Download Lecture 2: Demand, Supply & Markets

Econ 1000 Lecture 2
Mod2
C.L. Mattoli
(C) Red Hill Capital Corp. 2008
1
This week


Mod 2, part1
Chapter 3
(C) Red Hill Capital Corp. 2008
2
Learning objectives: Mod 2
On successful completion of this module (3 lectures),
you should be able to:
 Explain the concepts of demand , supply , and
market equilibrium
 Use the market model to predict the direction of
change in prices and quantities caused by changes
in the market-place, and by policy changes
 Explain the concept of market failure and discuss
causes of such failure
 Explain the concept of elasticity
 Calculate and interpret price, income and crossprice elasticity of demand
 Calculate and interpret price elasticity of supply .
(C) Red Hill Capital Corp. 2008
3
This week
 Supply
 Demand
 Market
interaction of supply and
demand.
 Market equilibrium
(C) Red Hill Capital Corp. 2008
4
Demand
(C) Red Hill Capital Corp. 2008
5
Demand




We refer to concepts in economics as tools:
demand is one of those tools.
Demand for goods and services in a
capitalist economy displays a high degree
of consumer sovereignty.
Consumer sovereignty means that
consumers have freedom to choose
without coercion from business or
government.
The law of demand states that the quantity
demanded has an inverse relation to price.
(C) Red Hill Capital Corp. 2008
6
Behavior and demand




The law of demand can be derived from
behavioral first principles.
The economic word for satisfaction is
utility.
The behavioral starting point is the law of
decreasing marginal utility. The first piece
of cake tastes so good, the second piece is
pretty good, but you start to appreciate cake
less by the third or fourth piece.
From decreasing marginal utility flows the law
of demand: people will purchase more, only
if the price is less, ceteris paribus.
(C) Red Hill Capital Corp. 2008
7
Demand schedules (curves)



In order to find the total demand for a
good or service, we begin at the bottom
with individuals.
The whole is the sum of the parts, so we
begin with individual demand schedules
and sum them up to get total aggregate
demand.
A demand schedule is a summary of
buying intentions.
(C) Red Hill Capital Corp. 2008
8
Demand schedules (curves)



We can construct demand schedules only after
we introduce a price variable. Then, the demand
schedule will show how many units of
something that a buyer would be willing to
purchase at a given price.
Contrary to mathematical convention, wherein the
dependent variable is always on the vertical axis,
in economics, the dependent variable is
sometimes displayed on the horizontal axis, as in
this case demand.
On the next slide we show Pete’s demand for
burgers.
(C) Red Hill Capital Corp. 2008
9
Peter’s Demand Schedule
•Pete’s demand is
inversely related to
price.
•He will buy only 1
burger per week, if the
price is $5.50 per burger.
•He will buy 9, if the
price drops to $1.50
•Note: ceteris paribus
applies to the schedule.
Other things can also
affect demand, in
addition to price.
(C) Red Hill Capital Corp. 2008
10
Aggregate (Market) Demand



An individual demand schedule is composed of prices
that a person thinks he or she would buy at given prices:
they are buying intentions.
Then, to find total aggregated demand for the whole
market, which is simply the aggregate of whatever
aggregate we are looking at, we simply add up all of the
intentions of the participants.
For example, a company might hire a market research
firm to survey a large number of people in a particular
area of the city or the country by having them fill out
questionnaires that ask how many units of a product they
would purchase at various prices.
(C) Red Hill Capital Corp. 2008
11
Tabular Aggregate Demand: Add Columns

Once we have demand schedules for all of the members
of a society, we can find aggregate demand by adding
up the individual demands.
Price
Petie’s
Demand
Daisy’s
Demand
Donald’s
Demand
Total
Demand
$6.00
0
1
0
1
5.50
1
2
0
3
5,00
2
3
0
5
4.50
3
4
1
8
4.00
4
5
2
11
3.50
5
6
3
14
3.00
6
7
4
17
2.50
7
8
5
20
2.00
8
10
6
24
1.50
9
12
7
28
(C) Red Hill Capital Corp. 2008
12
Market aggregate demand: an example of
graph addition

We can also add the graphs, either by adding the graphical
information, itself, or by making a table, adding the table
information, and, then, graphing that.
7.00
6.00
5.00
4.00
3.00
2.00
1.00
0.00
8.00
7.00
6.00
6.00
5.00
4.00
+
+
3.00
2.00
1.00
2.00
0.00
0.00
0 1 2 3 4 5 6 7 8 9
4.00
1
2
3
4
5
6
7
8 10 12
1
3
5
8 11 14 17 20 24 28
0 1 2 3 4 5 6 7 8 9
7.00
6.00
5.00
=
4.00
3.00
2.00
1.00
0.00
(C) Red Hill Capital Corp. 2008
13
Other determinants of demand



Although price is one variable in determining
demand, it is not the only variable. That is why
we used the ceteris paribus phrase in describing
Pete’s demand in the previous slide.
All other determinants of demand are referred to
as non-price determinants.
Some major non-price determinants of demand
(NPDD) include: 1) the number of market
participants, 2) tastes and preferences, 3) incomes,
4)expectations about any number of things, and 5)
prices of somehow-related goods.
(C) Red Hill Capital Corp. 2008
14
A Lesson in Economic Language
What we have been discussing, so
far, in the language of economics, is:
changes in quantity demanded,
which result solely from changes in
price.
 Thus, change in quantity
demanded means moving along a
stationary fixed demand curve, like
those shown in previous slides,
ceteris paribus.

(C) Red Hill Capital Corp. 2008
15
Demand & Opportunity Costs




Demand involves opportunity costs.
People can buy and use only so many
things.
Thus, in choosing to buy some, they give
up buying others.
What they give up is the opportunity cost
of what they buy.
(C) Red Hill Capital Corp. 2008
16
A Lesson in Economic Language
A change in demand refers to a
change of the whole demand curve to
a new demand curve. Such
changes in demand come from
changes in the non-price
determinants of demand.
 We illustrate these concepts in the
next slide.

(C) Red Hill Capital Corp. 2008
17
Demand Changes Illustrated

We show cases of changes in quantity demanded and
changes in demand, below.
Causal chain
Causal chain
Decrease
in price
Change in
non-price
Increase in
quantity demanded
P
P
D1
Change in
demand
D2
A
B
Quantity demanded
(C) Red Hill Capital Corp. 2008
18
Non-Price Determinants of
Demand
(C) Red Hill Capital Corp. 2008
19
Intro



To get downward-sloping demand we
assumed everything else was held constant
(ceteris paribus).
For example, if the price of Pepsi falls, but
the price of coca cola falls faster, will demand
for Pepsi really increase?
So, we take a look at what happens to the
whole demand curve if other things, beyond
the price of the good, change.
(C) Red Hill Capital Corp. 2008
20
Number of buyers


Looking back at our demand addition in
previous slides, we understand that
adding buyers to a market, e.g., an
increase in population, will shift the
demand curve to the right.
A decrease in buyers, e.g., a decrease
in population, in the market will shift the
demand curve to the left.
(C) Red Hill Capital Corp. 2008
21
Number of buyers


The market for a good or service might
include both domestic and foreign buyers.
Then, for example, if China had
restrictions on CD’s imported from the US
and suddenly removed the restrictions, the
market (number of buyers) for US CD’s
would increase and the demand curve
would shift to the right.
(C) Red Hill Capital Corp. 2008
22
Tastes and preferences
Even though there is consumer
sovereignty, we understand that what
people will demand (consumer
preference) is affected by fads,
fashions, new products, and
advertising.
 Scooters were very “in” with children in
the 1950’s. Then, cool bicycles took
over in the 1960’s thru the 1990’s.

(C) Red Hill Capital Corp. 2008
23
Tastes and preferences



Scooters became cool again in the early
2000’s when they became chrome-plated
with break-down joints.
Pointy-toed women’s shoes were very “in”
in the beginning of this century, but they
have since become “out”.
Even though people have free choice, they
are affected by advertising and other
people’s opinions.
(C) Red Hill Capital Corp. 2008
24
Income


To look at the affect of income on demand,
economics, first, divides goods into 2
categories: 1) normal goods and 2) inferior
goods.
Normal ‘goods’ are any good or service
for which there is a direct relationship
between changes in income and in
demand. Thus, an increase in income
causes demand to rise at all prices:
demand curve shifts to the right. Examples
are vacations, new cars, dinner at
expensive restaurants.
(C) Red Hill Capital Corp. 2008
25
Income


Inferior goods are goods and services
for which there is an inverse
relationship between changes in
income and in demand. Examples are
used cars, cheap jewelry, and rides on
the bus. If you have a higher income,
you will prefer a new car instead of a
used one, gold jewelry instead of tin,
and taxicabs instead of the bus.
Some textbooks use categories:
luxuries and necessities.
(C) Red Hill Capital Corp. 2008
26
Expectations of buyers




What would happen to present demand, if
buyers expected future changes in: price,
income, taxes, or other factors?
Suppose bad weather ruins the summer rice crop,
will consumers expect to pay higher prices and
bid up prices? They might increase quantity
demanded at the same time because they expect a
future shortage.
Suppose consumers expect prices to decrease?
Expectations can increase or decrease demand.
(C) Red Hill Capital Corp. 2008
27
Prices of related goods (or services)
Demand for a particular good can be
affected by the prices of other goods in
one of several possible ways, which are
related to it in some way.
 The first type of related good is called a
substitute.
 Substitute goods compete directly with a
good for consumer purchases.

(C) Red Hill Capital Corp. 2008
28
Prices of related goods (or services)
For example, a rise in the price of Pepsi
might cause a rise in demand for Coca
cola.
 Complementary goods are jointly
consumed.
 For example, if the price of DVD players
falls, there will be more DVD players
purchased and the demand for DVD’s
will increase.

(C) Red Hill Capital Corp. 2008
29
Exercises
1.
2.
3.
What will be the affect for demand of used
cars, if, ceteris paribus, the price of new cars
increases by $5,000.
If the price of popcorn at movie theaters
decreases, what might you expect to happen
to the demand for soft drinks?
Is Sprite a substitute or a complementary
product for Coke?
(C) Red Hill Capital Corp. 2008
30
Supply
(C) Red Hill Capital Corp. 2008
31
Supply



In economics supply is the relationship
between possible prices of goods and
services and the quantity supplied in the
law of supply.
The law of supply says that there is a direct
relationship between the quantity of a good
or service that a supplier is willing to supply,
in a fixed time frame, and the price, ceteris
paribus.
The relationship is underpinned by
increasing opportunity costs.
(C) Red Hill Capital Corp. 2008
32
Supply of one supplier

6.00
5.00

4.00
3.00

2.00
1.00
0.00
200 220 240 260 280 300 320 340 360
(C) Red Hill Capital Corp. 2008
Supply is directly
related to price.
The Supplier is willing
to supply 220 burgers
at $2/burger and 340 at
$5/burger.
Note: ceteris paribus
applies to the
schedule. Other
things can also affect
supply, in addition to
price.
33
Opportunity costs, Consumer Sovereignty,
and the law of supply


We looked at opportunity costs when we
studied the production possibilities frontier
(PPF).
Therein, we learned that one good or
service could be produced in higher
quantities only by sacrificing the
opportunity to produce the other, in the
example of only two choices.
(C) Red Hill Capital Corp. 2008
34
Opportunity costs, Consumer Sovereignty,
and the law of supply



Consider, then, a company that has a plant that
produces cloth goods, and that it has determined
that its maximal mix of producing parachutes or
towels is 70% towels and 30% parachutes.
To change their mix, one way or the other, they
will incur opportunity costs equal to the amount
of the one they sacrifice to produce more of the
other.
Moreover, we have seen that opportunity costs
are normally increasing.
(C) Red Hill Capital Corp. 2008
35
Opportunity costs, Consumer Sovereignty,
and the law of supply


Thus, in order to be induced to produce more of one,
parachutes or towels, there must be an incentive: a
higher price, which will overcome the increased
opportunity costs of producing less of the other,
ceteris paribus.
Consumer sovereignty plays a roll in this process.
If consumers want more of a certain good or service,
they will have to bribe producers to producer more:
they will have to offer a higher price to encourage
producers.
(C) Red Hill Capital Corp. 2008
36
Exercise: Law of supply & university
degrees



There was an increase in university applications
to study internet technology with the boom in IT
in the 1990’s, and a decrease after the IT fad went
bust.
Similar enrolment trends have been seen, for
example, in earth sciences. Enrolments increase
when there is a boom in the minerals industries
and decline dramatically when the boom is over.
Can you use the law of supply to explain
university enrolments as described above?
(C) Red Hill Capital Corp. 2008
37
Exercise answer



When students make a choice of which they
degree to pursue at university they are looking to
obtain qualifications that will allow them to
supply their services to an industry that will
welcome them with a quick job at a high pay.
Thus, the prospects for easy employment at a
good salary increase the supply of students
pursuing certain degrees, like USQ and
accounting.
Therefore, the law of supply can be used to
explain the phenomenon.
(C) Red Hill Capital Corp. 2008
38
Market supply




We can find market supply in a similar manner as we
found market demand: by summing up the quantities that
would be supplied (are willing to sell) by the various
suppliers in the market, which is the totality of suppliers
and demanders, at various prices.
We can define the market in any way we like. We
simply must be careful to include all the suppliers that
belong in what we are defining as “the market”, no more,
no less.
“The market” might be a section of a city, a city, a state, a
region, a country, or the whole world.
We show the supply curve for the city market of burgers,
of which the single supplier in the preceding slide is a
part, in the next slide.
(C) Red Hill Capital Corp. 2008
39
Supply of hamburgers in one city



(C) Red Hill Capital Corp. 2008
Quantities supplied each
by each supplier are
summed for each price.
Suppliers are willing to
supply 700 burgers at $2
and 1400 at $5/burger.
Note: ceteris paribus
applies to the
schedule. Other
things can also affect
supply, in addition to
price.
40
Graphical summed supply of hamburgers
Like in the case of demand, we can sum the various quantities supplied
by suppliers in the market in table form and graph it or directly sum the
graphs
10
0
80
60
40
11
00
13
00
15
00
6.00
5.00
4.00
3.00
2.00
1.00
0.00
70
0
=
+
20
0
24
0
28
0
32
0
36
0
+
6.00
5.00
4.00
3.00
2.00
1.00
0.00
10
6.00
5.00
4.00
3.00
2.00
1.00
0.00
90
0
6.00
5.00
4.00
3.00
2.00
1.00
0.00
49
0
62
0
76
0
90
0
10
40

(C) Red Hill Capital Corp. 2008
41
Again, a language lesson




A change in quantity supplied is a move along a
given supply curve, like those shown in previous
slides. At a higher price, suppliers will offer
larger quantities for sale.
Cause and effect: effect of price rise is increase
in quantity supplied.
In contradistinction, a change in supply is a shift
of the whole supply curve. A decrease in supply
is a shift to the left. An increase in supply is a
shift to the right.
These happen when ceteris paribus is lifted and
non-price factors come into play.
(C) Red Hill Capital Corp. 2008
42
Pictorial Supply Changes

We show cases of changes in quantity supplied and
changes in supply, below.
Causal chain
Causal chain
Increase
in price
Change in
non-price
Increase in
quantity supplied
P
P
Increase in
supply
S1
S2
B
A
Quantity Supplied
(C) Red Hill Capital Corp. 2008
43
Non-price factors of supply

In addition to price, as was also the case
with demand, non-price factors can
affect supply. Major factors include:
1. Number of
4. Taxes and subsidies
suppliers (sellers)
2. Technological
5. Expectations of
changes
producers
3. Prices of inputs
6. Prices of other goods
that could be produced

We cover each, in turn
(C) Red Hill Capital Corp. 2008
44
1. Number of suppliers (sellers)


We have defined the market for supply as
the sum of suppliers in the market, and
we have demonstrated in our beginning
study of supply that the quantity supplied
will increase at every price as more sellers
are added to the market.
Similarly, if suppliers exit the market for
one reason or another, the supply curve
will shift to the left.
(C) Red Hill Capital Corp. 2008
45
1. Number of suppliers (sellers)
Addition and disappearance of
suppliers can happen for obvious or
subtle reasons.
 A factory can shift its own production
from one good to another.
 Barriers to trade can be erected or
taken down by a country.
 Disease can destroy a farmer’s crop.

(C) Red Hill Capital Corp. 2008
46
Technological changes





Technological development has always made
it possible to produce more goods more
efficiently and cheaply.
Horses and oxen tied to a plough made it
easier for farmers to plant crops.
PC’s allow workers to design things and make
calculations more quickly and accurately.
Robots make automobiles more quickly and
with more precision than people.
Technological developments are continually
allowing supply curves to be shifted out.
(C) Red Hill Capital Corp. 2008
47
Prices of inputs



Natural resources, raw materials, semi-finished
goods, labor, capital, and entrepreneurship are
all required as input to produce the output of
supply.
Increases and decreases of any price of inputs
will affect the prices that suppliers need to
charge for output, and supply curves will be
shifted.
Suppose that automobile workers sign a contract
to increase their hourly wages. Then, the price
that automobile companies must charge for cars
will increase and the supply curve will be shifted
upward (in the convention of the book: left).
(C) Red Hill Capital Corp. 2008
48
Taxes and subsidies



Taxes are another type of expense that companies
have in their businesses.
If a company is taxed more heavily, it will want
to pass that extra cost on to the consumer.
Consequently, the supply curve will shift
upward, and the same quantities supplied will all
be at higher prices.
Subsidies to industries can have the opposite
affect. If a government pays subsidies to farmers
who produce corn, the supply of corn will
increase.
(C) Red Hill Capital Corp. 2008
49
Expectations of producers



Producer expectations can also affect the
supply curve.
Producers are doing business to make money,
and they will act in their own self-interest.
For example, if a particularly cold winter is
expected, there will be a high expected
demand for woolen sweater, scarves, and
coats. The response from suppliers of wool
may, therefore, be to restrict, not to increase,
supply, in order to get higher prices.
(C) Red Hill Capital Corp. 2008
50
Expectations of producers


On the other hand, if producers know that new
technology is coming out that will make
production cheaper, and also prices, they may
increase supply and dump it ahead of the
longer term price reduction from technological
change.
In general, anticipation of high demand will
cause them to restrict, and anticipation of low
demand will cause them to increase supply.
(C) Red Hill Capital Corp. 2008
51
Prices of other goods that could be
produced by producers
Since producers often have a choice
between diverting productive resources
to producing a number of different
outputs, the relative price of one good
may cause them to redirect their
production from one to the other.
 Shifting production to the good with the
relatively higher price will give them,
higher profits.

(C) Red Hill Capital Corp. 2008
52
Prices of other goods that could be
produced by producers
For example, if the price of tomatoes
rises relative to the price of lettuce,
farmers will divert more acreage to
growing more tomatoes and less lettuce .
 The underlying economics reason is that
the opportunity cost of producing
lettuce, in terms of foregone production
and profits from tomatoes, has increased

(C) Red Hill Capital Corp. 2008
53
Another language lesson




You can think of an increase in demand as
higher quantity demanded at every price, a
shift of the curve to the right.
Alternatively, you can think of the increase as
a higher price for every quantity, a shift
upward.
For supply, a shift to the right is increase in
supply: more quantity at every price.
Or, a shift down, lower price for every
quantity. And vice versa.
(C) Red Hill Capital Corp. 2008
54
Exercise
Aluminum beer and soda cans are litter, on the one
hand, and could be recycled, on the other hand.
Without incentives to recycle, not many are
recycled. However, what do you suppose will
happen, if consumers are required to pay a 5¢
deposit on cans, which will be refunded, if cans are
recycled?
1.
What will happen to supply of recycled cans?
2.
What is the likely affect on demand for beer and
soda?
3.
Can you identify any non-price demand
determinants that might be affected?
(C) Red Hill Capital Corp. 2008
55
Answer
1.
2.
3.
Supply will increase because people have an
incentive to return cans to get their 5 cents back
Demand may decrease because people are
offended to pay the extra cost and the hassle of
returning cans.
People might substitute other beverages that
don’t come in cans.
(C) Red Hill Capital Corp. 2008
56
Exercise

1.
2.
3.
What will be the affect for supply of the
following:
A cheaper means is found for producing
computer chips.
Farmers are paid not to plant wheat.
Frost destroys much of the orange crop.
(C) Red Hill Capital Corp. 2008
57
Answers
1.
2.
3.
The supply curve will shift right: more chips
supplied at a given price.
If they are paid to plant less wheat, the supply
will decrease: shift to the left, less wheat at same
price as previously.
Supply will shift left.
(C) Red Hill Capital Corp. 2008
58
Market Analysis:
Supply meets Demand
(C) Red Hill Capital Corp. 2008
59
Markets




Markets are one of the centerpieces of capitalist
economies.
A market is any arrangement whereby interaction of
buyers and sellers determine prices and quantities of
goods or services exchanged (traded).
A major aspect of this market interaction is competition.
Because, in the end, there are limited quantities, on the
one hand, and limited buyers, on the other hand, both
groups will compete among themselves.
The big question for supply and demand is what selling
price and quantity will prevail in the marketplace
(C) Red Hill Capital Corp. 2008
60
Surplus or shortage



Consider the city hamburger market for which we have
looked at supply and demand. We summarize the market in
the table, below.
Assume that burger bars decide to supply 1400 at a price of
$5. Then, according to the demand schedule, only 900 can
be sold, and that would result in a surplus of 500 burgers
per week, which would be thrown in the trash.
A surplus exists when the amount supplied is greater than
the quantity demanded.
(C) Red Hill Capital Corp. 2008
61
Dealing with surplus





Especially, in a competitive market, there will be
downward pressure on prices.
Suppliers will be left with excess supply that they will
want to get rid of.
In the case of burgers, they will have to thrown away.
For other non-perishable goods, they must be stored
somewhere as excess inventory, and the cost of storage
space becomes an additional cost
The best way to do that is to sell the excess at a lower
price. It is better to get paid something than nothing at
all.
Thus, the price will begin to drop.
(C) Red Hill Capital Corp. 2008
62
What if there is too little supply




What if, instead, the market starts out with a price of $2
per burger?
Then, demand will be 1500 burgers per week versus a
supply of only 800.
Consumers will be left with their wants unsatisfied, and
suppliers will face lost opportunity of selling those extra
burgers.
The market will have a shortage, the condition where
demand exceeds supply.
(C) Red Hill Capital Corp. 2008
63
Dealing with shortage
When there is a shortage, at least some
people will try to get their wants satisfied
by offering to pay a higher price for the
good or service.
 After all consumer sovereignty says the
consumer is king, and he will use that to
try to beat out other consumers: money,
sometimes, talks.

(C) Red Hill Capital Corp. 2008
64
Dealing with shortage


As he beats out his consumer competition,
others will follow because they do not want
to be left even shorter of the good.
As suppliers see that price is increasing,
they will be willing to sacrifice
opportunities elsewhere and apply more of
their productive resources to burger
production, and the supply will also
increase.
(C) Red Hill Capital Corp. 2008
65
The market processes



Suppliers probably do not know what the
actual demand curve is, and demanders
probably do not know what the supply
curve is.
If there is a shortage, demanders will
want to pay more to satisfy their needs,
and suppliers will raise the price and
supply more.
They might not get it right, the first time,
and a shortage will still exists.
(C) Red Hill Capital Corp. 2008
66
The market processes



They will just have to keep adjusting until a
point is reached at which the market is exactly
cleared: demand = supply.
Similarly, if a surplus exists, especially, if it is
in an industry where the excess is kept in
limited inventory storage space, sellers will
drop their prices to try to get rid of excess
inventories.
Producers will begin to produce less and
lower prices, but it might also take a few
rounds of adjustment before a proper point is
reached at which supply=demand.
(C) Red Hill Capital Corp. 2008
67
The market processes




Indeed, suppliers might undershoot the proper point when
a surplus initially existed, and a slight shortage might
ensue.
Suppliers might overshoot after an initial shortage and
create a slight surplus.
In the end, because of this balancing act of interaction
between supply and demand, because of consumer
sovereignty, the decreasing marginal utility, and
increasing opportunity costs, a final point of equilibrium
will be reached in free markets, at which the market is
exactly cleared of goods at the price at which they are
offered where supply ≡ demand.
We show this in the next slide.
(C) Red Hill Capital Corp. 2008
68
Reaching market equilibrium

The processes of price decreases for surplus and increases for
shortages are shown in the graph of supply meets demand,
below, along with the final equilibrium.
•In the diagram, the
initial reactions are
shown by solid arrows,
and the secondary
reactions are sown by
dashed arrows.
•Thus, in surplus, the
suppliers begin to drop
prices and the
demanders begin to buy
more.
•In shortage, the
consumers bids up the
price, and suppliers
begin to supply more.
Supply curve
Demand curve
(C) Red Hill Capital Corp. 2008
69
Causal chains: shortage or surplus (famine
or feast)

We can show the processes that act in shortage
and surplus using causal chain diagrams, below:
Causal Chains
Quantity supplied
exceeds quantity
demanded
Quantity supplied is
less than quantity
demanded
Surplus
Prices will be offered
down until equilibrium
is reached
Shortage
Prices will be bid up
until equilibrium is
reached
(C) Red Hill Capital Corp. 2008
70
Equilibrium price and quantity



At any price except the proper one, there will be
no balance between supply and demand, and
shortage or surplus will result until producers are
in agreement with consumers in the market.
At the proper equilibrium, there will be
agreement, and consumers will exactly clear the
market of all goods at that price.
In that regard, any other point will be temporary,
and only at the unique equilibrium point of
price and quantity will there there be market
stability.
(C) Red Hill Capital Corp. 2008
71
Efficiency





When the forces of supply and demand are exactly in
balance, we say that the outcome is efficient.
Indeed, you might recall that when producers are
operating on their PPF’s they are also at efficient points.
Now, when demand is balanced by supply, producers
have settled on only one of their PPF efficient points to
produce what consumers want and get market clearing.
When supply balances with demand, we say that the
markets are acting efficiently.
In economics, an efficient outcome is, in general, one in
which society maximizes the benefits that it gets from
the use of its scarce resources.
(C) Red Hill Capital Corp. 2008
72
Cost versus benefit


We can look at situations of surplus and
shortage another way.
At a point in a market where there is a
shortage, the benefit to society, as
measured by the demand curve, is
greater than the cost, as measured by
the supply curve, and consumers are
willing to pay a price that is more than the
seller’s cost.
(C) Red Hill Capital Corp. 2008
73
Cost versus benefit



If output expands to reach equilibrium, the
additional benefit to society will exceed the
cost, and there will be a net gain to society.
Conversely, if there is shortage, the benefit
to society is less than the cost. Consumers
are not willing to pay suppliers’ costs. In
reducing supply towards equilibrium, the net
cost saving will be greater than the benefit
foregone, and society will gain, again.
In the end, we can say that the equilibrium
point is where marginal cost = marginal
benefit.
(C) Red Hill Capital Corp. 2008
74
The Price System


We have seen how the forces of supply and
demand in a free market can result in an
efficient outcome equilibrium at which price
results in clearing the quantity offered in the
market.
All other things equal, the price may be away
from equilibrium, but the forces due to
surplus and shortage will eventually push the
price to its proper efficient equilibrium level.
(C) Red Hill Capital Corp. 2008
75
The Price System
 This
is, in theory, how the so-called
price system operates.
 The price system is the mechanism
that brings about equilibrium.
 We say that price plays a rationing
role
(C) Red Hill Capital Corp. 2008
76
A Note on Curves
(C) Red Hill Capital Corp. 2008
77
Curves



We have studied a number of phenomena, so far,
like: production possibilities, supply and demand.
In all of these cases, the graphically
representations were curves, except when we
were looking to simplify models or explanations.
Indeed, we will discover that most things in
economics are not represented by simple straight
lines, and we need to understand some of the
simple mathematics of curves and how to extract
information from curved lines.
(C) Red Hill Capital Corp. 2008
78
Curve Analysis: slope



One of the most important basic tools for
analyzing curves or straight lines is the concept of
slope, which simply represents the change of one
variable with respect to change of the other:
ΔY/ΔX.
It is the chancre of Y per unit change in X since
we are dividing a finite change in Y by the
corresponding change in X.
For example, if Y changes by 10, ΔY = 10, when
X changes by 5, ΔX = 5, then, the change in Y per
unit change in X is ΔY/ΔX = 10/5 = 2. So, Y
changes by 2 for every change by one unit of X.
(C) Red Hill Capital Corp. 2008
79
Curve analysis: reasons



The simple slope calculation looks at pure
change, which is important to look at in any
analysis.
In fact we will also soon look at percentage
change per unit of percentage change when we
look at things like elasticity in upcoming
lectures, so you must get comfortable with these
concepts, in order to keep up with the course.
Looking at changes, percentages, and percentage
changes is a big part of a course in economics.
(C) Red Hill Capital Corp. 2008
80
Curve Analysis: meaning


When we looked at the PPF, we found that changing the
mix of outputs between two choices, e.g., producing
towels or parachutes, involved sacrificing the opportunity
to produce a certain amount of one to produce more of the
other. So, our opportunity cost of producing less towels
to produce more parachutes was – ΔP/ΔT, the minus sign
is due to the decrease in towel production, a negative
change, for increased parachute production, a positive
change.
Similarly, we look at the change in quantity supplied per
unit change in price as ΔS/ΔP in an analysis of supply.
(C) Red Hill Capital Corp. 2008
81
The slopes of curves




The slopes of curves changes at each point, as
we discussed in mod 1.
Indeed, that is the reason that most of the
graphs that we look at in economics are curves
instead of straight lines.
Fore example, the curved PPF has changing
slope as we move from one point to the other.
The interpretation of that is that opportunity
costs change as we sacrifice production of one
good to produce more of another.
(C) Red Hill Capital Corp. 2008
82
The slopes of curves



It is the mathematical result of the law of
increasing opportunity costs.
For a supply curve, for example, ΔS/ΔP gets
smaller and smaller as price increases because
of increasing marginal costs to produce more
and more output.
Again, there is a connection with increasing
opportunity costs, and the concept of marginal
analysis is important because the graph is a
curve and the slope changes for curves.
(C) Red Hill Capital Corp. 2008
83
Graphical Analysis of changing change

Notice that to calculate slope, properly, for the supply curve, we had to
turn it around to have the supply axis as vertical, and price on the
horizontal axis. Don’t let that confuse you, but get used to
understanding what graphs mean and not just memorizing graphs.
Slope =ΔG1/ΔG2
Slope =ΔS/ΔP
S
G1
G2
(C) Red Hill Capital Corp. 2008
P
84
Another look at estimating the slope of a
curve

You can try to find the exact tangent to a curve and
estimate the slope of the line. That is show by the dotted
line in the figure, below
alternative is to use two
sets of data points for the
graph and calculate the slope
of the line the line through
those points, as an
approximation to the tangent
line, as shown in the figure,
below.
Slope =ΔG1/ΔG2
An
G1
ΔG1
ΔG2
G2
(C) Red Hill Capital Corp. 2008
85
Ask yourself
1.
2.
3.
4.
5.
How do opportunity costs enter the laws of
supply and demand?
Why do we need to use ceteris paribus to get
the law of demand?
If supply increases and demand decreases
what will happen to price and quantity (draw a
picture to help you think about it)?
If there is a shortage, who will start the process
to change the price to get to a new equilibrium?
Who and how for surplus?
What is an efficient outcome, according to
economics?
(C) Red Hill Capital Corp. 2008
86
Exam-caliber problems
Question 1: If the same dairy can produce
either whole milk or skim milk, an increase in
the price of whole milk will results in a(n):
a) decrease in the quantity supplied of whole
milk
b) increase in the supply of whole milk
c) decrease in the supply of skim milk
d) increase in the supply of skim milk
e) decrease in the quantity supplied of skim
milk
(C) Red Hill Capital Corp. 2008
87
Exam-caliber problems
Question 2: Assuming that hamburgers and hot
dogs are substitutes, an increase in the price of
hamburgers, other things being equal, results in
a:
a) movement up along the demand curve for
hamburgers
b) leftward shift in the demand curve for
hamburgers
c) rightward shift in the demand curve for
hamburgers
d) leftward shift in the demand curve for hot dogs
e) movement up along the demand curve for hot
dogs
(C) Red Hill Capital Corp. 2008
88
Homework



Chapter 3
MC 1-18
Questions 1-12
(C) Red Hill Capital Corp. 2008
89
Homework
Homework is due each week in
tutorials.
 Do the homework before you come
to tutorials!!!!!!!!!!!!!!
 It should be handed in before the
tutorial starts.
 This is how attendance will be taken.

(C) Red Hill Capital Corp. 2008
90
END
(C) Red Hill Capital Corp. 2008
91