The MarketThe Market

Supply & Demand & all thatSupply & Demand & all that

The Big PictureThe Big Picture

Demand Supply

The Market

QQ

Q

PP

P

Equilibrium Price & Quantity

DemandDemand

Analysis based on individuals' behavior, then Analysis based on individuals' behavior, then summing of individuals into aggregate demand at summing of individuals into aggregate demand at various prices various prices

ExplanationsExplanations Verbal: quantity demanded changes inversely w/priceVerbal: quantity demanded changes inversely w/price Simple graph: downward sloping curve of P vs QSimple graph: downward sloping curve of P vs Q Graphic derivation: from preferencesGraphic derivation: from preferences Mathematical specification: D = f(P)Mathematical specification: D = f(P) Axiomatic derivationAxiomatic derivation

Indifference Curves - IIndifference Curves - I

Quantity of Good 1 Demanded (Q1)

Quant.of

Good2

Dem.(Q2)

I1 < I2 < I3

O P1qq'q"

higher levels of preferencehigher levels of utility

NB: under usual assumptions:1. Q1 and Q2 are infinitely divisible, so: infinite # of smooth curves 2. curves are open, I.e., you always prefer MORE of everything

Two space defines various combinations of Q1 & Q2

that you might choose. Some (Q1, Q1) you prefer to others,some you prefer less, some alternatives leave you indifferent.

An “indifference curve” is defined by set of combinationsamong which you are indifferent.

Indifference Curves - IIIndifference Curves - II

Quantity of Good 1 Demanded (Q1)

Quant.of

Good2

Dem.(Q2)

I1 < I2 < I3

O P1qq'q"

NB: if you drop the assumption that you always prefer MORE of everything, then at some point curves close,and MORE would mean a lower level of utility

Budget Line - IBudget Line - I

Q1

Q2

NB: if you spend less than M, you will be at some pointunder the budget line in the space defined by 0,q1,q2.

O

Available budget (money) = M

with prices of Q1 = P1, Q2 = P2 so, total expenditure = M = P1Q1+P2Q2

which defines the “budget line.”

If you rewrite M = P1Q1+P2Q2 as Q2 = (1/ P2)M - (P1 / P2) Q1

you can see that the slope of the line = P1/ P2 (and is negative)

q1

q2 If all M spent on Q2 then you would be at q2.If all M spent on Q1 then you would be at q1.

Budget Lines - IIBudget Lines - IIIf income (M) increases, budget line shifts rightIf income (M) increases, budget line shifts right

Q1O P1

M' =P1Q1+P2Q2

M=P1Q1+P2Q2

If M' > M, then line shifts right.

Q2

Budget Lines - IIIBudget Lines - IIIIf PIf P11 increases, budget line intercept shifts left increases, budget line intercept shifts left

Q1

Q2

O

If P1 increases, max Q1 falls(Change in P1 would have no effect on

vertical intercept if all M spent on Q2)

If P1<P1’, then intercept shifts left. If P2/P1 changes, slope changes

Utility MaximizationUtility MaximizationI3

O

M=P1Q1+P2Q2

q

Q2

Q1

To Maximize utility you will want to be on highest possible I.Highest possible I will be that which is tangent to budget line.

Graphic Derivation of Demand CurveGraphic Derivation of Demand CurveDemand Curve shows what happens to quantity demanded as price Demand Curve shows what happens to quantity demanded as price

changes. So we raise Pchanges. So we raise P11 and see what happens to Q and see what happens to Q11

Quantity of Good 1 Demanded (Q1)

I1 < I2 < I3

O

As price rises, P1< P1'< P1”, quantity demanded falls, q to q’ to q”and the combinations of P1 and q define a demand curve for Q1.

P1"

P1'

qq'q"

P1"

P1'

P1

qq" q'

P1

Mathematical SpecificationMathematical Specificationof Demand Curvesof Demand Curves

D = f(P)D = f(P)

dD/dP < 0dD/dP < 0

D/D/P < 0P < 0

Linear Demand FunctionsLinear Demand Functions

D = a - bPD = a - bP

D = 300 - 20PD = 300 - 20P

Axiomatic DerivationAxiomatic Derivation

Subset of AssumptionsSubset of Assumptions A > B, A < B, A = BA > B, A < B, A = B

axiom of transitivityaxiom of transitivity axiom of asymmetryaxiom of asymmetry

comparabilitycomparability egotism, no one else's consumption matters to youegotism, no one else's consumption matters to you continuity (continuous curves, eg., indifference curvescontinuity (continuous curves, eg., indifference curves insatiability (no maximium, always want more)insatiability (no maximium, always want more)

UtilityUtility

Indifference Curves defined by:Indifference Curves defined by: preference - further from origin preferedpreference - further from origin prefered utility - further from origin, higher utilityutility - further from origin, higher utility

Utility = satisfaction derived from consumptionUtility = satisfaction derived from consumption Utility derived from "utilitarians" - Eng. Philos.Utility derived from "utilitarians" - Eng. Philos.

all action taken with view to utility to be derivedall action taken with view to utility to be derived measured by "utils"measured by "utils"cardinalitycardinality law of diminishing marginal utility (maybe!)law of diminishing marginal utility (maybe!)

Utility functions: U = f(xUtility functions: U = f(x11, x, x22, .... x, .... xnn))

Problem w/utilityProblem w/utility CardinalityCardinality

you can compare utility for different peopleyou can compare utility for different people interpersonal comparisons interpersonal comparisons

Law of Diminishing Mar. UtilityLaw of Diminishing Mar. Utility how much utility depended upon how much you how much utility depended upon how much you

havehave

Cardinality + Law of Diminishing UtilityCardinality + Law of Diminishing Utility total social utility would increase through total social utility would increase through

redistribution of money from rich to poorredistribution of money from rich to poor a a politicalpolitical problem! Solution: shift to ordinality( ±) problem! Solution: shift to ordinality( ±) utility theory replaced by preference theoryutility theory replaced by preference theory

SupplySupply

Analysis based on each firm's behavior, then Analysis based on each firm's behavior, then summing of firms into aggregate supply at various summing of firms into aggregate supply at various prices prices

ExplanationsExplanations Verbal: quantity supplied changes directly w/priceVerbal: quantity supplied changes directly w/price Simple graph: upward sloping curve of P vs QSimple graph: upward sloping curve of P vs Q Graphic derivation: from costs + profit maximizationGraphic derivation: from costs + profit maximization Mathematical specification: S = f(P)Mathematical specification: S = f(P) Axiomatic derivationAxiomatic derivation

CostsCosts

average cost

Marginal cost (MC)

price given=

marginal revenue(MR)

quantity produced

Price, costs

Profit Maximization occurs where MC = MR

Derivation of Supply CurveDerivation of Supply Curve

Marginal cost (MC) = S

quantity produced

Price, costs

Profit Maximization occurs where MC = MR

P2

P3

P1

q1 q2 q3

Mathematical SpecificationMathematical Specification

S = f(P)S = f(P)

dS/dP > 0dS/dP > 0

S/S/P > 0P > 0

Linear Supply FunctionsLinear Supply Functions

S = a + bPS = a + bP

S = 300 + 20PS = 300 + 20P

Axiomatic DerivationAxiomatic Derivation Subset of axiomsSubset of axioms Existence of ProductionExistence of Production

There exists some attainable element x that can be There exists some attainable element x that can be transformed into ytransformed into y

Neutrality of TransformationsNeutrality of Transformations any two transformations T are indifferentany two transformations T are indifferenttheir their

inputs are indifferent and their outputs are indifferentinputs are indifferent and their outputs are indifferent

ConvexityConvexity Production set YProduction set Yjj is convex is convex

Change in TechnologyChange in Technology

Improvements in Technology that lower costs of Improvements in Technology that lower costs of production, shift MC curve down, and Supply production, shift MC curve down, and Supply curve to Rightcurve to Right

MC/S MC'/S'

marginal costshifts down

Supply shiftsto the right

EquilibriumEquilibrium

Shapes of S & D guarantee "equilibrium", i.e., Shapes of S & D guarantee "equilibrium", i.e., tendency to return to price that equalizes themtendency to return to price that equalizes them

Demand

Supply

equilibrium price

equilibrium quantity

excess supply

Q

P

--END----END--