Unit II: The Market Economy

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Unit II The Market Economy
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Demand

• Demand indicates how much of a product consumers
  are both willing and able to buy at each possible
  price during a given period, other things
  remaining constant.

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Law of Demand

• The law of demand says that quantity demanded
  varies inversely with price, other things
  constant.
• Thus, the higher the price, the smaller the
  quantity demanded.

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What Explains the Law of Demand

• The Substitution Effect many goods services
  are capable of satisfying your particular wants
• Some options have more appeal than others (ex.
  pizza vs. raw oysters)
• However, scarcity is a reality
• As one good becomes relatively cheaper, consumers
  are more willing to buy it
• As a good becomes more expensive, consumers turn
  to substitutes

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What Explains the Law of Demand

• Income effect
• As price declines for a product, your real income
  increases
• This increases your ability to buy more of that
  good, and indirectly other goods
• Conversely, an increase in price reduces your
  real income

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Diminishing Marginal Utility

• Marginal utility the change in total utility
  resulting from a one-unit change in consumption
  of a good
• Law of diminishing marginal utility the more of
  a good a person consumes per period, the smaller
  the increase in total utility from consuming one
  more unit, ceteris paribus

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Diminshing Marginal Utility for Chick-fil-A Spicy
Chicken Sandwiches
Price Quantity of Sandwiches Consumed
2
1
.50
.25
.13
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What is Demand?

• There is a limited amount of goods out there
• How do we decide what we want?
• Demand is made up of two elements
• Desire for Goods and Services
• Means to purchase those Goods and Services

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Demand Schedules

• Let consider how many CDs you might demand in a
  month. (This is called Quantity Demanded)
• We will first look at this information in a table
  called a Demand Schedule
• Demand Schedule - a table showing the
  relationship between the price of a good and the
  quantity demanded per period of time, ceteris
  paribus.

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Demand Schedule
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Demand Schedule
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Demand Schedule
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Demand Schedule
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Demand Schedules and Curves

• Another way of characterizing Demand instead of
  using a schedule is a Demand Curve.
• Demand Curve - a diagram showing the relationship
  between the price of a good and the quantity
  demanded per period of time, ceteris paribus.

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Demand Curve
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Demand Curve
P()
Note ALWAYS label your axes!
Qd per month
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Demand Curve
P()
20
15
10
5
Qd per month
0
5
10
15
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Demand Curve
P()
A
20
15
10
5
Qd per month
0
5
10
15
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Demand Curve
P()
A
20
B
15
10
5
Qd per month
0
5
10
15
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Demand Curve
P()
A
20
B
15
C
10
5
Qd per month
0
5
10
15
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Demand Curve
P()
A
20
B
15
C
10
D
5
Qd per month
0
5
10
15
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Market Demand Curve

• The demand curve we just drew was the Demand for
  CDs by one person.
• Market Demand Curve - a curve showing the
  relationship between the price of a good and the
  total quantity demanded by all consumers in the
  market per period of time, ceteris paribus.Market
  demand curves are obtained by summing the demand
  curves of individual consumers.

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Market Demand Schedule

• Market Demand Schedule - a table showing the
  relationship between the price of a good and the
  total quantity demanded by all consumers in the
  market per period of time, ceteris paribus.
• Market demand schedules are obtained by summing
  the demand schedules of individual consumers.

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Market Demand Schedule
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Market Demand Schedule
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Market Demand Schedule
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Market Demand Schedule
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Individual Demand for Pizzas
Figure 4.4
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Market Demand for Pizzas
Figure 4.4
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Elasticity of Demand

• Elasticity responsiveness
• Elasticity of demand measures how responsive
  quantity demanded is to a price change

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Elasticity of Demand

• A demand curve can show how sensitive quantity
  demanded is to a price change
• Example A superstore would like to know what
  will happen to its total revenue if it introduces
  an Everything for a Dollar section
• The law of demand says the lower price will
  increase quantity demanded.
• But by how much?

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Computing the Elasticity of Demand

• Elasticity of demand measures the percentage
  change in quantity demanded divided by percentage
  change in price.

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Elasticity Values

• Elastic gt 1.0
• Unit elastic 1.0
• Inelastic lt 1.0

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Elasticity and Total Revenue

• Knowing a products elasticity can help
  businesses with their pricing decisions.
• Total revenue is price multiplied by the quantity
  demanded at that price.
• TR P x Q

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Elasticity Total Revenue

• What happens to total revenue when price
  decreases?
• A) lower price producers paid less per unit -
  this tends to lower TR
• B) BUT law of demand says a lower price
  increase in quantity demanded which tends to
  increase TR

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Elasticity Total Revenue

• Example
• When elasticity is gt 1.0 (elastic), reducing the
  price by 5 will cause quantity demanded to
  increase by more than 5 thus TR will increase
• When elasticity is 1.0 (unit elastic), reducing
  the price by 5 will cause quantity demanded to
  increase by 5 thus TR will remain unchanged

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Elasticity Total Revenue

• When elasticity is lt 1.0 (inelastic), reducing
  the price by 5 will cause quantity demanded to
  increase, but by less than 5 thus TR will fall
• If demand is inelastic producers will never
  willingly cut the price since that would reduce
  TR
• Why cut price if selling more reduces TR?

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The Revenue Test

• Price ? total revenue ? Elastic demand
• Price ? total revenue ? Elastic demand
• Price ? total revenue unchanged Unit elastic
• Price ? total revenue unchanged Unit elastic
• Price ? total revenue ? Inelastic demand
• Price ? total revenue ? Inelastic demand

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Determinants of Demand Elasticity

• 1) Availability of substitutes
• the more substitutes there are for a good, the
  greater its elasticity of demand
• The more broadly a good is defined, the fewer
  substitutes there are and the less elastic the
  demand
• Ex. Shoes (inelastic)
• Nike shoes (elastic)

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Determinants of Demand Elasticity

• 2) Share of consumers budget spent on the good
• If a good represents a large share of a
  consumers budget, a ? in price of such a good
  has a substantial impact on the amount consumers
  are able to purchase
• The more important the item is as a share of the
  consumers budget, the more elastic is the demand
  for them

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Determinants of Demand Elasticity

• 3) A matter of time
• consumers may substitute lower-priced goods for
  higher-priced goods, but finding substitutes
  usually takes time
• OPEC 73-74 gas prices ? 45 Qd ? 8
• Over time people ? smaller cars, public
  transportation, energy efficient appliances, etc.
  
• The longer the period of adjustment, the more
  elastic in demand a good is
• Demand is more elastic in the long run than in
  the short run

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Demand Becomes More Elastic Over Time
Figure 4.4
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Selected Elasticities of Demand
Product Short Run Long Run
Electricity (residential) 0.1 1.9
Air travel 0.1 2.4
Medical care and hospitalization 0.3 0.9
Gasoline 0.4 1.5
Movies 0.9 3.7
Natural gas (residential) 1.4 2.1
Figure 4.5
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Change in D vs. Change in Qd

• Change in Quantity Demanded - a change in the
  desire or means to purchase the good, thus there
  is a change in quantity demanded at EVERY price.
  (Price Effect)
• Change in Demand - a shift of the demand curve

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Change in D vs. Change in Qd

• Changes in Demand
• Increase in demand - demand curve shifts to the
  right
• Decrease in demand - demand curve shifts to the
  left

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Change in Demand

• Factors Which Cause a Change in Demand
• Consumer Income
• Price of Related Goods
• Number Composition of Buyers
• Consumer Expectations about Future Prices
• Consumer Tastes and Preferences

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Change in Demand - Income

• If you graduate from college and start making a
  substantial income - What might happen to the
  amount of CDs you would want to buy?
• It would increase! You would be willing and able
  to purchase more CDs at every price.
• Thus, demand has increased.

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Change in Demand - Income

• If after a year at your new job the boss cuts
  salaries by 30. What happens to Demand?
• It would decrease.
• You are now have less means to purchase CDs at
  all prices.

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Normal and Inferior Goods

• Given the information we have, CDs are a normal
  good
• Normal Good - any good which increases in demand
  as income increases (and vice-versa)
• Most goods are normal
• Inferior Good - any good which decreases in
  demand as income increases (and vice-versa)
• Ex. - Macaroni and Cheese

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Change in Demand - Price of Related Goods

• Substitute - a good which can be consumed in
  place of another good
• What would happen to the demand for pizza if the
  price of hamburgers fell?
• The demand for pizza would probably fall since
  people would be buying hamburgers instead.

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Change in Demand - Price of Related Goods

• Complement - a good which is consumed along with
  the consumption of another good
• Ex - Peanut Butter and Jelly are complements.
• If price of peanut butter increases, consumers
  purchase less peanut butter
• Result ? Consumers purchase less jelly
• Since people buy less peanut butter they need
  less jelly for PBJ sandwiches

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Change in Demand - Price of Related Goods

• Thus, either of the following will increase
  Demand
• Price of a substitute good increases
• Price of a complement good decreases
• And either of the following will decrease Demand
• Price of a substitute good decreases
• Price of a complement good increases

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Change in Demand Number of Buyers

• The more buyers in the market for a good, the
  greater the TOTAL quantity demanded (by the whole
  economy) of the good at a given price.
• Since the quantity demanded is higher at EVERY
  given price, the demand has increased.
• Likewise, if there are less buyers in the market
  there is less quantity demanded at every price,
  so demand has decreased.

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Change in Demand - Expectations about Future
Prices

• If we were to hear a new story about how CD
  prices were going to go up next month, would you
  buy that CD you have had your eye on now or
  later?
• Now. If you know prices will rise, you will want
  to buy more now, so you can avoid paying the
  higher price in the future.
• So demand will increase in response to this
  information

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Change in Demand - Expectations about Future
Prices

• Likewise, if we hear that CD prices are going to
  drop next month, what do we do now?
• It is likely that we will buy less now, waiting
  to buy that new CD until the prices fall next
  month, thus demand will decrease.

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Change in Demand - Tastes and Preferences

• Lets say we find out listening to CDs can
  improve your hearing, or what if suddenly CDs
  become very fashionable to buy? If consumers
  prefer more of a good, the demand for the good
  increases (a rightward shift of the demand
  curve).
• What if we find out CDs emit dangerous radiation?
  If consumers prefer a good less, the demand for
  the good decreases (a leftward shift of the
  demand curve).

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Increase in Demand
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Increase in Demand
P
Qd
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Increase in Demand
P
D
Qd
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Increase in Demand
P
D
Qd
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Increase in Demand
P
D
D
Qd
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Increase in Qd
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Increase in Qd
P()
Qd
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Increase in Qd
P()
D
Qd
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Increase in Qd
P()
A
D
Qd
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Increase in Qd
P()
A
D
Qd
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Increase in Qd
P()
A
B
D
Qd
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Supply
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What is Supply?

• Supply is how much a firm is willing to sell at
  every given price, ceteris paribus
• Thus, if the price of a good goes up, what would
  you expect the response of a firm to be?
• To produce more, since prices are going up, so
  will profits

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Law of Supply

• Law of Supply - the price of a product (or
  service) is directly related to the quantity
  supplied, ceteris paribus.
• Quantity Supplied - the amount of a good (or
  service) produced by firms at a particular price.
• While demand typically refers to consumers,
  supply typically refers to firms.

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Supply Schedules and Curves

• Supply Schedule - a table showing the
  relationship between the price of a good and the
  quantity supplied per period of time, ceteris
  paribus.

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Supply Schedule
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Supply Schedule
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Supply Schedule
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Supply Schedule
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Supply Schedules and Curves

• Supply Curve - a diagram showing the relationship
  between the price of a good and the quantity
  supplied per period of time, ceteris paribus.

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Supply Curve
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Supply Curve
P()
Remember to ALWAYS label your axes!
Qs per month
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Supply Curve
P()
20
15
10
5
Qs per month
0
5
10
15
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Supply Curve
P()
A
20
15
10
5
Qs per month
0
5
10
15
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Supply Curve
P()
A
20
B
15
10
5
Qs per month
0
5
10
15
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Supply Curve
P()
A
20
B
15
10
C
5
Qs per month
0
5
10
15
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Supply Curve
P()
S
A
20
B
15
10
C
5
Qs per month
0
5
10
15
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Market Supply Curve

• Market Supply Curve - a curve showing the
  relationship between the price of a good and the
  total quantity supplied by all firms in the
  market per period of time, ceteris paribus.
• Market supply curves are obtained by summing the
  supply curves of individual firms.

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Market Supply Schedule

• Market Supply Schedule - a table showing the
  relationship between the price of a good and the
  total quantity supplied by all firms in the
  market per period of time, ceteris paribus.
• Market supply schedules are obtained by summing
  the supply curves of individual firms.

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Market Supply Schedule
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Change in S vs. Change in Qs

• Change in Supply - a shift of the supply curve
• Increase in supply - supply curve shifts to the
  right
• Decrease in supply - supply curve shifts to the
  left

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Change in Supply

• Factors Which Cause a Change in Supply
• 1) The cost of resources used to make the good
• 2) The prices of other goods these resources
  could make
• 3) Technology used to make the good
• 4) Producer expectations
• 5) Number of sellers in the market

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1) The cost of resources used to make the good

• If the cost of plastic (making CDs) decreases
• Its now cheaper to make every quantity of CDs
• In summary, if the price of a resource goes down,
  supply increases (shifts to the right)

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Supply Curve
P()
A
20
15
A
10
5
Qs per month
0
5
10
15
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Supply Curve Shift
Old Supply Curve
P()
A
20
15
A
New Supply Curve
10
5
Qs per month
0
5
10
15
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Price of Relevant Resources

• Lets say the cost of plastic (making CDs)
  increases
• It is now more expensive to make every quantity
  of CDs
• In summary, if the cost of a resource goes up,
  supply decreases (shifts to the left)

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Supply Curve
P()
B
20
B
15
10
5
Qs per month
0
5
10
15
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Supply Curve Shift
New Supply Curve
P()
Old Supply Curve
B
20
B
15
10
5
Qs per month
0
5
10
15
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2) The prices of other goods these resources
could make

• Nearly all resources have alternative uses
• The labor, building, machinery, materials,
  knowledge needed to make CDs could make other
  products such as DVDs
• A change in price of another good these resources
  could make, affects the opportunity cost of
  making CDs

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2) The prices of other goods these resources
could make

• If the price of DVDs falls, the opportunity cost
  of making CDs declines.
• These resources are not as profitable in their
  best alternative use which is making CDs
• Now CD production becomes more attractive
• As resources shift from DVD to CD production ,
  the supply of CDs increases, or shifts to the
  right.

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2) The prices of other goods these resources
could make

• On the other hand, if the price of DVDs
  increases, so does the opportunity cost of making
  CDs.
• Some CD producers may make more DVDs less CDs,
  so the supply of CDs decreases, or shifts to the
  left.
• A change in the price of another good these
  resources could produce affects the profit
  opportunities of CD producers.

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3) Technology

• Improvement in technology lowers costs
• Lower cost of production increases Supply
• Worsening of technology increases costs
• Higher cost of production decreases Supply

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4) Expectations of Future Prices

• Firms expect the price of their good to decrease
  in the future
• Supply increases today
• Firm would prefer to sell today when price is
  higher

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Expectations of Future Prices

• Firms expect price of their good to increase in
  the future
• Supply decreases today
• Firm would prefer to wait until the good can be
  sold for a higher price

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5) Number of Sellers

• More sellers in the market means more quantity is
  being supplied at every price
• Increase in supply of the good
• Less sellers in the market means less quantity is
  being supplied at every price
• Decrease supply of the good

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Number of Sellers

• Government regulation
• Strict government regulation ? fewer sellers in
  the market
• Restrictions eased ? more sellers in the market
• Taxes
• Higher taxes ? reduces supply
• Lower taxes ? increases supply

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Change in Quantity Supplied

• Change in Quantity Supplied (DQs) - movement
  along a supply curve
• A change in quantity supplied can only be caused
  by a change in the price of the good.
• Changes in Quantity Supplied
• Increase in Qs - a movement to the right along a
  supply curve
• Decrease in Qs - a movement to the left along a
  supply curve

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Increase in Supply
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Increase in Supply
P
Qs
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Increase in Supply
S
P
Qs
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Increase in Supply
S
P
Qs
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Increase in Supply
S
P
S
Qs
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Increase in Qs
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Increase in Qs
P()
Qs per month
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Increase in Qs
S
P()
Qs per month
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Increase in Qs
S
P()
A
Qs per month
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Increase in Qs
S
P()
A
Qs per month
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Increase in Qs
S
P()
B
A
Qs per month
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Elasticity of Supply

• The elasticity of supply measures how responsive
  producers are to a price change.
• Responsiveness depends on how costly it is to
  alter output when the price changes

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Elasticity of Supply

• If the cost of supplying an additional unit rises
  sharply as output expands, then a higher price
  will generate little increase in quantity
  supplied ? inelastic
• Example producers of cars or electricity

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Elasticity of Supply

• If the cost of an additional unit rises slowly as
  output expands, the profit lure of a higher price
  will prompt a relatively large boost in output ?
  elastic
• Examples hot dog vending landscaping

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Measurement

• Elasticity of supply equals percentage change in
  quantity supplied divided by percentage change in
  price.

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Categories of Supply Elasticity

• Supply is elastic if supply elasticity exceeds
  1.0.
• Supply is unit elastic if supply elasticity
  equals 1.0.
• Supply is inelastic if supply elasticity is less
  than 1.0.

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Market Supply BecomesMore Elastic Over Time
3.50
3.00
Price per gallon
100
200
0
300
Millions of gallons per day
Figure 5.4
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Determinants of Supply Elasticity

• One important determinant of supply elasticity is
  the length of the adjustment period under
  consideration.
• The elasticity of supply is typically greater the
  longer the period of adjustment.

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Market Equilibrium

• When the quantity that consumers are willing and
  able to buy equals the quantity that producers
  are willing and able to sell, that market reaches
  market equilibrium.

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Equilibrium in the Pizza Market
Figure 6.1
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Surplus Forces the Price Down

• At a given price, the amount by which quantity
  supplied exceeds quantity demanded is called the
  surplus.
• As long as quantity supplied exceeds quantity
  demanded, the surplus forces the price lower.

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Shortage Forces the Price Up

• At a given price, the amount by which quantity
  demanded exceeds quantity supplied is called the
  shortage.
• As long as quantity demanded and quantity
  supplied differ, this difference forces a price
  change.

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Market Forces Lead toEquilibrium Price and
Quantity

• The equilibrium price, or market-clearing price,
  equates quantity demanded with quantity supplied.
• Because there is no shortage and no surplus,
  there is no longer any pressure for the price to
  change.

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Adam Smiths Invisible Hand

• Although each individual pursues his or her own
  self-interest, the invisible hand of market
  competition promotes the general welfare.

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Equilibrium in the Pizza Market
Figure 6.1
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Market Exchange Is Voluntary

• Neither buyers nor sellers would participate in
  the market unless they expected to be better off.
• Prices help people recognize market opportunities
  to make better choices as consumers and as
  producers.

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Markets Reduce Transaction Costs

• Transaction costs are the cost of time and
  information needed to carry out market exchange.
• The higher the transaction cost, the less likely
  the exchange will take place.
• Example car dealers find land on outskirts of
  town (land is cheaper) tend to locate near each
  other to be on hand when buyers shop for cars
• Doing this, dealers reduce transaction costs of
  car shopping

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An Increase in Demand
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A Decrease in Demand
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An Increase in Supply
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A Decrease in Supply
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Both Curves Shift

• Curves shift in the same direction
• Equilibrium quantity will increase.
• What happens to price depends on which curve
  shifts more.
• Curves shift in opposite directions
• Equilibrium price will increase if demand
  increases and supply decreases.
• Equilibrium price will decrease if demand
  decreases and supply increases.

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Equilibrium price change is indeterminate. Equili
brium quantity increases.
Equilibrium price falls. Equilibrium quantity
change is indeterminate.
Equilibrium price rises. Equilibrium quantity
change is indeterminate.
Equilibrium price change is indeterminate. Equili
brium quantity decreases.
Figure 6.6
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Competition and Efficiency

• Productive efficiency
• Making stuff right
• Allocative efficiency
• Making the right stuff
• Market competition promotes both productive
  efficiency and allocative proficiency.

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Productive EfficiencyMaking Stuff Right

• Productive efficiency occurs when a firm produces
  at the lowest possible cost per unit.
• Competition ensures that firms produce at the
  lowest possible cost per unit.

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Allocative EfficiencyMaking the Right Stuff

• Allocative efficiency occurs when firms produce
  the output that is most valued by consumers.
• Competition among sellers encourage producers to
  supply more of what consumers value the most.

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Disequilibrium

• Disequilibrium is a mismatch between quantity
  demanded and quantity supplied as the market
  seeks equilibrium
• A price floor is a minimum selling price that is
  above the equilibrium price.
• A price ceiling is a maximum selling price that
  is below the equilibrium.

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Price Floor

• If a price floor is established above the
  equilibrium price, a permanent surplus results.
• A price floor established at or below the
  equilibrium price has no effect.

Figure 6.7a
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Price Ceiling

• If a price ceiling is established below the
  equilibrium price, a permanent shortage results.
• A price ceiling established at or above the
  equilibrium price has no effect.

Figure 6.7b
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The Black Market

• If a price ceiling is imposed below the
  equilibrium price, a black market could develop.

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Other Sources of Disequilibrium

• Government intervention in the market
• Sometimes the market takes a while to adjust
• New products
• Sudden change in demand or supply

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Consumer Surplus

• Consumer surplus is the difference between the
  most that consumers would be willing and able to
  pay for a given quantity and the amount they
  actually do pay.

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Market Demand and Consumer Surplus

• Consumer surplus at a price of 2 is shown by the
  darker area.
• If the price falls to 1, consumer surplus
  increases to include the lighter area between 1
  and 2.
• If the good is free, consumer surplus would
  increase by the lightest area under the demand
  curve.

Figure 6.8
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