1.2. The simple market model
Objective
+ Understand the elements of the simple market model
+ Identify the nature of the supply and the demand relationships
+ Define equilibrium in the market
+ Investigate what causes prices and quantities to change
+ To use the market model as a tool to understand behavior
Lecture What is the simple market model and why do economists use it?
Part I – Building the Model
One of the most fundamental models in economics is the simple market model. The “X” diagram, the “scissors” diagram. It is a simple model, but a powerful one.
Check out this video presenting the Simple Market Model
Notes to accompany the video (can be reviewed after viewing the video.)
1. Supply relationship Qs = f(Ps, Pi, T, Z) where Qs is quantity supplied, Ps is price per unit suppliers are willing to accept, Pi is a vector of prices of inputs, T is technology and Z is a vector of all other factors affecting supply.
2. Demand relationship Qd = g(Pd, Po, M, X) where Qd is quantity demanded, Pd is price per unit demanders are willing to pay, Po is a vector of prices of other commodities, M is income, and X is a vector of all other factor affecting demand.
3. If we hold all other factors constant we can focus on the simple relationships of Qs and Ps, and Qd and Pd.
4. In a space with axes of price (in dollars) and quantity (in units of the commodity) we can draw the demand and the supply relationships Pd = D(Qd) and Ps = S(Qs). Note, these simple functions are invertible, so that we can have price as the dependent variable, or quantity as the dependent variable, it doesn’t matter much!
5. Supply relationship is up-sloping to reflect increasing marginal cost per unit to produce.
6. Demand relationship is down-sloping to reflect decreasing marginal utility per unit from consumption. (See Aside: Utility)
7. Market is in equilibrium when Qd=Qs and Pd=Ps. The Marshallian mechanism is one in which quantities adjust to clear the market. (Qd=Qs=)Qe: Pd=Ps. The Walrasian mechanism is one where prices adjust to clear the market. (Pd=Ps=)Pe: Qd=Qs. Again, not much to distinguish which mechanism is actually at work in particular markets.
Initial conclusions drawn from Market Model (read this after watching the video):
a) Demand curves are generally down-sloping: people are willing to pay more for something that they have relatively little of. The more they have of it, the less they are willing to pay to get another unit. Demand curves are sometimes called willingness to pay curves.
b) Supply curves are generally up-sloping. Businesses are only willing to offer more units for sale if they can get a higher price for every unit they sell. This is not simply trying to make more profit, but a reflection of the higher cost of producing more of a commodity. Supply curves are sometimes called willingness to accept curves.
c) A market is in equilibrium when it clears–when the price is just right to ensure the quantity demanded is the same as the quantity supplied (or the willingness to pay is equal to the willingness to accept.)
d) “The law of one price” says that every unit of a commodity will sell for the same price. If a gallon of gas sells for different prices around a city, then each gallon is not exactly the same, by definition. There must be some factor explaining why prices are different: local demand, transportation or storage or delivery costs?
e) There are natural forces ensuring that a market stays in equilibrium, so long as nothing changes.
Part II – Modeling Change
Markets do not remain constant. Things always change. The market model allows us to investigate why things change, and what to expect when they do. It allows to predict behavior as well as understand it.
Watch the second video about the Simple Market Model
Notes to accompany the second video (can be reviewed after viewing the video.)
1. Initially the market is in equilibrium. Price is Pe and quantity is Qe.
2. The equilibrium is stable until something changes.
3. Let income increase. Income is a factor affecting demand.
4. All variables in the demand function except price are assumed to remain fixed, but if one (such as M) changes, then the demand curve (the relationship between Qd and Pd) shifts. We must redraw the demand curve in the diagram to reflect the increase in income.
5. Presumably more of the commodity will be demanded at each and every price now that consumers have more income to spend on this product, as well as other products. (For example, wealthier people drink more wine!)
6. Income is not a factor affecting supply, so that relationship remains the same, and the supply curve does not move.
7. The new demand curve crosses the supply curve at a point with higher Q and higher P than before. The new equilibrium is at Pe’ and Qe’.
8. An increase in income, all other factors remaining the same, will shift demand, increase the equilibrium price of the commodity, and more units will be sold and bought.
9. The increase in demand induced by a rise in income causes the suppliers to increase the quantity supplied to match the new demand. Price rises, and quantity sold and bought increases.
10. Any change in a factor affecting supply or demand, other than price, is likely to shift either the supply or demand curve, and cause the market to move to a new equilibrium.
Conclusions to draw from the Market Model, Part II (read this after watching the video):
The power of the simple market model lies in its simplicity. Much of the detail is assumed away, or held fixed, yet by doing so we can focus on the basic responses to changes. When a hurricane flattens a town, the demand for building supplies goes up, and we can expect the Home Depots in nearby towns to raise the price of 2x4s. They are not gouging hard-hit customers, but responding in a way the market model would predict. You may remember (or not,) when the oil producing countries restricted oil supplies in the 1970s. Gas stations were not allowed to raise prices for gas, (which is what the market model would predict,) so what happened? People lined up for hours to put a couple of gallons in their cars. More money was wasted by people lining up (lost hours of work, etc.) than was ever “saved” by keeping the price of gasoline down.
The market model (often referred to as the supply/demand model) is often criticized as overly simplistic, and unrealistic. Yet it remains the “go-to” model for understanding basic behavior of markets. Understand and recognize the limitations of the model and it can be used to illuminate insights and tell important stories.
If you search the web for “supply and demand comparative statics” you’ll find a lot of information that might extend your understanding of the simple market model. There’s also a Khan Academy presentation on Changes in Market Equilibrium. (Some Khan Academy stuff is OK.)
Take the Quiz on the Learn website.
Part III – Modeling the Stock Market
Watch the Part III video presentation
Notes to accompany the video
1. Draw price and quantity axes. Price is price per unit of stock (or more generally any financial asset,) and Quantity is usually a Lot of shares (100 shares is a standard lot,) or some other standard unit for the more general financial asset.
2. The Demand relationship is more specifically called an offer or bid relationship, and indicates the price a buyer is willing to pay per share for owning stock in a company.
Factors affecting the quantity of shares demanded include the current bid price, anticipated future price for the share, the price of other assets including stocks in other companies, income, and many other things to do with the economy, the company, the buyer and the future, even political events.
3. The Supply relationship is referred to as the ask relationship, and represents the price sellers are willing to accept per share to relinquish owning stock in a company. Factors affecting the quantity of shares supplied include the current ask price, anticipated future price of the share, the price of other assets, the need for liquidity, and many other things.
4. Note that many of the same factors affect both the buyers and sellers of stocks, or financial assets more generally. It’s more HOW these factors affect buyers and sellers that differs. Even with the same information, buyers may interpret that information differently than sellers. Actually, for the market to work, people must have different views of the future of the company, the alternatives, and the economy in general.
5. To put things in perspective, the average Quantity of Apple (APPL) shares sold per trading day is about 35million, at a Price around $170 recently. Movements in the supply/sell and demand/buy curves (the relationship between price and quantity, holding other factors constant) can explain why the price of APPL shares rises and falls. Although each trade can be for different quantities, at slightly different prices (just look at the price chart throughout the day to show this,) the general features of markets can explain, for example, why APPL shares fluctuate. Apple introduces new products and demand increases, causing share price to rise. Apple announces lower profits than expected and supply increases, causing share price to fall.
Aside: Utility
Stemming from the classical Utilitarian philosophers Jeremy Bentham and John Stuart Mill, economics took up the idea that satisfaction, or happiness, or welfare could be measured. Utility is the objective that people are assumed to maximize by buying and consuming commodities. If you Google utility theory you’ll find many “standard” definitions, and a few critics–it’s not an uncontroversial theory. And it might not be a very useful theory, but it does provide a basis for why people demand things–and we need a demand theory in order to explain markets, and exchange, and trade.
According to utility theory, people gain utility (satisfaction, well-being) from using or consuming goods and services. As a person consumes more of a particular commodity, the total utility increases, but at a decreasing rate. The extra utility from another unit consumed decreases, and may even become negative (you get sick from it.) This extra utility is called marginal utility, and it (generally) decreases as quantity increases.
A more sophisticated version of utility theory recognizes that there are many commodities to choose from, and what is really important is a decreasing marginal rate of substitution (MRS) between commodities. For example, this means that I am willing to exchange/swap more of one good for another as I increase the amount of that first good I have. If I have lots of pizza, but only a small amount of beer, I will trade more pizza to get another beer, just because I enjoy my pizza and beer in a nice proportion: I don’t want too much beer, or too much pizza.
Although that last bit about diminishing MRS is a bit abstract, it’s actually all that utility theory needs to ensure demand curves are downward sloping. Requiring decreasing marginal utility is formally a bit too strong of a requirement.
Aside: Expectations
It’s almost too obvious to state: expectations play a large role in the purchase (demand), and sale (supply) of financial assets. There are two basic reasons to hold financial assets: (i) they offer a regular return such as dividends, and (ii) they offer the chance of capital gains as they appreciate in value over time. (There is a third possibility–that of insurance against other positions, but I’ll leave that for later.) But none of this is certain, although the regular payment of interest on bonds is a pretty sure thing. Dividends aren’t always so predictable. Capital gains are not assured (that’s for sure!) Once uncertainty is acknowledged (and this is covered in the next Topic) and formally introduced into the analysis of financial assets and financial planning, expectations become more important.
Buyers expect to buy low, and sell high. Sellers might be expecting asset values to fall, so they want to sell at a high point in the market. Each participant in the market expects something to happen in the future, but no-one knows exactly what will happen for sure.
Expectations play a large role, but they are not the only factor, nor perhaps are they the major factor, in determining why people buy, or sell, assets when they do.
Understanding expectations is the hard part. With the same information, two people may come to very different conclusions about the future, leading to different expectations. One will become a buyer, the other a seller. Then a market forms.
Resources/links
1. Investopedia provides a (very) basic explanation of Utility Theory here:
http://www.investopedia.com/university/economics/economics5.asp
2. Here’s an article from The Economist about what makes people happy.
http://www.economist.com/node/321075
Philip Ganderton 