2. Microeconomics: Competitive Markets

market

any arrangement (physical or non-physical) which allows buyers and sellers to interact and exchange goods and services

• G&S sold in product markets

• Resources (factors of production)sold in resource markets

perfect competition

a market structure where many small firms sell identical products, and no single firm has market power (when sellers have control over the price of the product it sells)

• Many buyers and sellers

• Homogeneous goods

• Ease of entry and exit

• Perfect information for producers and consumers

• Firms are price takers rather than price setters

• Minimal gov. intervention

Individual demand

The various quantities of a good/service the consumer is willing and able to buy at different possible prices during a particular time period, ceteris paribus.

Law of Demand

There is a negative causal relationship between the price of a product and its quantity demanded over a particular time period: as price increases, quantity demanded decreases, ceteris paribus

What are the 2 explanations for the Law of Demand

Income effect: a change in a good’s price affects a consumer’s real income/purchasing power (more important for expensive goods)

• Increase in price —> less real income/purchasing power —> quantity demanded decreases

Substitution effect: a price change makes a good relatively cheaper or more expensive compared to alternatives (more important for cheaper goods)

• Increase in price —> relatively more expensive than alternative —> more consumers switch to the alternative —> quantity demanded decreases

These two effects reinforce each other (are not separate explanations)

utility

the satisfaction that consumers gain from consuming a good/service, hypothetically measured in utils

What explains the downward slope of the demand curve?

Consumers are only willing to pay a price equal to or lower than their perceived value for a good/service

Law of diminishing marginal utility: as consumption of a good increases, each successive unit of the good consumed provides the consumer with less utility, therefore consumers are only incentivised to buy an additional unit of it if the price decreases (since their perceived value of the product decreases)

market demand (Dm)

Total quantities for the good that consumers are willing and able to purchase in a market (=the sum of all individual demands for the product in the market)

Increase in price on demand curve —>

decrease in quantity demanded (contraction along the curve)

Decrease in price on demand curve —>

increase in quantity demanded (expansion along the curve)

What are the 7 non-price determinants of demand (assumed to be unchanging in ceteris paribus)?

1. Disposable income

2. Discretionary income

3. Price of substitutes

4. Price of complements

5. Preferences and tastes

6. Population changes (change in no. of potential consumers)

7. Consumer confidence/sentiment

What do changes in non-price determinants of demand cause?

shift of the demand curve (change in demand at any price level)

Shift right: increase in demand (greater quantity demanded at every given price)

Shift left: decrease in demand (lower quantity demanded at every given price)

1. Disposable income

The rewards from direct and indirect contribution to the production process (including gov. transfers) available for spending or saving after direct income taxes have been deducted

normal goods

goods for which demand increases in response to an increase in disposable income

• increase in disposable income —> rightward shift

inferior goods

goods for which demand falls as disposable income increases (e.g. second-hand cars, fast food, public transport tickets)

• Increase in disposable income —> leftward shift

2. discretionary income

The portion of disposable income remaining after paying for necessities

= disposable income — spending on necessities

• Affects the demand for non-essential goods

• Affected by interest rate (usually a high interest rate would decrease discretionary income due to increased borrowing interests)

Subsitute

Another viable good or service that satisfies a similar need to the product in question

3. Impact of the price of substitues on demand curve

An increase in the price of a good will result in a shift of the demand curve for its substitute to the right

4. Impact of the price of complements on the demand curve

An increase in the price of one good will cause a decrease in its quantity demanded, causing a leftward shift of the demand curve of its complementary product

5. Impact of preferences and tastes on demand

If preferences and tastes change in favour of the product, demand increases and the demand curve shifts to the right

6. Population change/change in number of potential consumers

Increase in no. of potential consumers —> rightward shift

Changing structure of the population may affect the demand for different types of goods and services (e.g. aging population —> increased demand for aged-care services)

7. consumer confidence/sentiment

how optimistic or pessimistic consumers are about their future income, employment, and the overall economy

• affects consumers’ marginal propensity to consume (MPC), affecting their willingness to spend and take on debt

• particularly affects the purchase of discretionary items

marginal propensity to consume (MPC)

the change in consumption resulting from one dollar increase in income

• Change in consumption/change in income

how does an increase in income affect a person’s MPC?

High income earners: decrease in MPC (tendency to save)

Low income earners: increase in MPC (tendency to spend)

individual supply

The various quantities of a good/service a firm is willing and able to produce and supply to the market at different possible prices during a particular time period, ceteris paribus

market supply (Sm)

the total quantities of a good that firms are willing and able to supply in the market at different possible prices

• Sum of all individual firms’ supply for a good

Law of Supply

There is a positive causal relationship between the price of a product and its quantity supplied: as price increases, quantity supplied increases (ceteris paribus)

what explains the upward slope of the supply curve?

Law of diminishing marginal returns: As each additional unit of variable input (e.g. labour) is added, the increase in output starts to fall, resulting in increasing marginal costs

• only higher prices will incentivise producers to make more units of the product

• increase in marginal returns —> decrease in marginal costs (vice versa)

how do we draw the supply curve when there is only a fixed quantity of a product (e.g. a famous painting)?

vertical supply curve

what are the 8 non-price determinants of supply/factors of supply?

1. Cost of production

2. Competitive supply

3. Joint supply

4. Tech change and productivity growth

5. Supply-side shocks

6. Government intervention (taxes & subsidies)

7. Number of firms

8. Price expectations

1. Common costs of production

• cost of factors of production

• company tax

• utility bills

• transportation

• exchange rates (importing materials might be more expensive)

higher costs of production —> decrease in supply (leftward shift)

2. competitive supply

a situation in which two or more products compete for the use of the same resources, and producing more of one good means producing less of the other due to scarcity

• Producers tend to allocate more resources to products with higher relative prices

• Increase in the price of Good A —> increase in quantity supplied of A —> decrease in supply of Good B —> leftward shift of B’s supply curve

3. joint supply

When the production of one good automatically results in the production of another good because they are by-products of each other produced together from the same process or resource

• Not possible to produce more of one without also producing more of the other

• Price-interdependence

• E.g. crude oil refinement, beef and leather

• Increase in the price of A —> increase in quantity supplied of A —> increase in supply of B —> rightward shift of B’s supply curve

4. Technological change & productivity growth

An improvement in technology lowers the cost of production, making production more profitable for suppliers. Therefore, there would be an increase in supply, shifting the supply curve to the right

5. Supply-side shocks

A shock (natural or man-made) usually causes costs of production to rise, resulting in a decrease in supply, shifting the supply curve to the left

6. Government intervention

Government tax: treated as costs of production by firms —> increase in tax causes a leftward shift of the supply curve

Government subsidy (payment made to the firm by the government): fall in costs of production —> new subsidy shifts the supply curve to the right

7. Number of firms

Increase in the number of firms —> rightward shift of the supply curve

8. Producer price expectations

Expectation of higher future prices: decrease in current supply

Expectation of lower future prices: increase in current supply

• Self-fulfilling prophecies

market equilibrium

the point where the quantity demanded of a good or service equals the quantity supplied at a particular price. This occurs at the equilibrium price (market-clearing price) and equilibrium quantity, where there is no surplus nor shortage

• No tendency for price to change

• most efficient outcome (no waste)

define shortage and surplus

shortage: excess demand (below Pe)

surplus: excess supply (above Pe)

why might the market equilibrium change

due to non-price factors (shift in either the demand or supply curve)

In a free competitive market, what happens when there is market disequilibrium?

The market mechanism would change the price until the market returns to equilibrium

relative price

the price of any one good or service measured in terms of the price of another

• measure of opportunity cost

• expressed in ratio form

• guides resource allocation (products with higher relative prices usually have more resources allocated to them)

how do markets determine what to produce in a consumer-sovereign market (free market economy)?

Relative prices act as signals and incentives for producers regarding what to produce as prices represent the relative value that society places upon a good or service (the price of any one product measured in terms of the price of another, showing the opportunity cost)

• Price (market) mechanism: the system by which prices are determined by the forces of supply and demand, hence guiding the allocation of resources in a market economy without need for government intervention (invisible hand of the market)

‘Invisible hand’ — Adam Smith

individual self-interest in a free market leads to efficient allocation of resources and maximises economic welfare

price rationing

Price rationing refers to the process by which the price mechanism allocates scarce goods and services in situations of excess demand (shortage). As the price rises due to increased competition among buyers, some consumers are priced out of the market, ensuring that the good or service is allocated to those who are most willing and able to pay. This results in the good or service being used for its highest end-use.

allocative efficiency (most efficient allocation of resources)

When the market allocates its resources in a way that satisfies the highest end-use, hence maximising society’s wellbeing (not possible to make someone better off without making someone worse off)

consumer sovereignty

Consumer sovereignty refers to the idea that in a free market economy, the buying decisions of consumers determine the allocation of resources and the types of goods and services that are produced. Producers respond to consumer demand by adjusting their output to maximize profits.

Describe the labour demand curve and labour supply curve (y-axis = wages, x-axis = quantity of labour)

labour demand curve: downward sloping to reflect how as wages decreases, firms are more inclined to hire labour as its relative price is lower compared to capital

labour supply curve: upward sloping to reflect how as wages rise, more workers are willing to enter the labour force or complete more hours to receive more rewards

consumer surplus

difference between the maximum price a consumer is willing to pay for a good or service and the actual price they pay

• Consumers receive extra benefit from consumer surplus

• Individual consumer surplus (at one quantity): subtraction of the two prices

• Total consumer surplus (all quantities): area below the demand curve above the market price

producer surplus

difference between the price a producer is willing to accept for a good or service and the price they actually receive for it

• Producers receive extra benefit from producer surplus

• Individual producer surplus (at one quantity): subtraction of the two prices

• Total producer surplus: area below the market price and above the supply curve

social surplus ($)

sum of consumer surplus and producer surplus in a market; total benefit to society from the production and consumption of goods and services

• = social welfare

• area between the supply and demand curves left of the equilibrium point

• maximised at market equilibrium (allocative efficiency)

marginal benefit (MB)

the additional satisfaction or value that a consumer receives from consuming one more unit of a good or service

• represented by demand curve

• obeys the Law of Diminishing Marginal Utility

marginal cost (MC)

additional cost incurred by a producer when producing one more unit of a good or service

• represented by the supply curve

• obeys the Law of Increasing Marginal Cost

where on the MB, MC graph is allocative efficiency achieved?

at the intersection of the MB curve and MC curve; when MB=MC (at the market equilibrium)

MB>MC

MB<MC

resources under-allocated

resources over-allocated