Welcome to Unit 3.1: How Markets Work!

Hello future economist! This chapter is the foundation of microeconomics – the study of how individual consumers and firms make decisions. Think of it as learning the rules of the economic game. Understanding "How Markets Work" helps you see why the price of your favourite coffee changes, why certain businesses succeed, and when the government needs to step in to fix things. Don't worry if some concepts seem difficult; we’ll break them down with real-world examples!

3.1.2 The Mechanics of Demand and Supply

The Concept of Demand

Demand is simply the amount of a good or service that consumers are willing and able to buy at a given price over a specific period.

The Law of Demand

This is straightforward: As the price of a good increases, the quantity demanded decreases, and vice versa. This is an inverse relationship.

  • Demand Curve: This shows the relationship between price and quantity demanded. It always slopes downwards (from left to right).
Factors Affecting Demand (Shifts in the Demand Curve)

When the price changes, we move along the curve (a change in quantity demanded). But when non-price factors change, the whole curve shifts (a change in demand). These non-price factors include:

  1. Income (Y): If income rises, demand for most goods rises (Normal Goods, e.g., steak). If income rises and demand falls, it’s an Inferior Good (e.g., cheap instant noodles).
  2. Price of Related Goods:
    • Substitutes: Goods that can be used in place of each other (e.g., Pepsi and Coke). If the price of Coke increases, the demand for Pepsi shifts right (increases).
    • Complements: Goods that are consumed together (e.g., cars and petrol). If the price of cars increases, the demand for petrol shifts left (decreases).
  3. Tastes and Preferences: If a product becomes fashionable, demand shifts right.
  4. Population (P): More consumers mean higher overall demand.
  5. Expectations: If consumers expect prices to rise next week, demand increases today.

Memory Aid: Think of the acronym PIRATE (Population, Income, Related goods, Advertising/Tastes, Expectations) for demand shifters!

The Concept of Supply

Supply is the amount of a good or service that producers are willing and able to sell at a given price over a specific period.

Producers are motivated by profit. Higher prices imply higher profits, providing an incentive to expand production.

The Law of Supply

As the price of a good increases, the quantity supplied also increases. This is a positive relationship.

  • Supply Curve: This slopes upwards (from left to right).
Factors Affecting Supply (Shifts in the Supply Curve)

These are non-price factors that affect the producer's willingness or ability to produce:

  1. Costs of Production (CoP): If wages or raw material prices fall, supply shifts right (increases, as it’s cheaper to produce).
  2. Technology: Improved technology makes production more efficient, increasing supply (shift right).
  3. Government Intervention:
    • Indirect Taxes: Increase CoP, shifting supply left (decreases).
    • Subsidies: Decrease CoP, shifting supply right (increases).
  4. Natural Factors/Weather: Especially important for commodity prices (e.g., a good harvest increases the supply of wheat).
  5. Price of Other Goods in Joint Supply: If producing one good automatically produces another (joint supply), increasing the supply of the first increases the supply of the second.
Quick Review: Movement vs. Shift

Price change -> Movement along D or S curve (Quantity demanded/supplied changes).

Non-price change -> Shift of D or S curve (Demand/Supply changes).

Market Equilibrium and Price Determination (3.1.2.5)

In a market economy, the interaction of demand and supply determines the equilibrium price (\(P^*\)) and equilibrium quantity (\(Q^*\)).

Equilibrium is a state where the quantity demanded equals the quantity supplied. There is no tendency for the price to change.

Disequilibrium: The Price Adjustment Mechanism

If the market is not at equilibrium, forces will push the price towards it:

  1. Excess Supply (Surplus): Occurs when the price is above equilibrium. Quantity supplied > Quantity demanded.

    The consequence: Firms have unsold stock. They are forced to lower the price to clear inventory, moving the market back to equilibrium.

  2. Excess Demand (Shortage): Occurs when the price is below equilibrium. Quantity demanded > Quantity supplied.

    The consequence: Consumers are willing to pay more but can’t find the product. Firms realise they can raise the price (and still sell everything), moving the market back to equilibrium.

Key Takeaway: Demand and supply are the invisible hands that allocate resources. They signal to producers what to make and how much, and they ration the goods among consumers.

3.1.2.2 & 3.1.2.4 Measuring Responsiveness: Elasticity

Elasticity measures how much one variable (like quantity demanded) responds to a change in another variable (like price or income). Think of it like a rubber band – some things are very stretchy (elastic), and others barely budge (inelastic).

1. Price Elasticity of Demand (PED)

Measures the responsiveness of quantity demanded to a change in price.

Formula: \(PED = \frac{\%\Delta Q_d}{\%\Delta P}\)

The Rule of PED and Total Revenue (TR)

Total Revenue (TR) is Price (P) multiplied by Quantity (Q).

  • Elastic (\(|PED| > 1\)): Demand is responsive. If Price decreases, TR increases (because the increase in Q outweighs the drop in P).
  • Inelastic (\(|PED| < 1\)): Demand is unresponsive. If Price increases, TR increases (because the drop in Q is minor compared to the rise in P).
  • Did you know? Firms use PED constantly. If a mobile phone company wants to boost revenue, they must know if demand for their phones is elastic or inelastic!

Factors Influencing Price Elasticity of Demand

How do we know if a good is elastic or inelastic? Consider SPLAT:

Substitutes (Availability of): More substitutes = More elastic (easier to switch).

Proportion of Income: Goods that take up a large share of income (e.g., a car) = More elastic.

Luxury vs. Necessity: Luxuries = More elastic.

Addiction: Addictive goods (e.g., cigarettes) = Inelastic.

Time: Longer time period = More elastic (consumers have time to find alternatives).

2. Income Elasticity of Demand (YED)

Measures the responsiveness of quantity demanded to a change in income.

Formula: \(YED = \frac{\%\Delta Q_d}{\%\Delta Y}\)

  • Normal Goods: YED is positive (\(> 0\)). As income rises, demand rises.
  • Inferior Goods: YED is negative (\(< 0\)). As income rises, demand falls.

3. Cross Elasticity of Demand (XED)

Measures the responsiveness of demand for good A to a change in the price of good B.

Formula: \(XED = \frac{\%\Delta Q_{d} A}{\%\Delta P B}\)

  • Substitutes: XED is positive (\(> 0\)). If the price of tea (B) rises, the demand for coffee (A) rises.
  • Complements: XED is negative (\(< 0\)). If the price of cinema tickets (B) rises, the demand for popcorn (A) falls.

4. Price Elasticity of Supply (PES)

Measures the responsiveness of quantity supplied to a change in price.

Formula: \(PES = \frac{\%\Delta Q_s}{\%\Delta P}\)

  • Elastic Supply (\(PES > 1\)): Producers can quickly and easily increase output when prices rise.
  • Inelastic Supply (\(PES < 1\)): Producers struggle to increase output quickly (e.g., agricultural products or fine art).

Factors Influencing Price Elasticity of Supply

  • Time Period: In the long run, supply is always more elastic (firms can build new factories).
  • Spare Capacity: If a firm has lots of unused machinery, supply is elastic.
  • Ease of Switching Factors: If inputs can easily be moved between uses (factor mobility), supply is elastic.

Key Takeaway: Elasticity tells us the strength of relationships in economics. This is vital for predicting consumer and producer reactions to changes in the market.

3.1.3 Production, Costs, Revenue and Profit

This section explores the decisions firms make about what to produce and how to manage their money to achieve their goals.

3.1.3.1 Production and Productivity

Production is the process of converting inputs (raw materials, labour, capital) into final outputs (goods and services).

Productivity is output per unit of input. Labour productivity (output per worker hour) is particularly important for economic growth.

The environment is crucial: It provides inputs (resources) and absorbs outputs (waste). Sustainable activity must respect these environmental limits.

3.1.3.2 Specialisation, Division of Labour and Exchange

Specialisation occurs when economic agents (individuals, firms, or countries) concentrate on producing a specific limited range of goods or services.

Division of Labour is when the production process is broken down into separate, smaller tasks (e.g., Henry Ford's assembly line).

  • Benefits: Increased productivity, better quality, lower costs.
  • Costs: Boredom/alienation, risk of industrial action, dependence on efficient exchange.

Specialisation requires an efficient means of Exchange, which is why we use money as a medium of exchange, rather than relying on inefficient barter systems.

3.1.3.3 Costs of Production

Economists distinguish between time periods and types of costs:

Short Run vs. Long Run
  • Short Run (SR): At least one factor of production is fixed (usually capital, like a factory size).
  • Long Run (LR): All factors of production are variable (a firm can expand or shrink its entire operation).
Fixed vs. Variable Costs (in the Short Run)
  • Fixed Costs (FC): Do not change with output (e.g., rent, insurance).
  • Variable Costs (VC): Change directly with output (e.g., raw materials, hourly wages).
  • Total Costs (TC): \(TC = FC + VC\).

Students should be able to calculate Average Costs (AC = TC/Q) and Marginal Costs (MC = change in TC from one extra unit of output).

3.1.3.4 Economies and Diseconomies of Scale

These relate to the Long Run, where all costs are variable. They explain the shape of the Long-Run Average Cost (LRAC) curve.

  • Economies of Scale (EoS): Cost advantages reaped by firms when production becomes efficient, resulting in falling Long-Run Average Costs (LRAC) as output increases.
    Example (Internal EoS): Buying raw materials in bulk (purchasing economies).
  • Diseconomies of Scale (DoS): When a firm grows so large that coordination problems arise, leading to rising LRACs.
    Example (DoS): Slow communication, demotivated workforce.
  • Minimum Efficient Scale (MES): The lowest point of the LRAC curve, representing the minimum output needed to achieve the lowest possible average cost. This is important for determining market structure.

3.1.3.5 Revenue and Profit

  • Total Revenue (TR): Total income from sales (\(TR = P \times Q\)).
  • Average Revenue (AR): Revenue per unit sold (\(AR = TR / Q\)). Note: The AR curve is the firm's demand curve.
  • Marginal Revenue (MR): Revenue gained from selling one additional unit.

Profit is the difference between Total Revenue and Total Costs (\(Profit = TR - TC\)).

We distinguish between two types of profit:

  • Normal Profit: The minimum revenue required to keep the factors of production in their current use. It’s counted as an economic cost (part of total cost).
  • Abnormal (Supernormal) Profit: Any profit earned above normal profit.

Key Takeaway: Production costs determine how efficiently a firm can operate. The concepts of EoS and the LRAC explain why large companies often have lower per-unit costs than small ones.

3.1.4 Competitive and Concentrated Markets

Not all markets are the same. We classify them based on structure, which affects how firms behave and what their objectives are.

3.1.4.1 Market Structures

Market structures lie along a spectrum:

Perfect Competition ----------------> Monopolistic Competition ----------------> Oligopoly ----------------> Monopoly

Structures are defined by:

  • Number of Firms: Many vs. few/one.
  • Product Differentiation: Identical (homogeneous) vs. highly differentiated.
  • Barriers to Entry (BTE): Ease with which new firms can join the market (None vs. High).

3.1.4.2 Objectives of Firms

While Profit Maximisation (producing where Marginal Cost = Marginal Revenue) is the traditional objective, firms often pursue others:

  • Survival: Especially during recessions or for new businesses.
  • Growth/Market Share Maximisation: To gain dominance or achieve EoS.
  • Satisficing: Achieving a minimum acceptable level of profit, rather than maximising it (often seen when managers run the firm but owners own it – the 'divorce of ownership from control').

3.1.4.3 Perfect Competition (PC)

A hypothetical structure that provides a benchmark for efficiency.

  • Characteristics: Many small firms, identical products, no barriers to entry, perfect knowledge.
  • Behaviour: Firms are Price Takers (they must accept the market price determined by D & S).
  • Profits: Due to the lack of BTE, new firms enter if supernormal profits are made, driving profits down to Normal Profit in the long run.

3.1.4.4 Monopoly and Monopoly Power

A Pure Monopoly is a single firm controlling 100% of the market. This is rare.

Monopoly Power refers to the degree to which a firm can set its own price without losing too much demand (i.e., it faces a downward-sloping demand curve).

  • Source of Power: High Barriers to Entry (e.g., legal patents, high start-up costs, EoS).
  • Concentration Ratio: Measures the market share controlled by the largest firms (e.g., a 5-firm concentration ratio of 80% means the top 5 firms control 80% of the market).
  • Natural Monopoly: When EoS are so large that the MES is only reached when the firm supplies the entire market (e.g., national rail networks, utility companies).

Impact: Monopolies usually result in higher prices and lower output compared to competitive markets (a misallocation of resources). However, they may benefit from large EoS and have higher profits available for Research & Development (R&D).

3.1.4.5 Competitive Market Process

Competition is not just about price. Firms compete by:

  • Improving product quality.
  • Investing in R&D and innovation.
  • Reducing costs to gain a competitive edge.

This dynamic process leads to Creative Destruction (invented by Joseph Schumpeter), where new innovations destroy existing dominant markets (e.g., Netflix destroying Blockbuster).

3.3.3.6 Price Discrimination

This is when a firm with monopoly power charges different prices to different customers for the same product, where the difference is not due to cost differences.

  • Third-Degree Price Discrimination: Charging different prices in separate markets (e.g., student/senior discounts, peak/off-peak train tickets).
  • Conditions Necessary: Monopoly power, ability to separate markets (e.g., checking IDs), and different price elasticities of demand in each market (charging higher prices to the more inelastic market).

Key Takeaway: Market structure dictates behaviour. High barriers to entry allow firms to exercise monopoly power, often leading to higher profits and prices, though potentially funding innovation.

3.1.5 Market Failure and Government Intervention

The market is usually very good at allocating resources, but sometimes it goes wrong. This is called Market Failure.

3.1.5.1 The Meaning of Market Failure

Market Failure occurs when the free market mechanism leads to an inefficient or misallocation of resources, resulting in a loss of economic welfare. In simple terms, society is producing too much of a bad thing or too little of a good thing.

Causes of Market Failure include:

3.1.5.2 Private, Public and Quasi-Public Goods

Private Goods: (e.g., an apple) are rivalrous (if I eat it, you can't) and excludable (I can stop you from having it).

Pure Public Goods: (e.g., national defence, street lighting) are:

  1. Non-rivalrous: One person consuming it does not stop another from consuming it.
  2. Non-excludable: Once provided, it is impossible to stop anyone from benefiting.

The market fails to provide public goods because of the Free-Rider Problem: people can enjoy the good without paying, so no firm has an incentive to produce it.

Quasi-Public Goods: Goods that are partially non-rivalrous and/or non-excludable (e.g., a toll road which becomes congested, making it rivalrous).

The Tragedy of the Commons is relevant here: It describes the overuse and depletion of a shared resource (like fish stocks) because no one owns the resource, leading to market failure.

3.1.5.3 Externalities

An Externality occurs when the production or consumption of a good affects a third party who is not directly involved in the transaction. This creates a divergence between Private Costs/Benefits (felt by the producer/consumer) and Social Costs/Benefits (felt by society as a whole).

  • Negative Externalities (e.g., Pollution from a factory): Social Cost > Private Cost. The market leads to overproduction (the good is too cheap because the external cost is ignored).
  • Positive Externalities (e.g., Vaccinations): Social Benefit > Private Benefit. The market leads to underproduction (the external benefit is ignored).

Analogy: If a factory pollutes a river, the factory owner’s private costs are low, but society (the fisherman downstream) pays the external cost. The price mechanism fails because there are no clear property rights over the river.

3.1.5.4 Merit and Demerit Goods

These classifications rely on a value judgement.

  • Merit Goods: Goods that are under-consumed when left to the market, often because consumers suffer from imperfect information or under-estimate the long-term benefit (e.g., education, healthcare). This leads to underprovision.
  • Demerit Goods: Goods that are over-consumed, often because consumers suffer from imperfect information or under-estimate the long-term cost (e.g., smoking, gambling). This leads to overprovision.

Note: Merit and demerit goods often generate positive or negative externalities, respectively, but they are primarily defined by the issue of information.

3.1.5.5 Other Market Imperfections

  • Imperfect/Asymmetric Information: When one party (buyer or seller) has more information than the other, leading to poor decision-making and misallocation (e.g., a used car salesman hiding mechanical faults).
  • Monopoly Power: As discussed above, monopolies restrict output and charge high prices.
  • Immobility of Factors of Production: Labour may be geographically or occupationally immobile (hard to move/re-skill), leading to structural unemployment and market failure.
  • Price Instability: Especially in commodity markets, large fluctuations make planning difficult, reducing investment.

3.1.5.6 Inequitable Distribution of Income and Wealth

The market system, driven by profit, often produces highly unequal outcomes. While equality means everyone gets the same, equity means fair and just distribution (a value judgement). Extreme inequality can lead to social unrest and resource misallocation, constituting a form of market failure.

3.1.5.7 Government Intervention to Correct Market Failure

When markets fail, governments step in. Methods include:

  1. Indirect Taxation: Used to discourage negative externalities and consumption of demerit goods (e.g., high tax on fuel or tobacco).
  2. Subsidies: Used to encourage positive externalities and consumption of merit goods (e.g., subsidy for solar panels or public transport).
  3. Regulation/Legislation: Rules and laws to control behaviour (e.g., banning pollution, minimum quality standards).
  4. State Provision: The government provides public goods or merit goods directly (e.g., national defence, public healthcare).
  5. Price Controls: Setting minimum or maximum prices (e.g., a maximum rent price).
  6. Extending Property Rights: Defining who owns what (e.g., pollution permits) to internalise externalities.

3.1.5.8 Government Failure

Just as markets can fail, so too can government intervention. Government Failure occurs when intervention leads to a worse allocation of resources and a reduction in economic welfare.

Sources of Government Failure:

  • Inadequate Information: Governments may lack the precise data needed to set the correct tax or subsidy level.
  • Conflicting Objectives: Policies aimed at one goal (e.g., reducing pollution) may undermine another (e.g., economic growth).
  • Administrative Costs: The cost of implementing the policy may be greater than the benefit achieved.
  • Unintended Consequences: Policies often have unforeseen side effects (e.g., a tax on sugar leading consumers to buy cheaper, equally unhealthy alternatives).
  • Political Self-Interest/Corruption: Policies may serve the interests of politicians or lobbyists, not the public.

Key Takeaway: Market failure justifies government action, but students must always evaluate whether the intervention (e.g., a tax or subsidy) might lead to an even worse outcome (government failure).