Chapter 1 - Demand and supply analysis: Introduction. The focus of the reading is on demand and supply analysis (microeconomics): How are prices and quantities of transactions determined? The theory of the consumer deals with how consumers make choices, and the theory of the firm is how profit-maximizing firms make choices.
Chapter Demand and Supply Analysis: Introduction Presenter’s name Presenter’s title dd Month yyyy Introduction Copyright © 2014 CFA 2 Types of markets • • Factor markets are markets for the factors of production - The factors of production are the inputs to production - Factor markets include labor markets Goods markets are markets for the outputs of production - • The outputs of production are goods and services, which may be intermediate goods and services or final goods and services Capital markets serve as a means for providers of capital (that is, the providers or suppliers of long-term sources of funding, or savers) to exchange their capital for long-term claims on a firm’s cash flow and assets (that is, debt and equity securities) Copyright © 2014 CFA 3 Basic Principles and Concepts Copyright © 2014 CFA The demand function (1-1) Copyright © 2014 CFA The Supply function (1-7) Copyright © 2014 CFA Changes and movements Changes in quantity demanded Changes in quantity supplied Change in its own-factor prices Movement along the demand curve Change in price of other goods Shift in the demand curve Change in supply Shift in the supply curve Price Price Change in its own-price Movement along the demand curve Quantity Copyright © 2014 CFA Quantity Aggregating Supply and demand curves • • Moving from the individual consumer or firm to the aggregate: - Aggregating demand curves requires adding the individual quantities demanded at each price - Aggregating supply curves requires adding the firms’ quantities supplied at each price A market equilibrium is the situation in which the quantity demanded at a given price is equal to the quantity supplied at that price Price Quantity Copyright © 2014 CFA Solving for the equilibrium Copyright © 2014 CFA Equilibria • • A stable equilibrium occurs when the price adjusts so that demand = supply An unstable equilibrium occurs when the demand or supply curves are such that an upward change of price does not reduce excess demand or supply (or a downward change does not reduce excess demand or supply) - Price bubbles are an example of an unstable equilibrium Copyright © 2014 CFA 10 Aggregate Supply and Demand Copyright © 2014 CFA 12 Excess supply and demand Copyright â 2014 CFA 13 Types of auctions • • • • Common value auction: The item’s true value is revealed after bidding Private value auction: Each bidder places a subjective value on the item, but these valuations differ Ascending price auction: Also known as an English auction; highest bidder wins auction for item First price sealed-bid auction: Bidders submit sealed bids that are not known to other bidders; winning bidder is the one submitting the highest price Second price sealed-bid auction: Also known as a Vickery auction; the bidder that submits the highest bid wins, but the price paid for the item is the next-lowest bid price Descending price auction: Also known as a Dutch auction; the auctioneer begins with a very high price and lowers the price in increments until there is a willing buyer In a multiple-unit format, price is lowered until all units are sold Copyright © 2014 CFA - 14 Dutch Auction: US Treasury securities Example: Dutch auction for $120 billion of US Treasury 28-day bills Competitive Bids (in billions) Cumulative Competitive Bids (in billions) Noncompetitive Bids (in billions) Total Cumulative Bids (in billions) Discount Rate Bid Bid Price per $100 0.0280% 99.99782 $5 $5 $5 $10 0.0285% 99.99778 $10 $15 $5 $30 0.0287% 99.99777 $15 $30 $5 $65 0.0290% 99.99774 $20 $50 $5 $120 0.0291% 99.99774 $15 $65 $5 $190 0.0292% 99.99773 $10 $75 $5 $270 Copyright © 2014 CFA 15 Surplus Consumer surplus is the difference between the maximum price the consumer was willing to pay and the actual price Producer surplus is the difference between what the producer sells a good or service for and the price at which the supplier was willing to sell Price Consumer surplus Producer surplus Quantity Total surplus = Consumer surplus + Producer surplus Copyright © 2014 CFA 16 Calculating Surplus Copyright © 2014 CFA 17 Market Interference • • A government-imposed ceiling on a price that is less than the market equilibrium price results in a reduction of surplus: Buyers want more than sellers are willing to supply at that price - Some consumers gain consumer surplus lost by suppliers, but some consumer surplus is lost and not picked up by suppliers - The loss in surplus is deadweight loss, which is a loss of surplus that is not transferred to another party A government-imposed price floor that is higher than the market equilibrium results in a reduction of surplus - Sellers want to sell more, but buyers purchase less - Sellers gain some producer surplus lost by consumers, but some of this producer surplus is lost and not picked up by consumers In general, market interference inhibits the role of the market to allocate resources efficiently Copyright â 2014 CFA 18 Effect of market interference Equilibrium price = €1 Price Ceiling Price Floor 10 10 8 6 4 Price 12 Price A 12 2 C A B 0 Quantity Copyright © 2014 CFA Quantity 19 Demand Elasticities Qx a b Px slope coefficient Copyright © 2014 CFA 20 Elasticities • Elasticity is the sensitivity of the change in quantity for a given change in the price of a good - • • The ratio of the percentage change in the quantity to the percentage change in the price Own-price elasticity refers to the sensitivity of the quantity of a good demanded to its own-price change Cross-price elasticity of demand is the response in the demand of a good to a change in the price of another good - A substitute is a good that has a positive cross-price elasticity - A complement is a good that has a negative cross-price elasticity Copyright © 2014 CFA 21 Elasticities: Summary Copyright © 2014 CFA 22 Elasticities: Example Consider the case of the sensitivity of the demand for tires, in response to the price of gas per gallon: Tires = 95 million – 3.2 Price per gallon of gas • • There is negative cross-elasticity between tires and gas; therefore, gas and tires are complements If the price per gallon increases by $1, the number of tires declines by 3.2 million Copyright © 2014 CFA 23 Factors that affect elasticities Degree of substitutability - The greater the degree of substitutability, the greater the elasticity Portion of budget spent on the good - The greater the portion, the greater the elasticity Time allowed to respond to the change in price - The longer the time allowed, the greater the elasticity Extent to which the good is deemed necessary - The greater the extent to which the good is deemed as necessary, the more inelastic its demand Copyright © 2014 CFA 24 Income elasticities Copyright © 2014 CFA 25 Conclusions and Summary • The basic model of markets is the demand and supply model: Equilibrium occurs at the price at which the quantity demanded is equal to the quantity supplied • Markets are interactions between buyers and sellers • The price of a good in a market is determined by supply and demand • Auctions are sometimes used to seek equilibrium prices • Markets ensure that the total surplus is maximized - • Sometimes, government policies interfere with the free working of markets, shifting surplus between consumers and producers, with some loss Elasticity is the ratio of the percentage change in the dependent variable to the percentage change in the independent variable of interest - Elasticities are sensitivities of the quantity demanded to either the good’s own price, the price of other goods, or income Copyright © 2014 CFA 26 ... 2 014 CFA The demand function ( 1- 1) Copyright © 2 014 CFA The Supply function ( 1- 7) Copyright © 2 014 CFA Changes and movements Changes in quantity demanded Changes in quantity supplied Change in. .. supply) - Price bubbles are an example of an unstable equilibrium Copyright © 2 014 CFA 10 Demand and supply functions Copyright © 2 014 CFA 11 Aggregate Supply and Demand Copyright © 2 014 CFA 12 Excess... Copyright © 2 014 CFA Quantity Aggregating Supply and demand curves • • Moving from the individual consumer or firm to the aggregate: - Aggregating demand curves requires adding the individual quantities