LECTURE NUMBER 4 : TYPES OF MARKET, Aggregate Supply & Demand

Part A : Markets

Why markets are important ?

One of the most important characteristics of a market economy, also called a free
enterprise economy, is the role of a limited government. Buyers and sellers, not the
government, make most economic decisions. It is a self-regulating and self-adjusting economy.
No significant economic role for government is necessary. A market economy has freedom of
choice and free enterprise. Private entrepreneurs are free to get and use resources and use
them to produce goods and services. They are free to sell these goods and services in markets
of their choice. Consumers are free to buy the goods and services that best fill their wants and
needs. Workers are free to seek any jobs for which they are qualified.

• Strengthening markets can improve everyone and livelihoods.

• Markets are a part of everyone’s lives

• Most people – especially the poor – rely on markets to provide food, essential goods
and services.

How the Economy as a Whole Works?

In order to better figure out the details of GDP we will use the "circular flow model". The
main purpose of the circular flow is to show how goods, services and money flow to and
from various sectors in the economy. Such a model may be more or less detailed. We
will start with the least detailed version and then construct a more complete model to
which we will refer for this.

In this below model goods (and services) flow counter clockwise while money flows clockwise.
Note that the flow of money from firms to the factor markets is the same as the flow of money
from the goods market to the firms. If this were not the case, firms as a group would make a
profit or a loss. However, since all firms are owned by individuals (directly or indirectly through
pension funds and other funds), all profits or losses must eventually fall on the consumers. This
flow is part of the return on capital, a flow of money to the factor market. The circular
flow of income and spending shows connections between different sectors of an economy. It
shows flows of goods and services and factors of production between firms and households.
The circular flow shows how national income or Gross Domestic Product is calculated.

The circular flow of income or circular flow is a model of the economy in which the major
exchanges are represented as flows of money, goods and services, etc. between economic
agents. The flows of money and goods exchanged in a closed circuit correspond in value, but
run in the opposite direction. The circular flow of income is a concept for better understanding
of the economy as a whole.
Factors of production are the resources used by a company to produce goods and services. The
universally recognized factors of production include land, labor, and capital.
Types Of Market :

1. Labor Markets : employers finds the labour they need.

A labor Market is the place where workers and employees interact with each other.
In economics, labor is a measure of the work done by human beings. It is conventionally
contrasted with such other factors of production as land and capital. In the labour
market, employers compete to hire the best, and the workers compete for the best
satisfying job. The demand for labor depends on total output. As production increases,
the demand for labor also increases. The demand and supply of labor are determined in
the labor market.
 Labor Demand :
 The purchasers of labor services are firms.

 Many factors influence how many people a business is willing and able to take on. But
we start with the most obvious – the wage rate or salary
 There is an inverse relationship between the demand for labour and the wage rate that
a business needs to pay as they take on more workers

 If the wage rate is high, it is more costly to hire extra employees

 When wages are lower, labour becomes relatively cheaper than for example using
capital inputs. A fall in the wage rate might create a substitution effect and lead to an
expansion in labour demand.

The need for employees and workers in a particular job market such as
construction or manufacturing.

Labor Supply :

Availability of suitable human resources in a particular labor market. The labor

supply is the total hours that workers or employees are willing to work at a given
wage rate. The labour supply curve for any industry or occupation will be upward
sloping. This is because, as wages rise, other workers enter this industry
attracted by the incentive of higher rewards. In labor market equilibrium,
Workers prefer to work when the wage is high, and firms prefer to hire when the
wage is low. Labor market equilibrium “balances out” the conflicting desires of
workers and firms and determines the wage and employment observed in the
labor market.
 Labor Market Issues and Policy in Pakistan :
The labour market is presently
confronted with the twin menace of unemployment and underemployment.
Pakistan’s labour market is showing its inability to continue the past trend of
labour absorption. The situation in the labour market is serious on yet another
account. The working conditions of those lucky found employed, largely, are not
satisfactory, rather they are deplorable. Long working hours and poor working
conditions are the normal features of a significant number of work places. A
number of them also carry occupational safety and health hazards. The situation
is compounded further by observing denial of basic rights to a large number of
workers. Existing labour laws require reforms and whatever exist face
implementation lacunas. Further discomforting is the fact that the trade union
movement in Pakistan stands divided and fragmented. The internal hostilities
and mistrust has greatly weakened the labour movement in Pakistan. Despite 50
years of their existence and the related work, the trade unions have miserably
failed to respond effectively and collectively to the challenges confronting them
and the society. The labour market situation is also being affected by the
existence of widespread prevalence of “child labour.” Children, at times as small
as being 5 to 6 years of age, are found working in numerous work places, a
number of their activities carry considerable occupational and health hazards. In
addition, this is besides the fact that these children are denied their very
fundamental right of the “childhood” i.e. to have sufficient time to play and rest,
and existing facility for the education. It is also important to point out that
children are also active in the labour market. Lack of adequate safeguards is the
major characteristics of numerous work places in Pakistan. The textile sector, for
instance, which demonstrates the largest manufacturing activity in Pakistan, is
known to display poor and even hazardous working conditions. Notwithstanding
this serious lack, yet another dimension of the labour market issue in Pakistan is
the longer working hours. One-third of the employed in Pakistan are found to be
working for 56 and above hours a week. Pakistan inherited a number of labour
laws at the time of independence. They have been updated over the years to
respond to the emerging needs of the economy and labour market. Some new
have also been made. Presently, the labour laws are dealing with working
conditions, hours of work, wages, occupational health and safety, social security,
workers’ welfare, old age benefits, industrial relations, child and bonded labour,
etc. Yet another dimension of the labour laws is their inadequate
implementation. The economy of Pakistan is not able to absorb productively
the labour force and all indications point towards a worsening of labour market
conditions in the future. In addition, those employed, a significant proportion of
them are confronted with poor working conditions at times carrying
occupational health and safety hazards. The existing labour laws aiming at the
protection of the rights of workers and to promote their welfare are
inadequately implemented. Pakistan has one of the largest labour and labor
 resources in the world, due to its large population, which is the sixth largest in
the world.

• Pakistan has been blessed with unprecedented youth human resources. This young
population has tremendous energy and talent
• A rapid increase in population growth creates pressure on resources, employment
opportunities, income distribution, poverty and social protection projects.
• Energy crisis, fight against terrorism and political instability have created an
unconducive environment to foreign investment and capital formation. Falling
international prices of some key export sectors have triggered a loss of many formal
jobs.
• Government Initiatives :
In 2010, subjects of labor and employment devolved to
Provinces under the 18th Amendment to the Constitution of Pakistan, as a result of
which the Federal labor laws made applicable on Provinces under Article 270AA(6) of
the Constitution of Pakistan.
• PM Youth Training scheme (National Internship Programme)
• Prime Minister Youth Skill Development Programme
• Skill Development through Donor’s Special Initiative
National Talent Pool.
2. Goods Markets :
The marketplace in which a final good or service is bought and sold. A marketplace
where factors of production such as labor, capital, and resources are purchased
and sold.

A thing or place that brings together buyers and sellers (where goods and services are
 sold to consumers that want to buy goods). A factor market facilitates the purchase and
sale of services of factors of production. Someone purchases market goods that are
produced. The exchange of goods or services, with or without money, is
transaction. Market participants consist of all the buyers and sellers of a good who
influence its price.

3. Money Markets :

Withdrawing money from the money market is easier. Money markets are different
from capital markets as they are for a shorter period while capital markets are used for
longer times. It is an important part of the financial system that helps in fulfilling the
short term and very short-term requirements of the companies, banks, financial
institution, government agencies and so forth. A country's money market consists of all
the banks and other organizations that deal with short-term loans, capital, and foreign
exchange.

Demand For Money :

Demand for money means demand for holding cash. The main reason for holding money is to
facilitate transactions. The demand for money represents the desire of households and
businesses to hold assets in a form that can be easily exchanged for goods and services.

Supply Of Money :

The total stock of money circulating in an economy is the money supply. The circulating money
involves the currency and printed notes.

Part B : Aggregate Demand

Aggregate Demand for Goods & Services : A.D

Aggregate demand refers to the total demand for final goods and services in the economy.
Since aggregate demand is measured by total expenditure of the community on goods and
services, therefore, aggregate demand is also defined as ‘total amount of money which all
sectors (households, firms, government) of the economy are ready to spend on purchase of
goods and services. Aggregate Demand is the amount of goods and services in the economy
that will be purchased at all possible price levels. Aggregate demand is an economic
measurement of the sum of all final goods and services produced in an economy, expressed as
the total amount of money exchanged for those goods and services.

The Aggregate Demand Curve :

Aggregate demand curve shows relationship between price and real GDP demanded. The AD
curve shows the relationship between AD and the price level. It is assumed that the AD curve
will slope down from left to right. This is because all the components of AD, except imports, are
inversely related to the price level.
Aggregate demand (AD) is the total demand by domestic and foreign households and firms for
an economy's scarce resources, less the demand by domestic households and firms for
resources from abroad. The aggregate demand curve is an economic graph that indicates how
many goods and services households, firms, and the government are willing and able to buy. If
you plot the quantity demanded at each price level on a graph and connect the data points, you
will get what has called an aggregate demand curve. An aggregate demand curve is downward
sloping. A negative relationship exists between price level and demand, which results in a
downward-sloping aggregate demand curve. In other words, if everything else remains
constant, a decline in price level will increase demand, and an increase in price level will lead to
a decrease in demand.

Shifts : A.D

A decrease in the price level for goods and services will cause aggregate demand to increase if
all other factors remain unchanged. On the other hand, a shift in demand occurs where the
quantity demanded changes even when the price level is unchanged. If the quantity demanded
increases at the same price level, the aggregate demand curve shifts to the right, but if the
quantity demanded decreases at the same price level, the curve will shift to the left. You can
see a demand shift in the illustration below.
The AD curve shows the relationship between the general price level and real GDP.

Why Does the Aggregate Demand Curve Slope Downward ?

• A lower price level increases the purchasing power of the fixed quantity of money.

• A lower price level will reduce the demand for money and lower the real interest rate,
which then stimulates additional purchases during the current period.

• Other things constant, a lower price level will make domestically produced goods less
expensive relative to foreign goods.
 Part C : Aggregate Supply

Aggregate Supply of Goods and Services : A.S

Aggregate supply (A.S) is defined as the total amount of goods and services (real output)
produced and supplied by an economy’s firms over a period of time. It includes the supply of a
number of types of goods and services including private consumer goods, capital
goods, public and merit goods and goods for overseas markets.

Total of all goods and services (including exports and imports) supplied at every price level,
within a national economy during a given period. Also called total output.
It is the total amount of goods and services that firms are willing and able to sell at a given price
level in an economy. It is usually represented by a supply curve, which describes the
relationship between price levels and the quantity of output that firms are willing to provide.

Aggregate supply measures the volume of goods and services produced each year. AS
represents the ability of an economy to deliver goods and services to meet demand. When the
economy reaches its level of full capacity (full employment – when the economy is on the
production possibility frontier) the aggregate supply curve becomes inelastic because, even at
higher prices, firms cannot produce more in the short term. Aggregate Supply is the total
amount of goods and services in the economy available at all possible price levels.
The graph tells us that, as the prices of all goods and services (the GDP Deflator) rise (fall), the
supply of all goods and services (aggregate supply) will rise (fall).

The Long-Run Aggregate Supply (LAS) represents the relationship between the price level and
output in the long-run.

The Aggregate Supply Curve : The Basic A.S curve

At higher price levels across the economy firms expect that they can sell their final products at
higher prices, and there will be a positive relationship between the price level and aggregate
supply. Any increase in input prices (costs) which may follow is assumed to lag behind increases
in the general price level. Because of this firms expect that they will benefit - at least in the
short run - from a rise in the price level. Based on this we can derive a simple AS supply
schedule, as shown below :
The aggregate supply curve shows the amount of goods that can be produced at different price
levels. The aggregate supply curve is related to a production possibility frontier (PPF). The
aggregate supply curve is one that shows the total quantity of goods and services that will be
produced (supplied) at different price levels. Aggregate supply is the relationship between the
price level and the production of the economy.
Aggregate supply is the total quantity of goods and services supplied at a given price. Its
intersection with aggregate demand determines the equilibrium quantity supplied and price.
The aggregate supply curve on a graph illustrates the relationship between prices and output
supplied.

 Long-run aggregate supply : LRAS

In the long-run, the aggregate supply is graphed vertically on the supply curve.
In the long-run, the aggregate supply is graphed vertically on the supply curve. The
equation used to determine the long-run aggregate supply is: Y = Y*. In the equation, Y
is the production of the economy and Y* is the natural level of production of the
economy. In the long run, the ability of an economy to produce goods and services to
meet demand is based on the state of production technology and the availability and
quality of factor inputs.
 LRAS is vertical because the economy is at its full capacity. It is impossible to increase
production in response to growing aggregate demand.

Reasons why Long Run Aggregate Supply shifts :

 Changes in the stock of resources (labor, land, etc.)

 Changes in technology
  Changes in quality of factors of production (leading to improvements
in efficiency/productivity)
 Institutional changes

Short-Run Aggregate Supply Curve :

The SRAS is viewed as elastic, because in the short-run firms can increase output by
getting workers to do overtime. In the short-run, the aggregate supply is graphed as an
upward sloping curve. Aggregate supply in the short run(SRAS) is best defined as the
total production of goods and services available in an economy at different price levels
while some resources to produce are fixed. ... As prices increase, quantity supplied
increases along the curve. Short-run Aggregate Supply (SAS) shows the different
quantities of real output in the short-run that will be supplied at different prices. The
SAS curve is upward sloping because firms tend to increase price levels when demand
increases.

The short-run aggregate supply curve is upward sloping because the quantity supplied increases
when the price rises. In the short-run, firms have one fixed factor of production (usually capital
). When the curve shifts outward the output and real GDP increase at a given price. As a result,
there is a positive correlation between the price level and output, which is shown on the short-
run aggregate supply curve. SRAS slopes upwards because as prices increase, it becomes more
profitable for firms to increase their output and new firms start producing.

Reasons why Short Run Aggregate Supply shifts :

 Changes in resource prices (labor, raw materials, etc.)

 Changes in business (corporate) taxes and subsidies
 Supply shocks
Short-Run Equilibrium in the Goods and Services Market :

• If the price were lower than P, general excess demand in the goods & services market
would push prices upward.

• Conversely, if the price level were higher than P, excess supply would result in falling
prices.