1SUPPLY, DEMAND, MARKETS AND APPLICATIONSUnderstanding How Markets Work1Markets I: Supply and DemandMarkets II: We Love Free Markets!Markets III: Sometimes We Don’t!Markets IV: Applications of MarketsMARKETS II:MARKETS IN ACTION!How do markets work?What do markets do for us?2Talk is cheap because supply exceeds demand!OVERVIEW / Questions of the DayWhat role do markets play in our economy?• What is a ‘market’?• How do markets work in action?• How do they allocate our resources?• What do they do for us?32I. WHAT IS A MARKET?What exactly do we mean by ‘a market’?4I. What is a Market?Demand and supply make up two sides of a MARKET•A collection of buyers and sellers that, through their actions orpotential interactions, determine the price of goods/services•Any institution that facilitates the voluntary exchange ofgoods and services for other goods/services or money•The institution through which buyers and sellers interact andengage in voluntary exchange•Interactions between buyers and sellers that determine theprice of good/serviceA market is created anytime a5I. Market: Examples•Output Markets (Goods and Services)• Goods Markets: Milk, Hamburgers, Airplanes, Homes• Services Markets: Car repair, Haircuts, Law services•Input Markets (Factors of Production)• Commodities Markets: Wheat, Gold, Oil, Copper, Tin• Markets for borrowing/lending (determines interest rates)•Foreign Exchange Markets• Currency Markets: Dollars, Euros, Yen, Yuan, Baht63I. Market: DefinitionMarket definition: who is included and who is excluded from a particular market• This can be a subjective processYou can examine the model from different perspectives• From very broad to very narrow• Market for • Market for new automobiles (no used)• Market for new cars (no trucks or SUV’s)• Market for new sedans (4 – door only)• Market for 7I. Markets: Definition8Market for all passenger vehiclesMarket for all used passenger vehiclesMarket for all new passenger vehiclesMarket for used carsMarket for used pick-ups, SUV’s, etc.Market for new carsMarkets for new pick-ups, SUV’s, etc.All of these are legitimate markets – it just depends on which is the most appropriate to what you want to studyII. HOW DOES THE MARKET WORK?How do markets find the ‘correct’ price?94The Market for “Do-Dads”Suppose we bring our 5 market participants together• K, L, M, Mr. Bud and Ms. Coors•What will happen?1. How many do-dads will Mr. Bud and Ms. Coors produce in total?• How much will each one produce?2. How many do-dads will K, L and M buy in total?• How many will K get? M? L?3. What will be the market price?1011Market Equilibrium11 128 145Q (do-dads/month)181512936SDP(do-dads)14216PriceMarket SupplyMarketDemand$18 17 0$15 14 1$12 11 4$9 8 8$6 5 12$3 2 16P* is the Q* is At Equilibrium…•The market is at rest• no forces pushing P or Q higher or lower•Sellers can sell as much as they want• provided • (how much does Bud want to sell?)•Buyers can buy as much as they want• provided • (how much does K want to buy?)•Quantity demanded (Qd) equals • the exact amount buyers want is the exact amount sellers produce125What if we aren’t at equilibrium?If the market is not in equilibrium, then “market forces” will begin to push itself back towards equilibrium…•What if the current price is higher than P*?•What if the current price is lower than P*?• Either way, K, L, M, Mr. Bud and Ms. Coors will be guided to change their behavior that will effectively push P back to P*•How does these ‘market forces’ work?13Market Out of EquilibriumPriceMarket SupplyMarketDemand$18 17 0$15 14 1$12 11 4$9 8 8$6 5 12$3 2 16How do our market participants behave (react) if the price is $12 instead of $9?Bud and Coors produce K, L and M would One group will be unhappy with this situation – which one?Who didn’t get what they wanted?1415Market Forces: P > P*1184Q (do-dads/month)18129SDPWhat happens to K, L, M, Bud and Coors if P = $12?6Market Out of EquilibriumPriceMarket SupplyMarketDemand$18 17 0$15 14 1$12 11 4$9 8 8$6 5 12$3 2 16How do our market participants behave (react) if the price is $6 instead of $9?Bud and Coors produce K, L and M would One group will be unhappy with this situation – which one?Who didn’t get what they wanted?1617Market Forces: P < P*1285Q (do-dads/month)186SDPWhat happens to K, L, M, Bud and Coors if P = $6?18Market Equilibrium11 128 145Q (do-dads/month)181512936SDP(do-dads)14216PriceMarket SupplyMarketDemand$18 17 0$15 14 1$12 11 4$9 8 8$6 5 12$3 2 167Big Idea In EconomicsThe price of $9 is the only price where At a price of $9… • Bud wishes to produce (and sell) 4, and he does• Coors wishes to produce (and sell) 4, and she does• K wants to buy 3 and he does• L wants to buy 4 and she does• M wants to buy 1, and he does19III. MARKETS: WHAT THEY DOEvery individual…neither intends to promote the public interest, not knows how much he is promoting it…he intends only his own security; and by directing that industry in such a manner as its produce me be of the greatest value, he intends only his own gain, and hi is in this as in many other cases, led by an invisible hand to promote an end what was no part of his intention.20Markets Determine Prices, So What?Q: Why do we care about the market ?A: Because markets determine Q: So what? Why do we care aboutA: Because 218Markets Determine Prices, So What?Q: Why do we care about the market ?A: Because the market, through the ‘price mechanism’, directs all of our economic activity and answers our 3 Big Questions1. What goods/services to produce?2. How to produce them?3. How to allocate the goods/servicesUsing a market mechanism is one way to coordinate economic activityQ. How does it work?2223Markets and Allocation8Q (do-dads/month)9Market SupplyMarket DemandAt P = $9, buyers wish to buy a total of 8 do-dads:At P = $9, sellers wish to supply a total of 8 do-dads:PBIG IDEA IN ECONOMICS!!The market allocates goods and services among competing buyers and sellers•In a theoretically free market system, markets determine the price for each good/service (P*), and this determines:• how much of the good to produce (Q*)• who gets to buy the good• who gets to sell the good• how much each buyer gets and how much each seller sells •This is how we answer our “3 Big Questions”• What to make, how to make, and how to divide249What does this all mean?What do prices