ECON 100 Lecture 11 Monday, March 10

Announcements PS #4 is big! and contains a few more challenging questions PS#5 will be even bigger. (and more challenging) Sample exam(s) will be posted on webpage later this week (or early next week). I will schedule additional office hours next week for the exam.

The equilibrium in the competitive market Today’s lecture The equilibrium in the competitive market 36

The equilibrium in the competitive market Equilibrium : The price has reached the level where the quantity supplied equals the quantity demanded. 36

The equilibrium in the competitive market The equilibrium price is the price … at which the quantity supplied equals the quantity demanded. The equilibrium quantity is the … quantity supplied and the quantity demanded at the equilibrium price. 36

Quantity of Ice-Cream Cones Price of Ice-Cream Cone Demand 1 2 3 4 5 6 7 8 9 10 11 12 13 Quantity of Ice-Cream Cones Copyright©2003 Southwestern/Thomson Learning

Quantity of Ice-Cream Cones Price of Ice-Cream Cone Supply 1 2 3 4 5 6 7 8 9 10 11 12 13 Quantity of Ice-Cream Cones Copyright©2003 Southwestern/Thomson Learning

Quantity of Ice-Cream Cones Price of Ice-Cream Cone Supply Demand Equilibrium price $2.00 Equilibrium quantity 1 2 3 4 5 6 7 8 9 10 11 12 13 Quantity of Ice-Cream Cones Copyright©2003 Southwestern/Thomson Learning

The equilibrium in the ice-cream market The market demand schedule The market supply schedule At P = $2.00, the quantity demanded = the quantity supplied The equilibrium price is Pe = $2.00. The equilibrium quantity is Qe = 7 units. 36

Same thing with the supply and demand graph Price of Demand: QD = 19 – 6P (if P≤19/6) Supply: QS = –5 + 6P, (if P≥5/6) Ice-Cream 3.17 Demand Supply 2.00 7 5/6 19 Quantity of Ice-Cream Copyright©2003 Southwestern/Thomson Learning

Computing the equilibrium price and quantity with the equations The equation for the market demand is QD = 19 – 6P, if P ≤ 19/6, QD = 0 if P > 19/6 The equation for the market supply is QS = –5 + 6P, if P ≥ 5/6, QS = 0 if P < 5/6 Let’s compute the equilibrium price and quantity. QD = QS (this means Q demanded equals Q supplied) 19 – 6P = –5 + 6P Solve for P: 24 = 12P  Pe = 2 To compute the equilibrium quantity, we let P = 2 in the demand equation: Qe = 19 – 6x2 = 7. ((or let P = 2 in the supply equation)

Your turn now

Question #1: There are four identical buyers and three identical sellers. Each individual buyer has the same demand schedule as shown in the table below. Each individual seller has the same supply schedule as shown in the table below. INDIVIDUAL DEMAND SUPPLY Price Quantity demanded Quantity supplied 1 5 2 4 3 6 8

Question #1 A competitive market with four buyers, and three sellers Is there a shortage or a surplus when price is P =2? Is there a shortage or a surplus when price is P = 4? What is the equilibrium price? What is the equilibrium quantity? What is the quantity supplied in equilibrium?

A few words on the role of prices: The price mechanism at work

Equilibrium: The price mechanism at work The price adjusts to bring the quantity supplied and the quantity demanded into balance. Competitive markets reach the equilibrium through the interaction of many buyers and sellers. The price is the tool through which the market is cleared.

The price mechanism works as follows: If the quantity demanded > the quantity supplied at the existing market price, then the market price will rise until the excess demand is eliminated.

The price mechanism works as follows: If the quantity demanded < the quantity supplied at the existing market price, then the market price declines until the excess supply is eliminated.

One more time, with the demand and supply graphs

Excess Supply, surplus Price of Ice-Cream Supply Cone Surplus Demand $2.50 10 4 2.00 7 Quantity of Quantity demanded Quantity supplied Ice-Cream Cones Copyright©2003 Southwestern/Thomson Learning

Figure 9 Markets Not in Equilibrium Excess Demand, shortage Price of Ice-Cream Supply Cone Demand $2.00 7 1.50 10 4 Shortage Quantity of Quantity supplied Quantity demanded Ice-Cream Cones Copyright©2003 Southwestern/Thomson Learning

A few words on the meaning of the market equilibrium Equilibrium: quantity demanded = quantity supplied

A few words … At the equilibrium price every individual buyer can buy as much as they want. There is no shortage of the good. There is not a single buyer who says: “I want to buy more of the good but I can’t find any.”

A few words … At the equilibrium price every individual seller can sell as much as they want. There is no surplus (unsold goods). There is not a single seller who says: “I want to sell more of the good but I cant find any buyers.”

A few words … This is not to say that everyone is happy and content The buyers will be happier if they can buy more of the good at a lower price than the equilibrium price.

A few words … The sellers will be happier if they can sell more of the good at a higher price than the equilibrium price.

Now something really important

Analyzing Changes in Equilibrium: The three steps method 0. Something (an event) happens: e.g., a meteor hits the earth. 45

Analyzing Changes in Equilibrium: The three steps method Decide whether the event shifts the supply curve, or the demand curve, or both. Decide whether the curve(s) shift(s) to the left or to the right. Use the supply-and-demand diagram to see how the shift affects the equilibrium price and the equilibrium quantity. 45

This is called The comparative statics analysis It is used to analyze how the equilibrium price and equilibrium quantity are affected by changes in the demand and supply determinants

An example: The ice-cream market

Figure 10 How an Increase in Demand Affects the Equilibrium 1. News says that regular consumption of vanilla ice-cream reduces the Rrsk of cardiovascular diseases Price of Ice-Cream Cone D D Supply New equilibrium $2.50 10 2. . . . resulting in a higher price . . . 2.00 7 Initial equilibrium Excess demand at P = 2 12 Quantity of 3. . . . and a higher quantity sold. Ice-Cream Cones Copyright©2003 Southwestern/Thomson Learning

This is what prices do: Prices communicate information Demand rises: people want more ice-cream. There must be more production to meet the higher demand. How can you convince/make the sellers supply more? They are self interested, they need higher prices to work harder and supply more. So. The price must rise to create more supply (raise the quantity supplied) The “demand-induced-higher-price” is a message from the buyers to the sellers: We want more ice-cream.

This is how the sellers learn the relative desirability (consumption value, benefit to consumers etc) of ice-cream: they learn it through its price.

Prices act as signals that guide the allocation of scarce resources in a market economy.

One more example A supply shift

Figure 11 How a Decrease in Supply Affects the Equilibrium Price of 1.There is an increase in the price of sugar (a major input In the production of ice cream) Ice-Cream Cone Excess demand, shortage S2 S1 Demand New equilibrium $2.50 4 2. . . . resulting in a higher price of ice cream . . . Initial equilibrium 2.00 7 Quantity of 3. . . . and a lower quantity sold. Ice-Cream Cones Copyright©2003 Southwestern/Thomson Learning

Again, prices communicate Ice-cream production is now more costly. Demand must be reduced. How can you make the buyers reduce their consumption? They are self interested, they respond to prices: Higher prices will make them consume less. As the price of ice-cream rises, buyers will reduce their quantity demanded and substitute towards other goods. Buyers find out about the relative scarcity of a good through its price. Each individual buyer then decides what to do him/herself; decision making is decentralized.

Your turn now

Some questions from Exercise Set #4

12. Which of the four graphs represents the market for peanut butter after a major hurricane hits the peanut-growing parts of the country? a. A b. B c. C d. D

13. Which of the four graphs represents the market for winter coats as we progress from winter to spring? a. A b. B c. C d. D

20. Suppose the events depicted in graphs A and C were illustrated together on a single graph. A definitive result of the two events would be a. an increase in the equilibrium quantity. b. an increase in the equilibrium price. c. an instance in which the law of demand fails to hold. d. all of the above are correct

What happens to the equilibrium price and quantity of bicycles if the consumers' incomes decrease, (assume bicycles are an inferior good). Please draw a graph!

What happens to the equilibrium price and quantity of bicycles if the consumers' incomes decrease, (assume bicycles are an inferior good). Please draw a graph!

This one is very difficult!

Exercise Set #4 Q5 What happens to the equilibrium price and quantity in the fresh seafood market if both of the following events occur at the same time: (1) A scientific report finds that fish contains mercury, which is toxic to humans, and (2) the price of diesel fuel falls significantly?

The demand and supply of bicycles The demand and supply of bicycles. For each event, determine which curve is affected (supply or demand for bicycles), and what direction is it shifted? a. The price of cars increases. (assume cars and bicycles are substitute goods.) b. Consumers' incomes decrease, (assume bicycles are a normal good). c. The price of steel used to make bicycle frames increases. d. An environmental movement shifts tastes toward bicycling. e. A technological advance in the manufacture of bicycles occurs. f. The price of bicycle helmets and shoes is reduced. g. Consumers' incomes decrease, (assume bicycles are an inferior good).

A “real world” application

The food vs. fuel dilemma A study in demand and supply

All scarce goods must be rationed! Food vs. bio-fuel debate

The food vs. fuel dilemma is about using farmland or crops for bio-fuels production (mostly ethanol) This threatens the food supply on a global scale.

The main problem with subsidizing the production of ethanol (bio-fuel) from corn is that it is causing people in low-income countries to go hungry.

A few facts (from wiki!) From 1974 to 2005 food prices (adjusted for inflation) dropped by 75%. Prices were stable after reaching lows in 2000 and 2001. Prices sharply increased in 2005 despite record production levels worldwide. From January 2005 until June 2008, maize prices almost tripled, wheat increased 127 percent, and rice rose 170 percent.

A few facts (from wiki!) MAIZE (looks like corn)

This is Paul Bulcke, the chief executive of Nestlé

Nestlé is a multinational food and beverage company, the world's largest measured by revenues! Stock markert value $234 B, employees 336,000, sales $100B

Nestlé has added its weight to calls by the UN and development groups for the US and EU to change their bio-fuel targets because of food shortages and price rises. http://www.guardian.co.uk/global-development/2012/sep/04/us-eu-biofuel-food-crisis-nestle

"We say no food for fuel," said Paul Bulcke, chief executive of Nestlé, at the end of the World Water Week conference in Sweden. "Agricultural food-based bio-fuel is an aberration. We say that the EU and US should put money behind the right bio-fuels."

This from Guardian Sept 2012 Under law 40% of US maize (corn) harvest must be used to make bio-fuels. The EU countries are expected to move towards drawing 10-20% of their energy supply from bio-fuels.

Bio-fuels help reduce carbon emissions

More facts

All scarce goods must be rationed! Food vs. bio-fuel debate: a simple numerical example

INDIVIDIAL P demand supply 1 5 2 4 3 6 Imagine a competitive markets with 4 buyers and 3 sellers. MARKET P demand supply 1 5X4=20 0X3=0 2 4X4=16 2X3=6 3 3X4=12 4X3=12 4 2X4=8 6X3=18 The equilibrium price is P = 3. each consumer buys 3 units. Each seller produces 4 units.

4 buyers + 3 sellers. Now, a big buyer enters the market! INDIVIDIAL P demand supply 1 5 2 4 3 6 P DEMAND 1 16 2 14 3 12 4 10 The new market demand is the sum of the 4 buyers’ and the newcomer’s demand. Please compute the new equilibrium price. How many units of the good are now consumer by each of the original 4 buyers? How many units are now supplied by each seller? Who is benefiting and who is worse off from the arrival of the new buyer?

Now, a big buyer comes into the market! P DEMAND 1 16 2 14 3 12 4 10 The equilibrium price is P = 4. The 4 buyers buy 2 units each, and pay a higher price. Each seller produces 6 units. MARKET P demand supply 1 20+16 2 16+14 6 3 12+12 12 4 8+10 18 The new market demand is the sum of the 4 buyers and the newcomer.

End of the lecture