6. Prices bring the choices of buyers and sellers into balance. 12 Key Elements of Economics

MARKETS! SUPPLY DEMAND

Supply and Demand The terms supply and demand refer to the behavior of people. . . . . .as they interact with one another in markets. 3

Law of Demand When a rise in the price of a good or service makes it more expensive for buyers to purchase it, they will normally choose to buy fewer units. The opposite is true when a price falls. Thus, there is an inverse relationship between the price of a good and the amount buyers will purchase. This is the law of demand.

Law of Supply Higher prices will make it more attractive for sellers to provide the good or service. The opposite is true if prices fall. Thus, there is a positive relationship between the price of a good or service and the quantity sellers will be willing to supply. This is the law of supply.

Markets: What are they? Markets – where buyers and sellers come together to execute the exchange or trade process (transact business). Markets do not necessarily have to be a physical location – internet, can be worldwide market. When I buy Reese’s peanut butter cups at Wal Mart the market is not Wal Mart but the worldwide exchange of Reese’s and the worldwide market for peanut butter and chocolate. The love market for example.

Profit is the motivator Adam Smith “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their self interest. We address ourselves, not to their humanity, but to their self love and never talk to them of our necessities but of their advantages.” Profit is the motivator Discuss the invisible hand and how profit is the motivator and competition is the regulator using the Making Muffins simulation. 2

Competition is the regulator Adam Smith “For if he charges too much for his wares, or if he refuses to pay as much as everybody else for his workers, he will find himself without buyers in the one case, and without workers in the other.” Competition is the regulator 2

Does the market work? If profit is the motivator, should we do something about price gouging? Show Stossel video on price gouging (4:30) 6

Cooperation and Markets Messages: Need information about scarce resources for cooperation Motivation: Need to encourage people to respond appropriately to information Need to get people to respond to the concerns of others Means: Need the ability to respond appropriately Messages – market economies are successful because thy allow us to make the best use of the information required for people to cooperate with each other. The messages given need to have accurate information – difficult to ensure that people are not overstating their desire for a product. Motivation – if someone says they desire something more than you then you need to reduce your consumption so that they can increase their consumption. Producers can send signals to each other about their desire for resources and some producers may need to go out of business so that others can produce more. Means – If we say we want more of something then producers need the means to produce more of it. Market prices give us the information needed to respond to the concerns of people all over the world and the motivation to do so. 6

Competitive Markets Prices Supply and Demand Scarcity and Rationing of Goods: How do we ration goods in a market economy? How are prices determined? Prices are determined by the interaction of buyers and sellers Prices Supply and Demand It is important to know how prices are determined because prices are how we allocate goods and services in a market economy. Prices play the critical role in regulating the flow of goods. Prices are not moral or immoral – prices are a measure of relative scarcity. Play In the Chips game? 6

Buyers want the lowest possible price, but.... Quantity For Sale DEMAND

they have to compete against all other buyers. Price Quantity For Sale

Sellers want to charge the highest price possible, but ...... Quantity For Sale Supply

they have to compete against all other sellers. Price Quantity Supply For Sale

Competition determines the Equilibrium Price Quantity SUPPLY Pe For Sale Demand

Equilibrium Equilibrium occurs at the price where the amount demanded by consumers is just equal to the amount sellers are willing to supply. In equilibrium, all mutually advantageous exchanges will occur.

Supply, Demand, and Equilibrium Economists often use graphics to illustrate the relationships among price, quantity demanded, and quantity supplied. P Q $5 10 $4 20 $3 30 $2 50 40 $1 D S Pe Qe

Actions of buyers and sellers that move toward equilibrium Price S Excess Demand Pe P1 D QS Quantity QD 44

Actions of buyers and sellers that move toward equilibrium Excess Supply Price S P1 Pe D QD QS Q 42

Actions of buyers and sellers that move toward equilibrium Shortage (Excess Demand) Buyers unable to buy all they want at the going price – drives up price Buyers competing against each other Surplus (Excess Supply) Sellers unable to sell all they want at the going price – drives down price Sellers competing against each other 40

Determinants of Demand What factors determine when demand will shift? 10

5 Variables that Shift Demand P = Price of other goods: Substitutes and Complements

Determinant of Demand: Prices of Related Goods Substitutes-Coke & Pepsi When the fall in price of one good reduces the demand for another good, the two goods are substitutes. 15

Determinant of Demand: Prices of Related Goods Complements – peanut butter & jelly When the fall in price of one good increases the demand for another good, the two goods are complements. 15

5 Variables that Shift Demand P = Price of other goods: Substitutes and Complements I = Income--Normal Goods vs. Inferior Goods

Determinant of Demand: Income P As income increases the demand for normal goods will increase. As income increases the demand for inferior goods decrease. Normal Inferior Q 14

5 Variables that Shift Demand P = Price of other goods: Substitutes and Complements I = Income--Normal Goods/Inferior Goods N = # of consumers T = Tastes and Preferences

5 Variables that Shift Demand P = Price of other goods: Substitutes and Complements I = Income--Normal Goods/Inferior Goods N = # of consumers T = Tastes and Preferences E = Expectations of future prices/income by consumers

Determinants of Supply What factors determine when supply will shift? 10

5 Variables that Shift Supply C = Costs of Production- Resource Prices Land, Labor, Capital 27

5 Variables that Shift Supply C = Costs of Production- Resource Prices E = Expectations of producers Anticipation of future events and demand 27

5 Variables that Shift Supply C = Costs of Production- Resource Prices E = Expectations of producers N = Number of Sellers T = Technology New technology can help increase production 27

5 Variables that Shift Supply C = Costs of Production- Resource Prices E = Expectations of producers N = Number of Sellers T = Technology S = Subsidies and Taxes Taxes increase the cost of production Subsidies are government payments to encourage or protect certain economic activities 27

Determinants of Supply - Supply Shifters Any factor that increases the cost of production decreases supply Any factor that decreases the cost of production increases supply

Prices are: Dollar ballots - Indicate how badly consumers want good produced Signals – effect availability of goods High prices tell producers to produce more and buyers to buy less Low prices tell producers to produce less and buyers to buy more One of the things that prices do is carry information to buyers and sellers. When prices are low enough, they send a “buy” signal to consumers, who can now afford the things they want. When prices are high enough, they send a “sell” signal to retailers, who can now earn a profit at the new price. Sometimes you can find a good deal. People make mistakes. In this sense there is not one price for which an item sells for but multiple prices. The equilibrium price is generally the price around which the product will sell for.

Prices: Measure relative scarcity For example…

Order these products in terms of relative scarcity yacht candy bar nice dinner for two new truck laptop computer 6 5

Order these products in terms of relative scarcity 1 yacht 5 candy bar 4 nice dinner for two 2 new truck 3 laptop computer Without knowing anything about these particular products you have a good idea about their relative scarcity because of their prices 5 6

Prices: Measure relative scarcity Feet and inches measure distance Pounds and ounces measure weight Degrees Fahrenheit measure heat Cups and pints and quarts measure volume Dollars and cents measure relative scarcity in the U.S. Do not measure “worth” or “value” – price is not a measure of the moral or social value of a product Because prices are a measure of relative scarcity they don’t tell us what something is worth or what we value. Saying a price is immoral is like saying being 6’ tall is immoral, or being upset about your shoe size.

Advantages of Prices: Encourage Efficient Production – Prices encourage production of goods at the lowest possible cost At the equilibrium price, the marginal utility of consuming the product is equal to the marginal resource cost of producing the product This is the optimal resource allocation to this particular activity Neutral – Prices favor neither the producer or consumer (both buyers and sellers play a role in determining the price) For example…

Why are convertibles more expensive than other cars? Because people like them more (demand) Because they are more expensive to make (supply) It is only because some people are willing to pay a higher price that they exist at all

Advantages of Prices: Flexible – Prices change easily, they are not fixed (supply and demand helps us remember this) Allow specialization – prices let us rely on others to provide much of what we want, knowing that the market will make it available No Administrative Cost – No one has to be hired to determine prices for the country (no one plans prices)

In a market economy, firms will: Search for those opportunities where market conditions are such that they are able to generate revenue sufficient to cover their costs. Continue to produce a good or service only if consumers value it enough to pay prices sufficient to cover per unit costs.

We live in a dynamic world and conditions change. Consider the impact of each event on demand and/or supply and the market equilibrium price and quantity. How will an increase in the income levels in China impact the market for tourism in the U.S.? How will an increase in the tax on gas impact the market for fuel efficient cars? How will political uncertainty, social unrest and unsound legal institutions impact markets in Afghanistan?

Caveat Emptor – Let the buyer beware