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Introduction To Economics Chapter 7 Coordination After Changes In Market Conditions J. Patrick Gunning February 20, 2007.

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1 Introduction To Economics Chapter 7 Coordination After Changes In Market Conditions J. Patrick Gunning February 20, 2007

2 Introduction Purpose of the chapter: next two chapters: to present some simple examples of entrepreneurial adjustment to change in demand and supply conditions. Purpose of the chapter: next two chapters: to present some simple examples of entrepreneurial adjustment to change in demand and supply conditions. Structure of the chapter: Structure of the chapter: Part 1: The entrepreneurial coordination that occurs after a change in demand conditions. Part 1: The entrepreneurial coordination that occurs after a change in demand conditions. Part 2: The entrepreneurial adjustments that results from a change in supply conditions. Part 2: The entrepreneurial adjustments that results from a change in supply conditions. Part 3: How government price controls may interfere with the communication process and thereby inhibit entrepreneurial coordination. Part 3: How government price controls may interfere with the communication process and thereby inhibit entrepreneurial coordination.

3 Part 1: Entrepreneurial Adjustment To A Change In Demand Conditions A change in the quantity demanded due to a change in price is shown by a movement along a demand curve. A change in the quantity demanded due to a change in price is shown by a movement along a demand curve. In figure 7-1, a decrease in the sellers price from $10 to $5 causes an increase in quantity demanded from 590 to 1530 loaves. In figure 7-1, a decrease in the sellers price from $10 to $5 causes an increase in quantity demanded from 590 to 1530 loaves. An increase in sellers price from $5 to $10 decreases quantity demanded from 1530 to 590 loaves. An increase in sellers price from $5 to $10 decreases quantity demanded from 1530 to 590 loaves.

4 The Demand For White Bread (Figure 7-1) A change in quantity demanded caused by a change in price.

5 Figure 7-2 An increase in demand: the marginal consumer is willing to pay a higher price for each quantity.

6 Explanation Of Figure 7-2 The increase in demand is shown by an upward shift of the demand curve from D 1 to D 2. The increase in demand is shown by an upward shift of the demand curve from D 1 to D 2. This means that at each price, the quantity demanded is greater. This means that at each price, the quantity demanded is greater. Examine the quantities demanded at $10 and $8 per unit, before the increase in demand. Examine the quantities demanded at $10 and $8 per unit, before the increase in demand. Examine the quantities demanded at $10 and $8 after the increase in demand. Examine the quantities demanded at $10 and $8 after the increase in demand.

7 Decrease In Demand: Figure 7-3 A decrease in demand shifts the curve downward to the left. Consumers are willing to buy less at each price.

8 A Change in the Demand and the Marginal Consumer (Figure 7-4)

9 Explanation Of Figure 7-4 An increase in demand also means that for any quantity, the price that the marginal consumer is willing to pay is higher than before. An increase in demand also means that for any quantity, the price that the marginal consumer is willing to pay is higher than before. For the quantity 590, if the demand is D 1, the marginal consumer is willing to pay a maximum of $10. If the demand is D 2, the marginal consumer is willing to pay a maximum of $ For the quantity 590, if the demand is D 1, the marginal consumer is willing to pay a maximum of $10. If the demand is D 2, the marginal consumer is willing to pay a maximum of $ For the quantity 980, the marginal consumer is willing to pay $8 if the demand is D 1 and $11.80 if the demand is D 2. For the quantity 980, the marginal consumer is willing to pay $8 if the demand is D 1 and $11.80 if the demand is D 2.

10 Representing How Producers Adjust: Two Parts 1. Compare a completely coordinated market before the change with a completely coordinated market after the change. 1. Compare a completely coordinated market before the change with a completely coordinated market after the change. 2. Describe the communication and the incentive to adjust. 2. Describe the communication and the incentive to adjust.

11 The Completely Coordinated Industry (1) (From Chapter 6)

12 The Completely Coordinated Industry (2) The price of each good equals the marginal cost. The price of each good equals the marginal cost. Each seller of the good sells at exactly the same price. Each seller of the good sells at exactly the same price. The marginal cost rises because in order to produce more bread, bakers must bid specialized resources away from other entrepreneurs. The marginal cost rises because in order to produce more bread, bakers must bid specialized resources away from other entrepreneurs.

13 Effects Of An Increase In Demand (Figure 7-5) An increase in demand would cause a shortage if producers do not raise price.

14 The Completely Coordinated Industry: Before And After (Figure 7-5) The increase in demand is represented by a shift from D 1 to D 2. The increase in demand is represented by a shift from D 1 to D 2. The increase causes the completely coordinated price and quantity to change from position 1 to position 2. The increase causes the completely coordinated price and quantity to change from position 1 to position 2.

15 Communication And Incentives to Adjust (Figure 7-5) The increase in demand by consumers raises quantity demanded at the price of $.99 from 600 to 1360 loaves. The increase in demand by consumers raises quantity demanded at the price of $.99 from 600 to 1360 loaves. This leads producers to try to produce a larger amount. This leads producers to try to produce a larger amount. To obtain the additional resources, producers must pay more per unit for resources. To obtain the additional resources, producers must pay more per unit for resources. Producers communicate this to consumers by raising their price. Producers communicate this to consumers by raising their price. As the price rises, consumers demand less than 1360 at the higher price. As the price rises, consumers demand less than 1360 at the higher price.

16 What If Producers Did Not Raise The Price? If producers did not raise price, the quantity would fall to 600 units. If producers did not raise price, the quantity would fall to 600 units. The utility of the marginal consumer (the price she was willing to pay) ($1.38) would be higher than the marginal cost ($.99). The utility of the marginal consumer (the price she was willing to pay) ($1.38) would be higher than the marginal cost ($.99). Consumers would give producers an incentive to produce more because they are willing to pay a higher price. Otherwise, there would be a shortage. Consumers would give producers an incentive to produce more because they are willing to pay a higher price. Otherwise, there would be a shortage.

17 Who Is To Blame For The Higher Prices? The ultimate responsibility for bidding up these prices lies with the consumers themselves. The ultimate responsibility for bidding up these prices lies with the consumers themselves. Consumers of white bread have decided that they are willing and able to buy more at each price. Consumers of white bread have decided that they are willing and able to buy more at each price. Other consumers are unwilling to give up the other goods that could be produced with the resources needed to satisfy the increased demand for bread. Other consumers are unwilling to give up the other goods that could be produced with the resources needed to satisfy the increased demand for bread. What happens in effect is that the consumers of white bread must bid higher prices because they must compete for resources with the consumers of other consumer goods. What happens in effect is that the consumers of white bread must bid higher prices because they must compete for resources with the consumers of other consumer goods.

18 Effects Of An Decrease In Demand (Figure 7-6)

19 Explanation Of Figure 7-6 The decrease in demand is represented by a shift from D 1 to D 2. The decrease in demand is represented by a shift from D 1 to D 2. The decrease causes the completely coordinated price to fall from position 1 to position 2. The decrease causes the completely coordinated price to fall from position 1 to position 2.

20 Communication In Terms Of Figure 7-6 (1) The decrease in demand by consumers for white bread may lead producers to reduce output but not to reduce price. If so, there would be a surplus of 430 loaves (600 – 170). Price and quantity would temporarily move from position 1 to position 3. The decrease in demand by consumers for white bread may lead producers to reduce output but not to reduce price. If so, there would be a surplus of 430 loaves (600 – 170). Price and quantity would temporarily move from position 1 to position 3. As producers reduced their output, they would lay off resources. As producers reduced their output, they would lay off resources. Competition among the owners of the resources for employment, particularly among the owners of specialized resources, would causes the prices of these resources to fall. Competition among the owners of the resources for employment, particularly among the owners of specialized resources, would causes the prices of these resources to fall. The marginal cost at 170 loaves would fall to $.49 while the price remained at $.99. The marginal cost at 170 loaves would fall to $.49 while the price remained at $.99.

21 Communication In Terms Of Figure 7-6 (2) Competition among producers for customers would reduce the price. Competition among producers for customers would reduce the price. Competition would also bid up the prices of resources. Competition would also bid up the prices of resources. Consumers would demand more than otherwise due to the lower price. Consumers would demand more than otherwise due to the lower price. Falling prices of bread and the increasing amount of bread produced would cause a movement from position 3 to position 2. Falling prices of bread and the increasing amount of bread produced would cause a movement from position 3 to position 2.

22 Part 2: Entrepreneurial Adjustments To A Change In Supply We first show how to represent a change in the conditions of production. We first show how to represent a change in the conditions of production. Then we show the effects of a change that causes marginal costs to rise. Then we show the effects of a change that causes marginal costs to rise.

23 Figure 7-7

24 Change In Quantity Supplied (Figure 7-7) A change in the quantity supplied due to a change in price is shown by a movement along a demand curve. A change in the quantity supplied due to a change in price is shown by a movement along a demand curve. In figure 7-7, an increase in the price that producers expect to receive from $.99 to $1.25 causes an increase in quantity supplied from 600 to 830 loaves. The price and quantity supplied move from position A to B. In figure 7-7, an increase in the price that producers expect to receive from $.99 to $1.25 causes an increase in quantity supplied from 600 to 830 loaves. The price and quantity supplied move from position A to B. An decrease in the expected price from $1.25 to $.99 causes a decrease in quantity supplied from 830 to 600 loaves. The price and quantity supplied move from position B to A. An decrease in the expected price from $1.25 to $.99 causes a decrease in quantity supplied from 830 to 600 loaves. The price and quantity supplied move from position B to A.

25 A Decrease In Marginal Cost Causes An Increase in Supply (Figure 7-9) An increase in supply is shown on a graph by a shift of the supply curve downwards and to the right. An increase in supply is shown on a graph by a shift of the supply curve downwards and to the right.

26 Explanation Of Figure 7-8 At each quantity, the marginal cost is lower than before the increase. At each quantity, the marginal cost is lower than before the increase. Producers are willing to supply more at each price. Producers are willing to supply more at each price. Before the change, producers are willing to supply 46 loaves at a price of $.80 per loaf; afterwards, they are willing to supply 95 loaves. Before the change, producers are willing to supply 46 loaves at a price of $.80 per loaf; afterwards, they are willing to supply 95 loaves. Before the change, producers are willing to supply 78 loaves at a price of $1.18 per loaf; afterwards, they are willing to supply 128 loaves. Before the change, producers are willing to supply 78 loaves at a price of $1.18 per loaf; afterwards, they are willing to supply 128 loaves.

27 An Increase In Marginal Cost Causes A Decrease in Supply (Figure 7-9) A decrease in supply is shown on a graph by a shift of the supply curve upwards and to the left.

28 Explanation Of Figure 7-9 At each quantity, the marginal cost is higher than before the increase. At each quantity, the marginal cost is higher than before the increase. Producers are willing to supply less at each price. Producers are willing to supply less at each price. Before the change, producers are willing to supply 78 loaves at a price of $1.18 per loaf; afterwards, they are willing to supply 70 loaves only if the price is $1.72. Before the change, producers are willing to supply 78 loaves at a price of $1.18 per loaf; afterwards, they are willing to supply 70 loaves only if the price is $1.72. Before the change, producers are willing to supply 102 loaves at a price of $1.44 per loaf; afterwards, they are willing to supply 102 loaves only if the price is $2.02. Before the change, producers are willing to supply 102 loaves at a price of $1.44 per loaf; afterwards, they are willing to supply 102 loaves only if the price is $2.02.

29 Effects Of A Decrease In Marginal Cost (Figure 7-11) Effects Of A Decrease In Marginal Cost

30 Explanation Of Figure 7-11 A decrease in marginal cost would cause the completely coordinated price to fall from $.92 to $.78. The completely coordinated quantity would rise from 1280 to 1480 loaves. From position 1 to position 2. A decrease in marginal cost would cause the completely coordinated price to fall from $.92 to $.78. The completely coordinated quantity would rise from 1280 to 1480 loaves. From position 1 to position 2. Suppose that producers did not reduce price. Then consumers would only buy loaves. At 1280 loaves MU > MC, as shown in the figure. Suppose that producers did not reduce price. Then consumers would only buy loaves. At 1280 loaves MU > MC, as shown in the figure. Some entrepreneur would perceive that he could profit by hiring more resources to produce a larger quantity. To sell the large quantity, he would have to reduce price. Some entrepreneur would perceive that he could profit by hiring more resources to produce a larger quantity. To sell the large quantity, he would have to reduce price.

31 Effects Of An Increase In Marginal Cost (Figure 7-12) Effects Of An Increase In Marginal Cost

32 Explanation Of Figure 7-12 An increase in marginal cost would cause the completely coordinated price to rise from $.78 to $.92. The completely coordinated quantity would fall from 1480 to 1280 loaves. From position 1 to position 2. An increase in marginal cost would cause the completely coordinated price to rise from $.78 to $.92. The completely coordinated quantity would fall from 1480 to 1280 loaves. From position 1 to position 2. Suppose that producers did not raise price. Then they would want to reduce their quantity supplied 630 loaves, as shown in the figure. Suppose that producers did not raise price. Then they would want to reduce their quantity supplied 630 loaves, as shown in the figure. But at this quantity, consumers would bid up the price. The price would become $1.08 per loaf. But at this quantity, consumers would bid up the price. The price would become $1.08 per loaf. Some entrepreneur would perceive that he could profit by raising price and hiring more resources to produce a larger quantity. Some entrepreneur would perceive that he could profit by raising price and hiring more resources to produce a larger quantity.

33 The Scenario Through The Eyes Of A Surviving Baker Before the change, the typical baker was barely making enough profit to continue in this activity. After marginal costs rise, she adjusts in the short run by reducing the amount of bread that she produces and sells. In the meantime, other bakers leave the industry. This increases her customers and reduces her costs because owners of the laid off resources are willing to supply them at lower prices. This combination of more customers and falling costs ultimately enables the surviving baker to earn a minimal profit again.

34 Part 3: How Price Controls Block Communication And Coordination (1) Retailers communicate with consumers and producers of goods by offering and accepting goods and resources for prices. Retailers communicate with consumers and producers of goods by offering and accepting goods and resources for prices. Communication by means of markets and prices enables the plans and decisions of consumers to be coordinated with the plans and decisions of producers. Communication by means of markets and prices enables the plans and decisions of consumers to be coordinated with the plans and decisions of producers.

35 How Price Controls Block Communication And Coordination (2) Price controls: laws that deter actors in market interaction from changing the prices as they would do under the conditions of a pure market economy. Price controls: laws that deter actors in market interaction from changing the prices as they would do under the conditions of a pure market economy. We consider two types of price controls: We consider two types of price controls: A price ceiling. A price ceiling. A price floor. A price floor.

36 How Price Controls Block Communication And Coordination (3) Price controls are likely to interfere with communication and, therefore, with coordination. Price controls are likely to interfere with communication and, therefore, with coordination. They may eliminate the incentive to shift resources in response to a change in market conditions. They may eliminate the incentive to shift resources in response to a change in market conditions.

37 A Theory Of The Effects Of A Price Ceiling Price ceiling: a maximum price above which sellers are prohibited from selling. Price ceiling: a maximum price above which sellers are prohibited from selling. Beginning with a completely coordinated economy, suppose that you are a neighborhood baker and that there is an increase in demand for white bread. Beginning with a completely coordinated economy, suppose that you are a neighborhood baker and that there is an increase in demand for white bread. Assume that the ceiling price is exactly equal to the price that retailers are now charging. Assume that the ceiling price is exactly equal to the price that retailers are now charging.

38 Unwillingness To Respond To An Increase In Demand Before the increase in demand, you are earning a small profit. Before the increase in demand, you are earning a small profit. Because there is a price control, you cannot afford to offer higher prices to resource suppliers. Because there is a price control, you cannot afford to offer higher prices to resource suppliers. So you are unwilling to respond to the increase in demand by shifting resources. So you are unwilling to respond to the increase in demand by shifting resources. The effect is a shortage. The quantity demanded is greater than the quantity supplied at the current price. The effect is a shortage. The quantity demanded is greater than the quantity supplied at the current price.

39 Shortages In Markets Without Price Controls Shortages are common in market interaction, particularly among goods that take a long time to produce. Shortages are common in market interaction, particularly among goods that take a long time to produce. They lead sellers to raise the price and to give resource suppliers incentives to shift resources in and out of industries in response to changes in market conditions. They lead sellers to raise the price and to give resource suppliers incentives to shift resources in and out of industries in response to changes in market conditions. The resource shift tends to eliminate the shortage. The resource shift tends to eliminate the shortage.

40 Shortages In Markets With Price Controls A price ceiling can prevent adjustment to an increase in demand. A price ceiling can prevent adjustment to an increase in demand. A shortage may be permanent. A shortage may be permanent.

41 A Graph To Represent A Shortage Due to a Price Ceiling (Figure 7-13) Under a price ceiling, an increase in demand may cause a shortage. In the graph the shortage is 720 loaves, as quantity demanded rises from 610 to 1330 loaves at the ceiling price of $2.

42 Dis-coordination The price ceiling prevents producing entrepreneurs from receiving the message that they should shift resources so that the higher consumer demand can be accommodated with more production. The price ceiling prevents producing entrepreneurs from receiving the message that they should shift resources so that the higher consumer demand can be accommodated with more production. To achieve a completely coordinated market, producing entrepreneurs would have to shift resources away from the production of other goods and into the production of the good for which demand has risen. To achieve a completely coordinated market, producing entrepreneurs would have to shift resources away from the production of other goods and into the production of the good for which demand has risen. But this cannot occur because the entrepreneurs do not receive the price signals that are necessary to give them incentives to shift. But this cannot occur because the entrepreneurs do not receive the price signals that are necessary to give them incentives to shift.

43 Incentive To Act Illegally The gap between the price that the marginal consumer is willing to pay and the marginal cost at 600 units (see figure 7-13) implies an incentive to break the law by selling at a price that is higher than the ceiling. The gap between the price that the marginal consumer is willing to pay and the marginal cost at 600 units (see figure 7-13) implies an incentive to break the law by selling at a price that is higher than the ceiling. Would-be law-breakers balance the prospective gain against the risk cost. Would-be law-breakers balance the prospective gain against the risk cost. Law-breakers risk cost: a law-breakers estimate of the harm he would incur if he was caught times the probability that he would incur that harm. Law-breakers risk cost: a law-breakers estimate of the harm he would incur if he was caught times the probability that he would incur that harm.

44 The Prospect for Corruption A prospective law-breaker may be able to reduce her risk cost by bribing a police officer, prosecutor, judge, or prison official. A prospective law-breaker may be able to reduce her risk cost by bribing a police officer, prosecutor, judge, or prison official. In the real world, some types of exchanges are banned. In the real world, some types of exchanges are banned. The ceiling price is zero. The ceiling price is zero. This leads to crime and corruption. This leads to crime and corruption.

45 A Puzzle Suppose that the government controls the price of airline tickets. Suppose that the government controls the price of airline tickets. A holiday arrives and there is an increase in demand for tickets. The result is a shortage of flights. A holiday arrives and there is an increase in demand for tickets. The result is a shortage of flights. What caused the shortage? What caused the shortage? Was it the increased holiday demand? Was it the increased holiday demand? Was it the price ceiling? Was it the price ceiling?

46 Shortage Due To An Increase In Marginal Cost (Figure 7-14) Under a price ceiling, an increase in cost may cause a shortage.In the graph the shortage is 720 loaves, as quantity supplied falls from 1330 to 610 loaves, at the ceiling price of $2. Under a price ceiling, an increase in cost may cause a shortage. In the graph the shortage is 720 loaves, as quantity supplied falls from 1330 to 610 loaves, at the ceiling price of $2.

47 A Shortage Due To An Increase In Costs Example: a bad growing season causes the prices of wheat flour to rise. Example: a bad growing season causes the prices of wheat flour to rise. This, in turn, raises the costs to bakers. What caused the shortage? This, in turn, raises the costs to bakers. What caused the shortage? 1. Was it the bad weather? 1. Was it the bad weather? 2. Was it the price control? 2. Was it the price control? Governments cannot change the weather, but they can change a price control. Governments cannot change the weather, but they can change a price control.

48 Dis-coordination The price ceiling causes more resources to shift out of the industry than are necessary to achieve complete coordination. The price ceiling causes more resources to shift out of the industry than are necessary to achieve complete coordination. Because sellers do not communicate that marginal price is higher than marginal cost at 610 units, producing entrepreneurs allow too many resources to leave the industry. Because sellers do not communicate that marginal price is higher than marginal cost at 610 units, producing entrepreneurs allow too many resources to leave the industry.

49 A Theory Of The Effects Of A Price Floor Price floor: a minimum price, established by law, below which sellers are prohibited from selling. Price floor: a minimum price, established by law, below which sellers are prohibited from selling. The price floor is often used in industries like farm products. The price floor is often used in industries like farm products. Assume that the floor price on milk is exactly equal to the price that milk producers are now charging. Assume that the floor price on milk is exactly equal to the price that milk producers are now charging. There is a decrease in industry demand. There is a decrease in industry demand.

50 What Would Happen In the Absence of a Price Floor? Milk producers would order fewer dairy workers and other resources. Milk producers would order fewer dairy workers and other resources. Competing for employment, the owners of those resources would reduce their prices. Competing for employment, the owners of those resources would reduce their prices. Competing milk producers would respond by reducing their milk prices. Competing milk producers would respond by reducing their milk prices. In figure 7-15, the price and quantity would tend toward the complete coordination at position 3. In figure 7-15, the price and quantity would tend toward the complete coordination at position 3.

51 Graph Of A Price Floor (Figure 7-15) EFFECTS OF A DECREASE IN DEMAND ON PRICE AND QUANTITY

52 The Price Floor Causes A Gap Between Price and MC The price floor prevents price from falling. Milk producers move from position 1 to position 2, since consumers demand only 180 liters. The price floor prevents price from falling. Milk producers move from position 1 to position 2, since consumers demand only 180 liters. But at position 2, there is a gap between price and MC. But at position 2, there is a gap between price and MC. It would seem that milk producers would be making profit on the units they produce. It would seem that milk producers would be making profit on the units they produce.

53 Alternative Ways To Compete Milk producers would like to compete for customers by reducing price. But they cannot. Milk producers would like to compete for customers by reducing price. But they cannot. They have alternative ways to compete: They have alternative ways to compete: Maintain higher inventories. Maintain higher inventories. Increasing their advertising. Increasing their advertising. Offer other services, like greater convenience or delivery, that would otherwise not be offered. Offer other services, like greater convenience or delivery, that would otherwise not be offered. Evade the law by offering discount prices on complementary goods or other products. Evade the law by offering discount prices on complementary goods or other products. Each of the alternatives is likely to cause costs to be higher than otherwise. Each of the alternatives is likely to cause costs to be higher than otherwise.

54 Dis-coordination These competing actions would increase the marginal cost of supplying milk. These competing actions would increase the marginal cost of supplying milk. Marginal cost may even reach the point where it equals the price of the product. Marginal cost may even reach the point where it equals the price of the product. If so, there would be no surplus and the market would become coordinated. If so, there would be no surplus and the market would become coordinated. However, there would not be a completely coordinated economy because costs would be higher than they need to be. However, there would not be a completely coordinated economy because costs would be higher than they need to be. Not enough resources would be used to produce other goods. Not enough resources would be used to produce other goods.


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