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ECON 1 The functioning of Markets The interaction of buyers and sellers (Chapter 4) ECONOMIC Form of Competition • Economic competition: We compete for goods by offering to trade $ dollars. • Circular flow diagram: Shows the interaction of households and firms in two kinds of markets. Circular Flow Diagram of the Exchange Economy Goods & Services Goods & Services Product Markets $'s $'s Revenue HOUSEHOLD FIRMS $'s $'s Income Inputs Resources Resource Markets Study of Markets • Markets are the interaction of buyers and sellers. • Some markets are local, some worldwide. • Focus on buyers and sellers separately: Separate graphs for each group. • Ceteris paribus: look at one thing at a time; All other things held equal. Marginal Value • Focusing on a buyer, we measure the personal marginal value of a good as the most $’s you are willing to give up to acquire an additional unit. (How much you are willing to trade) • Graph the marginal value as a height above each additional unit per time period. Marginal Value Declines • Plot the marginal value as a height above additional units. • As you have more of any good, the marginal value declines. Marginal Value = The Most you are willing to pay for each additional unit 80 70 60 50 40 Marginal Value 30 20 10 0 1 2 3 4 MVx $ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1 Marginal Value Marginal Value The height above each additional unit = the most you are willing to pay 1 2 3 4 5 6 7 8 9 10 Qtyx/T How much are you willing to Buy? • By comparing the marginal value with the $ Price at which the good is available, we can read the quantity you are willing to buy at each $ price. (horizontal distance) • Demand: A schedule of the alternative quantities that an individual is willing and able to buy at alternative $ prices. $Price x Demand Curve $ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1 MVx = Demand X 1 2 3 4 5 6 7 8 9 10 Qtyx/T Demand for X $Px $ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1 Dx Demand shows the amounts purchased at alternative prices (horizontal distances at each price) Demand x Dx 1 2 3 4 5 6 7 8 9 10 Qtyx /T Demand Curve $ Price per Unit $10 2 $8 4 $6 6 $4 8 $2 10 0 2 4 6 8 Quantity Demanded / Time period 10 12 First Law of Demand • The higher the price of a good, the smaller the quantity demanded; the lower the price of a good, the greater the quantity demanded. • Demand is downward sloping. • A change in price leads to a change in quantity demanded = a movement along the function Change in Price vs. Change in Demand • A change in price is a move on the demand schedule. • A change in demand is a shift of the function due to something else changing. $Px $ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1 Increase in Demand Dx Dx’ Increase in demand is a rightward shift (greater quantity demanded at each price.) Dx Dx’ 1 2 3 4 5 6 7 8 9 10 11 12 Qtyx /T Determinants of Demand • What factors determine the position of demand ? • What changes in other factors will cause demand to increase (shift right) or decrease (shift left)? Determinants of Demand: (Shift Factors) • Taste & preference: how much you like the good. If T&P increase, demand increases. (Rightward shift). • Income: a change in income affects demand. – Normal good: increase in income increases demand. (Right Shift) – Inferior good: increase in income decreases demand. (Left Shift) Determinants of Demand, Continued • Price of other goods: – Substitutes: most other goods are substitutes; An increase in the price of a substitute increases demand (rightward shift). – Complements: Goods used together; an increase in the price of complements decreases demand (leftward shift). Determinants of Demand, Continued • Future Price Expectations: an increase in the expected future price will increase demand today. Market Demand • The market demand is the sum of the individual demands of the buyers. • An increase in the number of buyers will increase market demand. Market Supply • Supply is a schedule of the alternative quantities which sellers are willing and able to sell at alternative prices. • Supply is generally a positive relationship: at higher prices the quantity supplied is larger. Supply Curve $Price $10 Supply 8 6 4 2 2 T 4 6 8 10 12 14 16 Qty x/ $Px $ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1 Supply Reflects Marginal Cost The height reflects the marginal cost of producing an additional unit. 1 2 3 4 5 6 7 8 9 10 11 12 Qtyx /T Change in Quantity Vrs Shift in Supply • If sellers can get a higher price, the increase in quantity supplied is a movement on the supply curve. • If some other factor changes, the supply curve will shift. • An increase in supply is a rightward shift. • A decrease in supply is a leftward shift. Determinants of Supply: (Shift Factors) • Price of inputs: an increase in price of inputs will decrease supply (leftward shift). • Change in technology: an increase in technology will increase supply (rightward shift). • Number of sellers: as more sellers enter a market the supply shifts rightward. $Price $4 3 The Market Demand Surplus at this $ Price 2.50 Supply 2.00 1.50 1.00 .50 .25 100 200 300 400 500 600 700 800 900 1000 1100 Q x/ T $Price $4 The Market Demand 3 2.50 Supply 2.00 1.50 1.00 .50 .25 Shortage at this $ Price 100 200 300 400 500 600 700 800 900 1000 1100 Q x/ T $Price 4 3 2.50 Market Equilibrium Demand Dx = Sx at Pe Supply 2.00 1.50 Pe 1.00 .50 .25 100 200 300 400 500 600 700 800 900 1000 1100 Q x/ T Qe $Px $ 10 $ 9 $ 8 $ 7 Pe $ 6 $ 5 $ 4 $ 3 $ 2 $ 1 Market: Demand & Supply Demand Supply At the equilibrium Price, the Dx = Sx Sx Dx 1 2 3 4 5 6 7 8 9 10 11 12 Qe Qtyx /T