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N. Gregory Mankiw Economics Principles of Sixth Edition 4 The Market Forces of Supply and Demand © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Premium PowerPoint 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? © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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… © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 8 Demand Curve Shifters: # of Buyers Increase in # of buyers increases quantity demanded at each price, shifts D curve to the right. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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.) © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 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. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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… © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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) © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 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. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 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. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 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. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 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 © 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 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 57 EXAMPLE: The Market for Hybrid Cars P price of hybrid cars S1 P1 D1 Q1 Q quantity of hybrid cars © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 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. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 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. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 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) © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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.) © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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…. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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.” © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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… © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 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. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 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. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 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 • 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. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 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 • 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. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.