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Summary Core Econ: The Economy Unit 11-15 Notes
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Core Econ: The Economy Unit 11-15 Summary Notes
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UNIT 11: MARKET DYNAMICSRENT-SEEKING, PRICE-SETTING, AND MARKET DYNAMICS
Law of one price- Holds when a good is traded at the same price across all buyers and sellers.
If a good were sold at different prices in different places, a trader could buy it cheaply in one
place and sell it at a higher price in another.
11.1 HOW PEOPLE CHANGING PRICES TO GAIN RENTS CAN LEAD TO A MARKET
EQUILIBRIUM.
The hats example illustrates how markets adjust to equilibrium through the pursuit
of disequilibrium economic rents:
• When a market is in competitive equilibrium: If there is an exogenous change in
demand or supply, there will be either excess demand or excess supply at the
original price.
• Then, there are potential rents: Some buyers are willing to pay prices that are
different from the original price, but above the marginal cost for the seller.
• While the market is in disequilibrium: Buyers and sellers can gain these rents by
transacting at different prices. They become price-makers.
• This process continues until there is a new competitive equilibrium: At this point
there is no excess demand or supply, and buyers and sellers are price-takers again.
11.2 HOW MARKET ORGANIZATIONS CAN INFLUENCE PRICES.
If you give loyal customers priority over others—perhaps by serving them first—you improve
their experience buying from you, making them more likely to return. Over time these
customers become so loyal that they will remain despite a small increase in the prices that
you charge them. In this manner, individual relationships and past experiences influence
prices.
11.3 SHORT-RUN AND LONG-RUN EQUILIBRIUM
Short-run equilibrium- An equilibrium that will prevail while certain variables (for example,
the number of firms in a market) remain constant, but where we expect these variables to
change when people have time to respond to the situation.
Long-run equilibrium- An equilibrium that is achieved when variables that were held constant
in the short run (for example, the number of firms in a market) are allowed to adjust, as
people have time to respond the situation.
In the short run, the number of firms is exogenous—it is assumed to remain constant at 50.
In the long run, the number of bakeries can change through the endogenous rent-seeking
responses of firms. The number of firms in the long-run equilibrium is endogenous—it is
determined by the model.
,11.4 PRICES, RENT-SEEKING AND MARKET DYNAMICS AT work: oil prices.
Demand – main use of oil products is in transport services, demand is inelastic in the short
run, if petrol prices surprise commuters will continue to use the existing cars to travel. So the
short run demand curve is steep.
Income elasticity of demand- The percentage change in demand that would occur in
response to a 1% increase in the individual’s income.
In this case, it is the inelastic short-run supply curve for oil that accounts for the big increase
in price and only a modest increase in world oil consumption.
The sharp price decrease in 2009 has the same explanation but in reverse: the financial crisis
of 2008–9 was a negative demand shock that moved the demand curve to the left, so world
consumption fell by about 3%, and the price of crude fell from over $100 per barrel in the
summer of 2008 to $40–50 in early 2009.
11.5 THE VALUE OF AN ASSET: BASICS
Two important determinants of the value of a financial asset (also called a security) are the
size of the cash flows that it is expected to generate, and uncertainty in one’s forecasts of
these cash flows.
Government bond- A financial instrument issued by governments that promises to pay flows
of money at specific intervals
The promised stream of payments is fixed, so the lower the price of the asset, the greater will
be the interest rate that it yields to a buyer.
Bond- A type of financial asset for which the issuer promises to pay a given amount over time
to the holder.
The greater the risk of default, the higher will be the interest rate that investors demand in
order to hold the asset. If two bonds promise exactly the same stream of payments, the
riskier one will have a lower price. Investors will earn a higher interest rate if they buy the
riskier bond and it happens not to default but face a greater risk that the promised payments
will not all materialize.
Share- A part of the assets of a firm that may be traded. It gives the holder a right to receive a
proportion of a firm’s profit and to benefit when the firm’s assets become more valuable.
Systematic risk (undiversifiable)-A risk that affects all assets in the market, so that it is not
possible for investors to reduce their exposure to the risk by holding a combination
of different assets.
Idiosyncratic risk- A risk that only affects a small number of assets at one time. Traders can
almost eliminate their exposure to such risks by holding a diverse portfolio of assets affected
by different risks.
, Diversifiable risk is essentially irrelevant in the valuation of securities, because investors can
almost eliminate it by constructing portfolios that contain a large number of assets, each of
which has a very small weight. In any given period, some of the firms in the portfolio will
experience positive shocks, and some negative, but as long as shocks are truly idiosyncratic,
they will ten
Systemic risk- A risk that threatens the financial system itself.
Arises from shocks that affect large classes of securities simultaneously and cannot be
diversified away. Different firms are exposed to different levels of systematic risk, depending
on the degree to which their earnings are correlated with those of the market as a whole.
e.g Ford - Heavily dependent on economic conditions in the economy as a whole - since
people postpone purchases of cars during economic downturns
e.g Gas + Electricity - sheltered from such risks since energy consumption is not very sensitive
to economic conditions.
Market capitalization rate- The rate of return that is just high enough to induce investors to
hold shares in a particular company. This will be high if the company is subject to a high level
of systematic risk.
Fundamental value of a share- The share price based on anticipated future earnings and the
level of risk.
Other strategies - some traders look for momentum in asset prices, buying → prices to rise or
selling → price is to fold
Speculation- Buying and selling assets in order to profit from an anticipated change in their
price.
11.6 CHANGING SUPPLY AND DEMAND FOR FINANCIAL ASSETS
Secondary and primary markets
The primary market is where goods or financial assets are sold for the first time. E.g the initial
sale of shares by a company to an investor (known as an initial public offering or IPO) is on
the primary market. The subsequent trading of those shares on the stock exchange is on the
secondary market. The terms are also used to describe the initial sale of tickets (primary
market) and the secondary market in which they are traded.
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