Foundation of Economic Analysis 3250:600 Instructor: Richard W. Stratton Meets: Thursday 5:20 – 7:50 pm CAS 136

The University of Akron Administration This Week’s Assignments Farnham Chapter 2 (D & S) Homework 02 Next Week’s Assignments Farnham Chapter 3 (Elasticity) Week four Test 1 2/17/2019 The University of Akron Decision Tree

The University of Akron Student Questions Groups Questions from last week? Can group members help clarify? Questions on reading for this week? Share common unanswered questions 2/17/2019 The University of Akron

Introduction Demand Supply Market equilibrium Decision Tree Introduction Demand Supply Market equilibrium Complications Applications

The University of Akron Introduction What is a market? Impact of transaction costs Factors reducing transaction costs Property rights Institutions Rules and enforcement Money 2/17/2019 The University of Akron

The University of Akron What is a market? Remember our discussion last week? Individuals who produced an excess in one good trade with those who produced an excess in another good That exchange is a market 2/17/2019 The University of Akron

The University of Akron What is a market? It need not be a place Though we often think about the New York Stock Exchange, Chicago Board of Trade, of the local flea market as examples It is not a person Markets do NOT get excited, nervous or depressed Markets do NOT expect, react, or hope Markets do NOT get tired, sick, or even bullish 2/17/2019 The University of Akron

The University of Akron What is a market? It is not a mechanism Though we sometime use mechanistic models to explain results It is a process of exchange Human beings trading items of value A process of completing bids and offers Sometimes we include the rules and regulations by which exchanges are made 2/17/2019 The University of Akron

The University of Akron Transaction costs Transactions costs are incurred when making an exchange (or trade) Remember our discussion last week? Individuals who produced an excess in one good trade with those who produced an excess in another good We ignored any costs incurred in making the trade (transaction costs) 2/17/2019 The University of Akron

The University of Akron Transaction costs For example: You have the winning bid on eBay of $4000 for a used car and this exceeds the seller’s reservation What are some transaction costs? Time spent searching for the car Cost of entering into a contract with the seller Cost of enforcing the agreement (PayPal, etc.) Shipping costs Cost to transfer the title Assume Total transaction costs of $500 2/17/2019 The University of Akron

The University of Akron Transaction costs For both parties to benefit from the trade, the opportunity cost of the received item must be greater than the item sacrificed plus the transaction cost of the trade In this example, you must value the car at more than for you to benefit from the trade. $4500 2/17/2019 The University of Akron

The University of Akron Transaction costs In this example, if the transaction costs are too high the exchange will not occur. Thus markets work best when transaction costs are low. 2/17/2019 The University of Akron

Reducing transaction costs Property rights Who has the authority to trade items? Can I do what I want with those items? Who has property rights to water in Lake Erie? Who has property rights to clean air? Who has property rights to space? Who has property rights to shoreline? 2/17/2019 The University of Akron

Reducing transaction costs If property rights are not well-defined, free, mutually beneficial trade is more difficult Institutions help to define “rules of the game” and enforce them 2/17/2019 The University of Akron

Reducing transaction costs Institutions help to define “rules of the game” and enforce them Social pressure or convention Government laws Judicial system 2/17/2019 The University of Akron

Reducing transaction costs Remember our discussion last week? Individuals who produced excess fish trade with those who produced excess rabbit This is called barter It tends to have high transaction costs, especially in larger economies Money can lower these costs 2/17/2019 The University of Akron

Reducing transaction costs Why might the use of money reduce transactions costs? Barter requires coincidence of wants Intersection of group who wants your excess and Group whose excess you want 2/17/2019 The University of Akron

Reducing transaction costs Why might the use of money reduce transactions costs? Want what I have Have what I want Barter Group 2/17/2019 The University of Akron

Reducing transaction costs Money allows you to search everyone who want your excess Functions of money Medium of exchange Unit of account Store of value Standard of deferred payment 2/17/2019 The University of Akron

The University of Akron Student Questions Individually What is the muddiest point about markets? What is the muddiest point about transaction cost? In groups compare muddiest points Are any in common? Can group members help clarify? List common unanswered questions Share common questions 2/17/2019 The University of Akron

The University of Akron Introduction What is a market? Impact of transaction costs Factors reducing transaction costs Property rights Institutions Rules and enforcement Money 2/17/2019 The University of Akron

Introduction Demand Supply Market equilibrium Decision Tree Introduction Demand Supply Market equilibrium Complications Applications

The University of Akron Demand Definition Determinants Demand function (curve) Movement along demand Shifting of demand Individual and market demand 2/17/2019 The University of Akron

The University of Akron Definition of Demand Relationship Price Quantity Per unit of time (it is a flow) Holding other things constant Inverse (negative) relationship Substitution effect Income effect 2/17/2019 The University of Akron

The University of Akron Demand - determinants Own price (varies) Price of related commodities (P) Substitutes Complements Consumer income (Y) Consumer preferences - tastes (T) Number of consumers (N) Expectations (E) PYNTE 2/17/2019 The University of Akron

The University of Akron Demand function Table Graph Algebraic function 2/17/2019 The University of Akron

The University of Akron Demand function Table 2/17/2019 The University of Akron

The University of Akron Demand function Graph 2/17/2019 The University of Akron

Demand - movement along Table A change in the price causes a movement along the demand curve As price declines from $9 to $6 to $2, quantity increases from 2, to 5, to 9 2/17/2019 The University of Akron

Demand - movement along Graph As price declines from $9 to $6 to $2, quantity increases from 2, to 5, to 9 2/17/2019 The University of Akron

The University of Akron Demand - shifts Shift or Change in demand Refer to changes in the functional relationship between price and quantity Table – new column Graph – new line Algebraic function – change in the parameters 2/17/2019 The University of Akron

The University of Akron Demand - shifts Algebraic function – change in the parameters Price of a complement Price of a substitute Consumer income Consumer tastes or preferences Number of consumers Expectations 2/17/2019 The University of Akron

The University of Akron Demand - shifts Algebraic function – change in the parameters Thus there is a new relationship between price and quantity For example: increase the price of a substitute good Old New? 2/17/2019 The University of Akron

The University of Akron Demand - shifts Table An increase in the price of substitute causes a right shift of the demand curve At each price the quantity demanded increases 2/17/2019 The University of Akron

The University of Akron Demand - shifts Graph 2/17/2019 The University of Akron

The University of Akron Demand – shifts (quiz) Number of consumers (N) Number of consumers increase => Demand shifts to Consumer preferences - tastes (T) Consumers’ preference increase => Right Right 2/17/2019 The University of Akron

The University of Akron Demand – shifts (quiz) Price of related commodities (P) Substitutes Price of substitute increase => Demand shifts to Price of substitute decrease => Complements Price of complement increase => Price of complement decrease => Right Left Left Right 2/17/2019 The University of Akron

The University of Akron Demand – shifts (quiz) Consumer income (Y) Normal goods Consumer income increase => Demand shifts to Consumer income decrease => Inferior goods Right Left Left Right 2/17/2019 The University of Akron

The University of Akron Demand – shifts (quiz) Expectations (E) Consumers expect future prices to increase => Current demand shifts to Consumers expect future prices to decrease => Right Left 2/17/2019 The University of Akron

Demand – individual to market Assume there are 5 individuals in the market, each with a different individual demand At any given price, the market demand is the sum of the individual quantities demanded Horizontal summation 2/17/2019 The University of Akron

Demand – individual to market Table 2/17/2019 The University of Akron

Demand – individual to market Graph 2/17/2019 The University of Akron

The University of Akron Student Questions Individually What is the muddiest point about demand? In groups compare muddiest points Are any in common? Can group members help clarify? List common unanswered questions Share common questions 2/17/2019 The University of Akron

The University of Akron Demand Definition Determinants Demand function (curve) Movement along demand Shifting of demand Individual and market demand 2/17/2019 The University of Akron

Introduction Demand Supply Market equilibrium Decision Tree Introduction Demand Supply Market equilibrium Complications Applications

The University of Akron Supply Definition Determinants Supply function (curve) Movement along supply Shifting of supply Individual and market supply 2/17/2019 The University of Akron

The University of Akron Definition of Supply Relationship Price Quantity Per unit of time (it is a flow) Holding other things constant Direct (positive) relationship 2/17/2019 The University of Akron

The University of Akron Supply - determinants Own price (varies) Technology (TX) Expectations (E) Number of suppliers (firms) (N) Price of related commodities (O) Substitutes in production Complements in production (by-products) Resource prices - inputs (R) TENOR 2/17/2019 The University of Akron

The University of Akron Supply function Table Graph Algebraic function 2/17/2019 The University of Akron

The University of Akron Supply function Table 2/17/2019 The University of Akron

The University of Akron Supply function Graph 2/17/2019 The University of Akron

Supply - movement along Table A change in the price causes a movement along the supply curve As price increases from $2 to $6 to $9, quantity increases from 0, to 4, to 7 2/17/2019 The University of Akron

Supply - movement along Graph As price increases from $2 to $6 to $9, quantity increases from 0, to 4, to 7 2/17/2019 The University of Akron

The University of Akron Supply - shifts Shift or Change in supply Refer to changes in the functional relationship between price and quantity Table – new column Graph – new line Algebraic function – change in the parameters 2/17/2019 The University of Akron

The University of Akron Supply - shifts Algebraic function – change in the parameters Technology Expectations (suppliers) Number of suppliers Price of a complement in production Price of a substitute in production Price of resources (inputs) 2/17/2019 The University of Akron

The University of Akron Supply - shifts Algebraic function – change in the parameters Thus there is a new relationship between price and quantity For example: increase the price of a substitute good Old New? 2/17/2019 The University of Akron

The University of Akron Supply - shifts Table An increase in the price of complement in production causes a right shift of the supply curve At each price the quantity supplied increases 2/17/2019 The University of Akron

The University of Akron Supply function Graph 2/17/2019 The University of Akron

The University of Akron Supply – shifts (quiz) Number of suppliers (Np) Number of suppliers increase => Supply shifts to Price of recourses (PR) Price of resources increase => Right Left 2/17/2019 The University of Akron

The University of Akron Supply – shifts (quiz) Technology (TX) Technology improves => More output with the same inputs Supply shifts to Right 2/17/2019 The University of Akron

The University of Akron Supply – shifts (quiz) Price of related commodities (Pcs, Pss) Substitutes in production Price of substitute increase => Supply shifts to Price of substitute decrease => Complements in production Price of complement increase => Price of complement decrease => Left Right Right Left 2/17/2019 The University of Akron

The University of Akron Supply – shifts (quiz) Expectations (E) Suppliers expect future prices to increase => Current supply shifts to Suppliers expect future prices to decrease => Left Right 2/17/2019 The University of Akron

Supply – individual to market Assume there are 5 suppliers in the market, each with a different individual supply At any given price, the market supply is the sum of the individual quantities supplied Horizontal summation Note: assumes resource prices constant 2/17/2019 The University of Akron

Supply – individual to market Table 2/17/2019 The University of Akron

Supply – individual to market Graph 2/17/2019 The University of Akron

The University of Akron Student Questions Individually What is the muddiest point about supply? In groups compare muddiest points Are any in common? Can group members help clarify? List common unanswered questions Share common questions 2/17/2019 The University of Akron

The University of Akron Supply Definition Determinants Supply function (curve) Movement along supply Shifting of supply Individual and market supply 2/17/2019 The University of Akron

Introduction Demand Supply Market equilibrium Decision Tree Introduction Demand Supply Market equilibrium Complications Applications

The University of Akron Market equilibrium Why do prices increase? Why do prices decrease? Definition of equilibrium Shifting Demand and Supply 2/17/2019 The University of Akron

The University of Akron Market equilibrium Why do prices increase? Consumers can’t buy as much of a commodity as they want Some consumers value the commodity much higher And are willing to pay a premium to obtain more Thus bidding the market price higher 2/17/2019 The University of Akron

The University of Akron Market equilibrium Why do prices decrease? Sellers can’t sell as much of a commodity as they want Inventories increase What can they do to improve their situation? 2/17/2019 The University of Akron

The University of Akron Market equilibrium What can they do to improve their situation? Store surplus Reduce production Have a sale – lower the price 2/17/2019 The University of Akron

The University of Akron Market equilibrium Consumers don’t want higher prices. So why would they bid the prices higher? Sellers don’t want lower prices. So why would they lower the price? It is better than other alternatives 2/17/2019 The University of Akron

Definition of Equilibrium Balance At rest (an attractor) No internal tendency to change 2/17/2019 The University of Akron

Definition of Equilibrium Price at which the quantity demanded equals the supplied Consumers are able to buy the quantity they are willing to Sellers are able to sell all they are willing to Thus neither consumers nor suppliers have any incentive to bid the price higher or lower 2/17/2019 The University of Akron

The University of Akron Market equilibrium Quantity demanded equals quantity supplied 2/17/2019 The University of Akron

The University of Akron Market equilibrium Px = 6.5 Qx = 4.5 2/17/2019 The University of Akron

The University of Akron Market equilibrium Table Can you do the table? 2/17/2019 The University of Akron

Shifting Demand and Supply Table Graph Algebraic function 2/17/2019 The University of Akron

Shifting Demand and Supply Quantity demanded equals quantity supplied 2/17/2019 The University of Akron

Shifting Demand and Supply Px = 6 Qx = 8 2/17/2019 The University of Akron

Shifting Demand and Supply Can you do the table? 2/17/2019 The University of Akron

The University of Akron Market surplus Qd < Qs Price is above equilibrium Sellers bid the price lower 2/17/2019 The University of Akron

The University of Akron Market shortage Qd > Qs Price is below equilibrium Consumers bid the price higher 2/17/2019 The University of Akron

The University of Akron Student Questions Individually What is the muddiest point about market equilibrium? In groups compare muddiest points Are any in common? Can group members help clarify? List common unanswered questions Share common questions 2/17/2019 The University of Akron

The University of Akron Market equilibrium Why do prices increase? Why do prices decrease? Definition of equilibrium Shifting Demand and Supply 2/17/2019 The University of Akron

Introduction Demand Supply Market equilibrium Decision Tree Introduction Demand Supply Market equilibrium Complications Applications

The University of Akron Complication Public goods Externalities Asymmetric information 2/17/2019 The University of Akron

The University of Akron Complication Private goods Exclusion Rival consumption Public goods Non-exclusion Non-rival consumption Can you provide examples? 2/17/2019 The University of Akron

The University of Akron Complication Externalities External benefits External costs Can you provide examples? Asymmetric information 2/17/2019 The University of Akron

The University of Akron Complication Public goods Externalities Asymmetric information 2/17/2019 The University of Akron

Introduction Demand Supply Market equilibrium Decision Tree Introduction Demand Supply Market equilibrium Complications Applications

The University of Akron Applications Ceilings and floors Income distribution 2/17/2019 The University of Akron

The University of Akron Ceilings and floors Ceiling $8.00 Qd = 3 Qs = 6 2/17/2019 The University of Akron

The University of Akron Ceilings and floors Floor $4.00 Qd = 7 Qs = 6 2/17/2019 The University of Akron

Introduction Demand Supply Market equilibrium Decision Tree Introduction Demand Supply Market equilibrium Complications Applications