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University of California-Davis
Economics 1B-Intro to Macro
Handout 2
TA: Jason Lee
Email: [email protected]
I. Interdependence and Gains from Trade
A. Specialization: Comparative and Absolute Advantage
An early economist, named David Ricardo came up with a theory called the Theory of
Comparative Advantage which basically stated that individuals should specialize in
what they do “best” in. But how do we determine who is “best” in a given task?
Let us introduce two terms that will help answer this question:
(1) Absolute Advantage: A person is said to have an absolute advantage of another
if he or she can produce more of a product with the same amount of resources
(2) Comparative Advantage: A person is said to have a comparative advantage if
he or she can produce a product at a lower opportunity cost.
It is easiest to see the distinction between these two terms by example.
Example 1: Suppose that Robinson and Crusoe produce only 2 items in the island
economy: basket of fruit and timber from cut trees. The following table summarizes the
production on the island on a given day
Baskets of Fruit
Number of Trees Cut
Robinson
10
5
Crusoe
30
10
The table says that if Robinson spent the entire day gathering fruit he could gather 10
baskets, while if he spent the day cutting trees he could have cut 5 trees. Similarly,
Crusoe can gather 30 baskets of fruit on a given day, or he can cut 10 trees.
1.
Who has an absolute advantage of cutting trees? Given the same resource (in
this case 1 day) who can produce more trees? The answer is clearly Crusoe. He
can cut 10 trees in 1 day, while Robinson can only cut 5 trees.
2. Who has an absolute advantage of gathering fruit? Again given the constraint
of 1 day, Crusoe can gather more fruit (30 baskets) than Robinson (10 baskets).
In this island economy, Crusoe has an absolute advantage in gathering berries AND
in cutting trees. Crusoe can produce more of both goods in a given day, but does that
mean he should produce both? Before we can answer that we have to see who has a
comparative advantage in the two goods.
3.
Who has a comparative advantage of cutting trees? Recall that by definition
that a person has a comparative advantage if he can produce a good at a lower
opportunity cost. We need to figure out what the opportunity cost is of cutting
down trees for both Robinson and Crusoe.

Opportunity Cost of Cutting Trees for Robinson: If Robinson spends the day
cutting down trees, he is sacrificing 10 baskets of fruits that he could have been
gathering. Thus the opportunity cost of spending the day cutting down 5 trees is
10 baskets of fruit. We can write the opportunity cost as follows.
10 baskets of fruits:5 cut trees
To figure out the opportunity cost of cutting 1 tree we can simply divide both
sides by 5.
2 baskets of fruit:1cut tree
The opportunity cost for Robinson of cutting 1 tree is 2 baskets of fruit

Opportunity Cost of Cutting Trees for Crusoe: If Crusoe spends the day cutting
down trees, he is sacrificing 30 baskets of fruits that he could have been
gathering. Thus the opportunity cost of spending the day cutting down 10 trees is
30 baskets of fruit. We can write the opportunity cost as follows.
30 baskets of fruits:10 cut trees
To figure out the opportunity cost of cutting 1 tree we can simply divide both
sides by 10.
3 baskets of fruit:1cut tree
The opportunity cost for Crusoe of cutting 1 tree is 3 baskets of fruit
Since the opportunity cost of cutting 1 tree is lower for Robinson (2 baskets of
fruit) than for Crusoe (3 baskets of fruit) we say that Robinson has a
comparative advantage in cutting down trees.
4.
Who has a comparative advantage in gathering fruit? We can do the exact
same analysis as we did before.

Opportunity Cost of gathering fruit for Robinson: If Robinson spent the day
gathering fruit, he would sacrifice the 5 trees he could have cut down.
5 trees:10 baskets of fruit or
½ tree: 1 basket of fruit
The opportunity cost for Robinson of gathering 1 basket of fruit is ½ tree.
 Opportunity Cost of gathering fruit for Crusoe: If Crusoe spent the day gathering
fruit, he would sacrifice the 10 trees he could have cut down.
10 trees:30 baskets of fruit or
1/3 tree: 1 basket of fruit
The opportunity cost for Crusoe of gathering 1 basket of fruit is 1/3 tree
Since the opportunity cost of gathering a basket of fruit is lower for Crusoe (1/3
tree) than for Robinson (1/2 tree) we say that Crusoe has a comparative
advantage in gathering basket of fruit
Now that we have a better understanding of what absolute and comparative advantage
are, we can restate the theory of comparative advantage.
KEY POINT: PRODUCERS SHOULD SPECIALIZE IN THE PRODUCTION OF
GOODS IN WHICH THEY HAVE A COMPARATIVE ADVANTAGE. BY
SPECIALIZING AND TRADING, SOCIETY WILL BE BETTER OFF.
In our example, Robinson should focus on cutting down trees while Crusoe should
specialize in gathering fruit. This will occur even though Crusoe has an absolute
advantage in the production of both products. In our next step we will see how
specialization and trade will make this island better off.
B. Gains From Trade
Example 2: We can illustrate graphically how there specialization and trade can lead to
both Robinson and Crusoe to be better off. To start with, let’s see what Robinson and
Crusoe could produce in a given month (30 days) using our data from Example 1. Figure
1 illustrates Robinson’s production possibilities in a month. To graph we must first start
at the end points. We need to figure out how much Robinson would have produced if he
spent his entire time producing only 1 good. For example, if Robinson had spent every
day gathering fruit, he would have gathered 300 baskets of fruit (10 baskets x 30 days).
This production possibility is marked as Point B in Figure 1. Conversely, if Robinson
had spent every day cutting trees, he would have cut 150 trees (5 trees x 30 days). This
production possibility is marked as Point A. Thus we have our end points. Suppose that
Robinson actually chooses to spend half his time collecting fruit and the other half cutting
trees. In other words, he’ll spend 15 days cutting trees (75 trees will be cut) and he’ll
spend 15 days gathering fruit (150 baskets of fruits will be collected). We can show that
production possibility as Point C in Figure 1. We can draw a line through all the
production possibilities. Each point along the curve is a production option for Robinson.
Figure 1: Robinson’s Production Possibilities (for 1 Month)
Figure 2: Crusoe’s Production Possibilities (for 1 Month)
Consider if Crusoe spent all 30
days collecting fruit then he
would have collected 900 baskets
of fruits over the course of the
month (Point B). If Crusoe had
spent the entire month cutting
trees then he would have cut a
total of 300 trees in a month
(Point A).
Suppose that in
actuality, Crusoe decides to
divide his time equally between
cutting trees and gathering fruit.
If that were true then he would
collect 450 baskets of fruit and
150 trees will be cut (Point C in
Figure 2).
If we assume that both Robinson and Crusoe divided their time equally between the two
tasks then the total amount produced in the economy will be 600 baskets of fruit (450
produced by Crusoe and 150 produced by Robinson) and 225 trees will be cut (150 cut by
Crusoe and 75 by Robinson).
Now we can illustrate how the theory of comparative advantage can lead to gains. Recall
that we saw earlier that Robinson should specialize in cutting trees, and that Crusoe
should specialize in gathering fruit. Suppose that Robinson spend his entire time cutting
trees, so that 150 trees are cut. Meanwhile, Crusoe will spend the majority of his time in
gathering fruit. Suppose Crusoe spends 22 days gathering fruit and 8 days cutting trees.
Crusoe will then produce 660 baskets of fruit (22 days x 30 baskets) while also cutting 80
trees (8 days x 10 trees). We can easily see how a trade could make both parties better
off. Suppose that Robinson and Crusoe come up with a trade agreement in which Crusoe
will give Robinson 180 baskets of fruit in exchange for 73 trees.
After the trade Robinson would have 180 baskets of fruit and 77 trees. Robinson now
has more trees and more fruits than he had before (Point D). He is clearly better off than
he was when he was at Point C. Similarly, after the trade, Crusoe would have 153 trees
and 480 baskets of fruits. Like Robinson, Crusoe will have more trees and fruits (Point
D) than if he had at point C. Overall, the island economy will produce 660 baskets of
fruit and 230 trees with specialization and trade, compared to the non-specialization, nontrade case (600 baskets of fruit, 225 trees).
Note: The price of the trade 180 fruits for 73 trees can also have been stated as 2.47
fruits for every 1 tree. How did we come up with this price? Parties will trade as long as
the price of the trade is between the two opportunity costs. In our example we
calculated that the opportunity cost for Robinson of cutting 1 tree was 2 baskets of fruit.
The opportunity cost for Crusoe of cutting 1 tree was 3 baskets of fruit. As long as the
trade agreement states that the price of 1 tree is somewhere between 2 and 3 baskets of
fruit, both parties will be made better off.
Figure 3: Gains from Trade for Robinson
Figure 4: Gains from Trade for Crusoe
II. Introduction to Markets
Recall that microeconomics is the study of the behavior of individual decision making
units. We will be primarily focusing on two specific individual decision making units:
(1) households and (2) firms. These two individual units interact with each other in two
markets: (1) the input market and (2) the output market. The input market (also called
factor markets) is the market for factors of production. There are markets for land,
markets for capital and markets for labor. In this market it is the households that supply
the inputs, and it is the firms that demand inputs to produce goods. Firms pay to get
inputs, while households receive money as they supply their inputs. The output market
(also called product market) is the market for goods and services. In this market it is the
firm that supplies the output, while the households demand output. Consumers pay
money to the factor market in order to purchase output, and that money is received by
firms.
Figure 1 summarizes the interaction between households and firms in the input and
output market.
Both firms and households face decisions in this market system
Firms must decide
(1) How much output to supply in the product market?
(2) How much input to demand in the factor market?
While households must decide
(3) How much output to demand in the product market
(4) How much input to supply in the factor market.
In the next several chapters we will focus on questions (1) and (3) and take a closer look
at the functioning of the product market.
III. Demand in Product Markets
What determines how much of a good will be demanded by a household? There are
several possible determining factors that could play a role in the household decision.
These could include:
(1)
(2)
(3)
(4)
(5)
(6)
The price of the product
Income of the household
Wealth of the household
Prices of other products
Consumer tastes and preferences
Expectations of future income, wealth and prices
However, the relationship that we’re most interested in is the relationship between the
price of the product and quantity demanded. Quantity demanded (qd) is the total amount
that a household would buy in a given period (if it could buy all it wanted) at a given
price. It is this relationship between price and quantity demanded that we want to
examine in isolation. Recall from Chapter 1, that in order to isolate the effect on one
variable on another, we have to hold all other variables fixed (“ceteris paribus”)
It turns out that changes in price will affect the quantity demanded. While changes in
other factors, such as income or preferences, will affect demand. We will make clear the
distinction between this subtle difference shortly.
A. The Law of Demand
To illustrate the relationship between price and quantity demanded we first present a
demand schedule. The schedule shows the quantity of a good that a household would be
willing to purchase at different price levels.
Table 1 shows a hypothetical demand schedule for Al for pizzas.
Table 1: Al’s Demand Schedule for Pizza
Point
Price
qd
A
$10
1
B
$8
4
C
$6
7
D
$4
10
E
$2
13
We oftentimes present the demand schedule graphically. When we do so it is called a
demand curve. By convention we plot price on the y-axis and quantity demanded on the
x-axis. Figure 2 show’s Al demand curve for pizza.
Figure 2: Al’s Demand Curve
As can be seen in Figure 2, there is a negative relationship between prices and quantity
demanded. When prices go up, the quantity demanded falls (ceteris paribus), and when
prices fall, the quantity demanded rises. The demand curve always slopes downward.
This negative relationship between prices and quantity demanded is called the law of
demand.
B. Other Determinants of Demand
1.
Income and Wealth
Let’s first define what we mean by income and wealth. Income is the sum of all
household wages, salaries, interest, etc… that are earned in a given period of time.
Income is what we call a flow measure because we must specify a time period.
Wealth, on the other hand, is the total value of what a household owns net what it
owes. It is a stock measure because it is measured at a given point in time.
We would expect that households with higher incomes and/or higher wealth can
afford to buy more goods and services if the good is normal. A normal good is a
good for which demand increases when income is higher, and which demand
decreases if income is lower. Most goods are normal goods.
There are however a group of goods in which households would demand less when
their income rises, and would demand more when their income falls. These types of
goods are called inferior goods. Examples of inferior goods are typically harder to
find. Some good examples are long bus rides. When households have low income,
they might only be able to afford a trip from San Francisco to Los Angeles on a bus.
However, when their income rises they will demand less bus rides and start flying
more. Foods such as Ramen noodles or spam may also decrease as income increases.
To summarize:
For normal goods
Income/wealth↑ Demand ↑
Income/wealth↓ Demand ↓
For inferior goods
Income/wealth ↑ Demand ↓
Income/wealth ↓ Demand ↑
2.
Prices of Other Goods
Sometimes a change in the prices of other goods can have an effect on the quantity
demanded of a particular good.
Goods are substitutes if they serve as a replacement for each other. Suppose goods X
and Y are substitutes. Then an increase in the price of good X will cause the demand for
good Y to increase. Conversely, a decrease in the price of good X will cause the demand
for good Y to decrease. Coke and Pepsi are good examples of substitutes. If the price of
Coke were to suddenly double, we would expect that the demand for Pepsi would
increase as a result.
Goods are complements if they “go together”. Several examples can include hot dogs
and hot dog buns, PCs and printers and Blu-Rays and Blu-Ray players. Suppose good X
and good Y are complements. An increase in the price of good X will cause a decrease in
the demand for good Y. On the other hand, a decrease in the price of good X will cause
an increase in the demand for good Y. As an example, if the price of hot dogs double, we
would expect the demand for hot dog buns to decrease.
To summarize:
For substitutes
Price of Good X↑ Demand for Good Y↑
Price of Good X↓ Demand for Good Y ↓
For complements
Price of Good X ↑ Demand for Good Y ↓
Price of Good X ↓ Demand for Good Y ↑
3. Tastes and Preferences
Changes in tastes and preferences can cause demand to change. For example, suppose
the Food and Drug Agency issued a report showing that diet Sodas are a leading cause of
cancer. How do you suppose that would affect demand? We would expect that such a
report would adversely affect consumer preferences for diet sodas and there will be a
sharp decrease in the demand for diet sodas. Unlike income/wealth and prices of other
goods we cannot summarize what will happen to demand when tastes and preference
change.
4. Expectations of future income, wealth, and prices
Expectations of the future can affect household decisions today. Households that expect
higher income in the future would probably spend more today and thus demand should
increase. For example, imagine that you expect to get $500 for your birthday. Even
though your birthday is not for another month, you might go to the store and purchase
goods today because you expect your wealth to increase by $500 one month from now.
Obviously, expectations of higher future income or wealth will cause demand to increase
today. While, expectations of lower future income or wealth will cause demand to
decrease today.
Expectation of price changes will cause demand to shift as well. For example, if you
believed that the price of cars will drop in the near future, it would make sense to delay
the purchase of buying a car until the price drops. Thus an expectation of lower price in
the future will cause demand today to decrease. Conversely, an expectation of higher
price in the future will cause demand to increase today.
C. Shift of Demand Curve vs. Movement Along the Curve
We have already seen that when price increases or decreases this will have an effect on
quantity demanded. For example, refer back to Figure 2 which showed Al’s demand
curve for pizza. We see that if the price of pizza went from $6 to $8, Al will move from
Point C to Point B and his quantity demanded would decrease from 7 pizzas to 4 pizzas.
In this example, Al has moved along his demand curve. What if some other factor
changed? Suppose that Al saw an increase in income. We have already argued that an
increase in income will lead to an increase in demand. If the price of pizza was $6, Al
would demand more pizza than he did before his income went up. This will be true at
every possible price level. An increase in income will result in a new demand schedule
for Al and hence a new demand curve.
Table 2: Al’s Initial and New Demand Schedule for Pizza after an increase in income
Point
Price
A
B
C
D
E
$10
$8
$6
$4
$2
Figure 3: Al’s New Demand Curve
qd (Initial
Demand)
1
4
7
10
13
qd (New Demand)
4
7
10
13
17
We see that when another variable other than price changes this will mean an entirely
different demand schedule and an entirely different demand curve. In Figure 3 we
illustrate this by the demand curve shifting to the right.
This leads to two important points.
(1) Changes in the price of a good will lead to a change in quantity demanded (movement
along the demand curve).
(2) Changes in any other factors (income, wealth, prices of other goods, tastes,
expectations) will result in a change in demand (shift the demand curve).
a. When demand increases the demand curve will shift to the right
b. When demand decreases the demand curve will shift to the left
Tables 3a and 3b summarizes what will cause the demand curve to shift either to the right or the
left. Instead of trying to memorize each scenario, think about why the demand curve would
shift if the given variable changes.
Table 3a: Increases in Demand will Shift the Demand Curve to the Right
Variable
Increases/Decreases
Income with normal good
↑
Income with inferior good
↓
Price of substitute good
↑
Price of complementary good
↓
Consumer preference for good
↑
Expected future price
↑
Table 3b: Decreases in Demand will Shift the Demand Curve to the Left
Variable
Increases/Decreases
Income with normal good
↓
Income with inferior good
Price of substitute good
Price of complementary good
Consumer preference for good
Expected future price
↑
↓
↑
↓
↓
D. Market Demand Curve
In our example so far we have examined the demand schedule and demand curve for one
individual. There are millions of individuals in the economy each with his or her own
demand schedule. A market demand curve is simply a graphical representation of a
demand schedule that adds up all the quantity demanded by all households at a given
price. Let’s return to Al’s original demand schedule that we showed in Table 1. For the
sake of simplicity, suppose that there is only 1 additional person in the economy named
Bea who also has a demand schedule for pizza. Table 4 shows the two individual
demand schedules and the market demand schedule.
Table 4: Market Demand Schedule
Price
qd (Al)
$10
1
$8
4
$6
7
$4
10
$2
13
Figure 4: Market Demand Curve
qd (Bea)
0
2
4
6
8
Market Demand
1+0 = 1
4+2 = 6
7 + 4 = 11
10 + 6 = 16
13 + 8 = 21
I. Supply in Product Markets
Now we turn the other side of the equation and look at how firms make decisions on how
much output to produce. Although there are many variables that factor in the decision,
there is one overriding goal that most firms try to achieve and that is to maximize profit.
Here we will define profit as total revenue – total costs.
With that in mind here is a short list of variables that could affect the supply decision for a firm:
(1) Price of the product
(2) Cost of inputs (cost of labor, cost of capital, cost of land)
(3) Prices of related products
(4) Technology
(5) Taxes or Subsidies
(6) Producer’s expectations about future prices
(7) Number of Producers
As with demand the relationship we are most interested in is the relationship between price of
the product and quantity supplied. Quantity supplied is the amount of a good that a firm would
be willing to sell at a given price. In studying the relationship between price and quantity
supplied, we will be holding all other factors that might affect supply constant (ceteris paribus
assumption).
A. Law of Supply
A supply schedule shows how much a firm would be willing to produce at given price
levels. A supply curve is a graphical representation of a supply schedule. Table 5 shows
a representative supply schedule for a pizza firm, while Figure 5 shows the supply curve
for the Pizzeria.
Table 5: Pizzeria Uno’s Supply Schedule for Pizza
Point
Price
qs
A
$2
0
B
$4
100
C
$6
200
D
$8
300
E
$10
400
Figure 5: Pizzeria Uno’s Supply Curve
Note the positive relationship between price and quantity supplied. An increase in the
market price will lead to an increase in quantity supplied, while a decrease in the market
price will lead to a decrease in the quantity supplied. The supply curve is drawn upward
with a positive slope. This relationship between price and quantity supplied is called the
law of supply.
B. Other Determinants of Supply
1.
Costs of Inputs: A change in the cost of inputs will affect the firms supply
decision. For example, suppose that wages were to decline. This would have the
effect of decreasing the cost of production for the firm. Since total costs have
decreased, pizza production becomes more profitable at any given price levels.
The pizzeria should then be able to supply more pizza at the given prices. The
opposite will be true if costs of inputs were to increase.
2. Technology: A change in technology has the same effect as a change in the cost
of inputs. An improvement of technology allows firms to save on labor or capital
costs since they will be able to produce more goods with the same amount of
3.
4.
5.
6.
labor and capital. Technological improvement will lead to a decline in costs and
thus an increase in supply.
Prices of related products: To the extent that firms have an ability to switch
production easily the prices of related products can impact supply. Suppose for
example we have a grapefruit farmer in Florida. If the price of oranges
skyrockets (assume grapefruit prices are constant), the grapefruit farmer will have
an incentive to switch production away from grapefruits and towards oranges. As
a result the supply of grapefruits will decrease.
Taxes or Subsidies: Taxes have the effect of increasing the cost of production
for firms. We would expect an increase in taxes to decrease supply. Subsidies
(payments by the government for production) will have the opposite effect and
lower the cost of production for firms. An increase in subsidies should increase
supply.
Producer Expectations about Future Prices: Suppose that firms believe that
next month’s price will be lower than today’s price. In other words they will get
less for their products next month than they would this month. We would expect
firms to supply more today to take advantage of the higher prices before they fall.
Number of Producers: Since the market supply curve is the sum of the quantity
supplied for all producers in an economy, an increase in the number of producers
will increase market supply.
C. Shift of Supply Curve vs. Movement Along the Curve
Just like with demand curves when the price of a product changes, ceteris paribus, there
will be a change in the quantity supplied. We will see movement along the supply
curve.
When other factors other than price changes (prices of related goods, input prices,
technology, taxes, expected prices, number of producers) then we will see a shift in the
supply curve.
When we say the supply curve “increases” we generally mean that the cost of production
has decreased and the firm can supply more. We show this by shifting the supply curve
downward and to the right. When the supply curve “decreases”, the cost of production
has increased and the firm can supply less. We show this scenario by shifting the supply
curve upward and to the left.
Tables 6(a) and 6(b) summarizes the factors that would cause the supply curve to shift
either upwards or downwards
Table 6a: Changes in Supply will Shift the Supply Curve Downward and to the Right
Variable
Increases/Decreases
Cost of Inputs (land, labor or capital)
↓
Technological Advance
↑
Government Subsidy
Number of Producers
Expected future price
↑
↑
↓
Table 6b: Changes in Supply will Shift the Supply Curve Upward and to the Left
Variable
Increases/Decreases
Cost of Inputs (land, labor or capital)
↑
Technological Advance
↓
Government Tax
↑
Number of Producers
↓
Expected future price
↑
D. Market Supply Curve
The market supply curve is derived by adding the individual supply curves of all the
firms in a particular market. It is the sum of all the individual quantity supplied at each
given price. For example, suppose that there were two pizza firms providing pizza.
Pizzeria Uno and Domino’s. T able 7 shows each firm’s individual demand schedule and
the market demand schedule.
Table 7: Market Supply Schedule
Price
qs (Pizzeria Uno)
qs (Dominos)
Market Supply (Qs)
$2
0
0
0+0 = 0
$4
100
0
100 + 0 = 100
$6
200
0
200 + 0 = 200
$8
300
100
300 + 100 = 400
$10
400
200
400 + 200 = 600
Figure 7: Market Supply Curve
II. Market Equilibrium
So far we have looked at how two side of the product market (demand and supply) have
worked. Now we bring the two sides of the market together to show how market prices
and quantities are determined.
Let’s examine the market supply and demand for pizza. Table 8(a) and (b) show
hypothetical market demand and supply schedules.
Table 8(a): Hypothetical market demand schedule for pizzas.
Point
Price
Quantity Demanded
D
$12
18,000
A
$8
30,000
C
$6
36,000
Table 8(b): Hypothetical market supply schedule for pizzas.
Point
Price
Quantity Supplied
E
$12
50,000
A
$8
30,000
B
$6
20,000
Figure 8 shows graphically what would happen if we draw the market supply and demand
schedules together.
Figure 8: Market Supply and Demand Curves
We will now look at three scenarios
A. Scenario #1: Excess Demand (Qd > Qs)
Suppose the price for pizzas was $6. Looking at the demand and supply schedules we
see that at $6, firms will supply 20,000 pizzas (Point B) while households will demand
36,000 pizzas (Point C). A situation where at the prevailing market price the quantity
demanded is greater than the quantity supplied is called excess demand. Excess demand
is also called a shortage. Figure 9 shows the shortage.
Figure 9: Excess Demand
In Figure 9 we can see that the shortage is equal to 16,000 pizzas. This shortage will
cause the price of pizza to rise. Firms will increase the price they charge for their limited
supply of pizza, and anxious consumers will pay higher prices to get one of the fewer
pizzas available. As the price increases, the excess demand shrinks for two reasons:
(1) As price increases, the market moves upward along the demand curve (from Point C
to Point A), decreasing the quantity demanded.
(2) As price increases, the market moves upward along the supply curve (from Point B to
Point A), increasing the quantity supplied.
The price will continue to rise until excess demand is eliminated (Point A).
B. Scenario #2: Excess Supply (Qd < Qs)
What happens if the price for pizza was $12? Looking at the supply and demand curves
in Figure 9 we see that the quantity demanded at $12 will be 18,000 pizzas (Point D)
while the quantity supplied at that price will be 50,000 pizzas. A situation where the
quantity supplied is greater than the quantity demanded is called an excess supply (or
surplus). In this example the surplus will be 32,000 pizzas This mismatch will cause the
price of pizzas to fall. Firms will have a lot of leftover pizzas and rather than letting them
go to waste will start cutting prices. As prices fall, excess supply will fall because:
(1) As prices decrease, the market moves downward along the demand curve (from Point
D to Point A), increasing the quantity demanded
(2) As prices decreases, the market moves downward along the supply curve (from Point
E to Point A), decreasing the quantity supplied.
The price will continue to fall until excess supply is eliminated. See Figure 10
Figure 10: Excess Supply
C. Scenario #3: Market Equilibrium (Qd = Qs)
Suppose the market price for pizza is $8. We can see that at $8 the quantity demanded of
pizzas is equal to 30,000 pizzas, while the quantity supplied is equal to 30,000 pizzas.
When the quantity demanded of a product equals the quantity supplied at a given price
we have reached market equilibrium. At the market equilibrium there will be no
pressure to change the price. This is illustrated in Point A. Market equilibrium price will
be $8 and the equilibrium quantity will be 30,000.
V. Shifts in Supply and Demand: Effect on Market
Equilibrium
A. Change in Demand
Let us examine how a change in demand will affect equilibrium price and equilibrium
quantity. Let’s assume that pizza is a normal good and that households are seeing a
reduction in income due to the recession. How will this affect price and quantity?
Figure 11: Change in Demand
Suppose the market was initially at equilibrium at Point A. At Point A, the price of
pizza was $8 and the quantity of pizza was 30,000. Now suppose that income
decreases for households. As we saw earlier, this will cause the demand curve to
shift to the left. At $8, the new quantity demanded will be 14,000 (Point B), while
the quantity supplied will remain unchanged at 30,000. Now because of the decrease
in demand we have excess supply at $8. The market price cannot stay at that level for
long. Prices will fall and will continue to fall until quantity supplied equals quantity
demanded (Point C). At Point C, the equilibrium price is now $6, while the
equilibrium quantity is at 20,000. A decrease in demand has resulted in lower
equilibrium price and quantity.
B. Change in Supply
Let’s now see how changes in supply can affect equilibrium price and quantity. Suppose
that input costs for firms were to increase. Higher wages, for example, will increase the
costs for pizza firms and we should see the supply curve decrease (shift upward to the
left). This is illustrated in Figure 12. We start at initial equilibrium at Point A. At that
point equilibrium price is at $8 and equilibrium quantity is at 30,000. Now the supply
curve shifts to the left. At the original $8 price, the quantity supplied is now equal to
14,000 while the quantity demanded remains at 30,000. We now have a shortage (excess
demand) of 16,000. Prices must increase until we reach equilibrium. The new
equilibrium is where the demand curve intersects the new supply curve (Point C). At
Point C, equilibrium price is higher than before, and quantity is now lower.
Practice Problems
Kyle and Antoine are rival bakers. The table below show how many brownies and toffee bars
each can bake in 1 hour.
Kyle
Antoine
Brownies
15
4
Toffee Bars
5
4
(a) Who has an absolute advantage in producing brownies?
(b) Who has an absolute advantage in producing toffee bars?
(c) Who has a comparative advantage in producing brownies
(d) Who has a comparative advantage in producing toffee bars?
(e) Who should specialize in producing brownies? Who should specialize in producing toffee
bars?
(f) If each baker works a typical 40 hour workweek, draw the production possibility frontier for
each baker. Put “Brownies” on the horizontal (x-axis) and “Toffee bars” on the vertical (y-axis).
Be sure to identify the intercept values on your graphs.
(g) Suppose each baker decides to split their workweek evenly between baking brownies and
baking toffee bars. That is each worker will spend 20 hours baking brownies and 20 hours
baking toffee bars. Show each baker’s output of the two products in your graph in part (f).
(h) Suppose the two bakers decide to specialize (by spending every hour of the work week
baking either brownies or toffee bars) and trade. Antoine will send Kyle 80 toffee bars in
exchange for 160 brownies. Is this a good price for the trade?
(i) Show on the graph the consumption for both Kyle and Antoine after the trade. Does your
graph show that both parties are now better off?