ECON 161 Week 02: September 05, 2012 The functioning of Markets: The interaction of buyers and sellers. (Chapter 3)

Construction of Theory Abstractions Definitions Assumptions Implications Adoption of Theory

Definitions Good: Anything that an individual wants to have more of, at zero price. Resource: Anything that can be used to produce goods.

Assumptions Humankind has unlimited wants Our resources are limited Scarcity : Individually, and as a Society, we do not have enough resources to produce all the things we want.

Implications of Scarcity Choice Economic Cost Competition

Forms of Competition in Society Violence, or Threat of Violence Social/Political Economic/Market: competition based on offering the highest value in exchange.

Primary Social Goal = Fairness Violence: not fair. Social political: not fair. Economic: not fair, Life is NOT FAIR !! But, the market offers the broadest and most fair system

What Economics Is About Microeconomics: decisions of individuals and firms: what to buy and what to produce. Macroeconomics: the whole economic system and the role of government.

Mechanisms of Choice Political: our representatives make choices Economic/market: individuals and firms make choices based on relative prices about what to produce

ECONOMIC Form of Competition Economic competition: We acquire $s by producing value for others. We compete for goods by offering to trade $ dollars. Circular flow diagram: Shows the interaction of households and firms in two kinds of markets.

Product Markets FIRMS HOUSEHOLD Resource Markets $'s $'s Revenue $'s Income $'s Goods & Services Goods & Services Resources Inputs Circular Flow Diagram of the Exchange Economy Credit Markets $'s

Circular Flow Diagram of the Exchange Economy Households: Decisions: What to sell? What to buy? Assume Maximize Utility Firms: Decisions: What inputs to use? What to produce? Assume Maximize Profits: (Total Revenue –Total Cost) Markets: Factor Markets, Product Markets, Credit Markets Role of Money: The medium of exchange

Scarcity Society Choices What to produce? Goal find the mixture of outputs that maximizes societys value. How to produce? Goal: find the optimal mix of inputs to maximize technical output. For whom to produce? Who will get to consume the goods produced.

Study of Markets MarketsMarkets are the interaction of buyers and sellers. Some markets are local, some worldwide. Focus on buyers and sellers separately: Separate graphs for each group. Ceteris paribus: look at one thing at a time; All other things held equal.

Marginal Value Marginal Value Focusing on a buyer, we measure the personal marginal value of a good as the most $ s you are willing to give up to acquire an additional unit. (How much you are willing to trade) Graph the marginal value as a height above each additional unit per time period.

Marginal Value Declines Plot the marginal value as a height above additional units. As you have more of any good, the marginal value declines.

Marginal Value = The Most you are willing to pay for each additional unit

MVx Qty x /T $ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ Marginal Value The height above each additional unit = the most you are willing to pay Marginal Value

How much are you willing to Buy? By comparing the marginal value with the $ Price at which the good is available, we can read the quantity you are willing to buy at each $ price. (horizontal distance) DemandDemand: A schedule of the alternative quantities that an individual is willing and able to buy at alternative $ prices.

$Price x Qty x /T $ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ MVx = Demand X Demand Curve

$ P x $ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ Demand x Demand shows the amounts purchased at alternative prices (horizontal distances at each price) Qty x /T DxDx DxDx Demand for X

Demand Curve

First Law of Demand The higher the price of a good, the smaller the quantity demanded; the lower the price of a good, the greater the quantity demanded. Demand is downward sloping. A change in price leads to a change in quantity demanded = a movement along the function

Change in Price Vs. Change in Demand A change in price is a move on the demand schedule. A change in demand is a shift of the function due to something else changing.

$ P x $ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ Qty x /T DxDx DxDx D x Increase in Demand Increase in demand is a rightward shift (greater quantity demanded at each price.)

Determinants of Demand What factors determine the position of demand ? What changes in other factors will cause demand to increase (shift right) or decrease (shift left)?

Determinants of Demand: (Shift Factors) Taste & preference: how much you like the good. If T&P increase, demand increases. (Rightward shift). Income: a change in income affects demand. –Normal good: increase in income increases demand. (Right Shift) –Inferior good: increase in income decreases demand. (Left Shift)

Determinants of Demand, Continued Price of other goods: –Substitutes: most other goods are substitutes; An increase in the price of a substitute increases demand (rightward shift). –Complements: Goods used together; an increase in the price of complements decreases demand (leftward shift).

Determinants of Demand, Continued Future Price Expectations: an increase in the expected future price will increase demand today.

Market Demand The market demand is the sum of the individual demands of the buyers. An increase in the number of buyers will increase market demand.

Market Supply Supply is a schedule of the alternative quantities which sellers are willing and able to sell at alternative prices. Supply is generally a positive relationship: at higher prices the quantity supplied is larger.

Supply Curve $Price $ Qty x/ T

Change in Quantity vs Shift in Supply If sellers can get a higher price, the increase in quantity supplied is a movement on the supply curve. If some other factor changes, the supply curve will shift. An increase in supply is a rightward shift. A decrease in supply is a leftward shift.

Determinants of Supply:(Shift Factors) Price of inputs: an increase in price of inputs will decrease supply (leftward shift). Change in the value of alternative outputs: a rise in the value of alternative outputs would decrease supply Change in technology: an increase in technology will increase supply (rightward shift). Number of sellers: as more sellers enter a market the supply shifts rightward.

$Price $ Q x/ T Demand Supply Surplus at this $ Price The Market

$Price $ Q x/ T Demand Supply Shortage at this $ Price The Market

$Price Pe Pe Q x/ T Qe Demand Supply Market Equilibrium D x = S x at P e D x = S x at P e

$ P x $ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ Qty x /T Supply Demand DxDx SxSx Market: Demand & Supply At the equilibrium Price, the Dx = Sx Pe Qe