Download Micro Lecture 2: Market Basics

Micro Lecture 2: Market Basics
Review: The Economics Problem: Scarcity – Wants Exceed Possibilities
Wish List - Wants
Wants
Possibilities
Suppose that you were asked to compile a list of all
the items you would like to have. Typically, such a list
would be long indeed. For example, it might include a
60 inch 3D high definition LED television, an iPhone,
a BMW Z4, etc. When we add your wish list to the
lists of even a few friends we end up with a very
lengthy list of items. If we were to ask all Americans
what they would like to have, we would have an
astronomically long list of goods.
Figure 2.1: Wants and possibilities
Possibilities
Every economy has only a finite amount of labor,
land, machines, tools, etc.; that is, every economy has
only a finite amount of resources. These finite resources can only produce a limited number of
goods.
Scarcity: Wants Exceed Possibilities
Figure 2.1 compares the wish lists of all Americans, our wants, and the limited number of goods
our economy can produce with our finite resources, our possibilities. We discover that our wants
vastly exceed our possibilities. That is, the number of goods Americans would ideally like to
consume vastly exceeds what our economy can actually produce. Economists call this situation
scarcity. Scarcity exists in every society: rich and poor, developed and developing, etc.
Investment Goods
Production Possibility Curve: An Illustration of the Possibilities
– A Useful Conceptual Tool
Since all wants cannot be met, decisions must be made to
determine which goods should be produced and which should
not be produced. The production possibility curve is a
conceptual tool that illustrates the options available to an
economy in view of its limited resources.
Consumption Goods
To illustrate the production possibility curve let us divide all
Figure 2.2: Production
goods into two broad categories: consumption and investment
possibilities curve
goods. Consumption goods are the goods that households
themselves consume: food, clothing, beer, etc. Investment
goods are new machines, tools, factories, assembly lines, etc. that our economy produces. Note that
investment goods are not consumed by households directly; but rather machines, tools, etc. are used to
produce goods that households do consume. For example, tractors on farms are used to produce
wheat, mills convert the wheat to flour, and ovens in bakeries convert the wheat into bread which is
then consumed by households. The production possibilities curve appearing in figure 2.2 illustrates all
the combinations of consumption and investment goods that an economy can produce given its limited
resources in a given year.
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Each point on the production possibility curve
represents one alternative that is available to
our economy. As shown in figure 2.3, the
vertical intercept represents the case in which
we use all our resources to produce investment
goods. The horizontal intercept represents the
case in which all resources are used to
produce consumption goods. As we move
down the production possibility curve, we use
more of our resources to produce consumption
goods and fewer resources to produce
investment goods.
Investment Goods
produce only investment goods
produce more consumption goods
and fewer investment goods
produce only consumption goods
Consumption Goods
Figure 2.3: Production-possibilities curve
Where an economy operates on its production possibility curve makes a difference. At first glance, it
looks like the horizontal intercept would be desirable. After all, we households are interested in those
goods that we actually consume: food, clothing, beer, etc. Few of us receive much pleasure from
looking at a new tractor or a new drill press. Why not use all our resources to produce what household
enjoy, consumption goods? At first, everything would be fine, but what would happen over time?
Machines, tools, factories, etc. do not last forever; they wear out or, as economists say, depreciate. If
we do not replace those machines, tools, etc. that wear out this year with new ones, our economy will
have fewer resources in the future. With fewer resources, the production possibility curve will shift in.
While at first glance it looks like it is desirable to produce nothing but consumer goods, we see that in
the long run there would be negative consequences.
Opportunity Cost
Opportunity cost refers to the fact that when one activity is pursued other activities cannot be
pursued. For example, if you decide to study economics tonight you will not be studying
chemistry or math or English or, as might be more likely, you will not be partying. The
opportunity cost of studying economics tonight is the activity that you are foregoing.
The production possibility curve illustrates the notion of opportunity costs. To produce more
consumption goods, investment goods must be sacrificed. This is, the opportunity cost of
consumption goods is the investment goods that must be foregone.
Rich and Poor Economies
Figure 2.4 illustrates how we use production possibility curves
to illustrate rich and poor economies. A rich economy has
many resources and consequently, can produce many goods;
its production possibility curve lies far from the origin. A
poor economy has few resources and consequently cannot
produce many goods; its production possibility curve lies
close to the origin.
Investment Goods
Rich economy
Poor economy
Consumption Goods
Figure 2.4
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Central Planning and Markets
Every society must decide where to produce on its production
possibilities curve. Different economies use different procedures to
make this decision, however. For many years, the former Soviet
Union attempted to decide explicitly where to be on its production
possibility curve. It used central planning.
Investment Goods
Central Planning Decision Making: Former Soviet Union
1920
The Soviet planners in Moscow tried to choose precisely where
to operate on their economy’s production possibility curve. The
Central Planning Bureau devised a plan that explicitly stated
Consumption Goods
how many cars to produce, how many refrigerators to produce,
Figure
2.5
how many ingots of steel to produce, etc. While the Soviet
Union possessed much labor and natural resources, in 1920, it
had very few machines, tools, factories, etc. In 1920, its production possibility curve was near the
origin as illustrated in figure 2.5. Consequently, the Soviet leadership decided to stress the
production of investment goods. The production possibility curve tells us that in order to produce
many investment goods, few consumption goods must be produced. What were the consequences
of this decision?
 The bad news: Soviet consumers experienced
Investment Goods
hard times. Very few consumption goods were
produced for Soviet households to consume.
1985
 The good news: The production of investment
goods allowed the production possibility curve to
expend outward rapidly.
1920
By 1985, the Soviet’s production possibility curve had
moved outward dramatically (see figure 2.6); it had
succeeded in becoming a highly industrialized economy.
Consumption Goods
Soviet leaders now wanted to reward Soviet consumers for
Figure
2.6
the sacrifices that they had endured by moving "down" the
production possibility curve in order to produce more
consumption goods. This proved to be difficult to achieve, however. Soviet planners had an
ingrained bias that favored production of investment goods.
Investment Goods
Soviet leadership found it very difficult to change the
planners’ mindset.
Even worse, other more serious problems arose.
Absenteeism in factories was high; many workers who did
report to work failed to work hard and quite a few even
came drunk; etc. The Soviet economy was not able to use
all its resources effectively; in this way, resources were
being wasted. Figure 2.7 shows that the Soviet Union found
itself inside its production possibility curve. This in no
small part led to the collapse of the Soviet empire.
1985
Consumption Goods
Figure 2.7
Decentralized Decision Making: Markets
Since the mid-1980's the economies of Eastern Europe, Russia, China, etc. have all adopted
market reforms. In part, they have emulated the U.S. economy. Consequently, we will now turn
our attention to markets and the crucial role prices play.
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Project: Market for Personal Computers in the 1980's
In 1980, the typewriter was the office staple. Every
office had one. Every letter, every report, every
paper was written on a typewriter. The IBM
Selectric shown in figure 2.8 was the most popular
office typewriter. The personal computer had not
made an appearance in the office. The 1980’s saw a
dramatic change, however.
Figure 2.8: IBM Selectric
In 1977, the Apple II debuted on the “personal
computer” market. Four years later, in 1981, IBM
unveiled its PC. By today’s standard, both computers
were primitive. The IBM PC did not have a hard drive,
only two 5-1/4” floppies with a capacity of 360 kilobytes
each. A floppy disk was inserted into each of the two
black compartments shown in figure 2.9. Needless to
say, the 1980’s saw tremendous changes in the personal
computer market. Table 2.1 reports on the price and
quantity of personal computers produced in the United
States from 1982 through 1988:
Figure 2.9: IBM PC
Year
1982
1983
1984
1985
1986
1987
1988
Personal Computers
Price
Quantity
($ per PC) (millions)
1,700
3.5
Cost of 16 Bit
Processors
($ per bit)
18
1,900
7.5
12
2,700
7.0
18
2,900
9.5
9
New
Operating
Systems
Windows
New
Word
Processors
WordStar
Word
Windows 1.0
WordPerfect
Windows 2.0
New
Spreadsheets
Multiplan
Lotus 1-2-3
Excel
Table 2.1
Between 1982 and 1988 the number of personal computers produced annually nearly tripled; the price
nearly doubled. The price and quantity did not increase in a steady manner, however.
Price rose
Quantity rose by four
Between 1982 and 1984:
by $200.
million, more than doubling.
Price rose
Quantity fell by
Between 1984 and 1986:
by $800.
half a million.
Price rose
Quantity rose by
Between 1986 and 1988:
by $200.
two and a half million.
How can we explain the erratic behavior?
The interaction of demand and supply in the market for PC’s will provide us with powerful tools that allow
us to make sense from what appears to be the erratic behavior of PC prices and quantities. Therefore, we
will now introduce what are arguably the economist’s most valuable tools: demand and supply.
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Markets: Demand and Supply
Every market includes two essential elements: demand and supply. To make our discussion sound less
abstract, we will discuss demand and supply in the context of a particular good that most students
know and love, beer.
Market Demand Curve for Beer
To illustrate the market demand curve for beer we place the
price of beer on the vertical axis and the quantity of beer on the
horizontal axis.
The market demand curve for beer provides the answers to the
following series of hypothetical questions:
How many cans of beer would consumers purchase (the
quantity demanded), if the price of beer were ____, given
that everything else relevant to the demand for beer
remains the same.
Price of Beer ($/can)
If P=2.00
If P=1.50
If P=1.00
If P=.50
D
Quantity of Beer (cans)
Figure 2.10: Demand curve for beer
As shown in figure 2.10 the demand curve is downward
sloping. This just means that as the price of beer increases
consumers respond by buying less beer. This makes sense, doesn’t it? When something becomes
more expensive we typically respond by purchasing less of it.
Does the demand curve by itself determine what the price of beer will actually equal? No, the
demand curve only provides the answers to a series of hypothetical questions. The demand curve
only tells us how much beer consumers would purchase if the price of beer equaled a certain
amount.
Market Supply Curve for Beer
To illustrate the market supply curve for beer we again place
the price of beer on the vertical axis and the quantity of beer
on the horizontal axis.
The market supply curve for beer provides the answers to the
following series of hypothetical questions:
How many cans of beer would firms produce (the
quantity supplied), if the price of beer were ____, given
that everything else relevant to the supply of beer remains
the same.
Price of Beer ($/can)
S
If P=2.00
If P=1.50
If P=1.00
If P=.50
Quantity of Beer (cans)
Figure 2.11: Supply curve for beer
As shown in figure 2.11 the supply curve is upward sloping.
This just means that as the price of beer increases firms
respond by producing more beer. This makes sense, doesn’t
it? When a beer firm can sell beer at a higher price, beer becomes a more profitable item for the
firm to produce. Since firms desire to earn profits, they produce more beer when the price rises.
Does the supply curve by itself determine what the price of beer will actually equal? No, the
supply curve only provides the answers to a series of hypothetical questions. The supply curve
only tells us how much beer firms would produce if the price of beer equaled a certain amount.
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Equilibrium, Surplus, and Shortage
Let us now quickly summarize:
 The downward sloping market demand curve by itself does not
tell us what the price actually equals.
 The upward sloping market supply curve by itself does not tell
us what the price actually equals.
Why then have we gone to the trouble of introducing the market demand
and supply curves? While neither curve by itself determines the price,
when we put them together we can predict the actual price and quantity.
P
S
P*
D
Figure 2.12 superimposes the market demand and supply curves on a
single diagram. We can now determine the equilibrium price, the price at
which the quantity demanded equals the quantity supplied. P* is the
equilibrium price and Q* is the equilibrium quantity. When the price
is P* the quantity demand and the quantity supplied both equal Q*; the
market is said to be in equilibrium.
Why are we interested in the equilibrium price? The equilibrium price is
important because the actual price will either equal the equilibrium price
or be moving toward it (assuming that the government does not interfere
with laws restricting price movements – more about government
intervention later). We will argue this point in two steps:
 If the actual price is less than the equilibrium price, the actual
price will rise;
 If the actual price is greater than the equilibrium price, the
actual price will fall.
Market
Q
Q*
Figure 2.12: Market
Equilibrium
P
S
P*
shortage
D
Q
First, suppose that the actual price is less than the equilibrium price as
Q*
depicted in figure 2.13. Clearly, the quantity demanded exceeds the
Figure 2.13: Shortage
quantity supplied. Whenever the quantity demanded exceeds the
quantity supplied a shortage exists, consumers are trying to purchase
more units of the good than firms are producing. When a shortage exists we would expect the
price to increase. To justify this, suppose that you own a dairy store
P
and receive your supply of milk once a week, every Monday morning.
S
You take an inventory on Thursday and discover that you are going to
surplus
run out of milk on Friday; you will have no milk to sell over the
weekend. What will you do? You would raise the price, wouldn’t
you? By doing so, you could still sell all you milk by Monday when
P*
your new shipment arrives and increase your profits in the meantime.
Second, suppose that the actual price is greater than the equilibrium
price as shown in figure 2.14. Clearly, the quantity supplied exceeds
the quantity demanded. Whenever the quantity supplied exceeds the
D
Q
quantity demanded a surplus exists, firms are producing more units of
Q*
the good than consumers are purchasing. When a surplus exists we
Figure 2.14: Surplus
would expect the price to decrease. In this case, when you take an
inventory on Thursday, you discover that you are not selling your milk
quickly enough. Unless you start selling you milk more quickly, it will spoil. Furthermore, you
have a new shipment arriving next Monday. To sell your milk faster, you would reduce the price.
The response of prices to shortages and surplus is often referred to as "market forces." Market
forces push the price toward its equilibrium level.
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Summary of Market Forces
Figure 2.15 summarizes market forces:
If Actual Price < Equilibrium Price

Quantity Demanded > Quantity Supplied

Shortage exists

Actual Price rises
until the equilibrium is reached
If Actual Price > Equilibrium Price

Quantity Demanded < Quantity Supplied

Surplus exists

Actual Price falls
until the equilibrium is reached
P
surplus
S
Market forces push the actual price toward its
equilibrium level.
P*
shortage
Assuming that the actual price is free to move, the
actual price will equal the equilibrium price in
short order.
D
Q*
Q
Figure 2.15: Market forces


If the actual price is less than the equilibrium price, a shortage exists; in the face of a
shortage, the price rises.
If the actual price is greater than the equilibrium price a surplus exists; in the face of a
surplus, the price falls.
Note that the existence of a shortage or surplus depends entirely on the actual price. If the actual
price is less than the equilibrium price a shortage exists; if the actual price exceeds the equilibrium
price a surplus exists.
The following lab illustrates these points. To access the lab, click on the red computer icon.

Micro Lab 2.1: Equilibrium