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
Amherst College Department of Economics Economics 111 – Section 3 Fall 2012 Monday, September 10 Lecture: Scarcity, Decisions, and Markets The Economics Problem: Scarcity 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. 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 When we compare 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. Production Possibility Curve: An Illustration of the Available Choices – A Conceptual Tool Since all wants can not 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 all the options available to an economy in view of its limited resources. To illustrate the production possibility curve we can divide all Investment Goods goods into two broad categories: consumption and investment goods. Consumption goods are the goods that households themselves consume: food, clothing, 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 corn, ovens in bakeries are used to produce bread, etc. The production Consumption Goods possibilities curve 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 Investment Goods curve represents one alternative that is produce only investment goods available to our economy. The vertical produce more consumption goods intercept represents the case in which we and fewer investment goods used all our resources to produce investment goods. The horizontal intercept represents the case in which all produce only consumption goods resources are used to produce consumption goods. As we move down the production possibility curve, we use Consumption Goods more of our resources to produce consumption goods and fewer resources to produce investment goods. Where an economy is 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, etc. Few of us receive much pleasure from looking at a new tractor or a new piece of machinery. What would occur if we used all our resources to produce 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 are 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 We can 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 3 Central Planning and Markets Every society must somehow decide where to produce on its production possibilities curve. Different economies use different procedures to make this decision. For many years, the former Soviet Union attempted to decide explicitly where to be on its production possibility curve. It used central planning. Central Planning Decision Making: Former Soviet Union The Soviet planners tried to choose precisely where to be on Investment Goods their economy’s production possibility curve. The Central Planning Bureau devised a plan that explicitly stated how many cars to produce, how many refrigerators to produce, etc. While the Soviet Union possessed much labor and natural resources, in 1920, it had very few machines, tools, factories, etc. Consequently, in 1920, its production possibility curve was near 1920 the origin. At that time, the Soviet leadership decided to stress the production of investment goods. The production possibility curve tells us that to produce many investment goods, few Consumption Goods consumption goods must be produced. What were the consequences of this decision? • The bad news: Soviet consumers experienced hard times. Very few consumption goods were produced for Soviet households to consume. • The good news: The production of investment goods allowed the production possibility curve to expend outward rapidly. Investment Goods By 1985, the Soviet’s production possibility curve had moved outward dramatically; it had succeeded in becoming a highly industrialized economy. Soviet leaders now wanted to reward Soviet consumers for the sacrifices that they had endured by moving "down" the production possibility curve in order to produce more consumption goods. This proved to be a difficult to achieve, however. Soviet planners had an ingrained bias that favored production of investment goods. Soviet leadership found it very difficult to change this mindset. Even worse, other even more serious problems arose. Absenteeism in factories was high; many workers came to work drunk; etc. The Soviet economy was not able to use all its resources effectively; in a real sense, resources were being wasted. The Soviet Union found itself inside its production possibility curve. In part, this led to the collapse of the Soviet empire. 1985 1920 Consumption Goods Investment Goods 1985 Decentralized Decision Making: Markets Consumption Goods 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 shall 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 was written on a typewriter. The personal computer had not made an appearance in the office. That was to change dramatically of the course of the 1980’s, however. 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. Needless to say, the 1980’s saw tremendous changes in the personal computer market. The following table reports on the price and quantity of personal computers produced in the United States from 1982 through 1988: Personal Computers Cost of 16 Bit New New Price Quantity Processors Operating Word New Year ($ per PC) (millions) ($ per bit) Systems Processors Spreadsheets 1982 1700 3.5 18 WordStar Multiplan 1983 Windows Word Lotus 1-2-3 1984 1900 7.5 12 1985 Windows 1.0 WordPerfect 1986 2700 7.0 18 1987 Windows 2.0 Excel 1988 2900 9.5 9 Data from Tables 1340 and 1342 of the Statistical Abstract of the United States 1991. 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. • Between 1982 and 1984: Price rose by Quantity rose by four $200. million, more than doubling. • Between 1984 and 1986: Price rose by Quantity fell by $800. a half a million. • Between 1986 and 1988: Price rose by Quantity rose by $200. two and a half million. How can you explain the erratic behavior? The interaction of demand and supply in the market for PC’s will provide us with powerful tools that allow us to make sense from what appears to be very erratic behavior of PC prices and quantities. Therefore, we shall now introduce what are arguably the economist’s most valuable tools, demand and supply. 5 Markets: Demand and Supply Every market includes two essential elements: demand and supply. To make our discussion sound less abstract, we shall discuss demand and supply in the context of a particular good, beer. Market Demand Curve for Beer To illustrate the market demand curve for beer we place the price of beer on the vertical axis and the quantity of beer on the horizontal axis. Price of Beer ($/can) 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. If P=1.50 If P=2.00 If P=1.00 If P=.50 D Quantity of Beer (cans) Note that 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 Price of Beer ($/can) 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. S If P=2.00 If P=1.50 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. If P=1.00 If P=.50 Quantity of Beer (cans) Note that 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 firm can sell a good at a higher price, it becomes a more profitable for the firm to produce the good. When a good becomes a more profitable item, firms produce more because firms are interested in earning profit. 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 The market demand curve by itself does not tell us what the price actually equals. The 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. By superimposing the market demand and supply curves on a single diagram, we can 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* both the quantity demand and the quantity supplied equals Q*; the market is said to be in equilibrium. P Market S P* 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 intervene with laws restricting price Q* movements – more about government intervention later). We shall 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. First, suppose that the actual price is less than the equilibrium price. Clearly, the quantity demanded exceeds the quantity supplied. Whenever the quantity demanded exceeds the quantity supplied a shortage exist, 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 and receive your supply of milk once a week, every Monday morning. You take an inventory on Thursday and discover that you are going to run out of milk on Friday; you will have none to sell over the weekend. What will you do? You would raise the price somewhat. By doing so, you could still sell all you milk by Monday when your new shipment arrives and increase your profits in the meantime. Second, suppose that the actual price is greater than the equilibrium price. Clearly, the quantity supplied exceeds the quantity demanded. Whenever the quantity supplied exceeds the quantity demanded a surplus exists, firms are producing more units of the good than consumers are purchasing. When a surplus exists we 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. D Q P S P* shortage D Q Q* P surplus S P* D Q* The response of prices to shortages and surplus is often referred to as "market forces." Market forces push the price toward its equilibrium level. Q 7 Summary of 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. P surplus S P* 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. shortage Q* Shifts Of Versus Movements Along Demand and Supply Curves Recall the series of hypothetical questions to which the demand and supply curves for beer provide the answers: 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. How many cans of beer would firms produce (the quantity supplied), if the price of beer were ____, given that everything else relevant to supply of beer remains the same. Price of Beer ($/can) Price of Beer ($/can) If P=2.00 If P=2.00 If P=1.50 If P=1.50 If P=1.00 If P=1.00 S If P=.50 If P=.50 D Quantity of Beer (cans) Quantity of Beer (cans) D Q 8 Given That Everything Else … Remains the Same What role does the phrase “given that everything else Price of Beer ($/can) … remains the same” play? To explain this, focus on demand. While the quantity of beer demanded If P=2.00 certainly depends on the price of beer, many other factors affect the quantity demanded also: the price of If P=1.50 wine, the incomes of the consumers, the month of the If P=1.00 year, etc. The phrase “given that everything else remains the same” refers to all factors that affect the If P=.50 demand for beer other than the price of beer itself. D D’ When one of these other factors changes, that is, when Quantity of Beer (cans) something relevant to the demand for beer changes other than the price of beer itself, the entire demand curve for beer will shift. For example, if the price of wine increases, then the entire demand curve for beer would shift to the right. If the price of beer were $2.00, consumers would now purchase more beer since the price of wine is now higher. Similarly, if the price of beer were $1.50, consumers would now purchase more beer than before since the price of wine is now higher. Geometrically, this phenomenon is captured by the rightward shift of the market demand curve. Similarly, if a factor relevant to the supply of beer Price of Beer ($/can) other than the price of beer itself changes, then the S S’ market supply curve for beer would shift. For If P=2.00 example, if the price of barley, hops, and oats, the grains that are used to brew beer, decreased, then beer If P=1.50 production costs would fall. Consequently, beer If P=1.00 would become a more profitable item for firms to produce. Since firms are interested in earning profits, If P=.50 they would produce more beer. If the price of beer were $2.00, firms would now produce more beer since Quantity of Beer (cans) the price of grain is now lower. Similarly, if the price of beer were $1.50, firms would now produce more beer than before since the price of grain is now lower. Geometrically, this phenomenon is captured by the rightward shift of the market supply curve. It is important to remember, however, that a change in the price of beer itself never causes the demand curve or supply curve of beer to shift. A change in the price of beer itself only leads to a movement along the demand and supply curves. The slopes of the demand and supply curves capture the effect of a change in the price of beer itself. Summary: Movements Along and Shifts Of the Demand and Supply Curves: • A change in the price of beer itself leads to a movement along the demand and supply curves; the effect of a change in the price of beer is captured by the slopes of the demand and supply curves for beer. • Only when something other than the price of beer itself changes is it possible for the demand or supply curve to shift. If a factor other than the price of beer itself changes that is relevant to the demand for beer (for example, the price of wine), then the demand curve for beer will shift. Similarly, if a factor that is relevant to the supply of beer, other than the price of beer itself, changes (for example, the price of grain), then the supply curve for beer will shift.