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Chapter 2: Observing and Explaining the Economy
Overview:
If people are left to choose for themselves what to consume and produce, what will society consume and produce? In this
chapter, you will be introduced to the most important tool that economists have developed to answer this question. This is the
market model of supply and demand. It starts with a description of buyers’ behavior and a description of sellers’ behavior and
shows how their choices respond to changes in the economic environment. We will learn that neither buyers alone nor sellers
alone, but both together, determine how much will be bought and sold and what the selling price will be. We will also see that
when buyers and sellers respond to changes in the economic environment, the quantity bought and sold and the price are likely
to change too. In this way, a price change signals to consumers and suppliers that something important has happened in the
economy. This provides them with an incentive to make an adjustment to their new circumstances. Finally, we will see that
interfering with the interaction of buyers and sellers in the marketplace, even with the best of intentions, can frequently make
things worse.
Review:
1. Economics is concerned with explaining how people behave. To understand how buyers and sellers interact with
each other, we need three things: a description of buyers’ behavior, a description of sellers’ behavior, and a
description of how they deal with each other.
2. The term demand describes the relationship between the price of a particular good and the amount of that good
that consumers want to buy, which is called quantity demanded. It is important to distinguish between these two
concepts. Quantity demanded is an amount; it is measured in pounds, or gallons, or haircuts; and it is determined
by price. Demand is a relationship (a function, in mathematical terms); it gives an amount for each possible price,
not a single amount for a single price.
3. The demand relationship can be represented in several ways. One is in the form of a table of numbers that gives
the amount that consumers want to buy (quantity demanded) at different prices; this presentation is called
a demand schedule. Another is in the form of a graph of the amounts that consumers want to buy (quantity
demanded) at different prices; this is called a demand curve.When graphing a demand curve, it is important to
put the quantity demanded on the horizontal axis and the price on the vertical axis.
4. The law of demand says that the demand relationship is a negative relationship; that is, the amount of a good that
people wish to buy (the quantity demanded) goes down as the price goes up, all other things being equal. More
people will buy, and those who are buying will buy more, at lower prices because at the lower price the good
looks more attractive compared to the alternatives than it did before and because people are better able to
purchase the good. Remember the ceteris paribus condition, however. If other variables are changing at the same
time that the price is falling, you cannot tell what the relationship is between price and the amount that people
want to buy.
5. Changes in other variables that affect the amount that people want to buy lead to a shift in demand. That is, they
change the amount that people want to buy (quantity demanded) at each and every price. This is seen in the
demand graph as a shift in the curve to the right or to the left and is called a change in demand. Among the most
important variables that can shift the demand for a product are consumers’ preferences, consumers’ information,
consumers’ incomes, the number of consumers in the market, consumers’ expectations of future prices, and the
price of related goods.
6. Changes in consumers’ preferences can clearly change the amount that people want to buy. If consumers decide
that a product is more or less desirable, they will obviously want to buy more or less of it at each price. Be careful
to distinguish this effect from consumers’ desire to buy more when the price falls. In that case, their tastes have
not changed (and the demand curve has not shifted); instead, consumers now find it more affordable to indulge
their tastes.
7. When people learn more about a good, they may change the amount that they want to buy at every price.
Additional information about the benefits of a good will increase demand for it, and additional information about
the harm from consuming a good will reduce demand for it.
8. When consumers’ incomes increase, they can afford to buy more things, and demand for most goods will
increase. These goods are called normal goods. However, the demand for inferior goods will decrease when
consumers become richer and can afford better goods. For example, students with low incomes may buy a lot of
ramen noodles because they are a low-cost food. When these students graduate and start full-time jobs, they may
buy less ramen and more pizza (or steak if they get a really good job). In that case, ramen is an inferior good,
whereas pizza is a normal good.
9. Since demand is the relationship between the price of a good and the quantity demanded that all consumers want
to buy, a change in the number of consumers is likely to change the amount that people want to buy at many
prices. Therefore, the demand curve shifts when the number of consumers changes.
10. The demand for a good will shift when the price of a substitute good changes. If the substitute becomes less
expensive, it becomes relatively more attractive, and some consumers will switch. For example, if the price of
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crab falls and all other things remain equal, consumers as a group (although perhaps not every consumer) will
want to buy less lobster. If the price of Corvettes increases and all other things remain equal, then consumers will
want to buy more Camaros. Generally, demand for a good increases when the price of a substitute rises, and
demand for a good decreases when the price of a substitute falls. The demand for a good is also shifted by
changes in the price of a complement, a good that tends to be consumed together with another good. For
example, if the price of playing a round of golf rises, the demand for golf carts will be reduced. If the price of
coffee falls, the demand for coffee creamer increases. Generally, demand for a good decreases when the price of a
complement rises, and demand for a good increases when the price of a complement falls.
Finally, demand will also respond to consumers’ expectations of changes in the price of that good and of changes
in other variables. For example, if consumers think they will be wealthier in the near future, they will start making
additional purchases right now. Think about the graduating senior who just got that great job offer; isn’t she
already driving a new car? Similarly, if people believe that the price of something is going to change, their
demand for it may change right away. For example, in December 1973, Johnny Carson’s monologue joke on
the Tonight show about the possibility of a toilet paper shortage led to such a large increase in the demand for
toilet paper that in some places it really did become hard to find. (OK, so you probably don’t know who Johnny
Carson was. He was the Jay Leno of your parents’ generation).
Changes in variables other than the price of the good in question shift the demand curve for that good. Changes in
the price of the good in question, all other things being equal, result in consumers moving along the demand
curve, but don’t shift the demand curve. This is an important distinction to draw; don’t confuse the two.
The term supply describes the relationship between the price of a good and the amount of that good that firms are
willing to sell, which is called quantity supplied. As with demand, it is important to distinguish between these
two concepts. Quantity supplied is an amount; it is measured in tons, or barrels, or shirts cleaned. Supply is
a relationship or function; it gives an amount for each possible price, not a single amount.
Like the demand relationship, the supply relationship can be represented in several ways. One is in the form of a
table of numbers that gives the amount that firms are willing and able to sell (quantity supplied) at different
prices; this presentation is called a supply schedule. Another is in the form of a graph of the amount that firms are
willing to sell (quantity supplied) at different prices; this is called a supply curve. When graphing a supply curve,
it is important to put the quantity supplied on the horizontal axis and the price on the vertical axis.
The law of supply says that all other things being equal, the higher the price, the more firms will be willing to
supply. Thus, the price and the quantity supplied are positively related. More firms will wish to sell and the firms
that are selling will wish to sell more when the price rises because producing this product looks more profitable
than the alternatives. Again, remember the ceteris paribuscondition; if other variables that affect the amount that
firms wish to sell are changing at the same time that the price is changing, the quantity supplied can either rise or
fall.
When other variables that affect the amount that producers are willing and able to sell change, this leads to
a shift in the supply curve. That is, those changes alter the amount that firms are willing to sell (quantity supplied)
at each and every price. Among the most important variables that can shift the supply of a product are technology;
the price of goods used in production; the number of firms in the market; expectations of future
prices; and government taxes, subsidies, and regulations.
Technology refers to the ability to utilize other goods in order to produce the good or service. This can mean
being able to utilize a chair, scissors, and someone’s time and skill to produce a haircut, or being able to utilize
complex equipment, silicon, and many people’s time and skills to produce microchips. When knowledge
improves in such a way that producers can produce the same amount of a good with fewer inputs, the cost of
producing that good falls. Producing it becomes more attractive, all other things being equal, and the quantity
supplied will increase at each and every price.
For some goods, a change in the weather can lead to a shift in the supply curve. For example, it is harder to grow
bananas if the weather is unusually cold, and easier to grow wine grapes if the weather is hot and dry (but not too
hot or too dry). Changes in weather are like changes in technology; they affect the amount that can be produced
(quantity supplied) with given inputs, at each and every price.
Similarly, if the price of the goods used in the production of a good falls, then the cost of producing that good
falls. Again, producing that good becomes more profitable, all other things being equal, and firms will wish to sell
more of it. This results in a rightward shift of the supply curve. Conversely, if the price of one or more inputs used
in producing something rises, then firms will find it less profitable to produce that good and will be willing to sell
less at each and every price, shifting the entire supply curve to the left.
Since the supply curve shows the amount that all of the producers together are willing to supply at different
prices, an increase in the number of suppliers will increase that total and shift the supply curve to the right.
Conversely, a decline in the number of sellers will reduce the total amount offered for sale at each and every
price. This would lead to a leftward shift of the supply curve.
If firms expect that the price of their output is going to increase in the future, they will wish to delay selling their
output until that price increase occurs. This results in less being offered for sale at any current price and a leftward
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shift of the supply curve. If the price of the goods that they sell is expected to fall in the future, sellers will want to
sell more now; this increases supply and shifts the supply curve to the right.
Taxes imposed by the government raise firms’ costs of production and, like increases in input prices, make selling
the product less attractive. Subsidies to producers, on the other hand, lower the costs of production and make sales
more attractive. Thus, taxes shift the supply curve to the left (decreasing supply), and subsidies shift the supply
curve to the right (increasing supply). Government regulations can also increase the costs of production—for
example, by requiring the installation of pollution control equipment or additional safety testing of the product.
These regulations will have the effect of decreasing supply.
As with the demand curve, it is important to distinguish shifts of the supply curve from movements along the
supply curve. Changes in variables other than the price of the good in question shift the supply curve for that
good. Changes in the price of the good in question, all other things being equal, result in a movement along the
supply curve but do not shift the supply curve.
The demand curve describes how much consumers want to purchase at different prices, and the supply curve
describes how much producers want to sell at different prices. In order to determine how much of a good actually
gets bought (and sold), we need to understand how these two groups interact with each other. Economists believe
that when consumers and producers get together, they will put pressure on the price that brings it to the level at
which the amount that consumers want to purchase is just the amount that producers want to sell. This situation is
called an equilibrium, because the quantity supplied and the quantity demanded are in balance. How much will be
traded and the price at which those purchases take place can be determined from the numbers in the supply and
demand schedules, or from a diagram that includes both the supply curve and the demand curve.
A shortage of a good occurs when, at the current price, consumers want to purchase more of the good than
producers want to sell; the quantity demanded exceeds the quantity supplied at the current price in the market. In
that case, we would expect some producers to take advantage of the situation by trying to get more from those
who want to buy, and those consumers who are willing to pay more to try to outbid other consumers. This will
cause the price to rise. Some consumers will decide that they are no longer willing to buy at the higher prices, and
some producers will decide that they are willing to sell more at the higher prices. Eventually, the price increases
will bring the quantity supplied and the quantity demanded together, and there will be no further upward pressure
on the price.
A surplus of a good, on the other hand, occurs when producers want to sell more units of the good than
consumers want to purchase at the current price; the quantity supplied exceeds the quantity demanded. When
there is a surplus, we would expect producers to start lowering the price to get their products sold. The surplus
results in a falling price, which will cause some producers to decide that they no longer want to sell as much and
some consumers to decide that they want to buy more. When the price falls to a level at which the quantity
supplied equals the quantity demanded, there will be no further downward pressure on the price.
Market equilibrium is a situation with neither upward nor downward pressure on the price. This occurs when the
quantity supplied equals the quantity demanded at the current price. We call this price the equilibrium price, and
the quantity that gets bought and sold at that price the equilibrium quantity. If we have the supply and demand
schedules for a good, we can find the equilibrium price by finding the price at which the quantity supplied equals
the quantity demanded. If we have a supply and demand diagram that graphs the same information, we can find
the equilibrium price and equilibrium quantity by finding where the supply curve and the demand curve cross.
Look over to the vertical axis from the point at which the curves cross to find the equilibrium price, and look
down to the horizontal axis from that point to find the equilibrium quantity.
Suppose a market is in equilibrium, and one or more of the variables that affect supply and demand change. As a
result, either the demand curve or the supply curve or both will shift. At the original equilibrium price, there will
now be either a shortage or a surplus (depending on which way the curves have shifted and by how much), and
pressure on the price will lead to a new equilibrium price and quantity. For example, if an increase in income
leads to an increase (rightward shift) in demand, then there will be a shortage at the original equilibrium price, and
the price will be forced up to a new equilibrium. A decrease in input prices leading to an increase (rightward shift)
in supply will cause a surplus at the original equilibrium price, and the price will fall until a new equilibrium is
reached. In this way, the equilibrium price and quantity respond to changes in variables that affect consumers’
demand and producers’ supply.
I - Chapter 2 “Observing and Explaining the Economy” Internet Exercises:
Exercise 1: Concert Ticket Pricing
Visit www.stubhub.com. Compare this to the original price of a ticket to this event (you can find most
event prices at Ticketmaster [http://www.ticketmaster.com]).
Questions:
a. Which ticket did you select? List the original price and the resale price of the ticket for the
concert that you selected.
b. Was the original price an equilibrium price? How can you explain the difference between the
original price and the resale price?
c. Would the same price differential exist if the concert had not sold out? For concerts that do not
sell out, what can be said about the original price (i.e., was the original price at, below, or above
the equilibrium price?
Exercise 2: Hurricanes and Market Prices
Questions:
Read the WikiNews article on the effect of Hurricane Katrina on oil
prices[http://en.wikinews.org/wiki/Hurricane_Katrina_causes_upwards_of_$12bn_of_damage%3B_oil_p
rices_surge] and the transcript of the PBS broadcast on the effect of Hurricane Katrina on oil and lumber
prices. [http://www.pbs.org/nbr/site/onair/transcripts/050829_oil]
a. Draw a demand and supply diagram to illustrate the effect of the loss in refining capacity on
gasoline prices.
b. Use a demand and supply diagram to illustrate the effects of a hurricane on lumber prices.
Exercise 3: Computer Prices Over Time
Question:
Examine Chapter 3 of the CBO report on The Role of Computer Technology in the Growth of
Productivity. [http://www.cbo.gov/showdoc.cfm?index=3448&sequence=4]Draw a demand and supply
diagram to illustrate the effect of technological improvements in computer manufacturing on the
equilibrium price and quantity of computers.
II - Chapter 3 W.I.R.E.D. Activities: The Supply and Demand Model
These Economics W.I.R.E.D. activities recommend web links that relate to key concepts of each chapter
of the textbook. For each link, there are instructions to guide you to specific information, followed by
several discussion questions or exercises.
Key Concepts: Demand, Supply, and Market Equilibrium: Combining Supply and Demand
1. ) E*TRADE
Enter "MSFT" for Microsoft Corporation or "Yhoo" for Yahoo! in the "Quotes" box. Review the Quote
information for the selected stock.
1) What factors "determine" your decision to purchase (demand) or sell (supply) any given stocks?
2) Explain how some traders might try to use the bid size and ask size to measure impending short
term upward or downward pressure on the stock's price.
3) Review the 1 or 3 month "Chart" (e.g. price movement) and "News" information for the selected
stock. Identify specific news that may have "shifted" its demand or supply curve.
2.) Hollywood Star Exchange
Review the home page information and select the "movies" link. Examine the current "box office"
information at the bottom of the screen.
1) Identify potential factors that may determine the current value or Hollywood Price (H$) for
selected movies.
2) Why do movie studios spend millions of dollars on advertising prior to the opening of their
movies?
III - Chapter 3 Practice Tests
http://college.cengage.com/economics/taylor/economics/6e/assets/students/ace/index.html?layer=act&src
=workflow_ace3.xml