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Distinguish among types of markets
Two Types of markets are
- Factor Markets – These are markets for the sale and purchase of factors of production. Factors of production are land, labor, physical capital and materials used in production
- For e.g., in factor labor market, households are seller of service while firms are buyers of service
- Goods Markets – These are markets for the sale and purchase of output of production
- For e.g., in PC market, firms are seller of hardware and households are buyer of product
Explain the principles of demand and supply
Demand is the willingness and ability of consumers to purchase a given amount of a good or service at a given price
Buyer's behavior is captured in demand function and in demand curve. Demand curve shows highest price which a buyer is willing to pay for each quantity and maximum quantity which a buyer is willing to buy at a particular price
Demand Function:
Quantity demanded of good x = f(Price per unit of x, Consumer's income, Price per unit of y, ...)
Inverse demand function presents price of goods supplied as a function of quantity and other variables. Slope of demand curve is the coefficient of quantity in inverse demand function.
Supply is the willingness of sellers to offer a given quantity of a good or service for a given price
Seller's behavior is captured in supply function and in supply curve. Supply curve shows lowest price which seller is willing to accept for each quantity and highest quantity sellers are willing to supply at each price
Supply Function
Quantity Supplied of good x = f(Price per unit of x, wage rate of labor, …)
Inverse supply function presents price of goods supplied as a function of quantity and other variables. Slope of supply curve is the coefficient of quantity in inverse supply function.
Describe causes of shifts in and movements along demand and supply curves
Movement along the demand curve Vs. Shift of Demand Curve
Movement along the demand curve is due to change in good’s own price. Quantity of goods demanded changes as price of product changes. Change in other variable of a demand function leads to shift in demand curve.
Movement along the supply curve Vs. Shift of Supply Curve
Movement along the supply curve is due to change in good’s own price. Quantity of goods supplied changes as price of product changes. Change in other variable of a supply function leads to shift in supply curve.
Describe the process of aggregating demand and supply curves, including the concept of equilibrium and mechanisms by which markets achieve equilibrium
- Market consists of collection of demanders and suppliers. Market demand and supply is aggregate of individual demand and supply functions.
- Aggregation process sums up individual buyer’s quantities and not prices
- Market equilibrium is a state in which quantity willingly offered for sale by suppliers at a given price is equal to quantity willingly demanded by buyers at same price
- Equilibrium occurs at a unique combination of price and quantity that simultaneously satisfies both demand and supply functions
- Partial Equilibrium Analysis – When value of exogenous variables are considered as given, then equilibrium analysis is called as partial equilibrium analysis
- General Equilibrium Analysis – When all the changes in all the variables (both endogenous and exogenous) are considered simultaneously, then equilibrium analysis is called as general equilibrium analysis
Distinguish between stable and unstable equilibrium and identify instances of such equilibrium
- Market mechanism when there is excess supply – When quantity supplied is greater than quantity demanded, price of good will come down and it will reach a point at which quantity demanded is equal to quantity supplied
- Market mechanism when there is excess demand – When quantity demanded is greater than quantity supplied, then price of good will increase and it will reach a point at which quantity demanded is equal to quantity supplied
- If supply curve intersects demand curve from above, then equilibrium is dynamically stable
- If supply curve intersects demand curve from below, then equilibrium is dynamically unstable. In this case, market mechanism will not lead to an equilibrium price.
Calculate and interpret individual and aggregate inverse demand and supply functions and individual and aggregate demand and supply curves
Individual and aggregate inverse demand functions
- Let us consider a demand function as Quantity = 100 - 2*Price
- Inverse demand function is Price = 50 - 0.5*Quantity
- Aggregate demand function sums up demand functions of individual buyers. This market demand function can then be inversed to find aggregate inverse demand function
- Demand curve can be drawn by using inverse demand function
Individual and aggregate inverse Supply functions
- Let us consider a supply function as Quantity = 100 + 2*Price
- Inverse supply function is Price = 0.5*Quantity – 50
- Aggregate supply function sums up supply functions of individual sellers. This market supply function can then be inversed to find aggregate inverse supply function
- Supply curve can be drawn by using inverse supply function
Calculate and interpret the amount of excess demand or excess supply associated with a non-equilibrium price
- Let us consider a supply function as Quantity = 100 + 2*Price
- Let us consider a demand function as Quantity = 200 – 2*Price
- Equilibrium price is equal to 25, which can be obtained by equating these two equations
- At price above the equilibrium price, there will be excess supply. Let us consider price as 30, quantity supplied at this price is equal to 160 while quantity demanded at this price is equal to 140. Difference of 20 is equal to excess supply
- Similarly at price below the equilibrium price, there will be excess demand. Let us consider price as 2, quantity supplied at this price is equal to 140 while quantity demanded at this price is equal to 160. Difference of 20 is equal to excess demand
Describe types of auctions and winning price of an auction
Common Value Auction
- In this auction, there is some actual common value which will be revealed at the end of the auction
- For e.g., if a piggy bank with gold coins is auctioned, actual value will be known once the auction winner counts actual number of gold coins
Private Value Auction
- Each buyer places a subjective value on item and in general their subjective value differ
- For e.g., if an antique jewelry is being auctioned, multiple buyers will place different value based on what they think is the true worth
Auction classification based on mechanism used to make price discovery
- Ascending Price Auction – Auction is made in an open arena wherein buyers openly reveal their willingness to buy at a price mentioned by auctioneer
- First Price Sealed Bid Auction – Envelopes containing bids are opened simultaneously and item is sold to highest bidder for actual bid price
- Second Price Sealed Bid Auction (Vickery Auction) – Bids are submitted in sealed envelopes and are opened simultaneously. Price paid is equal to that of second highest bid. Optimal strategy is to bid for one’s true reservation price
- Descending Price Auction (Dutch auction) – Auctioneer begins at a very high price (A price at which there are no willing buyers). Auctioneer then lowers the price until a willing buyer is found
Analyze the causes of a demand or supply imbalance that affects a good or service
- Natural causes like bad weather can lead to lower production of a good and thus result in lower supply
- For e.g., sugarcane production can be hampered by bad weather thereby leading to lower supply of sugar
- Recessionary environment can lead to lower demand for goods. Demand for discretionary good will fall more than that of normal good
Describe the impact of government regulation and intervention on demand and supply
Enforcement of Tax by Government
- Government can enforce tax on either buyer or seller of goods
- If tax is enforced on buyer, it shifts demand curve downwards by t. It leads to transfer of some surplus to government but results in deadweight loss
- If tax is enforced on seller, it shifts supply curve upwards by t. It leads to transfer of some surplus to government but results in deadweight loss
- Tax burden is higher on buyer if demand curve is steeper. Tax burden is higher on seller if supply curve is steeper than demand curve
Other examples
- Imposing of tariff on import of goods, setting quotas on imports or banning trade of goods
- If government imposes tariff on import of good, then it promotes less efficient domestic firms to compete with more efficient external firms
- Setting of quotas on imports helps those firms who have licenses to import. But it increases cost of goods for public
- When social marginal benefits are truly reflected in market demand curves and social marginal cost are truly reflected in supply curves, total surplus is maximized when markets are allowed to operate freely
- Some regulation may be required in case of public good (like national defense or where prices don’t reflect true marginal social value or cost, as in externalities such as pollution
Forecast the effect of the introduction and removal of a market interference (e.g., a price floor or ceiling) on price and quantity
Price Ceiling
- Price ceiling is enforcement of maximum price which can be charged by a seller to a buyer
- Total quantity of goods sold is less than equilibrium quantity
- This leads to transfer of surplus b from seller to buyer
- But it results in loss of portion c and d from total surplus. This loss is called as deadweight loss
- For e.g. price of essential goods (like medicine, gasoline in some countries) are administered by government and they fix maximum price that can be charged
Price Floor
- Price floor is enforcement of minimum price which can be charged by a seller to a buyer
- Total quantity of goods sold is less than equilibrium quantity
- This leads to transfer surplus a from consumer to producer
- But it results in loss of portion c and d from total surplus. This loss is called as deadweight loss
- For e.g. price of agricultural produce are given minimum support price by government to help farmers get fair price for their produce
Calculate and interpret consumer surplus, producer surplus, and total surplus
Consumer Surplus
- It is net benefit which buyers enjoy by participating in a particular market
- It is defined as difference between value which consumer places on goods and actual money paid to acquire those goods
- Value of consumer surplus is equal to area of upper triangle. Value = ½ * (Pmax – P1) * Q1
- Total expenditure is equal to area of rectangle with red line = P1 * Q1
Producer Surplus
- It is the difference between total revenue that sellers receive from selling a certain amount of good and total variable cost of producing that amount
- Value of producer surplus is equal to area of upper triangle = ½ * (P1 – Pmin) * Q1
Total Surplus
- It is equal to total value minus total variable cost
- Total surplus is equal to sum of consumer surplus and producer surplus
- If demand curve is more steeper than supply curve then more of total surplus is captured by consumers
- If supply curve is more steeper than demand curve then more of total surplus is captured by producer
Calculate and interpret price, income, and cross-price elasticity of demand, including factors that affect each measure
Own price elasticity of demand
- It is equal to percentage change in demand divided by percentage change in price
- For e.g., when price rises by 10% and demand falls by 8%, then price elasticity of demand is equal to -0.8
- Demand is said to be inelastic when it is not very sensitive to price changes. If absolute value of elasticity of demand is less than 1, demand is said to be inelastic
- If absolute value of elasticity of demand is greater than 1, then demand is said to be elastic and if its equal to 1 then demand is said to be unitary elastic
- If demand is not at all sensitive to price, then it is said to be perfectly inelastic
- Demand curve facing a perfectly competitive seller is perfectly elastic
- When demand is inelastic, decrease in price leads to fall in total expenditure
Factors affecting demand and supply
- If close substitutes are available, then demand is highly elastic otherwise demand is less elastic
- If only a small portion of total income is spent on purchase of produce, then demand is less elastic (For e.g. demand for purchase of salt is less elastic)
- Long run demand is more elastic than short run demand. If price of gasoline increases, then demand would not change in short run but in long run people will switch to cheaper alternatives and demand will fall
- Demand for necessary good is less elastic than those of discretionary goods
Income elasticity of demand for normal and inferior goods
- It is equal to percentage change in quantity demanded by percentage change in income
- Income elasticity can be positive, negative or zero. Positive income elasticity means that demand for product increases as income increases
- Normal good – Those product for which income elasticity of demand is positive are called normal good
- For normal good, rise in income will lead to upward right shift of demand curve
- Inferior good – Those product for which income elasticity of demand is negative are called as inferior good
- For inferior good, rise in income will lead to downward left shift of demand curve
Cross price elasticity of demand for substitutes and compliments
- It is equal to percentage change in demand divided by percentage change in price of other good
- If cross price elasticity of two products is positive then they are considered as substitutes
- For substitutes, increase in price of one good will lead to upward right shift in demand curve of other good
- If cross price elasticity of two products is negative then they are considered as compliments
- For compliments, increase in price of one good will lead to downward left shift in demand curve of other good
Important Terms
- Demand and Supply equations are called behavior equations because they respectively model the behavior of buyers and suppliers
- Variables which are determined within the model (for e.g., price and quantity) are called endogenous variables
- Variables which are determined outside the model are called exogenous variables
- Equilibrium condition occurs when quantity demanded is equal to quantity supplied
- Winner’s Curse – If winner of a bid has paid more than true value of an asset, then it is known as winner’s curse
- Marginal Value Curve – It shows highest price which a consumer is willing to pay for an additional unit of product
- Marginal Cost – Cost of producing one more unit
