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Unit II: The Market Economy Demand • Demand indicates how much of a product consumers are both willing and able to buy at each possible price during a given period, other things remaining constant. Law of Demand • The law of demand says that quantity demanded varies inversely with price, other things constant. • Thus, the higher the price, the smaller the quantity demanded. What Explains the Law of Demand • The Substitution Effect – many goods & services are capable of satisfying your particular wants • Some options have more appeal than others (ex. pizza vs. raw oysters) • However, scarcity is a reality • As one good becomes relatively cheaper, consumers are more willing to buy it • As a good becomes more expensive, consumers turn to substitutes What Explains the Law of Demand • Income effect – • As price declines for a product, your real income increases • This increases your ability to buy more of that good, and indirectly other goods • Conversely, an increase in price reduces your real income Diminishing Marginal Utility • Marginal utility – the change in total utility resulting from a one-unit change in consumption of a good • Law of diminishing marginal utility – the more of a good a person consumes per period, the smaller the increase in total utility from consuming one more unit, ceteris paribus Diminshing Marginal Utility for Chick-fil-A Spicy Chicken Sandwiches Price $2 $1 $.50 $.25 $.13 Quantity of Sandwiches Consumed What is Demand? • There is a limited amount of goods out there • How do we decide what we want? • Demand is made up of two elements: – Desire for Goods and Services – Means to purchase those Goods and Services Demand Schedules • Let consider how many CDs you might demand in a month. (This is called “Quantity Demanded”) • We will first look at this information in a table called a “Demand Schedule” • Demand Schedule - a table showing the relationship between the price of a good and the quantity demanded per period of time, ceteris paribus. Demand Schedule Price of CDs ($) Quantity Demanded per month Demand Schedule P ($) Qd $20 5 Demand Schedule P ($) Qd $20 5 $15 7 Demand Schedule P ($) Qd $20 5 $15 7 $10 15 Demand Schedules and Curves • Another way of characterizing Demand instead of using a schedule is a Demand Curve. • Demand Curve - a diagram showing the relationship between the price of a good and the quantity demanded per period of time, ceteris paribus. Demand Curve Demand Curve P($) Note: ALWAYS label your axes! Qd per month Demand Curve P($) 20 15 10 5 0 5 10 15 Qd per month Demand Curve P($) A 20 15 10 5 0 5 10 15 Qd per month Demand Curve P($) A 20 B 15 10 5 0 5 10 15 Qd per month Demand Curve P($) A 20 B 15 C 10 5 0 5 10 15 Qd per month Demand Curve P($) A 20 B 15 C 10 D 5 0 5 10 15 Qd per month Market Demand Curve • The demand curve we just drew was the Demand for CDs by one person. • Market Demand Curve - a curve showing the relationship between the price of a good and the total quantity demanded by all consumers in the market per period of time, ceteris paribus.Market demand curves are obtained by summing the demand curves of individual consumers. Market Demand Schedule • Market Demand Schedule - a table showing the relationship between the price of a good and the total quantity demanded by all consumers in the market per period of time, ceteris paribus. • Market demand schedules are obtained by summing the demand schedules of individual consumers. Market Demand Schedule 5 Mary’s Qd 3 10 2 15 1 P($) Market Demand Schedule 5 Mary’s Qd 3 John’s Qd 12 10 2 8 15 1 3 P($) Market Demand Schedule 5 Mary’s Qd 3 John’s Qd 12 Tom’s Qd 7 10 2 8 5 15 1 3 4 P($) Market Demand Schedule 5 Mary’s Qd 3 John’s Qd 12 Tom’s Qd 7 Market Qd 22 10 2 8 5 15 15 1 3 4 8 P($) Individual Demand for Pizzas (a) Hector (b) Brianna (c) Chris $12 $12 8 4 8 4 8 4 Price $12 dH 1 2 3 Figure 4.4 1 2 Pizzas (per week) dB dC 1 Market Demand for Pizzas (d) Market demand for pizzas dH + dB + dC = D Price $12 8 4 1 2 3 Figure 4.4 6 Pizzas (per week) Elasticity of Demand • Elasticity = responsiveness • Elasticity of demand measures how responsive quantity demanded is to a price change Elasticity of Demand • A demand curve can show how sensitive quantity demanded is to a price change • Example: A superstore would like to know what will happen to its total revenue if it introduces an “Everything for a Dollar” section • The law of demand says the lower price will increase quantity demanded. • But by how much? Computing the Elasticity of Demand • Elasticity of demand measures the percentage change in quantity demanded divided by percentage change in price. Elasticity of demand = Percentage change in quantity demanded Percentage change in price Elasticity Values • Elastic: > 1.0 • Unit elastic: = 1.0 • Inelastic: < 1.0 Elasticity and Total Revenue • Knowing a product’s elasticity can help businesses with their pricing decisions. • Total revenue is price multiplied by the quantity demanded at that price. • TR = P x Q Elasticity & Total Revenue • What happens to total revenue when price decreases? • A) lower price = producers paid less per unit - this tends to lower TR • B) BUT law of demand says a lower price = increase in quantity demanded which tends to increase TR Elasticity & Total Revenue • Example: • When elasticity is > 1.0 (elastic), reducing the price by 5% will cause quantity demanded to increase by more than 5 %; thus TR will increase • When elasticity is 1.0 (unit elastic), reducing the price by 5% will cause quantity demanded to increase by 5 %; thus TR will remain unchanged Elasticity & Total Revenue • When elasticity is < 1.0 (inelastic), reducing the price by 5% will cause quantity demanded to increase, but by less than 5 %; thus TR will fall • If demand is inelastic – producers will never willingly cut the price since that would reduce TR • Why cut price if selling more reduces TR? The Revenue Test • • • • • • Price ↑ total revenue ↓ = Elastic demand Price ↓ total revenue ↑ = Elastic demand Price ↑ total revenue unchanged = Unit elastic Price ↓ total revenue unchanged = Unit elastic Price ↑ total revenue ↑ = Inelastic demand Price ↓ total revenue ↓ = Inelastic demand Determinants of Demand Elasticity • 1) Availability of substitutes • the more substitutes there are for a good, the greater its elasticity of demand • The more broadly a good is defined, the fewer substitutes there are and the less elastic the demand • Ex. Shoes (inelastic) • Nike shoes (elastic) Determinants of Demand Elasticity • 2) Share of consumer’s budget spent on the good • If a good represents a large share of a consumer’s budget, a ∆ in price of such a good has a substantial impact on the amount consumers are able to purchase • The more important the item is as a share of the consumer’s budget, the more elastic is the demand for them Determinants of Demand Elasticity • 3) A matter of time • consumers may substitute lower-priced goods for higher-priced goods, but finding substitutes usually takes time • OPEC: ’73-’74 gas prices ↑ 45%; Qd ↓ 8% • Over time people smaller cars, public transportation, energy efficient appliances, etc. • The longer the period of adjustment, the more elastic in demand a good is • Demand is more elastic in the long run than in the short run Demand Becomes More Elastic Over Time $3.50 3.00 Price per gallon Dy Dm Dw 0 Figure 4.4 50 75 95100 Millions of gallons per day Selected Elasticities of Demand Product Short Run Long Run Electricity (residential) 0.1 1.9 Air travel 0.1 2.4 Medical care and hospitalization 0.3 0.9 Gasoline 0.4 1.5 Movies 0.9 3.7 Natural gas (residential) 1.4 2.1 Figure 4.5 Change in D vs. Change in Qd • Change in Quantity Demanded - a change in the desire or means to purchase the good, thus there is a change in quantity demanded at EVERY price. (Price Effect) • Change in Demand - a shift of the demand curve Change in D vs. Change in Qd • Changes in Demand • Increase in demand - demand curve shifts to the right • Decrease in demand - demand curve shifts to the left Change in Demand • Factors Which Cause a Change in Demand 1) 2) 3) 4) 5) Consumer Income Price of Related Goods Number & Composition of Buyers Consumer Expectations about Future Prices Consumer Tastes and Preferences Change in Demand - Income • If you graduate from college and start making a substantial income - What might happen to the amount of CDs you would want to buy? – It would increase! You would be willing and able to purchase more CDs at every price. – Thus, demand has increased. Change in Demand - Income • If after a year at your new job the boss cuts salaries by 30%. What happens to Demand? – It would decrease. – You are now have less means to purchase CDs at all prices. Normal and Inferior Goods • Given the information we have, CDs are a “normal good” • Normal Good - any good which increases in demand as income increases (and vice-versa) • Most goods are normal • Inferior Good - any good which decreases in demand as income increases (and vice-versa) • Ex. - Macaroni and Cheese Change in Demand - Price of Related Goods • Substitute - a good which can be consumed in place of another good • What would happen to the demand for pizza if the price of hamburgers fell? – The demand for pizza would probably fall since people would be buying hamburgers instead. Change in Demand - Price of Related Goods • Complement - a good which is consumed along with the consumption of another good • Ex - Peanut Butter and Jelly are complements. • If price of peanut butter increases, consumers purchase less peanut butter • Result Consumers purchase less jelly • Since people buy less peanut butter they need less jelly for PB&J sandwiches Change in Demand - Price of Related Goods • Thus, either of the following will increase Demand • Price of a substitute good increases • Price of a complement good decreases • And either of the following will decrease Demand • Price of a substitute good decreases • Price of a complement good increases Change in Demand – Number of Buyers The more buyers in the market for a good, the greater the TOTAL quantity demanded (by the whole economy) of the good at a given price. Since the quantity demanded is higher at EVERY given price, the demand has increased. Likewise, if there are less buyers in the market there is less quantity demanded at every price, so demand has decreased. Change in Demand Expectations about Future Prices • If we were to hear a new story about how CD prices were going to go up next month, would you buy that CD you have had your eye on now or later? – Now. If you know prices will rise, you will want to buy more now, so you can avoid paying the higher price in the future. – So demand will increase in response to this information Change in Demand Expectations about Future Prices • Likewise, if we hear that CD prices are going to drop next month, what do we do now? – It is likely that we will buy less now, waiting to buy that new CD until the prices fall next month, thus demand will decrease. Change in Demand - Tastes and Preferences • Let’s say we find out listening to CDs can improve your hearing, or what if suddenly CDs become very fashionable to buy? If consumers prefer more of a good, the demand for the good increases (a rightward shift of the demand curve). • What if we find out CDs emit dangerous radiation? If consumers prefer a good less, the demand for the good decreases (a leftward shift of the demand curve). Increase in Demand Increase in Demand P Qd Increase in Demand P D Qd Increase in Demand P D Qd Increase in Demand P D D’ Qd Increase in Qd Increase in Qd P($) Qd Increase in Qd P($) D Qd Increase in Qd P($) A D Qd Increase in Qd P($) A D Qd Increase in Qd P($) A B D Qd Supply What is Supply? • Supply is how much a firm is willing to sell at every given price, ceteris paribus • Thus, if the price of a good goes up, what would you expect the response of a firm to be? – To produce more, since prices are going up, so will profits Law of Supply • Law of Supply - the price of a product (or service) is directly related to the quantity supplied, ceteris paribus. • Quantity Supplied - the amount of a good (or service) produced by firms at a particular price. • While demand typically refers to consumers, supply typically refers to firms. Supply Schedules and Curves • Supply Schedule - a table showing the relationship between the price of a good and the quantity supplied per period of time, ceteris paribus. Supply Schedule Price of CDs ($) Quantity of CDs Supplied per month Supply Schedule P ($) Qs per month $20 15 Supply Schedule P ($) Qs per month $20 15 $15 7 Supply Schedule P ($) Qs per month $20 15 $15 7 $10 5 Supply Schedules and Curves • Supply Curve - a diagram showing the relationship between the price of a good and the quantity supplied per period of time, ceteris paribus. Supply Curve Supply Curve P($) Remember to ALWAYS label your axes! Qs per month Supply Curve P($) 20 15 10 5 0 5 10 15 Qs per month Supply Curve P($) A 20 15 10 5 0 5 10 15 Qs per month Supply Curve P($) A 20 B 15 10 5 0 5 10 15 Qs per month Supply Curve P($) A 20 B 15 10 C 5 0 5 10 15 Qs per month Supply Curve P($) AS 20 B 15 10 C 5 0 5 10 15 Qs per month Market Supply Curve • Market Supply Curve - a curve showing the relationship between the price of a good and the total quantity supplied by all firms in the market per period of time, ceteris paribus. • Market supply curves are obtained by summing the supply curves of individual firms. Market Supply Schedule • Market Supply Schedule - a table showing the relationship between the price of a good and the total quantity supplied by all firms in the market per period of time, ceteris paribus. • Market supply schedules are obtained by summing the supply curves of individual firms. Market Supply Schedule P($) 5 Firm A Firm B Firm C Market Qs Qs Qs Qs 1 3 4 8 10 2 8 5 15 15 3 12 7 22 Change in S vs. Change in Qs • Change in Supply - a shift of the supply curve • Increase in supply - supply curve shifts to the right • Decrease in supply - supply curve shifts to the left Change in Supply Factors Which Cause a Change in Supply • 1) The cost of resources used to make the good • 2) The prices of other goods these resources could make • 3) Technology used to make the good • 4) Producer expectations • 5) Number of sellers in the market 1) The cost of resources used to make the good • If the cost of plastic (making CDs) decreases • It’s now cheaper to make every quantity of CDs • In summary, if the price of a resource goes down, supply increases (shifts to the right) Supply Curve P($) A 20 A’ 15 10 5 0 5 10 15 Qs per month Supply Curve Shift Old Supply Curve A P($) 20 A’ 15 New Supply Curve 10 5 0 5 10 15 Qs per month Price of Relevant Resources • Let’s say the cost of plastic (making CDs) increases • It is now more expensive to make every quantity of CDs • In summary, if the cost of a resource goes up, supply decreases (shifts to the left) Supply Curve P($) B’ 20 B 15 10 5 0 5 10 15 Qs per month Supply Curve Shift P($) New Supply Curve Old Supply Curve B’ 20 B 15 10 5 0 5 10 15 Qs per month 2) The prices of other goods these resources could make • Nearly all resources have alternative uses • The labor, building, machinery, materials, & knowledge needed to make CDs could make other products such as DVDs • A change in price of another good these resources could make, affects the opportunity cost of making CDs 2) The prices of other goods these resources could make • If the price of DVDs falls, the opportunity cost of making CDs declines. • These resources are not as profitable in their best alternative use – which is making CDs • Now CD production becomes more attractive • As resources shift from DVD to CD production , the supply of CDs increases, or shifts to the right. 2) The prices of other goods these resources could make • On the other hand, if the price of DVDs increases, so does the opportunity cost of making CDs. • Some CD producers may make more DVDs & less CDs, so the supply of CDs decreases, or shifts to the left. • A change in the price of another good these resources could produce affects the profit opportunities of CD producers. 3) Technology • Improvement in technology lowers costs • Lower cost of production increases Supply • Worsening of technology increases costs • Higher cost of production decreases Supply 4) Expectations of Future Prices • Firms expect the price of their good to decrease in the future • Supply increases today • Firm would prefer to sell today when price is higher Expectations of Future Prices • Firms expect price of their good to increase in the future • Supply decreases today • Firm would prefer to wait until the good can be sold for a higher price 5) Number of Sellers • More sellers in the market means more quantity is being supplied at every price • Increase in supply of the good • Less sellers in the market means less quantity is being supplied at every price • Decrease supply of the good Number of Sellers • Government regulation • Strict government regulation fewer sellers in the market • Restrictions eased more sellers in the market • Taxes • Higher taxes reduces supply • Lower taxes increases supply Change in Quantity Supplied • Change in Quantity Supplied (DQs) movement along a supply curve • A change in quantity supplied can only be caused by a change in the price of the good. • Changes in Quantity Supplied • Increase in Qs - a movement to the right along a supply curve • Decrease in Qs - a movement to the left along a supply curve Increase in Supply Increase in Supply P Qs Increase in Supply P S Qs Increase in Supply P S Qs Increase in Supply P S S’ Qs Increase in Qs Increase in Qs P($) Qs per month Increase in Qs P($) S Qs per month Increase in Qs S P($) A Qs per month Increase in Qs S P($) A Qs per month Increase in Qs S P($) B A Qs per month Elasticity of Supply • The elasticity of supply measures how responsive producers are to a price change. • Responsiveness depends on how costly it is to alter output when the price changes Elasticity of Supply • If the cost of supplying an additional unit rises sharply as output expands, then a higher price will generate little increase in quantity supplied inelastic • Example: producers of cars or electricity Elasticity of Supply • If the cost of an additional unit rises slowly as output expands, the profit lure of a higher price will prompt a relatively large boost in output elastic • Examples: hot dog vending & landscaping Measurement • Elasticity of supply equals percentage change in quantity supplied divided by percentage change in price. Elasticity of supply = Percentage change in quantity supplied Percentage change in price Categories of Supply Elasticity • Supply is elastic if supply elasticity exceeds 1.0. • Supply is unit elastic if supply elasticity equals 1.0. • Supply is inelastic if supply elasticity is less than 1.0. Market Supply Becomes More Elastic Over Time Sw Sm Sy Price per gallon $3.50 3.00 0 Figure 5.4 100 200 Millions of gallons per day 300 Determinants of Supply Elasticity • One important determinant of supply elasticity is the length of the adjustment period under consideration. • The elasticity of supply is typically greater the longer the period of adjustment. Market Equilibrium • When the quantity that consumers are willing and able to buy equals the quantity that producers are willing and able to sell, that market reaches market equilibrium. Equilibrium in the Pizza Market Figure 6.1 Surplus Forces the Price Down • At a given price, the amount by which quantity supplied exceeds quantity demanded is called the surplus. • As long as quantity supplied exceeds quantity demanded, the surplus forces the price lower. Shortage Forces the Price Up • At a given price, the amount by which quantity demanded exceeds quantity supplied is called the shortage. • As long as quantity demanded and quantity supplied differ, this difference forces a price change. Market Forces Lead to Equilibrium Price and Quantity • The equilibrium price, or market-clearing price, equates quantity demanded with quantity supplied. • Because there is no shortage and no surplus, there is no longer any pressure for the price to change. Adam Smith’s Invisible Hand • Although each individual pursues his or her own self-interest, the “invisible hand” of market competition promotes the general welfare. Equilibrium in the Pizza Market Figure 6.1 Market Exchange Is Voluntary • Neither buyers nor sellers would participate in the market unless they expected to be better off. • Prices help people recognize market opportunities to make better choices as consumers and as producers. Markets Reduce Transaction Costs • Transaction costs are the cost of time and information needed to carry out market exchange. • The higher the transaction cost, the less likely the exchange will take place. • Example: car dealers find land on outskirts of town (land is cheaper); tend to locate near each other to be on hand when buyers shop for cars • Doing this, dealers reduce transaction costs of car shopping An Increase in Demand A Decrease in Demand An Increase in Supply A Decrease in Supply Both Curves Shift • Curves shift in the same direction – Equilibrium quantity will increase. – What happens to price depends on which curve shifts more. • Curves shift in opposite directions – Equilibrium price will increase if demand increases and supply decreases. – Equilibrium price will decrease if demand decreases and supply increases. Change in Demand Change in Supply Increases Figure 6.6 Decreases Equilibrium price change is indeterminate. Equilibrium price falls. Equilibrium quantity increases. Equilibrium quantity change is indeterminate. Equilibrium price rises. Equilibrium price change is indeterminate. Equilibrium quantity change is indeterminate. Equilibrium quantity decreases. Competition and Efficiency • Productive efficiency – Making stuff right • Allocative efficiency – Making the right stuff • Market competition promotes both productive efficiency and allocative proficiency. Productive Efficiency: Making Stuff Right • Productive efficiency occurs when a firm produces at the lowest possible cost per unit. • Competition ensures that firms produce at the lowest possible cost per unit. Allocative Efficiency: Making the Right Stuff • Allocative efficiency occurs when firms produce the output that is most valued by consumers. • Competition among sellers encourage producers to supply more of what consumers value the most. Disequilibrium • Disequilibrium is a mismatch between quantity demanded and quantity supplied as the market seeks equilibrium • A price floor is a minimum selling price that is above the equilibrium price. • A price ceiling is a maximum selling price that is below the equilibrium. Price Floor Figure 6.7a • If a price floor is established above the equilibrium price, a permanent surplus results. • A price floor established at or below the equilibrium price has no effect. Price Ceiling Figure 6.7b • If a price ceiling is established below the equilibrium price, a permanent shortage results. • A price ceiling established at or above the equilibrium price has no effect. The Black Market • If a price ceiling is imposed below the equilibrium price, a black market could develop. Other Sources of Disequilibrium • Government intervention in the market • Sometimes the market takes a while to adjust – New products – Sudden change in demand or supply Consumer Surplus • Consumer surplus is the difference between the most that consumers would be willing and able to pay for a given quantity and the amount they actually do pay. Market Demand and Consumer Surplus • Consumer surplus at a price of $2 is shown by the darker area. • If the price falls to $1, consumer surplus increases to include the lighter area between $1 and $2. • If the good is free, consumer surplus would increase by the lightest area under the demand curve. Figure 6.8