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Preliminary Economics

Sabrina Ho

TOPIC THREE 9.3 MARKETS


The focus of this topic is the operation of markets. The way in which market prices are determined and the need and means available for governments to intervene in markets are highlighted. The role of the market A market is a situation in which buyers and sellers are in contact with each other for the purpose of exchange. arkets don!t have to be physical places due to changes in technology and telecommunications" enabling exchange to take place through mobiles" telephones and computers. Product or good a!d er"#ce market # where and how final goods and services are bought and sold. e.g. markets for fresh fruits and vegetables" meats and fish" groceries goods" and personal service. They allocate goods to consumers who are prepared to pay the highest price. $actor market # markets where the factors of production are bought and old such as the labour market" the capital market" the market for raw materials and the market for management or entrepreneurial resources. They allocate scarce resources to make the goods in highest demand and provide income for consumers. Product and factor markets interact to determine e$uilibrium prices and $uantities of the various goods" services and resources bought and sold Determining solutions to the economic problem The importance of relative price in reflecting opportunity costs in the goods and services and factor markets The interaction between demand and supply determines e$uilibrium prices in markets. The prices of goods and services serve % functions in market economies such as Australia& '. Pr#ce reflect the relat#"e carc#t% of good a!d er"#ce in terms of their supply (. Pr#ce hel& to allocate re ource in the production of goods and services which yield the highest returns to producers ). Pr#ce act a #!ce!t#"e or signals for producers and entrepreneurs to take risks in organising the factors of production to produce the goods and services demanded by consumers *. Pr#ce act a a rat#o!#!g de"#ce in enabling markets to clear. e.g. surplus of goods in a market will usually lead to a fall in price" to encourage demand and discourage production. +onversely" a shortage of goods in a market would lead to a rise in price" causing demand to fall and production or supply to rise %. Pr#ce are a! e'u#l#(rat#!g de"#ce in markets. +hanges in price bring about e$uilibrium between demand and supply if they are in a dise$uilibrium situation such as a shortage or surplus of goods )ema!d a!d u&&l% Demand # the $uantity of a particular good or service that consumers are willing and able to purchase at various price levels at a given point in time Law of demand, individual and market demand, the demand curve *a+ of dema!d #states that as prices rise the $uantity demanded by consumers falls" and as prices falls" the $uantity demanded rises I!d#"#dual dema!d # the demand of each individual consumer for a particular good or service Market dema!d # demands by all consumers for a particular good or service. ,t is obtained by summing the $uantities demanded by all individual consumers at the various price levels

Preliminary Economics

Sabrina Ho

Factors affecting demand price, income, population, tastes, prices of substitutes and complements, expected future prices o Pr#ce of other good a!d er"#ce # e.g. if the price of a substitute good falls" the demand for its substitute will decrease. e.g. tea and coffee" public transport and car ,f the price of a complementary good rises" the demand for its complement will decrease o E,&ected future &r#ce # if consumers expect the price of the product will rise in the future" they may decide to buy -demand. that good before the price rise o Co! umer ta te a!d &refere!ce o Co! umer #!come # as income falls in the economy" demand for luxuries should decrease o S#-e a!d age d# tr#(ut#o! of &o&ulat#o! # as the population increases" the demand for most goods and services should increase. ,f a population gets older" the pattern of demand will see increase for goods appropriate for that populations! age /ET 0A+T12S A00E+T,3/ SHEET ,f a change in these factors causes demand to increase" it is shown as a movement to the right of the demand curve from 4'4' to 4(4( ,f a change in these factors causes demand to decrease" it is shown as a movement to the left of the demand curve from 4'4' to 4(4(

Movements along the demand curve and shifts of the demand curve 5hen the price of good changes" the change in demand is called a co!tract#o! or an e,&a! #o!. 5hen the price of the good or service rises" demands contract and when prices falls" demands expand. ,n the diagram" a rise in the price from 1P' to 1P( results in a contraction in demand from 16' to 16( and a corresponding movement upwards to the left along the existing demand curve. ,f price falls from 1P' to 1P)" demand expands from 16' to 16). The demand for a good or service will change due to factors other than the price of that good or service. Supply # the $uantity of a good or service that all firms in a particular industry are willing and able to offer for sale at different price levels" at a given point in time Law of supply, individual and market supply, the supply curve *a+ of u&&l% # as the price of a product rises" the $uantity supplied by producers will also rise because it is more profitable. This essentially represents the market supply of a particular product, which is the sum of the individual firm supplies of individual producers at the various price levels. Co!tract#o! # in supply occurs when a decrease in price from 1P' to 1P( causes $uality supplied to fall from 16' to 16( E,&a! #o! # in supply occurs when an increase in price in 1P' to 1P) causes $uantity supplied to rise from 16' to 16) Factors affecting supply

Preliminary Economics

Sabrina Ho

# ,mprovements in technology # +hanges in the cost of factors of production. E.g. if wages rise" a firm may retrench some of its workers" decreasing its ability to supply # Price of other goods" the suppliers could produce. E.g. if the price of wheat falls" relative to the price of corn" farmers may plant more corn" increasing the supply # +limate" seasons and natural ha7ards # Personal preferences of suppliers to enter an industry or leave Movements along the supply curve and shifts of the supply curve ,ncrease in supply 4ecrease in supply

Market price Market e uilibrium where at a certain price level" the $uantity supplied and the $uantity demanded of a commodity are e$ual. This means that the market clears -there is no excess supply or demand. and there is no tendency for change in either price or $uantity Pr#ce mecha!# m # process by which the forces of supply and demand interact to determine the market price at which goods and services are sold and the $uantity produced Movement to e uilibrium Sellers are selling the good at the price 1P'" which is below the e$uilibrium price 1PE. At this price -1P'." there is a shortage of goods because consumers are demanding 164 and suppliers are supplying at 16S. The excess demand" results in consumers forcing the price up as they compete for the limited supply. As the price rises" demand contracts and supply expands. This will continue until e$uilibrium is established at 1PE.

Suppliers are selling their good at the price 1P'" which is above e$uilibrium price. At the price 1P'" there is excess supply e$ual to 646S. To sell this excess supply" suppliers will lower the price resulting in an expansion in demand and a contraction in supply. The price will fall until e$uilibrium is achieved at 1PE.

!ffects of changes in supply and"or demand on e uilibrium market price and uantity through the

Preliminary Economics use of diagrams

Sabrina Ho

I!crea e #! dema!d # this diagram is for the umbrella market and Sydney experiences a long spell of wet weather

)ecrea e #! dema!d # the diagram represents the international airline market. Assume we have a global recession

I!crea e #! u&&l% # the diagram represents the market for computers and computer manufacturing technology improves

)ecrea e #! u&&l% # the diagram represents 1ne 4irection concert tickets and it is discovered one member gets sick and they cancel some concerts

Preliminary Economics !ffects of changing levels of competition and market power on price and output

Sabrina Ho

Alternatives to market solutions the role of government 5hen a free market fails to produce a satisfactory outcome for society" it is called market fa#lure. ,f this occurs" the government may intervene and influence the price or $uantity being supplied in the market. This intervention can take form of& '. Price ceiling (. Price floor ). ,ndirect taxes -/ST. *. Subsidies -financial assistance. %. 6uotas -production limit. 8. /overnment production -public services. e.g. public hospitals" public schools" public transport #eiling prices, floor prices Pr#ce ce#l#!g& A price ceiling is imposed by the government" if the market price is considered too high. E.g. if a necessity such as milk or water had a market price that was too high" the government will set a maximum price or price ceiling below the e$uilibrium price.

A &r#ce ce#l#!g redistributes money away from sellers and to consumers. The problem with it is it creates excess demand. Pr#ce floor& ,f the market sets an e$uilibrium that is too low for producers to be profitable" the government may consider setting a minimum price" or price floor above the e$uilibrium price. ,t would do this for necessities such as food to ensure producers don!t leave the market and create a shortage the following year.

A &r#ce floor redistributes income away from consumers who now pay a higher price and to the producers or sellers. The problem with it is it creates excess supply. Market failure merit goods, public goods, externalities

Price elasticity of demand # PE) 9 refers to the responsiveness of demand to changes in the price of the good or service demanded $ignificance of price elasticity of demand market research Business firms need to understand price elasticity of demand for the goods they sell in order to decide on their optimal pricing strategy. If demand was relatively elastic, the firm would know that lowering the price would greatly expand the volume of sales, thus increasing total revenue. On the other hand, if demand was relatively inelastic, the firm could increase the price, which would also

Preliminary Economics

Sabrina Ho

lead to an increase in total revenue, since the reduction in sales would be less than the price increase. Awareness of the elasticity of demand in different price ranges is important for determining the best pricing strategy for a firm and in deciding whether or not to change prices. Government needs to understand price elasticity of demand when pricing the goods and services that it provides for the community (such as public transport fares). Further, it also needs to be able to predict the effects of changes in the level of any indirect taxes, such as sales taxes, excise duties and special levies that it imposes on goods such as alcohol, tobacco products and petrol. These taxes and charges raise the price of the goods affected, and the government needs to be able to gauge the responsiveness of demand in order to accurately estimate the amount of revenue they will raise. %rice elasticity # !lastic, inelastic and unit elastic ,f the demand for a good is !ot "er% re &o! #"e to a change in price" its demand is relat#"el% &r#ce #!ela t#c

,f the demand for a good is "er% re &o! #"e to a change in price" its demand is relat#"el% &r#ce ela t#c

,f the change in price is e'ual #! &ro&ort#o!al cha!ge in the $uantity demanded" demand has u!#t ela t#c#t% and the total spending -outlay. by consumers is unchanged

Perfectl% #!ela t#c dema!d # customers are willing to pay any price in order to obtain a given $uantity of a good or service. This is represented by a vertical demand curve. Perfectly elastic demand consumers will demand an infinite (unlimited) quantity at a certain price, but nothing at all at a price above this. As no such situation exists in reality, this situation can be regarded as merely theoretical. This is represented by a horizontal demand curve.

Preliminary Economics

Sabrina Ho

# #alculation of elasticity using total outlay method Total Outla% . Pr#ce , /ua!t#t% )ema!ded Total outlay can also be called total re"e!ue ,f price and total outlay are moving in o&&o #te d#rect#o! " the PE4 is ela t#c -E1& Emma 1!rourke.. E.g. if prices rise and total outlay falls" the PE4 is elastic for that good ,f price and total outlay are moving in the ame d#rect#o!0 the PE4 is #!ela t#c -,S.. E.g. if price and total outlay are both rising or both falling ,f total outlay is unchanged from one price to the next" demand is experiencing u!#t ela t#c#t% # # # # # Factors affecting elasticity of demand 5hether that good is a luxury or necessity 5hether that good has any close substitutes 5hether the good is addictive or habit9forming Proportion of income spent on the good :ength of time between the price change and the change in demand

Price elasticity of supply # PES 9 measures the responsiveness of $uantity supplied to a change in price !lastic supply, inelastic supply ,f the supply for a good is !ot "er% re &o! #"e to a change in price" its supply is relat#"el% &r#ce #!ela t#c

,f the supply for a good is "er% re &o! #"e to a change in price" its supply is relat#"el% &r#ce ela t#c

,f the supply in price is e'ual #! &ro&ort#o!al cha!ge in the $uantity supplied" supply has u!#t ela t#c#t%

Factors affecting elasticity of supply &no calculations are re uired.

Preliminary Economics

Sabrina Ho

# T#me lag after a &r#ce cha!ge1 The greater the amount of time that producers have to respond to a price change" the more elastic the supply for the product. ,n the time immediately after the price change" the supply of most producers would be perfectly inelastic because producers can!t increase any of their input. Therefore in the short run" the price inelasticity of supply increases" although likely to be relatively inelastic. ,n the long run" however the producers would be able to increase in production in response to a price change" making supply relatively price elastic # The a(#l#t% to hold a!d tore tock1 ,t is possible to store some goods and not offer them for sale when there is a downturn in market conditions and the price falls. This stock of good is known as #!"e!tor% -the total stock of goods and services held by a firm at a point in time" which is intended for sale to consumers." and can be offered for sale when prices rise again. The ability to hold stock will affect the ease with which producers can respond to price changes. The easier it is to hold stock" the more elastic the supply. E.g. highly perishable items" such as fresh fruits would be difficult to hold in stock" where as holding stock for durable goods such as furniture" would make it easier" making supply more elastic # E,ce ca&ac#t%1 Excess capacity exists when a firm is not using its existing resources to their full capacity. Supply will be elastic when firms have excess capacity" because they can respond $uickly to any price increase by using their existing resources more intensively. E.g. a firm operating its plant and machinery at only half capacity could double its output very $uickly in response to a price increase. 1n the other hand" supply will tend to be inelastic when resources are already being used at full capacity. 2ar#at#o! #! com&et#t#o! Market &o+er # of a firm refers to its ability to raise its prices above the market e$uilibrium price. 0irms with a high degree of market power are either monopolies or are so large" they dominate their market and act as the market leaders exercising monopoly like power. ,f a market is dominated by a large firm" there is less competitions in that market. +ompetition can be either price or non9price competition. firms can compete by either lowering prices or using non9 price means" such as advertising" after sale services" and warranty. The greater the degree of competition in the market" the greater the number of firms competing against each other. Market tructure # number of firms in an industry and the type of goods being sold Market structures %ure competition Monopolistic competition 'ligopoly Monopoly Market tructure Pure competition onopolistic competition 1ligopoly onopoly 3um(er a!d #-e of f#rm any firms" very small any firms" relatively small A few" relatively large firms 1ne firm only" generally large Product character# t#c Homogeneous products 4ifferentiated products ;sually differentiated products 3o close substitutes 4arr#er to e!tr% 3o barriers to entry 2elatively easy entry High barriers to entry Extremely high barriers to entry E,am&le 0ruits and vegetables" fish markets otels" restaurants Supermarkets" banks" oil companies" airlines 5ater supply