Market Forces CHAPTER 6 6.1 Price, Quantity, and Market Equilibrium 6.2 Shifts of Demand and Supply Curves 6.3 Market Efficiency and the Gains from Exchange 6.4 Behavioral Economics

6.1 Price, Quantity, and Market Equilibrium Learning Objectives LO1 Understand how markets reach equilibrium. LO2 Explain how markets reduce transaction costs. CHAPTER 6

Key Terms market equilibrium surplus shortage transaction costs CHAPTER 6

Market Equilibrium When the quantity that consumers are willing and able to buy equals the quantity that producers are willing and able to sell, that market reaches market equilibrium. CHAPTER 6

Equilibrium in the Pizza Market Figure 6.1a Price per Pizza Quantity Demanded Quantity Supplied Surplus or Shortage Effect on Price $15 8 28 Surplus of 20 Falls 12 14 24 Surplus of 10 9 20 Equilibrium Remains the same 6 26 16 Shortage of 10 Rises 3 32 Shortage of 20 CHAPTER 6

Equilibrium in the Pizza Market Figure 6.1b CHAPTER 6

Surplus Forces the Price Down At a given price, the amount by which quantity supplied exceeds quantity demanded is called the surplus. As long as quantity supplied exceeds quantity demanded, the surplus forces the price lower. CHAPTER 6

Shortage Forces the Price Up At a given price, the amount by which quantity demanded exceeds quantity supplied is called the shortage. As long as quantity demanded and quantity supplied differ, this difference forces a price change. CHAPTER 6

Market Forces Lead to Equilibrium Price and Quantity The equilibrium price, or market-clearing price, equates quantity demanded with quantity supplied. Because there is no shortage and no surplus, there is no longer any pressure for the price to change. CHAPTER 6

Market Exchange Markets answer the questions What to produce How to produce it For whom to produce it CHAPTER 6

Adam Smith’s Invisible Hand Although each individual pursues his or her own self-interest, the “invisible hand” of market competition promotes the general welfare. CHAPTER 6

Market Exchange Is Voluntary Neither buyers nor sellers would participate in the market unless they expected to be better off. Prices help people recognize market opportunities to make better choices as consumers and as producers. CHAPTER 6

Markets Reduce Transaction Costs Transaction costs are the costs of time and information needed to carry out market exchange. The higher the transaction cost, the less likely the exchange will take place. CHAPTER 6

6.2 Shifts of Demand and Supply Curves CONTEMPORARY ECONOMICS 6.2 Shifts of Demand and Supply Curves Learning Objectives LO1 Explain how a shift of the demand curve affects equilibrium price and quantity. LO2 Explain how a shift of the supply curve affects equilibrium price and quantity. CHAPTER 6 CHAPTER 6

Key Terms increase in demand decrease in demand increase in supply decrease in supply CHAPTER 6

Shifts of the Demand Curve A shift of the demand curve means that quantity demanded changes at each price. CHAPTER 6

What Could Shift the Demand Curve? An increase in the money income of consumers An increase in the price of a substitute A change in expectations A growth in the number of consumers A change in consumer tastes CHAPTER 6

An Increase in Demand An increase in demand means that consumers are more willing and able to buy the product at each price. CHAPTER 6

Effects of an Increase in Demand Figure 6.2 CHAPTER 6

A Decrease in Demand A decrease in demand means that consumers are less willing and able to buy the product at every price. CHAPTER 6

Effects of a Decrease in Demand Figure 6.3 CHAPTER 6

Summary of Demand Shifts If the demand curve shifts rightward, price and quantity increase. If the demand curve shifts leftward, price and quantity decrease. CHAPTER 6

Shifts of the Supply Curve A shift of the supply curve means that quantity supplied changes at each price. CHAPTER 6

What Could Shift the Supply Curve? A reduction in the price of a resource A decline in the price of another good these resources could make A technological breakthrough A change in expectations An increase in the number of producers CHAPTER 6

An Increase in Supply An increase in supply means that producers are more willing and able to sell more the product at each price. CHAPTER 6

Effects of an Increase in Supply Figure 6.4 CHAPTER 6

A Decrease in Supply A decrease in supply means that producers are willing and able to sell less of the product at each price. CHAPTER 6

Effects of a Decrease in Supply Figure 6.5 CHAPTER 6

Summary of Supply Shifts If the supply curve shifts rightward, price decreases but quantity increases. If supply shifts leftward, price increases but quantity decreases. CHAPTER 6

6.3 Market Efficiency and Gains from Exchange CONTEMPORARY ECONOMICS 6.3 Market Efficiency and Gains from Exchange Learning Objectives LO1 Distinguish between productive efficiency and allocative efficiency. LO2 Explain what happens when government imposes price floors and price ceilings. LO3 Identify the benefits that consumers get from market exchange. CHAPTER 6 CHAPTER 6

Key Terms productive efficiency allocative efficiency disequilibrium price floor price ceiling consumer surplus CHAPTER 6

Competition and Efficiency Productive efficiency Making stuff right Allocative efficiency Making the right stuff Market competition promotes both productive efficiency and allocative efficiency. CHAPTER 6

Productive Efficiency: Making Stuff Right Productive efficiency occurs when a firm produces at the lowest possible cost per unit. Competition ensures that firms produce at the lowest possible cost per unit. CHAPTER 6

Allocative Efficiency: Making the Right Stuff Allocative efficiency occurs when firms produce the output that is most valued by consumers. Competition among sellers encourages producers to supply more of what consumers value the most. CHAPTER 6

Disequilibrium Disequilibrium is a mismatch between quantity demanded and quantity supplied as the market seeks equilibrium A price floor is a minimum legal price below which a product cannot be sold. A price ceiling is a maximum legal price above which a product cannot be sold. CHAPTER 6

Price Floor If a price floor is established above the equilibrium price, a permanent surplus results. A price floor established at or below the equilibrium price has no effect. CHAPTER 6

Price Ceiling If a price ceiling is established below the equilibrium price, a permanent shortage results. A price ceiling established at or above the equilibrium price has no effect. CHAPTER 6

Effects of a Price Floor and a Price Ceiling Figure 6.6 CHAPTER 6

Other Sources of Disequilibrium Government intervention in the market Sometimes the market takes a while to adjust New products Sudden change in demand or supply CHAPTER 6

Consumer Surplus Consumer surplus is the difference between the most that consumers would be willing and able to pay for a given quantity and the amount they actually do pay. CHAPTER 6

Market Demand and Consumer Surplus Figure 6.7 Consumer surplus at a price of $2 is shown by the darker area. If the price falls to $1, consumer surplus increases to include the lighter area between $1 and $2. If the good is free, consumer surplus would increase by the lightest area under the demand curve. CHAPTER 6

An Application of Consumer Surplus: Free Medical Care Certain Americans are provided government-subsidized medical care. When something is provided for free, people consume it until their marginal benefit is zero. CHAPTER 6

Medicaid/Medicare Average Annual Cost per Beneficiary Figure 6.8 CHAPTER 6

6.4 BEHAVIORAL ECONOMICS Learning Objectives L O1 Understand the limits of rational self-interest. LO 2 Explain the effects of bounded rationality on making economic decisions. L O3 Understand the effects of limited willpower on making economic decisions. LO4 Explain why some economists are mapping brain activity in the laboratory. CHAPTER 6

Key Terms behavioral economics bounded rationality limited willpower neuroeconomics CHAPTER 6

People Aren’t Robots Psychologists have found that people are prone to mistakes, are fickle and inconsistent, and often do not get the best deal for themselves when making choices. Psychologists have investigated the biases, faulty assumptions, and errors that affect how people make decisions in all aspects of life. CHAPTER 6

Behavioral Economics Behavioral economics borrows insights from psychology to help explain economic choices. This approach questions some assumptions of traditional economics, particularly the assumptions of unbounded rationality and unlimited willpower. CHAPTER 6

Bounded Rationality Bounded rationality is the idea that there are limits on the amount of information people can comprehend and act on. Rules of thumb Inertia CHAPTER 6

Limited Willpower Limited willpower is limited self-discipline in following through with decisions that are in one’s self-interest, especially in one’s long-term interest. Overcoming self-discipline problems Postponing immediate gratification CHAPTER 6

Neuroeconomics Neuroeconomics is the mapping of brain activity while subjects make economic choices to develop better models of economic decision making. CHAPTER 6

Findings of Neuroeconomists Challenge the traditional view that economic choices boil down to a simple process of utility maximization Suggest a more complex interaction among competing objectives CHAPTER 6