Economics for Educatorseconomicstexas.org/wp-content/uploads/2011/10/Binder6.pdf · 35 Economics...
Transcript of Economics for Educatorseconomicstexas.org/wp-content/uploads/2011/10/Binder6.pdf · 35 Economics...
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Economics for Educators Revised Edition
Lesson 6 and 5E Model
Robert F. Hodgin, Ph.D. Texas Council on Economic Education
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ii Economics for Educators, Revised
Copyright © 2012 Texas Council on Economic Education All Rights Reserved
Texas Council on Economic Education
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30 Economics for Educators, Revised
Lesson 6: How Markets Coordinate Exchange Exchange Creates Wealth People trade because when they do, the wealth of both buyer and seller increases. Some regard that statement skeptically because “trade” carries a poor connotation. Should trade between two people not be an exchange of equals? Some people are wedded to the idea that only material things like property, cars, or gold constitute wealth. Neither sentiment is correct to an economist. Wealth gets confused with material well-being—as opposed to perceived value, the preferred and far more useful economic idea. Consider that no object is “wealth” unless someone values it. An object’s value is entirely subjective, and it depends solely on the willingness of admirers to sacrifice something to acquire it. Once that idea about value is accepted, it becomes clear that exchange occurs when there is a tradable difference in a good’s value—providing an increase in wealth to each party in the transaction. Information also is a good that has value. Because economic actions are undertaken based on expectations about the future and the future is never certain. A used car purchase, for example, may look superficially worthy. Once acquired, latent defects could surface to reduce or destroy the value anticipated by the buyer prior to the exchange. Buyer and seller possess unequal amounts of information, and the seller often holds the favored position. Acquiring additional information has an economic value as well as a cost. This difference in information between buyer and seller may affect negotiating power and the outcome of the exchange. Market Price as a Signal Much like the two cutting blades on a pair of scissors, price in the market place is determined by the interplay between supply and demand. Market actors—buyers and sellers—can efficiently exchange private goods because market price serves as a signal, telling those wanting the good the size of the sacrifice—opportunity cost—others have paid to acquire it. A market exists anywhere a transaction between buyer and seller occurs. Free and competitive markets efficiently allocate goods and services through an anonymously determined market price reflecting substitutes available to buyers and the expectations of sellers, at a particular moment. Market equilibrium price works as a beacon, coordinating the choices of buyer and seller by providing at least one measure of a good’s current worth—the market’s value. That value turns away those buyers seeking less expensive options and those sellers whose production costs are too high, while attracting others who may be more able to find a favorable price for the exchange. The more open, competitive and informed the market’s bargaining processes, the more efficient is the allocation of relatively scarce private goods. In economics, efficiency implies several things. Most fundamentally, it means that goods are sold at a price equal to opportunity cost. Efficiency also means that goods flow to their most highly valued use.
Texas Council on Economic Education
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31 Economics for Educators, Revised
The lower the transaction costs—costs of arranging transactions between buyer and seller—the more efficient is the market. The clearer and more accepted the property rights—what belongs to whom under what circumstances—the more efficient is the market. You can see how the efficiency mantra pervades all aspects of production, exchange and distribution in economics. Choices and Trade-offs at the Margin To the untrained eye, market processes can appear chaotic and directionless. Using economics’ fundamental division, buyers versus sellers, then separating time into current and future periods, allows market dynamics to make sense. In the chart below, market demand (in blue) slopes down to the right and market supply (in green) slopes up to the right, the two lines cross at a quantity of 5 units.
To the right of their intersection, both curves are dotted to suggest that no transactions can occur there. The only area where transactions can logically occur is in the reddish-silver triangular area bounded by the solid blue upper range of the demand curve and the solid red lower range of the supply curve up to their intersection. Why is this so? The reddish-silver triangular area is the only place where a potentially negotiable price is both below the maximum demand price for some buyers and above the minimum opportunity supply cost for some sellers. Buyers know their maximum value price for a good and wish to pay that price or less. Sellers know the minimum opportunity costs of bringing the good to market and wish to get that price or more.
Texas Council on Economic Education
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32 Economics for Educators, Revised
The intersection of the demand and supply schedules reveals the market equilibrium price, where the quantity demanded just equals the quantity supplied. While competitive market exchanges tend toward an equilibrating price that will clear the market of goods, not all prices negotiated between buyers and sellers will be at the equilibrium amount. Any transaction completed in the reddish-silver triangular area will be for a price no higher than some buyer’s maximum value and no lower than some supplier’s minimum cost. Higher equilibrium prices indicate that sellers held the stronger bargaining position and lower equilibrium prices indicate that buyers held the stronger position in the market. Now look once more at the point of equilibrium in the graph—where the demand and supply curves meet. At that point it can be said that the price of the good reflects the opportunity value of the “last” purchaser and, at the same instant, the opportunity cost of the “last” seller in that market. Someone did purchase the 5th unit of the good at the equilibrium price. For that buyer the sacrifice was just worth the exchange. Also as clearly, some producer sold the good at the market equilibrium price. For that producer the sale just covered all production opportunity costs—including a minimum profit. For all units of the good sold at that particular equilibrium, and at that time, market value just equaled the opportunity cost value to the last buyer and to the last seller. Other buyers in the market place held different and higher values for the good. Other sellers in the market place held different and lower opportunity costs of production for the good. Some buyers could have paid less than market equilibrium price and reaped the extra value. Some sellers could have sold for more than market equilibrium price and reaped the extra profits. Equilibrium Responses to Non-price Changes So far this discussion has focused on the short run time period where current market price reflects the quantity demanded and the quantity supplied. What happens to equilibrium price when non-price market forces cause demand or supply to shift?
Three steps to assess equilibrium effects of market change � Determine if the force affects the demand or the supply curve � Decide the direction the curve shifts—increase (rightward) or decrease (leftward) � Note the change in equilibrium price and quantity from the original demand and
supply curve intersection to the resulting demand and supply equilibrium. From the facts given in a situation, the first step means to determine if the market force pertains to buyers—the demand side, or to producers—the supply side. Next, reason through which particular force is at work for that side of the market, then note its direction. Shift the demand or supply curve in the appropriate direction—increases to the right or decreases to the left. Finally, compared to the original equilibrium price and quantity, note the position of the new equilibrium price and quantity.
Texas Council on Economic Education
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33 Economics for Educators, Revised
Inspect the chart above. See how the current market demand schedule (in blue) and the current market supply schedule (in green) together determine the market equilibrium Price (= $5) and quantity (= 5 units) for a good. Now suppose that buyers believe the future market price of the good will increase, and that sellers perceive the same thing to be true. What will happen to market equilibrium price—and why? Step 1: How to shift demand? Recall when buyers believe prices will rise in the future they tend to buy more now, at all current prices. That is an INcrease in demand, a shift to the right from the blue demand to the dotted blue demand curve, labeled B. Step 2: How to shift supply? Suppliers will want to restrict current supply (if the good is not perishable) and sell later at the higher expected price. That is a DEcrease in supply, a shift to the left from the green supply to the dotted green supply curve labeled A. Step 3: What is the effect on equilibrium price and quantity? The blue demand has increased to the now higher demand (more units are demanded at each price) labeled B. The green supply has decreased to the now “lower” supply (fewer units are supplied at each price) labeled A. The increased demand and decreased supply together raise the market equilibrium price to $7 and lower the equilibrium quantity to 4.5 units. When both demand and supply shift, it is necessary to work through the logic to correctly determine the effect on the resulting equilibrium price and quantity in the market.
Texas Council on Economic Education
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34 Economics for Educators, Revised
In Sum
� Trade creates wealth because both parties perceive a gain in a voluntary exchange. � An economic good provides wealth only to someone who values it. � A market exists anywhere an exchange transaction occurs. � The forces of supply and demand working together efficiently determine market equilibrium price when:
o Competitive markets tend toward an equilibrium price—one that clears the market, and o Many buyers and sellers exist to bargain freely when market information and mobility costs are low o Property rights—what belongs to whom under what conditions are known and respected o Transactions costs—the costs of completing a transaction are low
� Efficient markets in economics means: o Goods are produced at their opportunity cost and exchanged for their perceived value o Goods flow to their highest valued use o Market exchanges occur when the buyer’s maximum willing price exceeds the seller’s minimum offer price. o Market equilibrium is a tendency where the exchange price for the last buyer and last seller in that market are equal.
� Non-price market forces shift either the demand or supply curve and alter the market equilibrium price and quantity. Starting from a given demand and supply intersection with a given equilibrium price and quantity, the following are true:
o Increased demand (supply constant)—a rightward shift, increases both equilibrium price and quantity. o Decreased demand (supply constant)—a leftward shift, decreases both equilibrium price and quantity. o Increased supply (demand constant)—a rightward shift, decreases equilibrium price and increases equilibrium
quantity. o Decreased supply (demand constant)—a leftward shift, increases equilibrium price and decreases equilibrium quantity.
Texas Council on Economic Education
o Mixed movements in demand and supply must be determined using the facts in the problem statement. Equilibrium price and quantity can rise, fall or stay the same.
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35 Economics for Educators, Revised
Lesson 7: Competition, Market Power and Economic Efficiency Market Power and the Structure of Industry The economics of industry is about market power—the power to set product price, gain market share and improve profits. The study of economic welfare, where the social goal is to efficiently solve the economic problem for all citizens—prefers competitive markets above all others. For it is only purely competitive producers, due to their individual powerlessness to affect price, that offer society the most output at no more than the opportunity cost to produce it as firms pursue profit maximization. In stark contrast, monopolistic markets permit the ruling firm to restrict output and raise the price for their production as they search for the price, above opportunity cost, that maximizes their profit. Between the polar market structures of competition and monopoly lie two others: monopolistic competition—a blend of competitive extremes; and oligopoly—a peculiarly postured industry where a few large firms strategically spar for market share in game-like fashion. Competition’s Efficiency Promise Perfect competition is a fiction, though a highly useful one. It serves as an ideal against which to compare diversions from the economically desirable position of maximum efficiency and output. Much of competition’s value rests in its ability to show just how far from the ideal other market solutions may lie. Many public policies also can be judged against their progress toward reaching selected competitive criteria. Since perfect competition resides only in the economist’s mind, what does it look like and what is its logic? The industry characteristics that create this idealized market structure include the following: very many buyers and sellers; identical products; costless entry into and exit from the market; perfect market information and costless market mobility. These characteristics combine to form a market where no one actor—buyer or seller—or small group of actors can influence market equilibrium results. Competitors have no price-setting power. The market for selling and buying corn comes close to these requirements. Fast, faceless and efficient exchanges work through market demand and supply to achieve an equilibrium price that clears the market.
Texas Council on Economic Education
So powerless is each competitive seller to affect market price that they can only accept the established equilibrium price as the per unit revenue they will receive for selling their product. Effectively, their demand curve is horizontal (completely elastic). The result is that the only decision a producer needs to make for a current cycle is to choose the level of production.
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1801
Alle
n P
arkw
ay *
Hou
ston
, TX
770
19 *
(71
3)65
5-16
50 *
Fax
: (71
3)65
5-16
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ail:
tcee
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onom
icst
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Page
| 20
Less
on 6
: H
ow M
arke
ts C
oord
inat
e Ex
chan
ge,
pag
e 3
0
Eng
age
Dem
and
1. W
hat
is a
pro
duct
you
rea
lly w
ish
to p
urch
ase
but
lack
the
fun
ding
?
2.W
hat
are
the
char
acte
rist
ics
you
seek
in t
he p
rodu
ct?
3.
Wha
t w
ould
you
rea
lly li
ke t
o pa
y?
4.W
hat
is a
rea
listic
price
do
you
wan
t to
pay
and
why
?
Sup
ply
5.Yo
u ar
e a
supp
lier
of t
hat
prod
uct.
W
hat
char
acte
rist
ics
wou
ld y
ou p
rovi
de
at v
ario
us p
rice
s?
Why
?6.
Wha
t w
ould
you
REA
LLY
like
to c
harg
e fo
r th
e pr
oduc
t?
As
a se
ller
wha
t pr
ice
wou
ld b
e a
fair o
ne for
you
r bu
sine
ss in
vest
men
ts t
hat
wou
ld
attr
act
buye
rs?
The
answ
ers
will
var
y.
The
answ
ers
will
var
y, b
ut
be
sure
to
str
ess
that
su
pp
liers
wan
t to
ch
arg
e h
igh
er p
rice
s to
incr
ease
th
eir
pro
fits
an
d t
hat
th
ere
are
pri
ces
that
are
to
o
low
to
acc
ept
wh
en c
osts
are
not
cov
ered
.
Exp
lore
Vie
w t
he g
raph
bel
ow t
o an
swer
the
nex
t th
ree
ques
tions
.
Whe
re d
oes
your
#3
pric
e fr
om q
uest
ions
abo
ve f
all?
Whe
re d
oes
your
#6
pric
e fr
om q
uest
ions
abo
ve f
all?
Wha
t is
the
equ
ilibr
ium
price
tha
t w
ill a
llow
the
buy
er a
nd s
elle
r to
com
e to
an
agre
emen
t?
(#4
and
# 7
fro
m q
uest
ions
abo
ve)
#3
Will
ing
bu
yers
bu
t n
o s
elle
rs.
#6
Will
ing
sel
lers
bu
t n
o b
uye
rs.
#4
an
d #
7 w
ill m
eet
at t
he
big
eq
uili
bri
um
po
int
at $
5 m
arke
t p
rice
an
d 5
q
uan
tity
bo
ug
ht
and
so
ld.
Th
is i
s so
met
imes
cal
led
th
e m
arri
age
of
sup
ply
an
d d
eman
d.
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1801
Alle
n P
arkw
ay *
Hou
ston
, TX
770
19 *
(71
3)65
5-16
50 *
Fax
: (71
3)65
5-16
55
Em
ail:
tcee
@ec
onom
icst
exas
.org
* w
ww
.eco
nom
icst
exas
.org
Page
| 21
Exp
lain
In v
iew
ing
the
grap
h, d
escr
ibe
the
four
“qu
adra
nts”
and
exp
lain
why
the
buy
ers
and
selle
rs r
eact
the
way
tha
t th
ey d
o.
Top
are
a:
The
pri
ce is
too
hig
h f
or b
uye
rs b
ut
wou
ld r
eap
gre
ater
pro
fit
for
the
selle
r O
R t
he
op
po
rtu
nit
y to
sp
end
mo
re o
n f
acto
rs o
f p
rod
uct
ion
.
Rig
ht
area
: T
he
pri
ce is
to
o lo
w f
or
selle
rs t
o m
ake
a p
rofi
t o
r to
o h
igh
fo
r th
e b
uye
rs t
o p
ay f
or
the
tru
e va
lue
of
the
pro
du
ct.
Bo
tto
m a
rea:
Th
e p
rice
is
very
lo
w a
nd
wo
uld
be
ple
asin
g t
o t
he
bu
yer
bu
t th
e se
ller
can
no
t co
ver
exp
ense
s.
Left
are
a:
The
“mid
dle
are
a” o
f th
e le
ft a
rea
rep
rese
nts
a p
rice
th
at a
bu
yer
wo
uld
co
nsi
der
fai
r an
d t
he
selle
r w
ou
ld b
e ab
le t
o j
ust
ify.
Exte
nd
Cho
ose
a pr
oduc
t th
at y
ou b
uy o
n a
regu
lar
basi
s. W
hat
mar
ket
forc
es w
ould
ca
use
you
to b
uy m
ore
or le
ss o
f th
e ite
m?
Wha
t m
arke
t fo
rces
wou
ld c
ause
the
sel
ler
to s
uppl
y th
e pr
oduc
t at
a lo
wer
price
th
an t
heir e
quili
briu
m p
rice
? H
ighe
r pr
ice?
As
a b
uye
r th
e p
rod
uct
may
hav
e g
on
e o
n s
ale
or
the
per
ceiv
ed f
utu
re p
rice
h
as in
crea
sed
.
A n
ew p
rod
uct
wit
h i
mp
rove
d,
bet
ter
and
/o
r n
ewer
fea
ture
s h
as e
nte
red
th
e m
arke
t o
r w
ill s
oo
n.
Bu
yers
may
red
uce
th
eir
dem
and
fo
r th
e cu
rren
t p
rod
uct
an
d s
up
plie
rs m
ay r
estr
ict
thei
r p
rod
uct
ion
.
Tech
no
log
y fo
r p
rod
uct
ion
of
the
pro
du
ct h
as b
eco
me
mo
re e
con
om
ical
so
th
e su
pp
lier
can
su
pp
ly m
ore
at
a lo
wer
pri
ce.
The
sup
plie
r co
uld
res
tric
t th
e q
uan
tity
of
go
od
s o
n t
he
mar
ket
to m
ain
tain
a
hig
her
pri
ce.
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1801
Alle
n P
arkw
ay *
Hou
ston
, TX
770
19 *
(71
3)65
5-16
50 *
Fax
: (71
3)65
5-16
55
Em
ail:
tcee
@ec
onom
icst
exas
.org
* w
ww
.eco
nom
icst
exas
.org
Eval
uat
e
Cho
ose
a pr
oduc
t yo
u w
ould
like
to
prod
uce.
�
Res
earc
h th
e co
st o
f th
e fa
ctor
s of
pro
duct
ion.
�
Dev
elop
a b
udge
t an
d a
proj
ecte
d pr
ice
you
feel
is fai
r fo
r yo
u an
d fo
r th
e bu
yer.
�Cre
ate
a Po
wer
Poin
t sh
ow w
ith s
lides
tha
t sh
ow y
our
prod
uct,
the
cos
t of
fa
ctor
s of
pro
duct
ion
and
your
sou
rce
for
info
rmat
ion,
a b
udge
t, s
uppl
y an
d de
man
d ch
art
show
ing
equi
librium
, an
d a
mar
ketin
g sl
ide
to c
onvi
nce
cons
umer
s th
at y
ours
is t
he b
est
prod
uct
for
the
best
price
on
the
mar
ket.
Page
| 22
Ru
bri
c:1
0 p
oin
ts C
reat
ivit
y of
Pow
erP
oin
t 1
0 p
oin
ts P
roto
typ
e of
pro
du
ct
30
poi
nts
Cos
t of
Fac
tors
of
Pro
du
ctio
n
10
po
ints
So
urc
es
20
poi
nts
Gra
ph
sh
owin
g e
qu
ilib
riu
m a
nd
exp
lan
atio
n
2
0 p
oin
ts M
arke
tin
g
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The Texas Council on Economic Education (TCEE) thanks the Council for Economic Education and the Department of Education Office of Innovation and Improvement for awarding the Replication of Best Practices Program grant that allowed Economics for Educators, Revised Edition to be written and published.
The Texas Council on Economic Education also thanks six of its major partners whose support allows TCEE to provide the staff development that utilizes content and skills provided in Economics for Educators.
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