Finance 30210: Managerial Economics Supply, Demand, and Equilibrium When we talk about the market process, we are talking about the interaction between two groups of people: Consumers make decisions Businesses make decisions about about what to buy, where to what to produce and how to produce shop, etc. in order to maximize to maximize profit – we can their enjoyment– we can (sometimes) summarize their summarize these decisions decisions with a supply curve with a demand curve When consumers and producers interact in the marketplace, prices are determined – therefore, the market price contains a component from consumer decisions AND producer decisions Lets start with a very simple question…if you were to buy an ice cream cone right now, how much would you be willing to pay? What factors influence your choice? Lets suppose that you would pay up to, but not over $5 Now, suppose Price that the market price for ice cream is $3 $5 $2 $3 We refer to the $2 difference between what you are willing to pay and what you actually pay your consumer surplus Quantity 1 Now, lets suppose that you just ate the first ice cream. How much would you pay for a second ice cream cone? Why? Typically, the more you have of something, the less it is worth to you at the margin – we call this Now, at the same market diminishing marginal utility price, you would be willing to buy two ice Price cream cones $5 $4 $2 $1 $3 With 2 ice cream cones, you would earn $3 of consumer Quantity surplus 1 2 When we say that consumers are making choices to maximize their utility, what we mean is that consumers are making buying decisions to maximize their consumer surplus. A demand curve represents the outcome of this decision Price Quantity demanded for “is a function of” some commodity x $5 Qx D Px , I , Py ,... Price of X D Income Prices of other Quantity goods 1 Note that a particular demand curve shows the quantity demanded for any given price – HOLDING EVERYTHING ELSE CONSTANT!!! Demand curves slope down due to diminishing marginal utility. The elasticity of demand measures the strength of this effect Qx D Px , I , Py ,... Price - % Q x D $5 % Px - 20% 100 $4 D 5 20 D Quantity 1 2 100% If we know the form of the demand function, there is an easy way to calculate elasticity. Qx %Qx Qx Qx Px D Px P Q Price %Px x x Px Change in demand with respect to $10 price One particular point D on the demand curve Quantity 100 Q P 10 Q 200 10P 10 1 P Q 100 Look what happens as we change the point on the demand curve Q P 15 10 3 P Q 50 P $20 Q 200 10P $15 Q P 5 10 .3 $5 P Q 150 D 50 150 Q For linear demand curves, elasticity Q A BP is not constant! P How is knowing the A/B High elasticity elasticity of demand useful? Low elasticity D Q Q 200 10P Expenditures are maximized at the point on the demand curve where elasticity equals -1 3 Expenditures = $15*50=$750 P $20 1 Expenditures = $10*100=$1000 $15 $10 .3 $5 Expenditures = $5*150=$750 D 50 100 150 Q Elasticity and Expenditures E PQ $10(100) $1000 P E PQ $5(150) $750 .3 $10 $5 %E %P %Q %P %P D %P1 100 150 Q If the elasticity is less than one, the revenues increase – if elasticity is greater than negative one, revenues decrease At least for most goods, we assume that – all else equal – higher income will increase demand (you buy more of something when you can afford it). The income elasticity measures the strength of this response Qx D Px , I , Py ,... Suppose that a 40% increase in your income (say, from $100 Price per week to $140) + induces you to buy an additional ice cream at the initial $5 price $5 %Qx I D %I 100 1 2 Quantity I 2.5 40 100% Your response to other price changes depends on what the other commodity is. An increase in the price of a substitute typically raises demand while a rise in the price of a compliment lowers demand – cross price elasticity measures the strength of this response Qx D Px , I , Py ,... Suppose that a 50% increase in the price of Price soda induces you to + or - buy an additional ice cream at the initial $5 price $5 %Qx p D y %Py Quantity 100 0 1 2 p 2 y 50 100% While each consumer is making purchasing decisions (intensive margin), the market demand adds up these decisions across all consumers (extensive margin). Individual Aggregate P P P $3 D D1 D2 3 Q1 2 Q2 5 Q Now, suppose that you are an ice cream salesman. At what price would you be willing to sell ice cream? What factors influence your decision? Lets suppose that you would require at least $2 to cover your costs of producing that ice cream. We call this cost your marginal cost Now, suppose Price that the market price for ice cream is $5 $5 We refer to the $3 difference $3 between the market price and your marginal production $2 cost your producer surplus Quantity 1 Total Costs vs. Marginal costs vs. Average Costs Lets suppose that it cost you $100 to set up your ice cream stand. This is a fixed cost (otherwise known as overhead) because it does not depend on your level of production Quantity Total Cost Marginal Cost Average Cost 0 $100 1 $102 $2 $102 2 $105 $3 $52.50 3 $109 $4 $36.33 4 $114 $5 $28.50 Note that marginal costs are increasing with production If we assume that your marginal costs increase with production, then at any given market price, your surplus at the margin will shrink as your production increases Now, at the same market price, you would be willing to sell two ice Price cream cones $5 $2 $3 $3 With 2 ice cream $2 cones, you would earn $5 of producer surplus Quantity 1 2 When we say that producers are making choices to maximize their profit, what we mean is that producers are making production decisions to maximize their producer surplus. A supply curve represents the outcome of this decision Price Quantity supplied for “is a function of” some commodity x Qs S Px , MC x ,... $2 Price of X D Marginal Cost of X Quantity 1 Note that a particular supply curve shows the quantity supplied for any given price – HOLDING EVERYTHING ELSE CONSTANT!!! Supply curves slope up due to diminishing marginal utility. The elasticity of supply measures the strength of this effect Qs S Px , MC x ,... Price + % Qs $3 s 50% % Px $2 100 D s 2 50 Quantity 1 2 100% An increase in costs at the margin will lower quantity supplied. The cost elasticity of supply measures the strength of this effect Qs S Px , MC x ,... Suppose that a 50% rise in marginal Price costs lowers - supply from 2 to one at the $3 price $3 %Qs $2 MC D % MC x 50 1 2 Quantity MC 1 50 -50% While each producer is making supply decisions (intensive margin), the market demand adds up these decisions across all producers (extensive margin). Individual Aggregate P S1 P P S2 S $5 $10 4 Q1 2 Q2 6 Q A market equilibrium is defined at a price that clears the marketplace. That is, at the equilibrium price, every item that is produced is sold. Qs QD Price S At a market price that is to high, we have excess supply $4 At a market price that is to low, we have excess demand D Quantity 25 100 200 Also, note that every item that is sold is profitable for everyone involved Qs QD Price S $6 Consumer Surplus $4 Producer Surplus $2 Marginal Cost D Quantity 25 100 In fact, the market equilibrium maximizes both consumer surplus and producer surplus. Therefore, everyone involved has accomplished their objectives. Qs QD Price Total S Consumer Surplus Total $4 Producer Surplus D Total Production Quantity 100 Costs (Less Fixed Costs) The market process represents an aggregation of preferences. Freely adjusting prices give everyone the proper incentives. P Supply curves aggregate S the costs of producers $4 Demand curves aggregate the preferences of D consumers Q 100 An equilibrium is a price that “clears the market” (Supply equals demand). Therefore, the market price is a combination of producer cost and consumer value Suppose that the value of this product to consumers increases… P S $4 At the initial price, a temporary shortage D exists. Consumers Q battle to obtain the 100 good – prices get bid up A rising price creates the incentive for firms to raise production. Suppose that the production costs drop… P S At the initial price, a temporary surplus exists. Firms cut prices to increase $4 sales D Q 100 A falling price creates the incentive for consumers to increase their purchases. An Application of Supply and Demand What Factors are driving crude oil prices? OPEC is limiting production to maintain high prices IRAQ Iraqi Oil Production hasn’t Nigeria picked up as quickly as expected following the gulf war. Nigerian rebels are threatening oil production Venezuela Venezuela has yet to fully recover from the strike of 2003 What Factors are driving crude oil prices? Economic Growth Rates (Inflation Adjusted): 2004 Country Annualized Growth China 9.1% Hong Kong 7.4% India 6.2% United States 4.4% Japan 2.9% European Union 2.4% As world incomes rise, so does demand!! Over the past year, demand has continued to increase (relative to long run trends) while supply problems have generated a decrease in supply (also relative to long run trends). P S 2006 Both factors are S 2004 acting to increase price!! $60 $30 D2006 D2004 40 60 Q Market prices should be a reflection of value…to everybody! Suppose that your 10th hour of work produces $80 worth Productivity of output per hour $80 $50 $20 Your 60th hour produces much less than the 10th hour D Hours 10 30 60 Generally speaking, the more one works, the less productive they become. Market prices should be a reflection of value…to everybody! Time Value S $100 Your 100th hour of work (your 100th hour of foregone leisure) is worth $25 a lot more $5 Hours 4 20 100 Your 4th hour of work (your 4th hour of foregone leisure) is only worth $5 to you. A market equilibrium represents trades that are beneficial to everyone involved! Every hour worked is profitable for the firm Wage S The worker is $50 compensated by at least as much as is required for every working hour D Hours 38 So, why do we see wages rising over time? Wage Explanation #1: S Individuals are requiring more compensation over time $50 Explanation #2: Individuals are becoming more D productive over time Hours 38 So, which is it? Labor productivity growth has averaged 1-2.5% per year since WWII. Wages have grown (in real terms) by 2% per year Wage S $55 Suppose that new $50 technology makes us 10% more productive across the board D Hours 38 This is generally consistent with what we see in the short term as well. 5 4 3 2 Percentage Change 1 0 -1 1980 1984 1988 1992 1996 2000 -2 -3 -4 -5 -6 Wages Productivity Output Per Hour However, an anomaly appears at the micro level… Salary Salary $220,000 Productivity 4%/yr $46,000 Age 21 62 Its an established fact that average wages increase with age almost until retirement while average productivity is flat or actually declines with age (particularly after the age of 50) It appears that younger workers are systematically underpaid (Paris Hilton is a notable exception) while older workers are systematically overpaid….how can we explain this? Moral Hazard describes situations in which one agent can’t observe the behavior of another Its difficult for a corporation to observe the work habits of every employee. Therefore, incentives must be put in place to insure hard work: For young workers, the best incentive is a rising salary For older workers, the threat of being laid off is a much stronger incentive (being overpaid increases the possibility of being laid off) The preservation paradox By recycling one ton (2,000 lbs.) of paper, we save: 17 trees; 6,953 gallons of water; 463 gallons of oil; 587 pounds of air pollution; 3.06 cubic yards of landfill space and 4,077 Kilowatt hours of energy. The average American uses 650 pounds of paper per year. Lets do a “back of the envelope” calculation here… 300 million Americans translates into roughly 100 million tons of paper used per year – if this paper was recycled, we could save roughly 1.7 BILLION Trees per year!!! Is it possible for recycling to actually LOWER the number of trees in the US? Let’s think about this from the point of view of a logging company…suppose our logging company owns 100 acres of forest. Each acre of land produces 50 trees per year, but different terrains have different logging costs. 25 Acres: 20 Acres: $160 $150 per per acre acre 25 Acres: $190 30 Acres: $180 per acre per acre This logging company must be able to collect at least $190 dollars of revenue per acre to maintain all 100 acres of forest. As revenues drop, some areas are no longer worthwhile to maintain. Revenue per acre S $190 $180 $160 $150 Number of Trees supplied 1250 2250 3750 5000 per year For simplicity, lets assume that the demand for paper was high enough so that this company could collect $200 in lumber revenues per acre of land. All 100 acres of forest will be maintained. Now, suppose that Revenue per recycling programs acre S lower the need for trees. What $200 D happens? $190 $180 $170 D $160 $150 Number of Trees supplied 2250 5000 per year Is it possible for recycling to actually LOWER the number of trees in the US? Recycling lowers the demand for trees and, hence, the market value of forest land. Without the incentive to maintain its inventories, the logging company simply cuts the trees down and lets the land sit empty!! 25 Acres: 20 Acres: $160 $150 per per acre acre Treeless Land!! I’m not sure this is what conservationists had in mind!!! Partial vs. General Equilibrium Recall the example of going to college Total Costs: $59,290 X 4 = $237,160 Total Benefits = $20,000/yr for 40 yrs. $343,181(i = 5%) We have three markets interacting with each other The indifference principle states that the marginal consumer should be indifferent between any two choices! Economic Incentive = (Expected) Benefit – Opportunity Cost Determined in college Determined in job markets tuition market For the marginal consumer, Expected Benefits = Costs!! The indifference principle states that the marginal consumer should be indifferent between any two choices! P P P S S S $30k/yr $20k/yr $32k/yr D D D Q Q Q P P P S S S $30k/yr $20k/yr $32k/yr D D D Q Q Q Expenses Benefits $30k/yr Tuition $12k/yr Higher Salary $20k/yr Lost Wages The Present Value of $12K per $50k/yr x 4 = $200K year for 40 years (I = 5%) is $200K P P P S S S $30k/yr $20k/yr $50k/yr D D D Q Q Q Suppose that high education jobs were overvalued. How would markets adjust? As more people chose to leave unskilled jobs and return to school, the supply of unskilled labor would fall (raising unskilled wages) while demand for college rises (tuition increases) An economic riddle… It is routine public policy for the government to pay farmers to leave portions of their fields untended (this lowers the supply and, hence, raises the price) Why doesn’t the government pay hotels to leave some of their rooms unoccupied (shouldn’t the reduction in rooms raise the price)? Arbitrage Generally speaking, properly functioning, competitive markets should eliminate any risk free profit opportunities. Therefore, we shouldn’t see the same product selling for a different price in two locations Sell in DC P S $30 $20 P Washington DC S New York D Q $40 $30 D Buy in NY Q Arbitrage (Buy Low, Sell High) should eliminate any price discrepancies Speculation Speculation is the same concept as arbitrage. Simply replace locations in space with locations in time!! P P S S $40 $20 D D Q Q Now Next Year The key difference is that we can’t always predict the future!!
Pages to are hidden for
"Finance 360_ Managerial Economics"Please download to view full document