Lecture Notes for 09/07/2012

Chalkboard notes.

Last time we introduced the notion of a market very briefly as a segue from our historical analysis of other economic systems. Why are we concerned with markets? Under the capitalist form of the social provisioning process, markets serve as the primary institutions by which we organize production and distribution. So, we need to define in careful terms what it is that we mean by “the market.”


Usually when we hear about the market in our everyday lives we see terms like “The markets soar to a four-year high” on some news, in this case the news is that of the ECB’s decision to keep interest rates low. Or terms like “markets plunge” on news of weak jobs numbers coming out of the labor department.
What are they referring to? The stock market or the bond market – in short financial markets. These are one type of market, but not “the market.”

In economics we have a much broader conception of the market. Like I’ve said previously in class, the market or markets for us is the arena in which producers of a particular good or service meet with buyers who would like to purchase some of those goods or services. We’re talking about the market for gasoline, the market for various groceries, the market for clothing, the market for booze, and yes, the black markets for other illicit goods that shall go unnamed.

Note: the market need not be a specific location, such as an open-air market or bazaar. Rather, it encompasses something more abstract in both spacial and social aspects.

There can be as many markets as there are products, which presents a problem for the simple supply and demand model we’ll cover today and Monday in class, but nevertheless this is true.

So, how do we analyze this? We use the supply and demand model of the market.

Before we begin we need to invoke the fundamental assumption in neoclassical economic theory that agents are rational, calculating, fully informed, and motivated by self-interest. Pg. 108 of your text.

• Consumers (households): rational in the sense that they would like to try to maximize their own welfare through consuming more and more goods, subject to their own budget constraints. Conversely, they would prefer to avoid doing things that bring them discomfort, such as going to work.

• Producers: rational in the sense that they will calculate their costs of production and weigh this against their revenues to determine the amount of goods they will supply to the market at a given price, with the ultimate goal of maximizing their profits.

This assumption of the rational agent does not encompass other considerations behind their own self-interest, such as the effect of their decisions on others or society as a whole. The assumption in neoclassical economics is that if everyone behaves rationally by pursuing their own self-interest, then society as a whole will be better off.  This is problematic, but for now let’s just take this for what it’s worth to see how it enables us to analyze markets.

Demand: The buyer’s side of the market

What determines the demand for a product?

1. Tastes and preferences
2. Income: if incomes goes up, then demand will shift depending on whether we are considering normal vs. inferior goods. Income and normal goods move in the same direction, whereas more income leads to a decline in demand for inferior goods. Think instant ramen and otherwise really cheap food. People tend to eat higher quality food as their incomes increase. 
3. Prices of Related Goods - if two goods are substitutes for each other, then as the price of one good increases relative to the other, people will choose the cheaper good, increasing demand for it and decreasing the demand for the other. 
4. Number of Demanders - this should be intuitive. This is the same thing as saying that the market demand for a good is the sum of individual demand for the good. So, the more individual demanders you have, then the more demand there will be for the good at the level of the market.
5. Expectations of future prices - people do not make decisions for the very instance in which they live, but they try to hedge their actions of today against uncertain events of tomorrow. If people think the price of some goods they demand is going to fall in the future, they may delay their purchase. Or vice versa. And, this is the most important part, their expectations may be disappointed. 

Ceteris Paribus: We defined cet. par. last time, but here it is again. If we want to isolate the effect of price on the quantity demanded of a particular good, then we hold all the rest equal.

Drawing the Demand Curve: If we invoke the assumption of rational agents (above), then we generally draw the demand curve as a downward sloping line, showing a negative relationship between price of a good and the quantity demanded. While it is possible to change the slope and shape of this curve, by specifying our assumptions in a certain way, let us just assume the market we are concerned with faces a downward sloping demand curve.

Supply: The Seller’s Side

1. Resource prices: higher resource prices, will lower the supply
2. Technology: efficiency enhancing tech will generally increase the supply (personal computer revolution)
3. Prices of related goods: assuming a producer can produce the related good, a higher price relative to the one in question will induce them to produce more of the related good relative to it. 
4. Seller’s expectations: This is most important one here. See expectations for the consumer. Producers can also be disappointed, and if they have reason to think that's a real possibility they may forego investment today. So, negative expectations of profitability may shift the supply curve to the left. Optimistic views to the future will shift the supply curve to the right. 
5. Number of sellers in the market: more sellers mean more supply.

Drawing  Supply Curves: Generally we draw this as an upward sloping curve that is positively related between price and quantity. If we assume that firms are able and willing to respond to increasing prices by supplying more of the good for sale at that price, then we draw this curve as mentioned here. But, if there are reasons which inhibit the the supply to change much in the face of a price change, then we would draw a supply curve with a much steeper slope.

Putting them together we get the market with a clearing price.

Surpluses and shortages are automatically eliminated, as the price moves along the respective supply and demand curves, so that they meet at the equilibrium condition where supply = demand. Assuming the curves are not shifting, then any deviation away from the "market clearing" price, will be returned the forces of the market. See this video below for a very good explanation of how the market finds its equilibrium.