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Review of last week’s lecture Production possibilities and opportunity cost Productive and allocative efficiency Gains from trade © 2010 Pearson Education Canada Review - Production possibilities and opportunity cost Simple model that illustrates • Scarcity • Trade-offs and opportunity cost • Productive efficiency © 2010 Pearson Education Canada Production Possibilities Curve assumptions Two goods: cola and pizza Fixed resources Fixed technology Efficiency - the economy is achieving maximum production © 2010 Pearson Education Canada Production Possibilities and Opportunity Cost Production Possibilities Frontier Any point on the frontier such as E and any point inside the PPF such as Z are attainable. Points outside the PPF are unattainable. © 2010 Pearson Education Canada Production Possibilities and Opportunity Cost Any point inside the frontier, such as Z, is inefficient. At such a point, it is possible to produce more of one good without producing less of the other good. At Z, resources are either unemployed or misallocated. © 2010 Pearson Education Canada Production Possibilities and Opportunity Cost Production Efficiency We achieve production efficiency if we cannot produce more of one good without producing less of some other good. Points on the frontier are efficient. © 2010 Pearson Education Canada Production Possibilities and Opportunity Cost Tradeoff Along the PPF Every choice along the PPF involves a tradeoff. On this PPF, we must give up some cola to get more pizzas or give up some pizzas to get cola. © 2010 Pearson Education Canada Production Possibilities and Opportunity Cost Opportunity Cost As we move down along the PPF, we produce more pizzas, but the quantity of cola we can produce decreases. The opportunity cost of a pizza is the cola forgone. © 2010 Pearson Education Canada Production Possibilities and Opportunity Cost Note that the opportunity cost of a can of cola is the inverse of the opportunity cost of a pizza. One pizza costs 5 cans of cola. One can of cola costs 1/5 of a pizza. © 2010 Pearson Education Canada Allocative efficiency At all the points along the PPF, we attain production efficiency. As we move from one point on the PPF to another, we get more of some good and less of the other. What attainable combination is best? We want to choose the most highly valued combination. This depends on preferences, as well as costs. © 2010 Pearson Education Canada Allocative efficiency If we move from E to F, we give up 5 cans of cola and gain one pizza. If we value one more pizza more than we value the 5 cans of cola, this is a good move. If we value the 5 cans of cola more than we value one more pizza, this is a bad move. © 2010 Pearson Education Canada Allocative efficiency Is Point E preferred to point F? Depends both on: (1) How many cans of cola we have to give up (2) how many cans of cola we would be willing to give up © 2010 Pearson Education Canada Allocative efficiency The Marginal Cost of pizza is the number of cans of cola that we have to give up to get one more pizza The Marginal Benefit of pizza is the number of cans of cola that we would be willing to give up to get one more pizza (the value of something is what we are willing to give up to get it) Starting at any point on the PPF, if: MC of pizza < MB of pizza produce more pizza MC of pizza > MB of pizza produce less pizza MC of pizza = MB of pizza efficient (all resources are allocated to their most highly valued use) © 2010 Pearson Education Canada Using Resources Efficiently Figure 2.4 illustrates allocative efficiency. The point of allocative efficiency is the point on the PPF at which marginal benefit equals marginal cost. This point is determined by the quantity at which the marginal benefit curve intersects the marginal cost curve. © 2010 Pearson Education Canada Gains from Trade Gains from trade arise when: • individuals (groups, nations) specialize in the production of goods in which they have a comparative advantage • and trade to obtain the other good Trade can occur at any price that lies between the individuals’ opportunity costs © 2010 Pearson Education Canada Gains from Trade Figure 2.6 shows the gains from trade. Joe initially produces at point A on his PPF. Liz initially produces at point A on her PPF. © 2010 Pearson Education Canada Gains from Trade Joe’s opportunity cost of producing a salad is less than Liz’s. So Joe has a comparative advantage in producing salad. © 2010 Pearson Education Canada Gains from Trade Liz’s opportunity cost of producing a smoothie is less than Joe’s. So Liz has a comparative advantage in producing smoothies. © 2010 Pearson Education Canada Gains from Trade Joe specializes in producing salad and he produces 30 salads an hour at point B on his PPF. © 2010 Pearson Education Canada Gains from Trade Liz specializes in producing smoothies and produces 30 smoothies an hour at point B on her PPF. © 2010 Pearson Education Canada Gains from Trade They trade salads for smoothies along the red ―Trade line.‖ The price of a salad is 2 smoothies or the price of a smoothie is ½ of a salad. © 2010 Pearson Education Canada Gains from Trade Joe buys smoothies from Liz and moves to point C—a point outside his PPF. Liz buys salads from Joe and moves to point C—a point outside her PPF. © 2010 Pearson Education Canada Unfinished business from last week’s lecture – Economic coordination The economy is made up of a huge number of individuals and firms making decentralized decisions How are these decisions coordinated in order to ensure that the gains from trade are realized? To make coordination work, four complimentary social institutions have evolved over the centuries: Firms Markets Property rights Money © 2010 Pearson Education Canada Economic Coordination A firm is an economic unit that hires factors of production and organizes those factors to produce and sell goods and services. A market is any arrangement that enables buyers and sellers to get information and do business with each other. Property rights are the social arrangements that govern ownership, use, and disposal of resources, goods or services. Money is any commodity or token that is generally acceptable as a means of payment. © 2010 Pearson Education Canada Economic Coordination Circular Flows Through Markets Figure 2.7 illustrates how households and firms interact in the market economy. Factors of production and goods and services flow in one direction. Money flows in the opposite direction. © 2010 Pearson Education Canada Economic Coordination Coordinating Decisions Markets coordinate individual decisions through price adjustments. © 2010 Pearson Education Canada How does a market economy solve the coordinating problem? What, how and for whom? 1. How is it determined what and how much will be produced? Firms that produce the wrong stuff will lose money and contract or close. Firms that produce the right stuff will be highly profitable and expand. © 2010 Pearson Education Canada How does a market economy solve the coordinating problem? 2. How is it determined how output will be produced? Firms that find the least costly ways of combining productive inputs will be able to sell the good most profitably and will expand. © 2010 Pearson Education Canada How does a market economy solve the coordinating problem? 3. How is it determined who is to receive the output that is produced? Will talk about this in depth, but distribution of consumer goods is determined by willingness and abililty to pay for them in a market system. © 2010 Pearson Education Canada Overview of this week’s lecture Supply and demand How are prices and quantities determined through market exchange? © 2010 Pearson Education Canada Markets and Prices A market is any arrangement that enables buyers and sellers to get information and do business with each other. A competitive market is a market that has many buyers and many sellers so no single buyer or seller can influence the price. The money price of a good is the amount of money needed to buy it. The relative price of a good—the ratio of its money price to the money price of the next best alternative good—is its opportunity cost. © 2010 Pearson Education Canada Demand If you demand something, then you 1. Want it, 2. Can afford it, and 3. Have made a definite plan to buy it. Wants are the unlimited desires or wishes people have for goods and services. Demand reflects a decision about which wants to satisfy. The quantity demanded of a good or service is the amount that consumers plan to buy during a particular time period, and at a particular price. © 2010 Pearson Education Canada Demand The Law of Demand The law of demand states: Other things remaining the same, the higher the price of a good, the smaller is the quantity demanded; and the lower the price of a good, the larger is the quantity demanded. The law of demand results from Substitution effect Income effect © 2010 Pearson Education Canada Demand Substitution effect When the relative price (opportunity cost) of a good or service rises, people seek substitutes for it, so the quantity demanded of the good or service decreases. Income effect When the price of a good or service rises relative to income, people cannot afford all the things they previously bought, so the quantity demanded of the good or service decreases. © 2010 Pearson Education Canada Demand Demand Curve and Demand Schedule The term demand refers to the entire relationship between the price of the good and quantity demanded of the good. A demand curve shows the relationship between the quantity demanded of a good and its price when all other influences on consumers’ planned purchases remain the same. © 2010 Pearson Education Canada Demand Figure 3.1 shows a demand curve for energy bars. A rise in the price, other things remaining the same, brings a decrease in the quantity demanded and a movement along the demand curve. © 2010 Pearson Education Canada Demand Willingness and Ability to Pay A demand curve is also a willingness-and-ability-topay curve. The smaller the quantity available, the higher is the price that someone is willing to pay for another unit. Willingness to pay measures marginal benefit. © 2010 Pearson Education Canada Demand A Change in Demand When some influence on buying plans other than the price of the good changes, there is a change in demand for that good. The quantity of the good that people plan to buy changes at each and every price, so there is a new demand curve. When demand increases, the demand curve shifts rightward. When demand decreases, the demand curve shifts leftward. © 2010 Pearson Education Canada Demand Six main factors that change demand are The prices of related goods Expected future prices Income Expected future income and credit Population Preferences © 2010 Pearson Education Canada Demand Prices of Related Goods A substitute is a good that can be used in place of another good. A complement is a good that is used in conjunction with another good. When the price of substitute for an energy bar rises or when the price of a complement of an energy bar falls, the demand for energy bars increases. © 2010 Pearson Education Canada Demand Expected Future Prices If the price of a good is expected to rise in the future, current demand for the good increases and the demand curve shifts rightward. Income When income increases, consumers buy more of most goods and the demand curve shifts rightward. A normal good is one for which demand increases as income increases. An inferior good is a good for which demand decreases as income increases. © 2010 Pearson Education Canada Demand Expected Future Income and Credit When income is expected to increase in the future or when credit is easy to obtain, the demand might increase now. Population The larger the population, the greater is the demand for all goods. Preferences People with the same income have different demands if they have different preferences. © 2010 Pearson Education Canada Demand Figure 3.2 shows an increase in demand. Because an energy bar is a normal good, an increase in income increases the demand for energy bars. © 2010 Pearson Education Canada Demand A Change in the Quantity Demanded Versus a Change in Demand Figure 3.3 illustrates the distinction between a change in demand and a change in the quantity demanded. © 2010 Pearson Education Canada Demand A Movement along the Demand Curve When the price of the good changes and everything else remains the same, the quantity demanded changes and there is a movement along the demand curve. © 2010 Pearson Education Canada Demand A Shift of the Demand Curve If the price remains the same but one of the other influences on buyers’ plans changes, demand changes and the demand curve shifts. © 2010 Pearson Education Canada Supply If a firm supplies a good or service, then the firm 1. Has the resources and the technology to produce it, 2. Can profit from producing it, and 3. Has made a definite plan to produce and sell it. Resources and technology determine what it is possible to produce. Supply reflects a decision about which technologically feasible items to produce. The quantity supplied of a good or service is the amount that producers plan to sell during a given time period at a particular price. © 2010 Pearson Education Canada Supply The Law of Supply The law of supply states: Other things remaining the same, the higher the price of a good, the greater is the quantity supplied; and the lower the price of a good, the smaller is the quantity supplied. The law of supply results from the general tendency for the marginal cost of producing a good or service to increase as the quantity produced increases Producers are willing to supply a good only if they can at least cover their marginal cost of production. © 2010 Pearson Education Canada Supply Supply Curve and Supply Schedule The term supply refers to the entire relationship between the quantity supplied and the price of a good. The supply curve shows the relationship between the quantity supplied of a good and its price when all other influences on producers’ planned sales remain the same. © 2010 Pearson Education Canada Supply Figure 3.4 shows a supply curve of energy bars. A rise in the price of an energy bar, other things remaining the same, brings an increase in the quantity supplied. © 2010 Pearson Education Canada Supply Minimum Supply Price A supply curve is also a minimum-supply-price curve. As the quantity produced increases, marginal cost increases. The lowest price at which someone is willing to sell an additional unit rises. This lowest price is marginal cost. © 2010 Pearson Education Canada Supply A Change in Supply When some influence on selling plans other than the price of the good changes, there is a change in supply of that good. The quantity of the good that producers plan to sell changes at each and every price, so there is a new supply curve. When supply increases, the supply curve shifts rightward. When supply decreases, the supply curve shifts leftward. © 2010 Pearson Education Canada Supply The five main factors that change supply of a good are The prices of factors of production The prices of related goods produced Expected future prices The number of suppliers Technology State of nature © 2010 Pearson Education Canada Supply Prices of Factors of Production If the price of a factor of production used to produce a good rises, the minimum price that a supplier is willing to accept for producing each quantity of that good rises. So a rise in the price of a factor of production decreases supply and shifts the supply curve leftward. © 2010 Pearson Education Canada Supply Prices of Related Goods Produced A substitute in production for a good is another good that can be produced using the same resources. The supply of a good increases if the price of a substitute in production falls. Goods are complements in production if they must be produced together. The supply of a good increases if the price of a complement in production rises. © 2010 Pearson Education Canada Supply Expected Future Prices If the price of a good is expected to rise in the future, supply of the good today decreases and the supply curve shifts leftward. The Number of Suppliers The larger the number of suppliers of a good, the greater is the supply of the good. An increase in the number of suppliers shifts the supply curve rightward. © 2010 Pearson Education Canada Supply Technology Advances in technology create new products and lower the cost of producing existing products, so advances in technology increase supply and shift the supply curve rightward. The State of Nature The state of nature includes all the natural forces that influence production—for example, the weather. A natural disaster decreases supply and shifts the supply curve leftward. © 2010 Pearson Education Canada Supply Figure 3.5 shows an increase in supply. An advance in the technology for producing energy bars increases the supply of energy bars and shifts the supply curve rightward. © 2010 Pearson Education Canada Supply A Change in the Quantity Supplied Versus a Change in Supply Figure 3.6 illustrates the distinction between a change in supply and a change in the quantity supplied. © 2010 Pearson Education Canada Supply A Movement Along the Supply Curve When the price of the good changes and other influences on sellers’ plans remain the same, the quantity supplied changes and there is a movement along the supply curve. © 2010 Pearson Education Canada Supply A Shift of the Supply Curve If the price remains the same but some other influence on sellers’ plans changes, supply changes and the supply curve shifts. © 2010 Pearson Education Canada Market Equilibrium Equilibrium is a situation in which opposing forces balance each other. Equilibrium in a market occurs when the price balances the plans of buyers and sellers. The equilibrium price is the price at which the quantity demanded equals the quantity supplied. The equilibrium quantity is the quantity bought and sold at the equilibrium price. Price regulates buying and selling plans. Price adjusts when plans don’t match. © 2010 Pearson Education Canada Market Equilibrium Price as a Regulator Figure 3.7 illustrates the equilibrium price and equilibrium quantity. If the price is $2.00 a bar, the quantity supplied exceeds the quantity demanded. There is a surplus of 6 million energy bars. © 2010 Pearson Education Canada Market Equilibrium If the price is $1.00 a bar, the quantity demanded exceeds the quantity supplied. There is a shortage of 9 million energy bars. If the price is $1.50 a bar, the quantity demanded equals the quantity supplied. There is neither a shortage nor a surplus of energy bars. © 2010 Pearson Education Canada Market Equilibrium Price Adjustments At prices above the equilibrium price, a surplus forces the price down. At prices below the equilibrium price, a shortage forces the price up. At the equilibrium price, buyers’ plans and sellers’ plans agree and the price doesn’t change until some event changes either demand or supply. © 2010 Pearson Education Canada Market Equilibrium An Increase in Demand Figure 3.8 shows that when demand increases the demand curve shifts rightward. At the original price, there is now a shortage. The price rises, and the quantity supplied increases along the supply curve. © 2010 Pearson Education Canada Predicting Changes in Price and Quantity An Increase in Supply Figure 3.9 shows that when supply increases the supply curve shifts rightward. At the original price, there is now a surplus. The price falls, and the quantity demanded increases along the demand curve. © 2010 Pearson Education Canada Predicting Changes in Price and Quantity All Possible Changes in Demand and Supply A change in demand or supply or both demand and supply changes the equilibrium price and the equilibrium quantity. © 2010 Pearson Education Canada Predicting Changes in Price and Quantity Change in Demand with No Change in Supply When demand increases, equilibrium price rises and the equilibrium quantity increases. © 2010 Pearson Education Canada Predicting Changes in Price and Quantity Change in Demand with No Change in Supply When demand decreases, the equilibrium price falls and the equilibrium quantity decreases. © 2010 Pearson Education Canada Predicting Changes in Price and Quantity Change in Supply with No Change in Demand When supply increases, the equilibrium price falls and the equilibrium quantity increases. © 2010 Pearson Education Canada Predicting Changes in Price and Quantity Change in Supply with No Change in Demand When supply decreases, the equilibrium price rises and the equilibrium quantity decreases. © 2010 Pearson Education Canada Predicting Changes in Price and Quantity Increase in Both Demand and Supply An increase in demand and an increase in supply increase the equilibrium quantity. The change in equilibrium price is uncertain because the increase in demand raises the equilibrium price and the increase in supply lowers it. © 2010 Pearson Education Canada Predicting Changes in Price and Quantity Decrease in Both Demand and Supply A decrease in both demand and supply decreases the equilibrium quantity. The change in equilibrium price is uncertain because the decrease in demand lowers the equilibrium price and the decrease in supply raises it. © 2010 Pearson Education Canada Predicting Changes in Price and Quantity Decrease in Demand and Increase in Supply A decrease in demand and an increase in supply lowers the equilibrium price. The change in equilibrium quantity is uncertain because the decrease in demand decreases the equilibrium quantity and the increase in supply increases it. © 2010 Pearson Education Canada Predicting Changes in Price and Quantity Increase in Demand and Decrease in Supply An increase in demand and a decrease in supply raises the equilibrium price. The change in equilibrium quantity is uncertain because the increase in demand increases the equilibrium quantity and the decrease in supply decreases it. © 2010 Pearson Education Canada Homework Reading: Chapter 3 (skip mathematical note for now) Chapter 3 Problems and Applications 15, 18, 19, 20, 22, 24 © 2010 Pearson Education Canada