Download Demand - Arkansas Economist

Chapter 3
Supply and Demand
Second Edition
Introduction
 Most important tools in economics:
• Supply
• Demand
• Equilibrium
 Oil market: arguably the most
important market in the world.
 We will learn to use these tools in the
context of the oil market.
2
The Demand Curve for Oil
 Demand curve – a function that shows the
quantity demanded at different prices.
 Quantity demanded – the quantity that
buyers are willing and able to buy at a
particular price.
 Let’s look at a hypothetical demand curve
for oil.
3
The Demand Curve for Oil
Price of oil/barrel
$40
Price
Quantity
Demanded
$40
5
$20
25
$5
50
$20
Demand
$5
0
5
25
50
Quantity of Oil
(MBD)
4
The Demand Curve for Oil
Price of oil/barrel
Demand Curves are read two ways:
1. Horizontally – At a given price how
much are people willing to buy?
$40
2. Vertically – What are people willing
to pay for a given quantity?
$20
Demand
$5
0
5
25
50
Quantity of Oil
(MBD)
5
Why Is the Demand Curve Downward
Sloping?
 Oil is not equally valuable in all its uses.
• If the price of oil is high, it is used in only
higher valued uses.
 Air Force One
 Commuting
• If the price of oil is low, it can be used also in
lower valued uses.
 Manufacture “rubber duckies”
 Sight seeing
6
Why Is the Demand Curve Downward
Sloping?
Price of oil/barrel
$40
Higher valued uses
$20
Lower valued uses
Demand
$5
0
5
25
50
Quantity of Oil
(MBD)
Law of Demand: ↑ price → ↓ quantity demanded
7
Consumer Surplus
 Consumer surplus
• The consumer’s gains from exchange, or,…
• The difference between the maximum price
the consumer is willing to pay and the market
price.
 Total consumer surplus
• Measured by the area below the demand
curve and above the market price.
Let’s use the demand curve for oil to show these concepts.
8
Consumer Surplus
Price of oil/barrel
Suppose the market price = $20
$80
President’s consumer surplus
$60
Delta Airlines consumer surplus
Total Consumer Surplus
Frank’s (retiree) consumer surplus
$40
$20
0
Demand
30
60
90
120
150
Quantity of Oil
(MBD)
If the demand curve is linear, measuring consumer surplus is easy.
9
Consumer Surplus
Price of oil/barrel
Suppose the market price = $20
$80
President’s consumer surplus
$60
Delta Airlines consumer surplus
Total Consumer Surplus
Frank’s (retiree) consumer surplus
$40
$20
Demand
0
30
60
90
120
150
Quantity of Oil
(MBD)
If the demand curve is linear, measuring consumer surplus is easy.
10
Consumer Surplus
Price of oil/barrel
$80
$60
$40
$20
0
Demand
30
60
90
120
150
Quantity of Oil
(MBD)
11
Try it!
Your roommate just bought an iPad for
$600. She would have been willing to pay
$1,000 for a machine that could make her
life so much more worthwhile. How much
consumer surplus does your roommate
enjoy from the iPad?
a) $600
b) $400
c) $1600
d) $1400
To next
Try it!
Try it!
If the price is $2010, what is the consumer
surplus?
a) $3,588,000
b) $1,794,000
c) $6,000,000
d) $3,000,000
To next
Try it!
What Shifts the Demand Curve?
 Increase in demand - shifts the demand curve
to the right.
• At the same price people are willing to buy more.
• At the same quantity, people are willing to pay a
higher price.
 Decrease in demand – shifts the demand
curve to the left.
• At the same price people are willing to buy less.
• At the same quantity, people are willing to pay a
lower price.
Both of these can be shown in the following diagrams.
14
Shifting the Demand Curve
Price of oil/barrel
An Increase in Demand
Willing to pay a higher price for same quantity.
$50
Willing to buy more at the same price.
New Demand
$25
Old Demand
0
70
140
Quantity of Oil
(MBD)
15
Shifting the Demand Curve
Price of oil/barrel
An Decrease in Demand
Willing to buy less at the same price.
Willing to pay a lower price for the same quantity
$40
Old Demand
$20
New Demand
0
62
74
Quantity of Oil
(MBD)
16
What Shifts the Demand Curve?
 Important Demand Shifters
1. Income
 Normal goods
 Inferior goods
2.
3.
4.
5.
6.
Population
Price of substitutes
Price of complements
Expectations
Tastes
Let’s look at each of these in turn.
17
Demand Shifter: Income
 Normal good – demand ↑ when income ↑
• Example: As income increases in India, many
people will buy their first car. This increases
the demand for oil.
 Inferior good – demand ↓ when income ↑
• Example: As college students graduate, and
their incomes increase they eat less ramen
noodles.
Let’s illustrate each of these with the demand curve.
18
Demand Shifter: Population
 Increase in population → ↑ number of
consumers → ↑ demand.
 Demographic changes – some
subpopulations increase faster than others.
• Examples
 The average age gets older. (e.g. the U.S.)
 The average age gets younger. (many developing
countries)
• Result: as average income grows, the demand
for some categories of goods increases faster.
19
Demand Shifter: Price of Substitutes
 Substitute goods – those than can be used
as alternatives for the other.
 Decrease in the price of a substitute →
↓demand for a good.
• Examples:
 ↓ price of natural gas → ↓ demand for petroleum.
 ↓ price of coffee → ↓ demand for tea.
 ↓ price of Toyota cars → ↓ demand for Ford cars.
20
Demand Shifter: Price Complements
 Complements – goods that are used
together
 Decrease in the price of a complement →
↑demand for a good.
• Examples:
 ↓ price of computer software → ↑ demand for
computers.
 ↓ price of cars → ↑ demand for gasoline.
 ↓ price of hamburger → ↑ demand for hamburger
buns.
21
Try it!
When the price of petroleum goes up,
the demand for natural gas ______, the
demand for coal ______, and the
demand for solar power ______.
a) increases; increases; increases
b) increases; increases; decreases
c) decreases; decreases; increases
d) decreases; decreases; decreases
To next
Try it!
Demand Shifter: Expectations
 Expectation of the future price of a good
will shift the demand curve for that good.
• Expected higher price → ↑ demand.
• Expected lower price → ↓ demand.
 Examples:
• Trouble in the Middle East → higher expected
price of oil → ↑ current demand for oil.
• News of a spring freeze in Florida → higher
expected price of oranges → ↑ current
demand for oranges.
23
Demand Shifter: Tastes
 Changes in tastes shift demand curves all
of the time.
• Examples
 Fad diets that advocate eating mostly protein →
↑ demand for beef.
 People desire to have a lower “carbon footprint” →
↑ demand for hybrid cars.
 Social stigma for wearing real animal fur → ↓
demand for fur coats.
24
What Shifts the Demand Curve?
 A “change in quantity demanded” is NOT the
same as a “change in demand.”
• “Quantity demanded” changes only when the
price of a good changes.
 It is a movement along a fixed demand curve.
• “Demand” changes only when a non-price
factor (demand shifter) changes.
 It is a shift in the entire demand curve.
A “change in Quantity
Demanded”
A “change in
Demand”
Try it!
When the price of a good increases the
quantity demanded ______. When the price
of a good decreases the quantity
demanded ______.
a) rises; rises
b) rises; falls
c) falls; rises
d) falls; falls
To next
Try it!
The Supply Curve for Oil
 Supply curve – a function that shows the
quantity supplied at different prices.
 Quantity Supplied – the amount of a good
that sellers are willing and able to sell at a
particular price.
The next diagram shows a hypothetical supply curve.
27
The Supply Curve for Oil
Supply
Price of oil/barrel
$40
$20
Price
Quantity
Supplied
$40
44
$20
30
$5
10
$5
0
10
30
44
Quantity of Oil
(MBD)
28
The Supply Curve for Oil
Supply
Price of oil/barrel
$40
Supply Curves are read two
ways:
1. Horizontally – At a given
price, quantity sellers are
willing to sell.
$20
2. Vertically – Minimum price
that sellers must get to
produce a given quantity.
$5
0
10
30
44
Quantity of Oil
(MBD)
29
Supply Curves
 Why is the supply curve upward
sloping?
• The cost of producing a good is not
equal across all suppliers.
 At a low price, a good is produced and
sold only by the lowest cost suppliers.
 At a high price, a good is also
produced and sold by higher cost
suppliers.
30
The Supply Curve for Oil
 Why is the supply curve for oil upward
sloping?
• Not all oil costs the same to lift to the surface.
 Saudi Arabia - $2.00 per barrel
 Iran & Iraq - $2.00 plus a bit more
 Nigeria and Russia - $5 to $7 per barrel
 Alaska - $10 per barrel
 North Sea - $12 per barrel.
 Canada’s tar sands - $22.50 per barrel
 U.S. - $27.50 per barrel
 Oklahoma oil shale - $40
Let’s see what this looks like in a supply curve.
31
Why Is the Supply Curve for Oil Upward
Sloping?
Price of oil/barrel
Supply
$60
●
40
Oil shale becomes
profitable here
Higher-cost oil
●
20
Lowest-cost oil
0
0
20
40
60
80
Quantity of Oil
(MBD)
100
Law of Supply: ↑ price → ↑ quantity supplied
32
Producer Surplus
 Producer surplus
• The producer’s gain from exchange
• The difference between the minimum price
the seller is willing to accept and the market
price.
 Total producer surplus
• Measured by the area above the supply curve
and below the market price.
Let’s use the supply curve for oil to show these concepts.
33
Producer Surplus
Price of oil/barrel
$60
Supply
Total producer surplus
at a price of $40
40
20
0
0
20
40
60
80
Quantity of Oil
(MBD)
100
34
Try it!
Using the following diagram, calculate
total producer surplus if the price of oil is
$50 per barrel.
a) 0
b) $45
c) $1,350
d) $2,700
To next
Try it!
What Shifts the Supply Curve?
 Increase in Supply - shifts the supply curve to
the right.
• At the same price producers are willing to sell
more.
• At the same quantity, producers are willing to
accept a lower price
 Decrease in supply – shifts the supply curve
to the left.
• At the same price sellers will offer less.
• At the same quantity, sellers demand a higher
price.
Both of these can be shown in the following diagrams.
36
What Shifts the Supply Curve?
Price of oil/barrel
$60
Old supply
New supply
Increase in supply
40
Willing to accept
a lower price for
the same quantity
Greater quantity
supplied at the
same price
20
18
0
0
20
40
60
80
Quantity of Oil
(MBD)
100
37
What Shifts the Supply Curve?
Price of oil/barrel
New supply Old supply
$60
Decrease in supply
40
Higher price
required for the
same quantity
28
20
Smaller quantity
supplied at the
same price
0
0
20
40
60
80
Quantity of Oil
(MBD)
100
38
What Shifts the Supply Curve?
 General rule: Cost changes shift the
supply curve
•
•
↑ cost → supply curve shifts left (higher P)
↓ cost → supply curve shifts right (lower P)
 Important Supply Shifters
1. Technological innovations and changes in the
prices of inputs
2. Taxes and subsidies
3. Expectations
4. Entry and exit from the industry
5. Changes in opportunity costs
Let’s look at these supply shifters in turn.
39
Supply Shifter: Technological Innovations
and Changes in Price of Inputs
 Improvement in technology
• Results in lower cost to produce the same output.
 Example: sidewise drilling.
 Changes in prices of inputs
• Increased labor costs
 Higher wages
 Higher payroll taxes
 Higher cost of mandatory health insurance.
• Increased capital and materials costs
 Higher interest rates
 Higher energy costs
40
Supply Shifter: Taxes and Subsidies
 Taxes on commodities and services
• Higher tax is considered an increase in cost.
 Subsidy
• Same as a negative tax
• Considered a decrease in cost
It is easier to see this if we use a diagram.
41
Effect of a Tax on the Supply Curve of Oil
Price of oil/barrel
New supply
Sellers require a $10
higher price to sell the
same quantity
Old supply
$50
Tax = $10/barrel
$10
40
=
0
0
20
40
60
80
Quantity of Oil
(MBD)
100
Note: A subsidy of $10 per barrel would shift the supply curve down.
42
Taxes and Subsidies
 Taxes and subsidies affect profits and
therefore supply.
 A 10% yacht tax reduced the supply of yachts
53% in the early
1990s.
43
Supply Shifter: Expectations
 What sellers think the price of their product
will be in the future can have a dramatic effect
on current supply.
• Examples
 War in Middle East → ↑ expected prices of oil.
 Frost in Florida → ↑ expected price of orange juice.
 Favorable rains in mid-west →↓ expected price of wheat
 Higher expected prices → Decreased supply
 Lower expected prices → Increased supply
44
Supply Shifter: Expectations
 Higher expected future prices
Price of oil/barrel
$50
Supply today with higher
expected future price
Supply today
Into
storage
40
Lower quantity at
the same price
Quantity of Oil
(MBD)
40
60
45
Supply Shifter: Entry or Exit of Producers
 This one’s easy: ↑ producers → increase
supply
• NAFTA resulted in Canadian firms entering the
U.S. lumber market
• When patents expire more firms enter an
industry
 Net entry into a market → Increased supply
 Net exit from a market → Decreased supply
Let’s look at each of the examples in turn.
46
Supply Shifter: Entry or Exit of Producers
Entry Increases Supply
Price
Domestic
Supply
Greater Quantity
Supplied at the Same
Price
Domestic Supply Plus
Canadian Imports
Lower Price for the
Same Quantity
Supplied
47
Quantity
Supply Shifter: Entry or Exit of Producers
 Patent On a Medicine Expires
Price/dose
Old supply
$2.75
New supply
Entry
1.50
Higher quantity at
the same price
//
40
60
Quantity of Doses
(millions)
Supply Shifter: Opportunity Costs
 Opportunity cost applied to supply
• Suppose producers can produce alternative
products
 ↑ price of the alternative → ↑ opportunity cost of
producing the good.
 Example
• A farmer producing soybeans could also grow wheat.
• An increase in the price of wheat → ↑opportunity cost of
soy beans
• ↑ opportunity cost → ↓ supply
Supply Shifter: Opportunity Costs
 Effect of an increase in the price of wheat
Higher price
Price of
soybeans/bushel required to
sell the same
quantity
$7
Supply with higher
opportunity costs
Supply with low
opportunity costs
5
Lower quantity at
the same price
//
2,000
2,800
Quantity of soybeans
(millions of bushels)
Try it!
• Technological innovations in
chip making have driven down
the costs of producing
computers. What happens to the
supply curve for computers?
Why?
BACK TO
Try it!
• The U.S. subsidizes making
ethanol as a fuel made from
corn. What effect does this
subsidy have on the supply
curve for ethanol?
BACK TO
Takeaway
 A demand curve shows the quantity
demanded at different prices.
 A supply curve shows the quantity
supplied at different prices.
 You should be able to define and show
how consumer surplus and producer
surplus are measured.
 You should know what shifts the demand
and supply curves and which direction.
Second Edition
End of Chapter 3
Chapter 4
Equilibrium: How Supply
and Demand
Determine Prices
Second Edition
Chapter Outline
 Equilibrium and the adjustment process
 Gains from trade are maximized at the
equilibrium price and quantity
 Does the model work? Evidence from the
laboratory X
 Shifting demand and supply curves
 Terminology: Demand compared to quantity
demanded and supply compared to quantity
supplied
 Understanding the price of oil
56
Equilibrium and the Adjustment Process
 Definitions
• Surplus – situation in which quantity supplied
is greater than quantity demanded
 Sellers will offer lower prices
• Shortage – situation in which quantity
demanded is greater than quantity supplied
 Buyers will offer higher prices
• Equilibrium price – price at which quantity
demanded equals quantity supplied
57
Market Equilibrium
There is ONLY ONE PRICE
where Qs = Qd
This is “equilibrium price and
quantity”
• No shortages
• No surpluses
FREE MARKETS
ALWAYS MOVE TOWARD
EQUILIBRIUM PRICE
Equilibrium and the Adjustment Process
Price is Determined by Supply and Demand
Price of Oil per
Barrel
Equilibrium
Price
Supply Curve
$30
Demand Curve
65
Equilibrium
Quantity
Quantity of Oil
(MBD)
Equilibrium and the Adjustment Process
Price of Oil per barrel
Supply
P = $80 → surplus
$80
Equilibrium
price
$70
Price is driven ↓
Demand
//
50
70
90
Equilibrium quantity
Quantity
of Oil
(MBD)
60
Equilibrium and the Adjustment Process
Price of Oil per barrel
Supply
Equilibrium
price
$70
Price is driven ↑
$50
P = $50 → shortage
=
//
50
70
Demand
90
Equilibrium quantity
Quantity
of Oil
(MBD)
61
Try it!
At a price of $3, quantity
supplied is ______ and
quantity demanded is
______, leading to a
_______.
a) 6; 2; surplus of 4 units
b) 2; 4; surplus of 2 units
c) 2; 6; shortage of 8
units
d) 4; 2; shortage of 2
units
To next
Try it!
Gains from Trade are Maximized at the
Equilibrium Price and Quantity
 What this means
1. The supply of goods is bought by buyers with
the highest willingness to pay.
2. The supply of goods are sold by the buyers
with the lowest costs.
3. Between buyers and sellers, there are no
unexploited gains from trade or any wasteful
trades.
Let’s us the market model to show this.
63
Unexploited Gains From Trade
Price of Oil per barrel
Suppose quantity is
50: less than the
equilibrium quantity
Supply
$90
At Q = 50:
• Willingness to pay
equals P = $90
• Willingness to sell
equals P = $50
Equilibrium
price
70
50
Unexploited
Gaines from
trade
=
//
50
70
Demand
90
Equilibrium quantity
Quantity
of Oil
(MBD)
64
Unexploited Gains From Trade
Price of Oil per barrel
Suppose quantity is
90: greater than the
equilibrium quantity
Supply
$90
At Q = 90:
• Willingness to sell
at P = $90
• Willingness to pay
at P = $50
Equilibrium
price
70
50
Unexploited
Gaines from
trade
=
//
50
70
Demand
90
Equilibrium quantity
Quantity
of Oil
(MBD)
65
Free Market Maximized Gaines From Trade
Price of Oil per barrel
Suppose quantity is
Equal to the
equilibrium quantity
Supply
At Q = 70:
• Qd = Qs
At P = $70
• Pbuyers willing to pay =
Psellers willing to accept
Conclusion: No
unexploited gains
from trade
$90
Equilibrium
price
70
50
Demand
=
//
50
70
90
Equilibrium quantity
Quantity
of Oil
(MBD)
66
Gains from Trade Are Maximized at Equilibrium
Price and Quantity
A Free Market Maximizes Producer plus Consumer Surplus (the gains from trade)
Price of Oil
per Barrel
Supply Curve
Buyers
Equilibrium
Price
$30
Non-Sellers
Consumer
Surplus
Producer
Surplus
Sellers
Non-Buyers
Demand Curve
65
Equilibrium Quantity
Quantity of Oil
(MBD)
Equilibrium and Total Surplus
 Equilibrium in a free market yields two
important results:
• Goods must be produced at the lowest
possible cost.
• Goods must satisfy the highest valued
demands.
 These results indicate that total surplus
(both of the consumer and producer) is
maximized in free markets.
Shifting Demand and Supply Curves
 Another way to test the model is to
examine its predictions about what
happens when the demand and supply
curves shift.
 Key to learning
• Do: Focus on how to use the model
• Do not: try to memorize results of every
possible scenario
• Do: memorize the shifters
Let’s take the model for a few “test drives”.
69
Shifting Demand and Supply Curves:
Market for Laptops
 Effect of ↓P of computer chips
Price of laptops
Original Supply
New Supply
a
Pa
b
Pb
↓price of chips → ↓ cost of
laptops
Demand
=
//
Qa
Qb
Quantity
of laptops
70
Shifting Demand and Supply Curves:
Market for Software
 Effect of ↓P of laptops
Price of software
Original Supply
b
Pb
a
↓price of laptops →
↑ demand for software
Pa
New Demand
Original demand
=
//
Qa
Qb
Quantity
of software
71
Shifting Supply and Demand Curves:
Higher Expected Prices
 Expectations about future prices affect us
often.
• Let’s look at the effect of a hurricane
approaching the Gulf states
• Many oil refineries located in these states are
often shut down during hurricanes.
• Electrical service is often interrupted for days if
not weeks.
• What happens to the prices of some goods
before the hurricane arrives?
72
Shifting Demand and Supply Curves:
Market for Gasoline
 Effect of higher expected prices
Price of gasoline
b
Pb
a
Original Supply
Approaching hurricane
→ ↑ expected future
price.
Pa
New Demand
Original demand
=
//
Qa
Qb
Quantity
of gasoline
73
Shifting Demand and Supply Curves:
Market for Generators
 Effect of higher expected prices
Price of generators
b
Pb
a
Original Supply
Approaching hurricane
→ ↑ expected future
price.
Pa
New Demand
Original demand
=
//
Qa
Qb
Quantity
of generators
74
Try it!
Flooding in Iowa destroys some
of the corn and soybean crop.
What will happen to the price
and quantity for each of these
crops?
To next
Try it!
Try it!
With the increase in gasoline
prices, demand has shifted away
from large cars and SUVs and
toward hybrid cars like the Prius.
Draw a graph showing the supply
and demand for hybrid cars before
and after the increase in the price
of gasoline. What do you predict
will happen to the price of hybrids
as the price of gasoline rises?
To next
Try it!
Terminology: Demand Compared to
Quantity Demanded
 Change in demand
• Refers to a shift in the demand curve
• Caused by a change in one of the shifters of
the demand curve
 Change in quantity demanded
• Refers to a movement along the same
demand curve
• Caused by a change in the price
This can be illustrated with our model.
77
Terminology: Demand Compared to
Quantity Demanded
Change in demand
Change in quantity demanded
P
P
S
S1
S2
PE2
PE1
PE1
D2
PE2
D1
QE1 QE2
D
Q
QE1 QE2
Q
Note: the change in quantity demanded results from a change in supply.
78
Terminology: Supply Compared to Quantity
Supplied
 Change in supply
• Refers to a shift in the supply curve
• Caused by a change in one of the shifters of
the supply curve
 Change in quantity supplied
• Refers to a movement along the same supply
curve
• Caused by a change in the price
79
Terminology: Supply Compared to Quantity
Supplied
Change in supply
Change in quantity supplied
P
P
S1
S
S2
PE2
PE1
PE1
PE2
D2
D
QE1 QE2
D1
Q
Q
QE1 QE2
Note: the change in quantity supplied results from a change in demand.
80
Understanding the Price of Oil
 The supply and demand model can be
used to understand the behavior of oil
prices since 1960.
 Let’s turn to the following diagram.
81
Understanding the Price of Oil
82
Takeaway
Your understanding of this chapter should include
the following:
1. Market competition brings about an equilibrium in which
quantity demand equals quantity supplied.
2. Only one price/quantity combination is a market
equilibrium and you should be able to identify this
equilibrium in a diagram.
3. You should understand and be able to explain the
incentives that enforce the market equilibrium. What
happens when the price is above the equilibrium price?
Why? What happens when the price is below the
equilibrium price? Why?
83
Try it!
If garden gnomes regain
widespread popularity,
what will happen?
a) Equilibrium Price and
Quantity both fall.
b) Equilibrium Price and
Quantity both rise.
c) Equilibrium Price falls and
Quantity rises.
d) Equilibrium Price rises and
To next
Quantity falls.
Try it!
Try it!
To next
Try it!
Try it!
#1: New machine is invented that lowers the cost of harvesting oranges.
Try it!
#2: The FDA announces health benefits to eating oranges.
Try it!
#2: The income of consumers falls and some orange growers quit the business
and turn their orange groves into housing developments..
Second Edition
End of Chapter 4
Chapter 7
The Price System:
Signals, Speculation,
and Prediction
Second Edition
Chapter Outline




Markets link the world
Markets link to each other
Solving the great economic problem
A price is a signal wrapped up in an
incentive
 speculation
 signal watching
 prediction markets
91
Introduction
 Prices…
• Convey important information
• Create incentives
 In other words, prices integrate markets
and motivate entrepreneurs
 We will see how the price system enables
societies to mobilize knowledge and
resources toward common ends…
 All without central planning
92
Markets Link the World
 Just where did that rose
you gave or received last
Valentine’s Day come
from?
 Likely…
• Grown in Kenya
• Flown to the largest flower
auction in Holland
• Loaded onto cooled aircraft
• Becomes a gift of love in
Stillwater, Oklahoma
• All this in 72 hours.
93
Markets Link to Each Other
 Shifts of supply and demand in one market
affect the entire world market
 Let’s see how the market for Oil and flowers
are linked.
 Example
• Prior to 1970s – roses were grown in American
greenhouses.
• Higher oil prices in the 1970s → ↑ costs of
growing roses in greenhouses
• It became cheaper to grow flowers in warm
countries and ship them to colder countries
• Flower production moved from California to Kenya
94
Markets Link to Each Other
•The price of oil rose.
•Brazil shifted sugar
cane into ethanol
production (rather than
table sugar).
•As a result, table sugar
got more expensive.
Thus, one way that we economize on oil is by eating fewer donuts!
95
Try it!
Sawdust is used for bedding milk
cows.
What did the end of the housing
boom in 2007 do to the price of
milk?
96
From Oil to Candy Bars and Brick
Driveways
 The price of oil affects how driveways are
built.
• 42-gallon barrel of oil is refined into gasoline
and other products
• Asphalt is what is left after the other products
• High price of gasoline will cause refiners to ↑
production of gasoline and ↓ production of
asphalt → ↑ price of asphalt
• ↑ price of asphalt → ↑ use of concrete,
cobblestone, and brick
97
Solving the Great Economic Problem
 Great Economic Problem – limited
resources, unlimited wants
• Commodities (Oil) are not equally valuable in
all uses.
• If the supply of oil ↓, oil should shift to higher
valued uses. How?
 Central planner – lacks information and incentives
 There is a better way.
98
Solving the Great Economic Problem
 Price system
• Each user compares the values of
commodities in alternative uses.
• Each user has an incentive to give up a
commodity if it has a lower value than in
alternative uses.
 In the free market, the price of the good
(asphalt) is equal to its opportunity cost.
Let’s use our model to show how the market
allocates goods to their highest value uses
99
Solving the Great Economic Problem
Price of oil
per barrel
High Valued uses
Satisfied
demands
Market
price
Supply
Unsatisfied
demands
Any use of oil
valued less than
the market price
will not get oil
Low Valued uses
Demand
Market Quantity
Quantity
of oil
(MBD)
100
Solving the Great Economic Problem
 How does the market solve the problem created
by a decrease in supply?
Price of oil
per barrel
New
Market
price
High Valued uses
New Supply
Satisfied
demands
Market
price
Additional
unsatisfied
demands
Old Supply
Unsatisfied
demands
Low Valued uses
Demand
New market Market
Quantity Quantity
Quantity
of oil
(MBD)
101
SEE THE INVISIBLE HAND
Hayek saw the
invisible hand
“the marvel is that in a case like
that of the scarcity of one raw
material, without an order being
issued, without more than
perhaps a handful of people
knowing the cause, tens of
thousands of people… are made
to use the material or its
products more sparingly; i.e.,
they move in the right direction”
- Nobel Laureate Friedrich Hayek
102
A Price is a Signal Wrapped Up in an
Incentive
 How is order produced from freedom of
choice?
 When the price of oil rises,…
• all users are encouraged to economize…
 By using less, or,…
 Substituting to a lower cost alternative.
• It is a signal…
 To suppliers to invest more in exploration.
 To look for alternative sources of energy.
103
A Price is a Signal Wrapped Up in an
Incentive
 Politicians and consumers sometime fail to
understand the signaling role of prices.
• Example: After a hurricane, prices of ice,
generators, and chainsaws skyrocket
 Consumers complain of price gouging
 Politicians call for price controls.
• This is a bad rap on the market
because it is just doing its job:
signaling for more resources to come to the
rescue!
104
A Price is a Signal Wrapped Up in an
Incentive
 Losses are also a signal
• Businesses that fail to produce goods people
want at low prices will fail
• Resources will go to firms that are able to do
this
• Entrepreneurs with the best ideas may
succeed. Others will fail.
 Result: In a successful economy there will
be many unsuccessful firms.
105
Try it!
 Imagine that whenever the supply of
oil rose or fell, the government sent
text messages to every user of oil
asking them to use more or less oil as
the case warranted. Suppose that the
messaging system worked very well.
Is such a messaging system likely to
allocate resources as well as prices?
Why or why not? What is the
difference between the message
system and the price system?
To next
Try it!
Speculation
 Speculation is the attempt to profit from future price
changes.
• If a speculator believes the supply of a good will decrease
in the future (driving up its price), the speculator can make
money by buying the good now when the price is low and
selling the good in the future when the price is higher.
 Speculators may not always be correct, but they have
strong incentives to be as accurate as possible
because when they are wrong, they lose money.
 Speculation can smooth prices fluctuations.
107
Speculation Tends Smoothens Prices and
Increases Welfare
 Prices without speculation
Price
Supply
Price
Supply
Price in
future
Today’s
price
Demand
Demand
Q
Production
today
Production
future
Q
108
Speculation Tends Smoothens Prices and
Increases Welfare
 Prices with speculation
Price
Supply Supply
Into
storage
Price in
future
Price
with
speculation
Today’s
Price no
speculation
Price
Supply Supply
Loss in value
Production
today
Consumption =
Production minus storage
Gain in
value
Q
Out of
storage
Result:
• Stable price
• ↑Welfare
Q
Production
future Consumption =
Production plus inventory
109
Speculation
 Why Do Speculators Have an Image Problem?
• They raise prices today but lower prices in the future
 Everyone sees the price increase
 No one sees that the future price is lower than it would have
been
 Why is society better off with speculation?
• Oil is moved from when it is lower valued to when it is
higher valued.
 Speculators don’t always guess correctly, but…
• They use their own money.
• They have a huge incentive to be right.
• Bad speculators go bankrupt.
110
Takeaway
 Markets are linked
• Geographically
• Through time
• Across different goods
 The market acts like a giant computer that
arranges limited resources over space, time,
and across different goods to satisfy as many
of our wants as possible.
 Prices are the signals that coordinate this
economic activity.
111
Takeaway
 Free market prices reflect information.
 Prices in futures markets can signal…
• War in the Middle East
• Cold weather in Florida
• Who will win the next election
 Prediction markets are being created to
help businesses, governments, and
scientists predict future events.
112
End of Chapter 7
Second Edition