economics for educatorseconomicstexas.org/wp-content/uploads/2011/10/binder6.pdf · 35 economics...

Economics for Educators Revised Edition

Lesson 6 and 5E Model

Robert F. Hodgin, Ph.D. Texas Council on Economic Education

ii Economics for Educators, Revised

Copyright © 2012 Texas Council on Economic Education All Rights Reserved

Texas Council on Economic Education

30 Economics for Educators, Revised

Lesson 6: How Markets Coordinate Exchange Exchange Creates Wealth People trade because when they do, the wealth of both buyer and seller increases. Some regard that statement skeptically because “trade” carries a poor connotation. Should trade between two people not be an exchange of equals? Some people are wedded to the idea that only material things like property, cars, or gold constitute wealth. Neither sentiment is correct to an economist. Wealth gets confused with material well-being—as opposed to perceived value, the preferred and far more useful economic idea. Consider that no object is “wealth” unless someone values it. An object’s value is entirely subjective, and it depends solely on the willingness of admirers to sacrifice something to acquire it. Once that idea about value is accepted, it becomes clear that exchange occurs when there is a tradable difference in a good’s value—providing an increase in wealth to each party in the transaction. Information also is a good that has value. Because economic actions are undertaken based on expectations about the future and the future is never certain. A used car purchase, for example, may look superficially worthy. Once acquired, latent defects could surface to reduce or destroy the value anticipated by the buyer prior to the exchange. Buyer and seller possess unequal amounts of information, and the seller often holds the favored position. Acquiring additional information has an economic value as well as a cost. This difference in information between buyer and seller may affect negotiating power and the outcome of the exchange. Market Price as a Signal Much like the two cutting blades on a pair of scissors, price in the market place is determined by the interplay between supply and demand. Market actors—buyers and sellers—can efficiently exchange private goods because market price serves as a signal, telling those wanting the good the size of the sacrifice—opportunity cost—others have paid to acquire it. A market exists anywhere a transaction between buyer and seller occurs. Free and competitive markets efficiently allocate goods and services through an anonymously determined market price reflecting substitutes available to buyers and the expectations of sellers, at a particular moment. Market equilibrium price works as a beacon, coordinating the choices of buyer and seller by providing at least one measure of a good’s current worth—the market’s value. That value turns away those buyers seeking less expensive options and those sellers whose production costs are too high, while attracting others who may be more able to find a favorable price for the exchange. The more open, competitive and informed the market’s bargaining processes, the more efficient is the allocation of relatively scarce private goods. In economics, efficiency implies several things. Most fundamentally, it means that goods are sold at a price equal to opportunity cost. Efficiency also means that goods flow to their most highly valued use.



The lower the transaction costs—costs of arranging transactions between buyer and seller—the more efficient is the market. The clearer and more accepted the property rights—what belongs to whom under what circumstances—the more efficient is the market. You can see how the efficiency mantra pervades all aspects of production, exchange and distribution in economics. Choices and Trade-offs at the Margin To the untrained eye, market processes can appear chaotic and directionless. Using economics’ fundamental division, buyers versus sellers, then separating time into current and future periods, allows market dynamics to make sense. In the chart below, market demand (in blue) slopes down to the right and market supply (in green) slopes up to the right, the two lines cross at a quantity of 5 units.

To the right of their intersection, both curves are dotted to suggest that no transactions can occur there. The only area where transactions can logically occur is in the reddish-silver triangular area bounded by the solid blue upper range of the demand curve and the solid red lower range of the supply curve up to their intersection. Why is this so? The reddish-silver triangular area is the only place where a potentially negotiable price is both below the maximum demand price for some buyers and above the minimum opportunity supply cost for some sellers. Buyers know their maximum value price for a good and wish to pay that price or less. Sellers know the minimum opportunity costs of bringing the good to market and wish to get that price or more.



The intersection of the demand and supply schedules reveals the market equilibrium price, where the quantity demanded just equals the quantity supplied. While competitive market exchanges tend toward an equilibrating price that will clear the market of goods, not all prices negotiated between buyers and sellers will be at the equilibrium amount. Any transaction completed in the reddish-silver triangular area will be for a price no higher than some buyer’s maximum value and no lower than some supplier’s minimum cost. Higher equilibrium prices indicate that sellers held the stronger bargaining position and lower equilibrium prices indicate that buyers held the stronger position in the market. Now look once more at the point of equilibrium in the graph—where the demand and supply curves meet. At that point it can be said that the price of the good reflects the opportunity value of the “last” purchaser and, at the same instant, the opportunity cost of the “last” seller in that market. Someone did purchase the 5th unit of the good at the equilibrium price. For that buyer the sacrifice was just worth the exchange. Also as clearly, some producer sold the good at the market equilibrium price. For that producer the sale just covered all production opportunity costs—including a minimum profit. For all units of the good sold at that particular equilibrium, and at that time, market value just equaled the opportunity cost value to the last buyer and to the last seller. Other buyers in the market place held different and higher values for the good. Other sellers in the market place held different and lower opportunity costs of production for the good. Some buyers could have paid less than market equilibrium price and reaped the extra value. Some sellers could have sold for more than market equilibrium price and reaped the extra profits. Equilibrium Responses to Non-price Changes So far this discussion has focused on the short run time period where current market price reflects the quantity demanded and the quantity supplied. What happens to equilibrium price when non-price market forces cause demand or supply to shift?

Three steps to assess equilibrium effects of market change � Determine if the force affects the demand or the supply curve � Decide the direction the curve shifts—increase (rightward) or decrease (leftward) � Note the change in equilibrium price and quantity from the original demand and

supply curve intersection to the resulting demand and supply equilibrium. From the facts given in a situation, the first step means to determine if the market force pertains to buyers—the demand side, or to producers—the supply side. Next, reason through which particular force is at work for that side of the market, then note its direction. Shift the demand or supply curve in the appropriate direction—increases to the right or decreases to the left. Finally, compared to the original equilibrium price and quantity, note the position of the new equilibrium price and quantity.



Inspect the chart above. See how the current market demand schedule (in blue) and the current market supply schedule (in green) together determine the market equilibrium Price (= $5) and quantity (= 5 units) for a good. Now suppose that buyers believe the future market price of the good will increase, and that sellers perceive the same thing to be true. What will happen to market equilibrium price—and why? Step 1: How to shift demand? Recall when buyers believe prices will rise in the future they tend to buy more now, at all current prices. That is an INcrease in demand, a shift to the right from the blue demand to the dotted blue demand curve, labeled B. Step 2: How to shift supply? Suppliers will want to restrict current supply (if the good is not perishable) and sell later at the higher expected price. That is a DEcrease in supply, a shift to the left from the green supply to the dotted green supply curve labeled A. Step 3: What is the effect on equilibrium price and quantity? The blue demand has increased to the now higher demand (more units are demanded at each price) labeled B. The green supply has decreased to the now “lower” supply (fewer units are supplied at each price) labeled A. The increased demand and decreased supply together raise the market equilibrium price to $7 and lower the equilibrium quantity to 4.5 units. When both demand and supply shift, it is necessary to work through the logic to correctly determine the effect on the resulting equilibrium price and quantity in the market.



In Sum

� Trade creates wealth because both parties perceive a gain in a voluntary exchange. � An economic good provides wealth only to someone who values it. � A market exists anywhere an exchange transaction occurs. � The forces of supply and demand working together efficiently determine market equilibrium price when:

o Competitive markets tend toward an equilibrium price—one that clears the market, and o Many buyers and sellers exist to bargain freely when market information and mobility costs are low o Property rights—what belongs to whom under what conditions are known and respected o Transactions costs—the costs of completing a transaction are low

� Efficient markets in economics means: o Goods are produced at their opportunity cost and exchanged for their perceived value o Goods flow to their highest valued use o Market exchanges occur when the buyer’s maximum willing price exceeds the seller’s minimum offer price. o Market equilibrium is a tendency where the exchange price for the last buyer and last seller in that market are equal.

� Non-price market forces shift either the demand or supply curve and alter the market equilibrium price and quantity. Starting from a given demand and supply intersection with a given equilibrium price and quantity, the following are true:

o Increased demand (supply constant)—a rightward shift, increases both equilibrium price and quantity. o Decreased demand (supply constant)—a leftward shift, decreases both equilibrium price and quantity. o Increased supply (demand constant)—a rightward shift, decreases equilibrium price and increases equilibrium

quantity. o Decreased supply (demand constant)—a leftward shift, increases equilibrium price and decreases equilibrium quantity.


o Mixed movements in demand and supply must be determined using the facts in the problem statement. Equilibrium price and quantity can rise, fall or stay the same.


Lesson 7: Competition, Market Power and Economic Efficiency Market Power and the Structure of Industry The economics of industry is about market power—the power to set product price, gain market share and improve profits. The study of economic welfare, where the social goal is to efficiently solve the economic problem for all citizens—prefers competitive markets above all others. For it is only purely competitive producers, due to their individual powerlessness to affect price, that offer society the most output at no more than the opportunity cost to produce it as firms pursue profit maximization. In stark contrast, monopolistic markets permit the ruling firm to restrict output and raise the price for their production as they search for the price, above opportunity cost, that maximizes their profit. Between the polar market structures of competition and monopoly lie two others: monopolistic competition—a blend of competitive extremes; and oligopoly—a peculiarly postured industry where a few large firms strategically spar for market share in game-like fashion. Competition’s Efficiency Promise Perfect competition is a fiction, though a highly useful one. It serves as an ideal against which to compare diversions from the economically desirable position of maximum efficiency and output. Much of competition’s value rests in its ability to show just how far from the ideal other market solutions may lie. Many public policies also can be judged against their progress toward reaching selected competitive criteria. Since perfect competition resides only in the economist’s mind, what does it look like and what is its logic? The industry characteristics that create this idealized market structure include the following: very many buyers and sellers; identical products; costless entry into and exit from the market; perfect market information and costless market mobility. These characteristics combine to form a market where no one actor—buyer or seller—or small group of actors can influence market equilibrium results. Competitors have no price-setting power. The market for selling and buying corn comes close to these requirements. Fast, faceless and efficient exchanges work through market demand and supply to achieve an equilibrium price that clears the market.


So powerless is each competitive seller to affect market price that they can only accept the established equilibrium price as the per unit revenue they will receive for selling their product. Effectively, their demand curve is horizontal (completely elastic). The result is that the only decision a producer needs to make for a current cycle is to choose the level of production.

1801

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Less

on 6

: H

ow M

arke

ts C

oord

inat

e Ex

chan

ge,

pag

e 3

0

Eng

age

Dem

and

1. W

hat

is a

pro

duct

you

rea

lly w

ish

to p

urch

ase

but

lack

the

fun

ding

?

2.W

hat

are

the

char

acte

rist

ics

you

seek

in t

he p

rodu

ct?

3.

Wha

t w

ould

you

rea

lly li

ke t

o pa

y?

4.W

hat

is a

rea

listic

price

do

you

wan

t to

pay

and

why

?

Sup

ply

5.Yo

u ar

e a

supp

lier

of t

hat

prod

uct.

W

hat

char

acte

rist

ics

wou

ld y

ou p

rovi

de

at v

ario

us p

rice

s?

Why

?6.

Wha

t w

ould

you

REA

LLY

like

to c

harg

e fo

r th

e pr

oduc

t?

As

a se

ller

wha

t pr

ice

wou

ld b

e a

fair o

ne for

you

r bu

sine

ss in

vest

men

ts t

hat

wou

ld

attr

act

buye

rs?

The

answ

ers

will

var

y.

The

answ

ers

will

var

y, b

ut

be

sure

to

str

ess

that

su

pp

liers

wan

t to

ch

arg

e h

igh

er p

rice

s to

incr

ease

th

eir

pro

fits

an

d t

hat

th

ere

are

pri

ces

that

are

to

o

low

to

acc

ept

wh

en c

osts

are

not

cov

ered

.

Exp

lore

Vie

w t

he g

raph

bel

ow t

o an

swer

the

nex

t th

ree

ques

tions

.

Whe

re d

oes

your

#3

pric

e fr

om q

uest

ions

abo

ve f

all?

Whe

re d

oes

your

#6

pric

e fr

om q

uest

ions

abo

ve f

all?

Wha

t is

the

equ

ilibr

ium

price

tha

t w

ill a

llow

the

buy

er a

nd s

elle

r to

com

e to

an

agre

emen

t?

(#4

and

# 7

fro

m q

uest

ions

abo

ve)

#3

Will

ing

bu

yers

bu

t n

o s

elle

rs.

#6

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ing

sel

lers

bu

t n

o b

uye

rs.

#4

an

d #

7 w

ill m

eet

at t

he

big

eq

uili

bri

um

po

int

at $

5 m

arke

t p

rice

an

d 5

q

uan

tity

bo

ug

ht

and

so

ld.

Th

is i

s so

met

imes

cal

led

th

e m

arri

age

of

sup

ply

an

d d

eman

d.

1801

Alle

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Hou

ston

, TX

770

19 *

(71

3)65

5-16

50 *

Fax

: (71

3)65

5-16

55

Em

ail:

tcee

@ec

onom

icst

exas

.org

* w

ww

.eco

nom

icst

exas

.org

Page

| 21

Exp

lain

In v

iew

ing

the

grap

h, d

escr

ibe

the

four

“qu

adra

nts”

and

exp

lain

why

the

buy

ers

and

selle

rs r

eact

the

way

tha

t th

ey d

o.

Top

are

a:

The

pri

ce is

too

hig

h f

or b

uye

rs b

ut

wou

ld r

eap

gre

ater

pro

fit

for

the

selle

r O

R t

he

op

po

rtu

nit

y to

sp

end

mo

re o

n f

acto

rs o

f p

rod

uct

ion

.

Rig

ht

area

: T

he

pri

ce is

to

o lo

w f

or

selle

rs t

o m

ake

a p

rofi

t o

r to

o h

igh

fo

r th

e b

uye

rs t

o p

ay f

or

the

tru

e va

lue

of

the

pro

du

ct.

Bo

tto

m a

rea:

Th

e p

rice

is

very

lo

w a

nd

wo

uld

be

ple

asin

g t

o t

he

bu

yer

bu

t th

e se

ller

can

no

t co

ver

exp

ense

s.

Left

are

a:

The

“mid

dle

are

a” o

f th

e le

ft a

rea

rep

rese

nts

a p

rice

th

at a

bu

yer

wo

uld

co

nsi

der

fai

r an

d t

he

selle

r w

ou

ld b

e ab

le t

o j

ust

ify.

Exte

nd

Cho

ose

a pr

oduc

t th

at y

ou b

uy o

n a

regu

lar

basi

s. W

hat

mar

ket

forc

es w

ould

ca

use

you

to b

uy m

ore

or le

ss o

f th

e ite

m?

Wha

t m

arke

t fo

rces

wou

ld c

ause

the

sel

ler

to s

uppl

y th

e pr

oduc

t at

a lo

wer

price

th

an t

heir e

quili

briu

m p

rice

? H

ighe

r pr

ice?

As

a b

uye

r th

e p

rod

uct

may

hav

e g

on

e o

n s

ale

or

the

per

ceiv

ed f

utu

re p

rice

h

as in

crea

sed

.

A n

ew p

rod

uct

wit

h i

mp

rove

d,

bet

ter

and

/o

r n

ewer

fea

ture

s h

as e

nte

red

th

e m

arke

t o

r w

ill s

oo

n.

Bu

yers

may

red

uce

th

eir

dem

and

fo

r th

e cu

rren

t p

rod

uct

an

d s

up

plie

rs m

ay r

estr

ict

thei

r p

rod

uct

ion

.

Tech

no

log

y fo

r p

rod

uct

ion

of

the

pro

du

ct h

as b

eco

me

mo

re e

con

om

ical

so

th

e su

pp

lier

can

su

pp

ly m

ore

at

a lo

wer

pri

ce.

The

sup

plie

r co

uld

res

tric

t th

e q

uan

tity

of

go

od

s o

n t

he

mar

ket

to m

ain

tain

a

hig

her

pri

ce.

1801

Alle

n P

arkw

ay *

Hou

ston

, TX

770

19 *

(71

3)65

5-16

50 *

Fax

: (71

3)65

5-16

55

Em

ail:

tcee

@ec

onom

icst

exas

.org

* w

ww

.eco

nom

icst

exas

.org

Eval

uat

e

Cho

ose

a pr

oduc

t yo

u w

ould

like

to

prod

uce.

�

Res

earc

h th

e co

st o

f th

e fa

ctor

s of

pro

duct

ion.

�

Dev

elop

a b

udge

t an

d a

proj

ecte

d pr

ice

you

feel

is fai

r fo

r yo

u an

d fo

r th

e bu

yer.

�Cre

ate

a Po

wer

Poin

t sh

ow w

ith s

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tha

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ow y

our

prod

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the

cos

t of

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ctor

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pro

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ion

and

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sou

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for

info

rmat

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t, s

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show

ing

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librium

, an

d a

mar

ketin

g sl

ide

to c

onvi

nce

cons

umer

s th

at y

ours

is t

he b

est

prod

uct

for

the

best

price

on

the

mar

ket.

Page

| 22

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The Texas Council on Economic Education (TCEE) thanks the Council for Economic Education and the Department of Education Office of Innovation and Improvement for awarding the Replication of Best Practices Program grant that allowed Economics for Educators, Revised Edition to be written and published.

The Texas Council on Economic Education also thanks six of its major partners whose support allows TCEE to provide the staff development that utilizes content and skills provided in Economics for Educators.

Helping young people learn to think & make better economic & financial choices in a global economy.

1801 Allen Parkway Houston, Texas 77019 Telephone 713-655-1650 Fax 713-655-1655 Email: [email protected]

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