Econ 101- Chapter 3: Supply and Demand: Intro to Price Setting Competitive Markets

Transaction Cost

Anything that adds cost to trade (Ex. The time it takes to bargain, Cost of searching for a good, Enforcing property rights)

Market

A mechanism for the exchange and allocation of goods (Ex. Price setting market, Barter market, Lottery)

Money

A medium of exchange and store of value

Price

An amount of money required in exchange for a good

Price Taker

An agent who behaves as if they have no control or effect on prices

Price Setting Competitive Market

A market that uses prices to allocate goods and every agent is a price taker

3 Parts of a Price Setting Competitive Market

1. Decision makers: Consumers and Firms (Producers)

2. Choices: What to consume and what to produce

3. Payoffs: Some measure of consumer payoff (utility) and producer payoff (profit)

Competitive Equilibrium

An allocation and a set of prices such that:

1. Every consumer is maximizing their payoff

2. Every firm is maximizing their payoff (profit)

3. Total production equal total consumption (supply equals demand)

2 Important Notes about the Competitive Market and Competitive Equilibrium

1. Every agent acts as a price taker

2. Every agent only needs to know their own payoff function

4 Characteristics of a Competitive Market

1. There are many buyers and many sellers of similar goods

2. Prices are transparent

3. Free entry/exit

4. Transaction costs are low

These characteristics will tend to cause agents to act as price takers

What characterizes a Non-Competitive Market?

A market in which some agents are not price takers

In a price setting market, what two things affect what consumers choose to consume?

1. Preferences

2. Budget constraints

Quantity Demanded

The amount of a good consumers choose

Demand Curve

Tells us how much quantity of a good is consumed given price p, holding everything else is the world constant

Law of Demand

Demand is downward sloping in p (When p increases, D(p) decreases)

3 Parts of a Demand Model

1. Agents: Consumers

2. Choices: What bundle to purchase and consume

3. Payoffs: Preferences over bundles

Budget Set

The set of bundles a consumer can afford given the prices and income (Y)

Can demand change for any reason?

Yes! (Ex. Preferences, Prices of other goods, Weather, What time you woke up this morning, etc…)

Shift in Demand

When anything in the universe changes and has an effect on the demand curve, causing there to be a new demand curve

Variables that Could Cause Shifts in Demand

1. Income

2. Prices of related goods

3. Preferences

4. Expectations

5. Number of Buyers

Market Demand Curve

The sum of individual demand curves

Substitutes

Two goods in which an increase in the price of one leads to an increase in the demand for the other (Ex. Coffee and tea)

Complements

Two goods in which an increase in the price of one leads to a decrease in the demand for the other (Ex. Coffee and cream)

Normal Good

A good in which an increase in income cause an increase in its demand (Ex. Premium coffee)

Inferior Good

A good in which an increase in income cause a decrease in its demand (Ex. Instant coffee)

In a price setting market, do producers choose how much to produce? Why or why not?

Yes, in order to maximize their profit

Quantity Supplied

The amount of a good a producer chooses to create an sell

Supply Curve

A function that gives the profit maximizing quantity for any price

3 Parts if a Supply Model

1. Agents: Producers (Firms)

2. Choices: How much to produce

3. Payoffs: Profit

Firm

An organization that takes resources, called inputs, and converts them into something new, called outputs

Revenue (R(q))

The money collected from the sale of goods (p*q)

Cost (C(q))

The expenditure on the creating the output quantity

Profit (π(q))

Total revenue minus total cost (R(q)-C(q))

Marginal Revenue (MR)

The amount that revenue increases with the next unit of production

Marginal Cost (MC)

The amount that cost increases with the next unit of production

Relationship Between Marginal Revenue (MR) & Marginal Cost (MC)

1. If MR >MC, then producing the next unit increases profit

2. If MR<MC, then producing the next unit decreases profit

3. If MR=MC, then profit is maximized

Relationship Between Marginal Revenue (MR), Price (p), and Marginal Cost (MC)

If a firm is a price taker, MR=p, thus profit is maximized when p=MC (This relationship defines the supply curve)

Shift in Supply

When anything in the universe changes and has an effect on the supply curve, causing there to be a new supply curve

Variables that Could Cause a Shift in Supply

1. Input Prices

2. Technology

3. Expectations about future

4. Number of seller

Market Supply Curve

The sum of individual supply curves

Competitive Equilibrium

An allocation and a set of prices such that:

1. Every consumer is maximizing their payoff (D(p))

2. Every firm is maximizing their profit (S(p))

3. Total production equals total consumption (S(p)) = D(p))

In a price setting market, is all trade voluntary:

Yes, no one can force an agent to buy or sell at any price

What causes the market to not be at equilibrium?

When the supply and/or demand curve change (shift)

What happens if the market is not at equilibrium?

In a competitive market, the market tends to adjust very quickly back toward equilibrium, however nothing is literally instantaneous

Surplus (Excess Supply)

Occurs when S(p)>D(p) for the current price which is due to either:

1. A left shift (decrease) in demand

2. A right shift (increase) in supply

3. Or both of the above

Shortage (Excess Demand)

Occurs when S(p)<D(p) for the current price which is due to either:

1. A right shift (increase) in demand

2. A left shift (decrease) in supply

3. Or both of the above

If Demand Shifts Right:

1. Price increases

2. Quantity increases

If Demand Shifts Left:

1. Price decreases

2. Quantity decreases

If Supply Shifts Right:

1. Price decreases

2. Quantity increases

If Supply Shifts Left:

1. Price increases

2. Quantity decreases

If Both Demand and Supply Shift Right:

1. Price unknown

2. Quantity increases

If Both Demand and Supply Shift Left:

1. Price unknown

2. Quantity decreases

If Demand Shifts Right and Supply Shifts Left:

1. Price increases

2. Quantity unknown

If Demand Shifts Left and Supply Shifts Right:

1. Price decreases

2. Quantity unknown