Basic Economic Concepts: Production, Consumption, Market Dynamics, and Market Efficiency

Basic Economic Concepts: Production, Consumption, and Scarcity

  • Introduction: Basic economic concepts are crucial for understanding market dynamics.
  • Key Concepts:
    • Production
    • Consumption
    • Scarcity: Finite resources vs. unlimited wants
      • Contributing factors: increasing populations
      • Allocation problem: How to distribute limited resources among competing wants?

Rational Behavior Assumption

  • Households and firms are assumed to be rational.
  • Decisions are made by comparing marginal cost and marginal benefit.
  • Rationality implies undertaking activities only when marginal benefit equals or exceeds marginal cost.

Market Dynamics: Demand, Supply, and Price

  • Demand Increase:
    • Example: Shift in tastes favoring a product
    • Immediate effect: Demand increases
    • Price response: Prices rise due to market shortage (demand exceeds supply)
  • Price Signals:
    • Producers: Higher prices signal increased profitability, leading to increased production.
    • Consumers: Price changes influence consumer behavior through two effects:
      • Substitution effect: Higher price makes the product less competitive; consumers seek substitutes.
      • Income effect: Higher price reduces consumers' real income, decreasing affordability.
  • Consumer Behavior:
    • Consumers react to price changes via income and substitution effects.
    • Price increase: Reduces consumption due to lower real income and substitution to cheaper alternatives.
    • Negative relationship: Changes in price inversely affect quantity demanded.
  • Supply-Side Response:
    • Price increase: Signals producers to expand production.
    • Positive relationship: Changes in price positively affect the quantity supplied.
  • Market Equilibrium:
    • Shortage elimination: The process continues until demand equals supply.
    • Equilibrium price: The price at which demand equals supply.
    • Market equilibrium: A state where demand and supply are balanced.

Surplus Scenario

  • Demand Decrease:
    • Demand falls below supply, creating a surplus.
  • Price Adjustment:
    • Surplus puts downward pressure on prices.
    • Price fall signals producers to reduce production due to decreased profitability.
  • Consumer Response:
    • Income effect: Lower prices increase consumers' real incomes, enabling higher consumption.
    • Substitution effect: Lower prices make the product more competitive, attracting consumers.
  • Surplus Elimination:
    • Prices fall, producers decrease supply, and consumers increase demand until equilibrium is reached.

Market Efficiency and Assumptions

  • Efficient Allocation:
    • Economics assumes the price mechanism achieves efficient resource allocation.
  • Instantaneous Adjustment:
    • The model assumes immediate producer and consumer responses to demand and supply changes.
  • Real-World Considerations:
    • Real markets are more complex; producers and consumers may not adjust instantaneously.
    • Reasons: Time lags, constraints on production and consumption.
    • Implication: Price signals may reflect temporary shortages or surpluses, leading to over or underpricing.
  • Transitory Pricing:
    • Occurs when prices reflect short-term imbalances rather than equilibrium.
  • Limitations of the Model:
    • The biggest issue is the assumption of instantaneous adjustment, which rarely holds in real-world markets.

Further Illustration of the Price Mechanism

  • Initial Scenario:
    • Market for a specific product experiences increased demand (e.g., trendy beer).
  • Shortage and Price Increase:
    • Demand exceeds supply, leading to a shortage.
    • Shortage causes upward pressure on prices.
    • Price increase signals producers to increase supply.
  • Consumer Response to Higher Prices:
    • Income effect: Consumers are worse off due to increased prices.
    • Substitution effect: Consumers switch to more price-competitive alternatives.
  • Market Adjustment to Equilibrium:
    • Supply increases, demand decreases until equilibrium is achieved.
    • At equilibrium, demand equals supply, and the equilibrium price is established.
  • Scenario: Decrease in Demand
    • Demand falls below supply, leading to a surplus.
    • Surplus puts downward pressure on prices.
  • Producer Response to Lower Prices:
    • Producers reduce production due to decreased profitability.
  • Consumer Response to Lower Prices:
    • Income effect: Consumers are better off due to decreased prices.
    • Substitution effect: Consumers substitute into the product as it becomes more price competitive.
  • Market Adjustment to Equilibrium (Decrease in Demand)
    • Supply decreases, demand increases until equilibrium is achieved.
  • Relationships Between Price, Supply, and Demand:
    • Positive relationship: Price increases, supply increases.
    • Negative relationship: Price increases, demand decreases.

Graphical Analysis: Demand and Supply Curves

  • Demand Curve:
    • Represents the relationship between price and quantity demanded.
  • Supply Curve:
    • Represents the relationship between price and quantity supplied.

Real-World Considerations: Instantaneous Adjustment Revisited

  • Model Predication:
    • The simple market model relies on instantaneous adjustment.
  • Real-World Constraints:
    • Suppliers may face constraints in expanding production quickly.
    • Consumers may not be able to immediately alter consumption patterns.

Real Estate Market: A Case Study of Non-Instantaneous Adjustment

  • Distinction:
    • Real estate markets often deviate from the efficient allocation model.
  • Intrinsic Characteristics:
    • Legal and physical characteristics limit producers' and consumers' abilities to respond instantaneously.
  • Supply-Side Constraints:
    • Developers cannot quickly increase supply due to the time required for development.
  • Demand-Side Constraints:
    • Tenants may be locked into lease contracts, limiting their ability to respond to rent increases.
  • Disequilibrium and Transitory Pricing:
    • Real estate markets may rarely reach equilibrium.
    • Pricing is often transitory, reflecting shortages or surpluses.
  • Information Asymmetries:
    • Unequal information distribution disrupts market efficiency.
  • Market Segmentation:
    • Real estate involves different sectors and spatial dimensions, complicating market adjustments.

Summary: Markets, Prices, and Resource Allocation

  • Market Function:
    • Markets allocate resources through the price mechanism.
    • Prices eliminate shortages and surpluses and respond to changes in demand and supply.
  • Key Assumptions:
    • Efficient allocation.
    • Instantaneous responses from producers and consumers.
    • Market restoration of equilibrium (demand equals supply).
  • Real-World Complexities:
    • The real estate market illustrates the complexities and problems of real-world markets.
    • Lack of instantaneous adjustment.
    • Constraints on producer and consumer behavior.
    • Potential for overpricing and underpricing.
  • Demand and Supply Analysis:
    • Demand curve: Graphs the relationship between price and quantity demanded.
    • Supply curve: Graphs the relationship between price and quantity supplied.

Demand Curve Analysis

  • Relationship Recap:
    • Combination of income and substitution effect.
      • Income affect
      • Substitution affect

Demand Curve: Example

  • Carrots.
  • Consumers: Roger and Pamper
  • Showing the effect of price increase, and reduction in demand.
    • Roger consumed less quantity of Carrots when price went up.
    • Pamper consumed less quantity of because price went up.
    • Price increase causes a drop in demand because all consumers cut back consumption

Demand Curve: Graphing the Relationship

  • X/Y Axis. Price vs Quantity.
  • Downward Sloping Curve the higher the price, the lower the quantity demanded.

Complexing the Demand Curve

  • What happens when one of the non-price determinants of demand changes?
    • Sometimes products are popular. Sometimes products are less popular.
    • Depends on perception
  • Number and substitution of goods
  • Sometimes goods are jointly consumed
  • For most categories, as income increases, demand increases
  • Asset markets Consumers purchase assets on the expectation they are going to price.

Graphing the Shift in Demand Curve

  • Quantity vs demand At each level of Price, there is a higher level of demand.
  • Changes in price, are represented by a movement among the demand curve.

Graphing the Shift in Demand Curve

*Graphically Illustrate Shift from an increase in a non-price determinant of the demand for a good.
*For example a shift in taste, causes demand to increase
*The process involves, repositioning the Demand Curve on the graph to reflect the change

Focus on Supply

*The relationship states the: as price increases, supply increases because producers have an incentive to supply more. Again, we're going to graphically look at this relationship in terms of constructing a supply curve.
*Positive Relationship.

Real world, Empirical Demand Functions

  • Collect actual statistical data.
  • See the relationship between price and the quantity demanded. And how the it changes over time.

The Supply Curve

Shows graphically, price and quantity supplied in a market.
Shows how much a seller can, and is willing to sell, at all possible Prices.

The total Market is also effected with a change in price. If Price Increases, Total Market will also Increase as it acts as an incentive.

Non-Price based Determinants

  • Cost of Production
  • The cost of production effect the amount producers are willing to supply. In response, to changes in the cost of production

Graphing the non-price based determinants.

*Example: A new technology enables companies to produce more for less.
*As a result manufactures a willing to supply more. And to show this we graphically shift the curve

Determinants of Supply Curve Shape, (The ability to expand or shrink production depending on market demands)

  • Complexity of production
  • Initial capacity used in production
  • Stockpiles of good

Supply - Summary

  • Graphically, at how a relationship of price to quantity affects demand. . The supply curve is the graphical element.
  • The supply curve will trend positive
  • Determinates that are none price related are not captured on the curve. But can be empirically estimated.

Equilibrium Price & Output

*With two graphic state. As the graph of two state with price and quantity shown at one single point. And that points reflects what the market deems to be the fair price based on the supply and demand of the market.
*We show how those prices reflect supply and demand to find equilibrium
There is a range for everything in this, but only one fair market position.

If shortage a occurs where Demand is more that supply, Then price goes up.

*In this case producers, respond as the prices begins to increase. The reverse is the process in the event of a surplus.
*In both direction we reach fair equilibrium of the marke
t

We show, how shifts of curves effect pricing and quantity produced

*Static state shows that Demand curves are outward shifts.
*Shift is determined by non-pricing elements.
*We also have contractions, where shortages of supply occurs.
*This requires the price to be more relevant than the quantity in the market curve
*Static Analysis does, not always show how they affect one another
Instant, adjustment is always considered , and can cause different results.
*Price points effect Consumer an Producer response

Summary: The Concepts Introduced:

  • The concepts should give you a foundation of basic economic practice.
  • Look and interpret markets economically.
    Elasticity measurement and change , effect the market.

In cases of Market Failure, we will have to respond.

*Externalities
*Marketing Power
*Asymetric information & uncertainty.
Where the market completely fails., There is a need for the government and the economy.

Market Power.

  • Happens if only one supplier exists.
  • They also might over charge if only two or three companies are in Business and want to control prices. (Colluding)

The factors of reduction may be immobile.

  • Immoral factors
    Labor, Capital and Land

Market Failure, requires external interest.

  • External intrest
  • People consuming, bad things because they are not using, healthcare, health care and education.

Government intervenes to overcome the problem.

  • This effects, price & regulation, as shown when it comes to zoning laws
  • The government make, you act based of market conditions.