Foundations of Economic Analysis: Markets Flashcards
What are the differences between actual and desired (planned) supply and demand.
Supply and demand curves represent desired (or planned) supply and demand.
When a market is in equilibrium then the quantity demanded and supplied is the actual quantity and the price is the actual price.
These are actually observed in the market by consumers when purchasing goods and are put into company accounts.
What is an equilibrium?
Equilibrium is a “balance point” in the market between buyers and sellers.
There are no incentives to move away from the equilibrium price and quantity.
But - this is based on assumptions about the behaviour of individuals, i.e. psychological assumptions.
What is the “invisible hand”?
In the stock market there are “market makers” who adjust prices so that people converge on an equilibrium.
However in non-financial markets such people rarely exist. Instead demanders and suppliers converge on an equilibrium by a process of bargaining.
The unobservable market force that helps the demand and supply of goods in a free market to reach equilibrium automatically is the invisible hand.
What occurs at equilibrium?
At equilibrium (P, Q):
Qd = Qs = Q*
Demand and supply curves intersect
Excess Supply: when P > P*
Excess Demand: when P < P*
How do we explain market clearing with linear demand/ supply?
Qd = a - bP Qs = c + dP
where a, b, c and d are positive constants. Why?
By exploiting the equilibrium condition Qd = Qs = Q*, we have a – bP = c + dP.
Thus
P* = (a-c)/(b+d)
Setting this back into the demand equation,
Q* = (ab+ad-ba+bc)/(b+d) = (ad+bc)/(b+d)
What is Excess Supply?
Firms unable to sell all the goods they produce at the prevailing price
If a firm drops the price of the goods then the lower price will encourage people to buy more of that firm’s goods
This competition forces other firms to drop their prices as well - or go out of business.
The fall in price increases the quantity demanded for the good but decreases the quantity supplied of the good.
How do we move towards equilibrium with excess supply?
This means that there is still an incentive for a firm to drop its price in order to attract more customers for the good.
This in turn results in a fall in price and a drop in excess supply.
The process continues until equilibrium is reached:
What is Excess Demand?
Consumers unable to buy the goods they want
If a consumer increases the price of the goods then the higher price will enable that person to buy as much of the goods as necessary
Other consumers will also raise their price to stop themselves being priced out of the market or they will drop out.
The increase in price increases the quantity supplied but decreases the quantity demanded of the good.
How do we move towards equilibrium with excess demand?
This means that there are still some customers not getting the goods they want in the market, so there is still an incentive to raise the price.
This continues until there is no excess demand left in the market.
Prices keep rising till the market is cleared (or equilibrium is restored) - is this plausible?
Several problems have been put forward within economics:
Institutional blocks - e.g. rent controls. These are rules and regulations or “customs” which prevent the bidding process taking place.
What are market failures?
The nature of the good - e.g. a public good, like parks, street lighting as well as merit goods such as hospitals, schools etc.
The structure of the market- Monopoly and Monopsony.
Information problems.
Psychological biases - experiments have shown mixed results with market mechanisms.
What is an example of failure to come to an equilibrium?
Suppose that the local council decides that local rented housing is too expensive and wishes to keep a cap on the amounts of rent which would be allowed.
In order for this to be effective, the rent cap would have to be below the equilibrium level of rent.
As can be seen from this diagram, this results in a supply of houses at Q1 and a demand for houses at Q2. This means an excess demand of Q2 - Q1.
What is meant by price floor?
Rent control is an example of a “price ceiling”, which is the maximum price imposed below the market equilibrium price (to be effective, or binding)
Likewise, the government could also impose a “price floor” which is the minimum price imposed above the market equilibrium price
E.g. the National Minimum Wage (NMW) in the UK introduced in April 1999, set at £3.60 per hour;
The current rate (since October 2016) is £7.20 per hour for people aged 25+
Lower rates for younger people aged 21-24, 18-20 and below 18.
What is meant by market clearing?
In equilibrium a market is said to “clear”, i.e. everyone who wants a good at a given price can get that good.
No wastage - therefore can be described as “optimal”
However - only optimal with regard to the private preferences of the individuals involved in trading.
It is not necessarily socially optimal and may harm society.
The state may be justified in intervening to correct social abuses, alleviate poverty, protect the environment etc.
