Common Errors in Market Analysis

Keeping track of which market you are analyzing. Example: Explaining why peanut prices increased, not the effect of this increase on the market for peanut butter Hint: write the name of the product on the quantity axis Skipping steps-- assuming what is to be explained Showing a decrease in supply incorrectly: A decrease in supply is shown as a leftward shift in the supply curve (decreased quantity offered at each price). A downward shift is actually an increase (greater quantity) Confusing movements along a curve with shifts in the curve.

What is wrong with the following?

"Demand is lower now that peanut butter is increased in price" (as a result of increased costs of production) is INCORRECT. Experience tells us that people will buy less now. That is correct. They bought less because the price rose. That's what the demand curve tells us they will do: it shows that as the price rises, quantity demanded will decline. You don't need a new curve Assuming the demand curve shifted would result in the illogical conclusion that price doesn't change. The demand curve shifts ONLY when "other things" (income, price of related goods, population, tastes, consumer expectations change. It does NOT shift when the price of the good itself changes.

Change in demand versus change in quantity demanded

Demand 1 Demand 2 Price Quantity demanded Price Quantity demanded $2.50 42 2.50 50 2.60 40 2.60 48 2.70 38 2.70 46 An increase in quantity demanded means a change from 38 to 42. It is caused by-- a reaction 10-- a change in the price from $2.70 to $2.50. If the price were to go back to $2.70 the quantity demanded would again be 38. An increase in demand means a switch from demand schedule 1 to demand schedule 2. It is caused by a change in "other things," not the price. The quantity remains higher at each and every price. Even if the price were to be 2.70 again, the quantity people would purchase would be 46; it would not return to 38. A change in quantity demanded is depicted by a movement along the demand curve. A change in demand means the whole schedule or curve shifts.

Review of slides from last time listing the factors which can shift demand and shift supply

Making predictions

Usually only one curve shifts. You can then predict the direction of change in both price and quantity. Sometimes both curves shift due to independent and simultaneous changes in 2 determinants. Example: leather (handout) Can predict the change in price OR the change in quantity but NOT both. Example: a simultaneous decrease in supply and an increase in demand for leather with clearly increase the price of leather.But while increased demand increases quantity, the decrease in supply decreases quantity. The overall effect is indeterminate and depends on the relative size of the two effects. Without more information, you can't say what happens to the quantity exchanged.

Discussion of homework Answers posted after class.

The market reallocates

Suppose consumer preferences shift from TVs to computers. Demand for computers increases. Stores sell out and increase their orders from manufacturers. Prices rise as people compete for the available computers Computer manufacturers now have an incentive to produce more. They hire more workers and materials and increase production. Demand for TVs falls. Stores reduce prices to decrease inventory and order less from manufacturers. TV manufacturers lay off workers, order less from suppliers, close factories. Laid-off workers move to jobs in the computer industry; computer manufacturers expand into vacant factories; plastic companies make computer parts, not TV parts.

Consumer sovereignty
Consumer sovereignty means that counsumers decide what's produced by how they spend. In the example above, the change in consumer tastes led to more resources being devoted to computers and fewer resources being used to produce TVs.

Self interest

The reallocation occurs because it is in people's self-interest to make the change. The increasing price for computers gives firms an incentive to expand production: the additional marginal revenues now make it profitable to produce units with higher marginal cost. Increasing wages (price of labor services) and increasing job prospects are an incentive for workers to relocate: they can increase their satisfaction as a result of being able to purchase more goods with a higher income.

Rationing

If the price was zero, quantity demanded would greatly exceed quantity supplied. As the price rises, some consumers voluntarily decrease the quantity they want to buy. Those who drop out are those who put a low value (have a low willingness to pay) on the last unit of the good. The market rations the available goods to those who have the highest willingness to pay -- to those who gain the most from the good.

Efficiency
A market is efficient if there are not additional transactions that would benefit someone without making anyone worse off. All beneficial transactiosn have been made. A market is inefficient if there are additional tranactions that would benefit someone without harming others. Under certain conditions, establishment of market equilibrium results in efficiency.

Conditions for efficiency
There are many buyers and sellers. Buyers and sellers have adequate information about products and prices or can get the facts at low cost. There are no spillover costs or benefits that affect others besides buyers and sellers

Consumer gains
Consumers benefit if they buy a good for less than its value to them-- if the price is less than the maximum they are willing to pay. Their gain is called consumer surplus. It equals the sum of the difference between the value (the maximum they're willing to pay) and the actual price for each unit. Consumer surplus is shown graphically as the area between the demand curve and the market price.

Seller gains

Sellers gain if they can increase their profits by producing a good whose opportunity cost of producing is less than revenue the firm gets from selling it. Producer surplus is the sum of the difference between the market price and the opportunity cost of production for all units produced and sold. Producer surplus is shown graphically as the area between the market price and the supply curve. The total surplus in the market is the sum of consumer surplus plus producer surplus.

The market maximizes total surplus

At the market equilibrium, total surplus is maximized. If the price were lower, producers wouldn't produce as much. The total surplus would decrease because some units aren't produced and those units yielded additional surplus. Some surplus is also reallocated from producers to consumers. If the output increased beyond the market equilibrium quantity, the additional units would cost more to produce than the price at which sellers could sell them. This loss lowers total surplus.

Numerical Example using Apple Market Date

Maximum willingness to pay Consumer Surplus Opportunity cost Producer Surplus 64   39   62   41   60   43   58   45   56   47   54   49   52   51   50   53   48   55   46   57   How many do people want to buy at a price of $50? How many do sellers want to sell? Do the same for $52 and for $54. Calculate consumer and producer surplus if the price is $52. If the market price is $48, how many will be produced? What are consumer and producer surplus at this market price?