1. Dr. Duffy Microeconomics
Notes from
CHAPTER 3 of
Frank and Bernanke

2. Three Problems All Economic Systems Must Address
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?

3. 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.

4. . . .has never existed. The closest to it
A Pure Market Economy. . .
. . .has never existed. The closest to it
was 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.

5. 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?

6. 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.

7. Supply and Demand
Supply and Demand determine prices in
individual markets.
Price is the mechanism that brings supply
and demand together.

8. Rationing by prices
Through prices, the market rations the
scarce goods of society among possible
uses.

9. 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 the
quantity demanded.

10. The Dailey Demand Schedule for Pizza in Chicago
Price
($/slice)
Quantity Demanded
(1000s of slices per day)
$5 4
4 8
3 12
2 16
1 20

11. The Daily Demand Curve for Pizza in Chicago
Price
($ per slice)
Demand 4 8 3 12 2 16
Quantity
(1000s of slices per day)

12. Law of Downward Sloping Demand
When the price of a commodity is raised
(and other things are held constant), buyers
tend to buy less of the commodity. Similarly,
when the price is lowered, other things being
constant, quantity demanded increases.
There are two explanations for downward
sloping demand curves.

13. Reason 1: Substitution Effect
When the price of a good rises, I will
substitute other similar goods for it.
For example, if the price of beef rises,
I will eat more chicken and pork.

14. Reason 2: Income Effect
As the price of a commodity rises, my income
will not stretch as far as it used to. I am
therefore “poorer” in a relative sense,
than before the price increase and can’t buy
as many things as I did before.

15. 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

16. Buyers and Sellers In Markets
Horizontal Interpretation
Price
($ per slice)
Price determines quantity demanded 4 3 2
Demand 8 12 16

17. Buyers and Sellers In Markets
Vertical Interpretation
Price
($ per slice)
Quantity measures the marginal buyer’s reservation price 4 3 2
Demand 8 12 16

18. Market Demand Curve
The market demand curve “adds up”
all the quantities demanded by individual
consumers at a given price.
It shows the total amount of a commodity
consumers are willing and able to buy at
a given price.

19. The Supply Schedule
The supply schedule (or supply curve) for
a commodity shows the relationship between
the market price and the amount of that
commodity that producers are willing and able
to produce and sell, other things held
constant. Generally, the higher the price the
more producers will supply.

20. The Daily Supply Schedule for Pizza in Chicago
Price
($ per slice)
Quantity
(1000s of slices per day)
$4 16
3 12
2 8

21. The Daily Supply Curve for Pizza in Chicago
Price
($ per slice)
Supply 4 2 3 8 12 16
Quantity
(1000s of slices per day)

22. Opportunity Costs and Quantity Produced
Question
Will the opportunity cost of producing additional units of pizza increase or decrease?
Hint:Low-hanging-fruit principle

23. Supply Slopes Up
Supply slopes up because of the “law of
diminishing returns.” To get extra output
usually requires proportionally more extra
input.

24. Seller’s Reservation Price
The smallest dollar amount for which a seller would be willing to sell an additional unit, generally equal to marginal cost

25. 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

26. The Daily Supply Curve for Pizza in Chicago
Horizontal Interpretation
Price
($ per slice)
Supply 4
Shows the quantity produced for each price 3 2
Quantity
(1000s of slices per day) 8 12 16

27. The Daily Supply Curve for Pizza in Chicago
Vertical Interpretation
Price
($ per slice)
Supply 4
Shows the marginal cost (reservation price) for producing each additional unit 3 2
Quantity
(1000s of slices per day) 8 12 16

28. Supply and Demand: Equilibirum
A market equilibrium comes at the place
where quantity demanded equals quantity
supplied.
Equilibrium takes place at the intersection
of the supply and demand curves.

29. Market Equilibrium Equilibrium Market 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

30. Equilibrium Price and Equilibrium Quantity
The values of price and quantity for which quantity supplied and quantity demanded are equal

31. The Equilibrium Price and Quantity of Pizza In Chicago
($ per slice)
Supply
Demand 4
Equilibrium at $3
Quantity Demanded =
Quantity Supplied 3 2
Quantity
(1000s of slices per day) 8 12 16

32. Market Equilibrium What Do You Think?
Is the market equilibrium always an ideal outcome for all market participants?

33. Market Equilibrium What Do You Think?
Would buyers prefer a lower price than the equilibrium price?
Would sellers prefer a higher price than the equilibrium price?

34. 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)
Quantity supplied 1 8 2 6 4 3
Note: There is no point in the table where price would make quantity
demanded equal quantity supplied. Our equilibrium price must fall
between $2 and $3.

35. Graphing Supply and Demand and Finding the Equilibrium Price and Quantity
($per slice)
Supply 5 4
The Equilibrium Price = $2.50
The Equilibrium Quantity = 5 3
2.50 2 1
Demand
Quantity
(1000s of slices per day) 2 4 6 8 10 5
When we graph the curves, we can find the equilibrium price and
quantity.

36. Excess Demand: If price is below equilibrium
($ per slice)
Supply 4
Excess demand = 8,000
slices per day 3 2
Demand
Quantity
(1000s of slices per day) 8 16
This situation is called a shortage.

37. Excess Supply: If price is above equilibrium
Excess supply = 8,000 slices per day
Price
($ per slice)
Supply
Demand 4 3 2
Quantity
(1000s of slices per day) 8 12 16
This situation is called a surplus.

38. When economists use the word “surplus” or “shortage” they mean that
Caution!
When economists use the word
“surplus” or “shortage” they mean that
the market is not in equilibrium. If there
is a surplus, products pile up,
un-purchased.
If there is a shortage, many consumers
cannot find the product to buy.

39. 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 there
was no shortage because consumers
could find the gas to buy, although at
a higher price than before.

40. 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.

41. 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)

42. Shifts of Supply or Demand
If one of the factors affecting a demand
or supply curve changes, the curve will
shift. This means the entire curve moves
to a new position on the graph.

43. Example: Shift of the demand curve
For most products, demand shifts outward as income rises. P D' D Q

44. 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!

45. Another Example
When low-carb diets were popular,
fewer loaves of bread were sold.
This is a decrease in demand caused
by a change in tastes and preferences.

46. 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?

47. Normal Good vs. Inferior Good
If, when income rises, consumers purchase
more 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?

48. Shift of supply curve P S S’ Q If the price of an input falls,
the supply curve shifts out. S S’ Q

49. Shifts in curves change equilibrium price and quantity
Supply increases S’
S’’ P’ P” D Q Q’
Q’’

50. Shifts in curves change equilibriumP
Supply decreases
S’’ S’
P’’ P’ D Q Q” Q’

51. Shifts in curves change equilibriumP
Demand Increases S P” P’ D” D’ Q Q’ Q”

52. Shifts in curves change equilibriumP S
Demand Decreases P’ P” D’ D” Q Q” Q’

53. 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

54. An Unregulated Housing Market
Monthly Rent
($/apartment)
Supply
What Do You Think?
Is $1600 more than some people can afford?
1,600
Demand
Quantity
(Millions of apartments/day) 2

55. Excess demand = 2 million apartments per month
Rent Controls
Monthly Rent
($/apartment)
Supply
2,400
Excess demand = 2 million apartments per month
1,600
Controlled = 800
Demand
Quantity
(Millions of apartments/day) 1 2 3

56. 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

57. Affordable Housing What do you think?
How can we make housing affordable for poor people without using rent ceilings?

58. Price Controls In The Pizza Market
($ per slice)
Supply 4
Excess demand = 8,000 slices per day 3
Price ceiling = 2
Demand
Quantity
(1000s of slices per day) 8 12 16

59. 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.)

60. 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

61. An Increase In Quantity Demanded vs. An Increase In Demand
Price
($/can) 6
Increase in quantity demanded D 5 4 3 2 1
Quantity
(1000s of cans/day) 2 4 6 8 10 12

62. An Increase In Quantity Demanded vs. An Increase In Demand
Price
($/can) D’ D 6 5 4
Increase in demand 3 2 D’ 1 D
Quantity
(1000s of cans/day) 12

63. 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

64. An Increase In Quantity Supplied vs. An Increase In Supply
Price
($/can) S 6 5
Increase in quantity supplied 4 3 2 1
Quantity
(1000s of cans/day) 2 4 6 8 10

65. An Increase In Quantity Supplied vs. An Increase In Supply
Price
($/can) 6 S S’ 5 4 3
Increase in supply 2 1 S S’
Quantity
(1000s of cans/day) 2 4 6 8 10