Download Lecture 3

Review of last week’s lecture
Production possibilities and opportunity cost
Productive and allocative efficiency
Gains from trade
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Review - Production possibilities and
opportunity cost
Simple model that illustrates
• Scarcity
• Trade-offs and opportunity cost
• Productive efficiency
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Production Possibilities Curve assumptions
Two goods: cola and pizza
Fixed resources
Fixed technology
Efficiency - the economy is achieving
maximum production
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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
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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)
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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.
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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
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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.
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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.
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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.
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Gains from Trade
Joe specializes in producing salad and he produces
30 salads an hour at point B on his PPF.
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Gains from Trade
Liz specializes in producing smoothies and produces
30 smoothies an hour at point B on her PPF.
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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.
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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.
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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
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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.
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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.
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Economic Coordination
Coordinating
Decisions
Markets coordinate
individual
decisions through
price adjustments.
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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.
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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.
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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.
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Overview of this week’s lecture
Supply and demand
How are prices and quantities determined through
market exchange?
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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.
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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.
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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
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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.
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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.
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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.
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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.
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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.
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Demand
Six main factors that change demand are

The prices of related goods

Expected future prices

Income

Expected future income and credit

Population

Preferences
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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Homework
Reading: Chapter 3 (skip mathematical note for now)
Chapter 3 Problems and Applications
15, 18, 19, 20, 22, 24
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