Markets Manual

Purpose of the Program

This program allows you to manipulate a perfectly competitive market in a number of ways. In the process you can observe some of the ways this type of market reacts to assorted disturbances. The program also allows you to interfere with the market, as governments often do, and to observe the consequences of your interference. This should allow you to draw some conclusions about the usefulness of such interventions.

The Basic Model

The market you are about to disturb is the market for wheat. If people like you don't get in the way, this comes very close to the economist's definition of a "perfectly competitive market." Below is a comparison of the requirements of "perfect competition" and the facts about the wheat market.

Perfect Competition / Wheat Market
An infinite number of sellers (firms or individuals) / Tens of thousands of farms in the U.S., many more in other countries
An infinite number of buyers / Millions of buyers (but there are a few large firms that buy large amounts of the wheat produced in the U.S.)
Perfect free information about prices / Information is very cheap and easy to get.
Every seller produces exactly the same product ad all potential buyers know that the products are identical. / There are a number of different varieties of wheat, but within each variety, it doesn’t matter which farm it was grown on.
Free entry into the industry (no special start up costs), and free exit, no special costs for leaving the industry. / There are entry and exit costs, but they are not very large. Farmers borrow large amounts to start up, but the security is mostly the land and equipment bought, so it isn’t too hard or expensive to borrow.

Supplysupplydefinition

Suppliers—those prepared (if conditions are right) to sell a given product in this market—are assumed to be business firms. The suppliers, wheat farmers in this module, are assumed to be motivated by only one thing: profit. Ignoring all sorts of potential complexities, profit is defined as the total revenues of the firm minus the total costs of the firm. The amount of product that any firm is willing to sell depends on two things: the price of the product and the firm’s costs. Due to the special conditions of the perfectly competitive model the firm considers the price of the product to be a fixed value -- totally out of its control. The firm’s costs depend on how much it produces. The costs also depend on technology, resource prices, laws, and other matters, but those will be considered constant here.

In the short term firms are unable to change many of the resources they use in production—they can neither increase nor decrease the amount used. Example: the size of the building they have as a production facility. As a result, they are subject to the Law of Diminishing Marginal Returns. If they try to increase production, they add more and more of the resources they can control to the fixed amounts of the ones they cannot control. The result is that increasing production increases the cost of producing additional units. This can be seen from the following example:

Current production = 100

Adding 1 more unit takes 10 more hours of labor, each hour costs $10, the added unit costs $100

Current production =101

Adding 1 more unit takes 11 more hours of labor, each hour costs $10, the added unit costs $110

Current production =102

Adding 1 more unit takes 12 more hours of labor, each hour costs $10, the added unit costs $120

Holding constant all the other things that might affect the firm’s costs and production, the result is a Supply Curve as in Figure 1 below. A firm’s supply curve is defined as the line showing the quantity a firm is willing to produce at each possible price. The larger the quantity to be produced, the higher the unit cost of the extra unit and the higher the price required to cover that cost. No firm (just interested in profit) will be willing to supply a unit of the product that costs it $120 to produce if the price it expects to sell the unit for is less than $120. On the supply curve, therefore, the Law of SupplySupplyLaw shows that the higher the price, the larger the quantity the firm is willing to produce. That is why the supply curve slopes upward.


Figure 1 The Supply Curve

Influences other than the price of the product can change the quantity supplied at a given price. If something makes it cost less to add units to production, then the supply curve moves away from the vertical axis. (This is referred to as an “increase in supply”.) If something makes it more costly to add to production, the supply curve moves toward the vertical axis. (This is referred to as a “decrease in supply”.) (See Figure 2.)

The above describes supply by a single firm. The behavior of the (“infinite”) number of firms in the market is just like the supply by a single firm, only the quantities are larger.

Figure 2 The Supply Curve

The quantity of wheat supplied at all possible prices is described by the supply curve. It can also be presented with either an equation or a graph. For the wheat market, the equation for wheat supply is:

Qs = ( - 1000 + 700(Rain) + 50(Wheat Price)) * (# of Farms/Seed Cost)


Qs is the quantity of wheat supplied. It is positively affected by the price of wheat (the higher the price, the more wheat sold). Qs is positively related to the amount of rain that falls on farms (measured relative to an average year), positively related to the price of wheat, negatively related to seed cost, and positively related to the number of farms. If the amount of rainfall is 10 inches, seed cost is $10 per bushel, and the number of farms is 1,000, then the supply curve looks like Figure 3. (The price of $17.33 and the quantity of 60350, define one point on the supply curve.)

Figure 3 The Supply of Wheat

DemandDemandDefinition

Every individual in the market has to decide how much to buy of this product, and even whether to buy it. At a given price for this product, the decision for a single person is going to be based on three basic things: (1) the opportunity cost of buying the product; (2) the real income of the person; and (3) the preferences (tastes) of the person.

The opportunity cost is a matter of considering three types of prices. There is the price of the product itself, the prices of goods that are substitutes for this product, and the prices of goods that are complements to this product. Suppose the product is ice cream and its price is $2 per gallon. A substitute for ice cream is frozen yogurt, suppose its price is $1.50 per gallon. Ignoring complements for the moment, the opportunity cost of buying a gallon of ice cream is that the $2 spent on that is $2 less that can be spent on frozen yogurt. The “opportunity cost” of the gallon of ice cream is 1.33 gallons of yogurt that you now cannot buy. If the price of yogurt were $2 then the opportunity cost of buying ice cream drops to 1 gallon of yogurt. That encourages people to buy more ice cream.

A complement to ice cream is chocolate syrup. Suppose the “typical” buyer in the market likes a pint of chocolate syrup with an average gallon of ice cream, and the price of syrup is $1 a pint. The decision to buy the ice cream is conjoined with the decision to buy the syrup. Now the overall cost is really going to be $3, and the opportunity cost (if syrup and ice cream are not


consumed together) of buying the ice cream is now—at a yogurt price of $1.50—two gallons of yogurt. If the price of syrup went to $2 a pint, the opportunity cost of ice cream/syrup would go to 2.66 gallons of yogurt ($4 for the combo, versus $1.50 for the yogurt). This would discourage the purchase of ice cream.

How much ice cream a person buys depends on how much real income the person has. Obviously, if your income is such that at an ice cream price of $2 a gallon you would spend all your income for a week buying one gallon—you are not going to be buying two gallons a week. That’s true even if the ice cream was all there was in the world that you ever wanted. Overall, the lower your real income, the less you’ll buy. There are exceptions to this rule, but ice cream isn’t one of them.

If the price of ice cream goes up, the opportunity cost of ice cream goes up, the buyer’s real income goes down and for both reasons the amount of ice cream bought will go down. The Law of Demand:DemandLaw the amount bought moves in exactly the opposite direction from the way price moves – if price goes up, the amount bought goes down, if the price goes down, the amount bought increases. Holding constant all other things that might affect the consumer’s behavior, the result is a Demand Curve as in Figure 4.

Figure 4 The Demand Curve

Changes in the prices of other goods or in real income can increase of reduce demand. Those kinds of shifts in demand are illustrated in Figure 5. For example, assuming that wheat is a superior/normal good, if real income increases the demand will increase, or shift to the right. If real income decreases, the demand will decrease, or shift to the left.


Figure 5 Shifts in the Demand Curve

The amount of wheat that will be bought at all possible prices is described by the demand curve. The demand curve can be shown with either an equation or a graph. For the wheat market, the demand equation is:

Qd = 1000 – 10(Wheat Price) + 3(Corn Price) – 0.5(Butter Price) + .3(Pop) + 0.10(Inc)

Where Qd is the amount of wheat bought (measured in millions of bushels), Pop is population and Inc is income. Qd is negatively affected by the price of wheat (the higher the price, the less wheat is bought), it is positively related to the price of corn, negatively related to the price of butter, and positively related to the population and income of consumers (measured in trillions of dollars).

If the price of corn is $10 a bushel, the price of butter is $4 per pound, the population is two hundred and fifty million, and consumer income is $5 trillion dollars, then the demand looks like Figure 6. (The price of $50 and the quantity of 603.5 define one point on the demand curve.)

Figure 6 The Demand for Wheat

Market Equilibrium

In this kind of market, the movements in price and amounts bought and sold are explained by the interactions of buyers and sellers in the market. EquilibriumEquilibriumDefined in the market is a combination of price and quantity at which no one (buyer or seller) has any reason to change decisions. This is the point where the demand and supply curves cross (in Figure 7, the equilibrium price is Pe and the equilibrium quantity is Qe).

Figure 7 Market Equilibrium

A change in demand or supply changes where the equilibrium is, since either way there has been a change in behavior -- either by buyers (demand), or by sellers (supply).

Figure 8 shows the results of a rise in demand. For some reason (e.g., a rise in income) the amount demanded at the original equilibrium has increased. At the original equilibrium, the amount people want to buy is larger than the amount firms are willing to sell. Buyers offer higher prices to get what they want, sellers are willing to sell more if they get the higher price. Eventually price reaches a new (higher) equilibrium value (Pe’, Figure 8) and quantity reaches a new (higher) equilibrium value (Qe’, Figure 8).

Figure 8 Changes in Market Equilibrium

Putting supply and demand together for the wheat market gives the picture below. Equilibrium, given the values of other prices, income, population, input costs, the number of farms, and the weather, is at the intersection of the two lines.

Figure 9 Equilibrium in the Wheat Market

Market Disturbances

This program uses a market -- wheat -- that is as close to perfect competition as can be found in reality. Starting with an initial equilibrium, the program allows you to “disturb” the market in a number of different ways. You can shift demand (up or down) by altering the price of a substitute or a complement, or by changing real income. You can change supply by altering the rainfall, seed cost, or the number of farms. Such changes will cause (at the same price) larger or smaller production (crop) to come to the market. Doing any of these things changes the equilibrium price and quantity. Part of your job is to understand why a particular disturbance caused a move to a particular equilibrium. In the process work out why the total amount spent in each case increases or decreases. (Hint: use the concepts of “price elasticity of demand” and “price elasticity of supply” in figuring this out.)