Download Unit 1 Markets _ Efficiency

N. Gregory Mankiw
Economics
Principles of
Sixth Edition
4
The Market Forces of
Supply and Demand
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Slides by
Ron Cronovich
2013 UPDATE
In this chapter,
look for the answers to these questions:
• What factors affect buyers’ demand for goods?
• What factors affect sellers’ supply of goods?
• How do supply and demand determine the price
of a good and the quantity sold?
• How do changes in the factors that affect
demand or supply affect the market price and
quantity of a good?
• How do markets allocate resources?
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1
Markets and Competition
 A market is a group of buyers and sellers of a
particular product.
 A competitive market is one with many buyers
and sellers, each has a negligible effect on price.
 In a perfectly competitive market:
 All goods exactly the same
 Buyers & sellers so numerous that no one can
affect market price—each is a “price taker”
 In this chapter, we assume markets are perfectly
competitive.
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2
Demand
 The quantity demanded of any good is the
amount of the good that buyers are willing and
able to purchase.
 Law of demand: the claim that the quantity
demanded of a good falls when the price of the
good rises, other things equal
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3
The Demand Schedule
 Demand schedule:
a table that shows the
relationship between the
price of a good and the
quantity demanded
Price Quantity
of
of lattes
lattes demanded
$0.00
16
1.00
14
2.00
12
 Example:
Helen’s demand for lattes.
3.00
10
4.00
8
 Notice that Helen’s
preferences obey the
law of demand.
5.00
6
6.00
4
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4
Helen’s Demand Schedule & Curve
Price Quantity
of
of lattes
lattes demanded
Price of
Lattes
$6.00
$0.00
16
1.00
14
$4.00
2.00
12
$3.00
3.00
10
$2.00
4.00
8
5.00
6
6.00
4
$5.00
$1.00
$0.00
0
5
10
Quantity
15 of Lattes
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5
Market Demand versus Individual Demand
 The quantity demanded in the market is the sum of the
quantities demanded by all buyers at each price.
 Suppose Helen and Ken are the only two buyers in
the Latte market. (Qd = quantity demanded)
Price
Helen’s Qd
Ken’s Qd
$0.00
16
+
8
=
24
1.00
14
+
7
=
21
2.00
12
+
6
=
18
3.00
10
+
5
=
15
4.00
8
+
4
=
12
5.00
6
+
3
=
9
6.00
4
+
2
=
6
Market Qd
The Market Demand Curve for Lattes
P
Qd
(Market)
$0.00
24
$5.00
1.00
21
$4.00
2.00
18
3.00
15
4.00
12
5.00
9
6.00
6
P
$6.00
$3.00
$2.00
$1.00
$0.00
Q
0
5
10
15
20
25
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7
Demand Curve Shifters
 The demand curve shows how price affects
quantity demanded, other things being equal.
 These “other things” are non-price determinants
of demand (i.e., things that determine buyers’
demand for a good, other than the good’s price).
 Changes in them shift the D curve…
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8
Demand Curve Shifters: # of Buyers
 Increase in # of buyers
increases quantity demanded at each price,
shifts D curve to the right.
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9
Demand Curve Shifters: # of Buyers
Suppose the number
of buyers increases.
Then, at each P,
Qd will increase
(by 5 in this example).
P
$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
Q
$0.00
0
5
10
15
20
25
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30
10
Demand Curve Shifters: Income
 Demand for a normal good is positively related
to income.
 Increase in income causes
increase in quantity demanded at each price,
shifts D curve to the right.
(Demand for an inferior good is negatively
related to income. An increase in income shifts
D curves for inferior goods to the left.)
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11
Demand Curve Shifters:
Prices of
Related Goods
 Two goods are substitutes if
an increase in the price of one
causes an increase in demand for the other.
 Example: pizza and hamburgers.
An increase in the price of pizza
increases demand for hamburgers,
shifting hamburger demand curve to the right.
 Other examples: Coke and Pepsi,
laptops and desktop computers,
CDs and music downloads
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12
Demand Curve Shifters:
Prices of
Related Goods
 Two goods are complements if
an increase in the price of one
causes a fall in demand for the other.
 Example: computers and software.
If price of computers rises,
people buy fewer computers,
and therefore less software.
Software demand curve shifts left.
 Other examples: college tuition and textbooks,
bagels and cream cheese, eggs and bacon
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13
Demand Curve Shifters: Tastes
 Anything that causes a shift in tastes toward a
good will increase demand for that good
and shift its D curve to the right.
 Example:
The Atkins diet became popular in the ’90s,
caused an increase in demand for eggs,
shifted the egg demand curve to the right.
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14
Demand Curve Shifters: Expectations
 Expectations affect consumers’ buying decisions.
 Examples:
 If people expect their incomes to rise,
their demand for meals at expensive
restaurants may increase now.
 If the economy sours and people worry about
their future job security, demand for new autos
may fall now.
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15
Summary: Variables That Influence Buyers
Variable
A change in this variable…
Price
…causes a movement
along the D curve
# of buyers
…shifts the D curve
Income
…shifts the D curve
Price of
related goods
…shifts the D curve
Tastes
…shifts the D curve
Expectations
…shifts the D curve
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16
ACTIVE LEARNING
Demand Curve
1
Draw a demand curve for music downloads.
What happens to it in each of
the following scenarios? Why?
A. The price of iPods
falls
B. The price of music
downloads falls
C. The price of CDs falls
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ACTIVE LEARNING
1
A. Price of iPods falls
Music downloads
and iPods are
complements.
Price of
music
downloads
A fall in price of
iPods shifts the
demand curve for
music downloads
to the right.
P1
D1
Q1
Q2
D2
Quantity of
music downloads
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ACTIVE LEARNING
1
B. Price of music downloads falls
Price of
music
downloads
The D curve
does not shift.
Move down along
curve to a point with
lower P, higher Q.
P1
P2
D1
Q1
Q2
Quantity of
music downloads
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ACTIVE LEARNING
1
C. Price of CDs falls
CDs and
music downloads
are substitutes.
Price of
music
downloads
A fall in price of CDs
shifts demand for
music downloads
to the left.
P1
D2
Q2
Q1
D1
Quantity of
music downloads
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Supply
 The quantity supplied of any good is the
amount that sellers are willing and able to sell.
 Law of supply: the claim that the quantity
supplied of a good rises when the price of the
good rises, other things equal
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
21
The Supply Schedule
Price
of
lattes
Quantity
of lattes
supplied
$0.00
0
1.00
3
2.00
6
 Example:
Starbucks’ supply of lattes.
3.00
9
4.00
12
 Notice that Starbucks’
supply schedule obeys the
law of supply.
5.00
15
6.00
18
 Supply schedule:
A table that shows the
relationship between the
price of a good and the
quantity supplied.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22
Starbucks’ Supply Schedule & Curve
Price
of
lattes
Quantity
of lattes
supplied
$0.00
0
1.00
3
2.00
6
$3.00
3.00
9
$2.00
4.00
12
5.00
15
6.00
18
P
$6.00
$5.00
$4.00
$1.00
$0.00
Q
0
5
10
15
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23
Market Supply versus Individual Supply
 The quantity supplied in the market is the sum of
the quantities supplied by all sellers at each price.
 Suppose Starbucks and Jitters are the only two
sellers in this market. (Qs = quantity supplied)
Market Qs
Price
Starbucks
Jitters
$0.00
0
+
0
=
0
1.00
3
+
2
=
5
2.00
6
+
4
=
10
3.00
9
+
6
=
15
4.00
12
+
8
=
20
5.00
15
+
10
=
25
6.00
18
+
12
=
30
The Market Supply Curve
P
QS
(Market)
$0.00
0
1.00
5
2.00
10
$4.00
3.00
15
$3.00
4.00
20
$2.00
5.00
25
6.00
30
P
$6.00
$5.00
$1.00
Q
$0.00
0
5
10 15
20 25 30
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35
25
Supply Curve Shifters
 The supply curve shows how price affects
quantity supplied, other things being equal.
 These “other things” are non-price determinants
of supply.
 Changes in them shift the S curve…
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26
Supply Curve Shifters: Input Prices
 Examples of input prices:
wages, prices of raw materials.
 A fall in input prices makes production
more profitable at each output price,
so firms supply a larger quantity at each price,
and the S curve shifts to the right.
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27
Supply Curve Shifters: Input Prices
Suppose the
price of milk falls.
At each price,
the quantity of
lattes supplied
will increase
(by 5 in this
example).
P
$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
Q
$0.00
0
5
10 15
20 25 30
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35
28
Supply Curve Shifters: Technology
 Technology determines how much inputs are
required to produce a unit of output.
 A cost-saving technological improvement has
the same effect as a fall in input prices,
shifts S curve to the right.
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29
Supply Curve Shifters: # of Sellers
 An increase in the number of sellers increases
the quantity supplied at each price,
shifts S curve to the right.
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30
Supply Curve Shifters: Expectations
 Example:
 Events in the Middle East lead to expectations
of higher oil prices.
 In response, owners of Texas oilfields reduce
supply now, save some inventory to sell later at
the higher price.
 S curve shifts left.
 In general, sellers may adjust supply* when their
expectations of future prices change.
(*If good not perishable)
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31
Summary: Variables that Influence Sellers
Variable
A change in this variable…
Price
…causes a movement
along the S curve
Input Prices
…shifts the S curve
Technology
…shifts the S curve
# of Sellers
…shifts the S curve
Expectations
…shifts the S curve
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
32
ACTIVE LEARNING
Supply Curve
2
Draw a supply curve for tax
return preparation software.
What happens to it in each
of the following scenarios?
A. Retailers cut the price of
the software.
B. A technological advance
allows the software to be
produced at lower cost.
C. Professional tax return preparers raise the
price of the services they provide.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
ACTIVE LEARNING
2
A. Fall in price of tax return software
Price of
tax return
software
S1
S curve does
not shift.
Move down
along the curve
to a lower P
and lower Q.
P1
P2
Q2 Q1
Quantity of tax
return software
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
ACTIVE LEARNING
2
B. Fall in cost of producing the software
Price of
tax return
software
S1
S2
S curve shifts
to the right:
at each price,
Q increases.
P1
Q1
Q2 Quantity of tax
return software
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
ACTIVE LEARNING
2
C. Professional preparers raise their price
Price of
tax return
software
S1
This shifts the
demand curve for
tax preparation
software, not the
supply curve.
Quantity of tax
return software
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Cost and the Supply Curve
 Cost is the value of everything a seller must give
up to produce a good (i.e., opportunity cost).
 Includes cost of all resources used to produce
good, including value of the seller’s time.
 Example: Costs of 3 sellers in the lawn-cutting
business.
A seller will produce and sell
name cost
the good/service only if the
Jack
$10
price exceeds his or her cost.
Janet
20
Hence, cost is a measure of
Chrissy
35
willingness to sell.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
37
Cost and the Supply Curve
Derive the supply schedule
from the cost data:
name
P
Qs
$0 – 9
0
10 – 19
1
20 – 34
2
35 & up
3
cost
Jack
$10
Janet
20
Chrissy
35
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
38
Cost and the Supply Curve
P
$40
$30
$20
$10
$0
P
Qs
$0 – 9
0
10 – 19
1
20 – 34
2
35 & up
3
Q
0
1
2
3
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
39
Cost and the Supply Curve
P
$40
Chrissy’s
cost
$30
Janet’s
cost
$20
Jack’s cost
$10
$0
Q
0
1
2
At each Q,
the height of
the S curve
is the cost of the
marginal seller,
the seller who
would leave
the market if
the price were
any lower.
3
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40
Producer Surplus
PS = P – cost
P
$40
Producer surplus (PS):
the amount a seller
is paid for a good
minus the seller’s cost
$30
$20
$10
$0
Q
0
1
2
3
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
41
Producer Surplus and the S Curve
PS = P – cost
P
$40
Chrissy’s
cost
$30
Chrissy’s PS = $0
Total PS = $20
Jack’s cost
$10
$0
Q
0
1
2
3
Jack’s PS = $15
Janet’s PS = $5
Janet’s
cost
$20
Suppose P = $25.
Total PS equals the
area above the supply
curve under the price,
from 0 to Q.
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42
PS with Lots of Sellers & a Smooth S Curve
Suppose P = $40.
Price
per pair
At Q = 15(thousand),
the marginal seller’s
cost is $30,
and her producer
surplus is $10.
P
The supply of shoes
60
S
50
40
30
1000s of pairs
of shoes
20
10
Q
0
0
5 10 15 20 25 30
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43
PS with Lots of Sellers & a Smooth S Curve
PS is the area b/w
P and the S curve,
from 0 to Q.
The height of this
triangle is
$40 – 15 = $25.
So,
PS = ½ x b x h
= ½ x 25 x $25
= $312.50
P
The supply of shoes
60
S
50
40
30
h
20
10
Q
0
0
5 10 15 20 25 30
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44
How a Lower Price Reduces PS
If P falls to $30,
PS = ½ x 15 x $15
= $112.50
60
Two reasons for
the fall in PS.
40
2. Fall in PS due to
remaining sellers
getting lower P
P
50
1. Fall in PS
due to sellers
leaving market
S
30
20
10
Q
0
0
5 10 15 20 25 30
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
45
ACTIVE LEARNING
2
Producer surplus
P
50
A. Find marginal
45
seller’s cost
40
at Q = 10.
35
B. Find total PS for
30
P = $20.
25
Suppose P rises to $30.
20
Find the increase
15
in PS due to:
10
C. selling 5
5
additional units
D. getting a higher price 0
on the initial 10 units
0
supply curve
5
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Cengage
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AllReserved.
Rights Reserved.
May notMay
be copied,
not be copied,
scanned,scanned,
or duplicated,
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in part,
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except
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use.
use.
10
15
20
Q
25
46
ACTIVE LEARNING
Answers
A. At Q = 10,
marginal cost = $20
B. PS = ½ x 10 x $20
= $100
P rises to $30.
C. PS on
additional units
= ½ x 5 x $10 = $25
D. Increase in PS
on initial 10 units
= 10 x $10 = $100
2
supply curve
P
50
45
40
35
30
25
20
15
10
5
0
0
5
© 2014 ©
Cengage
2014 Cengage
Learning.
Learning.
All Rights
AllReserved.
Rights Reserved.
May notMay
be copied,
not be copied,
scanned,scanned,
or duplicated,
or duplicated,
in wholeinorwhole
in part,
or in
except
part,for
except
use as
for use as
permitted
permitted
in a license
in a distributed
license distributed
with a certain
with a product
certain product
or service
or or
service
otherwise
or otherwise
on a password-protected
on a password-protected
website website
for classroom
for classroom
use.
use.
10
15
20
Q
25
47
Supply and Demand Together
P
$6.00
D
S
$5.00
$4.00
$3.00
Equilibrium:
P has reached
the level where
quantity supplied
equals
quantity demanded
$2.00
$1.00
$0.00
Q
0
5
10 15 20 25 30 35
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
48
Equilibrium price:
the price that equates quantity supplied
with quantity demanded
P
$6.00
D
S
P
QD
QS
$5.00
$0
24
0
$4.00
1
21
5
2
18
10
3
15
15
4
12
20
5
9
25
6
6
30
$3.00
$2.00
$1.00
$0.00
Q
0
5
10 15 20 25 30 35
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
49
Equilibrium quantity:
the quantity supplied and quantity demanded
at the equilibrium price
P
$6.00
D
S
P
QD
QS
$5.00
$0
24
0
$4.00
1
21
5
2
18
10
3
15
15
4
12
20
5
9
25
6
6
30
$3.00
$2.00
$1.00
$0.00
Q
0
5
10 15 20 25 30 35
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
50
Surplus (a.k.a. excess supply):
when quantity supplied is greater than
quantity demanded
P
$6.00
D
Surplus
Example:
If P = $5,
S
$5.00
then
QD = 9 lattes
$4.00
and
QS = 25 lattes
$3.00
$2.00
resulting in a
surplus of 16 lattes
$1.00
$0.00
Q
0
5
10 15 20 25 30 35
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
51
Surplus (a.k.a. excess supply):
when quantity supplied is greater than
quantity demanded
P
$6.00
D
$5.00
$4.00
Surplus
S
Facing a surplus,
sellers try to increase
sales by cutting price.
This causes
QD to rise and QS to fall…
$3.00
…which reduces the
surplus.
$2.00
$1.00
$0.00
Q
0
5
10 15 20 25 30 35
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
52
Surplus (a.k.a. excess supply):
when quantity supplied is greater than
quantity demanded
P
$6.00
D
$5.00
$4.00
Surplus
S
Facing a surplus,
sellers try to increase
sales by cutting price.
This causes
QD to rise and QS to fall.
$3.00
Prices continue to fall
until market reaches
equilibrium.
$2.00
$1.00
$0.00
Q
0
5
10 15 20 25 30 35
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
53
Shortage (a.k.a. excess demand):
when quantity demanded is greater than
quantity supplied
P
$6.00
S
D
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
Shortage
0
5
Example:
If P = $1,
then
QD = 21 lattes
and
QS = 5 lattes
resulting in a
shortage of 16 lattes
Q
10 15 20 25 30 35
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54
Shortage (a.k.a. excess demand):
when quantity demanded is greater than
quantity supplied
P
$6.00
S
D
$5.00
Facing a shortage,
sellers raise the price,
causing QD to fall
and QS to rise,
…which reduces the
shortage.
$4.00
$3.00
$2.00
$1.00
Shortage
$0.00
Q
0
5
10 15 20 25 30 35
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
55
Shortage (a.k.a. excess demand):
when quantity demanded is greater than
quantity supplied
P
$6.00
S
D
$5.00
Facing a shortage,
sellers raise the price,
causing QD to fall
and QS to rise.
$4.00
$3.00
Prices continue to rise
until market reaches
equilibrium.
$2.00
$1.00
Shortage
$0.00
Q
0
5
10 15 20 25 30 35
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56
Three Steps to Analyzing Changes in Eq’m
To determine the effects of any event,
1. Decide whether event shifts S curve,
D curve, or both.
2. Decide in which direction curve shifts.
3. Use supply—demand diagram to see
how the shift changes eq’m P and Q.
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57
EXAMPLE: The Market for Hybrid Cars
P
price of
hybrid cars
S1
P1
D1
Q1
Q
quantity of
hybrid cars
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58
EXAMPLE 1: A Shift in Demand
EVENT TO BE
ANALYZED:
P
Increase in price of gas.
STEP 1:
D curve shifts
because
STEP 2: price of gas
affects demand for
D shifts right
hybrids.
because
high gas
STEP
3:
S
curve
doeshybrids
not
price
makes
The shift
causes
an
shift,
because
price
more attractive
increase
in price
of
gas
does
not cars.
relative to other
and quantity
affect
cost of of
hybrid cars.
producing
hybrids.
S1
P2
P1
D1
Q1 Q2
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D2
Q
59
EXAMPLE 1: A Shift in Demand
Notice:
When P rises,
producers supply
a larger quantity
of hybrids, even
though the S curve
has not shifted.
Always be careful
to distinguish b/w
a shift in a curve
and a movement
along the curve.
P
S1
P2
P1
D1
Q1 Q2
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D2
Q
60
Terms for Shift vs. Movement Along Curve
 Change in supply: a shift in the S curve
occurs when a non-price determinant of supply
changes (like technology or costs)
 Change in the quantity supplied:
a movement along a fixed S curve
occurs when P changes
 Change in demand: a shift in the D curve
occurs when a non-price determinant of demand
changes (like income or # of buyers)
 Change in the quantity demanded:
a movement along a fixed D curve
occurs when P changes
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61
EXAMPLE 2: A Shift in Supply
EVENT: New technology
P
reduces cost of
producing hybrid cars.
S1
S2
STEP 1:
S curve shifts
because
STEP 2: event affects P1
cost of production.
P2
S shifts right
D
curve does
not
because
event
STEPbecause
3:
shift,
reduces cost,
The shift causes
production
technology
makes production
price
to
fallof the
is
not
one
more profitable at
and quantity
to rise.
factors
that
affect
any given price.
demand.
D1
Q1 Q2
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Q
62
EXAMPLE 3: A Shift in Both Supply
and Demand
EVENTS:
Price of gas rises AND
new technology reduces
production costs
STEP 1:
Both curves shift.
P
S1
S2
P2
P1
STEP 2:
Both shift to the right.
STEP 3:
Q rises, but effect
on P is ambiguous:
If demand increases more
than supply, P rises.
D1
Q1
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Q2
D2
Q
63
EXAMPLE 3: A Shift in Both Supply
and Demand
EVENTS:
price of gas rises AND
new technology reduces
production costs
P
S1
S2
STEP 3, cont.
But if supply
increases more
than demand,
P falls.
P1
P2
D1
Q1
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Q2
D2
Q
64
ACTIVE LEARNING
3
Shifts in supply and demand
Use the three-step method to analyze the effects of
each event on the equilibrium price and quantity of
music downloads.
Event A: A fall in the price of CDs
Event B: Sellers of music downloads negotiate a
reduction in the royalties they must pay
for each song they sell.
Event C: Events A and B both occur.
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ACTIVE LEARNING
3
A. Fall in price of CDs
STEPS
P
1. D curve shifts
2. D shifts left
3. P and Q both
fall.
The market for
music downloads
S1
P1
P2
D2
Q2 Q 1
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
D1
Q
ACTIVE LEARNING
3
B. Fall in cost of royalties
STEPS
1. S curve shifts
(Royalties are part
2. S shifts right
of sellers’ costs)
P1
3. P falls,
P2
Q rises.
P
The market for
music downloads
S1
S2
D1
Q1 Q2
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Q
ACTIVE LEARNING
3
C. Fall in price of CDs and
fall in cost of royalties
STEPS
1. Both curves shift (see parts A & B).
2. D shifts left, S shifts right.
3. P unambiguously falls.
Effect on Q is ambiguous:
The fall in demand reduces Q,
the increase in supply increases Q.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
CS, PS, and Total Surplus
CS = (value to buyers) – (amount paid by buyers)
= buyers’ gains from participating in the market
PS = (amount received by sellers) – (cost to sellers)
= sellers’ gains from participating in the market
Total surplus = CS + PS
= total gains from trade in a market
= (value to buyers) – (cost to sellers)
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69
The Market’s Allocation of Resources
 In a market economy, the allocation of resources
is decentralized, determined by the interactions
of many self-interested buyers and sellers.
 Is the market’s allocation of resources desirable?
Or would a different allocation of resources make
society better off?
 To answer this, we use total surplus as a measure
of society’s well-being, and we consider whether
the market’s allocation is efficient.
(Policymakers also care about equality, though our
focus here is on efficiency.)
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70
Efficiency
Total
= (value to buyers) – (cost to sellers)
surplus
An allocation of resources is efficient if it maximizes
total surplus. Efficiency means:
 The goods are consumed by the buyers who
value them most highly.
 The goods are produced by the producers with the
lowest costs.
 Raising or lowering the quantity of a good
would not increase total surplus.
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71
Evaluating the Market Equilibrium
Market eq’m:
P = $30
Q = 15,000
P
60
Total surplus
= CS + PS
50
Is the market eq’m
efficient?
30
S
40
CS
PS
20
10
D
Q
0
0
5 10 15 20 25 30
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72
Which Buyers Consume the Good?
Every buyer
whose WTP is
≥ $30 will buy.
Every buyer
whose WTP is
< $30 will not.
So, the buyers
who value the
good most highly
are the ones who
consume it.
P
60
S
50
40
30
20
10
D
Q
0
0
5 10 15 20 25 30
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73
Which Sellers Produce the Good?
Every seller whose
cost is ≤ $30 will
produce the good.
Every seller whose
cost is > $30 will
not.
So, the sellers with
the lowest cost
produce the good.
P
60
S
50
40
30
20
10
D
Q
0
0
5 10 15 20 25 30
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74
Does Eq’m Q Maximize Total Surplus?
At Q = 20,
cost of producing
the marginal unit
is $35
P
60
S
50
value to consumers
of the marginal unit
is only $20
40
Hence, can increase
total surplus
by reducing Q.
20
This is true at any Q
greater than 15.
0
30
10
D
Q
0
5 10 15 20 25 30
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75
Does Eq’m Q Maximize Total Surplus?
At Q = 10,
cost of producing
the marginal unit
is $25
P
60
S
50
value to consumers
of the marginal unit
is $40
40
Hence, can increase
total surplus
by increasing Q.
20
This is true at any Q
less than 15.
0
30
10
D
Q
0
5 10 15 20 25 30
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76
Does Eq’m Q Maximize Total Surplus?
The market
eq’m quantity
maximizes
total surplus:
At any other
quantity,
can increase
total surplus by
moving toward
the market eq’m
quantity.
P
60
S
50
40
30
20
10
D
Q
0
0
5 10 15 20 25 30
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77
Adam Smith and the Invisible Hand
Passages from The Wealth of Nations, 1776
Adam Smith,
1723-1790
“Man has almost constant occasion
for the help of his brethren, and it is
vain for him to expect it from their
benevolence only. He will be more
likely to prevail if he can interest their
self-love in his favor, and show them
that it is for their own advantage to do
for him what he requires of them…
It is not from the benevolence of the
butcher, the brewer, or the baker that
we expect our dinner, but from their
regard to their own interest….
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78
Adam Smith and the Invisible Hand
Passages from The Wealth of Nations, 1776
Adam Smith,
1723-1790
“Every individual…neither intends to
promote the public interest, nor knows
how much he is promoting it….
He intends only his own gain, and he is
in this, as in many other cases, led by
an invisible hand to promote an end
which was no part of his intention.
Nor is it always the worse for the society
that it was no part of it. By pursuing his
own interest he frequently promotes
that of the society more effectually than
when he really intends to promote it.”
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79
The Free Market vs. Govt Intervention
 The market equilibrium is efficient. No other
outcome achieves higher total surplus.
 Govt cannot raise total surplus by changing the
market’s allocation of resources.
 Laissez faire (French for “allow them to do”):
the notion that govt should not interfere with the
market.
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80
The Free Market vs. Central Planning
 Suppose resources were allocated not by the
market, but by a central planner who cares about
society’s well-being.
 To allocate resources efficiently and maximize total
surplus, the planner would need to know every
seller’s cost and every buyer’s WTP for every good
in the entire economy.
 This is impossible, and why centrally-planned
economies are never very efficient.
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81
CONCLUSION
 This chapter used welfare economics to
demonstrate one of the Ten Principles:
Markets are usually a good way to
organize economic activity.
 Important note:
We derived these lessons assuming
perfectly competitive markets.
 In other conditions we will study in later
chapters, the market may fail to allocate
resources efficiently…
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
82
CONCLUSION
 Such market failures occur when:
 a buyer or seller has market power—the ability to
affect the market price.
 transactions have side effects, called externalities,
that affect bystanders. (example: pollution)
 We’ll use welfare economics to see how public policy
may improve on the market outcome in such cases.
 Despite the possibility of market failure, the analysis
in this chapter applies in many markets, and the
invisible hand remains extremely important.
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83
CONCLUSION:
How Prices Allocate Resources
 One of the Ten Principles from Chapter 1:
Markets are usually a good way
to organize economic activity.
 In market economies, prices adjust to balance
supply and demand. These equilibrium prices
are the signals that guide economic decisions
and thereby allocate scarce resources.
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84
S U MMA RY
• A competitive market has many buyers and
sellers, each of whom has little or no influence
on the market price.
• Economists use the supply and demand model
to analyze competitive markets.
• The downward-sloping demand curve reflects
the law of demand, which states that the quantity
buyers demand of a good depends negatively
on the good’s price.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
S U MMA RY
• Besides price, demand depends on buyers’ incomes,
tastes, expectations, the prices of substitutes and
complements, and number of buyers.
If one of these factors changes, the D curve shifts.
• The upward-sloping supply curve reflects the Law of
Supply, which states that the quantity sellers supply
depends positively on the good’s price.
• Other determinants of supply include input prices,
technology, expectations, and the # of sellers.
Changes in these factors shift the S curve.
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S U MMA RY
• The intersection of S and D curves determines
the market equilibrium. At the equilibrium price,
quantity supplied equals quantity demanded.
• If the market price is above equilibrium,
a surplus results, which causes the price to fall.
If the market price is below equilibrium,
a shortage results, causing the price to rise.
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S U MMA RY
• We can use the supply-demand diagram to
analyze the effects of any event on a market:
First, determine whether the event shifts one or
both curves. Second, determine the direction of
the shifts. Third, compare the new equilibrium to
the initial one.
• In market economies, prices are the signals that
guide economic decisions and allocate scarce
resources.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.