1. Decision-making and Demand and Supply Analysis

2. Thinking Economically: Marginal Analysis
Optimization Assumption: an assumption that suggests that the person in question is trying to maximize some objective
Marginal Benefit: the increase in the benefit that results from an action
Marginal Cost: the increase in the cost that results from an action
Total Net Benefits: the difference between all benefits and all costs

3. Maximizing Total Net Benefits
Total Way – select the level of the activity that maximizes the difference between total benefits and total costs
Marginal Way – set the marginal benefit of to the marginal cost of an extra unit
Economist prefer the later because many decisions are not all or nothing. Most times people are deciding to increase or decrease the amount of something that they are doing.

4. Marginal Way in Action The example of the boxes
If the marginal benefit of an extra unity of the activity is greater than its marginal cost, increasing the activity will increase total net benefits.
If the marginal cost of an extra unit of the activity is greater than its marginal cost, increasing the activity will decrease total net benefits.
Therefore, to maximize total net benefits the level of an activity that maximizes total net benefits is where the marginal benefit equals the marginal cost of an extra unit of the activity.

5. Boxes
If an extra unit of the activity (trades) results in getting more boxes (MB) than are being given up (MC) the stack of boxes grows (TNB).
If an extra unit of the activity (trades) results in getting less boxes (MB) than are being given up (MC) the stack of boxes shrinks (TNB).
If an extra unit of the activity (trades) results in getting the same amount of boxes (MB) that are being given up (MC) the stack of boxes is at its tallest ( maximum TNB).

7. Markets: The power of Demand and Supply
Competitive Markets
identical or homogeneous goods
many sellers and buyers
perfect Information
free entry and exit
Non-Competitive Markets
Monopoly – one seller
Oligopoly – few sellers
Monopolistically Competitive – differentiated products

8. Demand
Law of Demand – the price of a good and the quantity demanded are negatively (or inversely) related, ceteris paribus
Price and the quantity demanded
Rational behavior
Utility maximization (MB=MC all over again)
Cardinal Utility: Measurable Utility
Law of diminishing marginal utility
Jelly bean example and Econ U$A tape on the drought in California
MB fall as activity level increases
Ordinal Utility: Ability to rank bundles from most preferred to least preferred.
Less restrictive assumption with the same conclusions as the theory of cardinal utility.
Income and substitution effects
Substitution effect: as the price of a good falls its price relative to other goods fall, so consumers use more of the good and less of other goods
Income effect: as the price of a good falls, the real purchasing power of income increases and consumers will buy more of the good (if the good is normal).
The theories of cardinal and ordinal utility predict that price and quantity demand will be inversely related.
Demand schedule: numbers
Individual demand curve: graph
Demand Function: mathematical notation
Market demand curve: horizontal sum of individual demand curves

9. Catherine’s Demand Schedule17

10. Figure 1 Catherine’s Demand Schedule and Demand Curve
Price of
Ice-Cream Cone
$3.00
2.50
1. A decrease
in price
...
2.00
1.50
1.00
0.50 1 2 3 4 5 6 7 8 9 10 11 12
Quantity of 2.
...
increases quantity
of cones demanded.
Ice-Cream Cones
Copyright © South-Western

11. The demand function Qd=F (P, PR,Y,NB,T,E,G)
Price of related goods
Complements
Substitutes
Income
Number of Buyers
Tastes
Expectations
Government: Taxes and Subsidies
Qd=F (P, PR,Y,NB,T,E,G)
Market Demand Curve: The horizontal summation of all the individual demand curves.

12. Movement along and shifts of the demand curve
Curve versus function
The demand curve is created assuming ceteris paribus, so it maps only the relationship between P and QD.
The demand function shows all the determinants of demand. All the factors other than P, such a PR and Y, are shift factors.
Schedules
Changes in price are described by the demand schedule.
Shifts are shown as increases in QD at every price.
Graphs
A movement along the curve is a change in quantity demanded
A shift of the curve is a change in demand

13. Figure 3 Shifts in the Demand Curve
Price of
Ice-Cream
Cone
Increase
in demand
Decrease
in demand
Demand
curve, D 2
Demand
curve, D 1
Demand curve, D 3
Quantity of
Ice-Cream Cones
Copyright©2003 Southwestern/Thomson Learning

14. Supply
Law of Supply - price and the quantity supplied are positively related, ceteris paribus.
Rational behavior implies that firms try and maximize profits, where the MB = P and MC is dependent on how much output is produced.
MC increase as Q increases because of the following phenomena:
Law of increasing costs: as the production of a good increases, its opportunity cost increases (re: PPF and specialized resources)
Law of diminishing returns: as more and more of variable inputs is applied to a fixed factor, eventually the extra output for each additional variable input will fall, ceteris paribus.
Both the LIC and LDMR predict that as Q goes up the productivity of inputs will fall and MC will rise.
Supply schedule
Individual supply curve
Market supply curve

15. Ben’s Supply Schedule 29

16. Figure 5 Ben’s Supply Schedule and Supply Curve
Price of
Ice-Cream
Cone
$3.00
2.50
1. An
increase
in price
...
2.00
1.50
1.00
0.50 1 2 3 4 5 6 7 8 9 10 11 12
Quantity of
Ice-Cream Cones 2.
...
increases quantity of cones supplied.
Copyright©2003 Southwestern/Thomson Learning

17. The supply function Qs=F(P,PI,PO,T,E,NS,G)
Input prices
Prices of other outputs
Technology
Expectations
Number of sellers
Government taxes and subsidies
Qs=F(P,PI,PO,T,E,NS,G)
Market Supply: The horizontal summation of all the individual firms’ supply curves.

18. Figure 7 Shifts in the Supply Curve
Price of
Supply curve, S 3
Ice-Cream
curve,
Supply S 1
Cone
Supply
curve, S 2
Decrease
in supply
Increase
in supply
Quantity of
Ice-Cream Cones
Copyright©2003 Southwestern/Thomson Learning

19. Market Equilibrium
Equilibrium price and quantity = market clearing price and quantity
Disequilibrium prices and quantities
Shortage – Excess Demand
Surplus – Excess Supply
Comparative static analysis: changes in equilibrium prices and quantities
Shifts in curves versus movement along revisited
Changes in demand and supply

20. Figure 8 The Equilibrium of Supply and Demand
Price of
Ice-Cream
Cone
Supply
Demand
Equilibrium
Equilibrium price
$2.00
Equilibrium
quantity 1 2 3 4 5 6 7 8 9 10 11 12 13
Quantity of Ice-Cream Cones
Copyright©2003 Southwestern/Thomson Learning

21. Figure 9 Markets Not in Equilibrium
(a) Excess Supply
Price of
Ice-Cream
Supply
Cone
Surplus
Demand
$2.50 10 4
2.00 7
Quantity of
Quantity
demanded
Quantity
supplied
Ice-Cream
Cones
Copyright©2003 Southwestern/Thomson Learning

22. Figure 9 Markets Not in Equilibrium
(b) Excess Demand
Price of
Ice-Cream
Supply
Cone
Demand
$2.00 7
1.50 10 4
Shortage
Quantity of
Quantity
supplied
Quantity
demanded
Ice-Cream
Cones
Copyright©2003 Southwestern/Thomson Learning

23. Figure 10 How an Increase in Demand Affects the Equilibrium
Price of
Ice-Cream
1. Hot weather increases
the demand for ice cream . . .
Cone D D
Supply
New equilibrium
$2.50 10
resulting
in a higher
price . . .
2.00 7
Initial
equilibrium
Quantity of 3.
. . .
and a higher
quantity sold.
Ice-Cream Cones
Copyright©2003 Southwestern/Thomson Learning

24. Figure 11 How a Decrease in Supply Affects the Equilibrium
Price of
1. An increase in the
price of sugar reduces
the supply of ice cream. . .
Ice-Cream
Cone S2 S1
Demand
New
equilibrium
$2.50 4
resulting
in a higher
price of ice
cream . . .
Initial equilibrium
2.00 7
Quantity of 3.
. . .
and a lower
quantity sold.
Ice-Cream Cones
Copyright©2003 Southwestern/Thomson Learning

25. Comparative Statics
Animal tracks help one to tell what kind of an animal and the direction the animal went.
Demand and supply shifts leave different tracks to help us identify them and whether they are increasing or decreasing.
Movement of either D or S (confirm with graphs)
D↓, S constant → P↓, Q↓
D↑, S constant → P↑, Q↑
S↓, D constant → P↑, Q↓
S↑, D constant → P↓, Q↑

26. S↓ S↑ D↓ P?, Q↓ P↓, Q? D↑ P↑, Q? P?, Q↑
Movement of both D and S (confirm with graphs) S↓ S↑ D↓
P?, Q↓
P↓, Q? D↑
P↑, Q?
P?, Q↑

27. Using Comparative Statics
One can use comparative statics to identify whether shifts in demand or shifts in supply are the predominant influence in a market.
Once the above is determined, one can then use the demand or supply function to try and determine what factors are causing the shifts.
Two examples from NPR:
Mad Cow and Market for Beef
Tuition Increase in Higher Education

28. The Invisible Hand Economic Agents are motivated by self-interest
consumers by utility maximization
Producers by profit maximization
Market prices are
signals for resource allocation
coordinate consumer and producer behavior
incentives for buyers and sellers (MC for buyers and MB for sellers)
Ration scarce goods and services
Provide information about scarcity and value
Market or the Price System and Efficiency
Competitive markets:
produce the goods and service consumers want
helps to ensure that the goods and services are produced at least possible cost