Dr. Duffy Microeconomics

Notes fromCHAPTER 3 of Frank and Bernanke

Three Basic Questions

Three Problems All Economic Systems Must Address• What should be produced?• How should it be produced?• For whom will it be produced?

Types of Economies

• Command Economy: government makes all important decisions about production and distribution.

• Market Economy: individuals and private firms make the major decisions. Extreme case (no government intervention) is called “laissez-faire” economy.

• Mixed Economy has elements of both. All modern economies are mixed.

A Pure Market Economy. . .

. . .has never existed. The closest to itwas probably England in the 19th century.

There has never been a pure “command economy” either,although some of the older communist regimes (Stalin,Pol Pot) may have been close.

U.S. Economic System

• Largely a market system• However, we do have some laws and

regulations that affect market decisions.

• Can you think of some policies (state, federal or local) that affect certain markets?

Price Determination

• Assuming no or little government intervention in a market, what determines price?

• Explaining prices is a fundamental question that drove the development of modern economics.

• It is only recently (late 19th century) that a good understanding of price determination developed.

Supply and Demand

Supply and Demand determine prices inindividual markets.

Price is the mechanism that brings supply and demand together.

Rationing by prices

Through prices, the market rations thescarce goods of society among possibleuses.

The Demand Schedule

The demand schedule (demand curve)shows the relationship between a commodity’s market price and the quantity of that commodity that consumers are willing and able to purchase, other things held constant.

Generally, the higher the price, the less thequantity demanded.

The Dailey Demand Schedule for Pizza in Chicago

$5 4 4 8 3 12 2 16 1 20

Price($/slice)

Quantity Demanded(1000s of slices per day)

The Daily Demand Curve for Pizza in Chicago

Price($ per slice)

Quantity(1000s of slices per day)

4

8

2

16

3

12

Demand

Law of Downward Sloping Demand

When the price of a commodity is raised(and other things are held constant), buyerstend to buy less of the commodity. Similarly,when the price is lowered, other things beingconstant, quantity demanded increases.

There are two explanations for downwardsloping demand curves.

Reason 1: Substitution Effect

When the price of a good rises, I willsubstitute other similar goods for it.

For example, if the price of beef rises,I will eat more chicken and pork.

Reason 2: Income Effect

As the price of a commodity rises, my incomewill not stretch as far as it used to. I am therefore “poorer” in a relative sense,than before the price increase and can’t buyas many things as I did before.

Demand and Cost-Benefit

• The reservation price is the benefit the buyer receives from the good

• The cost of the good is its market price• If the reservation price (benefit) exceeds

the market price (cost) the consumer will purchase the good

• At higher prices, benefit will exceed cost for a smaller quantity than at lower prices

Buyers and Sellers In Markets

Horizontal Interpretation

Price determines quantity demanded

Price($ per slice)

4

2

3

8 12 16

Demand

Buyers and Sellers In Markets

Vertical Interpretation

Quantity measures the marginal buyer’s reservation price

Price($ per slice)

4

2

3

8 12 16

Demand

Market Demand Curve

The market demand curve “adds up” all the quantities demanded by individualconsumers at a given price.

It shows the total amount of a commodity consumers are willing and able to buy at a given price.

The Supply Schedule

The supply schedule (or supply curve) fora commodity shows the relationship betweenthe market price and the amount of thatcommodity that producers are willing and able to produce and sell, other things held constant. Generally, the higher the price themore producers will supply.

The Daily Supply Schedulefor Pizza in Chicago

Price($ per slice)

Quantity(1000s of slices per day)

$4 16

3 12

2 8

1 4

The Daily SupplyCurve for Pizza in Chicago

Price($ per slice)

Quantity(1000s of slices per day)

4

2

3

8 12 16

Supply

Opportunity Costs and Quantity Produced

• Question• Will the opportunity cost of producing

additional units of pizza increase or decrease?• Hint:Low-hanging-fruit principle

Supply Slopes Up

Supply slopes up because of the “law ofdiminishing returns.” To get extra outputusually requires proportionally more extrainput.

The smallest dollar amount for which a seller would be willing to sell an additional unit, generally equal to marginal cost

Seller’s Reservation Price

Opportunity Costs and Upward Sloping Supply

Sellers must receive a higher price to produce additional units of product to cover the higher opportunity costs of each additional unit

The Daily SupplyCurve for Pizza in Chicago

Price($ per slice)

Quantity(1000s of slices per day)

4

2

3

8 12 16

Supply

Horizontal Interpretation

Shows the quantity produced

for each price

The Daily SupplyCurve for Pizza in Chicago

Price($ per slice)

Quantity(1000s of slices per day)

4

2

3

8 12 16

Supply

Vertical Interpretation

Shows the marginal cost (reservation

price) for producing each additional unit

Supply and Demand: Equilibirum

A market equilibrium comes at the placewhere quantity demanded equals quantitysupplied.

Equilibrium takes place at the intersectionof the supply and demand curves.

Market Equilibrium

• Equilibrium• A system is in equilibrium when there is

no tendency for it to change

• Market Equilibrium• Occurs in a market when all buyers and

sellers are satisfied with their respective quantities at the market price

Equilibrium Price and Equilibrium Quantity

The values of price and quantity for which quantity supplied and quantity demanded are equal

The Equilibrium Price and Quantity of Pizza In Chicago

Price($ per slice)

Quantity(1000s of slices per day)

4

2

3

8 12 16

Supply

Demand

Equilibrium at $3

Quantity Demanded =

Quantity Supplied

Market Equilibrium

• What Do You Think?• Is the market equilibrium always an

ideal outcome for all market participants?

• What Do You Think?• Would buyers prefer a lower price than

the equilibrium price?• Would sellers prefer a higher price than

the equilibrium price?

Market Equilibrium

Points Along the Demand and Supply Curves of a Pizza Market

Demand for pizza Supply of pizza

Price($/slice)

Quantity demanded(1000s of slices/day)

Price($/slice)

Quantity supplied(1000s of

slices/day)

1 8 1 2

2 6 2 4

3 4 3 6

4 2 4 8

Note: There is no point in the table where price would make quantitydemanded equal quantity supplied. Our equilibrium price must fallbetween $2 and $3.

Graphing Supply and Demand and Finding the Equilibrium Price and Quantity

Price($per slice)

Quantity(1000s of slices per day)

5

2

3

4

1

4

102

Demand

0 6 8

Supply

2.50

5

The Equilibrium Price = $2.50The Equilibrium Quantity = 5

When we graph the curves, we can find the equilibrium price and quantity.

Excess Demand: If price is below equilibrium

Price($ per slice)

Quantity(1000s of slices per day)

4

2

3

8 16

Excess demand = 8,000slices per day

Supply

Demand

This situation is called a shortage.

Excess Supply: If price is above equilibrium

Price($ per slice)

Quantity(1000s of slices per day)

4

2

3

8 12 16

Supply

Demand

Excess supply = 8,000 slices per day

This situation is called a surplus.

Caution!

When economists use the word“surplus” or “shortage” they mean thatthe market is not in equilibrium. If thereis a surplus, products pile up, un-purchased.

If there is a shortage, many consumers cannot find the product to buy.

What is a shortage? Example.

The Christmas of 2000, there was a shortage of the PlayStation II. Consumers could not find the item on store shelves.

Gas prices rose this summer, but therewas no shortage because consumers could find the gas to buy, although ata higher price than before.

Factors Affecting Demand

• Size of market, e.g. how many consumers.

• Income levels of consumers.• Prices and availability of related

goods.• Tastes and preferences.• Special influences, e.g. climate and

conditions.

Factors Affecting supply

• Changes in costs of inputs• Technological change• Prices of alternative products that

could be produced with same resources.

• Government policy • Special factors (climate, culture)

Shifts of Supply or Demand

If one of the factors affecting a demandor supply curve changes, the curve willshift. This means the entire curve movesto a new position on the graph.

Example: Shift of the demand curve

For most products, demand shifts outward as income rises.

Q

P

D

D'

An Example

When students come back to school in the fall,more pizzas are sold locally.

This is an increase in demand caused by an increase in the size of the market!

Another Example

When low-carb diets were popular,fewer loaves of bread were sold.

This is a decrease in demand causedby a change in tastes and preferences.

Demand Increase or Decrease?

• What happens to demand for sunblock in the summer?

• What happens to demand for fish when chicken prices increase?

• What happens to the demand for luxury cars when incomes fall?

• What will happen to the demand for sugar if diabetes increases?

Normal Good vs. Inferior Good

If, when income rises, consumers purchasemore of a good, that good is called a “normal good.”

Sometimes consumers may buy less of a certain item when their incomes rise. That good is called an “inferior good.”

Most items are normal goods. Can you think of some inferior goods?

Shift of supply curve

Q

P

S S’

If the price of an input falls,the supply curve shifts out.

Shifts in curves change equilibrium price and quantity

D

S’

Q

P

P’

Q’

S’’

Q’’

P”

Supply increases

Shifts in curves change equilibrium

D

S’’

Q

P

P’’

Q”

S’

Q’

P’

Supply decreases

Shifts in curves change equilibrium

D’

S

Q

P

P’

Q’

D”

Q”

P”

Demand Increases

Shifts in curves change equilibrium

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S

Q

P

P’

Q’

D”

P”

Q”

Demand Decreases

There are four possibilities

• Price Up, Quantity Down ---- Supply decrease

• Price Down, Quantity Up -- Supply increase

• Price Up, Quantity Up -- Demand increase• Price Down, Quantity Down -- Demand

decrease

An Unregulated Housing Market

Monthly Rent($/apartment)

Quantity(Millions of apartments/day)

1,600

2

Supply

Demand

What Do You Think?Is $1600 more than some people can afford?

Rent Controls

Monthly Rent($/apartment)

Quantity(Millions of apartments/day)

1,600

2

Supply

Demand

2,400

Controlled = 800

1 30

Excess demand = 2 million apartments per month

Rent Control

• Other consequences of rent controls• Maintenance will decline and housing

quality will fall• Illegal payments• Creation of co-ops and conversion to

condominiums• Reduction in household mobility• Discrimination

Affordable Housing

• What do you think?• How can we make housing affordable

for poor people without using rent ceilings?

Price Controls In The Pizza Market

Price($ per slice)

Quantity(1000s of slices per day)

Supply

Demand

Excess demand = 8,000 slices per day

4

Price ceiling = 2

3

8 12 16

Market Equilibrium

• Pizza Price Controls?• Market responses to a pizza price ceiling

• Long lines• Preferential treatment to selected

customers• Alternative pricing strategies• Poorer quality ingredients• Black-market pizzas

(We can look to old USSR for real-life examples.)

Predicting and Explaining Changes In Prices and Quantities

• Distinguishing Between:• A change in the quantity demanded

• A movement along the demand curve that occurs in response to a change in price

• A change in demand• A shift of the entire demand curve

An Increase In Quantity Demanded vs. An Increase In Demand

Price($/can)

Quantity(1000s of cans/day)

5

2

3

4

1

4

122

6

0 106 8

Increase in quantity

demanded

D

An Increase In Quantity Demanded vs. An Increase In Demand

Price($/can)

Quantity(1000s of cans/day)

5

2

3

1

4

12

6

0

Increase in demand

D

D

D’

D’

Predicting and Explaining Changes In Prices and Quantities

• Change in the quantity supplied• A movement along the supply curve

that occurs in response to a change in price

• Change in supply• A shift of the entire supply curve

An Increase In Quantity Supplied vs. An Increase In Supply

Price($/can)

Quantity(1000s of cans/day)

5

2

3

4

1

4

102

6

0 6 8

S

S

Increase in quantity supplied

An Increase In Quantity Supplied vs. An Increase In Supply

Price($/can)

Quantity(1000s of cans/day)

5

2

3

4

1

4

102

6 S

0 6 8

S

S’

S’

Increase in supply