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Chapter 1

What is Economics

Chapter 1

What is Economics

Definition of Economics

SCIENCE of how individuals and societies deal with the fact that

wants are greater than resources available to satisfy those wants

Scarcity• Wants are greater than the resources available

to fill those wants• What do you have scarcity of???

– Money– Time

• What do firms have scarcity of???– Labor– Land– Capital

Thus….Economics is the

SCIENCE of SCARCITY

Normative vs. Positive Economics

• Normative– What “ought” to be

• Positive– What is

Examples: Positive or Normative?

• The government fought inflation during the early 1980s because it felt the inflation was damaging potential long-term economic growth.

• The government should cut taxes in order to stimulate consumption.

• Increases in consumer spending improved the Japanese economy last year.

• Balancing the federal budget would be good for the economy.

Micro vs. Macro

• Microeconomics– Study of human behavior and choices– Looks at SMALL units (individual, market, single

• Macroeconomics– Study of human behavior and choices– Looks at LARGE units (aggregated markets, whole

economy)

Economic Way of Thinking

• Watch– “An economist is someone that sees

something working in practice and asks if it would would in principle”

• Think

• Identify

Why Study Economics?

• Social Problems– Discrimination– Crime

• Understand why things happen– Coupons– Minimum Wage

• Understand the Political Process

Homeworkdue Friday April 4th

• Chapter 1– Questions 1 and 2

Beginning to Think Like an Economist

…is this a good thing?

Defining Economic Goods

• Utility– Satisfaction you receive from consuming a product– Good vs. Bad

• Tangibility– Can the good be touched or is it a service?

• Resources or factors of production used– Land: natural resources– Labor: Physical and mental talents of people– Capital: produced goods that can be used as inputs for

further production– Entrepreneurship: talent of organizing resources, seeking

new opportunities, and developing new ways of doing things

Remember Scarcity Runs the Show…

• What was scarcity??

• So…how do we make sure that only those who REALLY need the good get it??

• Prices– System of rationing of the good– Cause people to compete for the item

Opportunity Cost• Value of the next best alternative foregone• Pizza vs CD

– Pizza for $1.00 per slice; CD for $15.00

• Revolutionary War– The British and their red coats

• Big Macs– Big Macs in Japan cost $8.25

• Highway System– Paid for with taxes

Summary Statement of Scarcity

and Related Concepts

Costs and Benefits at the Margin

• What is the margin??– The “last” or “additional”

• Marginal Cost – The cost of the “last” unit employed

• Marginal Benefits– The benefit of the “last” unit employed

• Unintended effects– Minimum wage– Gun bounties– Seat belts

Efficiency

• What is the “right amount” of time to study?– Right amount = optimal or efficient amount– Marginal Costs = Marginal Benefits

Economic way of thinking includes…

• Analyzing scarcity

• Look at opportunity cost of decisions

• Measure costs and benefits

• Look at marginal effects

• Examine unintended effects

Economic Thinking Errors

• Association vs. Causation– You hit red lights because you are running late– Don’t study for a test so you fail

• Fallacy of Composition– What is good for the individual is good for the group

• Forgetting Ceteris Paribus– All else remains constant

What is this?

• Simplified version of reality– Includes only the “important” aspects

• Why is a model necessary??

Parts of a Theory

• Variables– Magnitudes that can change

• Assumptions– Ideas about event that will not allow to change

• Hypothesis– Educated guess

• Predictions– Based on hypothesis and assumptions

Scientific Approach

• What do you want to predict/explain?

• What variables are important?

• State assumptions

• State hypothesis

• Test

• If results are good…Yeah You!!

• If results are bad…amend or reject theory

Building and Testing a Theory Building and Testing a Theory

Evidence rejects the theory, soeither formulate a new theory,

or amend the old theory in termsof its variables, assumptions,

and hypotheses.

Identify thevariables that

you believe areimportant to

what you wantto explain or

predict.

Decide on whatit is you want to

explain orpredict.

State theassumptions of

the theory.

State thehypothesis.

Test the theoryby comparing

its predictionsagainst real-world events.

Return

Either

Evidence supports thetheory. No further action isnecessary, although it is agood idea to continue to

examine the theory closely.

How do we judge theories?

• Look at how well they predict

• NOT by the assumptions

• Example: Firms try to maximize profits– Do they thing about this every second?– Probably not– Over the course of the year…make decisions to

maximize profits

Appendix A

Working with Diagrams

Types of Relationships between variables

• Direct– Positive

• Inverse– Negative

• No Relationship– Variables are independent

Two-Variable Diagram Representing an Inverse Relationship

Price of CDs ($)

Quantity Demanded of CDs100 120 140 160 180

The variables priceand quantitydemanded areinversely related.

Demand for CDs

Two-Variable Diagram Representing a Direct Relationship

Consumption ($)

Income ($)

100 200 300 400 500

The variablesincome andconsumption aredirectly related.

Two Diagrams Representing Independence between Two

Variables

Two Diagrams Representing Independence between Two

Variables

(b)(a)

010 20 30 40

A B C D

Variables X and Y areindependent (neither variable

is related to the other).

010 20 30 40

Variables X and Yare independent.

• Used to see how a variable changes in response to another variable changing

horizontal

vertical

YSlope

To calculate slope

• Find two points on any straight line

What sign do you expect the slope to have?

• Direct relationship– Positive

• Inverse relationship– Negative

• No Relationship– 0 or infinity

Calculating Slopes Calculating Slopes

= +10+5

= +2Slope =Slope=Y

= = –1–10

010 20 30 40

010 20

(negative slope)X

(positive

Calculating SlopesCalculating Slopes

Slope =Y

= = `X(infinite slope)

Slope =Y

= = 0X(zero slope)

(d)(c)

010 20 30 40

A B C D

010 20 30 40

The 45 Line The 45 Line

Line45

Appendix B

Should you major in Economics??

Five myths about economics and an economics major

• Economics is all mathematics and statistics• Economics is only about inflation, interest rates,

unemployment, and other such things• People become economists only if they want to “make

money”• Economics wasn’t very interesting in high school, so it

isn’t going to be interesting now• Economics is a lot like business, but business is more

marketable

Chapter 2 Economic Activities:

Producing and Trading

Chapter 2 Economic Activities:

Producing and Trading

Efficiency

• Efficiency of Production is goal

• If a firm is producing the max possible given available resources and technology

Production Possibility Frontier(PPF)

• Shows all possible combinations of goods for a particular economy at a particular point in time, given its resources and technology constraints

Production Possibilities Frontier for Grades

POINT INPART (b)

GRADE INECONOMICS

HOURS SPENTSTUDYING

ECONOMICS

GRADE INSOCIOLOGY

HOURS SPENTSTUDYING

SOCIOLOGY

Production Possibilities Frontier for Grades Production Possibilities Frontier for Grades

Grade in Soc io logy

6065 70 75 80 90

Grade in Economics

ProductionPos s ibilities

Frontier (PPF)

Part (b)

(Soc . 90, Econ. 60)

(Soc . 85, Econ. 65)

Where are we on the PPF?

• Can we be on the PPF?– Yes!– efficient

• Can we be under the PPF?– Yes!– Inefficient

• Can we be over the PPF?– NO

Two types of Production Possibility Frontiers

Constant Opportunity Costs

• STRAIGHT LINE

• DOWNWARD SLOPED (inverse relationship)

• 1 to 1 relationship (slope constant)

Production Possibilities Frontier (Constant Opportunity Costs)

COMBINATIONCOMPUTERS AND TELEVISION SETS

(number of units per year)POINT INPANEL (b)

50,000

40,000

30,000

20,000

10,000

20,000

30,000

40,000

50,000

Part (a)

Production Possibilities Frontier (Constant Opportunity Costs)

Co mpute rs (thous ands per ye ar)

0 10 20 30 40 50

Tele vis io n Sets (tho us ands pe r year)

A s traight-line PPFillus trate s cons tantopportunity c os ts .

Part (b)

Second Type of PPF

Changing Opportunity Costs

• BOWED OUT PPF

• Real world PPF

• Changing slope with every point

Production Possibilities Frontier (Changing Opportunity Costs)

COMBINATIONCOMPUTERS AND TELEVISION SETS

(number of units pe r year)POINT IN

PANEL (b)

50,000

40,000

25,000

20,000

40,000

60,000

Part (a)

Production Possibilities

Frontier (Changing

Opportunity Costs)

Production Possibilities

Frontier (Changing

Opportunity Costs)

Computers (thous ands per year)

0 10 20 30 40 50

Televis ion Sets (thous ands per year)

Part (b)

A bowed outward

(concave) PPF illus trates

increas ing opportunity

cos ts .

Law of Increasing Opportunity Costs

• Goes along with CHANGING OPPORTUNITY COSTS

• As more of a good is produced the opportunity cost to produce that good increases.

A Summary Statement about Increasing

Opportunity Costs and a Production

Possibilities Frontier That Is Bowed

Outward (Concave Downward)

A Summary Statement about Increasing

Opportunity Costs and a Production

Possibilities Frontier That Is Bowed

Outward (Concave Downward)

60 70 110 120

Hous es

Good X

Economic Concepts illustrated by PPF

• Scarcity

• Choice

• Opportunity Costs

• Law of Increasing Opportunity Costs

Examples of Law of Increasing Opportunity Costs

• Armed Services– WWI, WWII and Korean War draft was irrelevant of

job or education level; Civil War education and job level mattered

• Home Improvements– Swedish men make more improvements

themselves compared to US men

Economic Growth

• Increase in resources

• Increase in technology

• Shift of PPF outward

How would each of the following affect the US PPF?

• A rise in the unemployment rate

• The invention of the computer

• An increase in the number of birth in the United States

• An increase in the number of births in Russia

Civilian Goods

Military Goods

Economic growth s hiftsthe PPF outward.

Economic Growth within a PPF Framework

Production Possibilities Frontier for Grades

POINT INPART (b)

GRADE INECONOMICS

HOURS SPENTSTUDYING

ECONOMICS

GRADE INSOCIOLOGY

HOURS SPENTSTUDYING

SOCIOLOGY

Production Possibilities Frontier for Grades Production Possibilities Frontier for Grades

6065 70 75 80 90

Grade in Economics

ProductionPos s ibilities

Frontier (PPF)

Part (b)

(Soc . 90, Econ. 60)

(Soc . 85, Econ. 65)

More Hours of Study Shifts the Production Possibilities Frontier More Hours of Study Shifts the

Production Possibilities Frontier

65 70 75 80 90

X (Soc . 80, Econ. 75)

Grade in Economics

PPF2(7 hours )

9577.5

77.5 Y (Soc . 77.5, Econ. 77.5)Z (Soc . 75, Econ. 80)

PPF1(6 hours )

Efficiency…Again

• Produce max amount possible given resources and technology

• ON PPF – EFFICIENT

• UNDER PPF – INEFFICIENT

• OVER PPF – NOT POSSIBLE

Unemployment

• Economy is not producing the maximum output given the resources and technology available

• Efficient?

• On, over, or under PPF?

Efficiency Criterion

• Will alternate arrangements of resources or goods make at least one person better off without hurting someone else?

• Yes? Inefficient

• No? Efficient

Efficiency, Inefficiency, and Unemployment Resources,

within a PPF Framework Efficiency, Inefficiency, and Unemployment Resources,

within a PPF Framework

5 15 35 45 520

Cars (thous ands )

Televis ion Sets

Effic ient points lie onthe production pos s ibilitiesfrontier; ineffic ient pointslie be low the frontier.

Trade or exchange

• Process of giving up one thing for something else

• Why would you trade?– Make yourself better off– Give up something that you value less for

something you value more

• Example: a leather jacket is $100…what does this show??– Value the $100 less than you value the jacket

Periods relevant to trade• Before the trade takes place

– Ex ante– Decision takes place $2000 of other goods or the $2000

television set?– Which makes me better off?

• At the point of the trade– The $2000 changing hands

• After the trade– Ex post– No guarantee that trade will meet expectations– Buyers remorse

Benefits of Trade

• Compare the consumer’s and producers point of views– Consumer Surplus

• Maximum buying price – price paid• Satisfaction gained by not having to pay as much

– Producer Surplus• Price received – minimum selling price• Satisfaction gained by getting more than anticipated for

the good

Which makes you better off?

• Increases in Consumer or Producer Surplus?– Consumer

• Why?– Price that you pay will be lower

Terms of Trade

• Trade is where things are given up to get something else– What things?

• Money, goods, services…

• Terms of trade is how much is given up

• Which part does buyers remorse fit into?– terms of trade – Where the money usually comes in

Costs of Trade

• Transaction costs– Time and effort needed to search out, negotiate,

and consummate a trade– May cause trades to not take place

• Don’t know about the good• Shipping costs are too high• Don’t like to work with salesperson

• Third-party effects– Impacts of trade on parties not immediately involved

• Second hand smoke (negative externality)

Producing and trading

• Two people: Elizabeth and Brian

• Each produce two goods: Bread and Apples

• Elizabeth 10 loaves of bread and 10 apples

• Brian 5 loaves of bread and 15 apples

Elizabeth Apples

Elizabeth Bread

Brian Apples Brian Bread

Comparative Advantage• Should both produce apples and bread or

should they specialize?

• What does specialize mean?– Produce the good that you do best– Produce at a lower costs than other person(s) can– Called comparative advantage– Looks at opportunity cost

• What was that?• What you have to give up• Give up less?? Have the comparative advantage

What are the opportunity costs?

• Elizabeth– If give up 10 apples how much

more bread can she produce?• 10 units

– If give up 10 loaves of bread how many more apples can she produce?

• 10 units

• Opportunity Costs– 10 Bread = 10 Apples– 1 Bread = 1 Apple

Elizabeth Apples

Elizabeth Bread

What are the opportunity costs?

• Brian– If give up 15 apples how much

more bread can he produce?• 5 units

– If give up 5 loaves of bread how many more apples can he produce?

• 15 units

• Opportunity Costs– 5 Bread = 15 Apples– 1 Bread = 3 Apples– 1/3 Bread = 1 Apple

Apples

Should we specialize?

• Elizabeth1 Bread = 1 Apple

• Brian1 Bread = 3 Apples 1/3 Bread = 1 Apple

• Who produces apples cheaper?• What does cheaper mean?

• Lower opportunity cost (give up less)• Brian!!! Give up only 1/3 loaves of bread

• Who produces bread cheaper?• Elizabeth!!! Give up only 1 apple

Here is the deal

• Elizabeth produces only bread (20 loaves)

• Brian produces only apples (30 apples)

• Trade 8 loaves of bread for 12 apples

• Breakdown of end result– Elizabeth Bread?

• 12 loaves (20 - 8 traded)

– Elizabeth Apples?• 12 apples (0 + 12 traded)

• Brian Bread– 8 loaves (0 + 8 traded)

• Brian Apples– 18 apples (30 -12 traded)

• Are they better off??

Are they better off??No

Specialization or Trade

Specialization and Trade

Gains from trade

Elizabeth Bread

Elizabeth Apples

Brian Bread

Brian Apples

Gains from trade

Elizabeth Bread

Elizabeth Apples

Brian Bread

Brian Apples

Gains from trade

Elizabeth Bread

Elizabeth Apples

Brian Bread

Brian Apples

Gains from trade

Elizabeth Bread

10 12 +2

Elizabeth Apples

10 12 +2

Brian Bread

5 8 +3

Brian Apples

15 18 +3

Gains from trade

Elizabeth Bread

Elizabeth Apples

Brian Bread

Brian Apples

Both are Better off!!

Economic System

• The way in which a society decides to answer key economic questions– What goods will be produced?– How will the goods be produced?– For whom will the goods be produced?– Where on the PPF will the economy operate?– What is the nature of trade?– What function do prices serve?

Two major economic systems

• Capitalism– An economic system based on private ownership of

capital– Market economy

• Socialism– An economic system based on state ownership of

capital

• Most use pieces of each mixed capitalism

How do they differ

• PPF– Capitalist: Buying behavior of consumers signal for

producers to produce more/less– Socialist: Government sets up how much to

produce

• What good to produce?– Capitalist: Consumers and producers decide– Socialist: Government decides

• How goods will be produced?

– Capitalist: producers decide– Socialist: government decides

• For whom to produce?– Capitalist: Consumers decide if they are able and

willing to purchase the good– Socialist: Government may redistribute funds to get

certain people certain items

• Trade– Capitalist view: Trade benefits both sides– Socialist view: Trade benefits one side at the

expense of the other

• Prices– Capitalism views

• Rations goods and services• Conveys information• Serves as an incentive to respond to information

– Socialism views• Price is set by greedy businesses with much economic

power• Price controls (can’t charge more or less than a certain

price)

Now we want to use these questions for the next chapter

as we look at:

Now we want to use these questions for the next chapter

as we look at: What a market is and how is it

established.

Chapter 3

Supply, Demand: Theory

Chapter 3

Supply, Demand: Theory

MarketMarket• Market is an arrangement by which people

exchange goods and services including money

• Two sides– Buyer– Seller

Starting with the Buyer SideStarting with the Buyer Side

• Quantity demanded– Amount of a good people are willing and able to buy

at a particular price at a particular point in time

Important parts of definitionImportant parts of definition

• Willing

• Able

• Particular Price

• Particular point in time

DemandDemandQuantity demanded over all prices during a

specific point in time

• Important parts:

• Quantity demanded

• All prices

• Specific point in time

So….So…. So….

Who does what in the Market?Who does what in the Market?

• Consumers – Buy goods– Sell Labor

• Firms– Sell goods– Buy Labor

Circular FlowCircular Flow• Depiction of how the market works in the

economy

• Includes both buyers and sellers

• Shows the flow of goods and services between consumers and firms

Law of DemandLaw of Demand

• As price of a good (decreases) increases the Quantity demanded of that good

(increases) decreases

Demand ScheduleDemand Schedule• Numerical table of quantity demanded at

different prices

QuantityPrice

Demand CurveDemand Curve• Graphical representation of the demand

schedule

• Used to represent the relationship between price and quantity

• Why type of relationship do you expect price and quantity to have?

Demand Schedule and Demand Curve

Price (dollars )

PRICE(dollars )

QUANTITYDEMANDED

POINT INPANEL (b)

DEMAND SCHEDULE FOR GOOD X

0 10 20 30 40

Demand Curve

Quantity Demanded of GoodX

Market Demand Curves

Market Demand Curves• Previous demand curve was for an individual

– Single buyer

• How can we get the market curve from individual demand curves?– All buyers

• Sum the individual Demand curves…

Therefore….Therefore….

Deriving a Market Demand Schedule & Curve

QUANTITY DEMANDED

Part (a)

OTHER BUYERS

ALL BUYERS

Deriving a Market

Demand Schedule & Curve

Deriving a Market

Demand Schedule & Curve

Quantity Demanded

Part (b)

Price ($)

100 130Quantity Demanded

Demand Curve(other buyers )

Price ($)

109 141

4 + 5 + 100

5 + 6 + 130

Market DemandCurve

Price ($)

Demand Curve(Jones )

Price ($)Demand Curve

(Smith)

5 6Quantity DemandedQuantity Demanded

Determinants of DemandDeterminants of Demand• Income

– Normal good– Inferior good

• Preferences

• Prices of Related Goods– Substitutes– Compliments

Determinants Continued…Determinants Continued…• Number of Buyers

• Expectations of Future

Change in Demand vs. Change in Quantity Demanded

Change in Demand vs. Change in Quantity Demanded• Change in Demand

– SHIFT OF CURVE• Due to any non-price determinate

• Change in Quantity demanded– MOVEMENT ON ORIGINAL CURVE

• Due only to a change in price

Change in Demand versus Change in Quantity Demanded

0 Quantity Demanded

A change in demand(a s hift in the

demand curve)

0 Quantity Demanded

A change inquantity demanded(a movement along

the demand curve , D )

(b)(a)

Change in DemandChange in Demand• SHIFT OF CURVE

• SHIFT LEFT??– DECREASE IN DEMAND

• SHIFT RIGHT??– INCREASE IN DEMAND

Shifts in the Demand Curve Shifts in the Demand Curve

Price (dollars )

0 500 700

Rightward s hiftin demand curve

(increas e in demand)

Quantity Demanded of Blue Jeans

Part (a)

Shifts in the Demand Curve Shifts in the Demand Curve

Price (dollars )

0 450 650

Leftward s hiftin demand curve

(decreas e in demand)

Quantity Demanded of Blue Jeans

Part (b)

Change in price of related goods

Change in price of related goods• Substitutes

– Something used in replace of another good– Price of Coke increases...

• Compliments– Something used with another good– Price of Tennis Rackets increase

Substitutes and Complements Substitutes and Complements

Part (a)SUBSTITUTES

Quantity Demanded of Coca-Cola

Quantity Demanded of Peps i-Cola

If Coca-Cola andPeps i-Cola ares ubs titutes , ahigher price forCoca-Cola leads to . . .

Qd1Qd 2

. . . a rightwards hift in the demandcurve for Peps i-Cola.

Substitutes and Complements Substitutes and Complements

COMPLEMENTSPart (b)

Quantity Demanded of Tennis Rackets

Quantity Demanded of Tennis Balls

If tennis rackets andtennis balls arecomplements , a higherprice for tennisrackets leads to . . .

Qd1Qd2

. . . a le ftwards hift in the demandcurve for tennis balls .

SELF TEST-Do we understand??

SELF TEST-Do we understand??• Substitutes

– Coke vs. Pepsi --- what happens if the price of Coke increases?

– Qd of Pepsi?• NOTHING

– Qd of Coke?• DECREASES

– Demand for Coke?• NOTHING

– Demand for Pepsi?• INCREASES

• Compliments– Tennis Balls and Tennis Rackets --- what happens

if the price of Tennis Rackets increase?– Qd of Tennis Balls?

• NOTHING

– Qd of Tennis Rackets?• DECREASES

– Demand for Tennis Balls?• DECREASES

– Demand for Tennis Rackets?• NOTHING

ExamplesExamples• The housing market: Consumer’s income

increases

• The sugar market: Saccharine is found to lead to cancer

• The jelly market: The price of peanut butter increases

• The beer market: The price of beer decreases

Does the Law of Demand Hold?

• The price of eating out increases from $10 to $15 and the quantity demanded of restaurants increases from 10 to 14 meals.

The Law of

Demand Holds

The Law of

Demand Holds

Price ($)

0Quantity Demanded

of Res taurant Meals (millions )

Price ($)

0Quantity Demandedof Res taurant Meals

(millions )

Price ($)

0Quantity Demandedof Res taurant Meals

(millions )

RIGHTWRONG

Thes e twopoints ,A and B,are obs erved.

The other side…supplyThe other side…supply

• Quantity supplied– Amount of a good that producers are willing and

able to sell at a particular point in time at a particular price

Important PartsImportant Parts• Able

• Willing

• Particular price

• Particular point in time

SupplySupply• Quantity Supplied at all prices during a specific

time period

• Thus…

Law of SupplyLaw of Supply

• As the price of a good increases (decreases) the quantity supplied of that good increases (decreases)

Supply ScheduleSupply Schedule• Numerical table of quantity supplied at different

prices

QuantityPrice

Supply CurveSupply Curve• Supply Curve

– Graphical representation of the relationship between price and quantity supplied

• What type of relationship do we have between price and quantity supplied?

Supply Curve Exhibit 7

Price (dollars )

10 20 30 40

Supply Curve

Quantity Supplied of GoodX

Stuff continued…Stuff continued…

• Change in supply– SHIFT OF SUPPLY CURVE

• Change in quantity supplied– MOVEMENT ALONG ORIGINAL SUPPLY

CURVE• Increase in supply --- shift right• Decrease in supply --- shift left

Change in Supply versus Change in Quantity Supplied

0 Quantity Supplied

A change in s upply(a s hift in thes upply curve)

(b)(a)

0 Quantity Supplied

A change inquantity

(a movement alongthe s upply curve ,S )

Shifts in the Supply Curve Shifts in the Supply Curve

Price (dollars )

Quantity Supplied of Good X

Rightward s hiftin s upply curve

(increas e in s upply)

Part (a)

200 300

Shifts in the Supply Curve Shifts in the Supply Curve

Part (b)

Quantity Supplied of Go od X

Price (do llars )

Leftward s hiftin s upply curve

(de creas e in s upply)

Question???Question???• Can the supply curve ever be vertical?

• First…what does a vertical curve indicate about the relationship between price and quantity supplied?

Supply Curves When There Is No Time to Produce More or No More

Can Be Produced

Supply Curves When There Is No Time to Produce More or No More

Can Be Produced

Supply Curve ofStradivarius Violins

Number of Stradivarius Vio lins0

Supply Curve ofTheater Seatsfor Tonight’sPerformance

Number of Theater Seats

Determinants of SupplyDeterminants of Supply

• Price of inputs

• Technology

• Number of sellers

• Price expectations

• Taxes and subsidies

Examples• The computer market: The price of computer chips

decreases• The fast food market: McDonalds opens three new

stores in Bakersfield• The pencil market: The price of pencils increases• The gasoline market: A tax is imposed on gas station

owners for each gallon of gas pumped out of their station

Market Supply CurvesMarket Supply Curves• Previous supply curve was for an individual

– Single seller

• How can we get the market curve from individual supply curves?– All sellers

• Sum the individual supply curves…

Therefore….Therefore….

Deriving a Market Supply Schedule & Curve

QUANTITY SUPPLIED

Part (a)

ALL SUPPLIERS

OTHER SUPPLIERS

ALBERTS

Deriving a Market Supply

Schedule & Curve

Deriving a Market Supply

Schedule & Curve

Price ($)

SupplyCurve

(Brown)Price ($) Supply

Curve(Alberts )

Price ($)

98 102Quantity Supplied

Quantity SuppliedQuantity Supplied

Supply Curve(other

s uppliers )Price ($)

Quantity Supplied

103 1092 + 3 + 983 + 4 + 102

MarketSupplyCurve

Part (b)

Next Step….Next Step….

Putting Supply and Demand Together

Auction Model

Can think of supply and demand as an auction

where buyers bid the price down and sellers bid the price up until Qs and Qd are equal at the same price

But…• There is only one price where Qs=Qd

• This is called the equilibrium price

• The market is always working towards this price

Scissors and economics?

• Alfred Marshall compared Supply and demand to a pair of scissors– “It is impossible to say which blade is actually doing

the cutting just like it is impossible to say whether demand or supply is responsible for the price

What determines the price?

• The interaction of supply and demand

Equilibrium• Also called the market clearing price

– When Qs=Qd

• Disequilibrium– When Qs=Qd

At Disequilibrium can have…

• Shortage (excess demand)– Qd > Qs– Price too low– Price must increase to rid shortage

• Surplus (excess supply)– Qd < Qs– Price too high– Price must decrease to rid surplus

Moving to Equilibrium Moving to Equilibrium

Price (dollars )

Quantity

50 150100

Surplus

Shortage

CONDITION

Surplus

Equilibrium

Shortage

QPRICE

Moving to Equilibrium

• If we have a surplus, price must _______ to get to equilibrium.

• Decrease

• If we have a shortage, price must _______ to get to equilibrium.

• Increase

Do Shortage and Scarcity refer to the same thing???

• NO!!

• Shortage is only when price is less than the equilibrium price

• Scarcity is always present (at all prices)

Applications of Supply and Demand

• Romanee-Conti Wine– Dated back to 1990 and sells for $800 a bottle or $8 a sip…

• Ticket scalping– Why would people pay higher prices to see an event?– Prices must have been below equilibrium.

• Freeway– Why would people be willing to pay a toll to use a road?

Remember..• Equilibrium price and quantity are determined

by the INTERACTION of supply and demand• A change in supply, demand, or both will

change the equilibrium price • Exception: If supply and demand move in

same direction and magnitude so changes are offset

Change in Supply and Demand but no change in equilibrium price

What Happens???• Increase D and S constant?• Decrease D and S constant?• D constant and increase S?• D constant and decrease S?• D increase and S decreases by equal amounts?• D decrease and S increases by equal amounts?• D increases more than S decreases?• D increases less than S decreases?

A Summary Exhibit of a Market A Summary Exhibit of a Market

SUPPLY

GovernmentRes tric tions

Taxesand

Sus idies

Numberof

Se llers

Expectationsof

Future Price

Technology

Prices ofRelevant

Res ouces

PRICE,QUANTITY

DEMAND

MARKET

Income

PreferencesNumber

of Buyers

Prices ofRelated Goods

(Subs titutesand

Complements )

Expectationsof Future Price

Price Controls

• Produces a barrier to which the economy can no longer operate freely– Can’t get to equilibrium price

• Two types– Price ceiling– Price Floor

Price Ceiling

• Government mandated maximum price above which legal trades cannot be made

• Price ceiling is below equilibrium price.

Price Ceiling Price Ceiling

0 100 150 190

A price ce ilingcre ates a s ho rtage

SPrice

(do llars

EquilibriumPrice

PriceCe iling

EquilibriumQuantity

Quantity of Good X

Shortag e

Impacts of Price Ceilings• Shortage sustained• Fewer exchanges• Non-price rationing schemes

– First come first served

• Buying & selling at prohibited prices– Black markets

• Tie in Sales– Pay certain amount for rent of the house and an amount for

renting the refrigerator

• Distort normal economic information and incentives– Lower prices is supposed to mean greater availability

Price Floor

• Government mandated minimum price below which legal trades cannot be made

• Price floor is above equilibrium price

Price Floor Price Floor

0 90 130 180

A price floorcreates a s urplus

SPrice

(dollars )

EquilibriumPrice

PriceFloor

EquilibriumQuantity

Quantity of Good X

Surplus

Impacts of Price Floors

• Sustained surpluses

• Fewer exchanges

• Example: Minimum wage

Minimum Wage

• In California the minimum wage is $6.75 per hour– Increased from $6.26 on January 1, 2002

• Government mandated minimum wage is $5.15– Last increase was on September 1, 1997

Impacts of Minimum Wage

• Surplus of unskilled

• Fewer workers overall employed

• Supply and Demand would determine wage

• Minimum wage doesn’t guarantee better standards of living for low wage employees

Effects of the Minimum

SWage Rate(dollars )

EquilibriumWage

MinimumWage

Number ofUns killed Workers

Surplus

Number of WorkersWho Want to Work at

Minimum Wage

Number of WorkersEmployed

atEquilibrium Wage

Number of WorkersEmployed at

Minimum Wage

Chapter 5

Elasticity

Chapter 5

Elasticity

You are responsible for reading Chapter 4!!!

What have we done?

• Chapter 3 gave us downward sloping demand curves– Law of demand

• Now want to see how Qd changes when price changes

Elasticity

• Response of one variable to a change in another variable

• Price elasticity of demand– Measure of the responsiveness of Qd of a product to

a change in the price of that product

• What if Ed = 3?– If price was increased from the prevailing

point the % change in Qd would be 3 times the change in price

• Shouldn’t it be negative?– So price increases and Qd decreases?

• Yes!!– For ease we look at the absolute value, but

know that the law of demand holds

Point elasticity

• Measures the change between two observed points.

example

• P1 = 10• P2 = 12• Q1 = 100• Q2 = 50• Elasticity??• Which is Point A??? • Big Problem!!!

121210

5050100

101012

10010050

Problem

• Answers vary depending on where you start

• Becomes more important the larger the change

Arc Elasticity

• To avoid the endpoint problem take elasticity at the midpoint (average) of the two points

Differences

• With arc elasticity it is clear which points are used

• P1 is the first price

• P2 is the second price

• Qd1 and Qd2 are the first and second quantity demanded respectively

Price elasticity of demand can yield 5 basic results

• Numerator > Denominator

• Numerator < Denominator

• Numerator = Denominator

• Numerator = 0

• Denominator = 0

• Each has a specific name and result

Elastic Demand

• Ed > 1

• % change in quantity demanded > % change in price

• FLATTER CURVE

• What are some examples of an elastic good???

Inelastic Demand

• Ed<1

• % change in the price > percent change in quantity demanded

• STEEPER CURVE

• What are some examples of an inelastic good?

Price Elasticity of Demand Price Elasticity of Demand

Quantity Demanded

Part (a)

Ed > 1Elastic

Quantity Demanded

Part (b)

Ed < 1Inelastic

Unit Elastic Demand

• Ed=1

• % change in price = % change in quantity demanded

• Change in price brings a proportionate change in quantity demanded

• CURVE

Quantity Demanded

Part (c)

Ed = 1Unit Elastic

Perfectly Elastic Demand

• Ed = (denominator = 0)• % change in quantity demanded is A LOT in

response to a change in price • Price increases and quantity demanded goes

to 0• Totally flat --- horizontal• Extreme• Examples???

Perfectly inelastic demand

• Ed = 0

• % change in quantity demanded DOESN’T CHANGE in response to a change in price

• Totally steep --- vertical

• Extreme

• Examples???

0Quantity Demanded

Part (d)

Ed = Perfectly Elastic

0Quantity Demanded

PriceD

Part (e)

Ed = 0Perfectly Inelastic

Aren’t demand curve downward sloping?

• Because the extremes (perfectly inelastic and perfectly elastic) are not.

• Use as points of reference only

How does a change in price affect Total Revenue of a Firm?

• Revenue depends on elasticity

• Michael Jordan and Nike shoes– No substitutes -- inelastic demand

• What happens to Qd if price increases?

– Substitutes – elastic demand• What happens to Qd if price increases?

What is total revenue??

• Total revenue = price*quantity

• Firm uses to decide if to produce more or less

examples

• Elastic demand– Price increase– Price decrease

• Inelastic demand– Price increase– Price decrease

• Unit elastic demand– Price increase– Price decrease

Elasticities, Price

Changes, and Total

Revenue

Elasticities, Price

Changes, and Total

Revenue

Ed > 1

Ed < 1

Ed = 1

Important to look at because…

• Elasticity of the demand determines if with a price increase…– Total revenue increases– Total revenue decreases– Total revenue remains the same

Price elasticity of demand and a straight line

• Demand is downward sloping

• Along the line elasticity varies from highly elastic to highly inelastic

• But…remember SLOPE is constant

Point P Qd

Price Elasticity of Demand along a Demand Curve

(1)POINT

(2)PRICE

(3)QUANTITY

DEMANDED

Price (dollars)

1 2 3 4 5 6 7 8 9

Quantity Demanded

ElasticRange

Unit ElasticRange

InelasticRange

Summary

• Upper end of Demand Curve– Qd is low and price is high– One unit change in demand is much larger

in terms of percent than change in price

• Lower end of Demand Curve– Qd is high and price is low– One unit change in demand is much

smaller in terms of percent than change in price

• As move down the demand curve from higher prices to lower the price elasticity of demand goes from elastic to inelastic

Determinants of price elasticity of demand

• Number of substitutes available– Increase substitutes increases elasticity– More narrowly defined goods have more substitutes

(compared to broadly defined)• Example: Fords vs all cars

More Determinants

• Percentage of one’s budget that is spent on the good– More expensive??? More elastic– More affected by price (even small changes)

Final Determinants

• Amount of time that passed since price change– Increase time passed gives more opportunity to

change behavior or react to price change– Overtime can look for substitutes– Increase time increases elasticity– More elastic in long term than short

Cross Elasticity of Demand

• Measures the responsiveness of quantity demanded to a change in price of ANOTHER good

When would you use Cross Price Elasticity?

• To determine if goods are substitutes or compliments• Ec>0 – substitutes

– % change in quantity demanded and price move in same direction

• Ec<0 – compliments– % change in quantity demanded and price move in

opposite directions• Ec=0 – goods unrelated

Income elasticity of demand

• Measures the responsiveness of quantity demanded to the change in income

income

Why use income elasticity of demand?

• Use to determine if a good is normal or inferior

• Ey>0 – normal good– As income increases Qd increases

• Ey<0 – inferior good– As income increases Qd decreases

Can also say…

• If |Ey| > 1– % change in Qd > % change in Y– Income elastic

• If |Ey| < 1– % change in Qd < % change in Y– Income inelastic

• If |Ey| = 1– % change in Qd = % change in Y– Income unit elastic

Can we use income elasticity in the real world??

• If invest in the stock market do you want to invest in a normal or inferior good?

• Normal

• Why

• Increase income would increase quantity bought and increase stock prices

Price Elasticity of Supply• Measures the responsiveness of quantity supplied of

a good to the change in the price of that good

Classification is like demand

• Es > 1– Elastic

• Es < 1– Inelastic

• Es = 1– Unit elastic

• Each of these will result in a “normal” upward sloped supply curve

Any extreme elasticities???

• Yes!!

• Es = – Perfectly elastic or horizontal

• Es = 0– Perfectly inelastic or vertical

Price Elasticity of Supply Price Elasticity of Supply

Quantity Supplied

Part (a)

Es > 1Elastic

Quantity Supplied

Part (b)

Es < 1Inelastic

0Quantity Supplied

Part (c)

P2Es = 1Unit Elastic

Quantity Supplied

Part (d)

Es = Perfectly Elastic

Quantity Supplied

PriceS

Part (e)

Es = 0PerfectlyInelastic

Does time play a role in elasticity of supply?

• Yes!!

• Overtime producers are able to adjust their behavior and production patterns

• Supply becomes more elastic as time passes

Elasticity and taxes

• If government levies a tax on a product who pays the tax??

• Producers?? Consumers?? Share??

• Depends on the elasticity of demand and supply

How find??• Find equilibrium price

• Supply shifts left in the amount of the tax

• Find new equilibrium

• Find point of second equilibrium on ORGINAL supply curve

– Shows the actual price realized by firm or equilibrium price – tax = point in question

• Difference between points determines how much of tax you pay

Who Pays the Tax? Who Pays the Tax?

Quantity of VCR Tapes

$1 Tax

S2 (after tax)

S1 (before tax)

Price(dollars)

Part of tax paidby consumers interms of higher

price paid.

Part of tax paidby producers interms of lower

price kept.

Who pays more of the tax??

• Perfectly inelastic demand

• Perfectly elastic demand

• Demand more elastic than supply

• Supply more elastic than demand

Different Elasticities and Who Pays the Tax

Price (dollars)

Consumers payfull tax

Part (a)

$1 Tax

Price (dollars)

Producers payfull tax

Part (b)

Summary

• Ed > Es producer bears most of the tax burden

• Ed < Es consumer bears most of the tax burden

• Ed = Es equally share the tax burden

Chapter 6Consumer Choice:

Maximizing Utility and Behavioral Economics

Chapter 6Consumer Choice:

Maximizing Utility and Behavioral Economics

Diamond-Water Paradox

• Why is water (necessary to life) so cheep while a diamond (not necessary to life) is so expensive?

Two types of value for a good

• Value of Exchange– Price

• Utility– Satisfaction or wellbeing

How do you measure utility?

• Construct an artificial measure called a UTIL

• Remember we assume people are rational

• What does it mean to be rational?– Will not consume a bad voluntarily

• All consumed goods have utility or you would not consume it.

Total Utility

• Amount of satisfaction or “use value” you receive from consuming a particular good

• Thus…

Marginal Utility

• Additional utility gained from consuming an additional unit of a good

• Change in total utility brought about by the additional consumption

Thus…

Calculate the Marginal Utility

Quantity Pizza Slices Total Utility

Law of Diminishing Marginal Utility

• The more units of a good we consume during a period of time the less additional satisfaction we get from the additional units

Total Utility (utils)

Good X0 1

2 3 4 5

(1) UNITS OFGOOD X

(2) TOTALUTILITY (utils)

(3) MARGINALUTILITY (utils)

Marginal Utility (utils)

Good X01

2 3 4 5

012345

01019273440

—109876

Does the “law” always hold?

• Some goods have increasing MU initially then decreasing later, but the law says satisfaction should begin to decrease with the second unit

• Tennis– As you get better you like it more, so the 10th game

may be more enjoyable

Soften the Law

• Principle of Diminishing Returns– For a given period of time the MU gained from

consuming equal successive units of a good will eventually decline as the amount consumed increases.

Examples…

• Car rides

• Fads

• eating

Thus…the law says

• At some point successive units of a good consumed by the SAME individual will become less valuable to that individual

• What about to someone else or the interpersonal utility?– Can’t do because we don’t know with certainty

another person’s preferences

Example

• Who would value a dollar more: a poor person or a millionaire?

• Money hungry millionaire?– Answer would be millionaire

• Dollar is not much of a million– Answer would be a poor person

• Don’t guess at utility

Diamond-Water Paradox revisited

• Goods have Total and Marginal Utility values

• Water – TU?

– High because need it to live

– MU?

– Low because it is plentiful and we consume it in large quantities

Diamond-Water Paradox continued

• Diamonds– TU??– Low because not really necessary to live– MU??– High because very limited supply and consume in

small quantities

Solution to Diamond-Water Paradox

• Things with great value in use have little value in exchange

• Those with little use value have higher exchange value

• Prices (value of exchange) are most often determined by…– Marginal Utility

Is gambling worth it?

• If only want to win??? NO!!

• If gain pleasure from the gambling process??? YES!!

How do we compare MU of different units?

• Example: What is the MU of an apple vs. an orange?

• Relative Marginal Utility of the good

• MU per dollar of purchase price

Decision Making Process

• If the MU of good A relative to its price is greater than the MU of good B relative to its price we should buy more of A and less of B

• Compare of each good

Example

• MUorange = 30• MUapple = 20• Income = $20• Buy 10 oranges for $1 each and 10 apples for $1

• Good??

Not Good…• We could do better by buying more oranges

because per dollar it brings more satisfaction

• Buy one more orange and one less apple increases TU

• What happens to the MU of oranges?– Decreases MU of oranges – Why?– Diminishing MU when buy more

• What happens to the MU of apples?– Increases MU of apples – Why?– Increasing MU when buy less

• When do we stop?

Consumer Equilibrium

• The combination of goods where our income can’t be redirected to improve our situation

• Therefore:

ExamplePM=$2; Pc=$1; Income=$60

# muffins MUM # cookies MUc

5 11 44 6

6 8 46 5

7 6 48 4

8 3 50 3

What if the price of a good changes?

• Must recalculate

Pa=$1;Pb=$1? Pa=$0.50;Pb=$1?Income = $7.00

#a MUa #b MUB

1 12 1 22

2 11.5 2 20

3 11 3 18

4 10 4 16

5 9 5 14

6 8 6 12

7 7 7 10

Consumer Equilibrium and a Fall in Price Consumer Equilibrium and a Fall in Price

GOOD B

Good A Good B

12 utils$1.00

Good A Good B

8 utils$.50

16 utils$1.00

Units of Good A

Marginal Utility

Units o f Good B

Marginal Utility

GOOD A

Orig inalPurchas e

NewPurchas e

Orig inalPurchas e

NewPurchas e

• As price decreases relative MU increases so consumers buy more to gain consumer equilibrium again

• Shows a negative relationship between price and amount people buy– JUST LIKE THE DEMAND CURVE

Do RATS understand the inverse relationship between price and quantity?

• Choice between two liquids– Root beer– Collins mix

• Given 300 pushes (each liquid had a different number of pushes to get it – price)

• Found rats switched to the “cheaper” liquid when the “price” changed

Why isn’t education and medical care free?

• If cost = 0 when do we stop using it?

• When MU = 0

• Thus we will see a lot of frivolous use of programs. It costs you nothing so use it.

Consumer Surplus

• The difference between the actual price buyers pay for a good and the maximum amount they are WILLING and ABLE to pay for it

• Dollar measure of benefit gained from a price decrease

Consumer Surplus cont.

• Triangle under the demand curve and above the equilibrium price out to the equilibrium quantity

Consumers' Surplus Consumers' Surplus

Quantity

Cons umers ’Surplus

WindowPart (a)

Changes in Supply affect Consumer Surplus

• Decrease in the number of sellers

• Advance in technology

• Increase in the price of relevant resources

• A per-unit subsidy placed on producers/seller

Consumers' Surplus Consumers' Surplus

0Quantity

Window

CS with S1:

CS with S2:

Part (b)

Sales schemes• Consumer is willing to buy

– One pair of shorts for $40– Second pair of shorts for $30

• Store has a choice– Sell shorts for $30 – Have sale where buy first for $40 get $10

off second pair?– Which has more CS??? (hint only use the

demand curve)

Consumers’ Surplus and Two Pricing Schemes

($30)F

0 2 Pairs ofTrous ers

Cas e wheneach

pair oftrous ers

is $30C

($30)F

0 2 Pairs ofTrous ers

Cas e whenfirs t

pair o ftrous ers

is $40 ands econd pair

is $30E

D0 2 Pairs of

Trous ers1

Bob’s demandfor pairs of

trous ers

Slides for Midterm

Documents