The Market System

1
The Market System
Partial Equilibrium Analysis Supply and Demand
2
Specific Objectives

1. Forecast changes in equilibrium price and
   quantity for a given change in a non-price
   determinant of demand or supply.
2. An Application of Market Demand and Supply
   Exchange Rate Markets
3. Using the model of market demand and supply
   explain how exchange rates are determined.
4. Explain the difference between currency
   appreciation and currency depreciation and
   determine if the dollar has appreciated or
   depreciated relative to a foreign currency.
5. Determine the impact of changes in exchange rates
   on international trade.

3
Demand

• A relation showing how much of a good consumers
  are willing and able to buy at each possible
  price during a given period of time, other things
  held constant

4
Candy Bar Auction

• Write the amount you are willing and able spend
  now, for this candy bar.

5
The Law of Demand

• The quantity of a good demanded is inversely
  related to its price, other things constant
• The law of demand can be explained by the
  substitution effect and the income effect
• Substitution effectWhen the price of a good
  falls, consumers will substitute it for other
  goods
• Income effectA fall in price increases
  consumers real income

6
The Demand Schedule and the Demand Curve
The demand curve slopes downward because of the
law of demand
7
Changes in Quantity Demanded
P
D
decrease in quantity demanded
increase in quantity demanded
Q
8
Changes in Demand (Determinants of Demand)

• Changes in demand can be caused by changes in-
• Consumer Income (flow)
• Change in Wealth (stock)
• The prices of related goods
• Consumer expectations
• The number of consumers in the market
• Consumer tastes and preferences

9
Changes in IncomeNormal and Inferior Goods

• A normal good is a good for which demand
  increases as consumer income rises
• An inferior good is a good for which demand
  decreases as consumer income rises

10
The Price of Related GoodsSubstitutes and
Complements

• Substitutes are goods that are related in such a
  way that in increase in the price of one good
  leads to an increase in demand for the other good
• Complements are goods that are related in such a
  way that an increase in the price of one leads to
  a decrease in the demand for the other

11
An Increase in Demand (Rightward shift)
P
D
D
Q
12
A Decrease in Demand (Leftward Shift)
P
D
D
Q
13
Supply

• A relation showing how much of a good producers
  are willing and able to sell at each possible
  price during a given period of time, other things
  held constant

14
The Law of Supply

• The quantity of a good supplied is directly
  related to its price, other things constant

15
The Supply Schedule and the Supply Curve
The supply curve slopes upward because of the law
of supply
16
Changes in Quantity Supplied (Increases and
Decreases)
P
decrease in quantity supplied
S
increase in quantity supplied
Q
17
Changes in Supply

• Changes in supply can be caused by changes in,
• Technology
• The prices of resources used in production
• The prices of alternative goods (related outputs)
• Producer expectations
• The number of producers

18
Increase in Supply
P
S
S
Q
19
Decrease in Supply
P
S
S
Q
20
Market equilibrium
In equilibrium, the plans of buyers match the
plans of sellers
P
D
S
Pe
Q
Qe
21
Market Schedules and Equilibrium
22
Equilibrium and Changes in Demand
D
P
D
S
Pe
Pe
Q
Qe
Qe
23
Equilibrium and Changes in Supply
P
D
S
S
Pe
Pe
Q
Qe
Qe
24
Effects of Changes in Both Supply and Demand
25
Part I Equilibrium Determination

• For each question identify what happens to price
  and quantity in equilibrium.
• 1. What happens in the diet pill market, if a
  study demonstrates conclusively that ephedrine
  increases the risk of heart attacks?
• 2. What happens to the market for Cocaine when
  the DEA dramatically increases its campaign
  against growers in Columbia?
• 3. What happens in the market for jelly if the
  peanut crop is experiences massive loss due to
  disease?
• 4. In 1992, new regulations in food labeling
  forced producers to have their information
  verified by an independent lab. The verification
  process can cost as much as 20,000 per item.
  What impact would this have on the price and
  quantity of food subject to this regulation?

26
Real World Check

• We do not observe supply and demand curves, we
  only observe selling prices and quantities, at
  different times.

27
Price Floors and Ceilings

• A price floor is a minimum legal price below
  which a good or service cannot be sold
• examples minimum wage, agricultural products
• A price ceiling is a maximum legal price above
  which a good or service cannot be sold
• examples rent controls, usury laws, organ
  donation

28
A Price Floor Above Equilibrium Price
P
D
surplus
S
Q
29
Examples of Price Floors

• Minimum Wage
• Farm Support (Milk)

30
A Price Ceiling Below Equilibrium Price
P
D
S
shortage
Q
31
Examples of Price Ceilings

• Usury Laws (Max interest rates)
• Rent controls
• Cabbage Patch Kids, Tickle Me Elmo, Beanie
  Babies, Pok e Mon, Xbox 360
• Dave Matthews Band Tickets
• Organ donation
• http//www.healthpolitics.com/media/prog_48/slides
  _prog_48.pdf

32
Elasticity

• Elasticity is a general concept that can be used
  to quantify the response in one variable when
  another variable changes.

33
Perfectly Elastic andPerfectly Inelastic Demand
Curves

• When demand does not respond at all to a change
  in price, demand is perfectly inelastic.

• Demand is perfectly elastic when quantity
  demanded drops to zero at the slightest increase
  in price.

34
Elasticity and the War on Drugs

• Can we win the War on drugs?
• Is the war on the demand or supply?
• How does elasticity help us understand the War?

35
Gas Prices

• What is Price Gouging?
• Why do prices change so frequently?
• Short run elasticity -0.11 to -0.25 for demand
  and 0.75 for supply.
• Solutions to high prices.

36
Exchange Rate Demonstration
37
Exchange Rate

• The price of one countrys currency measured in
  terms of another countrys currency
• ex. /Pound or Pound/

38
Why do people want Foreign Currency?

• The want to buy foreign goods
• They want to buy foreign financial assets
• The want to speculate

39
Actors in the Foreign Exchange Market

• Hedgers (Traders)
• Arbitrageur
• Speculators
• Central Bankers

40
The Foreign Exchange Market
Exchange rate Peso/
D
S
Supply of Dollars by people who want pesos
Demand for Dollars by people who have pesos
Foreign exchange (dollars)
41
Currency Depreciation and Appreciation

• Currency depreciation is an increase in the
  number of units of a particular currency needed
  to purchase one unit of foreign exchange
• Currency appreciation is a decrease in the number
  of units of a particular currency needed to
  purchase one unit of foreign exchange

42
Changes in the Equilibrium Exchange Rate
Supply of Dollars by people who want pesos
Exchange rate Peso/
D
S
S
-depreciation Peso- appreciation
Demand for Dollars by people who have pesos
Foreign exchange (dollars)
43
Purchasing Power Parity

• The purchasing power parity theory predicts that
  exchange rates between two national currencies
  will adjust in the long run to reflect
  price-level differences in the two countries
• example If a bike cost 100 in US, and 300pesos
  in Mexico, PPP predicts that the Peso/ exchange
  3. If not arbitrage would be profitable (buy
  bikes in Mexico and sell in US)

44
Why does PPP Fail?

• Non-Traded goods
• Tariffs and Quotas
• Productivity differentials
• People demand foreign currency for reasons other
  then to buy traded goods

45
Exchange Rate Regimes

• Flexible (Floating) exchange rates.
• Fixed exchange rates.
• Currency Board
• Monetary Union
• Managed Float (Dirty Float) exchange rates.

46
The Central Bank Can Intervene to Maintain
Exchange Rates
Exchange rate /pound
D
S
D
Foreign exchange (pounds)
47
Currency Crisis
Exchange rate Baht/
D
D
S
52
25
Foreign exchange ()
48
Asian Currencies vs. U.S. Dollar
49
Problems

• Foreigners cant make their dollar denominated
  debt payments
• Cant afford foreign goods
• Shopping opportunities

50
Currency Unions

• Currency Unions are the adoptions of a single
  currency among several countries
• European Union - currency (Euro)
• The United States - currency (Dollar)

51
Appendix

• Slides after this point will most likely not be
  covered in class. However they may contain useful
  definitions, or further elaborate on important
  concepts, particularly materials covered in the
  text book.
• They may contain examples Ive used in the past,
  or slides I just dont want to delete as I may
  use them in the future.

52
Never bet on a sentimental favorite in the
Superbowl

• How to make book
• Bookies serve as the middle man, they accept bets
  from people who believe that team X will win and
  those who believe that team Y will win
• If you bet 1,000 and win, you win 1,000.
  However if you bet 1,000 and lose you pay
  1,100, your bet plus 10.

53
Supply and Demand faced by the Bookie
54
Actors in the Foreign Exchange Market

• Hedgers (Traders)-A person who is buying a
  product or services from another country and is
  required to pay for it in that countrys currency
  
• ArbitrageurA person who takes advantage of
  temporary geographic differences in the exchange
  rate by simultaneously purchasing a currency in
  one market and selling it in another market
• SpeculatorsA person who buys or sells foreign
  exchange in hopes of profiting from fluctuations
  in the exchange rate over time
• Central Bankers- A government institution which
  can influence the exchange rate

55
Exchange Rates

• Spot Market- The market for currency, where the
  contract negotiated is carried out immediately.
• Forward Market- A contract is negotiated for the
  exchange of currency 3, 6, 9 months or more in
  the future. That is to say the rate is
  negotiated today for a transaction that will take
  place in the future.

56
Exchange Rate Regimes

• Flexible (floating) exchange rates are determined
  solely by the forces of supply and demand without
  government intervention
• Fixed exchange rates are pegged by a central
  banks and it conducts ongoing purchases and sales
  of currencies to defend the peg.
• Managed Float (Dirty), there is an implicit or
  explicit target range for the exchange rate and
  the central bank defends it.

57
Changing the Value of Currency

• Currency devaluation is an increase in the
  official pegged price of foreign exchange in
  terms of the domestic currency
• Currency revaluation is a reduction in the
  official pegged price of foreign exchange in
  terms of the domestic currency