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

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?

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.

. . .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.

U.S. Economic System Largely a market system However, we do have some laws and regulations that affect market decisions. Can you think of some policies (state, federal or local) that affect certain markets?

Price Determination Assuming no or little government intervention in a market, what determines price? Explaining prices is a fundamental question that drove the development of modern economics. It is only recently (late 19th century) that a good understanding of price determination developed.

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

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

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.

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

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

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.

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.

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.

Demand and Cost-Benefit The reservation price is the benefit the buyer receives from the good The cost of the good is its market price If the reservation price (benefit) exceeds the market price (cost) the consumer will purchase the good At higher prices, benefit will exceed cost for a smaller quantity than at lower prices

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

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

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.

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.

The Daily Supply Schedule for Pizza in Chicago Price ($ per slice) Quantity (1000s of slices per day) $4 16 3 12 2 8 1 4

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

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

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

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

Opportunity Costs and Upward Sloping Supply Sellers must receive a higher price to produce additional units of product to cover the higher opportunity costs of each additional unit

The Daily 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

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

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.

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

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

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

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

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?

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.

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.

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.

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.

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.

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.

Factors Affecting Demand Size of market, e.g. how many consumers. Income levels of consumers. Prices and availability of related goods. Tastes and preferences. Special influences, e.g. climate and conditions.

Factors Affecting supply Changes in costs of inputs Technological change Prices of alternative products that could be produced with same resources. Government policy Special factors (climate, culture)

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

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

An Example When students come back to school in the fall, more pizzas are sold locally. This is an increase in demand caused by an increase in the size of the market!

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

Demand Increase or Decrease? What happens to demand for sunblock in the summer? What happens to demand for fish when chicken prices increase? What happens to the demand for luxury cars when incomes fall? What will happen to the demand for sugar if diabetes increases?

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

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

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

Shifts in curves change equilibrium P Supply decreases S’’ S’ P’’ P’ D Q Q” Q’

Shifts in curves change equilibrium P Demand Increases S P” P’ D” D’ Q Q’ Q”

Shifts in curves change equilibrium P S Demand Decreases P’ P” D’ D” Q Q” Q’

There are four possibilities Price Up, Quantity Down ---- Supply decrease Price Down, Quantity Up -- Supply increase Price Up, Quantity Up -- Demand increase Price Down, Quantity Down -- Demand decrease

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

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

Rent Control Other consequences of rent controls Maintenance will decline and housing quality will fall Illegal payments Creation of co-ops and conversion to condominiums Reduction in household mobility Discrimination

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

Price Controls In The Pizza Market ($ 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

Market Equilibrium Pizza Price Controls? Market responses to a pizza price ceiling Long lines Preferential treatment to selected customers Alternative pricing strategies Poorer quality ingredients Black-market pizzas (We can look to old USSR for real-life examples.)

Predicting and Explaining Changes In Prices and Quantities Distinguishing Between: A change in the quantity demanded A movement along the demand curve that occurs in response to a change in price A change in demand A shift of the entire demand curve

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

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

Predicting and Explaining Changes In Prices and Quantities Change in the quantity supplied A movement along the supply curve that occurs in response to a change in price Change in supply A shift of the entire supply curve

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

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