Download Lecture Notes #2 on Chapters 3 and 4

ECON 202 Lecture 2
1
Metropolitan State University
ECON 202 – Microeconomics
Lecture Notes 2 – Chapters 3 and 4
Scarcity and Choice
Supply and Demand
Chapter 3: Scarcity and Choice
To understand scarcity, consider two basic facts.
First, all things exist in limited quantities. These things include clean air, land, 50 year
old Scotch whisky and French manicures.
Second, when these things are desirable (that is, when they are goods) people would
always like to have more of them. People would generally like to have cleaner air, more
land, more 50 year old Scotch whisky and more French manicures.
Now, the problem is that people would like to have more of these goods than is available.
When, at a price of zero, people would like more of a good than is available, that good is
said to be scarce.
When something is scarce, there must be some way to determine who will get how much
of it, a process called rationing. In a market economy, the people who are willing and
able to pay the most for a good will be the ones to get it.
If a market economy is working well, the price of a good will be related to how scarce it
is, and as a good becomes more scarce (either because less is available or because people
want more of it) the price should rise. If this happens, the markets will do a good job of
rationing scarce goods. If, however, this doesn’t happen, then markets will fail to ration
goods well.
There are other methods of rationing that have been used throughout history.
As an example of another rationing process, you might consider how spots in a
university’s student body are rationed, especially at competitive schools. Why are these
spots allocated in a non-market fashion?
A consequence of scarcity is that productive resources are scarce. That is, if you produce
one good using scarce productive resources, you forego the production of something else.
Thus, you need to think about the cost of producing one thing in terms of the other
production that is foregone as a result.
ECON 202 Lecture 2
2
For example, if one medical procedure is done on a person, the opportunity cost of using
scarce medical resources for that procedure is the next best thing that those resources
could have been used for. For example, the opportunity cost of a complicated and
difficult operation might be prenatal care for a dozen pregnant women.
Now, the choice part. We will assume that when individuals or firms face situations with
scarce resources, they will choose among the goods that they can have in such as way as
to make themselves as well off as possible.
For consumers, this means maximizing utility, or the happiness that they get from
consuming the goods that they consume.
For firms, this means maximizing profits.
Even very wealthy people or very large corporations face scarcity of some things. The
wealthiest people face scarcity of time, and must decide how to best use the 24 hours they
get in a day.
If you believe that people are mostly rational and that they allocate their available
resources in such a way as to maximize their utility, then if you want to help someone the
best thing you can do for them is to give them money and let them spend it in the way
that makes them as well off as possible.
Production Possibilities Frontier and Economic Efficiency
One way of representing the idea of scarcity is with a production possibilities frontier, or
a diagram showing the set of goods that an economy can produce.
For simplification, this is usually done for an economy that produces only two good.
The prototypical example is an economy that produces only guns and butter:
ECON 202 Lecture 2
3
Points inside the frontier are inefficient in that it is possible to have more of both guns
and butter.
Points on the frontier are efficient in that it is impossible to get more of one good without
giving up some of the other. This is sometimes referred to as Pareto Efficiency, a
situation in which you cannot get more of one good without giving up some of another.
Points outside the frontier are not achievable.
The shape is explained by the idea that different people or resources have comparative
advantage in the production of guns or in the production of butter. Imagine that you start
at a point where the economy is producing only guns and no butter. As the economy
starts to produce butter, the first resources that are transferred to butter production will be
those that are most efficient at producing butter, either because they are very good at
producing butter or because they are very bad at producing guns.
In any case, the first few units of butter can be produced at a cost of very few guns. As
more and more butter is produced, however, the opportunity cost in terms of guns will
rise because inputs that have a higher and higher opportunity cost (guns foregone for
butter production).
ECON 202 Lecture 2
4
An example for an individual might be the tradeoff between having leisure and having
stuff:
The first few hours that you choose to work (moving left from maximum leisure) will be
very productive and increase the amount of stuff you produce by a great amount.
Subsequent hours of work will be less productive. To consider the extreme example, you
are likely to produce very little additional stuff by moving from 167 hours of work a
week to 168 hours of work a week.
An economy that is at a point inside its production possibilities frontier is not operating
efficiently. That is, it is not making the most of the productive resources it have
available. The book Eat the Rich by P.J. O’Rourke is about how countries either do or do
not make the most of the productive resources available to them. In the end, how wealthy
a country is seems to be much more dependent on how efficient it is rather than on the
resources it has available.
ECON 202 Lecture 2
5
The Functions of an Economy
An economy is the system by which a society decides the following:
1. What will be produced?
2. How will it be produced?
3. To whom will the good produced be allocated?
In a market economy, the goods that may be produced most profitably will be produced.
They will be produced in the lowest cost way possible and will be distributed to those
willing and able to pay the most for them.
As mentioned before, there are other ways of making these decisions, but they generally
seem to be inferior to market economies.
The Invisible Hand
The invisible hand refers to the idea that in a market economy individuals acting in their
own self-interest are most frequently guided as if by an invisible hand to also act in the
best interest of society.
The best example of this may be the myriad steps necessary to get your breakfast to you.
There was no central coordination, and a large number of individuals had to be very well
coordinated to get your food to you, but it all happened and continues to happen very
well.
Chapter 4: Supply and Demand: An Initial Look
The fundamental model of economic behavior is supply and demand.
Demand and Quantity Demanded
1. Downward sloping demand curve
2. Quantity demanded – if the price of the good changes, the quantity demanded changes
3. Shifts in demand – if something else changes, the demand changes
4. Why the marginal value curve is the demand curve
The standard picture is:
ECON 202 Lecture 2
A change in the price of the good causes a change in the quantity demanded but no
change in demand (that is, no shift in the demand curve):
A change in something else will affect the relationship between price and quantity
demanded in this market and will shift demand, causing a change in demand:
6
ECON 202 Lecture 2
7
EX. Homer goes into Moe's Tavern. Here is his marginal value schedule for beer.
Q
1
2
3
4
5
6
MV
5
4
3
2
1
0
We can graph this out and think about the relationship between marginal value (the
willingness to pay for one more unit of the good) and demand.
If the price of beer changes, we have movement along this demand curve.
If something else changes (the price of pretzels or the temperature, for example) then we
have a shift of the demand curve.
If you took macroeconomics, you may have looked specifically at two markets, the labor
market and the credit or money market.
ECON 202 Lecture 2
In the labor market, the price of labor is the wage. At some prevailing wage, some
quantity of labor will be demanded by employers. If the wage rises, less labor will be
demanded, other things being the same. If the wage falls, more labor will be demanded,
other things being the same. If employers expect to have increased demand for their
products in the near future, they may respond by hiring more labor at the prevailing
wage, thus increase the demand for labor.
In the credit market, the price of credit, borrowing, cash or liquidity is the interest rate.
At the prevailing interest rate (if this actually means anything) some amount of
borrowing will be done. If the interest rate rises or falls the quantity of borrowing
demanded will change. If, however, firms’ expectations about the future change, they
may choose to borrow more or less than they previously did, even at the same interest
rate. This would be a change in the demand for borrowing.
Supply and Quantity Supplied
1. Upward sloping supply curve
2. Quantity supplied – if the price of the good changes, the quantity supplied changes
3. Shifts in supply – if something else changes, the supply changes
4. Why the marginal cost curve is the supply curve
The standard picture is:
8
ECON 202 Lecture 2
A change in the price of the good causes a change in the quantity supplied but no change
in supply (that is, no shift in the supply curve):
A change in something else will affect the relationship between price and quantity
supplied in this market and will shift the supply curve, causing a change in supply:
9
ECON 202 Lecture 2
10
For example, anything that increases the marginal cost of supplying a good will lead to a
decrease in the supply of that good.
Market Equilibrium
Putting the supply and demand curves together in a single diagram gives us the following
icon of economics:
At the equilibrium price, P*, the quantity supplied is equal to the quantity demanded. Put
another way, at P*, the quantity that people want to buy is equal to the quantity that
people want to sell.
What happens if the price is not at P*?
If P>P*, the quantity supplied will be greater than the quantity demanded, so sellers will
have excess stuff that they will want to get rid of.
ECON 202 Lecture 2
11
If P<P*, the quantity demanded will be greater than the quantity supplied and consumers
will compete to get the scarce goods by bidding up the price.
In Class Exercise:
There are four kinds of shifts that are possible here:
1.
2.
3.
4.
Increase in demand
Increase in supply
Decrease in demand
Decrease in supply
What happens with the equilibrium price and quantity in each case?
Examples from markets:
housing
gasoline
labor markets
ECON 202 Lecture 2
12
Interference in Markets
Price ceilings and price floors cause shortages and surpluses and lead to non-price
allocation methods. These are evil.
A great example from the book is how price controls in Pennsylvania during the winter
that George Washington’s army was at Valley Forge resulted in many soldiers starving to
death because farmers refused to sell their prices at prices that they thought were unfairly
low.
Shortage and surplus are economic terms often misused by non-economists.
A shortage occurs when the quantity demanded at the prevailing market price is greater
than the quantity supplied at that price.
A surplus occurs when the quantity supplied at the prevailing market price is greater than
the quantity demanded at that price.
Please note that neither of these is an equilibrium.
Shortages and surpluses may occur in markets over short periods of time. For these
things to persist, however, there must be some sort of price control in place.
Price ceilings are restrictions on the maximum price that may be charged in a market.
These may result in shortages.
Price floors are restrictions on the minimum price that may be charged in a market.
These may result in surpluses.
A fun aspect of shortages is that someone has to figure out who gets the scarce goods
which would normally go to the person willing and able to pay the most. Some fun
alternatives include:
-queuing
-bribes to sellers
-tie-in sales
-discrimination
-selling only to friends
-exchanges for "favors"
ECON 202 Lecture 2
13
Now for some fun.
Rationing of mineral resources and fossil fuels
Our planet has on it a finite quantity of mineral resources and fossil fuels. These goods
must be rationed contemporarily (at one point in time) and this is generally done through
markets. However, these goods must also be rationed intertemporarily or across different
generations. How is this done?
Rationing of Scarce Productive Resources
One example of the evils of price controls was George Washington’s army nearly
starving to death at Valley Forge. The army might have simply gone to farms and
confiscated (a polite word for stealing) the food that they needed. How would farmers
have responded to this in the long run? How would they have re-allocated their scarce
productive resources?
ECON 202 Lecture 2
14
Rent Control and Apartments
Imagine that you are the owner of an apartment building whose rental rates are held well
below what they would be in a free market. How are you likely to change your behavior
as a result of the rent controls?