1. 1.1 Competitive markets: Demand and Supply

2. 1. Outline the meaning of the term market. A market is a group of buyers and sellers of a particular product. Free market economies Markets enable mutually beneficial exchange between producers and consumers, and systems that rely on markets to solve the economic problem are called market economies. In a free market economy, resources are allocated through the interaction of free and self-directed market forces. This means that what to produce is determined consumers, how to produce is determined by producers, and who gets the products depends upon the purchasing power of consumers. Market economies work by allowing the direct interaction of consumers and producers who are pursuing their own self-interest. The pursuit of self-interest is at the heart of free market economics.

3. 2. Explain the negative (inverse) causal relationship between price and quantity demanded. Law of demand: the claim that the quantity demanded of a good falls when the price of the good rises, other things equal. The Law of demand implies a negative or inverse relationship between the two variables of price and quantity demanded.

4. 2. Explain the negative (inverse) causal relationship between price and quantity demanded. Demand comes from the behavior of buyers. The quantity demanded of any good is the amount of the good that buyers are willing and able to purchase. Demand schedule: A table that shows the relationship between the price of a good and the quantity demanded.

5. 2. Explain the negative (inverse) causal relationship between price and quantity demanded. Factors that underlie the law of demand:  The income effect. Real income refers to income that is adjusted for price changes, and implies the actual buying power of a consumer. As the price of a good decreases, the quantity demanded increases because consumers now have more real income to spend. With more buying power, they sometimes choose to buy more of the same product.  The substitution effect. As the price of a good decreases, consumers switch from other substitute goods to this good because its price is comparatively lower.  The law of diminishing marginal utility. This law states that as we consume additional units of something, the satisfaction (utility) we derive for each additional unit (marginal unit) grows smaller (diminishes).

6. 2. Explain the negative (inverse) causal relationship between price and quantity demanded. What’s wrong with this statement?

7. 3. Describe the relationship between an individual consumer’s demand and market demand. To get the total market demand for a good we take the sum of all the individual demand curves for the same good.

8. 4. Explain how factors including changes in income (in the cases of normal and inferior goods), preferences, prices of related goods (in the cases of substitutes and complements) and demographic changes may change demand. Non-price determinates of demand: 1. Income of buyers 2. Price of related goods 3. Taste and preferences 4. Expectations of future prices and income 5. Number of potential buyers

9. 4. Explain how factors including changes in income (in the cases of normal and inferior goods), preferences, prices of related goods (in the cases of substitutes and complements) and demographic changes may change demand. Non-price determinates of demand: 1. Income People tend to increase their spending when their income improves.  Normal goods These are goods which demand increases as income rises and falls as income falls.  Inferior goods These are goods for which demand decreases as income rises and increases as income falls. Typically these type of goods tend to be cheaper alternatives to higher quality goods.

10. 4. Explain how factors including changes in income (in the cases of normal and inferior goods), preferences, prices of related goods (in the cases of substitutes and complements) and demographic changes may change demand. Non-price determinates of demand: 2. Price of related goods  Substitute goods These are goods that one might easily use in place of another. Because they are so similar, an increase in the price of one may lead consumers to switch consumption to the substitute. Therefore, the price of one good and the demand for a substitute have a positive relationship.  Complementary goods These are goods that are typically purchased and consumed together. Therefore an increase in the price of a complementary good will appear to the consumer as an increase in the price of enjoying the combined experience of both goods. As a result, the price of one good and the demand for a complement have a negative relationship.

11. 4. Explain how factors including changes in income (in the cases of normal and inferior goods), preferences, prices of related goods (in the cases of substitutes and complements) and demographic changes may change demand. Non-price determinates of demand: 3. Taste and preferences Demand changes with consumer tastes and preference. Goods become more or less popular because of fashion, current events, and word of mouth recommendations.

12. 4. Explain how factors including changes in income (in the cases of normal and inferior goods), preferences, prices of related goods (in the cases of substitutes and complements) and demographic changes may change demand. Non-price determinates of demand: 4. Expectations of future prices and income  Expectation of future prices If consumers believe that price of a good is likely to climb rather quickly, they will be inclined to purchase more immediately. An expectation that prices will decline soon is likely to cause consumers to defer their purchases until the product becomes cheaper.  Expectation of future income If consumers are buying in an economic climate of high growth, they may reasonably conclude that their future incomes will rise, and thus consume more. This would shift demand right. The reverse can be true and demand shifts left.

13. Expectation of future prices

14. 4. Explain how factors including changes in income (in the cases of normal and inferior goods), preferences, prices of related goods (in the cases of substitutes and complements) and demographic changes may change demand. Non-price determinates of demand: 5. Number of potential buyers More buyers mean more demand and a shift to the right of the demand curve for goods. Correspondingly, a decrease in the potential number of buyers shrink demand.

15. 5. Distinguish between movements along the demand curve and shifts of the demand curve. One significant difference between change in price and change in the non-price determinants of demand is that a change in price will cause only a movement along the demand curve. However, when the non-price determinants of demand change, there is a shift of the entire demand curve. The quantity demanded will change at each price.

16. 5. Distinguish between movements along the demand curve and shifts of the demand curve

17. 6. Draw diagrams to show the difference between movements along the demand curve and shifts of the demand curve.

18. 7. Explain a demand function (equation) of the form Qd = a – bP.demand function Qd represents the quantity demanded: x-axis a represents the autonomous level of demand or the quantity demanded if the price were zero: X-intercept b represents the change in quantity demanded resulting from a change in price – it is negative, which reflects the fact that quantity demanded changes inversely with the price. P represents the price of a single item.

19. 7. Explain a demand function (equation) of the form Qd = a – bP. Intercepts The x-intercept: This is the point where the demand curve meets the x-axis. It is the quantity demanded where price equals zero. It is „a ‟. The y-intercept: This is the point where the demand curve meets the y-axis. It is the price at which quantity demanded becomes zero. All consumers have been driven out of the market.(a divided by b!)

20. 8. Plot a demand curve from a linear function (e.g. Qd = 400 – 8P). How to plot / draw the demand curve from a demand function (Using the example QD = 400 – 8P) Follow the steps: 1. Find the quantity demanded when the price is zero. This will be the “a ‟ value. In the example, it is 400 units. This gives one point on the demand curve, known as the x-intercept. In the example, it is the point (400,0), where 400 units are demanded at a price of $0. 2. Find the price where demand is zero. Make QD = 0 in the equation. In the example, we get 0 = 400 – 8P, and so by adding 8P to each side, we then get 8P = 400, and so P = 50. This gives a second point at the other end of the demand curve, known as the Y-intercept. In the example, it is the point (0,50), where 0 units are demanded at a price of $50. (Or you can just divide a by b = 400/8 = 50!) 3. So, you now have two points on the demand curve.

21. 8. Plot a demand curve from a linear function (e.g. Qd = 60 – 5P). 4. Draw your axes for the market on a piece of graph paper and insert values for price and quantity. (In IB exams, the axes will already have values on, but not labels. ) 5. Insert the two points that you have calculated. For our example, this is shown below left: (0,50), (400,0) 6. Label the axes and the demand curve. You have done it!

22. 9. Identify the slope of the demand curve as the slope of the demand function Qd = a – bP, that is –b (the coefficient of P). If the value of ”b ‟ changes in the demand function, then the slope of the demand curve will change. The slope of the demand curve is “– b ‟.

23. 10. Outline why, if the “a” term changes, there will be a shift of the demand curve. If the value of “a ‟ in the demand function changes, then the demand curve shifts to the left or the right, parallel to the original curve. If the demand curve shifts to the right, then it means that there has been a change in one of the non-price determinants of demand that has made the product more attractive to the consumer and so more is demanded at each price. If the demand curve shifts to the left, then it means that there has been a change in one of the non-price determinants of demand that has made the product less attractive to the consumer and so less is demanded at each price.

24. 10. Outline why, if the “a” term changes, there will be a shift of the demand curve.

25. 11. Outline how a change in “b” affects the steepness of the demand curve. If “b ‟ gets smaller, then the slope of the curve gets steeper and if “b”; gets bigger, the curve will be flatter.

26. 12. Explain the positive causal relationship between price and quantity supplied. Law of supply: the claim that the quantity supplied of a good rises when the price of the good rises, other things equal

27. 12. Explain the positive causal relationship between price and quantity supplied. Supply comes from the behavior of sellers. The quantity supplied of any good is the amount that sellers are willing and able to sell. Supply schedule: A table that shows the relationship between the price of a good and the quantity supplied.

28. 12. Explain the positive causal relationship between price and quantity supplied. Why is the supply curve upward sloping?  Market price rises When the market price rises (for example following an increase in consumer demand), it becomes more profitable for businesses to increase their output. Higher prices send signals to firms that they can increase their profits by satisfying demand in the market.  The Law of diminishing returns The law of diminishing marginal returns explains what happens to the output of products when a firm uses more variable inputs while keeping a least one factor of production fixed. Real capital, such as buildings, machinery, and equipment, is usually the factor kept fixed when demonstrating this principle. Economic theory predicts that, when employing these extra variable factors, such as labor, the marginal returns (additional output) from each extra unit of input will eventually diminish.  Diminishing returns and increasing costs Firms need to sell their extra output at a higher price so that they can pay the higher marginal cost of production. Hence, decisions to supply are largely determined by the marginal cost of production. The supply curve slopes upward, reflecting the higher price needed to cover the higher marginal cost of production. The higher marginal cost arises because of diminishing marginal returns to the variable factors. marginal cost of production

29. 13. Describe the relationship between an individual producer’s supply and market supply. The quantity supplied in the market is the sum of the quantities supplied by all sellers at each price.

30. 14. Explain that a supply curve represents the relationship between the price and the quantity supplied of a product, ceteris paribus.supply curve A movement along a supply curve only occurs when the price changes, ceteris paribus. In other words, the price changes but the other non-price determinants remain constant. The diagram shows that a price rise will cause an extension up the supply curve, whilst a price fall will cause a contraction back down the supply curve.

31. 14. Explain that a supply curve represents the relationship between the price and the quantity supplied of a product, ceteris paribus. As with shifts of demand curves, supply curves shift, at all prices, if there is a change in one or more of the non-price determinants of supply. Nearly all the non-price determinants of supply affect the costs of the firm and, therefore, its supply curve, which is its marginal cost curve.

32. 15. Draw a supply curve.

33. 16. Explain how factors including changes in costs of factors of production (land, labor, capital and entrepreneurship), technology, prices of related goods (joint/competitive supply), expectations, indirect taxes and subsidies and the number of firms in the market can change supply. Non-price determinates of supply: 1. Costs of factors of production (Inputs) 2. Changes in production technology 3. Prices of related goods (joint/competitive supply) 4. Expectations 5. Government intervention 6. Number of firms in the market 7. Climatic conditions (weather)

34. 16. Explain how factors including changes in costs of factors of production (land, labor, capital and entrepreneurship), technology, prices of related goods (joint/competitive supply), expectations, indirect taxes and subsidies and the number of firms in the market can change supply. What causes a shift in the supply curve? Non-price determinates of supply: 1. Costs of factors of production (Inputs) A fall in the costs of production leads to an increase in the supply of a good because the supply curve shifts to the right. Lower costs mean that a business can supply more at each price. If production costs increase, a business will not be able to supply as much at the same price - this will cause an inward shift of the supply curve.

35. 16. Explain how factors including changes in costs of factors of production (land, labor, capital and entrepreneurship), technology, prices of related goods (joint/competitive supply), expectations, indirect taxes and subsidies and the number of firms in the market can change supply. Non-price determinates of supply: 2. Changes in production technology Productivity is the amount of output per unit of input. If a firm is able to use fewer factor resources in the production process, it will spend less on those resources. Technology is what producers know about the ways to combine inputs into the production of outputs. An advance in technology makes it possible to sell more of a good. A decline in technology means producers can sell less of a good.

36. 16. Explain how factors including changes in costs of factors of production (land, labor, capital and entrepreneurship), technology, prices of related goods (joint/competitive supply), expectations, indirect taxes and subsidies and the number of firms in the market can change supply. Non-price determinates of supply: 3. Prices of related goods (joint/competitive supply) The supply for one good is based on the prices paid for other goods that use the same resources for production. A change in the price of a substitute good (or substitute-in- production) induces sellers to alter the mix of goods purchased. An increase in the price of a substitute motivates sellers to sell more of this good and less of the substitute good. A change in the price of a complement good (or complement-in- production) induces sellers to supply more or less of both goods. An increase in the price of a complement motivates sellers to sell more of this good as they sell more of the complement good.

37. 16. Explain how factors including changes in costs of factors of production (land, labor, capital and entrepreneurship), technology, prices of related goods (joint/competitive supply), expectations, indirect taxes and subsidies and the number of firms in the market can change supply. Non-price determinates of supply: 4. Expectations The decision to sell a good today depends on expectations of future prices. Sellers seek to sell the good at the highest possible price. If sellers expect the price to decline in the future, they are inclined to sell more now. If they expect the price to rise in the future, they are inclined to sell less now.

38. 16. Explain how factors including changes in costs of factors of production (land, labor, capital and entrepreneurship), technology, prices of related goods (joint/competitive supply), expectations, indirect taxes and subsidies and the number of firms in the market can change supply. Non-price determinates of supply: 5. Government intervention Government intervention in a market can have a major effect on supply. A tax on producers causes an increase in costs and will cause the supply curve to shift inwards. Less will be supplied after the tax is introduced. A subsidy has the opposite effect as a tax. A subsidy will increase supply because a guaranteed payment from the Government reduces a firm's costs allowing them to produce more output at a given price.

39. 16. Explain how factors including changes in costs of factors of production (land, labor, capital and entrepreneurship), technology, prices of related goods (joint/competitive supply), expectations, indirect taxes and subsidies and the number of firms in the market can change supply. Non-price determinates of supply: 6. Number of firms in the market The number of sellers in a market will affect total market supply. When new firms enter a market, supply increases and causes downward pressure on the market price. The entry of new firms into a market causes an increase in market supply and normally leads to a fall in the market price paid by consumers. More firms increases market supply and expands the range of choice available.

40. 16. Explain how factors including changes in costs of factors of production (land, labor, capital and entrepreneurship), technology, prices of related goods (joint/competitive supply), expectations, indirect taxes and subsidies and the number of firms in the market can change supply. Non-price determinates of supply: 7. Climatic conditions (weather) For agricultural commodities such as coffee, fruit and wheat the climate can exert a great influence on supply. Favorable weather will produce a bumper harvest and will increase supply. Unfavorable weather conditions such as a drought will lead to a poor harvest and decrease supply. These unpredictable changes in climate can have a dramatic effect on market prices for many agricultural goods.

41. 17. Distinguish between movements along the supply curve and shifts of the supply curve. A Change in Supply: This a change in the overall supply relation, a change in all price-quantity pairs. It is caused by a change in one of the seven supply non-price determinants and is indicated by a shift of the supply curve. A Change in Quantity Supplied: This is a change in the specific amount of the good that sellers are willing and able to purchase. It is caused by a change in the supply price and is indicated by a movement along the supply curve from one point to another.

42. 18. Draw diagrams to show the difference between movements along the supply curve and shifts of the supply curve.

43. 19. Explain a supply function (equation) of the form Qs = c + dP. Qs is quantity supplied: x-axis c is the quantity supplied when price is 0.: y-intercept d represents the rate which a change in price will cause the quantity supplied to increase. It is always positive, in keeping with the law of supply. It is the slope of the curve P is the price: y-axis

44. 20. Plot a supply curve from a linear function (e.g., Qs = 150 + 150 P). How to plot / draw the supply curve from a supply function (Using the example QS = 150 + 150P) Follow the steps: 1. Find the quantity supplied when the price is zero. This will be the “c ‟ value. In the example, it is 150 units. This gives one point on the supply curve, known as the x-intercept. In this case, it is the point (150,0), where 150 units are supplied at a price of $0. (It might be a point with a negative quantity and a price of zero, if “c ‟ is negative.) 2. Choose a price above zero. (In IB questions, you will be given the range of price values that you are to consider, so you can choose one of the prices given.) Put it into the equation instead of P, in order to get a quantity supplied at that price. In the example, we could choose a price of $1. We get QS = 150 + (150 x 1) = 150 + 150 = 300. So, you now have another point on the supply curve, in the example, it is (300,1).

45. 20. Plot a supply curve from a linear function (e.g., Qs = 150 + 150 P). 3. Draw your axes for the market on a piece of graph paper and insert values for price and quantity. (In IB exams, the axes will already have values on, but not labels.) 4. Insert the two points that you have calculated. For our example, this is shown below left: 5. Now extend the line upwards. For our example, this is shown right. 6. Label the axes and the supply curve. You have done it!

46. 21. Identify the slope of the supply curve as the slope of the supply function Qs = c + dP, that is d (the coefficient of P).

47. 22. Outline why, if the “c” term changes, there will be a shift of the supply curve. c is the x-intercept, so if that value is changed, the graph either translates a shift out or in.  Increases in the intercept value shifts the curve outwards by the amount of the increase in the intercept.  Decrease in the intercept value shifts the curve inwards by the amount of the decrease in the intercept.

48. 23. Outline how a change in “d” affects the steepness of the supply curve. Increase in d will make the slope steeper and decrease in d will make the slope more flat.  Increases in the slope causes the curve to be steeper.  decreases in the slope causes the curve to be flatter.

49. Market equilibrium

50. 24. Explain, using diagrams, how demand and supply interact to produce market equilibrium.market equilibrium. Consumers and producers react differently to price changes. Higher prices tend to reduce demand while encouraging supply, and lower prices increase demand while discouraging supply. Economic theory suggests that, in a free market there will be a single price which brings demand and supply into balance, called equilibrium price. Both parties require the scarce resource that the other has and hence there is a considerable incentive to engage in an exchange. For markets to work, an effective flow of information between buyer and seller is essential. Market clearing Equilibrium price is also called market clearing price because at this price the exact quantity that producers take to market will be bought by consumers, and there will be nothing ‘left over’. This is efficient because there is neither an excess of supply and wasted output, nor a shortage – the market clears efficiently.

51. 24. Explain, using diagrams, how demand and supply interact to produce market equilibrium. How is equilibrium established? At a price higher than equilibrium, demand will be less than 500, but supply will be more than 500 and there will be an excess of supply in the short run. Graphically, we say that demand contracts inwards along the curve and supply extends outwards along the curve. Both of these changes are called movements along the demand or supply curve in response to a price change.

52. 24. Explain, using diagrams, how demand and supply interact to produce market equilibrium. Demand contracts because at the higher price, the income effect and substitution effect combine to discourage demand, and demand extends at lower prices because the income and substitution effect combine to encourage demand. income effectsubstitution effect In terms of supply, higher prices encourage supply, given the supplier's expectation of higher revenue and profits, and hence higher prices reduce the opportunity cost of supplying more. Lower prices discourage supply because of the increased opportunity cost of supplying more. The opportunity cost of supply relates to the possible alternative of the factors of production. Changes in demand and supply in response to changes in price are referred to as the signaling and incentive effects of price changes.signalingincentive

53. 24. Explain, using diagrams, how demand and supply interact to produce market equilibrium. If the market is working effectively, with information passing quickly between buyer and seller, the market will quickly readjust, and the excess demand and supply will be eliminated. In the case of excess supply, sellers will be left holding excess stocks, and price will adjust downwards and supply will be reduced. In the case of excess demand, sellers will quickly run down their stocks, which will trigger a rise in price and increased supply. The more efficiently the market works, the quicker it will readjust to create a stable equilibrium price.

54. 24. Explain, using diagrams, how demand and supply interact to produce market equilibrium.

55. SURPLUS: When QS > QD A condition in the market in which the quantity demanded is less than the quantity supplied at the existing price. Because sellers are unable to sell as much of the good as they want, a surplus generally causes a decrease in the market price, which then acts to restore equilibrium. SHORTAGE: When QD > QS A condition in the market in which the quantity demanded is greater than the quantity supplied at the existing price. Because buyers are unable to buy as much of the good as they want, a shortage generally causes an increase in the market price, which then acts to restore equilibrium.

56. 25. Analyze, using diagrams and with reference to excess demand or excess supply, how changes in the determinants of demand and/or supply result in a new market equilibrium. Changes in equilibrium Graphically, changes in the underlying factors that affect demand and supply will cause shifts in the position of the demand or supply curve at every price. Whenever this happens, the original equilibrium price will no longer equate demand with supply, and price will adjust to bring about a return to equilibrium.

57. 25. Analyze, using diagrams and with reference to excess demand or excess supply, how changes in the determinants of demand and/or supply result in a new market equilibrium. There are four basic causes of a price change: An increase in demand shifts the demand curve to the right, and raises price and output. This leads to a change in demand and an increase in the quantity supplied. Demand shifts to the right

58. 25. Analyze, using diagrams and with reference to excess demand or excess supply, how changes in the determinants of demand and/or supply result in a new market equilibrium. Demand shifts to the left A decrease in demand shifts the demand curve to the left and reduces price and output. This leads to a change in demand and a decrease in the quantity supplied.

59. 25. Analyze, using diagrams and with reference to excess demand or excess supply, how changes in the determinants of demand and/or supply result in a new market equilibrium Supply shifts to the right An increase in supply shifts the supply curve to the right, which reduces price and increases output. This leads to a change in supply and a increase in quantity demanded.

60. 25. Analyze, using diagrams and with reference to excess demand or excess supply, how changes in the determinants of demand and/or supply result in a new market equilibrium Supply shifts to the left A decrease in supply shifts the supply curve to the left, which raises price but reduces output. This leads to a change in supply and a decrease in quantity demanded.

61. 25. Analyze, using diagrams and with reference to excess demand or excess supply, how changes in the determinants of demand and/or supply result in a new market equilibrium Complex Cases When demand and supply are changing at the same time, the analysis becomes more complex. In such cases, we are still able to say whether one of the two variables (equilibrium price or quantity) will increase or decrease, but we may not be able to say how both will change. When the shifts in demand and supply are driving price or quantity in opposite directions, we are unable to say how one of the two will change without further information.

62. 26. Calculate the equilibrium price and equilibrium quantity from linear demand and supply functions. (or Data) In general, total revenue is the price times quantity--the price received for selling a good times the quantity of the good sold at that price.total revenue Total expenditure is the total amount of money that is spent on a product in a given time period. This amount is achieved by multiplying the quantity of the product purchased by the price at which it was purchased.

63. 26. Calculate the equilibrium price and equilibrium quantity from linear demand and supply functions. (or Data) Calculating Equilibrium Price and Quantity In order to do this, we need to find where QD = QS. The steps are as follows: 1. Take the two functions that you are given and substitute QD and QS from them into an equilibrium equation. E.g. QD = 200 – 4P and QS = 4P So: 200 – 4P = 4P 2. Solve the equation for P and this gives the equilibrium price. E.g. 200 – 4P = 4P 200 = 8P 200/8 = P 25 = P

64. 26. Calculate the equilibrium price and equilibrium quantity from linear demand and supply functions. (or Data) 3. Substitute P into either of the demand or supply functions and solve for Q. E.g. QD = 200 – 4P QD = 200 – (4 x 25) QD = 200 – 100 QD = 100 4. You can check this by solving for Q in the function that you did not use the first time. E.g. QS = 4P QS = 4 x 25 QS = 100

65. 27. Plot demand and supply curves from linear functions, and identify the equilibrium price and equilibrium quantity. The equilibrium quantity and the equilibrium price of a product are determined by the point where the supply and demand curves intersect. For a given product, the supply is determined by the line Q supply = 30p - 45 and for the same product, the demand is determined by the line Q demanded = -15p + 855. Determine the price and the equilibrium quantity and trace the supply and demand curves on the same graph. Solution : We must determine the coordinates of point (q,p), situated at the intersection of the two lines. This point must therefore satisfy both the supply and the demand equations. The solution to this problem is to solve : Q = 30p - 45 Q = -15p + 855 Thus, 30p - 45 = -15 + 855 45p = 900 P = 20 and Q = 30(20) – 45 = 555 The equilibrium price and quantity are therefore $20 and 555.

66. 27. Plot demand and supply curves from a table, and identify the equilibrium price and equilibrium quantity. PriceQDQS $110010 $29040 $370 $440140

67. 28. Calculate the quantity of excess demand or excess supply in the above diagrams. Calculating Excess Demand or Supply You may be given demand and supply functions and a price that is not the equilibrium price. You may then be asked to calculate any excess demand or excess supply that exists. The steps are as follows: 1. Take the price that is given and substitute it into the demand function. E.g. If the price suggested is $20 and the demand function is QD = 200 – 4P. Then at $20, QD = 200 – (4 x 20) = 200 – 80 = 120. 2. Then take the price that is given and substitute it into the supply function. E.g. If the price suggested is $20 and the demand function is QS = 4P. Then at $20, QS = 4 x 20 = 80. 3. See which one is larger and then explain what it is in terms of either excess demand or excess supply. E.g. In this case, at a price of $20, 120 units are demanded and 80 units are supplied and so there is an excess demand of 40 units.

68. 28. Calculate the quantity of excess demand or excess supply in the above diagrams. Calculating Excess Demand or Supply You may be given demand and supply functions and a price that is not the equilibrium price. You may then be asked to calculate any total revenue or total spending that exists.  Calculate the total revenue at $2.00 ($2 x 40 = $80) and at $4.00 ($4 x 40 = $160)  Calculate the total spending at $1.00 ($1 x 10 = $10) and at $3.00 ($3 x 70 = $210)

69. 28. Calculate the quantity of excess demand or excess supply in the above diagrams. 350-150 = 200, 200 x.25 = $50300-200 = 100, 100 x.40 = $40

70. The role of the price mechanism Adam Smith, one of the Founding Fathers of economics described the “invisible hand of the price mechanism” in which the hidden-hand of the market operating in a competitive market through the pursuit of self-interest allocated resources in society’s best interest. The price mechanism describes the means by which millions of decisions taken by consumers and businesses interact to determine the allocation of scarce resources between competing uses The price mechanism plays three important functions in a market:

71. 29. Explain why scarcity necessitates choices that answer the “What to produce?” question. Markets answer these basic questions through prices. For example, resource owners (those producing goods) decide What? goods to produce based on relative prices. Prices work much the same way for answering the How? question. Producers decide which resources to use in the production of a good, based on relative prices. Prices are also the guiding light when markets answer the For Whom? question. In this case, the relative prices paid to labor and other resource owners for the production of different goods are the key. Resource owners paid relatively higher prices receive relatively more income, which they can use to purchase relatively more goods.

72. 30. Explain why choice results in an opportunity cost. Due to scarcity, each choice we make requires us to sacrifice or give something up. Opportunity cost is the highest value trade-off--the value of the next best option foregone.

73. 31. Explain, using diagrams, that price has a signaling function and an incentive function, which result in a reallocation of resources when prices change as a result of a change in demand or supply conditions. The rationing function of the price mechanism Whenever resources are particularly scarce, demand exceeds supply and prices are driven up. The effect of such a price rise is to discourage demand and conserve resources. The greater the scarcity, the higher the price and the more the resource is rationed. This can be seen in the market for oil. As oil slowly runs out, its price will rise, and this discourages demand and leads to more oil being conserved than at lower prices. The rationing function of a price rise is associated with a contraction of demand along the demand curve.

74. 31. Explain, using diagrams, that price has a signaling function and an incentive function, which result in a reallocation of resources when prices change as a result of a change in demand or supply conditions. The signaling function of the price mechanism Price changes send contrasting messages to consumers and producers about whether to enter or leave a market. Rising prices give a signal to consumers to reduce demand or withdraw from a market completely, and they give a signal to potential producers to enter a market. Conversely, falling prices give a positive message to consumers to enter a market while sending a negative signal to producers to leave a market. For example, a rise in the market price of 'smart' phones sends a signal to potential manufacturers to enter this market, and perhaps leave another one. The signaling function is associated with shifts in demand and supply curves.

75. 31. Explain, using diagrams, that price has a signaling function and an incentive function, which result in a reallocation of resources when prices change as a result of a change in demand or supply conditions. The incentive function of the price mechanism An incentive is something that motivates a producer or consumer to follow a course of action or to change behavior. Higher prices provide an incentive to existing producers to supply more because they provide the possibility or more revenue and increased profits. The incentive function of a price rise is associated with an extension of supply along the existing supply curve.

76. 31. Explain, using diagrams, that price has a signaling function and an incentive function, which result in a reallocation of resources when prices change as a result of a change in demand or supply conditions.

77. Market efficiency An allocation of resources is efficient if it maximizes total surplus. Efficiency means:  Raising or lowering the quantity of a good would not increase total surplus.  The goods are being produced by the producers with lowest cost.  The goods are being consumed by the buyers who value them most highly.  Efficiency means making the pie as big as possible.  In contrast, equity refers to whether the pie is divided fairly.

78. 32. Explain the concept of consumer surplus. Consumer surplus is derived whenever the price a consumer actually pays is less than they are prepared to pay. A demand curve indicates what price consumers are prepared to pay for a hypothetical quantity of a good, based on their expectation of private benefit. Consumer surplus (CS) is the amount a buyer is willing to pay minus the buyer actually pays: CS = WTP – P

79. 33. Identify consumer surplus on a demand and supply diagram. For example, at price P, the total private benefit in terms of utility derived by consumers from consuming quantity, Q is shown as the area ABQC in the diagram. The amount consumers actually spend is determined by the market price they pay, P, and the quantity they buy, Q - namely, P x Q, or area PBQC. This means that there is a net gain to the consumer, because area ABQC is greater that area PBQC. This net gain is called consumer surplus, which is the total benefit, area ABQC, less the amount spent, area PBQC. Hence ABQC - PBQC = area ABP.

80. P Q CS with Lots of Buyers & a Smooth D Curve The demand for shoes D CS is the area b/w P and the D curve, from 0 to Q. Recall: area of a triangle equals ½ x base x height Height of this triangle is $60 – 30 = $30. So, CS = ½ x (15 x $30) = $225. h $

81. P Q How a Higher Price Reduces CS D If P rises to $40, CS = ½ x (10 x $20) = $100. Two reasons for the fall in CS. 1. Fall in CS due to buyers leaving market 2. Fall in CS due to remaining buyers paying higher P

82. 34. Explain the concept of producer surplus. Producer surplus is the additional private benefit to producers, in terms of profit, gained when the price they receive in the market is more than the minimum they would be prepared to supply for. In other words they received a reward that more than covers their costs of production. Producer surplus (PS): the amount a seller is paid for a good minus the seller’s cost.

83. 35. Identify producer surplus on a demand and supply diagram. The producer surplus derived by all firms in the market is the area from the supply curve to the price line, EPB. The producer surplus is the area above the market supply curve and below the market price.

84. P Q PS with Lots of Sellers & a Smooth S Curve The supply of shoes S PS is the area b/w P and the S curve, from 0 to Q. The height of this triangle is $40 – 15 = $25. So, PS = ½ x b x h = ½ x 25 x $25 = $312.5 h

85. P Q How a Lower Price Reduces PS If P falls to $30, PS = ½ x 15 x $15 = $112.5 Two reasons for the fall in PS. S 1. Fall in PS due to sellers leaving market 2. Fall in PS due to remaining sellers getting lower P

86. 36. Evaluate the view that the best allocation of resources from society’s point of view is at competitive market equilibrium, where social (community) surplus (consumer surplus and producer surplus) is maximized (marginal benefit = marginal cost). Economic welfare is the total benefit available to society from an economic transaction or situation. Economic welfare is also called community surplus. Welfare is represented by the area ABE in the diagram beside, which is made up of the area for consumer surplus, ABP plus the area for producer surplus, PBE. In market analysis economic welfare at equilibrium can be calculated by adding consumer and producer surplus.

87. Evaluating the Market Equilibrium Market eq’m: P = $30 Q = 15,000 Total surplus = CS + PS Is the market eq’m efficient? Calculate the area of CS, PS and Total Surplus. P Q S D CS PS

88. Which Buyers Get to Consume the Good? P Q S D Every buyer whose WTP is ≥ $30 will buy. Every buyer whose WTP is < $30 will not. So, the buyers who value the good most highly are the ones who consume it.

89. Which Sellers Produce the Good? P Q S D Every seller whose cost is ≤ $30 will produce the good. Every seller whose cost is > $30 will not. Hence, the sellers with the lowest cost produce the good.

90. Does Eq’m Q Maximize Total Surplus? P Q S D At Q = 20, cost of producing the marginal unit is $35 value to consumers of the marginal unit is only $20 Hence, can increase total surplus by reducing Q. This is true at any Q greater than 15.

91. Does Eq’m Q Maximize Total Surplus? P Q S D At Q = 10, cost of producing the marginal unit is $25 value to consumers of the marginal unit is $40 Hence, can increase total surplus by increasing Q. This is true at any Q less than 15.

92. Evaluating the Market Eq’m: Summary The market equilibrium is efficient:  The equilibrium Q maximizes total surplus.  The goods are produced by the producers with lowest cost,  and consumed by the buyers who value them most highly. The government cannot improve on the market outcome. Laissez faire (French for “allow them to do”): the government should not interfere with the market.

93. CS & PS with shortage & surplus