Ch 3 The Market System

Market Economy Interaction between supply and demand determines what is

made and quantities. Economic activity determined but the sum of collective
decisions made by producers and consumers.

Command Economy production decisions controlled by government.

1. Mixed Economy a mix of free market and government intervention.

2. Market Forces

3.
Downward sloping demand curve, effect of price on demand assuming all other
factions are constant.
P= Equilibrium Price
Q= Equilibrium Quantity

Generally , the lower the price the higher the demand due to 1. Substitution Effect the consumer buys more of one product than another
due to a relative price change.

2. Income effect the change in price of a good effects the purchasing power of
the consumers' income. Normally weak unless the expenditure is on the
goods is a large proportion of income.

Increase in demand due to price change = Expansion

Decrease in demand due to price change = Contraction
Conditions of demand assuming that price is held constant

A shift in demand to the right = increase in demand

A shift in demand to the left = decrease in demand
Conditions of Demand
Income for normal (discretionary)goods increasing income leads to a increase in
demand for these goods.
For inferior goods, a rise in income reduces demand, eg. Demand for public
transport substituted for private cars.
Tastes fashions may make demand for certain goods volatile, can be manipulated
by advertising where producers "create" markets.
Price of other goods goods may be complements or substitutes of each other
eg. The price of a car falls there may be a corresponding increase in demand for
tyres.
Population Increase in population immigration increases the demand for most
goods shifting demand outwards.

Price change - will result in a movement along the demand curve resulting in
either an expansion or contraction in demand.
Conditions of demand change there will be a shift in the demand curve
resulting in an inrease or decrease in demand.

Price Elasticity of Demand (PED)

PED = % Change in Quantity Demanded

% Change in Price

PED and Gradient Elasticity and gradient are not he same thing. The PED will
depend on where you are on the demand curve.

As the calculation of the PED moves down a linear curve from top left to bottom
right, elasticity falls in value, ie the curve becomes relatively more elastic.

Factors that effect PED

Proportion of income spent on the good if the good is a very small proportion
of income, price movements are unlikely to change demand, eg. Milk inelastic,
clothing elastic.c,
Substitutes and the availability of close alternatives will make demand more
elastic, as consumers will switch to competing brands. However a specialised
unique product will be relatively inelastic.
Necessities demand for essential products such as sugar, milk and bread tends
to be inelastic, however luxury items such as foreign holidays tends to be highly
elastic.
Habit addictive products tobacco, alcohol, drugs - inelastic
Time inelasticity may lessen in the long term as consumers discover alternatives.
Definition of the market widely defined food, few alternatives inelastic.
Specified more narrowly orange juice will create elasticity in the demand for
these brands.

Link Between PED and Total Revenue If Total revenue increases following a price cut, then demand is price elastic.
If Total revenue increases following a price rise then demand is price inelastic.

If total revenue remains unchanged following a price movement then demand is of

unitary elasticity.
Supply
Upward Shift
Supply curve, shows how much producers are willing to offer for sale at a given
price. Normally upward sloping to reflect the desire to profit form selling more
expensive goods.

As with the demand curve changes in price cause an expansion or contraction in

supply (up or down in the curve rather than a change in the curve itself).
Upward shift in supply caused by the cost of supply increasing. At existing prices
less will be supplied.

At price P the quantity supply shifts from Q to Q1, hence the supply curve shifts
from S2 to S1.
This could be caused by
Higher production costs or indirect taxes.
Supply

Downward Shift
This is an increase in supply at a given price curve shifts from S1 to S2, showing
that the cost of production has fallen. Lower unit costs may be caused by Technology innovations, more efficient use of factors of productivity, lower input
process, reduction of indirect taxes or additional subsidies.
Elasticity of Supply (PES)

A normal supply curve will slope upwards indicating that producers will supply more
at higher prices.
Increase in price = expansion
Decrease in price = contraction
The price elasticity of supply (PES) is positive
PES > 1 - price elastic supply
PES < 1 - price inelastic supply
PES = 1 unit elasticity
Factors that influence elasticity of supply.
Time Supply tends to be more elastic in the long term.

Factors of production the availability of trained labour, raw materials and spare
capacity will make supply more elastic.
Stock levels high stock levels of finished goods will make supply elastic.
Number of firms in the industry supply is more elastic the more firms there are in
the industry.

The Price Mechanism

This graph shows the intended demand and planned supply.

Point P shows where the consumer demand and supply plans of producers
correspond, the equilibrium point. P is the equilibrium price and Q the equilibrium
quantity. At prices and outputs other than (P,Q) either demand or supply aspirations
can be met not both at the same time.
For example
P1 consumers only want Q1, but producers are making Q2 available, leaving an
excess supply of Q1Q2 output. Eventually a reduction in price will lead to a
contraction in supply and an expansion in demand until equilibrium price P is
reached.
P2 conversely, at price P2, the quantity demanded Q2 will exceed the quantity
supplied Q3, leaving a shortage (Q2-Q3) representing excess demand. This demand
will show as back orders, empty shelves and high second hand values. The excess
demand will lead to a rise in the market price until equilibrium point P is reached.

Shifts in Supply and Demand

The more inelastic the supply or demand the more the price volatility following
shifts in either supply or demand. The longer term effects of these changes in the
market depend somewhat on the reactions of the consumers. The longer the
production period, the more inelastic the supply and the more volatile the price will
tend to be.
Price acts as a signal to sellers on what to produce
Price rises, with all other factors constant, will stimulate extra supply.
Equilibrium price is where the plans of both buyers and sellers are aligned.
Increase in demand due to consumer tastes changing.

D1 is the new consumer demand curve reflecting increased consumer appetite.

Supply in initially Q and fixed in the short term, causing the price to be bid up to P1.
Producers respond to this price stimulus by expanding the quantity supplied,
bringing the price down to P2, the new equilibrium price (above the old equilibrium
P).

Interference with market prices

Minimum Price
If a government seeks to ensure that a minimum price above the equilibrium price,
is set for a particular goods or service, this will create an excess of supply.
Eg. Setting a minimum wage can lead to unemployment, minimum commodity
prices can lead to excess storage of these commodities or the need to pay
producers not to grow the product.

Maximum Price
Where the government seeks to protect the low paid or to control inflation. This
maximum price must be set below the equilibrium price and will have the effect of
creating a shortage of supply. This shortage is Q1Q2

The problem arises maximum prices can lead to a misallocation of resources,

shortages of supply and arbitrary ways of allocating resources.
A consequence of this shortage can be the emergence of black markets, where the
sellers agree on an illegal price that is higher than the government sanctioned
maximum price.

The Common Agricultural Policy (CAP)

This is a buffer stock system with an external tariff which protects European
producers from foreign competition. The EU sets target prices for foodstuffs and
buys stocks at intervention prices if target prices are not achieved. The EU stores
surplus quantities of food and EU consumers pay a price above the market price.

Agricultural Prices and Cobweb theorem

Agricultural commodities are often regulated because of the inherent instability in

prices which is linked to supply issues. In the short run supply is inelastic, in that
increasing output takes time, ie. Plant seed, grow crop, harvest, produce finished
product.
Price fluctuations may be due to rapid changes in demand linked to consumer
tastes, exchange rates and cost of storage.
This combination of rapid changes in demand coupled with inelastic supply can
cause volatility in prices and income for producers. To prevent such price
fluctuations buffer stock systems have been developed by the worlds main
suppliers. They form cartels to regulate prices which are only allowed to fluctuate
within narrow ranges. They buy surpluses if excess supply threatens to push prices
through the floor. Alternatively they sell from stock if shortages threaten to push
prices through the ceiling. Thus providing fairly constant prices, the policy also
maintains stable income for producers.
Market Failure
In theory market forces should result in an equilibrium that provides the optimal
benefits for consumers. Market Failure is the failure of the market to allocate
resources in a way that maximises utility.
Public Goods These are the goods that would not be provided at all by a market
economy eg street lighting.
These have the following characteristics Non-excludability - Provision of the good/service for one member of society
automatically benefits the rest of society.
Non-rivalry consumption of the good by on person does not reduce the amount
available to others.
These 2 characteristics mean that a market for this type of goods can not exist.
Externalities
These are social costs or benefits that are not automatically included in the supply
or demand curves for the product or service. For example, take smoking and
drinking, the consumer pas part of the cost at the point of purchase. However the
social costs are met by society as a whole, eg. Burden on the health care system,
emergency treatment for drunk drivers. These are described as negative
externalities. The role of the government is to ensure that the management of these
externalities factored in to the decision making eg. the polluter pays policy, the
larger the tax the more significant the impact.

Imposing a tax on to the supplier, would shift the supply curve to the left, resulting
in an equilibrium with a higher price and lower quantity.

For pricing policies to maximise net social benefits they would need to consider
such externalities by
Calculate Social Costs
Use indirect taxes/subsidies
Extend private property rights
Regulations
Tradeable permits
Merit Goods
These are defined by their positive externalities positive social benefits in
consumption. Also, merit goods are seen as ones that should be available to al
irrespective of ability to pay. Government often provide these merit goods even
though these can be provided by the market.The private sector provides
alternatives to consumers with the means and willingness to pay for them.
Demerit Goods
Goods or services that are seen as unhealthy or undesirable. The concern is that a
free market results in an excess consumption of the goods, eg. Smoking, drinking,
drugs and gambling. The focus on demerit goods is the negative impact on the
consumer rather than externalities.

Chapter 4 The Competitive Process

Competition Rivalry
Different Levels

Competition for market share between roughly equal sized firms.

New markets growth can be shred, mature markets, growth comes at the
expense of someone else.
Competition around differentiation making price a key factor.

Market Failure and Government Regulation

Left unchecked, market forces may result in large companies who can abuse their
market power and hold their customers to ransom with excessively high prices.
This creates the need for government intervention to protect consumers from this
abuse.

Market Structures
Defined by buyers and sellers of goods/services willingly participating trading these
goods/services transacted in an underlying currency. The participants in these
trades require information on the prices of the goods/services being traded. This
price acts as a signal as well as an incentive.

Extreme forms of market defined by the number of suppliers in the market

Perfect Competition
Imperfect Competition oligopoly and duopoly
Monopoly

Market structures are defined according to the following criteria -

Structure number of firms, seller concentration, type of product, barriers to

entry.
Conduct: pricing behaviour, how much freedom do sellers have to set prices.
Efficiency Technical (production at the lowest cost), Allocative(use of
resources optimal to consumers), X- Inefficiency (high barriers to entry)
Profit

Markets can be segmented as follows Geography international, national, regional or local

Time demand and supply conditions can change depending on day of week or
season
Customer Type preferential discounts may be offered to regular customers

Market concentration this describes the phenomenon whereby the growth of firms
leads to a few large firms dominating an industry's output, sales and employment.
For example the five firm concentration ratio is over 85 % in the car, cement
tobacco and steel industries.
Aggregate concentration ratio this measures the share of the total production or
employment contributed by the top 100 firms in an industry. This growth in firm size
and rise in concentration ratios have occurred more by takeovers and mergers than
by internal growth.
The Growth of Firms

Internal Expansion or Integration (horizontal, vertical and diversification)

Horizontal larger retailers enjoy greater economies of scale, buying power etc. An
example being a larger retailer taking over a smaller retailer or technology sharing
Renault Nissan. Less common now due to anti-monopoly legislation.
Vertical one form moves into another stage of production through acquisition in
the same industry eg. Ross Foods purchasing a fleet of trawlers to control the supply
chain (backwards vertical integration). This gives the following advantages
elimination of transaction costs, increasing barriers to entry, securing supplies
improving distribution network, gaining economies of scale, making better use of
existing technologies.

Diversification a firm expanding into a business with which is was previously

unconnected. Examples being Virgin Records, EasyJet, Hitachi resulting in
conglomerates.
Other than short term profits, the goals for diversification can be Minimise risk from market fluctuations
Transfer of expertise
Economies of scale particularly in administration.
Vertical disintegration the hiving off of service or product centres in order to
reduce costs and concentrate on its core business.

Perfect Competition many buyers and sellers, behaving rationally with perfect
information about unbranded homogenous products. No barriers to entry exist to
the market and normal profits as abnormal profits/losses are removed by
competitive forces. These rarely exist in real life, the closest would be the stock
exchange or the local farmers markets. An implication is that since suppliers can sell
all their stock at a given price, there is no incentive to offer discounts. Conversely
profits are constrained as any attempts to raise prices will shift customers to the
competition.
This level of rivalry forces firms to operate at minimum costs implying technical
efficiency and the lowest prices suggest allocative efficiency.
Although and extreme, this model demonstrates that high levels of competition are
good for the consumer (low prices) and good for the economy (low costs).
The down sides being - lack of choice for consumer and limited profits which
constrain growth and innovation.
Monopoly

Conditions where a market has a single dominant producer and no substitutes or

competition.This can arise though high barriers to entry caused by
Legal barriers, patents of state control
Cost structure of industry- high startup costs
Integration to the extent that the monopolists control the full end to end business
process, making it hard for a new entrant to become established.
Rather than market forces determining the equilibrium price the monopolist can
choose whether to

They fix the price and let demand determine the amount supplied or
Fix supply and let demand determine the amount supplied

Price discrimination
Examples
Time Gym fees cheaper during off peak hours
Customer- non members at a golf club pay more
Income pensioners pay more
Place house calls cost more than surgery visits
These pricing strategies can be successful if several conditions are met At least two distinct markets with no seepage between them. If there was seepage
then enterprising consumers could buy the product in the lower priced market and
sell in the higher priced market, hence undercutting the monopolist.
Differing demand elasticities a higher price could be set in the more inelastic
market.

Imperfect Competition
Between perfect competition and monopoly several forms of market exist which
share characteristics of these two extremes.
Monopolistic Competition
Large numbers of producers supplying similar but not homogenous products.
Competition on price to gain market share at the expense of rivals.
Consumers lack perfect knowledge but have a choice.
Low barriers to entry, firms can enter and leave at little cost.
Prices higher than at perfect competition but consumers benefit from more choice.
Example the market for greeting cards.

Oligopoly
A few large firms with a high concentration ratio.
Behaviour of firms dependent on actions of rivals, with an interdependence on
decision making.
Consumers lack detailed product information and are susceptible to the strategies
of suppliers.
Very high barriers to entry due to entrenched market dominance involvement of
economies of scale. Advances in technology and global corporations can still
provide a challenge to established oligopolies.
Typical strategies for an oligopolistic firm Cooperate with other large firms within the constraints of competition legislation.
Make their own decision and ignore rivals - try to set higher price and behave like a
monopolist or risk a price war if a price cut is copied by rivals.
Become a price follower by awaiting the action of a price leader (firm behaves like a
price taker).
Avoid price based competition. Price stability is often associated with oligopolistic
behaviour as they cannot predict how rivals will behave. Instead there is substantial
non price competition eg. Advertising campaigns. Firms often produce multiple non
branded goods in the same market at different price points (not homogenous).
In the absence of collusion and price fixing does not occur, consumers may benefit
from an oligopoly through access to a wide range of branded goods, price stability
and after sales support.
A duopoly in once such example of the above.

Regulation
3 aspects which require government regulation
1. Mergers and Acquisitions monitored to see if the resulting organisation has
excessive power that may not be in the public interest. In the UK the
Competition and Markets Authority sets this threshold at 25%.
2. Restrictive Trade Practices collusion by suppliers over price fixing
undermines consumer power, in the UK the OFT investigates such anti
competitive behaviour.
3. State Created Regional Monopolies the process of privitisation of state
owned utility companies has created regional monopolies. Regulators such as
OFWAT have been setup to regulate pricing and minimum investment and set
an appropriate return for investments e. maximum ROCE.
The European Commission
The Treaty of Rome allows the European Commission to control behaviour of
monopolists and to increase the level of competition across Europe. An example is
the prevention of dual pricing. For example distillers sold whisky at higher prices in
France and tried to prevent British buyers from buying more cheaply in England and
selling at lower prices in France. The European court ruled against the distillers dual
pricing.

Public vs Private provision of goods and services

Public Sector includes public corporations (state post offices), government
departments (MOD) with a government minister exercising overall control, local
authorities, QUANGOS quasi autonomous non governmental organisations (health
authorities).
Arguments for nationalisation
Low costs potential economies of scale
Capital from government support
Provides uneconomic services for consumers and allows for these to be distributed
more fairly.
Allows strategic control of key resources.
Protects employment and minimises social costs keeping open uneconomic pits to
protect jobs and communities.
Gives a fairer distribution of wealth surpluses can be re-invested for the benefit of
society instead for profits for capitalist investors.
Privatisation

The transfer of ownership of a business, public service or property from the public
sector to businesses or to non profit organisations, includes government outsourcing.
Can be achieved by either selling state owned assets or the introduction of
competition between an existing monopoly of existing suppliers (deregulation and
competitive tendering).
Arguments for privatisation
Improve efficiency in state owned industries
Wider share ownership employees are more invested, work harder and strike less
Improved quality privatised companies have to compete to survive and have to be
more efficient and responsive to customers.
Greater economic freedom market forces are more influential than political forces.
Will provide funds for the treasury.
Arguments against privatisation
Fewer services and higher prices
Private monopolies are created
Quality of service diminished example G4S and London Olympics
Assets sales under priced
Only the profitable parts of the public sectors are sold off
Impact on the balance of payments dividends payments go abroad
Executive bonuses and high salaries stand in contrast with wage restraint.
Competition is not enhanced - due to the creation of local monopolies that require
the creation of regulatory control to manage investment and pricing decisions.
The poor suffer, water privatisation in developing countries, the poorest 20% of the
population spend 10% on water.
Pricing as many privatised companies are now private monopolies they are
expected to follow profit maximisation principles. This on it's own does not lead to
technical or allocative efficiency as this would require perfect competition. The
government therefore is obliged to create such competition.
Public Private Partnerships (private finance initiatives)
Private sector financing of public services, transfer of council housing to housing
association using private loans or the contracting out of refuse collection to a
private firm.

Perceived advantages are finances public projects without the need for
government borrowing or more taxes.
Risk transferred to the private firm, who will be paid less if they miss performance
targets.
Introduces private sector efficiencies such innovation and raises the quality of the
provision.
Critics of PFI point out
This method of finance is more expensive as the government has access to the
cheapet of funds.
How much risk is really transferred to the private companies as the government has
a record of bailing out private firms manage troubled public services.
Efficiency savings are made at the expense of quality of service eg. hospital
cleaning.
Public and Merit Goods revisited
Public goods are those for which no market exists, characterised by consumption by
one individual does not prevent someone else from benefiting. This allows freeriders benefit from the service even though they would not be prepared to pay for
it. Hence Defence is provided at zero price but tax payers fund the service. As the
government can proide the services in bulk technical efficiencies could be achieved
through economies of scale.eack of choice.
Merit goods, which the government provides for the benefit of society and it's
general wellbeing have alternatives from the private sector eg private health,
private education, private security. In the case of merit goods provided by the
government, technical efficiency can be sought (state education is one third the
cost of private on a per pupil basis). This technical efficiency cannot be maximised
as in practice it has proven difficult to close local schools and hospitals. Free
marketeers would point out that zero pricing goes against allocative efficiency.

Chapter 5 - The Financial System 1

The Financial system is composed of 3 parts
Financial Markets Stock and bonds, Money, Commodity, Derivatives, Insurance and
Foreign exchange markets
Financial Institutions
Financial Assets and Liabilities

Financial Intermediaries their job is to match entities with trading surpluses who
seek to invest and make an economic return with parties who wish to borrow to
improve their liquidity position.
These two groups of end user can choose to interact in 3 way
1. Contact each other directly
2. Lenders and borrowers use an organised financial market
3. Lenders and borrowers use intermediaries.
Financial Intermediaries have a number of important roles.
Risk Reduction lending to a wide range of individuals mitigates the risk of a single
default causing a significant wipe out of assets.le d
Aggregation by pooling a large number of small deposits, intermediaries can make
larger advances than would otherwise be possible.
Maturity Transformation typically borrowers want to borrow for the long term and
savers do not want their money tied up for a long time. Financial intermediaries with
their floating pool of resources are able to satisfy both sets of conflicting
requirements.
Financial Intermediation the process by which financial intermediaries bring
together lenders and borrowers.
Liquidity Surpluses and Deficits
The lack k of synchronisation between payments and receipts effects businesses,
individuals and government.