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Economics for Leaders Lesson 3: Open Markets Economics for Leaders Economic Reasoning Principle # 3: People respond to incentives in predictable ways. • Choices are influenced by incentives, the rewards that encourage and the punishments that discourage actions. When incentives change, behavior changes in predictable ways. Economic Reasoning Principle # 4: Institutions are the “rules of the game” that influence choices. • Laws, customs, moral principles, superstitions, and cultural values influence people’s choices. These basic institutions controlling behavior set out and establish the incentive structure and the basic design of the economic system. Choose Between Alternatives People do things that make them better off. Do it if…… MB > MC Economics for Leaders Where do prices come from? Prices are the result of interaction between buyers and sellers (demanders and suppliers). Prices are determined in the marketplace. We just saw this happen! MB > MC Economics for Leaders Production (Supply) People do things that make them better off. For a producer, the benefit is the price received from selling the good. For the producer, the cost is the opportunity cost of the materials and risk involved in producing the good. MB > MC Economics for Leaders The World is Full of People The World is Full of People Let’s Graph it Law Of Supply sellers could produce other things price → opportunity cost high price → produce more higher price means more incentive to produce this good relative to what else you could do supply represents marginal (opportunity) cost willingness to sell (corn/ethanol) Economics for Leaders Sellers Consumption (Demand) People do things that make them better off. For a buyer, the benefit is the satisfaction from consuming the good. For a buyer, the cost is the price paid for the good (what is given up). MB > MC Economics for Leaders The World is Full of People The World is Full of People Let’s Graph it Law Of Demand consumers could purchase other things price → opportunity cost high price → purchase less higher price means less incentive to consume this good relative to what else you could do demand represents value (compared to alternatives) willingness to pay (gasoline) Buyers Economics for Leaders How Do Markets Work? Buyers and sellers each perform cost/benefit analysis. Buyers Price is a measure of relative scarcity. Price represents opportunity cost. Price sends signals/incentives to players. Economics for Leaders Sellers Buyers Economics for Leaders Equilibrium Sellers Buyers Economics for Leaders Equilibrium Sellers Buyers Dis-quilibrium Sellers Buyers Dis-quilibrium Sellers Buyers Equilibrium Sellers Property rights, information, interaction and competition. Price squeezes to where Qs = Qd & market clears. This price facilitates all transactions that can make both a buyer and a seller better off. Economics for Leaders What If Something Changes? price income, price of other goods, tastes & preferences Recall the market for ice cream. Suppose the weather gets hotter. What would you expect to happen? Buyers Economics for Leaders ↑ T&P Price of Ice-Cream Cone 1. Hot weather increases the demand for ice cream . . . D shifts right Supply shortage at P1 New equilibrium $2.50 2.00 2. . . . resulting in a higher price . . . ΔD Disequilibrium P adjusts Qs responds Law of S Initial equilibrium D D 7 3. . . . and a higher quantity sold. 10 Quantity of Ice-Cream Cones P ↑ to restore equilibrium (sellers respond, Qs ↑) new equilibrium: higher P & higher Q What If Something Changes? price price of inputs, technology, weather Recall the market for ice cream. Suppose the price of sugar increases. What would you expect to happen? Sellers Economics for Leaders ↑ P input Price of Ice-Cream Cone S2 S shifts left 1. An increase in the price of sugar reduces the supply of ice cream. . . S1 shortage at P1 New equilibrium $2.50 Initial equilibrium 2.00 2. . . . resulting in a higher price of ice cream . . . ΔS Disequilibrium P adjusts Qd responds Law of D Demand 4 7 3. . . . and a lower quantity sold. Quantity of Ice-Cream Cones P ↑ to restore equilibrium (buyers respond, Qd ↓) new equilibrium: higher P & lower Q Big Ideas Scarcity implies/necessitates rationing. Rationing implies/necessitates competition. Markets coordinate information & competition. Markets allocate scarce resources to the production of the goods and services. Markets distribute produced goods and services to society. Economics for Leaders Big Ideas Goods go to consumers with the highest value. Goods are produced by sellers with the lowest opportunity cost. The well-being of society is maximized. Economics for Leaders Big Ideas Markets dynamically adjust to reflect changes in relative scarcity and preferences. People respond to incentives in predictable ways. Profit is the Motivator! Competition is the Regulator! Economics for Leaders