ECON 262 - Notes on Markets - Supply and Demand

Notes on Markets - Supply and Demand (ECON 262)

What do Market Prices Do?

When we look at the interaction of demand and supply, we can now talk about a "market price."

Market prices contain the information regarding consumer wants that suppliers must have to allocate resources to where consumers want them. If consumers are willing and able to pay a market price that enables suppliers to make an economic profit -- that tells suppliers they are utilizing resources correctly. If they are losing money -- that provides another signal.

Note: As consumer's change their behavior -- the signals in the market reflect this and suppliers must adjust accordingly. Therefore, markets are an ever-changing process of knowledge generation, cooperation and coordination.

This section relates to IMPORTANT CONCEPT READING ELEVEN: WHAT DO MARKETS DO?

Therefore, markets allow for - Economic Calculation: Profits and losses are important signals (knowledge generators and disseminators) in markets that come from market clearing prices. The calculation of profits and losses (this is the importance of accountants) tells us where producers should allocate resources such that the value of those resources are increased - thereby increasing the welfare of consumers, producers, and workers (through more jobs and higher pay).

Without the knowledge generated from profits and losses -- massive shortages and surpluses take place -- even to the point where the population cannot obtain the basic necessities of life. Plus, resources are used less "productively" - therefore generating fewer jobs and fewer opportunities for people.

This is because government planners (the alternative to markets in directing resources) could NEVER know the knowledge of individual tastes (that change with time and circumstances) or the knowledge that individual producers have about their markets or the ways by which they produce their goods and services in order to meet their specific consumer demand. This is generated and disseminated through markets! Even the smartest people in the world don't have this kind of knowledge!

Hence - markets go a long way towards solving the coordination problem and resources are rationed to where they are wanted!

Commentary from Deb: Therefore, markets are beautiful things -- the knowledge they continuously generate creates enough productivity to give Deb the opportunity to get paid for talking about ideas! What a beautiful thing

So as we look at the model -- don't lose sight of what is happening in these markets. The model cannot really show the process that is taking place -- how dynamic markets are. They can show us some things - which is why they are useful, but we need to be aware of the model's limitations too.

The Model:

Market Clearing Price (or satisfactory inventory level):

Graph:

A market clearing price is always changing. Markets are dynamic -- never static -- so the graphs are somewhat unrealistic. But let's talk about what it means (in terms of real world human action) to talk about a "market clearing price."

Inventory:

Inventory costs:

Holding:

Out of Stock:

Market Clearing Price = Satisfactory Inventory Level:

So, if we are not at the market clearing price, what is happening? Suppose a supplier chose a selling price that turned out to be above the market clearing price - what will happen?

Surplus:

Graph:

A surplus is an important signal in markets! It signals that the supplier's inventory costs are too high. Specifically, holding costs are very high. To bring these down, the supplier needs to lower her price. When she does this two things happen (ceteris paribus) - the quantity supplied decreases and the quantity demanded increases until the supplier is satisfied with her inventory level (market clearing price).

This is a constant trial and error process of adjustment by suppliers -- they are adjusting to changes in both what consumers are doing but also to what other suppliers are doing.

Now suppose a supplier chose a selling price that turned out to be below the market clearing price - what will happen?

Shortage:

Graph:

A shortage is also an important signal in markets! It signals that the supplier's inventory costs are too high. Specifically, out of stock costs are very high. To bring these down, the supplier can increase her price. When she does this two things happen (ceteris paribus) - the quantity supplied increases and the quantity demanded decreases until the supplier is satisfied with her inventory level (market clearing price).

So notice how this adjustment process moves resources -- if supply increases due to a price increase (following a shortage), then resources move into that market and out of other markets.

So surpluses and shortages provide sellers with a great amount of information about consumers - and about other suppliers! This information then leads to changes in prices and resource allocation - moving resources to "better" places -- where consumers have a higher value for them.

Later we will discuss the even more important signals (information generators and disseminators) in markets that come from these market clearing prices profits and losses!

Price Controls:

Now - what if the seller could not adjust the price above or below a legally (government) established price?

Price Ceiling:

Price Floor:

Graph - Price Ceiling placed below the market clearing price:

What will happen in this market?

What if the price ceiling is above the market clearing price? Explain.

Graph - Price Floor placed above the market clearing price:

What will happen in this market?

What if the price floor is placed below the market clearing price? Explain.

Applications of the Supply and Demand Model: Rent Control and Minimum Wage Laws

Look for the unintended consequences or outcomes here! Are the government politicians/officials thinking about our model or are they ignorant of economic analysis (or perhaps they have other motives in mind - such as getting votes from people who think they will benefit from the laws)?

Rule (rent control or minimum wage law) Incentives Actions Outcomes (intended - do the rules work or do their unintended consequences undermine their intended outcomes)?

Rent Control: http://www.landlord.com/rent_control_laws_by_state.htm

Analysis:

Minimum Wage:

Analysis:

Labor demand elasticity evidence: http://econlog.econlib.org/archives/2016/08/labor_demand_el.html

Federal minimum wage = $7.25. For those who want it to be $15.00 - that would be a 106.9% increase. So with a labor demand elasticity of -.25, that would mean employment would go down by 26.725% for unskilled workers.

Colorado minimum wage = $9.30 (effective Jan. 1, 2017). For those who want it to be $12.00 - that would be a 29% increase. So with a labor demand elasticity of -.25, that would mean employment would go down by 7.25% for unskilled workers.

http://www.cbsnews.com/news/top-new-york-restaurateur-says-no-more-tipping/

DO ICE NINE

Supply and Demand and Resource Allocation - Using the Model

Now that we understand what markets do -- let's play with the demand and supply model to see how resources are allocated when prices change:

Let's start shifting to see what happens to the market clearing price and quantity (and resource allocation) when supply and/or demand changes.

Think of the market clearing quantity as the amount of trade that takes place in a market. Remember, think about resource allocation.

First let's just change demand and hold supply constant:

Then change supply and hold demand constant:

Then increase both demand and supply:

Then decrease both demand and supply:

Then increase demand, decrease supply:

Then decrease demand, increase supply:

What if demand or supply increases and then decreases? For example - what if demand increased, supply increased, and demand then decreased?

DO ICE TEN