Download Monday, September 10 Lecture: Scarcity, Decisions, and Markets

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.
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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
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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.
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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 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
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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
$200.
two and a half million.
How can you explain the erratic behavior?
The interaction of demand and supply in the market for PC’s will provide us with powerful tools
that allow us to make sense from what appears to be very erratic behavior of PC prices and
quantities. Therefore, we shall now introduce what are arguably the economist’s most valuable
tools, demand and supply.
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Markets: Demand and Supply
Every market includes two essential elements: demand and supply. To make our discussion
sound less abstract, we shall discuss demand and supply in the context of a particular good, beer.
Market Demand Curve for Beer
To illustrate the market demand curve for beer we place the
price of beer on the vertical axis and the quantity of beer on
the horizontal axis.
Price of Beer ($/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.
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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
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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 ($/can)
If P=2.00
If P=2.00
If P=1.50
If P=1.50
If P=1.00
If P=1.00
S
If P=.50
If P=.50
D
Quantity of Beer (cans)
Quantity of Beer (cans)
D
Q
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Given That Everything Else … Remains the Same
What role does the phrase “given that everything else
Price of Beer ($/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.