Longwood University

Personal Finance

Scott Wentland

wentlandsa@longwood.edu

434-395-2160Longwood University

201 High StreetFarmville, VA 23901

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Markets

Part 1 – What are markets?

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Individuals and Value

• Where does value really come from? – Individuals (last lecture)

• Looked at how individuals determine value for themselves (subjective value for goods we consume)

• Individuals think “on the margin”– Diamonds are more valuable than water, because an additional

diamond makes us much happier than an additional bottle of water (assuming we’re not in desert)

– But this story is incomplete…• Diamonds would be valuable to you, even if you didn’t

like diamonds…

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Markets and Value

• Even if you didn’t like diamonds, you could always sell a diamond on the market…– Markets (this lecture)

• Markets are made up of individuals (consumers and producers) who trade with one another

– Buying/selling is the market’s way to address scarcity– Prices help buyers and sellers make good decisions and help

make the market “efficient”

• Markets can be best understood by understanding the laws of supply and demand

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What is a market?

• Markets are everywhere and anywhere, where people buy and sell something for a price– This is a VERY general definition– Examples:

• Stock market• Shopping mall or flea market• Grocery store• Street corner (illegal or black markets are still markets)• Ebay or Amazon (markets don’t have to even be a

physical place)• Labor market (selling your services…wage = price)

– Prices don’t even have to be in cash, they can be barter exchanges

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Why markets?

• Why do we have markets? – We don’t live in a world where everyone begins

with everything he or she will ever want/need– We learn this at lunch in grade school

• Mom packed pudding, I want chips• Joe’s mom packed chips, Joe wants pudding

– I trade my pudding for Joe’s chips– We’re both happier a more efficient allocation

• Markets help us allocate resources efficiently– (This is just one of many things markets do…)

• Why is resource allocation important?

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Scarcity

• We live in a world of scarcity– Humans have infinite wants and needs

• Our resources are finite.

– In economics, scarcity is the idea that our wants/needs exceed our resources

• Even if our physical resources were infinite, we would still be constrained by time we cannot escape scarcity

• Markets help us get the most out of what we’ve got– Also provide incentives for advancement (more on

this later)

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Markets vs. Central Planning

• An economy that lets markets (i.e. buyers/sellers) produce, control, and allocate resources is a market economy. – Goods and services are freely traded at mutually

agreeable prices– Factors of production (land, labor, capital) or inputs are

primarily owned privately (not by government)– Low government involvement in the day-to-day economy– Also called capitalism, free market capitalism, or

laissez faire capitalism

• Are markets the only way to allocate resources?

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Markets vs. Central Planning

• Planned (or command) economy – The government (or “The People”):

• Decides what to produce, who produces it, and who gets it

• Decide how resources are allocated• Own the factors of production (land/natural resources,

labor, capital) and plan how they are used• Buying and selling in markets are largely prohibited

– Also called central planning or communism

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A Spectrum of Economies

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A Spectrum of Economies

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A Spectrum of Economies

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A Spectrum of Economies

Also called “mixed economies”…most economies are “mixed”

Next lecture: how do markets work?

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Markets

Part 2 – How do markets work?

A (very brief) intro to supply & demand

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How do markets work?

• Supply and demand– Supply represents the sellers

• In a pure free market many sellers

– Demand represents the buyers• In a pure free market many buyers

• In markets, buyers and sellers come together to exchange– For any given good, a price emerges as a market

price, as a result of negotiations between them

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Demand

• Consumer have a limited income and want to maximize utility (or happiness)– Buyers always want the lowest price they can get– When something becomes cheap, consumers tend

to buy more– When something becomes expensive, consumers

economize and cut back on quantity of that

• Common sense, right?

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Law of Demand

• Law of demand: “an increase in a product’s price results in a decrease in quantity demanded” holding all else constant1. Income

2. # of buyers in the market

3. Prices of other goods 1. Substitutes

2. Complements

4. Expectations

5. Tastes

• These may “shift demand” if they change– More about that in a full microeconomics course…

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Demand CurveThe Demand Curve for Oil is a Function Showing the Quantity of Oil

Demanded at Different PricesPrice of Oil per Barrel

Quantity of Oil (MBD)

$55

$5

$20

5 5025

Demand

PriceQuantity Demanded

$55 5

$20 25

$5 50

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Supply

• Producers/sellers want to maximize profit– Profit margin = Price – Average Cost

• They always want the highest price they can get

– When something becomes more expensive, businesses want to supply/sell more of their product

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Law of Supply

• Law of supply: “an increase in a product’s price will result in an increase in quantity supplied by the market” holding all else constant

• Holding what else constant?

1. Technological Innovations

2. Input Prices

3. Taxes and Subsidies

4. Expectations

5. Entry or Exit of Producers

6. Changes in Opportunity Costs

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Supply CurveThe Supply Curve for Oil is a Function Showing the Quantity of Oil

Supplied at Different Prices

Quantity of Oil (MBD)

Price of Oil per Barrel Supply Curve for Oil

503010

$5

$20

$55

PriceQuantity Supplied

$55 50

$20 30

$5 10

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Equilibrium

• Buyers want the lowest price• Sellers want the highest price

– When they come together, they generally meet somewhere in the middle

– They work out mutually beneficial exchanges and a market price emerges

• Supply = Demand

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Equilibrium

Demand Curve

Supply Curve

65

$30Equilibrium

Price

Equilibrium Quantity

Quantity of Oil (MBD)

Price of Oil per Barrel

Price is Determined by Supply and Demand

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In Equilibrium

• An optimal price emerges out of buyers and sellers interacting in the market

• Why is this price optimal or efficient?# Supplied = # Demanded (at the equilibrium price)– The lowest cost, most efficient sellers are the ones

who supply at that price– The highest valued buyers are the ones who buy at

that price– All possible mutually beneficial trades have taken

place at that price• There are no sellers left who want to sell at a price that

another buyer would agree to.

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In Equilibrium

• If we were to design an allocation of stuff at the beginning we would want: – The people who are best, lowest cost producers to

make stuff• We don’t want people in Alaska to grow oranges

wasteful and inefficient

– The people who have the highest value for stuff to get it and consume it

• We don’t want people who don’t like oranges to get them wasteful and inefficient

• Markets get us this efficient outcome, without anyone planning it

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Equilibrium

• An equilibrium will emerge in any free market– Check Ebay for the price of a specific product

• Buyers bid until a price settles on some equilibrium price• If a similar item goes up for auction, it sells for about the

same amount (assuming nothing else has changed)

– Compare travel sites for any given flight• Equilibrium price is very close

• That equilibrium may change, as other things that affect supply and demand change– Supply and demand conditions constantly change– Markets are dynamic prices change

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Value

• Back to our diamond/water paradox…– Diamonds are also valuable because they have a high

market price as a result of supply and demand• In the last lecture, we talked about from an individual

buyer’s perspective• Here, we take the entire market perspective

– Diamonds have a: • Low supply

– very rare, hard to find, labor intensive, few sellers

• High demand– Many uses, many buyers want them relative to supply

• High price.

– Water’s low market price is largely due to high supply

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Conclusions

• Understanding markets through supply and demand helps us understand– Value and prices in a market economy– How market economies allocate resources efficiently

• Full microeconomics course– Learn a lot more about supply and demand

• How to use supply and demand to understand markets better

• Predict prices based on particular events• Predict how certain government policies (e.g. minimum

wage) affects markets

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Thank You

http://en.wikipedia.org/wiki/Scarcity

http://en.wikipedia.org/wiki/Market_economy

http://en.wikipedia.org/wiki/Social_market_economy

http://en.wikipedia.org/wiki/Planned_economy

http://en.wikipedia.org/wiki/Factors_of_production

http://en.wikipedia.org/wiki/Supply_and_demand