Demand, Supply and Externalities v1.0. 2 -2- Market mechanism Demand and supply market Externalities.

Demand, Supply and Externalities

v1.0

2

-2-

Market mechanism

• Demand and supply market

• Externalities

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Principle # 6 Markets are usually a good way to organize economic activity

• The market economy is a central element of our economic system, it is important to understand it’s mechanisms.

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The market: demand and supply

What’s the demand?

• The demand expresses the intention to purchase a good or service at different prices by buyers during a given period.

• The law of demand: the inverse relationship between Prices and Quantities

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PRICES

QUANTITIES

DEMAND

P1

Q1

P2

Q2

P 2

P1

Q2 Q1

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A common mistake :

An increase in the price of a good, decreases the demand for the good.

Correction:

An increase in the price of a good, decreases the demanded quantity for that good.

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So if a price increase does not reduce the demand.

How does the demand for a good can be reduced?

Factors other than price will decrease (or increase) the demand for a good or service.

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Some factors changing the market demand for a consumption good?

• Tastes and preferences • Consumer’s income• The price of substitute goods • The price of complementary goods • The number of consumers • Expectations (of prices, availability, ...)

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How can we illustrate changes in the demand curve?

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What is the supply?

• The supply expresses the intentions to sell a good or service at different prices for all sellers in a given period.

• The law of supply: The direct relationship between prices and supplied quantities

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PRICES

QUANTITIES

SUPPLY

P1

Q1

P2

Q2

P 2

P1

Q1 Q2

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A common mistake:

An increase in the price of a good increases the supply of the good.

Correction:

An increase in the price of a good increases the supplied quantity of that good.

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Some factors changing the market supply of a good?

• Production costs • Technology • The number of producers or sellers• Expectations

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How can we illustrate the changes to the supply curve?

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What is the market equilibrium?

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What are the effects of changes in demand factors on the market equilibrium?

What are the effects of changes in supply factors on the market equilibrium?

Some examples on the PC laptop market

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PRIX

QUANTITÉS

O

D 1

P1

Q1

D2

P2

Q2

Higher income for the buyers (the computer is a normal good)

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PRIX

QUANTITÉS

O1

D

P1

Q1

O2

P2

Q2

Lower costs of production (new production technique)

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PRIX

Q

O

D 1

P1

Q1

D2

P2

Q2

XLower prices for tablets

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PRIX

Q

O 1

D 1

P1

Q1

D2

Q2

O 2

P2

Higher component prices and lower income for consumers

Variation of the supply = variation of the demand

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PRIX

Q

O 1

D 1

P1

Q1

D2

Q2

O 2

P2

Decrease in consumer likeness for the product and higher wages in the industry

supply variation > demand variation

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PRIX

Q

O 1

D 1

P1

Q1

D2

Q2

O 2

P2

Lower prices for tablets and some firms cease production

supply variation < demand variation

Conclusion :

Prices change according to changes in supply and demand.

This model runs without intervention (Laissez-faire)

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References :

• 1. Graphique tiré de Beauregard, Henri, Économie et Société

• 2. Ibid.• 3. Ibid.

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Externalities

Principle # 7: The government can sometimes improve the

market solutions

Laissez-faire is not always the best option

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Externalities

• Def.: The impact that the action of an agent has on the well-being of another agent who is not involved in the market

• Because buyers and sellers neglect the external effects of their actions, the market solution is not always optimal for a society as a whole.

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Examples

• Negative externalities Air pollution (cars, factories)

• Positive externalities Research and development in a company

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Production externalities

• Negative externality of production: The action of a producer has a negative impact on the welfare (well-being) of another agent

• Eg. an aluminum producer emits polluting fumes

• These fumes cause health problems• Cost society > Cost firm

Production costs

• The costs for the firm are: salaries, energy, raw materials ...

• Costs for society are: the same as the firm (it is part of the society) but adds the costs of pollution, especially on the health care system (whether public or private) because it is the production that causes the problems.

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Qté

Prix

O(Private Cost)

D

Qmarket

Market equilibrium

Social Cost

Cost of pollution

Pollution

Qoptimum

SocialOptimum

Fig. 10.2

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The social cost supply

This is the supply that takes into account the full costs of production. That is to say, the costs of the firm and the costs of production that the firm causes (costs caused by pollution)

Qté

Prix

D

Qmarket

Social Cost

Pollution

Qoptimum

Fig. 10.3

Po

Pm

a

b

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Deadweight loss

The deadweight loss represents the loss for society as a whole if we do not intervene to solve the externality problem.

In other words, if we let the market work freely, it creates a welfare loss for society as a whole. (In our case the environmental problems)

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Solutions to this type of externality

• Environmental standards to be met

• Pollution tax (eg taxing Co2)

• The implementation of pollution permits and carbon exchange.

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positive externality of production

• The action of a producer has a positive impact on the well-being of another agent

• Eg. a drug producer invests in R & D • This leads to a positive impact on health

– Cost society < Cost firm

A company that introduces a very effective drug will surely make a lot of profits.

And the benefits associated with such a drug exceed that of thepharmaceutical company since the entire society will benefit from access to such a good drug.

The increase in life expectancy and quality of life due to access to good drugs are positive externalities. This is the type of production that we want to encourage as a society.

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Qté

Prix

O(Private

Cost)

D

Qmarché

Équilibre

positive Overflow (Débordement)

Pm

Qoptimum

Optimum

Social CostOverflow

Po

Deadweight loss

Fig. 10.4

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Solutions to this type of externality

•Grant patents to innovative companies.

•Subsidize businesses in certain areas.

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Consumption externalities

• Negative consumption externality: the action a consumer has a negative impact on the welfare of another agent

• Eg. excessive alcohol consumption • Effects: disease, accidents, etc.• Benefits society < Benefits individual

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The negative externality of consumption

Some of our consumption behavior can benefit us personally (private benefits), but can have a negative impact on other (social benefits).

Imagine a mayor who would come to his office drunk.

43Qté

Prix

O

D( private benefits)

Alcohol consumption

Qmarché

Équilibre

Optimum

Qoptimum

Social benefits

Deadweight loss

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negative externality of consumptionIn this graph the amount of alcohol in the market is the amount that would have been if all consumption constraints would have been removed.

Thus, young children could consume alcohol and you could consume all the alcohol you wanted too, even before driving a car. Does it appear to be a good idea?

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The deadweight loss

The deadweight loss in the case of a negative consumption externality represents the loss of welfare for the society as a whole created when consuming too much or improperly certain goods or services. Eg. smoking, alcohol, junk food ...

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Solution to this type of externality :

• Regulations

• Taxes

• Prevention

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Positive consumption externality

• A consumer’s action has a positive impact on the well-being of another agent

• Eg. education • Effects: productivity, social involvement, etc• Benefits society > Benefits individual

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Positive externality of consumption

An individual who studies should then benefit from his efforts on the labor market (employment, wages, favorable conditions ...)

Society benefits even more since it will profit from the individual benefits (since he is a part of society) and also since everyone will gain from more education.

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• An individual who is studying management will surely have a good job but the whole society gets to have good managers in enterprises (prosperity, job creation ...).

• An individual who is studying medicine earns a good living, but as a whole society wins when it has good doctors.

• This is the type of consumption you want to encourage.

Examples :

50Qté

Prix

O

D(private benefits)

Équilibre

Education

Qmarché Qoptimum

Socialebenefits

Optimum

Deadweight loss

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The deadweight loss

In this graph it is the loss that a society faces when a part of the population has no access to education.

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Solutions to this type of externality

• Subsidizing some type of consumption (buying hybrid cars)

• Loans and Grants

Conclusion:

Governments are sometimes justified to intervene in different ways in the economy.

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