ECONOMICS FOR BUSINESS

MARKET FORCES

Marco Merelli

Mumbai | India
CONTENTS:

• Economists and their models

• Microeconomics

• Market forces: demand and supply

• Market equilibrium

• Consumer’s and producer’s surplus

• The efficiency of the market

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 WHAT IS ECONOMICS?

• Economics studies how society (and its members) manages its scarce resources that can
be applied to alternative uses.
• In our daily lives, we constantly make choices to achieve our goals. These choices are
not just preferences; they are a necessity. Why? Because we live in a world where our
desires are limitless, but the resources to fulfill them are not. This is what we call
scarcity.
• Economics studies the interactions between households and firms concerning the
exchange and the many decisions made.
• Economics explores how people make a living, how resources are allocated among the
many different uses they could be put to, and how our activities influence not only our
well-being but also that of others and the environment.

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 THINKING LIKE AN ECONOMIST

• Economics is a field of study with its own unique terminology, such as supply,
opportunity cost, elasticity, consumer surplus, demand, deadweight loss, marginal
cost, efficiency, short and long run, market equilibrium, …

• Economics trains you to. . . .

• Think in terms of alternatives.
• Evaluate the cost and benefit of individual and social choices.
• Examine how certain events and issues are related.
• Understand the alternatives available to policy-makers.

• Economists study these choices using economic models: simplified versions of reality
to analyze real-world economic situations. However, it is not just a theoretical
concept but a practical tool that can be applied to real-life and business situations.
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 ECONOMIC MODELS

• It is often worth thinking of models that architects use to show how a building will look. The model
will provide the observer with an image of what the eventual building will look like. It shows its
key features and helps in understanding the scale of the building and how it integrates with its
surroundings and main structures.
• Similarly, economists use models to represent the world around them. We use models to
represent how markets work, how the economy as a whole works, how consumers behave, and
how firms behave. Economists use models to simplify reality to improve our understanding of the
world. Thus, models are not meant to represent every feature, nuance, or aspect of the real world
it is attempting to explain.
• These models are based on assumptions. These assumptions help predict players’ decisions in an
economy and how different players use scarce resources.
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ECONOMIC MODELS: AN EXAMPLE

The Circular Flow diagram

• is a visual economic
model showing how
money flows through
markets among
households and firms.

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 MACROECONOMICS VS. MICROECONOMICS

• Macroeconomics looks at the economy as a whole. Economy-wide phenomena,

including inflation, unemployment, and economic growth
• Microeconomics focuses on the individual parts of the economy. How households
and firms make decisions and how they interact in specific markets
• Managerial Economics: how to direct scarce resources in the way that most
efficiently achieves a managerial goal.

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WHAT IS A MARKET?
• A market is a group of buyers and sellers of a particular good or
service: Buyers determine demand; Sellers determine supply.
• The terms supply and demand refer to people’s behavior as they
interact with one another in markets. Supply and demand are the
forces that make market economies work.
• The market may be physical like a retail outlet, where people meet
face-to-face, or virtual like an online market, where there is no direct
physical contact between buyers and sellers.
• In a market for a particular product, either the demand and/or the
supply can be concentrated (a monopoly in the case of one seller) or
fragmented (competition in the case of many sellers).
• A competitive market is a market in which there are many buyers and
sellers, so each has a negligible impact on the market price.
• A market is also defined by geography (eg, physical and legal
restrictions) and time.

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THE DEMAND SIDE OF THE MARKET

Which factors have influenced your choice to apply for a master’s program?

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THE DEMAND CURVE

• The quantity demanded of any good is the amount of the good that buyers are
willing and able to purchase at different prices.
• Many things determine the quantity demanded of any good, but one
determinant plays a central role: the price of the good.
• The demand curve (or schedule) is the relationship between the price of the
good and the quantity demanded, other things equal (“ceteris paribus”).
• The Law of Demand states that, other things equal (“ceteris paribus”), the
quantity demanded of a good falls when the price of the good rises.

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DEMAND SCHEDULE AND CURVE

Price Quantity Price

Change in Quantity
0 12
€12 Demanded: movement
1 11
along the demand curve.
2 10
10 Caused by a change in the
3 9
price of the product other
4 8 1. A decrease
in price ...
8 things equal.
5 7
6 6
6
7 5
8 4 4
9 3
10 2 2
11 1
12 0
0 1 2 3 4 5 6 7 8 9 10 11 12
Quantity
2. ...increases quantity demanded
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Copyright © 2004 South-Western
 MARKET DEMAND CURVE
• Market demand refers to the sum of all individual demands for a particular good or service.
• Graphically, individual demand curves are summed horizontally to obtain the market demand curve.

individual demand 1 + individual demand 2 = Market demand

At 12 EUR, the total quantity is 2 + 0 = 2

At 4 EUR, the total quantity is 6 + 2 = 8

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 SHIFTS IN THE DEMAND CURVE

Change in Demand:

A shift in the demand curve, either to

the left (decrease in demand) or to the
right (increase in demand).

This is caused by any change that alters

the quantity demanded at every price.

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 SHIFTS IN THE DEMAND CURVE

Drivers of shifts:
• Consumer income
• Normal good: as income increases, the demand will increase
• Inferior good: as income increases, the demand will decrease
• Prices of related goods
• Substitutes: when a fall in the price of one good reduces the demand for
another good
• Complements: when a fall in the price of one good increases the demand for
another good
• Tastes
• Price expectations
• Number of buyers
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 SHIFTS IN DEMAND CURVE

An increase in the quantity demanded

can be the outcome of:
• an increase in income
(if the good is “normal”);
• a decrease in income
(if the good is “inferior”);
• an increase in the price of a
substitute good;
• a decrease in the price of a
complementary good
• …..

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 THE SUPPLY CURVE

• The Supply curve (or schedule) is the relationship between the price of the good
and the quantity supplied.
• Law of Supply states that, other things equal, the quantity supplied of a good
rises when the price of the good rises.
• Quantity supplied is the amount of a good that sellers are willing and able to sell.

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SUPPLY SCHEDULE AND CURVE
Price
Price Quantity
1 0
Change in Quantity Supplied:
€6
Movement along the supply
2 1
curve.
3 2
5

4 3 Caused by a change in anything

4 that alters the quantity supplied
5 4
at each price other things equal.
6 5 3
1. An
increase
in price ... 2

0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity

2. ... increases quantity supplied.

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FIRM AND MARKET SUPPLY

Market supply refers to the sum of all individual supplies for all sellers of
a particular good or service. Graphically, individual supply curves are
summed horizontally to obtain the market supply curve.

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 SHIFTS IN THE SUPPLY CURVE

Change in Supply
A shift in the supply curve, either to
the left (decrease in supply) or to
the right (increase in supply).
This is caused by a change in a
determinant other than price:
a) Input prices
b)Technology
c) number of sellers

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 SHIFTS IN THE SUPPLY CURVE

An increase in quantity Price €6

demanded can be the
outcome of: 5

• a decrease in wages or 1. At the

4
other inputs same price
3
• a better technology
2
• an increase in the
number of sellers 1

0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity
2. ... increases quantity supplied.
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Copyright©2003 Southwestern/Thomson Learning
SUPPLY AND DEMAND TOGETHER

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 Supply and demand together
• Market equilibrium refers to a situation in which the price has reached the level
where quantity supplied equals quantity demanded, and there are no incentives
for agents (suppliers and consumers) to change behavior.
• Equilibrium Price: the price that balances quantity supplied and quantity
demanded. On a graph, it is the price at which the supply and demand curves
intersect.
• Equilibrium Quantity: the quantity supplied and the quantity demanded at the
equilibrium price. On a graph it is the quantity at which the supply and demand
curves intersect.
• Market equilibrium reflects the way markets allocate scarce resources.

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WHEN MARKETS ARE NOT IN EQUILIBRIUM

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Copyright©2003 Southwestern/Thomson Learning
 TOWARDS MARKET EQUILIBRIUM

• “Law of supply and demand”: The claim that the price of any good adjusts to bring
the quantity supplied and the quantity demanded for that good into balance.
• Surplus (excess of supply): When price > equilibrium price, then quantity supplied >
quantity demanded.
Suppliers will lower the price to increase sales, thereby moving toward
equilibrium.
• Shortage (excess of demand): When price < equilibrium price, then quantity
demanded > the quantity supplied.
Suppliers will raise the price due to too many buyers chasing too few goods,
thereby moving toward equilibrium.

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BUSINESS APPLICATION:
THREE STEPS TO ANALYZING CHANGES IN EQUILIBRIUM

1. Decide whether an event shifts the supply or demand curve (or both).
2. Decide whether the curve(s) shift(s) to the left or to the right.
3. Use the supply-and-demand diagram to see how the shift affects
equilibrium price and quantity.

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EXERCISE

In a supply and demand diagram, draw the shift of the curves for pizzas in your hometown due to
the following events. In each case, show the effect on equilibrium price and quantity.
a) The price of chicken increases
b) Income falls in town (assume that pizzas are a normal good for most people)
c) The cost of tomato sauce increases
d) The health hazards of meat are widely publicized.

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 MARKET EQUILIBRIUM AND WELFARE

• Do the equilibrium price and quantity maximize the total welfare of buyers and
sellers?
• Whether the market allocation is desirable can be addressed by welfare economics.
• Welfare economics is the study of how the allocation of resources affects economic
well-being. Buyers and sellers receive benefits from taking part in the market.
• Consumer surplus measures economic welfare from the buyer’s side.
• Producer surplus measures economic welfare from the seller’s side.

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 CONSUMER SURPLUS
Consumer surplus, measures the
benefit that buyers receive from a
good as the buyers themselves
perceive it.

Consumer surplus is:

the buyer’s willingness to pay for
the good minus the amount the
buyer actually pays for it.

Willingness to pay : the maximum

price that a consumer is willing to
pay for a product or service

https://online.hbs.edu/blog/post/willingness-to-pay
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CONSUMER SURPLUS

Price
consumer surplus is equal to the area below
the demand curve but above the price.

Increase in consumer surplus to

Price 1 original buyers
A fall in the market
price increases total Consumer surplus gained by
new buyers
consumer surplus

Price 2

0 Quantity 1 Quantity 2 Quantity

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 PRODUCER SURPLUS

• Just as consumer surplus is related to the demand curve, producer surplus is

closely related to the supply curve.
• Producer surplus is the amount a seller is paid for a good minus the seller’s cost.
• Here the term cost should be interpreted as the seller’s opportunity cost.
• It measures the benefit to sellers participating in a market.
• The area below the price and above the supply curve measures the producer
surplus (= economic profit) in a market.

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Supply Curve and Producer surplus

Potential sellers with

their respective costs
of production

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PRODUCER SURPLUS

A Rise in the Price

Producer
price increases Increase in
surplus gained S
producer surplus
total producer to original sellers
by new sellers

surplus Price 2

Price 1

producer surplus is
the area above the
supply curve but
below the price.
0 Quantity 1 Quantity 2 Quantity

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 TOTAL SURPLUS

Is the total net gain to consumers and producers from trading in the market.
Consumer Surplus = Value to buyers – Amount paid by buyers
Producer Surplus = Amount received by sellers – Cost to sellers
Total surplus = Consumer + Producer surplus =
= Value to buyers – Cost to sellers

The total surplus can help us understand why markets are an effective way to
organize economic activity.

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TOTAL SURPLUS

Price
S

Consumer
surplus E
Equilibrium price
Producer
surplus

0 Quantity
Equilibrium
quantity
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 EVALUATING THE MARKET EQUILIBRIUM:
THE EFFICIENCY OF THE MARKET

Free markets:
• produce the quantity of goods that maximizes the total surplus received by all
members of society.
• allocate the supply of goods to the buyers who value them most highly (as
measured by their willingness to pay).
• allocate the demand for goods to the sellers who can produce them at least cost.
• ensure that every consumer who makes a purchase values the good more than
every seller who makes a sale, so that all transactions are mutually beneficial

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THE EFFICIENCY OF THE MARKET
Price
Supply

Value Cost
to to
buyers sellers

Cost Value
to to
sellers buyers Demand

0 Equilibrium Quantity
quantity

Value to buyers is greater Value to buyers is less

than cost to sellers. than cost to sellers.

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 THE MARKET FOR ASSIGNMENTS

“At what price are you willing to do and sell the assignment for economics that is due on
the next week?”
OR
“At what price are you willing to pay and buy the assignment for economics that is due on
the next week?”
[You can buy or sell only 1 assignment]

1. Find the market equilibrium

2. Find an alternative solution as you were a planner in a centralized economy
3. Compare the different outcomes: which one do you prefer? Which one is the most
efficient?
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 APPENDIX /1
PRINCIPLES THAT UNDERLIE INDIVIDUAL CHOICE

1. People must make choices because resources are scarce.

2. The opportunity cost of an item—what you must give up to get it—is its true cost.
3. “How much” decisions require making trade-offs at the margin: comparing the
costs and benefits of doing a little more of an activity versus doing a little less.
4. People usually respond to incentives, exploiting opportunities to improve
themselves.
5. Rational decision-making is a key principle in economics. It involves using all
available information to achieve your goals.
Rational consumers and firms weigh the benefits and costs of each action and try
to make the best decision possible, given the circumstances.

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APPENDIX 2
INDIVIDUAL CHOICES AND MARKETS
1. There are gains from trade: specialization is better than self-sufficiency.
2. Because people respond to incentives, markets move toward equilibrium.
3. Resources should be used as efficiently as possible to achieve society’s goals ( ... but
what goals?)
4. Because people usually exploit gains from trade, markets usually lead to efficiency.
5. When markets don’t achieve efficiency, government intervention can improve
society’s welfare. ( ... When?)

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 APPENDIX 3
FEATURES OF WELL FUNCTIONING MARKETS
In the end, well-functioning markets owe their effectiveness to two powerful features:
• property rights: these are the rights of owners of valuable items, whether resources
or goods, to dispose of those items as they choose. That means that producers and
consumers consider all costs and benefits when making decisions.
• the role of prices as economic signals (i.e., any piece of information that helps
people make better economic decisions)

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 APPENDIX / 4
POSITIVE VS NORMATIVE ANALYSIS

• Positive economics is the analysis of the way the world works, in which there are
definite right and wrong answers.
• Normative economics makes prescriptions about how things ought to be. There are
often no right answers and only value judgments.

When economists make normative statements, they are acting more as policy advisors
than scientists. Economists do disagree for two main reasons:
• about which simplifications to make in a model,
• about values.
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