Micro Chapter 3 Supply and Demand
Micro Chapter 3 Supply and Demand ECON 1011
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This 6 page Class Notes was uploaded by Sophomore Notetaker on Saturday October 1, 2016. The Class Notes belongs to ECON 1011 at Washington University in St. Louis taught by Bandyopadhyhyay in Fall 2016. Since its upload, it has received 3 views. For similar materials see Microeconomics in Economics at Washington University in St. Louis.
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Date Created: 10/01/16
Chapter 3 Supply and Demand Central Planning Vs. the Market Capitalist, or freemarket, economies, people decide for themselves which careers to pursue and which products to produce and buy There are no pure freemarket economies today; most industrial economies are described as “mixed economies” o Their good and services are allocated by a combination of free markets, regulation, and other forms of collective control Buyers and Sellers in the Markets Market – the market for any good consists of all the buyers and sellers of that good o Ex: the market for a pizza any given day is the set of people potentially able to buy or sell pizza at that time and location Adam Smith and other economists thought that the market price of a good was determined by its cost of production; is it cost of product? Value to the user? It is both. Demand curve – a schedule or graph showing the quantity of a good that buyers wish to buy at each price o Price is on vertical axis, and quantity is on the horizontal axis o downwardsloping with respect to price Reasons demand curve slopes downwards o Individual consumer’s reactions to price changes substitution effect – the change in the quantity demanded of a good that results because buyers switch to or from substitutes when the price of the good changes income effect – the change in the quantity demanded of a good that results because a change in the price of a good changes the buyer’s purchasing power a consumer simply can’t afford to buy as many slices of pizza at higher prices as at lower prices o consumers differ in terms of how much they’re willing to pay for the good buyer’s reservation price – the highest dollar amount he’d be willing to pay for the good in most markets, different buyers have different reservation prices. When the good sells for a high price, it will satisfy the costbenefit principle test for fewer buyers than when it sells for a lower price the fact that the demand curve for a good is downwardsloping reflects that the reservation price of the marginal buyer declines as the quantity of the good bought increases horizontal interpretation of the demand curve – how much the consumers wish to purchase at various prices o start with the price on the vertical axis and read the corresponding quantity demanded on the horizontal axis vertical interpretation of the demand curve – tells us the marginal buyer’s reservation price o start with the quantity on the horizontal axis and then read the marginal buyer’s reservation price on the vertical axis supply curve – a schedule or graph showing the quantity of a good that sellers wish to sell at each price o upwardsloping with respect to price o slopes upward as a consequence of the Low Hanging Fruit Principle – as we expand production, we turn first to those whose opportunity cost of production is lowest, and then only then other with a higher opportunity cost horizontal interpretation of supply curve – begin with price and then go over to the supply cure to read the quantity that sellers wish to sell at that price on the horizontal axis o looks for quantity vertical interpretation of supply curve – begin with a quantity and then go up to the supply curve to read the marginal cost on the vertical axis o looks for marginal cost (price) seller’s reservation price – the smallest dollar amount for which a seller would be willing to sell an additional unit, generally equal to marginal cost o the smallest dollar amount for which she would not be worse off if she sold an additional unit Market Equilibrium equilibrium – a balanced of unchanging situation in which all forces at work within a system are cancelled by others o when no participant in the market has any reason to alter his or her behavior, so that there is no tendency for production or prices in that market to change intersection of the supply and demand curves for the good o equilibrium price – the price at which a good will sell o equilibrium quantity – the quantity at which of it that will be sold market equilibrium – occurs in a market when all buyers and sellers are satisfied with their respective quantities at the market price o they are only to buy exactly as many units of the good as they wish to at the equilibrium price o doesn’t necessarily produce an ideal outcome for all market participants; for a poor buyer this may signify little more than that he can’t buy additional pizza without sacrificing other more highly valued purchases excess supply – the amount by which quantity supplied exceeds quantity demanded when the price of a good exceeds the equilibrium price excess demand – the amount by which quantity demanded exceeds quantity supplied when the price of a good lies below the equilibrium price Incentive Principle – the mechanisms by which the adjustment happens are implicit in our definitions of excess supply and excess demand o Ex: sellers want to sell more than buyers are willing to buy, so sellers have an incentive to take whatever steps they can to increase their sales; so probably cut their prices (vice versa for buyers) o Price has tendency to gravitate to its equilibrium level under conditions of either excess supply or excess demand Economists realize that there are much more effective ways to help poor people than to try to given them apartments and other goods at artificially low prices Instead of controls over rent or other goods, they could give the poor additional income Regulations that peg prices below equilibrium levels have farreaching effects on market outcomes Price ceiling – a maximum allowable price, specified by law o A price ceiling below the equilibrium price of pizza would result in excess demand for pizza Predicting and Explaining Changes in Prices and Quantities Change in the quantity demanded – a movement along the demand curve that occurs in response to a change in price o The change in the quantity that people wish to buy that occurs in response to a change in price Change in demand – a shift of the entire demand curve o At every price, the quantity demanded is higher than before Change in the quantity supplied – a movement along the supply curve that occurs in response to a change in price Change in supply – a shift of the entire supply curve Complements – 2 goods are complements in consumption if an increase in the price of one causes a leftward shift in the demand curve for the other (or if a decrease causes a rightward shift) o Ex: tennis courts and tennis balls. Tennis balls would have little value if there were no tennis courts to play. As tennis court become cheaper to use, people will respond by playing more tennis, and this will increase their demand for tennis balls. A decline in courtrental fees will thus shift the demand curve for tennis balls to the right; “rightward or upward shift” o When the price of a complement falls, demand shifts right, causing equilibrium price and quantity to rise o Economists define goods as complements if an increase in the price of one causes a leftward shift in the demand curve for the other Substitutes – 2 goods are substitutes in consumption if an increase in the price of one causes a rightward shift in the demand curve for the other (or if a decrease causes a leftward shift) o Ex: email and overnight letters are examples of substitutes. A decrease in the prices for internet will cause a leftward/downward shift in the demand curve overnight delivery services. Cheaper internet access would cost many customers for UPS and FedEx. o When the price of a substitute falls, demand shifts left, causing equilibrium price and quantity to fall for the other good o Economists define goods as substitutes if an increase in the price of one causes a rightward shift in the demand curve for the other An increase in income shifts demand for a normal good to the right, causing equilibrium price and quantity to rise Normal goods – a good whose demand curve shifts rightward when the incomes of buyers increase and leftward when the incomes of buyers decrease Inferior goods – a good whose demand curve shifts leftwards when the incomes of buyers increase and rightward when the incomes of buyers decrease o Ex: apartments in unsafe neighborhoods, ground beef with high fat content Anything that changes the production costs will shift the supply curve, resulting in a new equilibrium quantity and price o Ex: the cost of fiberglass that is used to produce skateboards, so the number of potential sellers who can profitably sell skateboards at any given price will fall; this implies a leftward shift in the supply curve for skateboards o No shift in demand curve because the buyer’s reservation price doesn’t depend on the price of fiberglass The effects on equilibrium price and quantity run in the opposite whenever marginal costs of production decline o Ex: a decline in the wage rates of carpenters reduces the marginal cost of making new houses, which means that for any given price of houses, more builders can profitably serve the market than before; this means a rightward/downward shift in the supply curve of houses o No appreciable shift in the demand curve because carpenters only make up a tiny fraction of all potential home buyers Factors that causes supply curves to shift o Input prices o Technology o Weather o Expectations of future price changes o Changes in the number of sellers in the market 4 simple rules o an increase in demand will lead to an increase in both the equilibrium price and quantity o a decrease in demand will lead to a decrease in both the equilibrium price and quantity o an increase in supply will lead to a decrease in the equilibrium price and an increase in the equilibrium quantity o a decrease in supply will lead to an increase in the equilibrium price and a decrease in the equilibrium quantity Factors that cause an increase (rightward/upward shift) in demand o A decrease in the price of complements to the good or service o An increase in the price of substitutes for the good or service o An increase in income (for a normal good) o An increased preference by demanders for the good or service o An increase in population of potential buyers o An expectation of higher prices in the future o When these factors move in the opposite direction, demand will shift left Factors that cause an increase (rightward or downward shift) in supply o A decrease in the cost of materials, labor, or other inputs used in the production of the good/service o An improvement in technology that reduces the cost of producing the good/service o An improvement in the weather (especially for agricultural products) o An increase in the number of suppliers o An expectation of lower prices in the future o When these factors move in the opposite direction, supply will shift left When demand shifts left and supply shifts right, equilibrium price falls, but equilibrium quantity may either rise (if greater shift in supply than demand) or fall (if greater shift in demand than supply) Efficiency and Equilibrium A market that is out of equilibrium, always creates opportunities for individuals to arrange transactions that will increase their individual economic surplus A market for a good that is in equilibrium makes the largest possible contribution to total economic surplus only when its supply and demand curves fully reflect all costs and benefits associated with the production and consumption of that good Buyer’s surplus – the difference between the buyer’s reservation price and the price he/she actually pays Seller’s surplus – the difference between the price received by the seller and his/her reservation price Total surplus – the difference between the buyer’s reservation price and the seller’s reservation price o Sum of the buyer’s surplus and the seller’s surplus Cash on the table – an economic metaphor for unexploited gains from exchange o When the price in a market is below the equilibrium price, there’s cash on the table because the reservation price of sellers (marginal cost) will always be lower than the reservation price of buyers o When all beneficial opportunities for exchange have been exploited, there is not more cash on the table; when demand=supply, quantity=price Socially optimal quantity – the quantity of a good that results in the maximum possible economic surplus from producing and consuming the good o The level for which the marginal cost and marginal benefit of the good are the same When the quantity of a good is less than the socially optimal quantity, boosting its production will increase total economic surplus Economic efficiency – a condition that occurs when all goods and services are produced and consumed at their respective socially optimal levels o Failure to achieve efficiency means that total economic surplus is smaller than it could have been The Efficiency Principle – efficiency is an important social goal because when the economic pie grows larger, everyone can have a larger slice When the private market for a given good is in equilibrium, the cost to the seller of producing an additional unit of the good is the same as the benefit to the buyer of having an additional unit; the equilibrium quantity maximizes total economic surplus The Equilibrium Principle (“NoCashontheTable Principle) – a market in equilibrium leaves no unexploited opportunities for individuals but may not exploit all gains achievable through collective action
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