Markets and Efficiency I

ECONOMICS I
Chisom Ubabukoh
Assistant Professor
Jindal Global Law School
 Part 1: Preliminaries
Laws, Theories and Models
• Economics, just like any other natural science attempts to
explain observed phenomena
• The phenomenon observed could be described as a law once
it is recognised as being reasonably consistent via experiments
• Theories on the other hand are the explanations for why the
law holds or the predictions that result from the law.
• Theories are developed according to a set of rules or
assumptions
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 For example
• The Law of Supply describes a phenomenon
• This is explained by the theory of the firm, and
• The theory of the firm is based on this major
premise: Producers want to maximize profits.

But is this always true?

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 Law of Gravity
Particles attract based Vacuum?
on mass and distance

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• A model is just a mathematical/graphical representation of a law

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• Theories are inherently non-perfect, but they give us a useful
framework to analyse the world with.

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 Positive vs Normative Analysis
Positive analysis deals with relationships of cause and effect (what is). It establishes
hypotheses that can be empirically tested.
• Example:
Suppose the Indian government bans the export of covid vaccines, what will be the
effect on local and global prices of the drug?

Normative analysis deals with answering questions like: “what is best?” (what
ideals to strive for?). It is subjective.
• Example:
Should the government ban the export of covid vaccines?
How many pro-bono cases should I take up in a year? 7
 Poll Qs
Positive or Normative?

• I am prime minister, should I impose a carbon tax?

•Normative
• I make cars. How would my profits be affected if I produced 50 lakh new
vehicles?
•Positive
• I own an airline, if the government closes the airports due to covid, how
many pilots would have to be fired to stay afloat?
•Positive 8
Part 2: Markets in Economics

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 What is a market?
• A collection of buyers and sellers, who through their actions
or potential actions determine the price of a product
• Examples:
Stock market, Job/Labour market, Crypto-currency market,
Used car market, Forex market etc etc

What other examples of markets can you give?

Food market? Beware!

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 The extent of a market
• For the purposes of economic analysis, a “food market” may
be too broad a definition.
• We like to limit our definition of a market by certain factors:
• Geographical area (eg. New Delhi housing market) – important for
arbitrage
• Specific products (e.g Cereal market, Cocoa market etc) –
important for competition analysis
• Or by specific consumers (e.g Budget smartphone market)
• We must think about both the sellers (the industry) and
buyers (consumers)
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• If you are in business, defining your market properly may be your first,
toughest, but most important job.

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• The government also cares about market definitions to decide on
anti-trust regulation, allowing/blocking mergers and acquisitions etc

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 Case study: Smartphones
• Do these companies operate in the same market? Why or why not?

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• Markets could be competitive or non-competitive
• Non-competitive markets imply that sellers may have some more
market power (like in a monopoly) or the buyer may have greater
bargaining power (like in a monopsony)

• Competitive markets are… competitive

• Buyers compete to purchase and sellers compete to sell

• More on the characteristics and analyses of these later in the course

• Some form of competition is an essential requirement for the

operation of the price mechanism…
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Part 3: Demand and Supply (Foundation)

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The Price Mechanism

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 Market Price
• In a perfectly competitive market, a single price for a product
(the market price) would prevail.
• In a less than perfectly competitive situation, there could be
differences in prices for the same product; the less competitive
the market, the greater the potential differences.
• Some reasons for different prices:
• Attempt to win customers from competitors
• Exploiting brand loyalty
• Here, market price would refer to an average of store prices
• Price determines the amount of output produced
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• The market price often fluctuates in the short run
• However, it tends to settle at some level eventually
• This is a price at which there is no incentive for the
price to be changed (either increased or reduced)
• This is called the market equilibrium!
• The mechanism through which prices adjust to the
point of equilibrium is Adam Smith’s invisible hand.
• Now we attempt to introduce a couple of laws that
describe this observation: The laws of demand and
supply.
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 The law of Demand
• It conceptualizes the observation that consumers
would like to buy more of a product when the
price is lower.
• So demand indicates the quantity of a product
which consumers are willing and able to buy at
various prices.
• It is an inverse relationship and downward sloping
• We would explain the consumer theory later (and
see some exceptions to the law)
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 Demand Schedule/Curve
Price of
Lattes Price Quantity
of of lattes
$6.00 lattes demanded
$0.00 16
$5.00
1.00 14
$4.00 2.00 12

$3.00 3.00 10
4.00 8
$2.00
5.00 6
$1.00 6.00 4
$0.00 Quantity
of Lattes
0 5 10 15
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 Change in Demand vs
Change in Quantity Demanded

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 Substitute Goods
• Products/Services that can be used instead of each
other
• Some substitutes are closer than others

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 Complimentary Goods
• Products/Services used together or add value to each other
• Could be weak/strong, one-to-one, many-to-one, or many-
to-many

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 Causes of Change in Demand
• Change in price of substitute goods
• Change in price of complimentary goods
• Change in number of buyers in the market
• Change in buyers’ income (or credit)
• Change in buyers’ tastes and preferences
• Change in the composition of the population
• Change in buyers’ expectations about the future
• Change in information 25
 Example Analysis
P Suppose the number of
$6.00 latte buyers increases.
Then, at each Price, the
$5.00
Quantity Demanded
$4.00 will increase
$3.00 (by 5 in this example).

$2.00
$1.00
$0.00 Q
0 5 10 15 20 25 30
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 MS Forms Exercise
• Consider the market for flagship smartphones.
For each of these, state whether demand will increase, demand will
decrease, quantity demanded will increase, or quantity demanded will
decrease:
• The economy improves and people earn more money
Demand increases
• The price of smart-watches decrease
Demand increases
• The price of smartphone processor chips increase making
smartphones more expensive
Quantity demanded decreases
• People expect that 5G will be widespread in 2 years
Demand decreases at first, but increases later 27
 The law of Supply
• It conceptualizes the observation that sellers would
like to sell more when the price of a product is higher
vs when it is lower.
• We can talk about an individual sellers supply, or the
market supply
• So supply indicates the quantity of a product which
sellers are willing to supply at various prices.
• As might be expected, it is a direct relationship and
upward sloping
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 Supply Schedule/Curve
P Price Quantity
$6.00 of of lattes
$5.00 lattes supplied
$0.00 0
$4.00
1.00 3
$3.00
2.00 6
$2.00 3.00 9
$1.00 4.00 12
5.00 15
$0.00 Q
6.00 18
0 5 10 15
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 Change in Supply vs
Change in Quantity Supplied

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 Causes of Change in Supply
• Change in number of sellers in the market
• Change in sellers’ expectations about the future
• Change in input prices (or credit)
• Change in technology of production
• Change in the physical supply of a natural resource

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 Example Analysis
P Suppose the
$6.00
price of milk
$5.00 falls.
$4.00
At each price,
the quantity of
$3.00 Lattes supplied
$2.00 will increase
(by 5 in this
$1.00
example).
$0.00 Q
0 5 10 15 20 25 30 35
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 MS Forms Exercise
• Consider the market for private civil legal representation.
For each of these, state whether supply will increase, supply will decrease,
quantity supplied will increase, or quantity supplied will decrease:
• Government legal aid is more available
Supply decreases
• People in general get into trouble more
Supply increases
• More online libraries mean lawyers spend less time
researching cases
Supply increases
• Government puts a limit on how much lawyers can charge
Quantity supplied decreases 33
 Market Equilibrium:
Bringing them together
P
$6.00 D S Equilibrium:
This is reached
$5.00
when the quantity
$4.00 supplied equals the
$3.00 quantity demanded
$2.00
$1.00

$0.00 Q
0 5 10 15 20 25 30 35 34
 When the quantity supplied is greater than quantity
demanded
P
D S
$6.00 Surplus
Example:
$5.00 If Price = $5
Q Demanded = 9 lattes, and
$4.00 Q Supplied = 25 lattes
resulting in a
$3.00 surplus of = 16 lattes

$2.00
$1.00
$0.00
0 5 10 15 20 25 30 35 Q

Surplus (Excess 35
When quantity supplied is greater than quantity demanded

P
$6.00 D Surplus S Example:
$5.00 Facing a surplus,
sellers try to increase
$4.00 sales by cutting price.
$3.00 This causes
$2.00 Q Demanded to rise and
Q Supplied to fall…
$1.00
…which reduces the
$0.00 Q surplus.
0 5 10 15 20 25 30 35

Surplus (Excess
Supply) 36
When quantity supplied is greater than quantity demanded

P
$6.00 D Surplus S Example:
Facing a surplus,
$5.00
sellers try to increase
$4.00 sales by cutting price.
$3.00 This causes
$2.00
Q Demanded to rise and
Q Supplied to fall.
$1.00
Prices continue to fall until
$0.00 Q market reaches
0 5 10 15 20 25 30 35 equilibrium.

Surplus (Excess
Supply) 37
When quantity demanded is greater than quantity supplied

P
$6.00 D S Example:
$5.00 If P = $1, then
QD = 21 lattes and
$4.00
QS = 5 lattes
$3.00 resulting in a
$2.00 shortage of 16 lattes
$1.00
$0.00 Shortage Q
0 5 10 15 20 25 30 35

Shortage (Excess Demand)

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When quantity demanded is greater than quantity supplied

P
$6.00 D S Example:
Facing a shortage,
$5.00 sellers raise the price,
$4.00 causing QD to fall
$3.00 and QS to rise,
$2.00 …which reduces the
$1.00 shortage.
Shortage
$0.00 Q
0 5 10 15 20 25 30 35

Shortage (Excess Demand)

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When quantity demanded is greater than quantity supplied

P
$6.00 D S Example:
Facing a shortage,
$5.00
sellers raise the price,
$4.00
causing QD to fall
$3.00
and QS to rise.
$2.00
Prices continue to rise
$1.00 until market reaches
Shortage
$0.00
equilibrium.
Q
0 5 10 15 20 25 30 35

Shortage (Excess Demand)

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 Non-market forces
• The adjustment of prices and speed of adjustment is
sometimes determined by variables outside our
model.
• Sentimental/Nostalgic reasons
• Lack of information
• Habits
• Laziness
• Other forms of human randomness
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 Result of Shifts in Demand and Supply
Effect on equilibrium Effect on equilibrium
Market Change Price quantity

Increase in supply Decrease Increase

Decrease in supply Increase Decrease

Increase in demand Increase Increase

Decrease in demand Decrease Decrease

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What happens when they move together?

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What happens when they move together?

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What happens when they move together?
Effect on equilibrium Effect on equilibrium
Market Change Price quantity
Increase in supply, Ambiguous Increase
Increase in demand
Increase in supply, Decrease Ambiguous
Decrease in demand
Decrease in supply, Increase Ambiguous
Increase in demand
Decrease in supply, Ambiguous Decrease
Decrease in demand

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Example Analysis (Market for a College Education)
P S2002
(annual cost New equilibrium
in 1970 was reached at $3,917
dollars)
and a quantity of 13.2
million students
$3,917
S1970

$2,530

D1970 D2002

Q (millions enrolled))
8.6 13.2 46
What happens when they move together?
Effect on equilibrium Effect on equilibrium
Market Change Price quantity
Increase in supply, Ambiguous Increase
Increase in demand
Increase in supply, Decrease Ambiguous
Decrease in demand
Decrease in supply, Increase Ambiguous
Increase in demand
Decrease in supply, Ambiguous Decrease
Decrease in demand

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 Exercise
• Consider the market for SUV cars
For each of these, state whether equilibrium Price will
increase, decrease or be ambiguous
• People have more income AND Cars are cheaper to
produce
Ambiguous
• Iron reserves are getting depleted AND People now
hate sedans so much
Increase 48
 Exercise
• Consider the market for game consoles
For each of these, state whether equilibrium Quantity will
increase, decrease or be ambiguous
• Engineers are now so expensive to hire AND
Population is ageing
Decrease
• 3D Printing makes manufacturing easier and cheaper
AND board games are given away free
Ambiguous 49