Chapter 3 Principles of Microeconomics, 4th Edition Instructor’s Manual

Prices Communicate (a) Prices are how the economy communicates. Prices provide information and incentives. Price measures scarcity.

Prices Communicate (b) When the price of a good is high, consumers and businesses will buy less and substitute other goods. They economize on the use of scarce goods or resources. Therefore, scarce goods are used most efficiently. No announcement on radio or TV has to be made. Individuals find out about the relative scarcity of a good through its price. Individuals and firms then decide what to do; decision making is decentralized.

The Role of Supply and Demand (a) Price changes can be puzzling. Water is almost free but is a necessity of life. Diamonds are very expensive but are a luxury.

The Role of Supply and Demand (b) Price movements are in the news and are important topics of national debate. The price of housing in San Francisco increases. The effective, or quality-adjusted, price of computers falls. Average real wages of workers in the United States remain roughly constant. The inflation adjusted price of gasoline in the U.S. has remained approximately constant since the mid-1980s.

U.S. Gasoline Prices

Demand and Demand Curves (a) Demand is the quantity of a good or service purchased at a given price. The demand curve shows the quantity of the good demanded at each price.

Demand and Demand Curves (b) The individual demand curve shows the quantity demanded at each price by one consumer.

Demand and Demand Curves (c) Demand curves are downward sloping. As price falls, consumers buy more of the good. The position of an individual’s demand curve (but not its slope) also depends on: Income Social trends The price of related goods Expectations about the future

Demand and Demand Curves (d) The market demand curve is the horizontal sum of the demand curves of all individuals.

Shifts in a Demand Curve versus Movements along a Demand Curve A change in price is represented by a movement along the demand curve. All other changes that affect demand will shift the demand curve.

Sources of Shifts in the Demand Curves (a) Tastes Prices of related goods Income Demographics Information Availability of credit Changes in expectations

Sources of Shifts in Demand Curves (b) Tastes: If one day everyone in the United States woke up and liked Britney Spears CDs, the demand curve for Britney Spears CDs would shift to the right.

Sources of Shifts in Demand Curves (c) Prices of related goods Complementary goods: Peanut butter and jelly When the price of peanut butter rises, there is movement along the demand curve for peanut butter. When the demand for jelly falls, the demand curve for jelly shifts to the left.

Sources of Shifts in Demand Curves (d) Price of related goods Substitute goods When the price of coffee rises, there is movement along the demand curve for coffee. When the demand for tea increases, the demand curve for tea shifts to the right.

Sources of Shifts in Demand Curves (e) An increase in income increases the demand for most goods. The demand curve shifts to the right.

Sources of Shift in Demand Curves (f) Availability of credit If banks reduce the number of automobile loans they approve, the demand for cars decreases and the demand curve shifts to the left.

Sources of Shift in Demand Curves (f) (cont.) A change in expectations If consumers believe the price will increase in the future, demand increases today (when the good is cheaper); this shifts the demand curve to the right. A change in expectations about the future affects current variables. A change in expectations may be self-fulfilling.

Supply and Supply Curves Supply is the quantity of goods and services offered in the market at a given price. The supply curve shows the quantity of the good offered for sale at each price.

The Slope of the Supply Curve The supply curve is upward sloping. When the price of a good or service rises, the quantity supplied to the market rises. Suppliers find it more profitable to produce more goods or services when prices are higher. A higher price allows firms to cover the higher costs of producing more goods.

Market Supply The market supply curve is the horizontal sum of the supply curves of all the suppliers. Just as individual supply curves have a positive slope, so do market supply curves.

Shifts in a Supply Curve versus Movements along a Supply Curve A change in price is represented by a movement along the supply curve. All other changes that affect supply shift the supply curve.

Sources of Shifts in Supply Curves (a) A change in the price of inputs A change in technology A change in the natural environment A change in the availability of credit A change in expectations

Sources of Shifts in Supply Curves (b) A rise in the price of coffee increases the costs of making espresso. The supply of coffee decreases and the supply curve for coffee shifts left or up.

Sources of Shifts in Supply Curves (c) If a new technology improves coffee bean harvesting, the costs of producing coffee fall. This increases the suppliers’ desire to sell at each price. The supply increases and the supply curve shifts right.

Law of Supply and Demand (a) In equilibrium, there are no forces or reasons for change. A marble in a bowl is in stable equilibrium. It remains at the bottom if there are no external changes to the system. In a market in equilibrium, neither demanders nor suppliers have an incentive to change their actions.

Law of Supply and Demand (b) The equilibrium price is the market clearing price that equates quantity demanded with quantity supplied. Equilibrium occurs where the demand curve intersects the supply curve—Qd = Qs.

Excess Supply The law of supply and demand predicts that prices will move to equilibrium values. Excess supply causes prices to fall. Suppliers cannot sell all they wish, so they the cut price. Quantity demanded increases along the demand curve to point E0. Quantity supplied decreases along the supply curve to point E0.

Excess Demand Excess demand causes prices to rise. Consumers cannot buy as much of the item as they want. They bid up the price. As the price rises, the quantity supplied increases along the supply curve. As the price rises, the quantity demanded decreases along the demand curve.

Using Demand and Supply Curves (a)

Using Demand and Supply Curves (b)

Marginal Value Price is related to marginal value not to total value. The price of water can be very low, even though its initial value is immense. The marginal value is why the price of water is relatively low in Alaska and relatively high in New Mexico.

What Determines Price? Price does not reflect importance. Price only reflects supply and demand. Water and diamond paradox

Price and Cost (a) Price is not identical to cost but they are related. Price is what an item sells for. Cost is the expense of making an item. When the cost of producing an item increases, the equilibrium price will rise. Why? When cost rises, suppliers will supply less at any price; the supply curve will shift to the left or up.

Price and Cost (b) In the basic competitive model, the price equals the marginal cost. An example of the difference between price and marginal cost is land. The supply of land is fixed (ignore reclamation from the sea). So marginal cost is infinite or at least very high. But the price of land is finite.

W. W. Norton & Company Independent and Employee-Owned This concludes the Instructor’s Manual Slide Set for Chapter 3 Principles of Microeconomics, 4th Edition by Joseph E. Stiglitz Carl E. Walsh