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Unit 2 Microeconomics Standard SSEMI2 The student will explain how the Law of Demand, the Law of Supply, prices, and profits work to determine production and distribution in a market economy. a. Define the Law of Supply and the Law of Demand. b. Describe the role of buyers and sellers in determining market clearing price. c. Illustrate on a graph how supply and demand determine equilibrium price and quantity. d. Explain how prices serve as incentives in a market economy. DEMAND Demand: the amount of a g/s that a consumer is willing and able to buy at various possible prices Quantity Demanded: the amount of a g/s that a consumer is willing and able to buy at each particular price (or a specific price) DEMAND Quantity Demanded P P Various Possible Prices D Specific Price D Qd Qd The Law of Demand (an inverse relationship of Price and Quantity Demanded) P, Qd (an increase in price causes a decrease in quantity demanded) P, Qd (a decrease in price causes an increase in quantity demanded) Price P3 P2 P1 QD3 QD2 QD1 Quantity Three economic concepts help explain the law of demand: 1. Income Effect: an increase or decrease in purchasing power caused by a change in price Purchasing Power: the amount of money (income) people have available to spend on g/s Being able to buy more (or less) of a g/s because the price went down (or up) Ex. Sale items 2. Substitution Effect: the tendency of consumers to substitute a similar, lowerpriced product for a more expensive product Ex. Generic brands vs. name brands 3. Diminishing Marginal Utility: the natural decreases in the utility of a g/s as more units of it are consumed Helps explain why demand is not limitless Ex. Hot dogs The last isn’t as good as the first! Demand Schedule: shows the relationship between price and quantity demanded in a table Demand Curve: plots the above relationship on a graph (doesn’t have to be curved, but can be) Time to Practice! Changes in Demand Determinants of Demand: non-price factors that influence the demand for a g/s These include: 1. Consumer Tastes and Preferences Trends change demand Ex. Boy Bands D2 D1 Late 90s D2 D3 Today D1 Other Scenarios… Britney Spears Ricky Martin…Livin’ La Vida Loca??? 2. Market Size As a market expands, it has more consumers, greater demand Advertising, govt. policy, technology can affect market size Ex. iPods (advertising) Demand for all MP3 players Increases because of the popularity and advertising of Apple’s IPOD P D2 D1 Quantity Demanded for MP3 Players 3.Income The more $ you have, the more demand you have for g/s Or…the less $, less demand Ex. Donald Trump vs. Mrs. Perkins Who has greater demand for more g/s? 4.Price of Related Goods Changes in a product’s price can affect demand for the product’s related good Two Types: Price of Related Goods – A. Substitute Goods Goods that can be used to replace the purchase of a similar good Jeans vs. Khakis As the price of jeans continues to go sky high, you are likely to substitute khakis and therefore causing the demand for khakis to increase Jeans are too much! Switch to Khakis! P2 P1 D2 D1 Qd2 Qd1 Jeans Khakis Price of Related Goods – B. Complementary Goods Goods commonly used with other goods Kool-Aid and sugar As the price of Kool-Aid falls, the demand for sugar increases 5. Consumer Expectations Demand will generally rise or fall based on future predictions regarding income Possible increase in allowance...demand increases Possibly getting fired from your job…demand decreases Elasticity of Demand A measure of how consumers react to a change in price Inelastic: demand that is not very sensitive to changes in price Even a large change in price causes a small change in quantity demanded Necessities Ex. insulin, baby formula PERFECTLY INELASTIC INELASTIC D D Qd Qd Elastic Demand: demand that is very sensitive to a change in price Even a small change in price causes a large change in quantity demanded Luxuries Ex. Champagne, caviar, Coke Perfectly Elastic Elastic D D Qd Qd SUPPLY Supply: the amount of g/s producers are willing to offer at various possible prices during a given time period Quantity Supplied: the amount of a g/s that a producer is willing to sell at each particular price P S Qs Supply – all possible points Quantity Supplied – one particular point The Law of Supply (a direct relationship between Price and Quantity Supplied) P, Qs (an increase in price causes an increase in quantity supplied) P, Qs (a decrease in price causes a decrease in quantity supplied) One main factor helps explain supply… Profit: the amount of money remaining after producers have paid all of their costs Revenues > Costs of Production = Profit Costs of Production: costs incurred in the production of a g/s Ex. Wages, rent, electricity, raw materials, etc. Profit also signals other producers to enter the market! Time to Practice! Changes in Supply Determinants of Supply: non-price factors that cause shifts in the entire supply curve Price of Resources Any change in the factors of production can cause a change in supply Citrus fruit crop destroyed…decrease in supply of OJ Government Tools A. B. C. 3 Main Tools: Taxes – required payment of money to the govt. Subsidies – payments to private businesses by govt. Regulations – rules set by govt. on how companies must conduct business Technology New tools or processes that typically increase supply Competition More competition, more supply because there are more products on the market Price of Related Goods Change in price of one leads to an increase or decrease in supply of the other Producer Expectations Future demands of consumers leads to higher prices…causes an increase in supply Standard SSEMI3 The student will explain how markets, prices, and competition influence economic behavior. a. Identify and illustrate on a graph factors that cause changes in market supply and demand. b. Explain and illustrate on a graph how price floors create surpluses and price ceilings create shortages. c. Define price elasticity of demand and supply. Putting It All Together with Price Producers and Consumers speak a unique language called PRICE Producers say: this is how much it cost to produce Consumers say: this is how much I want to pay for a product Benefits of the Price System: 1. Information – Producers know which g/s is more profitable Consumers the relative worth of g/s 2. Incentives – Price encourages both Law of Supply and Law of Demand Benefits Continued… 3. Choice – 4. Efficiency – 5. encourages competition and therefore a variety of products at different price points provides for wise use of resources (it helps indicate demand) and also quickly delivers info to producers and consumers Flexibility – great ability to change with increase and decreases of supply and demand Limitations of the Price System: 1. Market Failures: (limitations) when the price system fails to account for some costs and therefore cannot distribute them appropriately These include: Externalities: the side effects of the production of a good that are not directly connected with the production or consumption of the good Limitations Continued… 2. 3. Public Goods: any good consumed by all members of a group Instability: prices can swing to extremes during times severe weather, natural disasters, or worker protests How do we determine prices? Prices are determined by market equilibrium. Market Equilibrium: when quantity supplied is equal to quantity demanded where the needs of both producers and consumers are satisfied shown on a graph where the supply and demand curves intersect Market Equilibrium (Market Clearing Price) P S Equilibrium Point Qd = Qs D Q What happens when the price systems “miscommunicates”? Surplus: exists when quantity supplied exceeds the quantity demanded at the price offered Shortage: exists when the quantity demanded exceeds the quantity supplied Government and Prices Govt. sometimes gets involved in managing prices in an attempt of preventing market instability Govt. sets prices to protect producer and consumers from major price swings 2 Ways Govt. Sets Prices: 1. Price Ceilings: govt. regulation that establishes a maximum price for a particular good producers cannot charge above this price Ex. rent control in NYC, milk P S MCP Price Ceiling D Q 2. Price Floors: govt. regulation that establishes a minimum level for prices more common than price ceilings helps protect farmers minimum wage: the lowest amount an employer legally can pay a worker for a job P Price Floor S MCP D Q Economists argue that artificially setting prices can prevent the market from reaching equilibrium! What problems might this cause? Rationing: system in which govt. or another institution decides how to distribute a product this is done because the supply of a good is so low Ex. WWII, Hurricane Katrina, college sports tickets Consequences of Rationing: 1. Unfair – this system does not treat people as equals…prices are neutral 2. Expensive – administrative costs involved in keeping rationing system in place 3. Creates Black Markets – market where goods are exchanged illegally at prices that are higher than officially established prices Ex. Ticket scalping Standard - SSEMI4 The student will explain the organization and role of business and analyze the four types of market structures in the U.S. economy. a. Compare and contrast three forms of business organization—sole proprietorship, partnership, and corporation. b. Explain the role of profit as an incentive for entrepreneurs. c. Identify the basic characteristics of monopoly, oligopoly, monopolistic competition, and pure competition. 3 Forms of Business Organization: 1. Sole Proprietorship – business owned and operated by one person Advantages: Ease of start-up Full control Exclusive Right to Profit Sole Proprietorship Cont. Disadvantages: Unlimited Liability: complete responsibility for debt Sole Responsibility Limited Growth Potential Lack of Longevity: the amount of time the business operates May not be able to offer fringe benefits 2. Partnership: business owned and controlled by two or more people Advantages: Ease of start-up Specialization Shared decision making Larger pool of capital (easier to borrow $) Partnership Cont. Disadvantages: Unlimited Liability (unless LLP) Limited Liability Partnership – can only lose initial investment Potential for conflict Lack of longevity 3. Corporation: business in which a group of owners, called stockholders, share in profits and losses Advantages: Limited Liability for Shareholders Transferable ownership Ability to attract capital Longevity Corporation Cont. Disadvantages: Expense & difficult to start-up Double Taxation Potential Loss of Control by founders More legal requirements/regulations Why start your own business? Profit! As a business owner you need to be aware of different market structures in order to be as profitable as possible! Horizontal Merger (ATT & BellSouth) Vertical Merger Market Structures Perfect Competition…must have… 1. Large # of firms Sell identical products Sellers are able to freely enter and exit market No price-setting power No non-price competition Examples of Perfect Competition Agricultural Products Socks Nails, nuts and bolts eBay Auctions 2. Monopolistic Competition: market structure where many companies sell products that are similar but not identical Many firms Differentiated products Few barriers to entry Slight control over price Considerable non-price competition Examples Restaurants Fast Food Clothing Stores Nonprice Competition A way to attract customers through style, service, or location, but not a lower price How? Physical Characteristics Location Service Level Advertising, image, or status Oligopoly: market structure where a few large firms dominate the market 3. Few firms Some variety of goods High barriers to entry Considerable price-setting power Considerable non-price competition Examples? Airlines Pharmaceuticals Soft Drink Companies Collusion: agreement among firms to divide market, set prices, limit production Cartel: a formal organization of producers that agree to coordinate prices and production (illegal in the US) OPEC (Organization of Petroleum Exporting Countries) Monopoly: a market dominated by a single seller 4. One firm No close substitute for product Complete barriers to entry Complete control over price No non-price competition Examples of Monopolies Electric Companies Standard Oil (Rockefeller) US Steel (Carnegie) Microsoft ??? Apple Inc. Legislation re: Monopolies Sherman Anti-Trust Act