Markets are the invisible hand, working mysteriously to allocate society’s scarce resources to their best use. Market based systems of organizing the economy (as contrasted with communal, or socialistic ways, which do not allow individuals or private organizations to have private property) rely on private property and the behaviors of buyers and sellers. Selfish behavior by these buyers (people who want to acquire things) and sellers (people who have things to sell) ironically create the best result for society as a whole. This is Adam Smith’s invisible hand.
How do markets function? When lots of buyers (and potential buyers) confront lots of sellers (or potential sellers), a market clearing price is set for the exchanges. If sellers start demanding high prices for products/services, then they won’t sell much, because consumers are often unwilling to buy much at high prices. The will find a substitution, competitor or go without. If price is established at very low levels, then consumers will want to buy a lot. However, sellers will often be unwilling to sell at such low prices (their alternatives are better). Somewhere, there is a median price where the price sellers want to set for a product is equal to the amount of the product that buyers want to buy at that price. This is the EQUILIBRIUM price.
If price is higher than this, then supply will exceed demand also known as SURPLUS. Supply exceeds demand. Such situations may cause unsuccessful suppliers to begin to lower their prices in order to sell their product. The price-is-too-high situation will precipitate price declines until supply equals demand (S=D) at the equilibrium price.
If price is lower than the equilibrium price, then the amount demanded will be greater than the amount supplied resulting in a SHORTAGE. Here, demand exceeds supply. Such situations may cause some unsuccessful consumers to raise their offers in order to receive the product to take home. In the shortage situation, prices will begin to creep up until S=D at the equilibrium price.
At the equilibrium price, the amount that suppliers want to sell at a set price price is equal to the amount that buyers are willing to buy at that price. This quantity (in equilibrium) is good for society (eg optimal for society). It makes best use of scarce resources required to produce it. How do we know this? Well, lets say that the following schedules represent the situation of suppliers and demanders (consumers):
quantity price willing to pay price willing to sell
1 20 5
2 17 7
3 14 10
4 11 11
5 9 12
6 7 13
7 5 15
Prices willing to be paid by demanders is a reflection of the amount of value they see in the product. In order to consume more products, demanders will need to a lower price or give up something else. Essentially to consume more, demanders have to be convinced of the value because of the scarcity of money and the availability of substitutes.
Prices required by suppliers reflects the cost to produce it or the level of scarcity of the resources being used up to produce it. To produce more, they need a higher price to compensate them for the alternatives they must also give up (eg there are always substitutes). Both demanders and suppliers have alternatives imposed by scarcity: buyers have scarce income and get value from consuming other things. Sellers could be using the resources to produce something else instead.
P=11 is the equilibrium price, because this is where the amount that buyers want to buy at that price is = to the amount that sellers want to sell at that price. There is no motivation for either buyers or sellers to nudge price up or down at this price!
According to the chart, the production level of 4 is the best society can do. If we ask why should society produce even 1 unit, the answer is because the 1st unit in society is valued at 20, and only has to give up scarce resources worth 5. We would argue based on the value compared to the cost to make. the second unit is thus worth making. Would society prefer to make 5 units? No. They would stop producing at 4 because the fifths value is $9 to consumers (in terms of willingness to pay) while it costs $12 in terms of resources required to produce it. So, production of 4 squeezes the maximum net value out of this market for society. Net benefits would total 29 (benefits-costs) at a level of output of 4. This is the most net benefit we can get.
In summary, markets set price and production quantity by ultimately producing what will have the most value for society. This is driven by two things: (1) the value placed on the product by consumers (in terms of willingness to pay), and (2) the resource cost or relative scarcity of the resources required to produce it. These drive PRICE and the level of quantity consumed in any market. So, why do nurses make more than teachers—- it is because of these two things. Why do Red Sox tickets have such a high price relative to milk? Same reason. Willingness to pay (as a reflection of value to consumers) and cost (as a reflection of the scarcity of resources required to make the product).
Comparative Statics: predicting the Impact of change.
Comparative statics refers to a dynamic process that moves the market solution (price, quantity) from one equilibrium to another. It is at the heart of economic analysis! We will talk about the process using words, but it can easily be done using Supply and demand graphs.
Lets begin by seeing what happens in the above market when a price of 11 is reached today in the market, and 4 units are exchanged between sellers and buyers. Lets say that these suppliers are NOT able to cover all of their sunk costs at this price point. What will happen over time? Well, if things don’t improve, it is likely that some of the suppliers will try to liquidate their investments and move them to situations where they can get decent returns (profits). Over time, some suppliers LEAVE the industry. Who leaves? Usually the higher cost suppliers leave first—because they are the ones most hurting from the price point reached in the market.
As they exit, what happens to the quantity supplied by suppliers in the market? Generally, the quantity supplied will be lower at every price point, resulting from the gap created by the firm that exited. This will mean that suppliers would not be willing to supply as before, creating a gap between S
So, where will all this end? At a new equilibrium. At a price where S=D as before, so that there is stability once again in the market. Will the new equilibrium price be higher or lower than the old one? If supply falls because a firm stopped selling, then the volume of goods traded will be less, and the new price will be higher (because it is scarcer).
What if firms had entered the industry, rather than exited? Supply would have increased at every price point. The fact that the product has become less scarce on the market would cause a result of lower prices, and a larger amount of product traded.
If the product becomes more valued by demanders, and people want to buy more, then more will be wanted at each price point. Given supply is constant, this will lead to higher prices and more goods traded. If demand fall for the product, then the opposite would occur—lower prices and less traded.
Event Some Causes Effect on Market Price Effect on Quantity
Increase in Supply more suppliers reduction increase
higher productivity
lower price for inputs
Decrease in Supply fewer suppliers increase decrease
at every price point lower productivity
higher input prices
Increase in Demand more interested consumers increase increase
at every price point more jobs/income
increase is price of substitutes
Decrease in Demand fewer interested consumers decrease decrease
at every price point loss of jobs/income
decrease in price of substitutes
Longer term Market dynamics and the effects of Profit
If suppliers are being paid higher prices, profits are going to be rising too. This will be an attractive signal to investors (existing companies will often want to expand their size, some other companies will be looking for new product lines to get into, some personal investors will want to buy stock, and some persons may even want to start new companies). Higher prices and higher profits will cause capital to flow into any market by one means or another. Lower prices and lower profits will cause capital to flow out of the market.
As capital flows in, supply of product will increase. As capital flows out, supply will decrease.
Thus, there is a market dynamic that looks to be self correcting. As prices rise (for whatever reason), profits rise, capital flows in, and this causes supply to increase, which will tend to decrease price (and profits) again. Or, as prices and profits fall (for whatever reason) capital will exit the market, supply will fall, and this will cause prices and profits to increase again.
What is the point? Over time, a given product (22” color monitors) may experience such price variations as situations change regarding supply and demand. The trends (over time) might look like:
The second plausible pattern is where the prices are going up over time. This trend is usually associated with:
- increases in the willingness of consumers to buy this product (for many reasons)
- increases in the costs (and relative scarcity) of the resources required to make the product (for many reasons)
- changes in the competitiveness of the industry (for many reasons including actions by government)
The first two factors make sense. If the product is more attractive to consumers for whatever reason, the n the variations in supply and demand will not have a neutral effect on price. Or if the effects over time in resource costs, or production efficiency (eg how much resource is required to produce it) then the trend in price will not be neutral.
Competitiveness
The “industry” is the name for the group of suppliers and products that constitute the SUPPLY side of the market. These firms COMPETE for the customers who are willing to pay for such things. So, we speak of the laptop industry, the auto industry, the drug manufacturing industry, and so forth. As these firms come into (and go) from the industry they offer more (less) choice to the consumers. This “pressure” is competition. The more competitive an industry gets, the more difficult it will be for a firm to survive. This risk of sustainability will motivate sellers. It will sharpen the incentives to lower prices or do other things in order to attract the number if customers they need to survive. The degree of competition is driven by several factors: (1) the number of firms in the industry, (2) the extent of barriers to entry, (3) the degree of similarity (or difference) between the products the firms are selling, (4) the availability of information to the consumers about the offers of the various suppliers. A short note about each of these follows.
Competition and competitive pressures in a market are the friend of the consumers. Prices are lower when competitive pressures are high, and value is higher (product quality per dollar). Firms are ‘pressured’ into doing more to attract the consumers so that they will buy from them and not the competitor. Businesses hate competition and spend most of their time pondering strategy and marketing tactics trying to figure out how to avoid competition.
The fewer the firms in an industry, the less competition there is, and the more free those few firms are to have their way with customers since those customers have little choice in the marketplace (witness the fees Ticketmaster charges, and how little choice ticket buyers have if they want to see a particular event). As the firms enter or leave the industry, supply will expand or contract (shift out or in) and market price would be expected to change.
Underlying the ease with which firms can enter or exit an industry easily is captured by the concept of BARRIERS TO ENTRY. When it is difficult for new firms to enter an industry, the existing firms are “protected” from competitive pressures even though they may be making high profits. Barriers to entry include things like (1) high capital requirements to get into the industry (like making steel, for example), (2) access to very specialized resources and/or knowledge, (3) access to preexisting networks for distributing and servicing products, and (4) government-granted protections from competition (licenses, patents).
A second factor in driving competition is the nature of the competing products or services themselves. Sometimes, the products being sold are identical. We call these commodities (a bushel of corn, a ream of paper). Sometimes the products are carefully differentiated, creating cadres of loyal customers, who don’t really bother to consider the alternatives very seriously (coke/pepsi, clothing labels, automobiles). Most industries are composed of firms producing products that are somewhere between extreme loyalty and commodities.
Competitiveness is also driven by the extent to which consumers possess (or can easily get) information about competing products. The more readily available the information, the more pressure firms will feel to improve their competitiveness with other firms. But, when information is hard to come by (say, in choosing a surgeon) for various reasons, then the sellers will not feel so pressured to compete. Things that are commodities (a pack of Marlboro’s) are known by consumers, have a ‘standard’ quality, and competition on price can be very fierce. The surgeon, on the other hand, can charge what they want, knowing that customers cannot access information on ‘quality’— knowing that they are unable to comparison shop on the best “value” for the money.
So, what is the impact of competition? Competition improves the value the consumer gets for their money. Suppliers are struggling to survive. They need to attract customers. Sometimes the firms compete by lowering their prices. Sometimes they improve product quality and reliability for the same price. Sometimes they offer guarantees, or loyalty programs to keep customers. Sometimes they simply use public relations to make customers feel better about themselves for “choosing” their product. All of these things improve ‘value for money’. Consumers are the winners when competition increases.
Consumers also get better quality when competition is increased. Competition drives bad products off the shelves! It protects those consumers who may not be able to judge product quality for themselves. SO, we might ask, why are the waiting rooms of ‘bad’ surgeons just as full as the waiting rooms of all other surgeons? Why doesn’t competition work so well here?
Society also wins if competition increases in a market. Competition will cause prices and profits to fall. This will threaten the survival of the firms in the industry. And, some firms may not survive. These survivors are not necessarily the oldest firms, or the newest firms, or the biggest firms. But, they will be the firms that can produce their products most economically. The exiting firms will be the ‘high cost’ firms. Why is this good? Well, it means that competition insures that products and services will be produced by those firms that are BEST at getting the most out of the scarce resources we have as a society. Competition eliminates waste.
And, in doing so, competition also eliminates excess profits (a form of waste). When profits are too high (or too low) it means that, from society’s point of view there is too little (too much) capital invested in the industry. If profits are high, capital should flowing INTO the market in the form of more, bigger sellers. If profits are too low, then capital should flow out as firms exit. So, when profits are high, capital should flow into the market, and this is the signal that SOCIETY WANTS MORE RESOURCES IN THE MARKET. Why? Because high prices and profits are signaling a SHORTAGE, when consumers value the product a lot and want more of it than sellers are offering for sale. So, society wants more investment in the industry. And when capital flows into the industry more is supplied, and prices and profits begin to fall because of more COMPETITION.
This dynamic of capital flowing between industries (autos, computers, toothpaste, clothing, etc) where because of competitive reactions to prices and profits is the way society allocates the scarce resources (capital resources, iron ore, land, know how, etc.) across products and across industries. Expanding industries (like smart phones) are attracting resources previously deployed in other industries because prices are going up and profits have been higher than in the other industries. This is good for society. It is reallocating resources the way consumers want those resources allocated. Some industries are expanding (phone apps, electric cars, etc) and some are drifting away because of less willingness to buy (laptops, trains, gas guzzling cars, etc.). Society is served by competitive forces in markets.
Competition and Anti Competitive Business Tactics
Competition in economics refers to a business condition where multiple suppliers vie for the business of consumers under a very explicit set of circumstances: the suppliers are producing similar products, and consumers have full information on price and quality. Businesses here also know that any excess profits will be met by entry of new competitors, who also have good information on how much money is being made by the suppliers. .
These ‘competitive’ conditions are valued by consumers because the get low prices, and better quality. Consumers benefit, but firms do not like it. They try hard to change the circumstances for ‘competition’, trying to differentiate themselves and their products, and to block entry of new firms.
Businesses who have some ‘monopoly power’ still engage in difficult battles to maintain their differentiation, grow market share, and build more monopoly power. These ‘difficult battles’ are also referred to as “competition” though what the firms are doing is trying to win the consumer by anti-competitive tactics. These tactics are product differentiation, control of supply sources and key resources, and generally trying to increase market share and monopoly power. I would call these difficult battles that businesses engage in daily as “anti competitive tactics”. If they are being successful in doing these things, profits improve and the business organization is more sustainable.
What are the Conditions Favoring Competition
Large numbers of suppliers and large number of buyers — this eliminates power-in-negotiations for any single buyer or any single seller. By power-in-negotiations I mean this. It is conceivable that any single buyer could demand a lower price or other special terms, or else they would “walk away” and not buy. This kind of take it or leave it brinksmanship works if the buyer has “power”, meaning that the seller would suffer if they didn’t concede to the offer. But if there are many many little buyers in a market, this kind of offer would be so insignificant to the seller, that they’d not be worse if they ignor it. This is “no buyer power”.
So what does “buying power” look like? If the city of Boston is trying to buy teachers, they can pretty much set their own price schedule for paying teachers, and stick to their guns—take it or leave it. And, because they employ maybe 75% of the public school teachers in Eastern Mass, they may be able to get their way. This means that teachers need jobs may have to swallow their first reactions to the low wages, and take the job since they may not have alternatives—this is market power of the buyer.
The seller side is the same. Except we call a single seller a monopoly.
Information and transparency— markets don’t work well when buyers and sellers don’t know what is being offered in the market. Buyers need to know who is selling what, and what prices are being charged. Sellers need to know who else is selling, and what their charging, and they need to know what buyers are looking for and what they are willing to pay. This, of course is unreasonable in most instances. But when bilateral information isn’t good, transactions occur that are mistakes, and sellers can survive even if their products are not top quality, and they may be able to sustain their operations even though their prices are too high (because buyers are ignorant).
Easy entry and exit from the market— this has to do with the role of profit in the economy. When a market is hot (like craft beers) we see the price rising for beer purchases, and profits are up. This causes other firms to try to enter the business to take advantage of the higher profits being made. If entry is possible (there are no restrictions, and capital is available for the new firm based on the expected profitability of the investment) then entry occurs, supply increases, and competition forces prices to come down for the product. One related way this works is that the existing firms in the market may also decide to expand operations when profits are up. This has the same influence on prices.
This is the way capitalism is supposed to work—capital follows profit. Causing prices and profits to eventually decline. And, the opposite occurs for products for which prices are falling. Capital flees the market, supply falls, causing prices to eventually rise again.
If there are restrictions on capital freely moving in and out of an industry, then capital cannot follow prices and profits, or at least it cannot adjust quickly. And, this represents an ineffectiveness of the market. What can be the barriers to entry and exit and to capital flows in and out? Things like
- Huge scale of operations is required to get in (so very few organizations are able to mobilize the capital requirements to enter the business)
- Special skills and knowledge is required and, which serve as a barrier to entry
- Other special resources that are not readily available
- If there is a process or other kind of Patent that prevents new suppliers from entering (Patents are rights to monopoly granted by the government—which is an incentive to innovate and to do research and development)
- Some other kind of license from government is required
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