How Markets Work – The Basics and a Little More

Session 3 – Managerial Economics – Prof. Carlos Serrano

THE OPENING STORY
OIL AS A CASE STUDY

What’s in the price of oil?

What was the price of oil as of early 2016?

Jane Dough had to predict the future price of oil

What do you think her prediction was based on?

There were significant disagreements about the future level

of the price of a barrel of oil. While some analysts believed
the price was likely to rise in a not-so-distant future, others
believed that it would stay durably low.

Let’s explore the reasons of that disagreement.

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OIL AS A CASE STUDY

What’s in the price of oil?

From the problem set and the “Big Drop”: Explain, with a
graph, the supply-side and demand-side phenomena that
led to the price drop.

On the supply-side, the combination of new actors

(booming US oil production) and resilient production levels
in Libya and in Iraq drove supply higher up than expected,
while demand only increased moderately (Think of China’s
economic slowdown).

The fact that the increase in supply was more significant

than the increase in demand drove quantities traded up and
prices significantly down.

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OIL AS A CASE STUDY

What’s in the price of oil?

From the problem set: A theory suggests that “low oil prices
today will lead to much higher prices tomorrow.” Using the
graph in part (1), explain why this could be the case.

Because of low prices, the least cost-competitive actors are

driven out, projects are delayed and (potentially) individuals
with significant know-how leave the industry. This can lead
to a supply crunch.

Combined with a potential pick-up of demand, this would

lead to prices to spike up.

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OIL AS A CASE STUDY

What’s in the price of oil?

From the problem set: An alternative theory suggests that

prices may be durably low. The other required reading by
Spencer Dale, the Chief Economist at BP, defends this theory.
Explain why, relying on microeconomics.

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OIL AS A CASE STUDY

What’s in the price of oil?

Dale’s argument relies on four principles

1. We used to consider that oil was a finite resource when in

fact, for every barrel of oil we consume, we produce two
additional ones.

2. The supply and demand curves are not as steep as they used
to be, making price adjustments far smoother and limiting
the amount of price spikes.

3. Demand patterns have changed, as oil does not flow from

East to West but from East to the Far East, making spikes in
demand less likely.

4. OPEQ isn’t in a position to influence markets, in particular

because this isn’t a temporary shock.

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OIL AS A CASE STUDY

What’s in the price of oil?

Very recent interview where the Head of Bank of America

Global Commodities and Price Derivatives relies on the
tools that managerial economics offers, and that we have
discussed, to explain the recent movements of the price of
oil as well as to make predictions on future prices.

Note: when you hear of (low/high) “elasticity” of demand

and supply think of (low/high) responsiveness of the
quantity demanded of oil by consumers and the quantity
supplied by producers to changes in the price of oil,
respectively.
SOURCE: https://www.youtube.com/embed/yq9HcooL668

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UNDERSTANDING YOUR MARKET

Remember: What’s your market?

In fact, we’ve learned that growing opportunities are driven by a

wide range of factors:

ü Increasing income
ü Increasing cost of the substitute
ü Decreasing cost of the complement
ü Increasing preference for the good
ü Changing price expectations
ü Decreasing production costs
ü Increasing productivity
ü Decreasing number of firms producing the good

What matters most is to recognize the sign that one or many of

these things are happening and to act on what they mean.

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UNDERSTANDING YOUR MARKET

Remember: What’s your market?

What matters most is to recognize the sign that one or many of

these things are happening and to act on what they mean.

Do they affect demand? Or supply? And ultimately, what does

this mean for the market outcome?

The name of the game: understand the dynamics so as not to

be blindsided!

What does this mean for your business ultimately? Need to

transform?

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LEARNING OBJECTIVES
WHAT WE AIM FOR IN THIS SESSION

At the end of the session, you should be

able to…

Revisit how demand and supply can interact and shape

market outcomes in theory (the notion of “equilibrium”)

Explain how demand and supply can interact and shape

market outcomes in practice

Identify how government interventions can change market

outcomes

Confirm that the notion of gains from trade is clear.

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THE THEORY
UNDERSTANDING YOUR MARKET

Remember: What’s your market?

In fact, we’ve learned that growing opportunities are driven by a

wide range of factors:

ü Increasing income
ü Increasing cost of the substitute
ü Decreasing cost of the complement
ü Increasing preference for the good
ü Changing price expectations
ü Decreasing production costs
ü Increasing productivity
ü Decreasing number of firms producing the good

What matters most is to recognize the sign that one or many of

these things are happening and to act on what they mean.

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THE MARKET: WHERE DEMAND MEETS SUPPLY
P
We need to understand how markets work S
This means introducing ourselves to demand, to supply and
putting them both in the same graph…

P*

Q* Q
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THE MARKET: WHERE DEMAND MEETS SUPPLY
P
We need to understand how markets work
S
This means introducing ourselves to demand, to supply and
putting them both in the same graph…

The equilibrium is defined by an equilibrium quantity (Q*)

and an equilibrium price (P*) at which quantity demanded
is exactly equal to quantity supplied. P*
This outcome is considered as the only sustainable one in
time and the status quo if nothing else changes.
D
If something does change (drivers on the demand side
and/or on the supply side), we can measure the effects on
the market outcome (namely on Q* and P*) with regards to
what was the situation previously.

Q* Q
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THE MARKET: WHERE DEMAND MEETS SUPPLY
P
We need to understand how markets work
S
This means introducing ourselves to demand, to supply and
putting them both in the same graph…

In addition, when equilibrium is reached, everyone who

wanted to trade could and did. This is the point at which
gains from trade are maximal and economic value is the P*
greatest.

In particular, at the equilibrium, we’ve exhausted all

opportunities to match up suppliers with consumers who D
value the product more than what it cost to produce it.

The resulting value creation is represented by the red area

which what we’ll refer to as gains from trade.

Q* Q
17
THE MARKET: WHERE DEMAND MEETS SUPPLY
Consumer surplus
P
We need to understand how markets work S
The resulting value creation is represented by the red area
which what we’ll refer to as gains from trade.

But who gets what?

P*
The top end of the gains from trade goes to the consumer
(consumer surplus) while the bottom end goes to the
producer (producer surplus).
D
The consumer surplus is the amount consumers were
willing to pay but did not need to because market forces set Producer surplus
prices at a lower level.

Q* Q
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THE MARKET: WHERE DEMAND MEETS SUPPLY

What happens when an actor intervenes?

This is what happens on a market without any interference

from regulators or from the government.

What happens when there is a minimum price? A maximum

price? Or a tax? How do these modify market outcomes?

Exploring these questions will help us refine our

understanding of gains from trade.

This will also help us, next session, understand the tradeoffs
we make when we choose a price for an event, or when we
opt for free trade.

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THE MARKET: WHERE DEMAND MEETS SUPPLY

What happens when an actor intervenes?

This is what happens on a market without any interference

from regulators or from the government.

What happens when there is a minimum price? A maximum

price? Or a tax? How do these modify market outcomes?

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THE MARKET: WHERE DEMAND MEETS SUPPLY
P
What happens when an actor intervenes? S
What happens when there is a minimum price (price floor)?

If it is below P*, it is irrelevant. Do you see why?

Supply will not be stimulated by that low price, but demand

P*
will.
Pmin
At Pmin, demand would exceed supply significantly. This D
would push prices up (which is possible here because the
price has a lower boundary not an upper boundary!).

We’d go straight back to equilibrium (P*,Q*) as a result.

Qmin Q* Qhigh Q
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THE MARKET: WHERE DEMAND MEETS SUPPLY
P
What happens when an actor intervenes? S
Excess
What happens when there is a minimum price (price floor)?
Supply
Pmin
If it’s above P*, at Pmin, suppliers will be willing to supply
Qhigh when demanders actually demand Qmin only.
P*
Qmin will be the amount traded whereas Q* would have
been traded otherwise in a market without any hurdles.
Trade is artificially limited because of price fixing.
D
The yellow area represents the gains from trade that fail to
materialize as a result of this minimum price.

Qmin Q* Qhigh Q
22
THE MARKET: WHERE DEMAND MEETS SUPPLY

What happens when an actor intervenes?

This is what happens on a market without any interference

from regulators or from the government.

What happens when there is a minimum price? A maximum

price? Or a tax? How do these modify market outcomes?

23
THE MARKET: WHERE DEMAND MEETS SUPPLY
P
What happens when an actor intervenes? S
What happens when there is a maximum price (price
ceiling)?
Pmax
If it is above P*, it is irrelevant. Do you see why?
P*
Such a high price may stimulate supply but it will limit
demand. Supply would be significantly higher than demand,
leading prices to drop (and they can, because this is a
maximum price, not a minimum one).
D

So, we’re back to square one, at the equilibrium (P*,Q*).

Qmin Q* Qhigh Q
24
THE MARKET: WHERE DEMAND MEETS SUPPLY
P
What happens when an actor intervenes? S
What happens when there is a maximum price (price
ceiling)?

When it is below P*, at Pmax, suppliers will be willing to

supply Qmin only when demanders actually demand Qhigh . P*
Qmin will be the amount traded at the price Pmax, whereas Pmax
Q* would have been traded otherwise in a market without Excess
any hurdles. Trade is artificially limited (once again) because
D
of price fixing (“shortage”). Demand

The yellow area represents yet again the gains from trade
that fail to materialize as a result of this maximum price.

Qmin Q* Qhigh Q
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THE MARKET: WHERE DEMAND MEETS SUPPLY
P
To summarize… S
Excess
Economists like “free markets” because of the claim that
only they are in a position to maximize gains from trade for Supply
society as a whole. Hurdles like a maximum or a minimum Pmin
prices limit artificially the amount of gains created by
creating excess supply or excess demand (shortages). P*
And yet, the political motive may be legitimate. This might
be about protecting an industry that needs to transition
Pmax
Excess
towards a new model, or protecting consumers against the D
practice of a dominant firm. Demand

Analysis matters.

Qmin Q* Qhigh Q
26
THE MARKET: WHERE DEMAND MEETS SUPPLY

What happens when an actor intervenes?

This is what happens on a market without any interference

from regulators or from the government.

What happens when there is a minimum price? A maximum

price? Or a tax? How do these modify market outcomes?

27
THE MARKET: WHERE DEMAND MEETS SUPPLY Stax
Consumer surplus
P
What happens when an actor intervenes?
S
What happens when there is a tax?

Think of a tax as either a higher cost on suppliers, shifting

the supply curve to the left… Pt
… or a burden on a product’s appeal when compared to a
P*
consumer’s preferences and tastes, or compared to possible Ps
substitutes, shifting the demand curve to the left.

When the tax is applied on supply, the curve shifts left.

Tax t
D
People end up buying less and (Qt instead of Q*) while
paying more (Pt instead of P*). Both the producer and the
consumer lose. Government revenue (in blue) is tQt, i.e.,
(Pt-Ps)Qt. There is deadweight loss again here (in yellow). Producer surplus

Qt Q* Q
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WHY THIS MATTERS
UNDERSTANDING YOUR MARKET

Remember: What’s your market?

The very definition of the market you adopt is important as

it will necessarily shape your strategy in a way you need to
be aware of.

With alternative definitions, that account for different

regions and different time horizons, you may be able to
identify new opportunities – in particular because the
market is where opportunities get created (or get
destroyed).

You may not see walking red or yellow triangles in your

everyday professional life, but you do have a hunch about
shrinking or growing opportunities.

30
THE MARKET: WHERE DEMAND MEETS SUPPLY
P
We need to understand how markets work
S
This means introducing ourselves to demand, to supply and
putting them both in the same graph…

In addition, when equilibrium is reached, everyone who

wanted to trade could and did. This is the point at which
gains from trade are maximal and economic value is the P*
greatest.

In particular, at the equilibrium, we’ve exhausted all

opportunities to match up suppliers with consumers who D
value the product more than what it cost to produce it.

The resulting value creation is represented by the red area

which what we’ll refer to as gains from trade.

Q* Q
31
THE MARKET: WHERE DEMAND MEETS SUPPLY
Consumer surplus
P
We need to understand how markets work S
The resulting value creation is represented by the red area
which is what we’ll refer to as gains from trade.

But who gets what?

P*
The top end of the gains from trade goes to the consumer
(consumer surplus) while the bottom end goes to the
producer (producer surplus).
D
The consumer surplus is the amount consumers were
willing to pay but did not need to because market forces set Producer surplus
prices at a lower level.

Q* Q
32
THE MARKET: WHERE DEMAND MEETS SUPPLY
P
To summarize… S
Excess
Economists like “free markets” because of the claim that
only they are in a position to maximize gains from trade for Supply
society as a whole. Hurdles like a maximum or a minimum Pmin
prices limit artificially the amount of gains created by
creating excess supply or excess demand (shortages). P*
And yet, the political motive may be legitimate. This might
be about protecting an industry that needs to transition
Pmax
Excess
towards a new model, or protecting consumers against the D
practice of a dominant firm. Demand

Analysis matters.

Qmin Q* Qhigh Q
33
UNDERSTANDING YOUR MARKET

Who’s on your market?

The waste sometimes caused by government interventions and

regulations (such as minimum or maximum prices or taxes) have
led many economists to argue that an unhindered market creates
the greatest amount of economic value by matching up
consumers with a high valuation and producers with a low cost of
production. This economic value is what microeconomists call
‘gains from trade.’

In addition, in this system, because they are determined by

market forces, prices force economic actors to adjust to realities
of the landscape. Any attempt to manipulate them through
regulation and/or subsidies will lead to distortions and limit the
amount of accurate information in an economy.

This debate is still going on.

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UNDERSTANDING YOUR MARKET

Remember: What’s your market?

The very definition of the market you adopt is important as

it will necessarily shape your strategy in a way you need to
be aware of.

With alternative definitions, that account for different

regions and different time horizons, you may be able to
identify new opportunities – in particular because the
market is where opportunities get created (or get
destroyed).

Understanding why is significant because it can

drive change in the way you approach business!

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HOW COULD THIS END UP ON THE FINAL TEST
WHAT COULD YOU SEE ON A FINAL TEST

You may be asked to… Remember…

ü Represent the effects of a minimum price, a maximum
price or a tax, including
• What happens to the market outcome
• What happens to gains from trade
• Why some prices may be irrelevant
The problem sets are here to help. You will practice each of
these points in a problem set at some point. So pay
attention to them.

ü Discuss the effects of a measure on the consumer

surplus or the producer surplus and identify who wins
and who loses

ü Consider whether there may be other justifications for

the measure, such as protecting an ageing/nascent
industry, or protecting weaker players, or collecting
revenues (through tax) thanks to the measure.

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KEY TAKE-AWAYS
WHAT WE AIM FOR IN THIS SESSION

At the end of the session, you should be

able to…

Revisit how demand and supply can interact and shape

market outcomes in theory (the notion of “equilibrium”)

Explain how demand and supply can interact and shape

market outcomes in practice

Identify how government interventions can change market

outcomes

Confirm that the notion of gains from trade is clear.

39