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Circular Flow Model: Demand, Supply, and Market Equilibrium

This lecture discusses the circular flow model, demand, and supply in the market, and explores the concept of market equilibrium. It also covers comparative statics, uniqueness of equilibrium, and demand analysis.

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Circular Flow Model: Demand, Supply, and Market Equilibrium

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  1. See Handout (contains whole of lectures 3-5) Topic 1: Lecture 3 • The circular flow model Agent: Households Demand Supply Market: Goods/Services Market: Inputs Agent: Firms Demand Supply Robin Naylor, Department of Economics, Warwick

  2. Topic 1: Lecture 3 • Demand • Consider a Demand Relation: • What are the influences on Demand for a good . . . ? How does a change in some other influence affect the demand curve? px a po What does the slope of the demand curve tell us? b D Xo X Robin Naylor, Department of Economics, Warwick

  3. Topic 1: Lecture 3 Robin Naylor, Department of Economics, Warwick

  4. Topic 1: Lecture 3 Robin Naylor, Department of Economics, Warwick

  5. Topic 1: Lecture 3 Robin Naylor, Department of Economics, Warwick

  6. Topic 1: Lecture 3 • Supply • Consider a Supply Relation: • What are the influences on Supply a good . . . ? How does a change in some other influence affect the Supply curve? px S What does the slope of the Supply curve tell us? a po b Xo X Robin Naylor, Department of Economics, Warwick

  7. Topic 1: Lecture 3 Robin Naylor, Department of Economics, Warwick

  8. Topic 1: Lecture 3 • Putting together Supply and Demand: What is meant by the ‘market equilibrium’? px S What are the possible properties of a market equilibrium? pe D Xe X Robin Naylor, Department of Economics, Warwick

  9. Topic 1: Lecture 3 • Comparative Statics: What is the effect on market equilibrium of a shift in demand? px S pe D Xe X Robin Naylor, Department of Economics, Warwick

  10. Topic 1: Lecture 3 • Comparative Statics: What is the effect on market equilibrium of a shift in supply? px S pe D Xe X Robin Naylor, Department of Economics, Warwick

  11. Topic 1: Lecture 3 • Uniqueness of equilibrium and price bubbles: Suppose D is the Willingness to Pay for housing. It’s likely to depend on Consumer Confidence (CC). (i) What happens if CC rises? (ii) What might cause CC to rise? What is the implication of this? px S pe D Xe X Robin Naylor, Department of Economics, Warwick

  12. Topic 1: Lecture 3 Robin Naylor, Department of Economics, Warwick

  13. Topic 1: Lecture 3 Robin Naylor, Department of Economics, Warwick

  14. Topic 1: Lecture 3 Robin Naylor, Department of Economics, Warwick

  15. Topic 1: Lecture 3 Robin Naylor, Department of Economics, Warwick

  16. Topic 1: Lecture 4 Demand Analysis (or analysis of ‘Consumer Choice’) Choice is based on . . . . . . Preferences and . . . Constraints We’ll analyse each of these in turn. Robin Naylor, Department of Economics, Warwick

  17. Topic 1: Lecture 4 Demand Analysis: Preferences Suppose your happiness depends on just 2 commodities (that you might buy in the market): e.g., ??? Robin Naylor, Department of Economics, Warwick

  18. Topic 1: Lecture 4 • Demand Analysis: Preferences • E.g., Books and Food • We assume that you have preferences over these goods and that the nature of your preferences satisfies various properties: • Non-satiation . . . . . . in words: • Ordinal Ranking • Transitivity • Completeness Robin Naylor, Department of Economics, Warwick

  19. Topic 1: Lecture 4 Demand Analysis: Preferences Non-satiation . . . in a diagram. B a b B1 F1 F2 F Robin Naylor, Department of Economics, Warwick

  20. Topic 1: Lecture 4 Demand Analysis: Preferences Our assumptions about the properties of preferences imply that we can represent preferences using Indifference Curves. These ICs will have properties which depend upon the properties of the underlying preferences. B We can show that an IC must slope downwards because of non-satiation. a b B1 F1 F2 F Robin Naylor, Department of Economics, Warwick

  21. Topic 1: Lecture 4 Demand Analysis: Preferences We can show that ICs cannot cross under the assumptions we have made about preferences: IC1 B IC2 a c b F Robin Naylor, Department of Economics, Warwick

  22. Topic 1: Lecture 4 Demand Analysis: Preferences The slope of the IC is the MRS between the 2 goods (refer to earlier slides). B a b IC1 F Robin Naylor, Department of Economics, Warwick

  23. Topic 1: Lecture 4 Demand Analysis: Preferences If the IC is linear, this means that the MRS is constant. B a b IC1 F Robin Naylor, Department of Economics, Warwick

  24. Topic 1: Lecture 4 Demand Analysis: Preferences It is more common to assume that the MRS is diminishing: why is this and what does it imply about the IC? B a b F Robin Naylor, Department of Economics, Warwick

  25. Topic 1: Lecture 4 Demand Analysis: Preferences It is more common to assume that the MRS is diminishing: why is this and what does it imply about the IC? B IC1 F Robin Naylor, Department of Economics, Warwick

  26. Topic 1: Lecture 4 Demand Analysis: Preferences What would it mean if the IC was upward-sloping? B IC1 F Robin Naylor, Department of Economics, Warwick

  27. Topic 1: Lecture 4 Demand Analysis: Preferences What would this mean? B IC1 F Robin Naylor, Department of Economics, Warwick

  28. Topic 1: Lecture 4 Demand Analysis: Preferences Under the assumption of completeness, there is an IC passing through every possible point: B b a IC2 IC1 F Robin Naylor, Department of Economics, Warwick

  29. Topic 1: Lecture 4 Demand Analysis: Preferences The consumer would like to get to the highest possible IC: what limits this? c ICn B b a IC2 IC1 F Robin Naylor, Department of Economics, Warwick

  30. Topic 1: Lecture 5 Demand Analysis: Constraints We said that our understanding of Consumer Choice rests on the analysis of Preferences and Constraints. Let’s now turn to consider Constraints. Y Ymax 0 X Xmax Robin Naylor, Department of Economics, Warwick

  31. Topic 1: Lecture 5 Demand Analysis: Constraints We can represent a budget set and a budget frontier (or constraint) Y Ymax 0 X Xmax Robin Naylor, Department of Economics, Warwick

  32. Topic 1: Lecture 5 Demand Analysis: Constraints We can represent a budget set and a budget frontier (or constraint) Y What equation can we give this constraint? Ymax 0 X Xmax Robin Naylor, Department of Economics, Warwick

  33. Topic 1: Lecture 5 Demand Analysis: Constraints The equation tells us that if we spend all our money income, M, on X and Y, our spending be equal to: Robin Naylor, Department of Economics, Warwick

  34. Topic 1: Lecture 5 Demand Analysis: Constraints Re-arranging, the equation for the budget constraint is: How do you interpret this equation? And Graphically? Robin Naylor, Department of Economics, Warwick

  35. Topic 1: Lecture 5 Demand Analysis: Constraints The equation of the budget constraint: Y Ymax 0 X Xmax Robin Naylor, Department of Economics, Warwick

  36. Topic 1: Lecture 5 Demand Analysis: Constraints Given the position of the budget constraint, what will be the consumer’s choice of X and Y? This will depend on their preferences: Y Ymax 0 X Xmax Robin Naylor, Department of Economics, Warwick

  37. Topic 1: Lecture 5 Demand Analysis: Constrained choice Given the position of the budget constraint, what will be the consumer’s choice of X and Y? This will depend on their preferences: IC3 Y IC1 IC2 Ymax 0 X Xmax Robin Naylor, Department of Economics, Warwick

  38. Topic 1: Lecture 5 Demand Analysis: Constrained choice Given the position of the budget constraint, what will be the consumer’s choice of X and Y? This will depend on their preferences: ICmax Y Ymax 0 X Xmax Robin Naylor, Department of Economics, Warwick

  39. Topic 1: Lecture 5 Demand Analysis: Constrained choice Given the position of the budget constraint, what will be the consumer’s choice of X and Y? This will depend on their preferences: Y Ymax a Y* 0 X* X Xmax Robin Naylor, Department of Economics, Warwick

  40. Topic 1: Lecture 5 Demand Analysis: Constrained choice So, by bringing together preferences and constraints, we have a model which predicts/explains the consumer’s choices (demands) for X and Y . . . given . . .? Y Ymax a Y* 0 X* X Xmax Robin Naylor, Department of Economics, Warwick

  41. Topic 1: Lecture 5 Demand Analysis: Comparative Statics What will happen to the optimal choices of X and Y if there are relevant changes to the parameters of the model? Y What are the ‘relevant parameters’? Ymax a Y* 0 X* X Xmax Robin Naylor, Department of Economics, Warwick

  42. Topic 1: Lecture 5 Demand Analysis: Comparative Statics What will happen to the optimal choices of X and Y if there are relevant changes to the parameters of the model? Y Consider a change in money income. How do we show this? Ymax a Y* 0 X* X Xmax Robin Naylor, Department of Economics, Warwick

  43. Topic 1: Lecture 5 Demand Analysis: Change in money income Y Ymax a Y* 0 X* X Xmax Robin Naylor, Department of Economics, Warwick

  44. Topic 1: Lecture 5 Demand Analysis: Change in money income Y What can you say about the demand for X as M↑? And the demand for Y? Ymax â a Y* 0 X* X Xmax Robin Naylor, Department of Economics, Warwick

  45. Topic 1: Lecture 5 Demand Analysis: Change in money income Y What can you say about the demand for X as M↑? And the demand for Y? â Ymax a Y* 0 X* X Xmax Robin Naylor, Department of Economics, Warwick

  46. Topic 1: Lecture 5 Demand Analysis: Change in money income Y What can you say about the demand for X as M↑? And the demand for Y? â Ymax a Y* 0 X* X Xmax Robin Naylor, Department of Economics, Warwick

  47. Topic 1: Lecture 5 Demand Analysis: Change in money income Y What can you say about the demand for X as M↑? And the demand for Y? Ymax â a Y* 0 X* X Xmax Robin Naylor, Department of Economics, Warwick

  48. Topic 1: Lecture 5 Demand Analysis: Change in money income Y What can you say about the demand for X as M↑? And the demand for Y? Ymax a Y* â 0 X* X Xmax Robin Naylor, Department of Economics, Warwick

  49. See Handout Topic 1: Lecture 6 Demand Analysis: Change in price of X Y Ymax What can you say about the demand for X as Px↓? Y* a 0 X* X Xmax Robin Naylor, Department of Economics, Warwick

  50. Topic 1: Lecture 6 Demand Analysis: Change in price of X (CASE 1) IC1 IC2 Y Ymax What can you say about the demand for X as Px↓? â Y* a 0 X* X Xmax Robin Naylor, Department of Economics, Warwick

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