Economics (Resource allocation in competitive markets I)

Circular flow of economic activity:

1. Households (consumers) demand consumer goods and services from the product (output) market, and supply labour into the factor (input) market.

2. Firms (producers) demand labour, capital (includes producer goods) and land from the factor (input) market, while supplying the product (output) market with goods and services

Price mechanism (market mechanism)

In the market economy, resource allocation results from many decentralized, independent decision made by both consumers (buyers) and producers (sellers) in the market.

The market is an economic situation (can occur anywhere like online, over the phone…) in which buyers and sellers negotiate the exchange of any well-defined commodity, like flour, laptops or T-shirts.

The buyers, as a group, will determine the demand for a product, while the producers will determine the supply. This result in a market price (Price consumers pay for a certain good of service) and quantity transacted (number of goods and services consumed)

Hence, the theory of price determination was developed, which assumes that the markets are perfectly competitive [Good and services offered for sale are identical (ie. Does not matter who you buy from), and there is no monopoly (ie. No individual can influence market solely)]

The product market is where consumer goods and services are bought and sold.

The theory of demand

Done by Nickolas Teo Jia Ming, CG 12/11

product (output) market

Households (consumers)

Factor (input) market

Firms (producers)

Demand is the willingness and ability of a consumer to pay a specific price for a good or service in a given period of time.

Willingness refers to the desire of a consumer to consume a good or service, to satisfy a need/want (they do not necessary obtain it)

Ability refers to the fact that the consumer can afford it.

Effective demand is the quantity of a good or service that consumers are willing and able to purchase in a given period of time, across a range of prices. Hence it involves opportunity cost, measured by the price of the good or service in monetary terms.

It is determined by own-price and non-own price determinants, which affects the willingness and ability of consumers to buy

The law of demand

The lower the price, ceteris paribus, the greater the quantity demanded.

Thus, there’s an inverse relationship between price and quantity demanded.

This is due to the substitution effect and income effect (Own-price determinants)

The substitution effect measures the change in quantity demanded, due to a change in its relative price

When the price of a good falls, it becomes cheaper relative to its substitutes, causing consumers to increase the quantity demand. Vice-versa

The income effect measures the change in quantity demanded, due to a change in consumer’s real income (purchasing power)

When the price of a good falls, ceteris paribus, the real income of the consumer rises, increasing the quantity demanded. Vice-versa (Note: the actual income of the consumer does not change)

Demand curve

The demand curve is downward slopping, due the marginalist principle in decision making and the law of demand.

Every additional unit of a good consumed, gives marginal utility (additional utility).

The marginal utility decreases with every additional unit consumed, hence consumers are willing to pay less for every additional unit, until marginal utility = marginal cost.

Market demand curve

The market demand is the demand for a good by all households. (overall demand)

It is obtained from the horizontal summation of all individual demand curves

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Affected by own-price and non-own-price determinants

Non-own-price determinants

1. Consumer tasters and preferences The taste of consumers is influenced by a range of factors. Like education, fashion,

advertisements, culture, age, new innovations A favorable change in consumer preferences will shift the demand curve to the right

2. Prices of related goods Substitutes are goods that satisfy similar needs within the same price range A change in the price of a substitute of a good will cause a similar change in the

quantity demanded of the substitute, but an opposite change will occur to the demand of the original good.

The effect is increased when both goods are in a closer price range Complementary goods are goods that are consumed together and are jointly

demanded A change in the price of the complement of a good will cause a similar change in the

quantity demanded of the complement, and a similar change will occur to the demand of the original good.

However, the complementary relationship may not work both ways. As in when a change in good A affects good B, a change in good B might not affect good A.

3. Changes in consumer’s income A change in real disposable incomes will cause a similar change to the demand for

normal goods. But the demand for inferior goods will experience an opposite change Real disposable incomes is the quantity of goods and services that a given money

income, after income tax, can buy. It is affected by money income, income tax, government subsidy and inflation. An increase in equity of income will also decrease the demand for luxury and

inferior goods (less rich and poor), but increase the demand for necessities.4. Changes in population statistics

When the overall population size changes, the demand for goods will experience a similar change, due to the change in consumers in the market.

This does not hold true for third-world countries. A change in population structure (age, sex, location), will affect goods according to

the needs for the current population (goods for young, for old, for disabled etc.)5. Changes in expectations

When people expect a change in the relative price of a good, a similar change will occur to the demand for the good

When people expect a change in their income, a similar change will occur to the demand for the goods

Side note: When the expected increase in income > actual increase, harm will be caused to the economy, as people cannot repay loans. E.g. US financial crisis

6. Seasonal factors Weather (temperature, rain. Disasters), affects the demand for goods

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Festive seasons (CNY, Christmas), affects the demand of certain goods7. Other factors

A change in interest rate, will bring about an opposite change to the demand for more expensive goods

A change in exchange rate will affect tourism, hence changing the demand for goods by tourists

Movement and shift of the demand curve

A movement along the demand curve results from the change in quantity demanded, due to a change in the own-price determinants

A shift of the demand curve results from a change in demand, due to a change in a non-own-price determinants

Consumer surplus

Consumer surplus is the difference between the maximum amount a consumer is willing to pay, and the price he actually paid.

It is the gain by consumers for paying less than what they are prepared to pay

The theory of supply

Supply is the amount of a commodity that producers are able and willing to produce in a given time over a given range of prices

The effective supply is backed by willingness and ability to produce The willingness of producers to produce is in the pursuit of their self-interest, to maximize

profit The ability of producers involves an opportunity cost or price Effective supply is determined by own-price and non-own-price determinants, which affects

the willingness and ability of producers to produce

The law of supply

The direct relationship between price and quantity supplied is the law of supply This is due to the marginalist principle in decision making. There is increasing marginal

costs and incentive for increasing production (own-price determinants) When producers produce an additional unit of a good, they have to use more factors of

production (increasing marginal costs) Given the ability to produce, as marginal cost continues to rise, the price to entice a rational

producer produce an additional unit will have to be higher. There is increasing relative profitability as price rises. Ceteris paribus, a rise in price of a product raises the marginal revenue and hence the profit

margin, making production of the product more profitable relative to other products and entices firms to move resources into this industry.

Hence the supply curve is upward-sloping

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Market supply curve

It is the horizontal summation of all the individual supply curves of all firms in the market for a good

It reflects the producers cost for producing the goods

Non-own-price determinants

1. Costs of production A change in factor prices will change the cost of production, causing an opposite

change in supply Changes in the state of technology will cause an opposite change in cost of

production due to a change in productivity (output per unit of input). Hence, changing the supply.

2. Government policies A change in indirect tax will change the cost of production, and cause an opposite

change in supply A government subsidy (direct financial aid given to producers) will decrease the cost

of production, and cause an increase in supply Other government policies will change the supply, like price floors/celling and trade

agreements 3. Prices of related goods

A change in the price of a competitive good will cause a similar change in the quantity demanded of the competitive good, but an opposite change will occur to the supply of the original good.

This is because producers move resources from the sunset industry into the sunrise industry

Jointly supplied goods are goods that are produced together. A change in the price of a jointly supplied good will cause a similar change in the

quantity demanded of the jointly supplied good, and a similar change will occur to the supply of the original good.

4. Number of suppliers A change in the number of producers will change the supply. A change in the scale of production (amount of resources invested) by producers

will change the supply5. Nature and other unpredictable events

Abnormal weather (e.g. flooding) will decrease the supply Good weather (e.g. enough rain and sun) will increase the supply Unpredictable events (e.g. wars, industrial disputes) will also decrease supply

6. Firms’ objectives Some producers might aim for sales maximization instead of profit maximization,

hence increasing supply7. Seller’s price expectation

When sellers expect a change in the relative price of a good, an opposite change will occur to the supply for the good, as they either withhold or unload their supply.

Done by Nickolas Teo Jia Ming, CG 12/11

Movement and shift of the supply curve

A movement along the supply curve results from the change in quantity supplied, due to a change in the own-price determinants

A shift of the supply curve results from a change in supply, due to a change in a non-own-price determinants

Exceptions to the law of supply

Some goods (e.g. antiques) have a fixed quantity, which will not change with regards to price. (Perfectly inelastic supply curve)

The quantity of other goods (e.g. crops) cannot be changed in the short run, hence the quantity is independent of price. (Perfectly inelastic supply curve)

Not all supply curves are upward-sloping in the long run, as costs do not always rise when output increases. They could remain constant, giving a perfectly elastic supply curve.

Producer surplus

It is the difference between the total amount producers receive for all units sold of a commodity and the minimum amount they are willing to accept to supply those units

It is the gain by producers for being paid more than what they are prepared to accept

Market equilibrium

Equilibrium is the state of balance between 2 opposing forces (demand and supply) The equilibrium price (market price) is the price that clears the market The equilibrium quantity is the quantity traded at the equilibrium price

Market disequilibrium

At all other prices, other than the equilibrium price, there is market disequilibrium. If the price is too high, a glut (surplus) will occur, pushing prices down If the price is too low, a shortage will occur, pushing prices up The invisible hand (collective actions in self-interest) causes the shortage and surplus to

correct themselves

Effects of changes in demand and supply

1. Increase in demand Shortage pushes prices up This signals the producers to produce more (for profit maximization) It also signals for more resources to be allocated to produce the product It helps to ration the product to those with ability to pay Hence increasing quantity supplied and decreasing quantity demanded

2. Decrease in demand Glut pushes prices down

Done by Nickolas Teo Jia Ming, CG 12/11

This signals the producers to produce less (for profit maximization) It also signals for less resources to be allocated to produce the product It helps to ration the product to those with ability to pay Thus decreasing quantity supplied and increasing quantity demanded

3. Increase in supply

Glut pushes prices down This provides the incentive for the consumers to consume more (for utility

maximization) It signals the producers to produce more as quantity demanded increases (for profit

maximization) It also signals for more resources be allocated to produce the product It helps to ration the product to those with ability to pay Hence increasing quantity demanded and supplied

4. Decrease in supply Shortage pushes prices up This provides a disincentive for consumers to consume (for utility maximization) It signals the producers to produce less as quantity demanded falls (for profit

maximization) It also signals for less resources be allocated to produce the product It helps to ration the product to those with ability to pay Hence decreasing quantity demanded and supplied

5. Change in both demand and supply Resultant effect depends on the relative strength (magnitude) of the shift

Done by Nickolas Teo Jia Ming, CG 12/11