Lecture 1: Principles of Economics & Markets

Business Economics

David Ronayne

Assistant Professor of Economics, ESMT Berlin

“Economics studies given ends and the allocation of scarce means”

Lionel Robbins, 1932

Scarcity
A resource is scarce if people want more than exists, when its free.
Resources are not scarce when unwanted or (virtually) unlimited
Allocation
How are scarce resources allocated?
• planned economies, ICU beds, parents and pet owners
• decentralized economies, central banks, auctions, markets

What are scarce resources for firms?

• time, capital, equipment, talent

What are some scarce resource allocation problems you may face?
• capital to investment decisions
• inputs to production
• production over locations
• managerial time
• R&D effort
• employees to tasks
Given ends
“Cool heads but warm hearts”

Alfred Marshall, 1885

 Two interrelated sides of economics

Normative economics studies the best way to achieve a given end:

• which price or quantity should I choose to maximize profit?
• which costs should I consider?
• should my firm enter a new market?

What information do you need to answer these?

Positive economics studies how markets work:

• how many people will buy my product if I raise price?
• how much will my costs rise if I produce more?
• how will an incumbent firm react if I enter?
Course tools
The value of models
“All models are wrong, but some are useful”

George Box, 1978

Business Economics Syllabus

Part I: Foundations
1. Principles of Economics and Markets
2. Changes in Demand and Supply, Elasticity
3. Profits and Costs
4. The Long Run & Externalities

Part II: Exploiting Market Power

5. Market Power I
6. Pricing Simulation
7. Market Power II
8. Strategic Interactions
Lecture 1: Principles of Economics & Markets

Business Economics

David Ronayne

Assistant Professor of Economics, ESMT Berlin

Self-interest
“It is not from the benevolence of the butcher, brewer, or baker
that we expect our dinner, but from their own [self-] interest.”

Adam Smith, 1776

Prices
Date Frankfurt Munich
Nov 1 175N 125N
Nov 2 194N 129N
Nov 3 192N 121N
Nov 4 185N 127N
Nov 5 200N 138N
 Summary so far

Scarce resources are allocated (in a free-market economy) by

self-interested actors responding to prices. This leads to resources
going to where they are valued more e.g., grain to Frankfurt.
In turn, prices respond to buying and selling pressure and so:
• are informative (e.g., Frankfurt’s grain sellers have higher costs
or its grain buyers have greater demand, or both, vs Munich)
• cannot be too different (for same resource) across locations.

Those are powerful high-level insights, but can we say more...

 Assumption: no market power

A buyer/seller has market power if it can affect the price.

We turn to the case of market power after lecture 3.
Lots of important market analysis assumes no market power.
Economists often call such markets “perfectly competitive”.
No market power = “no whales”: no buyers/sellers with enough
influence over a market that they can unilaterally affect the price.

Commodity markets are good examples: grain, meat, metals, etc.

Markets of buyers & sellers are everywhere, and can seem messy.

To combat the chaos, we will build and analyze a model.

Probably the most important model in economics.
But first, let’s experience the chaos first hand...
 Market for Oranges

www.moblab.com
Constructing Demand & Supply
Demand
Who would be willing to take a kilo of oranges for free?
What about 0.50N? 1N? 5N? 10N?
Say you each want 1kg and market research finds your max. WTP:

0.50, 5.23, 0.05, 2.17, ···

 0.50, 5.23, 0.05, 2.17, ···

8
7
6
5
Price

4
3
2
1
0
10 20 30 40 50 60
Buyer #
 8
7
6
5
Price

4
3
2
1
0
10 20 30 40 50 60
Quantity
 this consumer’s surplus is
8
7.57 − 5 = 2.57N
7 this consumer’s surplus is
6.34 − 5 = 1.34N
6
5
Price

4
3
2
1
0
10 20 30 40 50 60
Quantity
 8
7 consumer surplus = 32.69N
6
5
Price

4
3
2
1
0
10 20 30 40 50 60
Quantity
 8
7 consumer surplus = 129.93N
6
5
Price

4
3
2
1
0
10 20 30 40 50 60
Quantity
 8
7 consumer surplus = 200.95N
6
5
Price

4
3
2
1
0
10 20 30 40 50 60
Quantity
Halt! Definition Police!
demand 6= quantity demanded
Supply

Say market research finds 60 farmers’ cost of producing 1kg:

0.12, 0.04, 3.98, 1.34, ···

 0.12, 0.04, 3.98, 1.34, ···

8
7
6
5
Price

4
3
2
1
0
10 20 30 40 50 60
Seller #
 8
7
6
5
Price

4 this producer’s
surplus is
3 5 − 3.58 = 1.42N

2 this producer’s
surplus is
1 5 − 1.34 = 3.66N

0
10 20 30 40 50 60
Quantity
 8
7 producer surplus = 115.28N
6
5
Price

4
3
2
1
0
10 20 30 40 50 60
Quantity
 8
7 producer surplus = 20.15N
6
5
Price

4
3
2
1
0
10 20 30 40 50 60
Quantity
 8
7 producer surplus = 1.71N
6
5
Price

4
3
2
1
0
10 20 30 40 50 60
Quantity
Halt! Definition Police!
demand 6= quantity demanded
supply 6= quantity supplied
 Recap: understanding surplus

Producer surplus is:

• Profit (excluding fixed costs)
Consumer surplus is:
• B2B markets: buyers’ profits from the item
• B2C markets: benefits to buyers e.g., “woohoo” factor
Deriving Market Equilibrium
 8
7
6
5
Price

4
3
2
1
0
10 20 30 40 50 60
Quantity
Arbitrage opportunity! Ex: How much can you make?

8 quantity demanded = 20
quantity supplied = 45
7 excess supply = 25

6
5
Price

4
3
2
1
0
10 20 30 40 50 60
Quantity
The natural “market mechanism” has led to...

8 quantity demanded = 33
quantity supplied = 33
7 EQUILIBRIUM

6
5
Price

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3
2
1
0
10 20 30 40 50 60
Quantity
Welfare
 8 consumer surplus = 48.20N
producer surplus = 01.71N
7 welfare = 49.91N

6
5
Price

4
3
2
1
0
10 20 30 40 50 60
Quantity
 8 consumer surplus = 81.67N
producer surplus = 20.15N
7 welfare = 101.82N

6
5
Price

4
3
2
1
0
10 20 30 40 50 60
Quantity
 8 consumer surplus = 87.37N
producer surplus = 29.99N
7 welfare = 117.36N

6
5
Price

4
3
2
1
0
10 20 30 40 50 60
Quantity
 8 consumer surplus = 86.83N
producer surplus = 42.60N
7 welfare = 129.43N

6
5
Price

4
3
2
1
0
10 20 30 40 50 60
Quantity
Welfare is maximized at an equilibrium price and quantity

8 consumer surplus = 70.08N

producer surplus = 61.76N
7 welfare = 131.84N

6
5
Price

4
3
2
1
0
10 20 30 40 50 60
Quantity
 Market forces - summary

Equilibrium price: where supply and demand cross.

The equilibrium price is what we predict will prevail. Why?
If price > equilibrium level there would be excess supply: some
buyers priced out, some units left unsold.
→ The price falls as sellers who haven’t sold yet can lower their
prices a little to sell to some of those buyers. The process
continues until we hit the equilibrium price.
If the price < equilibrium level there would be excess demand:
some sellers priced out, some consumers left wanting.
→ The price rises as sellers with costs a bit above the price can sell
at a higher price to some of the buyers who have not bought yet.
The process continues until we hit the equilibrium price.
 Free markets maximize welfare - summary

“Win-win” trade: If a buyer’s value > a seller’s, and they transact

at a price between their values, both are better off after the trade.
• win-win trades increase total welfare;
• self-interest means the only trades that occur are win-win.

Non-equilibrium price:
→ excess supply or demand;
→ some win-win trades do not occur;
→ welfare not maximized at this price.

Equilibrium price:
→ supply = demand;
→ no more win-win trades available;
→ welfare is the highest it can be.
“It is not from the benevolence of the butcher, brewer, or baker
that we expect our dinner, but from their own [self-] interest.”

Adam Smith, 1776

Assumptions required
1. Many buyers and sellers (so that no-one has market power:
no-one can individually affect the price)
2. Perfect information about prices, own WTPs, own costs
(otherwise you cannot decide to buy or sell - but you do not
need to know anyone else’s WTP or cost!)
3. Homogeneous product (otherwise we are not comparing
apples with apples)
4. No frictions e.g., transaction or transportation costs (which
would prevent some efficient trades)
5. No “externalities” - we assumed private WTP and costs
within this one market are all that matters (we’ll come back
to this later in the course)
Economics studies given ends and the allocation of scarce resources
The power of arbitrage; prices allocate goods & carry information
Demand reflects buyers’ WTP; supply reflects producers’ costs
Market equilibrium is found where demand and supply cross
Welfare (total surplus) is maximized at any market equilibrium
(Remember the assumptions required for equilibrium analysis)