Chapter 3 (not so briefly)

1. Chapter 3 (not so briefly) • An Introduction to Supply and Demand • What is a market? • Where do prices come from? • What happens if prices are set “too high”? • What happens if prices are set “too low”? • Do markets really achieve equilibrium?

2. Questions • All economies must answer the following questions: • What should be produced? • How should it be produced? • For whom will it be produced?

3. Central Planning • Agrarian society • Former Soviet Union • Cuba, North Korea • China • Bureaucracy • A small number of individuals address these concerns: • Establish production targets for factories and farms • Plan how to achieve the goals • Distribute the goods and services produced

4. Market Forces • Free market • Capitalist economies • Individuals decide for themselves • Which careers to pursue • Which products to produce or buy • When to start businesses • Who gets what is decided by individual preferences and purchasing power

5. Markets • A market for any good consists of all buyers and sellers of that good • Includes individuals who either do sell or might sell = suppliers (usually firms) • Includes individuals who either do buy or might buy = demanders (usually people)

6. Prices • Why are some goods cheap and others expensive? • Through most of history, individuals had no idea • Most thought that it was because of the cost of production • Others thought only of the value people received from consumption • Answer: both supply and demand determine prices

7. Supply • Shows the quantity of a good or service that sellers wish to sell at eachprice • On a graph = supply curve • In a schedule = supply schedule • Positive relationship between P and QS • As price rises, a higher quantity can be sold because more opportunity costs can be covered • Application of the “low-hanging fruit principle” • Reflects the rising marginal costs of producing additional units

8. Supply Schedule

9. Supply Curve - Fig. 4.1Daily Supply Curve of Hamburgers in Greenwich Village

10. Demand • Shows the total quantity of a good or service that buyers wish to buy at eachprice • On a graph = demand curve • In a schedule = demand schedule • Inverse relationship between P and QD • As price rises, consumers want fewer items • People switch to substitutes • People cannot afford as much • At higher quantities, consumers are willing to pay less (application of the principle of diminishing marginal utility/benefit)

11. Demand Schedule

12. Demand Curve - Fig. 4.2Daily Demand Curve for Hamburgers

13. Market Equilibrium • When all buyers and sellers are satisfied with their respective quantities at the market price • There is a stable, balanced, unchanging situation • The supply and demand curves intersect • This results in the equilibrium price • The price the good sells for • This results in the equilibrium quantity • The quantity that will be sold

14. Market Equilibrium - Fig. 4.3The Equilibrium Price and Quantity of Hamburgers in Greenwich Village

15. Do markets really exist in equilibrium? • What would be evidence that a particular market is in equilibrium? • Stable prices • Stable quantities • Can you name a good for which price has not changed in a long time? • Can you name a good for which price changes daily? • Can you name a good for which price changes every second?

16. Does equilibrium mean all wants are satisfied ? • Market equilibrium does not mean that everyone has what they want • E.G. a poor person may not be able to afford the item at the equilibrium price

17. Disequilibrium • Excess supply • Market Surplus • Price is higher than equilibrium price • Sellers are dissatisfied • Excess demand • Market Shortage • Price is lower than equilibrium price • Buyers are dissatisfied

18. Fig. 4.4 Excess Supply

19. Fig. 4.5Excess Demand

20. Free Markets and Equilibrium • Free markets have an automatic tendency to eliminate excess supply and excess demand • A market surplus serves as a signal to sellers that price is too high and therefore leads producers to decrease the price • A market shortage serves as a signal to sellers that price is too low and therefore leads producers to increase the price

21. Legislation and Markets • Legislators protect producers and consumers by using price controls • Price ceilings • Price floors

22. Price controls • price ceilings – intended to help consumers • A maximum allowable price specified by law because the true equilibrium price was deemed “too high” • Price ceiling price < P* so now consumers want too much • e.g. rent controls, limits on the price of gasoline • Result in permanent shortages

23. Price Controls • price floors – intended to help producers • A minimum allowable price specified by law • For example, agricultural price supports, minimum wages • Price floor price is > P* so now sellers want to sell more • Result in surpluses

24. Fig. 4.6An Unregulated Housing Market

25. Fig. 4.7Rent Controls

26. Markets and Social Welfare • Social optimal quantity of a good • The quantity that results in the maximum possible economic surplus (net gains) • The socially optimal quantity will occur where the marginal cost equals the marginal benefit • Economic efficiency • Occurs when all goods and services are produced and consumed at their respective socially optimal levels

27. Markets and Efficiency • Efficiency Principle • Efficiency is an important social goal • Everyone can have a larger slice of a larger pie • Equilibrium Principle • A market in equilibrium leaves no unexploited opportunities for individuals • No “cash on the table” remains • All opportunities for profit have been exploited • Efficiency occurs when • the market-demand curve captures all the marginal benefits of the good • the market-supply curve captures all the marginal costs of the good

28. Terminology • If the good’s price changes, you have a • “change in quantity demanded” • A movement along the demand curve • “change in quantity supplied” • A movement along the supply curve • If something else changes, you have a • “change in demand” • A shift of the entire demand curve • change in supply” • A shift of the entire supply curve

29. Fig. 4.9An Increase in the Quantity Demanded Versus an Increase in Demand

30. Shifts in Supply • Favorable changes to the producer shift supply curve rightward • lower equilibrium price • higher equilibrium quantity • Unfavorable changes to the producer shift supply leftward • higher equilibrium price • lower equilibrium quantity

31. Fig. 4.10The Effect on the Skateboard Market of an Increase in the Price of Fiberglass

32. Shifts in Supply • Changes in the Cost of Production • Changes in Technology • Changes in Weather • Changes in Expectations

33. An Increase in Supply Sequence of events: • Conditions become more favorable to firms. Eg: lower cost of inputs • Firms now can earn higher per-unit profits at any price, so they wish to sell more units at all prices. • Firms increase Qs for all Prices = shift right in the supply curve (along demand). • Shift results in lower P* and higher Q*

34. Fig. 4.11The Effect on the Market for New Houses of a Decline in Carpenters’ Wage Rates

35. Fig. 4.12The Effect of Technical Change on the Market for Manuscript Revisions

36. Shifts in Demand • Complements • Substitutes • Income • Preferences • Demand curve shifts rightward • higher equilibrium price • higher equilibrium quantity • Demand curve shifts leftward • lower equilibrium price • lower equilibrium quantity

37. An Increase in Demand Sequence of events: • Conditions change such that consumers want more units at any price. Egs: lower price of complement good, higher price of a substitute, higher income, … • Higher Qd at all prices means rightward shift in the demand curve • Demand shifts right (along supply) resulting in higher P* and Q*

38. Fig. 4.13The Effect on the Market for Tennis Balls of a Decline in Court Rental Fees

39. Complements • Goods that are more valuable when used in combination--e.g. tennis balls and tennis courts • Two goods are complements in consumption if an increase in the price of one causes a leftward shift in the demand curve for the other

40. Substitutes • Goods that replace each other--e.g. email messages and overnight letters • Two goods are substitutes in consumption if an increase in the price of one causes a rightward shift in the demand curve for the other

41. Fig. 4.14Effect on the Market for Overnight Letter Delivery of a Decline in the Price of Internet Access

42. Income • Normal good • One whose demand curve shifts right when the incomes of buyers increase • Inferior good • One whose demand curves shifts left when the incomes of buyers increase

43. Fig. 4.15The Effect of a Federal Pay Raise on the Rent for Conveniently Located Apartments

44. Simultaneous Shifts • If, at the same time, • Demand decreases and Supply increases • Demand shifts left • Lower price, lower quantity • Supply shifts right • Lower price, higher quantity • We can predict that price will fall • But, what happens to quantity? • We must know the magnitude of the shifts

45. Fig. 4.17 The Effects of Simultaneous Shifts in Supply and Demand

46. Naturalist Question Why did you pay $60 for a Christmas tree in 2000 which only cost $40 in 1999? Assume: • Inflation was not 50% • The number of Christmas trees sold year to year in the United States is fairly stable. • It takes six to eight years to grow a tree to the right size for Christmas trees. • There are over 15,000 Christmas tree farms in the US • Recall: there were significant forest fires in the northwest in 2000