In our day to day, it is common to hear about the market and its consequences in our lives. We talk about the market when we complain about price increases, high unemployment rates or the death of a particular company or product. But what is the market? How are prices decided? Is the market always right? Is it fair? Let’s find out.
The market is defined as the exchange of goods and services between individuals. The market is not dependent on the existence of companies, money or governments. It is only a result of the human need to acquire things and the willingness of other people to satisfy that need in exchange for something else. Although things such as money clearly facilitate the exchange of goods and services, companies facilitate the production of these and governments provide security to these exchanges (most of the time).
And how are these prices decided? Through supply and demand. The supply is the quantity of a product that is offered on the market, and the demand is the amount of this product that the buyers desire. These two variables interact with each other to establish what is called the market price. The market price is not always what we see on the streets due to all kinds of distortions that exist in the economy: State regulations, subsidies, monopolies, contextual factors or incomplete information.
This chart was created by the British economist Alfred Marshall in 1890 and represents an ordinary market in its simplest expression. The vertical axis represents the price of the product to be analyzed, and the horizontal axis represents the quantity of this product.
The blue curve is the supply, what is produced by the companies. The red curve is the demand, what consumers want. The point of intersection between the two curves is the point of equilibrium, where producers get the maximum possible benefit from their product and at the same time sell everything that has been produced.
The supply curve shows us that as the prices increase, companies will produce more of this product because it is highly profitable. The demand curve instead tells us that when prices decrease, consumers will buy more of this product because it is more accessible.
Changes in supply and demand curves
The supply and demand curves may move because of non-price factors. For example subsidies to companies that produce a particular type of product would cause the supply curve to move outwards, reducing its market price.
On the other hand, some natural disaster that affects the productive capacity of the businesses would cause the supply curve to move inwards, raising the market price of this product.
On the demand side, most of the movements in its curve are related to the change of preferences. To understand this, we need to take a look at certain concepts such as substitute and complementary products, and normal and inferior goods.
Returning to the demand movements, take an example where there is a disease that affects livestock, specifically the one that produces milk. This would reduce the supply of butter, which is a derivative of milk, which would raise its price as we saw earlier.
But things do not stop there. As the price of butter rose people begin to look for an alternative, in this case, margarine. A more expensive butter will increase the demand for margarine because it is a substitute good.
On the other hand, we have a situation where a town that was relatively poor before has an economic boom (let’s say due to the discovery of oil reserves). The inhabitants of this town, who used to eat instant food because of income restrictions, now have access to healthier foods, reducing the demand for instant food.
Ceilings and price floors
There are certain situations where markets are not in equilibrium and therefore there is a scarcity or oversupply of goods and services. One of the ways in which these situations arise is through the implementation of government enforced price ceilings and floors.
A price ceiling refers to the maximum price at which a product can be sold. For example, let’s say the government implements a price control in which a gallon of milk can not be sold for more than $ 1. With the intention that the lower income population can access this product. If the market price of milk is below $ 1, nothing happens. But if the market price is above $ 1 the following happens:
In the previous image, we can see that there is a high demand (Qd) for milk due to its low price (Pr), but there is a low supply (Qs) of it because it is unprofitable for the producers. Therefore, supply does not match demand and scarcity arises.
The opposite situation is the price floors; this is when something can not be sold for less than the mandated value. The most common example of this is minimum wages (labor is subject to the same laws of supply and demand as products); Let’s say a government sets a minimum wage of $ 1200 per month for the whole country. In the prosperous capital, where wages tend to exceed $ 1200 this measure does not have much effect on the labor market. However, this is not the case in the more rural areas, where wages oscillate around the $ 800 monthly:
In this situation, there is an oversupply of labor (Qs), since people wish to work for the established wage (Pf). However many companies are not able or just do not want to pay those wages, and thus they decide to hire fewer people (Qd). So there is an oversupply of labor in a situation of low demand, that is, there is unemployment.
Elasticity of demand
Another important concept to understand the market is the elasticity of demand for certain products. And what is elasticity?
Elasticity is the change in demand in relation to the price of a product. If we raise the price of a product, how many people stop buying it?
The formula for finding elasticity is this:
E = ΔD / ΔP
ΔD is the variation in the demand and ΔP is the variation in the price.
When the elasticity is greater than one, it means that the product is elastic and its demand varies considerably with the price. Values of less than one indicate that the product is inelastic and its demand responds less to changes in the price.
Let’s say that we have a product of basic need, food for example, whose market price is $ 1. Under this price, the demand for this product is 1000 units. For reasons that do not interest us the price of this product increases to $ 1.5, and consequently, its demand is reduced to 800 units. Let’s see what its elasticity is:
ΔD = (800/1000) – 1 = -0.2 0 -20%
ΔP = ($ 1.5 / $ 1) – 1 = 0.5 or 50%
E = -0.2 / 0.5 = -0.4
Usually, the elasticity is expressed in positive terms, so the final result is 0.4. Being a value of less than one, we can say that this is an inelastic product. The product would be elastic if the demand fell, for example, to 400 (-0.6 / 0.5 = 1.2).
The question now is: Are there products with negative elasticity? These goods that break the law of demand (higher price = lower demand) exist, although they are very scarce and in some cases, merely theoretical, and these are the Veblen and Giffen goods.
The last aspect to talk about are the factors that affect the elasticity of products. What makes a product respond little or a lot to a change in price?
The first factor is the necessity mentioned above. If a product is essential in the lives of many people then they will be willing to pay any price for it, so the demand for that product will react little to changes in the price.
The second is the availability of substitutes. If you have a good X that is necessary to the daily life, but there is another Y good that fulfills the same function, then people will simply change to the Y good when the price of X increases.
The income of people is the third factor. Individuals with lower resources are more sensitive to price changes, while the wealthy are less affected when prices rise.
And the fourth factor is the duration of the product, when people have to buy a product regularly, the greater the sensitivity of consumers to its price, while the demand for durable products tends to be more inelastic.
Types of markets
Now that we know the basics of how prices are settled and how the supply and demand works, an important question comes up: How real are these models? Does everything we have just learned works this way in practice? The answer is … more or less.
The function of the supply and demand as a mechanism for settling prices works optimally in what is called a perfect competition market. And what is that?
A perfect competition market is one where there are a large number of agents involved in the commercialization of a product, and where none of these agents has considerable power over the market. In general terms, the easier it is to create a new company in a given market, the more the market will tend towards perfect competition.
However not all markets are perfectly competitive, there are two other types of markets that we see every day where competition is imperfect: monopolies and oligopolies.
Oligopolies are markets where a small number of businesses have enormous power over the market. Examples of oligopolies are the telecommunication companies and airlines.
Although competition exists in oligopolies, it is very different from competitive markets. Oligopolies, in general, are much more reluctant to price changes. A slight price increase will cause them to lose a significant number of consumers to other companies. And a price reduction will usually lead the other companies to do the same, generating losses for everyone.
Second, and probably more relevant concerning the creation of economic policy, is that in oligopolies companies can collude to maximize their profits to the detriment of the consumer, this can mean a pact to raise prices across the market or agreeing on areas of influence that would result in local monopolies.
And that brings us to the other market model, the monopoly. Monopolies are situations where a single company has all or almost all the control over a market. In some cases, monopolies are natural, such as public services, because the logistics to provide services to a city makes competition difficult.
In others, the monopoly is granted by the state, either by cronyism or a desire to take services to areas where the companies usually would not normally go (giving them the monopoly assures them that they will have benefits).
And last are the monopolies formed by mergers and acquisitions. Acquisitions involve the purchase of one company by another, while mergers are an agreement between two companies to become one. The result is the same: a company with greater market power. With enough mergers and acquisitions, we end up with an entity that has undisputed market control.
The negative effects of monopolies are evident. Consumers do not have options to choose from, being forced to consume only one type of product. The monopolist controls the supply of the product, being able to reduce supply to raise prices (as is the case of DeBeers and diamonds), and if the monopolized product is inelastic, the monopolist can raise prices without losing too many consumers.
In general, monopolies and oligopolies tend to be controlled by legislation: Laws to limit mergers and acquisitions, legislation to prevent collusion in the case of oligopolies, prohibition of anticompetitive practices that are intended to destroy competition, etc.
The effects of these laws tend to vary and are less effective if these entities have the capacity to influence the legislation of a country with its economic power.
The prices of products in the market are established using supply and demand: the more demand there is for a product, the higher the price. When there is more offer, the price is reduced.
Some non-supply and demand factors can affect the price of a product, from natural disasters to government-set regulations.
The relationship between price and demand is determined by something called elasticity, the more elastic a product is, the more sensitive it is to price. Essential products tend to be inelastic while Luxury products are elastic (with certain exceptions such as Veblen goods).
Pricing through supply and demand operates optimally when markets are perfect, that is when there are many companies, and no one controls the market.
However, this is not always the situation. There are two other types of markets, oligopolies, and monopolies, where competition is imperfect because there is a small number of competitors or only one, which can influence the market to maximize profits.
I hope this text has been of help to those who wish to know how the markets work in their most basic form, if you have any doubts or want to suggest a correction I invite you to leave a message below. If your contribution leads me to make any changes to the text, I will be sure to give you credit for this.