.

25. 25
Individual demand curves
Line up the price levels so Y-axis is the same scale.

26. 26
Market demand
Market demand is the horizontal summation of individual
demand schedules.

27. 27
WHEN price changes
When
price
changes,
quantity
demanded
changes.
There is a
movement
along the
demand
curve.

28. Non-price determinants
of demand
Changes in demand occurs when the following
non-price determinants of demand change:
• number of buyers in the market
• tastes and preferences
• income
• expectations of buyers
• prices of related goods
28

29. 29
WHEN non-price factors change
Change in
demand
Demand
curve shifts

30. 30
Summary: Demand
Price Changes:
• Increase:
• decrease in the quantity
demanded
• leftward movement up
the demand curve
• Decrease:
• increase in the quantity
demanded
• rightward movement
down the demand curve
Changes in a non-price
factors:
• Favourable:
• an increase in demand -
a rightward shift of the
whole curve
• Unfavourable:
• a decrease in demand –
a leftward shift of the
whole curve

31. 31
Supply
• A direct relationship between the price of a
good and the number of units sellers are
willing to offer for sale in a defined time
period, ceteris paribus.
• The supply schedule (table) shows the
quantity of a good or service that firms are
willing and able to offer for sale at different
prices.
• The supply curve shows this relationship.

32. 32
An individual seller’s supply curve
for DVDs
Note that the supply curve has a positive slope.

33. 33
A positive relationship
At a higher price, sellers will offer more units for sale.
It is more profitable for sellers to supply more at higher prices.

34. 34
Individual supply curves
Line up the price levels so Y-axis is the same scale.

35. 35
Market supply
Market supply is the horizontal summation of individual
supply schedules in the market.

36. 36
Changes in quantity supplied
If the price
changes,
quantity
supplied
changes.
This is a
movement
along the
supply curve.

37. Non-price determinants
of supply
37
Changes in supply occur when the following NON-
PRICE determinants of supply change:
• number of sellers in the market
• available technology
• input prices
• taxes and subsidies
• expectations of producers
• prices of other goods the firm could produce

38. 38
Changes in supply
A change in
non-price
factors is
known as a
change in
supply; i.e.
the supply
curve shifts.
Rightward
shift indicates
supply
increasing.

39. 39
Impacts of changes in non-price
determinants

40. The Price Mechanism
• Price acts as a coordination mechanism that
rations goods and services among consumers
• How does it do this? Let’s develop a simple
economic model to help explain the operation
of a market.

41. 41
Market supply and demand
• A market exists where interaction amongst
buyers and sellers determines the price
and quantity of goods and services
exchanged.
• This is often called the price mechanism or
price system – the forces of supply and
demand create market equilibrium.

42. 42
Equilibrium
• A market condition that occurs at any
price for which the quantity demanded
and the quantity supplied are equal.
• Equilibrium is the point of balance
between demand and supply in the
market.

43. Supply and demand for jeans
43

44. 44
Market forces bring change
• At any price other than the equilibrium
price, market forces act to bring the market into
balance.
• In a surplus there is excess supply: sellers
compete for buyers by cutting their selling
price.
• In a shortage there is excess demand: potential
customers try to attain the available goods by
paying a higher price.

45. What to Produce?
• One of the fundamental economic problems
• How the price mechanism help to coordinate
the allocation of scarce resources among the
hundreds of thousands of goods and services
we can produce in any given period?
• Let’s consider what would happen, for
example, if there was a change in consumer
preferences that caused many to shift away
from cars to bicycles.

46. The Market for Cars
• Fewer people buy cars
• Demand decreases (demand curve shifts to the
left)
• This creates a surplus at current prices
• Prices fall to remove the surplus
• Lower prices cause supply fall
• As supply falls fewer resources are drawn into
this sector of the economy

47. The Market for Bicycles
• More people buy bicycles
• Demand increases (demand curve shifts to the
right)
• This creates a shortage at current prices
• Prices rise in response to the shortage
• Higher prices cause supply to increase
• As supply increases more resources are drawn
into this sector of the economy

48. The Price Signal
• Price is a signal to producers/ entrepreneurs about the relative value that
consumers place on goods and services
• If consumers demand more of a product, price will rise and this will cause
production to increase – thereby drawing more resources into this sector
of the economy
• On the supply side, if a product (or resources required to product that
product) becomes scarce, it will become more expensive. This will lead to
an increase in price
• We can think of price as rationing goods and services among the
population
• If a consumers marginal valuation for a product is equal to (or greater
than) the price – and they have the income – they can acquire the product
• If their marginal valuation is below price – and/or their income is too low –
they will not be able to acquire the product
• Price therefore acts as a mechanism that rations our limited goods and
services among consumers
• Only when consumers are willing and able to buy a product will they do so

49. Water-Diamond Paradox
• Why are diamonds more expensive than
water, when it is water that is necessary to
sustain life?
• Economists refer to this as the paradox of value
• The answer is scarcity
• If we have an abundance of water, then we would
generally not value it very highly
• How quickly would you trade diamonds for water
if you were stranded in the desert?