Demand analysis

• Firms sell goods/services to buyers– Consumers (individuals) : utility– Firms : make profits

• Willingness to pay: maximum price buyer will pay for a good– Point of indifference between buying and not

buying– Lower price always preferred by buyer

• Willingness to pay is determined by– Buyer’s tastes or needs– Income and wealth

• Normal/inferior goods• Cyclical/acyclical demand

– Substitutes– Complementary goods

• Demand curve for an individual buyer– Willingness to pay for

different quantities of the good

– Or, quantity demanded at each price

– Usually downward sloping: lower willingness to pay for additional units

• Lower utility of consumption for consumers

• Lower productivity of resources for firms

• Shifts in demand curve

• Market demand– Sum of individual demand curves– Aggregate quantity demanded at each price– Arrays individual buyers in order of willingness to pay– Identical goods? Product differentiation?

• Market segments / Price discrimination– Different segments willing to pay different

prices– Consumer surplus– Can firms exploit this?

• Feasible?• Fair?

• Price sensitivity of demand– Slope of market demand curve– Flat demand curve: very price sensitive: Elastic

• Goods with good substitutes• Luxury items ?

– Steep demand curve: less sensitive: Inelastic• Necessities

• Time-frame: easier to find substitutes over long run

• Demand curves– Accept as given?– Seek to modify?

Supply analysis

• Supply curve– How much the firm will sell at each price– Assumption: price-taking firm

• Time-frame of supply decision– Long run: compete in the market at all?– Short run: how much to produce & sell?

• Short run supply• Based on costs

– Fixed costs: incurred regardless of volume• ‘headquarter’ costs, depreciation, rent, labor….

– Variable or marginal costs: cost per additional unit produced• Raw materials, electricity, labor….

• In the short run, fixed costs are inevitable• Should not affect short run supply decisions (?)

• Marginal costs– Cash costs: out-of-

pocket– Opportunity costs:

foregone profits

• Marginal cost curve : Short run supply curve

• Long run supply: entry & exit• Recover both fixed and variable costs• Fixed costs

– Out-of-pocket costs– Opportunity costs: return on capital

• Average costs– Includes both fixed

and variable costs– Typical U shape– Minimum of the

average cost curve: Optimal long run supply point

– Market price must exceed price at this point

– Determine entry and exit

– Dynamics?

• Shifts in supply curve– Input costs– Technology

• Market supply curve– Sum of individual supply curves– Usually slopes upward

• Less efficient firms enter market when price is high• Arrays firms from most efficient to least

• Supply elasticity– Flat supply curve: very sensitive to price:

Elastic– Steep supply curve: less sensitive: Inelastic

• Varies over the range of output– Elastic when spare capacity is available– Inelastic when capacity constrained

Market equilibrium

• Interesection of market demand and supply curves

• Disequilibrium will cause price to adjust and yield new equilibrium

• Real world: series of small disequilibriums, series of price adjustments

• Currency markets: rapid, continuous adjustments

• Profit calculation based on equilibrium price

• Average and marginal costs

• Marginal cost determines supply volume

• Average costs at that volume

Market adjustment

• Shifts in demand and supply curves– Increase: shift to the right– Decrease: shift to the left

• Impact on quantity and price

• Inelastic curves: adjustment largely through price

• Elastic curves: adjustment largely through quantity

• Short run versus long run

Perfect competition

• Three assumptions:1. Identical products

2. Many small price-taking buyers and sellers

3. Full information• Excess profits more firms enter

increased supply lower price zero excess profits

• Three more conditions:1. Identical sellers

2. Free entry

3. Free exit

• Zero excess profits• Long run profitability?

Departures from perfect competition

• Most markets have far from perfect competition– Exceptions: commodities

• Secret of long run profitability: deviations from perfect competition

• Few sellers or buyers– Extreme case: monopoly or monopsony– Oligopoly

• Collusion• Cartels: incentives to cheat the cartel

– Societal impact: anti-trust regulation

• Entry and exit barriers– First mover advantage

• Headstart on learning curve• Economies of scale• Reputation and branding

– High exit costs• May lead to firms accepting sustained losses

• Product differentiation– Special attributes: Real or imaginary

• Differences among sellers– Least cost producer– Innovation

• Imperfect information– Search costs protect

existing relations and discourage competition