Midterm No.1 Study Guide
Midterm No.1 Study Guide ECON 2010
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This 63 page Study Guide was uploaded by jared.stein Notetaker on Tuesday September 20, 2016. The Study Guide belongs to ECON 2010 at University of Colorado at Boulder taught by Dr. Charles A M de Bartolome in Fall 2016. Since its upload, it has received 192 views. For similar materials see Principles of Microeconomics in Microeconomics at University of Colorado at Boulder.
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Principles of Microeconomics/Econ 2010 Section 10 Lecture Notes Charles de Bartolemue Week 1 I. Eleven Big Ideas 0.) Things are Scarce: Resources are limited but people’s wants are unlimited. • Everybody cannot get everything they want. 1.) Because resources are limited, people face trade-offs. • To get something, one must give up something. This is the trade-off. • Ex: To spend more time studying, have to give up time partying. 2.) The cost of something is the cost of what you give up-Opportunity Cost. • Opportunity Cost: the loss of potential gain from other alternatives when one alternative is chosen. • Ex: Cost to go to university is: Tuition ($50,000) + Wages Lost ($30,000) = Opp. Cost ($80,000) 3.) When making decisions, useful to think “at the margin.” • We don’t think in terms of “all or nothing” but instead “a little more or a little less.” • Ex: We don’t have to choose between “never eat out” and “always eat out”, instead we think, “do I want to eat out one more time?” 4.) People respond to price changes. • People can be manipulated into doing things by raising or lowering the prices of goods, services, and commodities. • Ex: To get less people to use US 36 (Boulder Freeway) Option A: Broadcast appeals (Please don’t drive)=ineffective Option B: Charge or increase toll=effective 5.) Trade can make everybody better off • Ex: Japan makes good cars that the US wants, US makes good software that Japan wants. >Choose to trade<. Japan gives up cars in exchange for US software, and US gives up software in exchange for Japanese cars. + Trade is done voluntarily and thus both can feel better. 6.) Markets with many buyers and sellers are a “good” way to organize economic activity. • Denver Apt. Market vs. NY Apt. Market 7.) Government can sometimes improve on the market outcome. • In the case of: • Equity Concerns: Market gives too much to one group and not enough to another. • Market Power: Only a few sellers creates a monopoly. Ex: Apple is only seller of iPhones • Externality: Party is not responsible for the byproducts of their actions Ex: Oil refineries don’t pay for health hazards associated with breathing in the toxic air produced by the refinery. 8.) Conceptual difference between the benefit of a good and its price. • Ex: 1 day at the ski park: Benefit - “I had a great day, felt like $100.” Price - Lift ticket cost $50. Was it worth it? Yes. 9.) Production and consumption decisions coordinated through prices. • Ex: Electric cars use Lithium batteries and are becoming more popular. Thus, we need more Lithium. As Lithium is used up (demand increases) so does price, miners have more incentive to mine Lithium to keep up with demand and make $$. 10.) Economics is about predictions-guessing the future. • What would happen if…. Ex. “...Google broke into 2 firms?” II. Economics is a Social Science III. How to make quantitative predictions A. Use Theories or Models 1. A simplification to the most important points 2. A representation which tells us what we really need to know 3. Not a real thing, but a good representation of the real thing 4. Contains 90% truth Ex: Flowchart, map, model B. Testing 1. How good of a representation of the real thing is it? 2. Do we believe it makes good predictions? a. Has it made good predictions in the past? Econometrics b. Laboratory experiment IV. Normative and Positive Economics A. What are they? 1. Positive a. About linkages: need to know the process. b. About What is. c. About How the World Works. d. Linkages described by social scientists 2. Normative a. About ranking outcomes: need to know value judgments (How much is it worth). b. About What ought to be. c. About How we want the world to look. d. Policies advocated by policy analysts. • Normative Policy: “The right thing to do now is…” • Normative comes from root “norm” e. A Standard (ex. Social Norms) • “Normal” has same root: • ”Most babies start taking their first steps between 11 and 15 months, but...anywhere from 9 to 18 months is considered normal” • 18 months is the standard age and the child should go see a doctor if taking longer than 18 months. • Not “average” walking age • V. Circular Flow Model of Economy A. Normative Model to understand linkages between households and firms 1. Normative Model: a. Households: own resources (capital and labor) which are provided to firms Firms: use resources to make goods which are given to households. 2. Normative Question: “Should” a. How much labor should labors be providing to households? b. How many (insert good/service) should firms produce and households consume. B. Positive Model with linkage being by market 1. Positive Model: (Key difference: Exchange $$ to generate profit) a. Households: own resources which they sell to firms at voluntarily agreed prices (get income $$) b. Firms: Get $ from sale of goods to households at voluntarily agreed prices, and use $ to buy resources from households at voluntarily agreed prices. c. Money, Goods/Services, and Resources are all being moved around. 2. Positive Question: under the market system: a. How much income do houses get by selling labor to firms? b. How many (goods/services) produced by firms are consumed by households. VI. Production Possibility Model A. Model to understand the connections between ideas of: • Scarcity • Trade-offs • Opportunity Cost Line is called “Production Possibility Frontier. (Solid Line = Original Situation; Dashed Line = New/Changed Situation 1. Above Line: impossible 2. On Line: Possible a. Given any c, i is as large as possible, gets most output with no wastage b. Production efficient 3. Below Line: Possible a. Given any c, i can be larger but not getting most output, results in wastage b. Production inefficient 4. Production Frontier a. Scarcity: Because of limited amounts of resources, there is a frontier. If more resources, more can be produced and the frontier shifts up b. Trade-off: Frontier is downward sloping, this means resources devoted to one production take away resources from other production. One rises, other falls c. Opportunity Cost: if 1 extra unit of Product 1 produced, then 1 less unit of Product 2 produced. This creates slope of frontier. B. Case 1: 1. Simplest Case: All machines are the same, a machine can produce either 1 consumption good or ½ investment good. (Machines=Resource) a. If all machines produce investment: No c; 500 i b. If all machines produce consumption: 1000 c; no i c. If ½ machines produce consumption, and ½ produce investment: 500 c; 250 i 2. Slope of Frontier: -½ 3. Algebra along frontier: a. c prod. machines + i prod. machines = Total machines b. 1 unit of i uses 2 machines: c + 2i = 1000 C. Case 2: 1. Machines are not good at making c or i. (Good at producing c, bad at producing i; Ot good at producing i, bad at producing c.) Calculate opportunity cost of making c with each machine. Place machines in a line with lowest opportunity cost on left, and highest on right: +(Good c, bad i)+ +(Good i, bad c)+ <--------------------------------------------------------------------------------------------------------------> a. All machines producing i. • Asked to produce 1 unit consumption: • Switch across machine which causes least loss of investment (per unit c) • Switch across machine with lowest opportunity cost - 1st machine on L - Asked to produce 2nd unit of consumption: • Switch across machine which causes (next) least loss of investment (per unit c) • Switch across machine with lowest opportunity cost - 2nd machine on L. b. Curve gets steeper, or production possibility frontier bowed out. Machines with low opportunity cost shifted first, then machine with higher opportunity cost (curve steeper). Week 2 I. Introduction: A. Trade has been going on a long time: II. Thinking about Trade: A. Trade 1. 1700’s Mercantilism: Each country’s happiness measured by the bullion it accumulated: each country should try to sell goods to other countries (gain bullion) but not buy from other countries (give-up bullion). a. So thinking became: “Don’t buy from others, make it ourselves.” b. Policy became: “Go it alone” • Britain and France formed “Spheres of Influence” and prohibited buying from other spheres of influence. • Ex) North Korea and Former Soviet Bloc 2. 1776 Adam Smith: “An inquiry into the Nature and Causes of the Wealth of Nations.” a. An attack on Mercantilism • No farmer would “Go it alone.” • If said farmer had good cropland, he wouldn’t set some aside for grazing cattle. • Instead: He would use all his land for crops and get meat and milk by trading with farmers who had good cattle/ranch land. b. Said that each country’s happiness determined by the goods it consumes, not by the bullion it acquires. c. Power of free markets (allows countries to consume above PPF 3. 1815 Corn Laws introduced in Britain: Restricted corn imports. 4. 1817 David Recardo: “Principles of Political Economy and Taxation” a. Argued that trade is “good” and that banning trade is “bad.” b. Developed Comparative Advantage • The theory of comparative advantage is an economic theory about the work gains from trade for individuals, firms, or nations that arise from differences in their factor endowments or technological progress. • Countries who are good at making one thing ought to produce that because they are better at making it than other countries, then trade with other countries for the things that the other countries are good at making 5. 1846: Corn Laws repealed: Britain abandoned Mercantilism, embraced Free Trade. 6. Today: Many trade blocs formed to encourage trade a. US belongs to NAFTA, CAFTA, APEC, and WTO. Still signing free trade agreements b. c. Concern about jobs • Trade causes job loss (increased efficiency) but also creates jobs (increase production). • Jobs lost at Key Tronic and gained at suppliers B. Why Trade is Good 1. It is the mechanism that allows countries to consume above their Production Possibility Frontier (PPF). a. This is an example that demonstrates the mechanisms by which countries achieve consumption above PPF Total Hours: US 100 (million) Mexico 72 (million) 2. Each country acting alone cannot consume above its Production Possibility Frontier. a. b. US: • If all labor is used to make electronics: 100/10 = 10 (million) electronics. • If all labor used to make toys: 100/5 = 20 (million) toys. • Opportunity cost of 1 unit electronics = 2 unit toys (slope frontier) By calculation: 1 extra unit of electronic = 10 hours of labor shifted to produce it. 1 hr labor = 10 x ⅕ unit toys = 2 unit toys c. Mexico: • If all labor is used to make electronics: 72/24 = 3 (million) electronics • If all labor is used to make toys: 72/8 = 9 (million) toys • Opportunity cost of 1 unit electronic = 3 unit toys By calculation: 1 extra unit electronic made = 24 hours of labor shifted to produce it 24 hrs labor = 24 x ⅛ unit toys = 3 unit toys d. Different opportunity cost of production: • Opportunity cost of producing 1 unit electronics (give up...): US: 2 unit toys Mexico: 3 unit toys • Opportunity cost of producing 1 unit toys (give up…): US: ½ unit electronics Mexico: ⅓ unit electronics • If US has lower opportunity cost in electronics, Mexico must have lower opportunity cost in toys. • Each country must have lower opportunity cost in one product. C. Together, Countries can Reorganize Production to get more Output. 1. a. Suppose no trade: US is producing at US, Mexico is producing at Mexico. Both producing both products. 1. Shift production of each good to country with lower cost a. Relevant cost is opportunity cost b. Presumably related to monetary cost but fundamental cost is opportunity cost. c. By doing this, total resources are used more productively. • US makes: 1 more electronics; 2 less toys Mexico makes: 1 less electronics; 3 more toys + 0 electronics; +1 toys - US makes +1 electronics, Mexico makes -1 electronics; electronics unchanged - US makes -2 toys; Mexico makes +3 toys; +1 toys. Extra toys produced in Mexico exceeds toys given up in US. More toys produced if CD>AB d. To gain both electronics and toys US makes: 1 more electronics; 2 less toys Mexico makes: 0.8 less electronics; 2.4 more toys + .2 electronics; +.4 toys c. Specialization Work down PPF at each stage: • US makes: 1 more electronics; 2 less toys Mexico makes: 1 less electronics; 3 more toys + 0 electronics; +1 toys • At each stage toys increase. • Continue until: US is doing both and Mexico does only toys or Mexico is doing both and US does only electronics • Each country is making one more of one product than it consumes: Specialization. D. Extra output can be shared so that each country consumes more electronics, more toys,gets above its PPF. 1. a. US • Makes 1 more electronic; 2 less toys • Gives 1 electronics to mexico • To consume above PPF, must gain more than AB toys, more than 2 toys from Mexico b. Mexico • Makes 1 less electronics; 3 more toys • Gets 1 electronic from US • To consume above PPF, must give less than CD toys, less than 3 toys to US. c. Both gain if Mexico gives US some number toys between 2 and 3 units (between the opportunity costs) E. This is exactly what the Market Mechanism Does! 1. a. Both countries gain and therefore will want to specialize and trade if (voluntarily agreed) price lies between opportunity cost. • More than 2 (US gains) • Less than 3 (Mexico Gains • So 2.5 toys per electronic b. US • Makes 1 more electronics, 2 less toys • Gains if sells 1 electronic to Mexico for more than 2 toys (greater than AB) • Price greater than US opportunity cost • Gets above PPF C. Mexico • Makes 1 less electronics, 3 more toys • Gains if buys 1 electronics from US for less than 3 toys (less than CD) • Price less than Mexico Opportunity cost • Gets above PPF “What each cannot do alone, markets enable them to do together.” -Adam Smith III. Trade A. Trade & Jobs 1. Good News: More output is produced, creates new jobs and even new sectors. 2. Bad News: People must change jobs, NOT lose jobs and never get re-employed • Have to move to where the new jobs are in the new or expanding sectors • i.e. Last lecture in US move from shrinking sector (toys) to expanding sector (electronics) B. Comparing the Gains and Costs of Trade 1. The gain from trade is the increase in good consumed. • The gains are long-term or recurring. • Ex: 2017 +$150 2018 +$150 2019 +$150 …..and so on 2. The cost of trade is that workers in the shrinking sector lose their jobs. Aren’t going to be permanently unemployed though, there is an expanding sector that can hire them. Just need to move and be retrained. • The costs are short-term or once-off • Ex: 2017 -$200 2018 -$100 3. Overall: In the early years costs may exceed gains but total gains exceed total costs. The issue is that the cost burdens workers 4. Policy: Reduce cost on laid-off workers by using some of the growth to retrain them with the skills needed by the expanding sectors • NAFTA legislation included aid for workers who lost jobs: 117,000 signed up. • TPP is likely to have similar policies for displaced workers IV. Specialization A. Outsourcing 1. Don’t have to do every task ourselves (don’t have to be self sufficient), we can outsource. B. Each individual can specialize: 1. In what they do relatively best 2. In what they have lower opportunity cost 3. In what they have comparative advantage C. Example 1. 2 workers in firms A and B. Firm needs managerial and administrative output A: needs less labor than be to produce managerial or admin. CU Grad has absolute advantage in mgmt and in admin. 2. Each worker works 40 hours per week. Office initially organized so that each worker producing both outputs. Then boss wants more output from the office 3. Production Possibility Frontier for each person: a. CU Grad: • If only does management: 40/4 = 10 units mgmt • If only does admin: 40/2 = 20 units admin • To produce extra 1 mgmt, shifts 4 hours labor • Opportunity cost of 1 unit mgmt = 2 unit admin, so slope = -½ 1 hour = ½ mgmt 4 hours = 4 * ½ = 2 unti admin b. UNC Grad: • If only does management: 40/16 = 2.5 unit mgmt • If only does admin: 40/4 = 10 unit admin • To produce 1 extra unit mgmt, shifts 16 hours labor • Opportunity cost of 1 unit mgmt = 4 admin 1 hour = ¼ unit admin 16 hours = 16 * ¼ = 4 unit admin c. A has comparative advantage in mgmt. B has comparative advantage in admin. • CU Grad: Opportunity cost of 1 unit mgmt = 2 admin Opportunity cost of 1 unit admin = ½ unit mgmt • UNC Grad: Opportunity cost of 1 unit mgmt = 4 admin Opportunity cost of 1 unit admin = ¼ mgmt 4. By getting workers to specialize, boss gets more output. a. Suppose CU Grad is producing at A, and UNC Grad at B. Both are producing both outputs • Shift production of mgmt to worker with lowest of mgmt (CU) • Relevant cost is opportunity cost • Presumably related to money cost, but fundamental cost is opportunity cost • Shift production of admin to worker with lower cost of admin (UNC). By doing this, total resources are used more effectively • By Calculation: CU +1 mgmt -2 admin UNC -1 mgmt , +4 admin +0 mgmt +2 admin b. More admin produced if GH>EF. • Extra admin produced by UNC exceeds admin given up by UC. • Opportunity cost of mgmt by UNC > opportunity cost of mgmt by UC 5. To get more mgmt and more admin a. To get more mgmt and admin • UC Grad increases mgmt by 1 unit, B reduces mgmt by slightly less than 1 unit; more mgmt overall. • By Calculation CU +1 mgmt -2 admin UNC -0.8 mgmt +3.2 admin +0.2 mgmt +1.2 admin 6. Specialization a. Work down frontier, CU +1 mgmt -2 admin UNC -1 mgmt +4 admin +0 mgmt +2 admin b. At each stage admin increases: • Continue until CU Grad is doing only mgmt and UNC is doing both Or • CU Grad is doing both and UNC is doing only admin c. One grad is only doing one task - specialization. By specializing more work is done with same people 7. Outsourcing a. Consider CU Grad and UNC Grad • Now work at different firms CU at Firm A and UNC at Firm B • One firm specializes in consulting (mgmt) • Other firm specializes in service (admin) b. Each firm has its own PPF, possibility of specializing and outsourcing • Firm A sells admin services to clients, which it buys from Firm B • Firm B sells mgmt consulting to clients, which it buys from Firm A c. By Specializing and trading, each firm can sell more or get more than its PPF. • Firm A: • Produces 1 more mgmt, 2 less admin • Firm A doesn’t need all this mgmt so gives 1 mgmt to Firm B • To get above PPF, must gain more than 2 admin from Firm B • Firm B: • Produces 1 less mgmt, 4 more admin • Gets one mgmt from Firm A • To stay above PPF Firm B has to give less than 4 admin to Firm A • Admin. Trade • If Firm B gives Firm A between 2-4 units of admin. (let’s say 3 admin.), then both Firms are selling services above their individual PPF 8. This is what the Market Mechanism does! a. Both want to specialize and trade at a voluntarily agreed price between opportunity costs: • More than 2 (so Firm A gains) But also, • Less than 4 (so Firm B gains) b. So, Firm A can set price of 1 unit mgmt unit for 3 units admin. • Firm A sells 1 unit mgmt to Firm B and in exchange gets 3 units admin. • Firm A gains 1 unit admin above its PPF c. And, Firm B can sell 3 units mgmt to Firm A and in exchange gets 1 unit mgmt. • Firm B remains 1 unit admin above its PPF D. Household Example 1. Family Tasks: shopping, cooking, cleaning, fixing, driving a. Does each parent need to learn how to do each task, so that both are doing every task? b. Or, is it easier for each parent to specialize in a few tasks? • Better to specialize and trade. • Ex. “I’ll cook if you clean.” V . What determines Comparative Advantage? A. Trade between Countries, States, or Cities 1. Trade between countries, states, or cities: a. Nature/Vacation (natural endowments) • Colorado has lots of nature, needs low input to create vacation. • Ohio doesn’t have lots of nature, needs lots of input to create vacation • CO, not OH has comparative advantage for vacations b. Low-skilled Labor • Countries with much low-skill labor find it “easy” to make goods requiring low-skills. • Specialize in low-skill labor (i.e. Asia in textiles) 2. Path of Development a. By doing, workers acquire skills and need less time to produce goods • Fashion in Italy: historical accident, then practice reinforces • Semiconductors in Japan: Japan invested and trained workers for this. B. Organization of Workplace 1. Natural Endowments a. IQ b. Social Skills c. Interests 2. Training/Learned skills VI. Determination of the Market Price A. In trade discussion: 1. Goods are exchanged (bought and sold) at voluntarily agreed prices 2. Price often lies between opportunity cost of the two parties (in our example: the 2 countries or 2 firms) B. Competitive Market (Simplified Model) 1. Market with: a. Standardized product: little to no quality difference between goods • Corn • Neodymium (element) • Soup cans • Binders • Shares of a particular firm b. Many buyers and sellers …..this is called a competitive market c. Many buyers and sellers are “price-taking” • In a perfectly competitive market, the firm is a “price-taker”: meaning it cannot influence the market price through the quantity it produces. • Market Price: Price at which goods are exchanged 2. Price Taking a. Ex. Farmer selling wheat; Sees all farmers selling at $1 per bushel • $1 per bushel is market price • He knows he is just one of many farmers selling wheat • Other farmers and buyers are not noticing what he does • If he raises his price, others will not raise their prices • If he lowers his price, others will not lower their prices b. He cannot affect the market price. So he takes the market price as given. • If he raises his price above the market price, nobody will buy from him • If he lowers the price, it is still just as competitive but he gets less revenue • Key: Doesn’t have to lower his price because: • Everybody else is selling at $1 per bushel • Farmers wheat is as good as everybody else’s wheat • If theirs is selling at $1 per bushel, then so will his • He sells at market price 3. Baker buying wheat a. Sees everybody buying and selling at $1/bushel - Market price • Baker knows he is just one of many • Other buyers and sellers (farmers) are not noticing what he does • If he offers to pay more, prices at which others buy and sell will not change • If he offers to pay less, prices at which other buy and sell will not change b. He cannot affect the market price (just like the farmer in 2). So he takes the market price as given. • If he lowers the price he offers to pay, nobody will sell to him • Do you ever offer to pay less than sticker price at Target? No. • Even if you did they wouldn’t sell to you. • Why would they sell to you for less when they can expect to sell to others at market price (higher than you offer). • If he raises the price he is willing to pay, he ends up paying more than he would if he just bought at expected (market) price, $1/bushel. • He buys at the market price VI. Determination of the Market Price A. Price is determined by: 1. a. Eagerness of households to buy (demand side) b. Eagerness of firms to sell (supply side) B. How much do people buy? 1. Depends on: a. Price b. Income c. Price of related goods d. Tastes e. Expectations 2. Concentrate on prices because this is what is determined by the system. 3. Do one thing at a time a. Holds other variables constant b. “Ceteris paribus” - All other things the same 4. Example: Bob a. Ask Bob: • If price is $__ per can. • How much would you want to buy? b. As the price increases, buy less. • Law of Demand 5. Note curves, a curve is a relationship a. y=rad(x) b. Recitation problem set one did not matter which axis x or p fell on. c. Demand curves do not always slope downwards: • Mink’s demand curve for water C. Market Demand Curve 1 . 2 . a. To get market demand, stack the individual demand curves horizontally b. Since each individual demand curve is sloping downward, general market trend is sloping downward. Week 3 I. Determination of the Market Price A. Price is determined jointly by: 1. Eagerness of households to buy (demand side) 2. Eagerness of firms to sell (supply side) B. Focusing on eagerness of households to buy leads to formation of a demand curve. 1. Determined by price of product and total individual demand 2. Drawn ceteris paribus • see last lecture II. Movement along vs. Shift of Curve A. Drawing the Demand Curve 1.The Demand Curve is drawn ceteris paribus • One variable is changed and all else are held constant • Ex: Price is changed so quality, supply, etc are assumed to be constant 2. Table Graph = Demand Schedule = Demand Curve a. As p changes, curve shows how quantity demanded (x) changes; Ceteris paribus - hold everything else constant (in this case y) b. If p increases from 3 to 4, quantity demand changes from 3 to 1; as value on one axis is changing, move along the curve, move along the curve to find new value on other axis. 3. a. New schedule and new curve • As y changes, quantity demand changes • If y increases from 81 to 144 and p is unchanged, quantity demanded changes from 3 to 6 • ** New relationship between p and x • As something not on one of the axes changes. There is a new relationship between p and x. The curve shifts. • Represent pre-existing situations with solid line, “new” situation with dashed line. B. Shift of Demand Curve 1. a. Quantity demanded depends on: 1. Price: as p increases, value on one axis changes. Move along curve and quantity demanded 2. Tastes: Vacation: Something not on axis change, quantity demanded increases; demand curve shifts right. 3. Income: Income increases, value not on axis changes. Holding shoes price constant. 2. Individual spends some of extra income Individual buys less plastic shoes on more shoes Quantity demanded increases Quantity demanded decreases - Normal good - Inferior good 3. Goods a. Broad categories of goods (shoes, clothing, food..etc) tend to be normal b. Sub-categories of low quality are often inferior 4. Price of related goods a. In hamburger market: • Something on one of the axes has changed • Move along demand curve • Quantity demanded of hamburgers decreases b. In soup market • What is changing is not one of the taxes • What is changing is not one of the axes • D curve shifts c. People like to buy soup or hamburger • If people buy more soup, D curve shifts to right • substitutes 4. a. In sandwich market: • Something on one of the axes has changed, move along D (sandwhich) • Quantity demanded of sandwiches decreases b. In soup maret • What is changing is not one of the axes. D curve shifts c. People like to buy package of soup or sandwiches • Buying this bundle is more expensive so buy less sandwich and less soup • D curve shifts to the left • Complements “used with” 5. Ex: Gov’t wants to cut back on gasoline a. b. Either • Raise gas price to buyer (tax) • Move along demand curve c. Or • Reduce bus price • Give substitutes (demand curve shifts) III. Supply Side A. Move to supply side 1. 2. Price is determined by a. Eagerness of households to buy (demand side) b. Eagerness of firms to sell (supply side) B. How much do firms want to sell 1. It depends on: a. Price b. Technology c. Input prices d. Expectations 2. Focus on price - “ceteris paribus” a. Ask each soup firm: • “If price is __, how much do you want to sell?” b. Separating out demand and supply • How much do you want to sell • NOT how much you can sell (assumed that firm can sell) 3. Law of Supply a. Table presentation Graphical presentation = Supply schedule = supply curve b. Law of Supply: As price increases, it becomes profitable to produce more. Quantity supplied increases. 4. Market Supply Curve a. How much do all firms want to supply at given price. • Stack individual “curves” to get market “curve” IV. Movement Along v. Shift of Curve Example A. Gov’t wants firms to produce more solar heaters 1. Gov’t can either subsidize a. Firm can afford to pay more to produce more and sell at lower, same, or only higher price. b. Moves along curve OR 2. Gov’t labs work to improve technology a. Can produce more at same price b. Shifts curve (price stays same but number of heaters increases) V. Equilibrium A. What does equilibrium mean? 1. Equilibrium: “State of balance between opposing forces” - no net force pushing for change. 2. Equilibrium price by two forces a. • Eagerness of households to buy (Demand Curve) • Eagerness of firms to sell (Supply curve) b. Need to include both forces (supply AND demand) • Edgeworth (from lecture) VI. Supply and Demand Curve (Literally the cornerstone of economics) A. Equilibrium when, Quantity demanded=quantity supplied B. Curves put together: • Equilibrium price = $1.00 per can • Equilibrium quantity = 40 cans per month C. Suppose market price increases: 1. P goes up to $1.50 a. For changes in price (move along supply curve) look at supply curve. b. As price goes up (S curve moving to the right) demand goes down (D curve to the left) • less people want to buy as many or more cans at higher price c. Leads to a surplus, firms have more than they need. Unbalanced • As inventory from unsold soup cans builds, firms need to get rid of them • Firms begin to undercut prices (lower prices or have a sale) • Price drops and demand rises to meet it again. 2. For the same graph: market price starts decreasing. a. People want more (move along demand curve) b. If each firm produces less (move along supply curve) c. Surplus shrinks and force lowering the price slackens d. Prices continue to fluctuate until intersection of supply and demand is met. • amount people want to buy = amount firms want to sell • No force moving price down D. Suppose market price increases 1. P goes down to $.50 a. For changes in price (move along supply curve) look at supply curve. b. As price goes down (S curve moving to the left) demand goes up (D curve moving to the left) • More people want to buy as many or more at lower price c. Leads to a shortage. Other kind of unbalancing • Households want more than firms have to sell. Households find it difficult to get soup in shortage • Forces firms to act: can either raise price or produce more • Can raise prices without losing sales 2. For same graph: Market price starts increasing a. Each person wants less (move along demand curve) b. Each firm produces more (move along supply curve c. Shortage shrinks d. Force raising prices slackens, move towards equilibrium again E. Example: News Magazine 100 (million) households and 20 firms 1. Predict: What is equilibrium price and quantity of magazines 2. How to a. Construct market demand curve b. Construct market supply curve c. Put curves together d. By Law of Supply and Demand • Equilibrium Price: $3 per magazine • Equilibrium Quantity: 400 million magazines per year 3. By Calculation D a. Demand Curve: Q = -200p + 1000 Supply Curve: Q = 200p - 200 b. At Equilibrium Q =Q S Or…. -200p + 100 = 200p - 200 p=3 F. Example: Miners and Cooks 1. Miners were paid $2.50 a day for (usually) 12 hour days. Miners were cheap, unskilled laborers. Cooks were paid better because “it was hard to find a good cook” 2. How price of labor (wage is determined) a. Use Law of Supply and Demand b. Wage = price of 1 hour of labor 3. a. Low skill → high quantity demanded → low wage So… high quantity supplied, low wages paid b. Higher skill → lower quantity demanded → higher wages So….low quantity demanded, high wages paid Week 4 I. Changes in Market Conditions A. External Conditions 1. Change in income 2. Change in price of another good • Substitutes • Complements 3. Change in natural conditions B. If something changes 1. If something outside a market changes, either the demand or the supply curve shifts. 2. This creates a shortage or surplus :( 3. However, prices adjust and the economy moves along the supply and demand curve to the new equilibrium. II. What happens with Normal Goods A. Income increases 1. What happens to price and quantity of golf club membership as wealth increases. a. Golf club membership: normal good b. Norm at D and S, with Equilibrium at E c. Something outside the market changes...income increases d. Which curve is affected and how? • Demand curve is affected because people now have more money to spend on Golf • ‘Normal’ good: at any given price more people want to play Golf • Demand curve shifts to the right (D → D) ’ e. Income does not affect firm’s wish to sell memberships, supply curve unaffected. • Q moves along curve f. New equilibrium (E) is at the intersection of D and S’ D 2. Overall: As Q of Golf memberships, increases, so does price. B. How does the economy move from old to new equilibrium 1. If sells at old price (before income increase), there’s a shortage. a. Thus, a force moves the price up. b. In Golf example, each membership can increase price without losing members 2. As price increases a. Demand Side: • People buy less memberships • Move along D curve, Q decreases b. Supply Side: • Clubs by faster golf carts, hire more workers in restaurants, etc. • Move along S curve, Q increases D S 3. Process continues until shortage shrinks and Q = Q 4. Important point: effect on price and quantity is derived from income change. III. What happens as price of other goods changes. A. Substitutes 1. Substitute goods: at any given price people will substitute one good for another or vice versa. 2. Beef prices increase, what happens to price and quantity of Pork? a. Beef and Pork are substitutes • They are interchangeable, if people can’t buy Beed they’ll buy Pork • Thus, as demand for Beef decreases, demand for Pork increases. b. Norm at D and S with Equilibrium at E c. Something outside changes… Beef prices increase d. Which curve is affected? • Demand Curve affected, Q D: Bdecreases b/c it’s more expensive • High price of Beef affects people’s wish to buy Beef, would rather buy Pork b/c it’s less expensive • ‘Substitute’ good: As Q D: Bdecreases, Q D: increases. Demand curve shifts to the right, D → D ’ e. Higher Beef price does not affect firm’s wish to sell Pork. Supply Curve is unaffected. ’ ’ f. New equilibrium is at intersection of D and S: E 3. Overall: Price increases, quantity increases B. How does economy move from old to new equilibrium. 1. If sells at old price, before Beef price increase, Pork shortage a. Force causes price to increase b. Each farmer finds he can increase pork price and not lose sales, so price increases. 2. As Pork price increases a. Demand Side: • People eat less Pork as price increases, substitute with more fish ’ D • Move along D curve, Q decreases b. Supply Side: • Farmers shift resources to pigs, use better feed. S • Move along S curve, Q increases. c. Process continues. Prices rise and shortage shrinks till: Q = Q D S 3. Important Point: markets are linked - what happens in one market affects other markets C. Linked Markets 1. Headline: “Rising Prices for Gas Propel Auto Sales, as Shoppers Choose Among Fuel Efficient Models.” D. Complements 1. Complements: As price increases for one G/S, demand and then prices decrease for linked G/S 2. Airfares increase, what happens to price and quantity of hotel rooms. a. Air travel and hotels are complements. As airfare prices increase, people travel less and demand for hotels decreases b. Norm is at D and S, Equilibrium at E c. Something changed..airfares increase d. Which curve is affected? • High price of airfares affects people’s wish to travel and rent rooms. • Demand curve affected as less people want hotel rooms. At any given price, demand for hotel rooms has gone down. • Complement: At any given airfare, vacations are more expensive, so hotel-room demand curve shifts to the left, D → D’, since people are travelling less. 3. As price decreases: a. Demand Side: • People stay longer in hotels, travel a little more • Move along D, Q increases b. Supply Side: • Hotels lay-off staff, close wings because they can’t fill all the rooms s • Move along S curve, Q decrease c. Process continues, prices fall and surplus shrinks until Q = QD S IV. Changes in Supply A. 1. 1880-90 Opening up of Great Plains on Irish Food Prices a. b. Norm is D and S, equilibrium is at E c. Something changes: Railroads built in US Midwest, allowing corn products to be transported to East Coast and exported to Ireland. d. Which curve is affected? • Demand curve is unaffected. • Supply curve: at any given price, more corn available in Ireland, Q S increases • Supply curve shifts right to S → S ’ e. New equilibrium is at intersection of D and S. At E ’ 2. Overall: Prices decrease, Quantity increases B. How does economy move from old to new equilibrium 1. If sold at old price, there’s a surplus of 2. Force created which lowers price. • Farmers try to undercut other farmers to get rid of excess inventory. 3. Prices fall and surplus shrinks until equilibrium. C. Historical Consequences: 1. Irish farmers got less revenue of their own corn. 2. Poor became even poorer 3. Many emigrated to US D. What happens when several changes hit Beef Market 1. 2. Norm at D 200and S 200Equilibrium is at E 2002 3. Something Changes a. 2004: Mad Cow Disease: Japan boycotts US Beef, D 200→ D , E →4 2002 E 2004 corn b. 2006: Rules requiring ethanol mixed in gasoline, p increases. Input prices rise (more expensive to feed cows). S 200→ S , E → E2004 2006 2006 2008 2006 2008 c. 2008: Long-term drought starts, S → S . E → E d. 2013: Japan relaxes boycott. D 200→ D . E → E 2008 2013 2002 2008 4. Overall: E → E , p increases and Q decreases (35m → 30m). With removal of boycott p and Q predicted to increase. V. Magic of the Market A. Magic 1: Prices Coordinate Activities 1. A drought reduces grain crop a. People need to consume less. Coordinate people’s buying since quantity is lower. • Can advertise problems and ask for voluntary restraint. OR…Since people don’t really restrain themselves • Raise prices, force people to want less. Immediate response. b. Actually, price will raise automatically. Nobody needs to be told to raise prices. • Nobody needs to be told because farmers need to make a living and since there’s less grain to sell they need to raise prices to make as much as they would have normally (if there hadn’t been a drought). • Since there’s less grain available the farmers can sell at a higher price and people will still buy it c. “This is a magic of the market” d. Point #6: Market with many buyers and sellers are a good way to organize economic activity B. Magic 2: Firms will use better technology and the benefits are passed to consumer in the form of lower prices. 1. Slopping Hogs, the Assembly-Line Way (read the article from lecture 10) 2. How it works a. b. Norm at D and S, Equilibrium at E c. something happens... new technology d. Which curve is affected • Supply curve is affected: At any given price, pig farming costs less and is more profitable e. Two effects: • Some exisSing pork farmers switch to new technology and produce more. Q increases, S shifts right S → S’. • Some none pork farmers decide to build pig plants with the new technology, adding additional supply to market. Q increases, S shifts right, S → S’. f. Demand curve unaffected, move along demand curve g. New equilibrium at the intersection of D and S’’, E’ h. Overall: Prices decrease and Q increase 3. How does economy move from old equilibrium to new equilibrium. a. At old price there is a surplus b. Prices fall and surplus shrinks until new equilibrium is met. 4. How benefit reaches the consumer a. New technology allows farmer to make pork at a lower cost. b. Market ensures that the cost reduction is passed onto the consumer as lower prices. • Since it costs all farmers less to produce pork, they can make more for less. That means they can sell for less, but why would they? Ppl don’t know it’s cheaper to make pork, might as well keep extra profits. • But, since farmers are producing more they need to sell more, and to sell more they decrease prices to undercut competitors. • Everyone is producing more, everyone is trying to sell more, so everybody is dropping their prices. Market prices fall. 5. Example a. 1811: Before Steamboats, price to move 100Ibs from New Orleans to Louisville: $5. New Technology introduced: steamboats b. 1825: 75 Steamboats on Mississippi and Ohio R, price to move 100Ibs from New Orleans to Louisville: $2 c. 1835: 361 Steamboats on Mississippi and Ohio R, price to move 100Ibs from New Orleans to Louisville: $0.25 C. Price Sensitivity vs. Price Insensitivity 1. Price Sensitive/Price Elastic: Changes in price cause large changes in quantity. Sensitive to price changes. 2. Price Insensitive/Price Inelastic: Changes in price cause little change in quantities. Insensitive to price changes. VI. Cooperation through Voluntary Exchange A. Pencils 1. “Not a single person knows how to make me!” a. Somebody cuts the wood that makes the body, that wood is only cut in NorCal or OR, so lumberjack in OR cuts and sells the wood b. Miner somewhere in SE Asia (let’s say Sri Lanka) extracts graphite, sent to smelter to be refined into usable state. c. Factice made in Indonesia d. Then there are all the workers who make all the tools: the miners who extract iron and people who make steel for the axe heads of the lumberjack, the people who make machines used by the graphite mine. d. Thousands of people’s time and labor went into making a pencil. Some don’t even know what their work goes to, some don’t even know what a pencil is. 2. All these people went to work and provided a small amount of their services to the production of a good. None of them care who they sell to and who buys their goods because they get $$. None of them are told how much to produce, they just produce what they want to get the money they need. a. Lumberjack in OR only needs to know the price his wood sells for he decides how much to cut. b. Graphite miner in Sri Lanka only needs to know price his graphite sells for, he decides how much to mine c. Factice maker in Indonesia only needs to know the price his factice sells for, he decides how much to make. VIII. Interfering with Market Mechanism A. Market with many buyers and sellers are a good way to organize economic activity 1. Interference if you stop letting price coordinate quantity demanded and quantity supplied. Bad things happen. 2. Price Ceiling (ex: rent control) a. New York Apt. Market: b. Something Changes • Servicemen come back from WWII, Q D Increases. • Prices increase in response to demand increase (Equilibrium but now people can’t get apartments) • Gov. Institutes Rent Control, fixes rent prices c. Which curve moves • Demand curve: At given price, more apts. demanded, D → D’ • Supply curve: unaffected d. Curve w/o price ceiling • Immediate effects: • At old prices, shortage • Landlords increase prices, move along S until E → E’ • Shortage shrinks, landlords make huge profits • Long term effects • Profits incentivise people to build new apt. buildings, supply curve changes from S → S’ • As supply increases, price decreases until E’ → E’’ • Over time, higher prices and increased profits lead to investment in building new apts. Prices eventually fall back e. With Price ceiling • Immediate effects: • At old price, shortage • Landlords cannot raise prices • Market mechanism is disconnected, shortage persists • Long term effects: • No profits • No new apts. b/c landlords have no incentive to invest in new ones • Chronic shortage • Quality decreases because landlords can always rent apts. So no incentive to make them nice or maintained • Renters w/ apt. • Immediately less rent, but then levels out • Over time quality decreases, shabby apt. • Renters w/o apt. • Don’t get an apt. Immediately • Over time get a shabby apt. I. Interfering with the Market Mechanism A. Price Ceiling (last time) 1. CA Electricity Crisis a. b. Norm: D, S and E prior to 1996 c. Something happened in 1996...electricity deregulated • People worry that price might rise • Gov. imposes a price ceiling d. Curve w/o Price ceiling • As population grows, D → D’ •
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