Market Forces
Chapters 4,5,7,9, Principles of Economics (9th ed.), Mankiw 2020.
24 May 2024
A market is a group of buyers and sellers of a particular good or service. There is a product, a group of sellers who produce that product, and a separate group of buyers who buy the product. Both parties interact with each other in the market, and the result of this interaction is a price and quantity of the product that is exchanged in the market. The most important feature of a market is that the price and quantity of the product are determined by the market forces of supply and demand, without any central planner or authority. There is no one person or group of people who decide how much to produce and at what price to sell the product.
Buyers want to buy a product, and they are willing to buy different quantities of the product at different prices. For example, a buyer might be willing to buy 2 pounds of coffee at $5 per pound, but only 1 pound of coffee at $6 per pound. This general relationship between price and quantity demanded is called the law of demand: all else equal, when the price of a good rises, the quantity demanded of that good falls (and vice versa).
Likewise, sellers want to sell a product and earn profit from their sales. They are willing to produce different quantities of good, depending on the price they can sell the product for. If the price is high, then sellers produce more so that they can earn more revenue (and potentially more profit). This law is called the law of supply: all else equal, when the price of a good rises, the quantity supplied of that good rises (and vice versa).
Now: buyers want to buy, and sellers want to sell, and each party is willing to do so in different quantities at different prices. The crucial question is: at what actual price do transactions take place between buyers and sellers? The answer is simply the price at which the quantity demanded by buyers is equal to the quantity supplied by sellers! This is intuitive: sellers will only produce as much as buyers are willing to buy, any more and they will be left with unsold goods. This point, where the quantity demanded equals the quantity supplied, is called the market equilibrium. It is the point where the market clears, and all buyers and sellers are satisfied. The corresponding price at which this equilibrium occurs is called the equilibrium price.
However, the market price, the price at which goods are actually exchanged in the market, is not always the same as the equilibrium price. The simple reason for this is that the equilibrium price can shift due to changes in market conditions. For instance, when coffee beans are hit by a frost, the supply of coffee beans decreases. Sellers raise their prices to compensate for the lost sales (there are now fewer coffee beans to sell), and the equilibrium price of coffee rises. Some buyers become deterred by the higher price and decide not to buy coffee, but others who value coffee more highly are willing to pay the higher price. Transactions continue to take place, but at a higher price than before, resulting in a new market price.
There are other factors that can shift the demand and supply of a good. On the demand side, changes in consumer preferences, income, and the prices of related goods can all affect the quantity demanded of a good. On the supply side, changes in technology, input prices, and the number of sellers can all affect the quantity supplied of a good. When the demand or supply of a good changes, the equilibrium price and quantity of the good also change, and the market price adjusts to the new equilibrium.
Thus, we see that the market price is automatically determined by the interaction of supply and demand. Here, prices act as signals that help allocate resources efficiently in the market. When a product is brought to market, the product is allocated to the buyers who are willing to pay the highest price. Sellers raise their prices (to earn more profit) until the market clears.
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The law of demand/supply states that the quantity demanded/supplied of a good is related to its price. Buyers buy more when the price is low, and sellers produce more when the price is high. As prices change, the quantity demanded/supplied also changes. But by how much? This quantity is described by the elasticity of demand/supply. Elasticity measures the responsiveness of the quantity demanded/supplied of a good to changes in its price. When a small change in price leads to a large change in quantity demanded/supplied, the good is said to be elastic.
There are several factors which influence the elasticity of demand and supply. For example, if a good has many close substitutes, then it is more likely to have an elastic demand, as consumers can easily switch to another product if the price of the original product increases. A luxury good also tends to have a higher price elasticity of demand, as consumers can easily forgo the purchase of the good if the price increases. A good has a more elastic supply when it is considered on a long-term basis, as producers have more time to adjust their production levels in response to price changes.
The price elasticity of demand, in particualr, is a useful tool for predicting the impact of changes in price on the total revenue of a product. When a product has an elastic demand, an increase in price will lead to a decrease in total revenue. This is because some revenue is lost due to lower sales, and this loss is not offset by the increase in revenue from higher prices. Conversely, when a product has an inelastic demand, an increase in price will lead to an increase in total revenue.
Consider the market for wheat. When a new technology is introduced that increases the yield of wheat, the supply of wheat increases. This drives prices down, as sellers are willing to supply more wheat at a lower price. The change in total revenue received by sellers, in turn, depends on the price elasticity of demand for wheat. Assuming that the demand for wheat is inelastic (which is reasonable, as wheat is a staple food), the decrease in price will lead to a decrease in total revenue for sellers.
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We have seen that markets is one way of allocating resources in an economy. But is it efficient? That is, do markets allocate resources in a way that maximizes economic welfare? To answer this question, we must first define what we mean by economic welfare. One measure of economic welfare is the total surplus generated by a market. The total surplus is the sum of consumer surplus and producer surplus.
Consumer surplus is the benefit that buyers receive from participating in a market. Buyers receive more benefit from a transaction if they pay less than what they are willing to pay. Likewise, producer surplus is the benefit that sellers receive from participating in a market. Sellers receive more benefit if they are able to sell their product for more than what they are willing to accept. Thus, consumer surplus increases when prices fall, and producer surplus increases when prices rise.
Does the market equilibrium maximize the total surplus? The answer is yes. At the market equilibrium, any increase in price will reduce consumer surplus, as buyers receive less benefit from their transactions, with no corresponding increase in producer surplus: although sellers are willing to produce more at the higher price, these goods are left unsold. Conversely, when prices fall below the equilibrium price, producer surplus decreases, as sellers earn lesser revenue and benefit less from their sales. There is also no corresponding increase in consumer surplus, as no additional goods are produced. Thus, the market equilibrium must be the point where the total surplus is maximized.
Market forces, therefore, are efficient in allocating resources in an economy. However, in practice, there are many cases where markets fail to allocate resources efficiently. The most common reason for market failure is the presence of externalities.
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So far our discussion has centred around domestic markets, where buyers and sellers are located within the same country operating under the same set of rules and regulations. But what happens when countries trade with each other?
When countries open up to international trade, they either become importers or exporters of a good depending on whether they have a comparative advantage in producing that good. If the domestic price is lower, then the country will become an exporter of the good, since it can produce the good at a lower cost than other countries. Conversely, if the world price is lower, then the becomes an importer, because it is cheaper to buy from outside.
Interestingly, total surplus can increase when countries trade with each other. Although some local buyers or sellers may lose out due to increased competition from foreign producers, other will benefit. In an exporting country, producers benefit from higher prices in the world market, but consumers lose out as they now have to pay higher prices for the good. Still, the net effect is positive, as the increase in producer surplus outweighs the decrease in consumer surplus. Likewise for an importing country: consumers benefit from lower prices in the world market, but producers lose out as they now have to sell their goods at a lower price. Again, the net effect is positive.
International trade, therefore, can be beneficial for both importing and exporting countries. There are also other benefits to trade. For consumers, they have access to a wider variety of goods and services, and they can purchase goods at a lower price. For producers, they have access to a larger market, and they can exploit economies of scale to produce goods more efficiently. There is also the benefit of increased competition, which can lead to lower prices and higher quality goods. Furthermore, trade can lead to the transfer of technology and knowledge between countries, which can help to increase productivity and economic growth.
Some, however, argue that trade can have negative effects on the economy. Most prominently is that international trade can lead to job losses in certain industries, as domestic producers are unable to compete with foreign producers. Often they cite that other countries are able to produce goods at a lower cost due to differences in regulations, wages, or technology. This can lead to unemployment and social unrest. An economist would counter argue that although some jobs are lost, other jobs are created in industries that benefit from trade.