Fundamentals of Markets

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Let us go to the market...

Opportunity for buyers and
sellers to:
compare prices
estimate demand
estimate supply

Achieve an equilibrium
between supply and
demand

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How much do I value apples?

Price
One apple for my break
Take some back for lunch
Enough for every meal
Home-made apple pie
Home-made cider?

Quantity
Consumers spend until the price is equal to their marginal utility
2011 D. Kirschen and the University of Washington

Demand curve
Aggregation of the
individual demand of all
consumers
Demand function:

Price

q = D(p )
Inverse demand function:
Quantity

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p = D-1(q)

Elasticity of the demand

Price

High elasticity good

Slope is an indication of the

elasticity of the demand
High elasticity
Non-essential good
Easy substitution

Quantity

Low elasticity
Essential good
No substitutes

Price

Low elasticity good

Electrical energy has a very

low elasticity in the short
term

Quantity
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Elasticity of the demand

Mathematical definition:
dq
p dq
q
e=
=
dp q dp

Dimensionless quantity

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Supply side
How many widgets shall I produce?
Goal: make a profit on each widget sold
Produce one more widget if and only if the cost of
producing it is less than the market price
Need to know the cost of producing the next widget
Considers only the variable costs
Ignores the fixed costs
Investments in production plants and machines
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How much does the next one costs?

Cost of producing a widget

Total
Quantity
Normal production procedure

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How much does the next one costs?

Cost of producing a widget

Total
Quantity
Use older machines

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How much does the next one costs?

Cost of producing a widget

Total
Quantity
Second shift production

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How much does the next one costs?

Cost of producing a widget

Total
Quantity
Third shift production

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How much does the next one costs?

Cost of producing a widget

Total
Quantity
Extra maintenance costs

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Supply curve
Price or marginal cost

Aggregation of marginal cost

curves of all suppliers
Considers only variable
operating costs
Does not take cost of
investments into account
Supply function:

p = S (q)
-1

Quantity

Inverse supply function:

q = S(p )
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Market equilibrium
Price

Supply curve
Willingness to sell
market equilibrium

market
clearing
price

Demand curve
Willingness to buy
volume
transacted

2011 D. Kirschen and the University of Washington

Quantity

14

Supply and Demand

Price

supply

equilibrium point

demand
Quantity
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Market equilibrium
q = D(p ) = S(p )
*
-1 *
-1 *
p = D (q ) = S (q )
*

Price

supply

market
clearing
price

demand
volume
transacted

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Sellers have no incentive

to sell for less
Buyers have no incentive
to buy for more

Quantity

16

Centralized auction
Producers enter their bids:
quantity and price
Bids are stacked up to
construct the supply
curve
Consumers enter their
offers: quantity and price
Offers are stacked up to
construct the demand
curve
Intersection determines the
market equilibrium:
Market clearing price
Transacted quantity
2011 D. Kirschen and the University of Washington

Price

Quantity

17

Centralized auction
Everything is sold at the
market clearing price
Price is set by the last unit
sold
Marginal producer:
Sells this last unit
Gets exactly its bid
Infra-marginal producers:
Get paid more than their
bid
Collect economic profit
Extra-marginal producers:
Sell nothing

2011 D. Kirschen and the University of Washington

Price

supply

Extra-marginal

Inframarginal

demand
Quantity

Marginal producer

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Bilateral transactions
Producers and consumers trade directly and
independently
Consumers shop around for the best deal
Producers check the competitions prices
An efficient market discovers the
equilibrium price

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Efficient market
All buyers and sellers have access to sufficient
information about prices, supply and demand
Factors favouring an efficient market
number of participants
Standard definition of commodities
Good information exchange mechanisms

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Examples
Efficient markets:
Open air food market
Chicago mercantile exchange

Inefficient markets:
Used cars

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Consumers Surplus
Buy 5 apples at 10
Total cost = 50
At that price I am
getting apples for which
I would have been
ready to pay more
Surplus: 12.5

Price
15

Consumers surplus

10
Total cost

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Quantity

22

Economic Profit of Suppliers

Price

Price
supply

supply

Profit
demand

Revenue

demand

Cost

Quantity

Quantity

Cost includes only the variable cost of production

Economic profit covers fixed costs and shareholders
returns
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Social or Global Welfare

Price
Consumers surplus

supply

+
Suppliers profit

= Social welfare

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demand

Quantity

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Market equilibrium and social welfare

supply

Operating point
supply

Welfare loss
demand
demand

Market equilibrium

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Artificially high price:

larger supplier profit
smaller consumer surplus
smaller social welfare
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Market equilibrium and social welfare

supply

demand

Welfare loss
supply

demand

Operating point
Q

Market equilibrium

2011 D. Kirschen and the University of Washington

Artificially low price:

smaller supplier profit
higher consumer surplus
smaller social welfare
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Whats the price?

Price = marginal revenue of supplier
= marginal cost of supplier
= marginal cost of consumer
= marginal utility to consumer
Market price varies with offer and demand:
If demand increases
Price increases beyond utility for some
consumers
Demand decreases
Market settles at a new equilibrium
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Whats the price?

If demand decreases
Price decreases
Some producers leave the market
Market settles at a new equilibrium

In theory, there should never be a shortage

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Price vs. Tariff

Tariff: fixed price for a commodity
Assume tariff = average of market price
Period of high demand
Tariff < marginal utility and marginal cost
Consumers continue buying the commodity rather
than switch to another commodity
Period of low demand
Tariff > marginal utility and marginal cost
Consumers do not switch from other commodities
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Concepts from the Theory of the Firm

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Production function
y = f ( x1,x 2 )
y:
output
x1 , x2: factors of production
y

x2 fixed

x1 fixed

x1

x2

Law of diminishing marginal products

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Long run and short run

Some factors of production can be adjusted
faster than others
Example: fertilizer vs. planting more trees

Long run: all factors can be changed

Short run: some factors cannot be changed
No general rule separates long and short run

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Input-output function
y = f ( x1 ,x2 )

x 2 fixed

The inverse of the production function is the

input-output function

x 1 = g ( y ) for x 2 = x 2

Example: amount of fuel required to produce a

certain amount of power with a given plant

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Short run cost function

c SR ( y ) = w 1 x 1 + w 2 x 2 = w 1 g( y ) + w 2 x 2

w1, w2: unit cost of factors of production x1, x2

c SR ( y )

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Short run marginal cost function

c SR ( y )

dc SR ( y )

Convex due to law

of marginal returns

dy

Non-decreasing function

y
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Optimal production
Production that maximizes profit:
max { p y - c SR ( y ) }
y

d { p y - c SR ( y ) }
dy

p=

dc SR ( y )
dy

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=0

Only if the price does not depend

on y perfect competition
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Costs: Accountants perspective

In the short run, some costs are
variable and others are fixed
Variable costs:

labour
materials
fuel
transportation

Production cost [$]

Fixed costs (amortized):

equipments
land
Overheads

Quasi-fixed costs
Startup cost of power plant

Sunk costs vs. recoverable costs

2011 D. Kirschen and the University of Washington

Quantity

37

Average cost
c( y ) = c v ( y ) + c f
AC ( y ) =

c( y)
y

cv ( y )

Production cost [$]

Quantity
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cf
y

= AVC ( y ) + AFC ( y )

Average cost [$/unit]

Quantity
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Marginal vs. average cost

MC

AC

$/unit

Production
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When should I stop producing?

Marginal cost = cost of producing one more unit

If MC > next unit costs more than it returns
If MC < next unit returns more than it costs
Profitable only if Q4 > Q1 because of fixed costs
Average cost [$/unit]

Marginal
cost
[$/unit]

Q1

Q2

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Q3

Q4
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Opportunity cost
Use money to grow apples or to grow cherries?
If profit from growing cherries is larger than the profit from
growing apples, growing apples has an opportunity cost

Use money to grow apples or put it in the bank where it

earns interests?
Profit from growing apples must be larger than bank interest
because putting money in the bank has a lower risk

Profit from a business must be compared against the

normal profit, i.e. what putting money in the bank
would bring

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Costs: Economists perspective

Opportunity cost:
What would be the best use of the money spent to make
the product ?
Not taking the opportunity to sell at a higher price
represents a cost
Examples:
Use the money to grow apples or put it in the bank where
it earns interests?
Growing apples or growing kiwis?
Comparisons should be made against a normal profit
What putting money in the bank would bring

Selling at cost means making a normal profit

Usually not good enough because it does not compensate for the risk
involved in the business
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