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# What is a good example of supply and demand? Description

##### Description: As stated by the professor, the exam will cover everything we have learned so far. The file includes the quizzes we had in class and the examples we've had as well. I think this should be enough to prepare for the test. If you think otherwise, msg me and tell me what I can do for the next exam.
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ECN 212

## What is a good example of supply and demand?

Using the supply and demand model:

- Supply and demand is a simple yet powerful model that gives us an idea as  to what would happen in a competitive market when certain market  fundamentals change.

Supply and demand:

- If just demand shifts let’s say price of a substitute increases - Note demand shifts, but a movement along the curve for supply - The result (light blue line) : P (went up), Q (went up)

If just supply shifts (lets say price of an input increases):

Note: Supply shifts, but a movement along the curve for demand Result: P(increases), Q(decreases)

Two things happen: price of substitute went up and input cost went up. Easy way than drawing two shifts at the same time:

Shifts

Direction

P(corn)

Q(corn)

Price of

Substitute

(up)

D

Right

Up

Up

Price of

input (up)

S

Left

Up

Down

Combined:

D, S

D: right

S:: left

Up

ambiguous

## What happens to demand when substitute price increases?

1/23/17

Elasticity

- What kinds of changes? Three different ones: We also discuss several other topics like What does the prefix rythm mean?

o Price

 How does a change in price affect quantity demand?

o Income

 How does a change in income affect quantity demand?

o Price of a related good

 How does a change in the price of good B affect quantity

demanded?

- Think about a rubber band, you apply force to it to see how much it changes  in its shape

- Think of the force as either price (for price elasticity of demand) income (for  income elasticity of demand) or price of a related good (for cross price  elasticity of demand) and the shape as quantity demanded for all three cases

## How do substitutes affect your pricing strategy?

If you want to learn more check out What is the lenght of an er signal in a peptide sequence?

- How responsive is quantity demanded to price? Or income? Or price of a  related good?

To calculate the responsiveness to change of the quantity demand to price

- Slope will only work if you have the same units and data

- Instead use the Midpoint Method

1/25/17

Gasoline Market in the US

June 2007 and June 2008

- When estimating demand elasticity, need to hold fixed other determinants o  fdemand to isolate impact of change in price.

- Also need to take into account supply

- Why is what we calculated the elasticity of demand and not the elasticity of  supply?

o The demand didn’t shift, only the price was the one that shifted We show that it is the demand elasticity by seeing that:

- The supply curve did shift:

o Price of barrel of oil increased from \$65 to \$121. Oil is an input in  making gasoline. An increase in input prices shifts the supply surve up  and to left We also discuss several other topics like How many hydrogen lines are in the visible spectrum?

 Thus we cannt calculate price elasticity of supply

- Demand curve did not shift (So movement along Demand)

o Have to argue that the determinants of demand (the things that make  it shift) remained unchanged.

- If demand curve does not shift, this is a movement along the curve for  demand. Thus we can calculate price elasticity of demand

The determinants of demand:

1. Tastes of consumers If you want to learn more check out What is an observer’s point of view?

a. Seasonality in Demand (drive more in summer than spring). Hold this  fixed here by comparing June to June

2. Number of consumers

a. Population grows over time. Hold fixed here by using per capita  numbers. We also discuss several other topics like How is japan education different from america?

3. Income

a. Gas is a normal good. So in order for demand not to shift, income can’t change. Income not that much different June 2007 to June 2008. (But  things started looking different later in 2008, as the economy started  falling off a cliff on account of the economic crisis.)

4. Prices of substitutes and complements

a. Didn’t change much over this one-year period

Long run elasticity

- Elasticity we have estimated is a short-run elasticity

- Consumers have not had much time to make a response

- Over a long period of time, if gas is significantly higher in price: o Consumers will buy different cars

o Might live different places

o Society might change laws, like lower the speed limit

- For the long-run elasticity, need to compare cases where prices have been  different a long time

Long run price elasticity

- Should we just measure long run price elasticity of demand for gasoline by  taking a price and quantity from a long time ago, say, 1950, and compare it  to the price and quantity demanded today? Don't forget about the age old question of What is the relationship between time and space?

o No, lots of other things aside from price of gasoline changed between  1950 and now

o to get a more accurate estimate, we compare the US with another  country similar to us

 this country must have a higher price of gasoline than the U.S.  and must have had it for a long time. So people in that country  had time to react to the higher prices.

What makes Demand more price elastic?

1. Long time horizon (as we saw from the gasoline example)

2. When products are defined more narrowly so there are better substitutes a. Price elasticity of food as a group is low (inelastic). So if all prices  increase 10%, quantity falls less than 10% (spending on food goes up). i. Price of food goes up overall, you still need to eat.

1/27/17

EconLand:

- Like the map example from the first day of class, what happens in Econland  can tell us something useful about the real world

- Useful because we can use Econland to examine the efficiency of competitive markets and the impacts of government policies.

- Inhabitants: Demanders named D1, D2, D3,…., D10 and Suppliers named S1,  S2, S3,…, S10

- Assumption: Only Demanders eat Widgets, and each demander can eat at  most one widget.

- Each demander has a reservation value for one widget. This is the amount  he/she would be willing to give up to get a widget.

- Name Reservation price of one widget

- D1 9

- D2 8

- D3 7

- D4 6

D5 5

- D6 4

- D7 3

- D8 2

- D9 1

- D10 0

Suppliers:

- Don’t eat widgets

- Know how to make them

Ex.:

D1 indifferent between  having one widget and  having \$9

- Each supplier can make at most one widget

- However, they get hungry from widget work (so they won’t do it for free)

Cost to a supplier to make one widget can be interpreted as the amount of dollars  we have to give her so she is just willing to do it.

Quiz Question:

- D5 is happier with \$6 than he is with having a widget

- You can give S9 \$5 and S9 would be willing to produce a widget - D8 would be happy with how many \$s

- S5 will be willing to produce for \$4

Marginal Cost: the cost of the seller producing the next widget

Marginal Reservation Price: the value of a widget for the consumer consuming the  next unit

- Often referred to as marginal benefit

-

Suppose we set up a market economy in Econland. So there are prices and a way  for demanders and suppliers to interact with each other

At P = 3, who is wiling to sell?

�^� ^ = _3__ when � = 3

So from Marginal Cost curve, we get the supply curve

At P = 7, who is willing to but?

Q^D = 3 when P = 7

What happens when Econland is a Market Economy?

Equilibrium:

P = \$5, Q = 5

At the equilibrium:

S1, S2, S3, S4, S5 produce

D1, D2, D3, D4, D5 consume

What are the gains from trade?

- Consumer Surplus (CS) of a particulat buyer

o =reservation price = price paid

- Producer Surplus (PS) of a particular seller

o = price received – cost

- In equilibrium, Buyers pay sellers the equilibrium price, which means Sellers  receive the equilibrium price.

Total Surplus = Consumer Surplus + Producer Surplus

Ex. 20 = 10 + 10

The graph we have been looking at looks like a graph with steps. But with the  assumption of infinitely many buyers and sellers, we get the same supply and  demand diagram as straight lines instead of looking like steps.

How should we interpret the total surplus?

- Think of it as a “social surplus” or a “social pie”

Consumers get part of the social pie, producers get part of the social pie. But we say that the marker allocation is efficient?

What does it mean for an allocation to be efficient? We need a concept of efficience. The standard concept in economics is PARETO EFFICIENCY

An allocation is Pareto Efficient if it is feasible and there is no way to make someone better off without making someone worse off.

In Class Example of PARET EFFICIENCY:

2 cans to the student, 2 cans to me, and 2 cans in the trash  - No! can make one of us better without making the other worse off 4 cans to me, 2 cans to the student

- Yes! cannot make someone better off without making someone worse off.

6 cans to me, none for the student

- Yes! cannot make someone better off without making someone worse off 8 cans to me, none for the student

- No! this is not feasible

Where does equity show up in the definition of efficiency?

- It doesn’t

Concept is easy to understand is span was the only thing in the economy

In the world, we want to look at total surplus like spam. How is total surplus  allocated in the economy, and is it does so efficiently?

- To answer this, let’s suppose Econland is no longer a market economy. What  this means is rather than having a market where consumers and producers  can transact, we take the role of a “social planner”

- The social planner is benevolent (wants the best for Econland) and tells  consumers and producers exactly what to do.

Suppose we have an allocation where D* consumers a widget but D2 does not. Is  this Pareto efficient?

- D8 values a widget at \$2

- D2 values a widget at \$8

- Is there a way to make someone (only options here: D2 or D8.) better off  without making someone worse off?

o Yes!

- For Example, D2 can give \$5 to D8 for D8s widget

- Is D2 happier? (he pays \$5 for a widget)

- Is D8 happier? (he receives \$5 for a widget

- Since there was a way to do “better” the allocation where D8 consumes but  D2 does not is not Pareto Efficient

In class quiz:

Suppose we have an allocation where S7 produces a widget but S1 does not. Is this  Pareto Efficient?

- It cost S7 \$7 to produce a widget

- It cost S1 \$1 to produce a widget

- Is there a way to make someone (only options here S1 or S7) better off  without making anyone worse off?

o Yes!

- For example, S7 can give \$5 to S1 to S1 to produce the widget for him - Is S7 happier? (he pays \$5 to produce widget)

- Is S1 happier? (he receive \$5 to produce widget)

If we can find a better way to allocate consumption and production, then the current allocation is not efficient

General Principle 1:

Efficient allocation of consumption

- In any efficient allocation, consumers with the highest willingness to pay  consume

- Remember from the Econland example, D2 has higher willingness to pay than D8, but D8 consumes instead of D2.

o We found that there was a “better” (more efficient) way. So this  allocation is not efficient

General Principle 2:

Efficient allocation of consumption

- In any efficient allocation, producers with the lowest cost produce. - Remember from the Econland example, S7 has higher cost than S1, but S7  produces instead of S1.

o We found that there was a “better” (more efficient) way. So this  allocation is not efficient.

Suppose we have an allocation where the consumers with the eight highest  reservation prices (D1, D2, D3, D4, D5, D6, D7, D8) consume, and the producers  with the eight lowest costs (S1, S2, S3, S4, S5, S6, S7, S8) produces.

Notice that this follows General Principle 1 (since consumers with the highest values are the ones consuming) and General Principle 2 (since producers with the lowest  cost are the ones producing).

Quiz:

Does the first general principle of efficiency hold, given the current list of people  who are consuming and producing?

- Yes

Does the Second general principle of efficiency hold, given the current list of people  who are consuming and producing?

- Yes

If you want to create the largest total surplus, which pair of consumer and supplier  would you match? {Total Surplus=Consumer + Producer Surplus} - D1 and S1

On the other hand, which pair of consumer and supplier creates the least total  surplus? Remember, total surplus is consumer surplus producer surplus.  - D8 and S8

What did we learn?

- When Q=3, there is someone out there (D4) not consuming who is willing to  pay more than it will cost someone (S4) to produce. So quantity needs to be  higher.

- When Q=8, there is someone out there consuming (D8) who is willing to pay  less than what it is costing someone (S8) to produce. So quantity needs to be  lower

General Principle 3

Efficient Quantity:

- In any efficient allocation, the value (reservation price) of the final unit  consumed should be equal to the cost of the final unit produced

Principles 1, 2, and 3 imply that in an efficient allocation for the widget industry in  Econland is when:

- D1, D2, D3, D4, and D5 consume, S1, S2, S3, S4, and S5 produce o The final unit is consumed by D5, who value a widget at \$5

o The final unit is produced by S5, who has a cost of \$5

 This satisfies General Principle 3

- Quantity = 5 when total surplus is maximized

First Welfare Theorem

Assume

1. Market structure is perfectly competitive (not monopoly or oligopoly, for  example – more on this later in the semester)

2. No externalities (my action hurts or benefits others, but I don’t take into  account. Like pollution. More on this later in the semester.)

Taxes

Is society better off with a tax?

- Before answering the question, we need a way to model taxes in our basic  supply and demand model.

Ex. The government charges \$4 tax for each unit for cheesecake. - By using something called the “Wedge-Method”, it doesn’t not matter  whether the tax is imposed on consumers or producers.

- The way that we depict it is the same

To understand why the wedge method works, first see that a per-unit tax is a wedge between the price consumers pay and the price producers receive. For example, a \$4 tax: �^� ^ = tax + �^� ^

\$7 = \$4 + \$3

P^D is price that the demanders pay

P^s is price that the suppliers receive

- Important: With a tax, the price that demanders pay and price that suppliers  receive will no longer be the same. Hence a “wedge.”

- To find equilibrium under tax, find quantity where distance between demand  and supply equals the tax. (In other words, quantity where you can fit a  wedge with height equal to the amount of the tax.)

Graphically depicting the \$4 per-unit tax on widgets:

So, no matter who the gov’t imposes the \$4 tax on, we have the same situation,  where

P^D = 7 and P^S = 3

- The wedge here represents the \$4 tax per unit; the price consumers pay \$7  for each unit is \$4 more than the price suppliers receive \$3 for each unit. - Even though we won’t talk about it in class, a tax can also be represented by  supply or demand shifts

o The wedge method and shifting gives the same result, but the wedge  is easier to work with.

In class quiz:

First, what is the height of a tax wedge that represents an \$8 tax? - 8

To draw a tax wedge with the height that you answered for the previous  question [let’s call the height “X”], we have to start from the ______ and  draw a wedge of “X” units down to the ____.

- Demand curve, supply curve

Consumers must now pay how much for a widget after this tax is imposed? [at what price does the tax-wedge touch the demand curve?] - \$9

What about a \$4 widget subsidy?

- P^S = P^D + subsidy

-

Tax Burden

In Econland, after a \$4 tax,

ΔPD = +\$2 (price that demanders pay goes up by \$2)

- Consumers are worse off because they have to pay more

ΔPS = –\$2 (price that suppliers receive goes down by \$2)

- Producers are worse off because they receive less

Also, remember that ΔPD=+\$4 and ΔPS=–\$4 when tax = \$8.

Do buyers and sellers always split the tax burden 50/50?

Suppose supply is perfectly elastic. Equilibrium price and quantity when there is not  tax?

Now suppose we add a \$4 tax. Equilibrium?

The more inelastic the side of the market you are on, the more you pay of the tax If a side of the market (consumers or producers) is price inelastic, then you can’t  really respond much to a change in price

- Thus, that side of the market will bear more of the tax burden, as a tax simply changes the price that is paid by consumers or received by suppliers.

Price Ceiling:

Price is kept from going up to the equilibrium price. DO NOT be confused: A price  ceiling DOES NOT mean you draw a line above the equilibrium! A binding price  ceiling is represented by a line below the equilibrium price.

Price Floor:

Price is kept from going down to the equilibrium price. DO NOT be confused: A price  floor DOES NOT mean you draw a line below the equilibrium! A binding price floor is  represented by a line above the equilibrium price.

Quiz:

Price Floor in Econland

Law if EconLand: Illegal to sell widgets for leass than \$7

There is a price floor of \$7 in Econland now. First of all, is this a binding price floor?

- Binding

At \$7, how many consumers in Econland are willing to buy a widget? What is  quantity demanded?

- 3

At \$7, how many suppliers are willing to sell a widget? In Other words, what is the  quantity supplied?

- 7

How many total units will be bought and sold in Econland, based on your answers to the last 2 questions?

- 3

What is Q^D?

- 3

What is Q^S?

- 7

Price ceiling with Resales

Law in EconLand: Suppliers cannot sell widget for more than \$3. - Demanders are allowed to resell at any price

How will adding a resale market for widgets change the welfare of Econland? These are two markets – the original widget market and the rsale market. There is  price ceiling on the widget market, but not on the resale market

- Just as with any market, the resale market has one price that clears the  market (supply of resale widgets=demand of resale widgets)

- First, what is supply of resale widgets?

- Then, at what price is the demand for reslae widgets equal supply (in  equilibrium)?

- - what price of resold widgets is \$7

- At a price of \$7 in the resale market, only D1, D2, and D3 will purchase a  widget (exactly the amount of supply in the resale market)

The green box is “Scalping profit,” the money made when someone buys a widget  for \$3 and resells it for \$7.

Note that there is still a deadweight loss because Q=3.

Note that when resale is possible, market forces will ensure that the widgets end up  going to those with the highest willingness to pay. (That is, D1, D2, and D3 well end  up outbidding the others and each will consume a widget).

It may be the D10 gets lucky and buys all 3 widgets at the initial price of \$3 and  sells them to D1, D2, and D3 at \$7. In this case, D10 gets the green box of scalping  profit.

If a price ceiling of \$3 is set and resales are illegal, then in general we expect two  sources of inefficiency:

- Quantity is too low (violates General Principle 3)

- Highest valuation consumers don’t always get the good first (violates General Principle 1)

Quota

- Look at one more policy; the government can instead control the quantity  that is in the market.

- One way the government can control supply is with a quiota

o Government can limit the production by distributing a quota

 To produce a unit, a seller needs a quota

 Number of units produced is limited by the number of quotas o Producers can trade these quotas in the quota market

Price of quota = \$4

Quota supplied = 3

Quotas demanded = 3

Quiz for today:

Suppose you are S1. Your cost to produce a widget is \$1. You know that you can sell  a widget for \$7, but you need to purchase a permit costing \$5 before you can  produce. Will you be profitable?

- Yes

- No

You are still S1 [with cost = \$1], and you can still sell a widget for \$7. But suppose  the permit now cost \$9. Will you be profitable?

- Yes

- No

Let’s say you are now S5, with cost of \$5 to produce. You can sell a widget for \$7.  Say the price of a permit [which you need before you can produce] is \$3. Will you be profitable?

- Yes

- No

Quota Reading in case you missed the class today:

Step 1: Compare total quota to free market quantity. If quota is more than free  market, irrelevant and price of quota = 0. If quota quantity less, then market  quantity is quota.

- Here Quota=3 < 5 (where 5 is the unregulated market’s quantity) Step 2: Get widget-milk price from demand curve at the quantity of the quota.  - Here P = \$7

Step 3: Set price of quota so final producer breaks even taking into account the  price of the quota. Producer breaks even when total cost equals price that he can  sell widget milk for.

- Total cost = production cost + cost of quota

- Marginal production cost at Q = 3 is \$3 (S3’s cost).

- Since price of widget milk is \$7, marginal producer just breaks even when the price of quota is \$4.

Why does this rule work?

Think of opportunity cost!

Let farmers maintain two books:

One for their milk business (where they deduct opportunity cost of using quota.. as  in, they could have sold their quota instead of using it)

One for their quota business (where they can make money from selling quotas)

When price of quota equals \$4, the marginal producer just breaks even in their milk  business

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