Survey
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
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. 2 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 3 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. 4 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 $200. two and a half million. How can we explain the erratic behavior? The interaction of demand and supply in the market for PC’s will provide us with powerful tools that allow us to make sense from what appears to be the erratic behavior of PC prices and quantities. Therefore, we will now introduce what are arguably the economist’s most valuable tools: demand and supply. 5 Markets: Demand and Supply Every market includes two essential elements: demand and supply. To make our discussion sound less abstract, we will discuss demand and supply in the context of a particular good that most students know and love, beer. Market Demand Curve for Beer To illustrate the market demand curve for beer we place the price of beer on the vertical axis and the quantity of beer on the horizontal axis. The market demand curve for beer provides the answers to the following series of hypothetical questions: How many cans of beer would consumers purchase (the quantity demanded), if the price of beer were ____, given that everything else relevant to the demand for beer remains the same. Price of Beer ($/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. 6 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. 7 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