Supply and demand
Demand for an item (such as goods or services) refers to the market pressure from people trying to buy it. Buyers have a maximum price they are willing to pay and sellers have a minimum price they are willing to offer their product. The point at which the supply and demand curves meet is the equilibrium price of the good and quantity demanded. Sellers willing to offer their goods at a lower price than the equilibrium price receive the difference as producer surplus. Buyers willing to pay for goods at a higher price than the equilibrium price receive the difference as consumer surplus. The laissez-faire principle expresses a preference for an absence of non-market pressures on prices and wages, such as those from government taxes, subsidies, tariffs, regulations (other than protection from coercion and theft), or government-granted or coercive monopolies. Friedrich Hayek argued in The Pure Theory of Capital
that the goal is the preservation of the unique information contained in the price itself. General equilibrium theory
has demonstrated, with varying degrees of mathematical rigor over time, that under certain conditions of competition
, the law of supply and demand
predominates in this ideal free and competitive market, influencing prices toward an equilibrium
that balances the demands for the products against the supplies. At these equilibrium prices, the market distributes the products to the purchasers according to each purchaser's preference (or utility) for each product and within the relative limits of each buyer's purchasing power
. This result is described as market efficiency, or more specifically a Pareto optimum
. This equilibrating behavior of free markets requires certain assumptions about their agents, collectively known as Perfect Competition
, which therefore cannot be results of the market that they create. Among these assumptions are several which are impossible to fully achieve in a real market, such as complete information, interchangeable goods and services, and lack of market power. The question then is what approximations of these conditions guarantee approximations of market efficiency, and which failures in competition generate overall market failures. Several Nobel Prizes in Economics have been awarded for analyses of market failures due to asymmetric information
. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for society that it was no part of it. By pursuing his own interest [an individual] frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the [common] good. Critics, such as political economist Karl Polanyi, question whether a spontaneously ordered market can exist, completely free of "distortions" of political policy; claiming that even the ostensibly freest markets require a state to exercise coercive power in some areas â€“ to enforce contracts, to govern the formation of labor unions, to spell out the rights and obligations of corporations, to shape who has standing to bring legal actions, to define what constitutes an unacceptable conflict of interest, etc. The highest goals of a market economy are economic freedom and efficiency. Individuals and businesses are left at liberty to decide what, how and for whom to produce. The producers of goods and services make these decisions based largely on consumersâ€™ spending decisions. Because you are free to buy what you want. Producers must compete for your dollars. This competition means that you, the consumer, have many choices. It also forces producers to use resources efficiently. If they do not, a competitor will find a way to offer the same good or service at a price that consumers will be more willing to pay. ADVANTAGE
- the market produces a wide variety of goods and services to meet the consumer's wants
- the free market responds quickly to people's wants
- the market system encourages the use of new and better methods and machines to produce goods and services
Australiaâ€™s resources are used and what things are produced: â€¢ Using government legislation or laws. Government legislation affects what consumers and firms can and cannot purchase (e.g. laws about wearing bike helmets and purchasing and consumption of tobacco and alcohol). â€¢ Discouraging socially undesirable types of goods and services. Governments may limit the production or consumption of some socially undesirable or dangerous goods and services purchased by ill-informed buyers (e.g. hard drugs, guns, pollution, chemicals, prostitution, pornography, alcohol and tobacco for those under age). Apart from using laws and bans, special taxes may be put on particular things to discourage consumption (e.g. taxes on alcohol and tobacco), along with negative advertising to repel buyers (e.g. cigarette packaging showing illness caused by smoking). â€¢ Encouraging socially desirable production. Sometimes socially desirable and necessary types of goods and services are under-produced or are too expensive for many people to afford. In this situation, governments encourage the production or consumption of these goods and services (for example, public housing, hospitals, solar panels, transport, education, health insurance, the wearing of seat belts and bicycle helmets). Using money raised from taxes, the government itself can provide community services to users, below cost or free of direct charge. Sometimes subsidies or cash payments are made to encourage producers or consumers, or tax concessions may be offered as a financial incentive (for example, the tax rebate for those taking out private health insurance). â€¢ Promoting strong competition and efficiency. Strong competition in markets generally helps to increase efficiency, lower prices, and improve the quality of goods and services produced. However, in monopoly and oligopoly markets, competition is weak and sometimes resources are used inefficiently. To correct this, the government can try to increase the level of competition by cutting tariffs (i.e. taxes added onto imports to protect local producers). In Australia, the government established the Australian Competition and Consumer Commission, which enforces the Competition and Consumer Act of 2010 designed to outlaw the anti-competitive activities of firms. This will be discussed further on p. 20. In addition, figure 1.17 on p. 14, indicates that, apart from the operation of the market and government intervention, there are also other institutions that influence the type of goods and services produced (i.e. the â€˜whatâ€™ question) including the media, minority political parties such as the Greens, and other pressure groups.
- factors of production will be employed if only it's profitable to do so
- the free market can fail to provide certain goods and services
- the free market may encourage the consumption of harmful goods
- the social effects of production may be ignored
- the market system allocates more goods and services to those consumers who have more money than others
- Q2 b. Monopolistic competition, a type of imperfect competition such that many producers sell products that are differentiated from one another (e.g. by branding or quality) and hence are not perfect substitutes. In monopolistic competition, a firm takes the prices charged by its rivals as given and ignores the impact of its own prices on the prices of other firms
- Oligopoly, in which a market is run by a small number of firms that together control the majority of the market share.
- Duopoly, a special case of an oligopoly with two firms.
- Monopsony, when there is only a single buyer in a market.
- Oligopsony, a market where many sellers can be present but meet only a few buyers.
- Monopoly, where there is only one provider of a product or service.
- Natural monopoly, a monopoly in which economies of scale cause efficiency to increase continuously with the size of the firm. A firm is a natural monopoly if it is able to serve the entire market demand at a lower cost than any combination of two or more smaller, more specialized firms.
- Perfect competition, a theoretical market structure that features no barriers to entry, an unlimited number of producers and consumers, and a perfectly elastic demand curve.
Many sellers: each seller represents a very small portion of the overall market. Since supply and demand in the overall market set the equilibrium price and quantity, one small firm cannot influence the market price. Each firm must accept whatever market price exists. Because of this, firms in perfect competition are called price takers. Identical products: you may see this referred to as standardized products, or homogeneous products. Consumers have no preference for a product from one firm over the product of any other firm. The products of each firm are perfect substitutes for one another. There is no difference in quality. Consumers would always choose to purchase the product from the lowest priced source. Firms cannot differentiate products in any way, including packaging or advertising. Easy entry and exit: new firms can enter the market freely. This implies that economies of scale do not exist. Existing firms can just as easily stop production and exit the market. Buyers know where the product is being sold, and at what price. Sellers know the strategies used by their competitors, including price and quantity decisions. Monopoly is a market structure in which one firm supplies the entire market. The product supplied has no close substitutes. The market size can be large or small. A firm in a monopoly market structure is called a monopolist. Because there is only one firm in the market, the firm's demand curve is the same as the market demand curve. Unlike a firm in perfect competition, a monopolist is a price maker. It decides what price at which to sell its product. It also decides what quantity to offer for sale. A monopolist has market power. It is also not true that a monopolist always earns a profit. A monopolist has costs just like any other firm, and must earn revenue in excess of these costs in order to earn a profit. The demand curve faced by a monopolist is downward sloping. This means that it can only increase output if it lowers its price. It cannot lower its price only on any additional output that it wishes to sell, however. It must lower its price on all units sold, including the units that it could sell at a higher price. The exception to this is in the case of price discrimination, which will be discussed later in this section. If a monopolist raises its price, the downward sloping demand curve means that it will sell fewer units. By having to lower the price on all units instead of just the additional units, the marginal revenue curve lies below the demand curve. Like any firm in any market structure, profits are maximized at the quantity of output where marginal revenue (MR) is equal to marginal cost (MC). With the marginal revenue curve below the demand curve, this quantity will be lower than the profit-maximizing quantity in perfect competition. Since the monopolist sets the quantity where MR=MC, supply is determined by marginal cost. Also, unlike perfect competition, marginal revenue is not equal to price in a monopoly. Profits are maximized at the quantity where MR=MC, but the monopolist can charge the price where this quantity intersects the demand curve. Since the demand curve lies above the marginal revenue curve, this price will be higher than what would occur under perfect competition. Since the price is set by the demand curve, and price also equals average revenue, the average revenue curve is the demand curve. All else equal, then, the monopolist will sell a lower quantity at a higher price than what would occur under perfect competition. With the output quantity determined by the marginal revenue curve, and the price determined by the demand curve (which lies above the marginal revenue curve), a monopolist doesn't really have a supply curve. It has a supply point. This is because only one point in a graph factors in price, quantity, demand, and marginal revenue.
- A profit-maximising firm will produce at the productively and allocatively efficient level of output in a perfectly competitive industry
- The conventional argument against market power is that monopolists can earn abnormal (supernormal) profits at the expense of efficiency and the welfare of consumers and society.
- The monopoly price is assumed to be higher than both marginal and average costs leading to a loss of allocative efficiency and a failure of the market. The monopolist is extracting a price from consumers that is above the cost of resources used in making the product and, consumersâ€™ needs and wants are not being satisfied, as the product is being under-consumed.
- The higher average cost if there are inefficiencies in production means that the firm is not making optimum use of scarce resources. Under these conditions, there may be a case for government intervention for example through competition policy or market deregulation.
(1) The market inefficiency should provide the basis for a scheme to beat the market and earn excess returns. For this to hold true - (a) The asset (or assets) which is the source of the inefficiency has to be traded. (b) The transactions costs of executing the scheme have to be smaller than the expected profits from the scheme. (2) There should be profit maximizing investors who (a) recognize the 'potential for excess return' (b) can replicate the beat the market scheme that earns the excess return (c) have the resources to trade on the stock until the inefficiency disappears Efficient Markets and Profit-seeking investors: The Internal Contradiction There is an internal contradiction in claiming that there is no possibility of beating the market in an efficient market and then requiring profit-maximizing investors to constantly seek out ways of beating the market and thus making it efficient. If markets were, in fact, efficient, investors would stop looking for inefficiencies, which would lead to markets becoming inefficient again. (a) In an efficient market, equity research and valuation would be a costly task that provided no benefits. The odds of finding an undervalued stock should be random (50/50). At best, the benefits from information collection and equity research would cover the costs of doing the research. (b) In an efficient market, a strategy of randomly diversifying across stocks or indexing to the market, carrying little or no information cost and minimal execution costs, would be superior to any other strategy, that created larger information and execution costs. There would be no value added by portfolio managers and investment strategists. (c) In an efficient market, a strategy of minimizing trading, i.e., creating a portfolio and not trading unless cash was needed, would be superior to a strategy that required frequent trading. Market Efficiency for Investor Groups â€¢Definitions of market efficiency have to be specific not only about the market that is being considered but also the investor group that is covered. oIt is extremely unlikely that all markets are efficient to all investors, but it is entirely possible that a particular market (for instance, the New York Stock Exchange) is efficient with respect to the average investor. oIt is also possible that some markets are efficient while others are not, and that a market is efficient with respect to some investors and not to others. This is a direct consequence of differential tax rates and transactions costs, which confer advantages on some investors relative to others. What market efficiency does not imply: An efficient market does not imply that - (a) stock prices cannot deviate from true value; in fact, there can be large deviations from true value. The only requirement is that the deviations be random. (b) no investor will 'beat' the market in any time period. To the contrary, approximately half of all investors, prior to transactions costs, should beat the market in any period. (c) no group of investors will beat the market in the long term. Given the number of investors in financial markets, the laws of probability would suggest that a fairly large number are going to beat the market consistently over long periods, not because of their investment strategies but because they are lucky. It would not, however, be consistent if a disproportionately large number of these investors used the same investment strategy.
- The necessary conditions for a market inefficiency to be eliminated are as follows -