Markets• Markets are an important

mechanism for solving the problem of optimal use of scarce resources

• Buyers and sellers• Buyers:- consumers, who buy goods and

services- Firms, which buy labor, capital

equipment, etc.

Markets

• Sellers:- Consumers as workers sell their

labor services- Firms sell their goods and services

Markets

• Markets as a collection of buyers and sellers of a particular product/products

• An industry is a collection of firms while a market consists of both firms (as sellers) and consumers (as buyers)

Markets• Market definition (the extent of

market) can be important• Market definition identifies which

buyers and sellers should be included in a given market

• To determine which buyers and sellers to include, we need to determine the extent of a market

• Its boundaries – both geographically and in terms of the range of products.

Market definition - Geographic

• Some markets have restrictive geographic boundaries

• Consider market for housing• It is city-specific• Dwellers in a particular will not

want to stay in houses long distance away, even though this may be cheaper

• Homes and land cannot be shifted closer to cities

Market definition – range of products

Consider 35 mm SLR cameras• Are digital cameras and Polaroid

instant cameras in the same market?Consider cars• Are petrol cars and fuel cell powered

cars (REVA) in the same market?Sometimes the degree of substitution

depends on the current prices. Fuel cell powered cars may not be substitutes for petrol-run cars at current petrol prices, but may become substitutes if the price of petrol increases sufficiently.

Demand-supply Analysis

A market consists of the buyers and sellers of a good or service: abstraction from any concept of specific time and location of a market.

The market demand schedule shows the amounts of the commodity that buyers are prepared to buy at different prices.

Demand Schedule

The Demand Curve: The Relationship between Price and Quantity Demanded

• Demand Curve – The demand curve is a graph of the relationship

between the price of a good and the quantity demanded.

Demand Schedule and Demand Curve

Copyright © 2004 South-Western

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1. A decrease in price ...

2. ... increases quantity of cones demanded.

       The downward sloping demand curve obeys the law of demand: quantity demanded decreases as price increases.

       The slope is negative (but may not be constant) at all points of the demand curve.

It is obvious from even casual observation or introspection that demand depends on many things.

In general, the quantity demanded is expected to depend, in addition to the own price, on

       incomes

       tastes and preferences

       prices of “related” commodities       expectations, etc.

A change in any of these other factors thus leads to a shift in the entire curve.

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A tax that raises the price of ice-cream cones results in a

movement along the demand curve.

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Changes in Quantity Demanded

Shifts in the Demand Curve

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Demand curve, D3

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       If I (income) increases, we expect more to be demanded at every price – the demand curve will shift to the right.

When we draw the demand curve, we are focusing only on the relationship between price and quantity demanded. We can do this by assuming that “everything else” is being kept fixed at certain levels. How do we expect the “other things” to influence demand? 

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Increasein demand

An increase in income...

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D2

Consumer IncomeNormal Good

However, there may be some ‘inferior’ goods whose demand falls as income increases.

For example, an increase in the incomes of poor farmers might lead them to buy more of rice and wheat and less of coarse cereals like ragi, jowar, and bajra.

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Decreasein demand

An increase in income...

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Consumer IncomeInferior Good

·   If T (tastes and preferences) change such that buyers like a commodity more, again the same thing will happen.

Tastes and preferences can change for many reasons: 

Demographic changesIf population comes to consist of larger proportion of older people, this will affect pattern of demand.New Information Dissemination of the information on harmful side-effects of drugs can lead to a fall in demand for these drugs.

Government decisionsBan on advertising of certain goods can adversely affect demand for such goods

Prices of related goods:

If the price of a substitute rises, we expect the demand to rise, too (as price of coffee rises, the demand curve for tea shifts upward and to the right).

If the price of a complement rises, we expect the demand to fall (as price of sugar rises, the demand curve for tea shifts downward and to the left).

• Prices of related goods contd.

Complements• The dramatic fall in the price of

computers over the past twenty years has significantly increased the demand for printers, monitors and internet access.

• air travel and hotel rooms • movies and popcorn • bathing suits and sun tan lotion• candy and dentistry

• Prices of related goods contd.

Substitutes• computers and typewriters• movies (in theaters) and sporting

events• restaurants and dining at home • holiday in Goa versus holiday in

Mussourie• marijuana and alcohol• economics courses and political

science courses

   An expectation that prices will rise in the future shifts the demand curve to the right.

The simple thing to remember is:

a change in commodity’s own price by itself can only represent a movement along the demand curve and not a shift in the curve;

however, a change in any of the “other things” will lead to a shift of the demand curve.

A numerical exampleSuppose that the demand function is

Qd = 1800 – 20P +0.6M – 50PR

Also suppose M = 20,000 and PR = 250

Then Qd = 1800 – 20P +0.6(20,000) – 50(250) = 1800 – 20P + 12,000 – 12,500

Qd = 1300 – 20P

Note: (i) Any change in M or PR affects the demand curve through the intercept term – shifts the demand curve

(ii) The sign of the coefficient of PR is negative – hence this is a complement

The market supply schedule shows the amounts of the commodity that sellers are prepared to sell at different prices.

Supply Schedule

The Supply Curve: The Relationship

between Price and Quantity Supplied • Supply Curve

– The supply curve is the graph of the relationship between the price of a good and the quantity supplied.

Supply Schedule and Supply Curve

Copyright©2003 Southwestern/Thomson Learning

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1. Anincrease in price ...

2. ... increases quantity of cones supplied.

 

The upward sloping supply curve that has been drawn exemplifies the law of supply: quantity supplied increases as price increases. Like demand, supply also depends on many things.      

       own price

       technological knowledge

       input prices,

       expectations, etc.

In general, the quantity supplied is expected to depend on

How do we expect the “other things” to influence supply?

A change in technology that allows the commodity to be produced more cheaply should shift the supply curve downwards and to the right.If input prices increase, exactly the opposite should happen.

As wages rise, the supply of goods and services is reduced, because wages are the input price of labor. Labor sometimes accounts for about two-thirds of all input costs, and thus wage increases createsupply reductions (a higher price is necessary to provide the same quantity) for most goods and services. Costs of materials of course increase the price ofgoods using those materials. Petrol - crude oil

Another significant input in many industries is capital. Increases in interest rates increase the cost of production, and thus tend to decrease the supply of goods.

A numerical example

• Suppose that the supply function is Qs = 50 + 10P – 8PI + 5T

If PI = 50 and T = 90, then

Qs = 50 + 10P – 8(50) + 5(90)

= 50 + 10P – 400 + 450Qs = 100 + 10P

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of ice cream cones results in a movement along the supply curve.

Change in Quantity Supplied

Shifts in the Supply Curve

• Change in Supply– A shift in the supply curve, either to the left or

right. – Caused by a change in a determinant other than

price.

Shifts in the Supply Curve

Copyright©2003 Southwestern/Thomson Learning

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Increasein supply

Decreasein supply

Supply curve, S3

curve, Supply

S1Supply

curve, S2

Equilibrium

• The demand and supply curves intersect to determine the market equilibrium

• Equilibrium: a price-quantity pair• Why call it equilibrium?1. If the market is at (P*, Q*), there are no

forces to move it away from (P*, Q*)2. If the market is not at equilibrium, it

tends to come back to equilibrium

At $2.00, the quantity demanded is equal to the quantity supplied!

SUPPLY AND DEMAND TOGETHER

Demand Schedule

Supply Schedule

The Equilibrium of Supply and Demand

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Equilibriumquantity

Equilibrium price Equilibrium

Supply

Demand

$2.00

A numerical example

Equation of demand curve:

Qd = 1300 – 20P

Equation of supply curve:

Qs = 100 + 10P

At equilibrium Qd = Qs

1300 – 20P = 100 + 10P

Solving, P = 40

Qd = Qs = 500

Equilibrium

• Surplus– When price > equilibrium price, then quantity

supplied > quantity demanded. • There is excess supply or a surplus.

• Suppliers will lower the price to increase sales, thereby moving toward equilibrium.

Equilibrium

• Shortage– When price < equilibrium price, then quantity

demanded > the quantity supplied. • There is excess demand or a shortage.

• Suppliers will raise the price due to too many buyers chasing too few goods, thereby moving toward equilibrium.

QQ*

P*

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P

DS

DS

P’

P’’

Excess supply

Excess demand

Just why is gas so expensive?

Shifts in equilibrium

• More interesting is the case where there are shifts in supply and/or demand curves

• As a result, the equilibrium shifts• Sometimes, it is useful to predict

the direction of shift

Three Steps to Analyzing Changes in Equilibrium• Decide whether the event shifts the supply

or demand curve (or both).

• Decide whether the curve(s) shift(s) to the left or to the right.

• Use the supply-and-demand diagram to see how the shift affects equilibrium price and quantity.

A war in the Middle East disrupts the supply of oil to India.

At the same time, the minimum age for driving is lowered to 16 years.

We would expect that

(a) both the price of petrol and the quantity purchased would definitely rise.(b) both the price and the quantity purchased of petrol would definitely fall.(c) the price of petrol might rise or fall, but the quantity purchased would definitely fall.(d) the quantity purchased of petrol might rise or fall, but the price of petrol must rise.

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S2 D1

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Pop Quiz

• Consider the market for apples. What would be effect on price and quantity of the following events?

1. Scientists find that an apple a day does not keep the doctor away and a drought shrinks the apple crop to one quarter of its normal size

2. The price of oranges triples and a new insecticide eliminates pests in the apple crop

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Government interventions

• Sometimes Governments try to correct the the existing pattern of income distribution.

• They often try to achieve the results indirectly, by interfering with the market processes.

• Examples are rent control laws and minimum wage legislation.

Rent Control Laws

• Governments sometimes try to set a ceiling on rents in the belief that rents in free market equilibrium would be too high for most people to afford renting flats/apartments.

• Thus in the market for housing, the maximum rent allowed is r’ which is less than the equilibrium level r*

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r

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S

S

D

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r’Excess demand

Rent Control Laws

• At r’, there will be excess demand for housing.

• Who gains from this arrangement? • The people who are able to get

housing at the low rents.

Rent Control Laws• But the unsatisfied demand shows up

in various ways. - First, landlords charge high deposits

and “pugrees”.- Secondly, illegal transactions take

place in the form of charging high rents without issuing corresponding receipts.

- Landlords also might use their discretion to screen applicants, e.g., some landlords might rent out flats only to vegetarians.

Rent Control Laws• More importantly, in the long run,

the smaller value from housing as an asset might discourage landlords from providing adequate maintenance services.

• Over time, funds are switched to other types of investment and less funds are deployed in the housing industry, thus shifting the supply curve to the left, (from SS to S'S') and aggravating the initial condition of excess demand.

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Rent Control Laws in India• In India, different states have passed

different rent control acts. • Generally, for pre-war buildings, rents are

frozen as of a specified year without any provision for subsequent increases in rents.

• For post-war buildings, rents are determined on the basis of specified returns on total investment in housing.

• In many rent acts, there is a provision of a rent control holiday on new buildings for 5-7 years from the date of first letting out.

Rent Control Laws in India• The gross returns that are allowed on post-

war buildings vary from 6-8.25 per cent on the total cost of land and building at the time of construction.

• This is much less than returns from other sources (e.g. fixed deposit interest rates till recently could be 12-13 per cent).

• Moreover, some acts do not allow landlords to recover the increase in local taxes and rates from tenants.

Rent Control Laws in India• It is clear that construction of housing for

rental is strongly discouraged under these acts.

- In all the major cities in India, housing for long term rental is difficult to get. In Bombay, for example, a system of “leave and license” has developed, under which apartments are rented out for 11 months at a time.

- Moreover, landlords have the incentive to neglect maintenance, so that the housing becomes unsafe and then can be pulled down and the vacant land sold at a huge profit.

Minimum Wage Legislation

• Minimum wage legislation is undertaken to ensure that wages paid to workers do not fall below a certain minimum.

• Hence, in the labor market, a floor is set on wages, i.e., wages are not allowed to fall below a certain level.

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w

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S

S

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D

w*

w’Excess supply

Minimum Wage Legislation• At wage rate w*, there is excess

supply of labor.- Since some workers would have

been willing to work for lower wages, a “contract” system of wages tends to develop.

- Workers are employed for smaller periods or in smaller numbers, so that the minimum wage provision does not apply, or they are not paid other benefits like medical benefits, PF, gratuity, etc.

Minimum Wage Legislation

- In the longer run, employers might switch to more machine-intensive processes to economize on labor costs.

- This shifts the demand curve for labor to the left and aggravates the initial condition of excess supply.

Minimum Wage Legislation in India

• The Central Government in India sets minimum wages for workers in different employments at different rates for different categories of workers (unskilled, semi-skilled, skilled, etc.)

• The minimum wages also vary by location, being the highest for the major cities.

• In addition, the state governments also fix minimum wages for certain employments.

Conclusion• Are interventions in the forms of

price ceilings or price floors always undesirable?

• There is some gain from each of these actions and there are some losses, and these must be balanced by society against each other.

• But when markets are not allowed to operate freely, forces build up that tend to bypass regulations, with unintended and undesirable outcomes.