Reading 13 LOS's Flashcards
LOS 13a: Distinguish among types of markets
- Factor Markets are markets for factors of production (land, labor, capital). In the factor market, firms purchase the services of factors of production from households and transform those services into intermediate and final goods and services
-
Goods market are markets for the output produced by firms using the services of production. In the goods market, households and firms act as buyers
- Intermediate goods and services are used as inputs to produce other goods and services
- Final goods and services are goods purchased by households
- Capital Markets are markets for long-term financial capital. Firms use capital markets to raise funds for investing in their business, while household savings are the primary source of these funds.
LOS 13b: Explain the principles of demand and supply
LOS 13c: Describe causes of shifts in and movements along demand and supply curves
Demand is the willingness and ability of consumers to purchase a given amount of a good or a service at a particular price.
The law of demand states that as the price of a product increase (decreases), consumers will be willing and able to purchase less (more) of it.
The demand function caputres the law of demand with other factors such as tastes and preferences. An example of a demand funtion is:
- QDG = 7.5 -.5PG + .1I - .05PA
- PG= price of gas
- I = household income
- PA= price of automobile
- QDG= quantity demanded for gas
From this Equation notice, how the price of gas and automobiles is inversely related to quantitiy demanded (due to negative signs), while income is positively.
Economists prefer to present demand curves with quantity on the x-axis and price on the y-axis. To satisfy this we use the inverse demand function, which would simply put the price by itself on the left side, and quantity demanded with the other factors on the right. for example:
- QDG = 12- .5PG ==> PG = 24- 2QDG
The demand curve is developed using the inverse demand function.
Changes in Demand versus Movements Along the Demand Curve
Change in quantity demanded - occurs when the price of the good changes, then we see movement along the demand curve. For example if the price of gas went up, the quantity demanded would shrink as the point would move up the demand curve.
Change in demand - when any other factor effecting demand changes, there is a shift in the demand curve. For example if the price of automobiles went up, the demand curve would shift inwards.
Supply refers to the willingness and ability of producers to sell a good or a service at a given price.
The Law of Supply states that price and quantity supplied are positively related
The supply function will capture all the effects on supply, including price and costs of production
The inverse supply function simply makes price our independent variable (on left side of equation), and we use this to make our supply curve.
Changes in Supply vs Movements Along the Supply Curve
Change in the quantity supplied happens when there is a change in the price of the good and causes movement along the supply curve
Change in Supply happens when any of the dependent factors change value and causes the supply curve to shift in or out
LOS 13d: Describe the process of aggregating demand and supply curves
Aggregating the Demand Function
The market demand function is determined by aggregating everyone’s individual demand functions. Simply summing all of these demand curves will give you the aggregate.
Here again we will use the market inverse demand function to develop our market demand curve.
Note that we multiplied the individual demand function, not the individual inverse demand function, by the number of households to aggregate the demand function. This is because the aggregation process requires us to add up the quantities that individual households are willing and able to purchase, not adding their prices. For example if each household is willing to buy 11 gallons of gas at $2 a gallon, then 1,000 such households should be willing and able to buy a total of 11,000 gallons at $2.
Aggregating the Supply Function
This follows the same process, we simply add up the total individual supply functions, to get one unison. Then inverse the function to derive the supply curve.
LOS 13e: Describe the concept of equilibrium (partial and general) and mechanisms by which markets achieve equilibrium
Market equilibrium can be defined in two ways:
- It occurs at the price at which quantity demanded equals quantity supplied
- It occurs at the quantity at which the highest price a buyer is willing and able to pay equals the lowest price that a producer is willing and able to accept
We can determine this point by equalling the market demand function to the market supply function or equalling the inverses.
Exogenous variables are determined outside of demand and supply for the market being studied (in previous example price of automobiles and household income)
Endogenous variables are determined in the market being studied ( quantity and price of gas)
When we concentrate on one market and assume that the values of all exogenous variables are given, we are undertaking partial equilibrium analysis. This does not account for any feedback effects associated with our exogenous variables. This is suitable for a small market.
When we are considering the market on a national scale, we want to use general equilibrium analysis, as this will account for all feedback effects from all variables.
LOS 13g: Distinguish between stable and unstable equilibria and identify instances of such equilibria
Stable equilibrium dictates that when there is excess supply, prices will fall till they come in line with demand, and when there is excess demand, prices will rise until they come in line with supply.
Unstable equilibrium occurs when instead of reverting toward equilibrium, the prices keep moving away from equilibrium.
To understand this, consider two different markets with both demand and supply curves downward sloping. In one market the supply intersects demand from above, when price is above equilibrium, we will have excess supply, and the price will be dragged down, meaning this market has stable equilibrium.
For the other market, supply intersects demand from below. Here when price is above equilibrium, we acually have excess demand over supply. In this case price will keep growing as there are shortages for the product.
It is also possible for markets to have multiple equilibria.
LOS 13h: calculate and interpret the amount of excess demand or excess supply associated with a non-equilibrium price
When price is above equilibrium, we will experience excess supply over demand.
When price is below equilibrium, we will experience excess demand over supply.
To calculate the amount, simply see how much is willing to be supplied at a certain price and how much demand there is at a certain price. Find the difference in these quantities.
LOS 13i: Describe the types of auctions and calculate the winning prices of an auction.
Auctionscan be classified into two types based on whether or not the value of the item to each bidder is the same
- Common value auction - the value of the product is the same to each bidder. Bidders estimate the value of the product before the auction is settled and the common value of the product is revealed once the auction is complete
- Private Value Auction - each bidder places a subjective value on the product and the value each bidder places is generally different.
Auctions also differ with respect to how the final price and eventual buyer are determined.
- Ascending price auction - Potential buyers openly reveal their bids at prices that are called out by the auctioneer. The auctioneer starts the bidding at a particular price and then raises the price in response to the bidders.
- Sealed Bid Auction - for a common value item potential buyers bid for the item with no knowledge of the values bid by other potential buyers
- _First price sealed bid auction -_all enveloped containing bids are opened simultaneously and the item is sold to the highest bidder for the price bid. Further eventual profits are only known once the asset is exploited. This opens up the possibility of winner’s curse, where a buyer pays more than what the asset is worth
- If the item being sold is a private value item, there is no danger of the winner’s curse as no one would bid more than their own valuation
-
Descending Price of Dutch auction - the bidding begins at a very high price and the auctioneer lowers the price until the item is sold. A Dutch auction can have a single-unit or a multiple-unit format.
- In a multiple-unit the price is a per-unit price, and the winner can buy as many items at this price as desired. If they do not purchase all units, the auction continues
- A modified Dutch Auction (widely used in securities markets) establishes one price for all purchases. Stock repurchases are conducted using this method, where the aim is to establish the minimum price at which the company can repurchase all the shares it wants to.
- Single Price Auction (variation of Dutch) is used in the US Treasury Market. the treasury puts up Treasury Bills for sale with both competitive and non-competitive bidding. Non-competitive bidders simply state the total face value they are willing to purchase at the final price. Compettitve bidders specify the total par value they want to purchase and the exact price at which they are willing to purchase that quantity.
LOS 13j: Calculate and interpret consumer surplus, producer surplus, and total surplus
Marginal benefit (MB) is the utility derived from consumption of the last unit of good or service. The marginal benefit curve is the demand curve where the benefit or utility that we derive from the good is quantified by the maximum price we are willing and able to pay for it.
Marginal Benefit curve is downward sloping due to the law of diminishing marginal utility which states that the utility derived from consumption of the next unit will be lower than the utility derived from consumption of the last unit.
Consumer Surplus
This surplus occurs when a consumer is able to purchase a good or service for less than the maximum price that they are willing and able to pay for it. It is the difference between what a consumer is willing to pay for a good (indicated by demand curve) and the price they actually pay for the good (the market price).
the way to figure out consumer surplus, is to subtract the highets price on the demand curve by the market price and multiply it by the quantity purchased and .5 ( because it is a triangle and we are trying to derive the area of the triangle. In this sense consumer demand price - market price is height, and quantitiy demanded is width).
Producer surplus
This occurs when a supplier is able to sell a good or service for more than the price they are willing and able to sell it for. It is the difference between the lowest point on the supply curve and the market price. Its calculation is the same as consumer surplus. Subtract the lowest price on the supply by the market price, and then multiply it by quantity and .5.
Total Surplus: Total Value minus Total Variable Cost
Total surplus is simply the sum of consumer and producer surplus. The distribution of total surplus between consumers and producers depends on the relative slopes of the demand and supply curve. If the supply curve is steeper, more of the surplus will be captured by suppliers.
Total surplus can be looked upon as society’s gain from the existence of a free market where goods can be exchanged voluntarily. Total surplus is maximized at equilibrium.
Markets Maximize Society’s Total Surplus
At equilibrium, the highest price someone is willing to pay for a good is equal to the lowest price someone is willing to supply the good. When we are not in equilibrium, we experience deadweight loss, which is simply the loss on total surplus due to not being at equilibrium.
If the amount supplied if less than equilibrium, then suppliers are missing out on a chance to provide products to the market for profits. If the amount supplied is more than equilibrium, then producers are suppling a product that will sell for less than it costs. The deadweight loss in both of these situations is the difference between the supply and demand curve at the quantity points.
In terms of consumers, when all consumers face the same price, consumer surplus is maximized when each consumer purchases a quantity that equates their marginal value from the last unit consumed to market price. If we had two consumers that purchased up to this point, and then we took one unit away from consumer A and gave it to consumer B, the result would be that the total value of the loss from consumer A, would be greater than the total value of gain from consumer B.
LOS 13k: Describe how government regulation and intervention affect demand and supply
LOS 13l: Forecast the effect of the introduction and removal of a market interference (ex a price floor or ceiling) on price and quantity.
Price Ceilings
When the government feels a product or service is priced too high (such as rent in NYC), they may put a ceiling on it. If the market is in equilibrium and the ceiling is set below, we will experience loss in total utility. The reason is that if the price is set below equilibrium price, then the quantity demanded will exceed the quantity supplied. This will cause a shortfall of goods. Some consumers that are able to purchase the good or service, will experience a gain in consumer surplus,as they can now purchase the good or service for less. Some consumers will be squeezed out though, and though they are willing and able to buy the product at the price, they will not be able to due to shortage. Producers will completely lose out, as they now supply less for a lower price.
In terms of looking at a graph (the two triangles of consumer and producer surplus), consumer surplus will gain for those able to enjoy the low price, and will proceed below the equilibrium price into producer surplus. They both will lose the tips of their triangles, which are cut off by the new ceiling price when it intersects supply.
Price Floors
When the government feels like a good is underpriced, it will put a floor on it, meaning a minimum level. When this level is above equilibrium price, there will be a loss in both consumer and producer surplus. Here some producers will be able to experience gains in surplus, as they are now able to sell their product for more than market price. Yet some producers will miss out, as there is not enough demand to sell all products. Consumers will completely lose as they now purchase less for more money.
In terms of the graph, the producer surplus triangle will move past the equilibrium price and take over some of the consumer surplus triangle. They both will lose the tips of their triangles at the new floor price, when it intersects demand.
Taxes
Per-Unit Tax on Sellers
When there is a tax on suppliers, it shifts the supply curve from equilibirum up. Now suppliers supply less to the market for a higher price. Both consumer and producer surplus shrink drastically, but their shrink involves two parts. One part is deadweight loss. This is the amount of loss caused by the less supply for more money, due to the new tax price.
The other part of the loss, is the amount of money that is given to the government. This amount is represented by the difference between the amount the customer pays and the amount the producer receives after taxes, times the quantity sold. This loss can come from either completely consumers or producers, but more ofte n than not it comes from both. The steepness of the demand and supply curve will decide how much is taken on by whom. When the demand curve is steeper than supply, consumers taken on the greater burden than suppliers
Tax on Buyers
This is the same thing as tax on consumers, instead of the supply curve shifting though, the demand curve shifts. Once again there is dead weight loss and also loss to the government, equally the difference in the price the consumer pays minus the price the suppliers receive times the quantity sold.
Search Costs
Are the costs of matching buyers and sellers in the market. If there is not someone like a broker who can set up people looking to trade, a producer may not find a consumer who is willing to pay a higher price for their product. In this case there will be total societal loss and deadweight loss.
NOTE To make things clearer I would go back and review the graphs in the book
LOS 13m: Calculate and interpret price, income, and cross-price elasticities of demand, including factors that affect each measure
Own-Price Elasticity of Demand
Given that price and quantity demanded are negatively related, a firm needs to know how sensitive quantity demanded is to changes in price to determine the overall impact of a price change on total revenue.
One measure of the sensitivity of quantity demanded to changes in the price is elasticity, which uses percentage changes in the variables and is independent of the units used to measure the variables.
- EDPx= % change in QDx / % Change in Px
Which can be expanded to be:
- EDPx = (Change in quantity demanded / Change in Price) X (Price / QD)
We usually look at the absolute value of own-price elasticity of demand when classifying how sensitive quantity demanded is to changes in price
- If own-price elasticiy = 1 (percentage change in QD is the same as the percentage change in P), demand is said to be unit elastic.
- If it = 0 (QD does not change in response to change in P), demand is said to be perfectly inelastic.
- If it equals infinity (QD changes infinitely large to smallest change in price), demand is said to be perfectly elastic
- If it lies between 0 and 1, it is relatively inelastic
- If its absolute value is more than 1 it is relatively elastic.
An important thing to note is that the ratio of price to quantity is different at each point along the demand curve:
- At low prices, and high quantities, the ratio of price to quantity is low, so own-price elasticity of demand is low and demand is relatively inelastic
- For the opposite, demand will be relatively elastic
- Deman is unit elastic at the midpoint of the demand curve
When info on the entire demand curve is not available, but any two observations of price and quantity demanded are, arc elasticity may be used to gauge the responsiveness of quantity demanded to changes in price:
- Ep = { [ (Q0-Q1) / ((Q0+ Q1) /2) X 100} / { [ (P0 - P1) / ((P0 +P1) /2) X 100 }
Factors Affecting Own-Price Elasticity of Demand
- Availability of Close Substitutes- If consumers can easily switch to another good, there demand will be relatively elastic
- Proportion of Income Spend on Good- If the consumer spends a low proportion of income on the good, their demand will be relatively inelastic
- Time Elapsed Since Price Change- The longer the time that has elapsed the more elastic demand will be
- The extent to which a good is viewed as necessary or optional- If necessary then demand will be inelastic
Own-Price Elasticity of Demand and Total Expenditure
Total expenditure equals price times quantity purchased. If prices are reduced to simulate sales, total revenue will only increase if the percentage increase in sales is greater than the percentage decrease in prices
- If the price cut increases total revenue, demand is relatively elastic (greater than 1)
- If the price cut decreases total revenue, demand is relatively inelastic ( less than 1)
- If the price cut does not change total revenue, demand is unit elastic
Total Revenue and Price Elasticity
looking at things from a producers perspective, the change in the total amount of money earned from sales also depends on sensitivity of quantity demanded to changes in price
- If the demand curve facing the producer is relatively elastic, an increase in price will decrease total revenue
- If the demand curve facing a producer is relatively inelastic, an increase in price will increase total revenue
- If the demand curve facing the produce is unit elastic, an increase in price will not change total revenue.
Note, that a producer can increase revenue by increasing their prices. The benefit of higher prices would outweight the negative impact of lower quanities, plus less units produced would cost less. Therefore, no producer would knowingly set a price that falls in the inelastic region of the demand curve
Income Elasticity of Demand
This measure the responsiveness of demand for a particular good to a change in income, holding all other things constant
- EDI = (Change in QDx / Change in Income) ( Income / QD x)
- or EI = % change in DQ / % change in income
Income elasticity of demand can be positive, negative, or zero. Products are classified along the following lines:
- If income elasticity is greater than 1, demand is income elastic and the product is classified as a normal good.
- As income rises, the percentage increase in demand excees the percentage change in income
- AS income increases, a consumer spends a higher proportion of her income on the product
- If income elasticity lies below 0 and 1, demand is income inelastic, but the product is still classified as a normal good.
- As income rises, the % increase in demand is less than % increase in income
- As income increases, a consumer spends a lower proportion of her income on the product
- If income elasticity is less than zero, the product is classified as an inferior good.
- As income rises, there is a negative change in demand
- The amount spend on the good decreases as income rises
Cross-Price Elasticity of Demand
Cross elasticity of demand measures the responsiveness of demand for a particular good to a change in price of another good, holding all things constant.
- EDPy= (Change in QDx / Change in Py) (Py/ QDx)
- of Ec= % change in QD / % change in price of substitute or complement
Substitutes
The magnitude of the cross elasticity figure tells us how closely the two products serve as substitutes for each other. A high value indicates that the products are very close substitutes. Cross-price elasticity of demand for substitutes is positive, therefore any products with positive cross-price are classified as substitutes
Complements
For complements, the numerator and denominator head in opposite directions, so the cross-price is always negative. The greater the absolute magnitude, the higher the two products are tied together and how great of complements they are for each other.
