(Mechanical Engineering Series) Sara McAllister, Jyh-Yuan Chen, A. Carlos Fernandez-Pello (Auth.) - Fundamentals of Combustion Processes (2011, Springer-Verlag New York)

Fundamentals
of Markets
© 2017 B. Zhang and the University of Washington
1
Let us go to the market...
•  Opportunity for buyers and
sellers to:

–  compare prices

–  esFmate demand

–  esFmate supply
•  Achieve an equilibrium
between supply and
demand
© 2017 B. Zhang and the University of Washington 2

How much do I value apples?
Price
One apple for my break
Take some back for lunch
Enough for every meal
Home-made apple pie
Home-made cider?
Quantity
Consumers spend until the price is equal to their marginal utility

Demand curve
Price •  AggregaFon of the
individual demand of all
consumers
•  Demand funcFon:
q = D(π )
•  Inverse demand funcFon:
Quantity −1
π = D (q)

ElasFcity of the demand
Price
•  Slope is an indicaFon of the
elasFcity of the demand
High elasticity good
•  High elasFcity
–  Non-essenFal good
–  Easy subsFtuFon
Quantity
•  Low elasFcity
–  EssenFal good
Price
–  No subsFtutes
Low elasticity good •  Electrical energy has a very

low elasFcity in the short
term
Quantity

Price elasFcity of the demand
•  MathemaFcal definiFon:
dq
q π dq
ε= = ⋅
dπ q dπ
π
•  Dimensionless quanFty

Supply side
•  How many widgets shall I produce?
–  Goal: make a profit on each widget sold
–  Produce one more widget if and only if the cost of
producing it is less than the market price
•  Need to know the cost of producing the next widget

•  Considers only the variable costs
•  Ignores the fixed costs
–  Investments in producFon plants and machines

How much does the next one costs?
Cost of producing a widget
Total
Quantity
Normal production procedure

Total
Quantity
Use older machines

Total
Quantity
Second shift production

Total
Quantity
Third shift production

Total
Quantity
Extra maintenance costs

Supply curve
•  AggregaFon of marginal cost
Price or marginal cost curves of all suppliers
•  Considers only variable
operaFng costs
•  Does not take cost of
investments into account
•  Supply funcFon:
Quantity
π = S −1 (q)
•  Inverse supply funcFon:
q = S(π )
Price elasFcity of the supply
Price or marginal cost
dq
q π dq
ε= = ⋅
dπ q dπ
π
Quantity

Market equilibrium
Price Supply curve
Willingness to sell
market
market equilibrium
clearing
price
Demand curve
Willingness to buy
volume Quantity
transacted

Supply and Demand
Price
supply
equilibrium point
demand
Quantity

Market equilibrium
q* = D(π * ) = S(π * )
Price
supply π * = D−1 (q* ) = S −1 (q* )
market •  Sellers have no incenFve

clearing to sell for less
price
•  Buyers have no incenFve
demand to buy for more
volume Quantity
transacted

Centralized aucFon
•  Producers enter their
offers: quanFty and price
–  Offers are stacked up to
construct the supply Price
curve
•  Consumers enter their bids:
quanFty and price
–  Bids are stacked up to
construct the demand
curve
•  IntersecFon determines the
market equilibrium:
–  Market clearing price Quantity
–  Transacted quanFty

Centralized aucFon
•  Everything is sold at the
market clearing price
•  Price is set by the “last” unit Price supply
sold
•  Marginal producer:
–  Sells this last unit
Extra-marginal
–  Gets exactly its offer
•  Infra-marginal producers:
–  Get paid more than their
offer Infra-
demand
–  Collect economic profit marginal
Quantity
•  Extra-marginal producers:
–  Sell nothing
Marginal producer

Bilateral transacFons
•  Producers and consumers trade directly and
independently
•  Consumers “shop around” for the best deal
•  Producers check the compeFFon’s prices
•  An efficient market “discovers” the
equilibrium price

What makes a market efficient?
•  All buyers and sellers have access to sufficient
informaFon about prices, supply and demand
•  Factors favouring an efficient market
–  Number of parFcipants
–  Standard definiFon of commodiFes
–  Good informaFon exchange mechanisms

Examples
•  Efficient markets:
–  Open air food market
–  Chicago mercanFle exchange

•  Inefficient markets:
–  Used cars

Consumer’s Surplus
•  Buy 6 apples at 10¢
•  Total cost = 60¢ Price
•  At that price I am
15¢
gedng apples for which Consumer’s surplus
I would have been

10¢
ready to pay more
Total cost
•  Surplus:
5+4+3+2+1=15¢
6 Quantity

Economic Profit of Suppliers
Price Price
supply supply
π
Profit
demand
demand Cost
Quantity Quantity
Revenue
•  Cost includes only the variable cost of producFon

•  Economic profit covers fixed costs and shareholders’
returns
Social or Global Welfare
Price
supply
Consumers’ surplus
+
Suppliers’ profit demand
= Social or global welfare Quantity

Market equilibrium and social welfare
Operating point
π π
supply supply
Welfare loss
demand
demand
Q Q
Market equilibrium Artificially high price:

•  larger supplier profit
•  smaller consumer surplus
•  smaller social welfare
Market equilibrium and social welfare
Welfare loss
π π
supply supply
demand
demand
Operating point
Q Q
Market equilibrium Artificially low price:

•  smaller supplier profit
•  higher consumer surplus
•  smaller social welfare
Market Equilibrium: Summary
•  Price = marginal revenue of supplier
= marginal cost of supplier
= marginal cost of consumer
= marginal uFlity to consumer

Time varying prices
•  Market price varies with offer and demand:
–  If demand increases
•  Price increases beyond uFlity for some
consumers
•  Demand decreases
•  Market sefles at a new equilibrium
–  If demand decreases
•  Price decreases
•  Some producers leave the market
•  Market sefles at a new equilibrium
•  In theory, there should never be a shortage
•  Encourages efficient use of resources
Time-varying prices vs. fixed price
•  Assume fixed price = average of market price
•  Period of high demand
–  Fixed price < marginal uFlity and marginal cost
–  Consumers conFnue buying the commodity rather
than switch to another commodity
•  Period of low demand
–  Fixed price > marginal uFlity and marginal cost
–  Consumers do not switch from other commodiFes
•  Inefficient allocaFon of resources

Concepts from the Theory of the Firm
31
ProducFon funcFon
y = f ( x1,x 2 )
•  y: output
•  x1 , x2: factors of producFon
y y
x2 fixed x1 fixed
x1 x2
Law of diminishing marginal return

Long run and short run
•  Some factors of producFon can be adjusted
faster than others
–  Example: ferFlizer vs. planFng more trees
•  Long run: all factors can be changed
•  Short run: some factors cannot be changed
•  No specific duraFon separates long and short
run
•  Long run = long term
•  Short run = short term
Input-output funcFon
y = f (x1 ,x2 ) x 2 fixed
The inverse of the production function is the

input-output function
x 1 = g ( y ) for x 2 = x 2
Example: amount of fuel required to produce a

certain amount of power with a given plant

Short run cost funcFon
c SR ( y ) = w 1 ⋅ x 1 + w 2 ⋅ x 2 = w 1 ⋅ g( y ) + w 2 ⋅ x 2
•  w1, w2: unit cost of factors of producFon x1, x2
c SR ( y )
© 2017 B. Zhang and the University of Washington y 35

Short run marginal cost funcFon
c SR ( y )
Convex due to law
of marginal returns
dc SR ( y )
y
dy
Non-decreasing function
y
OpFmal producFon
•  ProducFon that maximizes profit:
max { π ⋅ y − c SR ( y ) }
y
d {π ⋅ y − c SR ( y ) }
=0
dy
dc SR ( y ) Only if the price π does not depend

π= on y è perfect competition
dy
Costs: Accountant’s perspecFve
•  In the short run, some costs are
variable and others are fixed
•  Variable costs:
–  labour Production cost [$]
–  materials
–  fuel
–  transportaFon
•  Fixed costs (amorFzed):
–  equipment
–  land
–  Overheads
•  Quasi-fixed costs
–  Start-up cost of power plant
•  Sunk costs vs. recoverable costs Quantity

Average cost
c( y ) = c v ( y ) + c f
c( y) cv (y ) c f
AC ( y ) = = + = AVC ( y ) + AFC ( y )
y y y
Production cost [$] Average cost [$/unit]
Quantity Quantity

Marginal vs. average cost
MC AC
$/unit
Production

When should I stop producing?
•  Marginal cost = cost of producing one more unit

•  If MC > π next unit costs more than it returns
•  If MC < π next unit returns more than it costs
•  Profitable only if Q4 > Q1 because of fixed costs
Average cost [$/unit] Marginal

cost
[$/unit]
π
Q1 Q2 Q3 Q4

Costs: Economist’s perspecFve
•  Opportunity cost:
–  What would be the best use of the money spent to make
the product ?
–  Not taking the opportunity to sell at a higher price
represents a cost
•  Examples:
–  Use the money to grow apples or put it in the bank where
it earns interests?
–  Growing apples or growing kiwis?
•  Comparisons should be made against a “normal profit”
–  What putting money in the bank would bring
•  Selling “at cost” means making a “normal profit”
–  Usually not good enough because it does not compensate for the risk
involved in the business

Risks, Markets and Contracts
43
Concept of Risk
•  Future is uncertain
•  Uncertainty translates into risk
–  In this case, risk of loss of income
•  Risk = probability x consequences
•  Doing business means accepFng some risks
•  Willingness to accept risk varies:
–  Venture capitalist vs. reFree
•  Ability to control risk varies:
–  Professional traders vs. novice investors

Sources of Risk
•  Technical risk
–  Fail to produce or deliver because of technical
problem
•  Power plant outage, congesFon in the transmission system
•  External risk
–  Fail to produce or deliver because of cataclysmic
event
•  Weather, earthquake, war
•  Price risk
–  Having to buy at a price much higher than expected
–  Having to sell at a price much lower than expected

Managing Risks
•  Excessive risk hampers economic acFvity
– Not everybody can survive short term losses
– Society benefits if more people can take part
– Business should not be limited to large
companies with deep pockets
•  How can risk be managed:
– Reduce the risk
– Share the risk
– Relocate the risk
Reducing the Risks
•  Reduce frequency or consequences of technical
problems
–  Those who can reduce risk should have an incenFve to do it!
•  Owners of power plants
•  Reduce consequences of natural catastrophes
–  Owners and operators of transmission system
–  Design systems to be able to withstand rare events
•  Enough crews to repair the power system aser a hurricane
•  Security margin in power system operaFon
–  Limits the consequences of rare but unpredictable and
catastrophic events
–  Increases the daily cost of electrical energy
–  Does not cover all possible problems because that would cost
too much

Sharing the Risks
•  Insurance:
–  All the members of a large group pay a small
amount to compensate the few who suffer a big
loss
–  The consequences of a catastrophic event are
shared by a large group rather than a few
•  Grid operator does not have to pay
compensaFon in the event of a blackout

RelocaFng Risk
•  Possible if one party is more willing or able to
accept it
–  Loss is not catastrophic for this party
–  This party can offset this loss against gains in
other acFviFes
•  Applies mostly to price risk
•  How does this relate to markets?

Spot Market
Spot
Sellers Buyers
Market
•  Immediate market, “On the Spot”

–  Agreement on price
–  Agreement on quanFty
–  Agreement on locaFon
–  UncondiFonal delivery
–  Immediate delivery

Examples of Spot Markets
•  Examples
–  Food market
–  Basic shopping
–  Roferdam spot market for oil
–  CommodiFes markets: corn, wheat, cocoa, coffee
•  Formal or informal
Advantages and Disadvantages
•  Advantages:
–  Simple
–  Flexible
–  Immediate
•  Disadvantages
–  Prices can fluctuate widely based on
circumstances
–  Example:
•  Effect of frost in Brazil on the price of coffee
beans
•  Effect of trouble in the Middle East on the price
of oil

Spot Market Risks
•  Market may not have much depth
–  Not enough sellers: market is short
–  Not enough buyers: market is long
•  Lack of depth causes large price fluctuaFons
–  Small producer may have to sell at a low price
–  Small purchaser may have to buy at a high price
–  “Price risk”
•  Relying on the spot market for buying or selling large
quanFFes is a bad idea

Example: buying and selling wheat
•  Farmer produces wheat

•  Miller buys wheat to make flour
•  Farmer carries the risk of bad weather
•  Miller carries the risk of breakdown of flour mill
•  Neither farmer nor miller control price of wheat
Harvest Fme
•  If price of wheat is low:

–  Possibly devastaFng for the farmer
–  Good deal for the miller
•  If the price is high:
–  Good deal for the farmer
–  Possibly devastaFng for the miller
What should they do?
•  OpFon 1: Accept the spot price of wheat
–  Equivalent to gambling
•  OpFon 2: Agree ahead of Fme on a price that
is acceptable to both parFes
–  Forward contract

Forward Contract
•  Agreement:
–  QuanFty and quality
–  Price
–  Date of delivery (not immediate)
•  Paid at Fme of delivery
•  UncondiFonal delivery

Forward Contract
Contract (1June)
1 ton of wheat at $100
on 1 September
Maturity (1 September)
Seller delivers 1 ton of wheat
Buyer pays $100
Spot Price = $90
Profit to seller = $10 58
How is the forward price set?
Spot Price
Time
•  Both parFes look at their alternaFve: spot price
•  Both forecast what the spot price is likely to be
Sharing risk
•  In a forward contract, the buyer and seller
share the risk that the price differs from their
expectaFon
•  Difference between contract price and spot
price at Fme of delivery represents a “profit”
for one party and a “loss” for the other
•  However, in the meanFme they have been
able to get on with their business
–  Buy new farm machinery
–  Sell the flour to bakeries

Adtudes towards risk
•  Suppose that both parFes forecast the same value
spot price at Fme of delivery
•  Equal adtude towards risk

–  Forward price is equal to expected spot price
•  “Risk aversion”

•  If buyer is less risk averse than seller
–  Buyer can negoFate a forward price lower than
the expected spot price
–  Seller agrees to this lower price because it reduces
its risk
–  Difference between expected spot price and
forward price is called a premium
–  Premium = price that seller is willing to pay to
reduce risk

•  If buyer is more risk averse than seller
–  Seller can negoFate a forward price higher than
the expected spot price
–  Buyer agrees to this higher price because it
reduces its risk
–  Buyer is willing to pay the premium to reduce risk

Case 1:
•  Farmer esFmates that the spot price will be
$100
•  Miller also forecasts that the spot price will
be $100
•  They can agree on a forward price of $100

Case 2:
$90
•  Miller forecasts that the spot price will be
$110
•  They can easily agree on a forward price of
somewhere between $90 and $110
•  Exact price will depend on negoFaFon ability
and relaFve risk aversion

Case 3:
$110
•  Miller forecasts that the spot price will be
$90
•  Agreeing on a forward price is likely to be
difficult unless they have widely different risk
aversions

Forward Markets
•  Since there are many millers and farmers, a
market can be organised for forward
contracts
•  Forward price represents the aggregated
expectaFon of the spot price, plus or minus
a risk premium

What if...
Spot Price
Forward
Price
Time
•  Suppose that millers are less risk adverse
•  Premium below the expected spot price
•  Spot price turns out to be much lower than forward price because
of a bumper harvest
What if...
Spot Price
Forward
Price
Time
•  Farmers breathe a sigh of relief…
•  Millers take a big loss
•  The following year the millers ask for a much
bigger premium
•  Is agreement between the millers and the
farmers going to be possible?
Undiversified risk
•  Farmers and millers deal only in wheat
•  Their risk is undiversified
•  Can only offset “good years” against “bad
years”
•  Risk remains high
•  Reducing the risk further would help business

DiversificaFon
•  DiversificaFon: deal with more than

one commodity
•  Average risk over different
commodiFes
•  Farmers may not want to diversify
their producFon because it could be
inefficient

Physical parFcipants vs. traders
•  Physical parFcipants
–  Produce, consume or can store the commodity
–  Face undiversified risk because they deal in only one
commodity
•  Traders (a.k.a. speculators)

–  Cannot take physical delivery of the commodity
–  Diversify their risk by dealing in many commodiFes
–  Specialize in risk management
Trading by speculators
•  Cannot take physical delivery of the commodity
•  Must balance their posiFon on date of delivery
–  QuanFty bought must equal quanFty sold
–  Buy or sell from spot market if necessary
•  May involve many transacFons
•  Forward contracts limited to parFes who can take
physical delivery
•  Need a standardised contract to reduce the cost of
trading: future contract
•  Future contracts (futures) allow others to
parFcipate in the market and share the risk

Futures Contract
2 tons at $110
1 ton
2 tons at $90 At $ 95
1 ton
At $115
All contracts for wheat

on 1 September

Futures Contract
Shortly before 1 September Spot Price $100
bought 2 tons at $110
bought 1 ton at $95
sold 1 ton at $115
sold 2 tons at $110

sold 2 tons at $90
Delivers 4 tons
Sells 2 tons at $100
sold 1 ton at $95
bought 1 ton at $115

Sells 1 ton at $100

Futures Contract
bought 1 ton at $95
sold 1 ton at $115
sold 2 tons at $100
sold 2 tons at $110 net profit: $0
sold 2 tons at $90

sold 1 ton at $95 Spot Price = $100
sold 1 ton at $100
net profit: $15
bought 1 ton at $115

bought 3 tons at $100 76
Importance of informaFon
•  Speculators own some of the commodity before it is
delivered
•  They carry the risk of a price change during that
period
•  Need deep pockets
•  Without addiFonal informaFon, this is gambling
•  InformaFon helps speculators make money
•  Example:
–  Global perspecFve on the harvest for wheat
–  Long term weather forecast and its effect on the
demand for gas and electricity
OpFons
•  Spot, forward and future contracts: uncondiFonal
delivery
•  OpFons: condiFonal delivery

–  Call OpFon: right to buy at a certain price at a
certain Fme
–  Put OpFon: right to sell at a certain price at a certain
Fme
•  Two elements of the price:
–  Exercise or strike price = price paid when opFon is
exercised
–  Premium or opFon fee = price paid for the opFon
itself
Example of Call OpFon
•  Call OpFon with an exercise price of $100
•  About to expire
•  If the spot market price is $90 the opFon is
worth nothing
worth $10
•  Holder makes money if value > opFon fee

Example of Put OpFon
•  Put OpFon with an exercise price of $100
•  About to expire
worth $10
worth nothing
•  Holder makes money if value > opFon fee

Financial Contracts
•  Contracts without any physical delivery
B C
A D
Financial
contract Physical Market
(Spot)
X Z
Y W

One-way contract for difference
•  Example:
–  Buyer has call opFon for 50 units at $100 per unit
–  Spot price goes up to $110 per unit
–  Buyer pays $5500 for the 50 units in the physical
market
–  Seller receives $5500 for the 50 units in the
physical market
–  Buyer calls the opFon to buy 50 units at $100
–  Seller transfers $500 to the buyer to sefle the
contract
Two-Way Contract for Difference
•  CombinaFon of a call and a put opFon for the
same price --> will always be used
•  Example 1: CFD for 50 units at $100
–  spot price = $110
–  buyer pays $5500 on physical (spot) market
–  seller receives $5500 from the physical market
–  seller pays buyer $500
–  buyer effecFvely pays $5000
–  seller effecFvely gets $5000

Two-Way Contract for Difference
•  Example 2: CFD for 50 units at $100
–  spot price = $90
–  buyer pays $4500 to the physical (spot) market
–  seller receives $4500 from the physical market
–  buyer pays seller $500
–  buyer effecFvely pays $5000
–  seller effecFvely gets $5000
•  Buyer and seller “insulated” from physical
market

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Fundamentals

© 2017 B. Zhang and the University of Washington

© 2017 B. Zhang and the University of Washington 2

Take some back for lunch

Enough for every meal

Home-made apple pie

Consumers spend until the price is equal to their marginal utility

© 2017 B. Zhang and the University of Washington 4

Low elasticity good • Electrical energy has a very

© 2017 B. Zhang and the University of Washington 5

© 2017 B. Zhang and the University of Washington 6

• Need to know the cost of producing the next widget

© 2017 B. Zhang and the University of Washington 7

Normal production procedure

© 2017 B. Zhang and the University of Washington 8

Use older machines

© 2017 B. Zhang and the University of Washington 9

Second shift production

© 2017 B. Zhang and the University of Washington 10

Third shift production

© 2017 B. Zhang and the University of Washington 11

Extra maintenance costs

© 2017 B. Zhang and the University of Washington 12

© 2017 B. Zhang and the University of Washington 14

© 2017 B. Zhang and the University of Washington 15

© 2017 B. Zhang and the University of Washington 16

market • Sellers have no incenFve

© 2017 B. Zhang and the University of Washington 17

© 2017 B. Zhang and the University of Washington 18

© 2017 B. Zhang and the University of Washington 19

© 2017 B. Zhang and the University of Washington 20

© 2017 B. Zhang and the University of Washington 21

© 2017 B. Zhang and the University of Washington 22

I would have been

© 2017 B. Zhang and the University of Washington 23

• Cost includes only the variable cost of producFon

= Social or global welfare Quantity

© 2017 B. Zhang and the University of Washington 25

Market equilibrium Artificially high price:

Market equilibrium Artificially low price:

© 2017 B. Zhang and the University of Washington 28

© 2017 B. Zhang and the University of Washington 30

© 2017 B. Zhang and the University of Washington

Law of diminishing marginal return

The inverse of the production function is the

Example: amount of fuel required to produce a

© 2017 B. Zhang and the University of Washington 34

• w1, w2: unit cost of factors of producFon x1, x2

© 2017 B. Zhang and the University of Washington y 35

dc SR ( y ) Only if the price π does not depend

© 2017 B. Zhang and the University of Washington 38

Production cost [$] Average cost [$/unit]

© 2017 B. Zhang and the University of Washington 39

© 2017 B. Zhang and the University of Washington 40

• Marginal cost = cost of producing one more unit

Average cost [$/unit] Marginal

© 2017 B. Zhang and the University of Washington 41

© 2017 B. Zhang and the University of Washington 42

© 2017 B. Zhang and the University of Washington 44

© 2017 B. Zhang and the University of Washington 45

© 2017 B. Zhang and the University of Washington 47

© 2017 B. Zhang and the University of Washington 48

© 2017 B. Zhang and the University of Washington 49

Low elasticity good •  Electrical energy has a very

•  Need to know the cost of producing the next widget

market •  Sellers have no incenFve

•  Cost includes only the variable cost of producFon

•  w1, w2: unit cost of factors of producFon x1, x2

•  Marginal cost = cost of producing one more unit

•  Immediate market, “On the Spot”

•  Farmer produces wheat

•  If price of wheat is low:

•  Equal adtude towards risk

•  DiversiﬁcaFon: deal with more than

•  Traders (a.k.a. speculators)

•  OpFons: condiFonal delivery