1 Chapter 3 (not so briefly)  An Introduction to Supply and Demand  What is a market?  Where do prices come from?  What happens if prices are set “too high”?  What happens if prices are set “too low”?  Do markets really achieve equilibrium?

2 Questions  All economies must answer the following questions:  What should be produced?  How should it be produced?  For whom will it be produced?

3 Central Planning  Agrarian society  Former Soviet Union  Cuba, North Korea  China  Bureaucracy  A small number of individuals address these concerns:  Establish production targets for factories and farms  Plan how to achieve the goals  Distribute the goods and services produced

4 Market Forces  Free market  Capitalist economies  Individuals decide for themselves  Which careers to pursue  Which products to produce or buy  When to start businesses  Who gets what is decided by individual preferences and purchasing power

5 Markets  A market for any good consists of all buyers and sellers of that good  Includes individuals who either do sell or might sell = suppliers (usually firms)  Includes individuals who either do buy or might buy = demanders (usually people)

6 Prices  Why are some goods cheap and others expensive?  Through most of history, individuals had no idea  Most thought that it was because of the cost of production  Others thought only of the value people received from consumption  Answer: both supply and demand determine prices

7 Supply  Shows the quantity of a good or service that sellers wish to sell at each price  On a graph = supply curve  In a schedule = supply schedule  Positive relationship between P and Q S  As price rises, a higher quantity can be sold because more opportunity costs can be covered  Application of the “low-hanging fruit principle”  Reflects the rising marginal costs of producing additional units

8 Supply Schedule PriceQuantity Supplied $416 $312 $28 $14

9 Supply Curve - Fig. 4.1 Daily Supply Curve of Hamburgers in Greenwich Village

10 Demand  Shows the total quantity of a good or service that buyers wish to buy at each price  On a graph = demand curve  In a schedule = demand schedule  Inverse relationship between P and Q D  As price rises, consumers want fewer items  People switch to substitutes  People cannot afford as much  At higher quantities, consumers are willing to pay less (application of the principle of diminishing marginal utility/benefit)

11 Demand Schedule PriceQuantity Demanded $48 $312 $216 $120

12 Demand Curve - Fig. 4.2 Daily Demand Curve for Hamburgers

13 Market Equilibrium  When all buyers and sellers are satisfied with their respective quantities at the market price  There is a stable, balanced, unchanging situation  The supply and demand curves intersect  This results in the equilibrium price  The price the good sells for  This results in the equilibrium quantity  The quantity that will be sold

14 Market Equilibrium - Fig. 4.3 The Equilibrium Price and Quantity of Hamburgers in Greenwich Village

15 Do markets really exist in equilibrium?  What would be evidence that a particular market is in equilibrium?  Stable prices  Stable quantities  Can you name a good for which price has not changed in a long time?  Can you name a good for which price changes daily?  Can you name a good for which price changes every second?

16 Does equilibrium mean all wants are satisfied ?  Market equilibrium does not mean that everyone has what they want  E.G. a poor person may not be able to afford the item at the equilibrium price

17 Disequilibrium  Excess supply  Market Surplus  Price is higher than equilibrium price  Sellers are dissatisfied  Excess demand  Market Shortage  Price is lower than equilibrium price  Buyers are dissatisfied

18 Fig. 4.4 Excess Supply

19 Fig. 4.5 Excess Demand

20 Free Markets and Equilibrium  Free markets have an automatic tendency to eliminate excess supply and excess demand  A market surplus serves as a signal to sellers that price is too high and therefore leads producers to decrease the price  A market shortage serves as a signal to sellers that price is too low and therefore leads producers to increase the price

21 Legislation and Markets  Legislators protect producers and consumers by using price controls  Price ceilings  Price floors

22 Price controls  price ceilings – intended to help consumers  A maximum allowable price specified by law because the true equilibrium price was deemed “too high”  Price ceiling price < P* so now consumers want too much  e.g. rent controls, limits on the price of gasoline  Result in permanent shortages

23 Price Controls  price floors – intended to help producers  A minimum allowable price specified by law  For example, agricultural price supports, minimum wages  Price floor price is > P* so now sellers want to sell more  Result in surpluses

24 Fig. 4.6 An Unregulated Housing Market

25 Fig. 4.7 Rent Controls

26 Markets and Social Welfare  Social optimal quantity of a good  The quantity that results in the maximum possible economic surplus (net gains)  The socially optimal quantity will occur where the marginal cost equals the marginal benefit  Economic efficiency  Occurs when all goods and services are produced and consumed at their respective socially optimal levels

27 Markets and Efficiency  Efficiency Principle  Efficiency is an important social goal  Everyone can have a larger slice of a larger pie  Equilibrium Principle  A market in equilibrium leaves no unexploited opportunities for individuals  No “cash on the table” remains  All opportunities for profit have been exploited  Efficiency occurs when  the market-demand curve captures all the marginal benefits of the good  the market-supply curve captures all the marginal costs of the good

28 Terminology  If the good’s price changes, you have a  “change in quantity demanded”  A movement along the demand curve  “change in quantity supplied”  A movement along the supply curve  If something else changes, you have a  “change in demand”  A shift of the entire demand curve  change in supply”  A shift of the entire supply curve

29 Fig. 4.9 An Increase in the Quantity Demanded Versus an Increase in Demand

30 Shifts in Supply  Favorable changes to the producer shift supply curve rightward  lower equilibrium price  higher equilibrium quantity  Unfavorable changes to the producer shift supply leftward  higher equilibrium price  lower equilibrium quantity

31 Fig The Effect on the Skateboard Market of an Increase in the Price of Fiberglass

32 Shifts in Supply  Changes in the Cost of Production  Changes in Technology  Changes in Weather  Changes in Expectations

33 An Increase in Supply Sequence of events: 1.Conditions become more favorable to firms. Eg: lower cost of inputs 2.Firms now can earn higher per-unit profits at any price, so they wish to sell more units at all prices. 3.Firms increase Qs for all Prices = shift right in the supply curve (along demand). 4.Shift results in lower P* and higher Q*

34 Fig The Effect on the Market for New Houses of a Decline in Carpenters’ Wage Rates

35 Fig The Effect of Technical Change on the Market for Manuscript Revisions

36 Shifts in Demand  Complements  Substitutes  Income  Preferences  Demand curve shifts rightward  higher equilibrium price  higher equilibrium quantity  Demand curve shifts leftward  lower equilibrium price  lower equilibrium quantity

37 An Increase in Demand Sequence of events: 1.Conditions change such that consumers want more units at any price. Egs: lower price of complement good, higher price of a substitute, higher income, … 2.Higher Qd at all prices means rightward shift in the demand curve 3.Demand shifts right (along supply) resulting in higher P* and Q*

38 Fig The Effect on the Market for Tennis Balls of a Decline in Court Rental Fees

39 Complements  Goods that are more valuable when used in combination--e.g. tennis balls and tennis courts  Two goods are complements in consumption if an increase in the price of one causes a leftward shift in the demand curve for the other

40 Substitutes  Goods that replace each other--e.g. messages and overnight letters  Two goods are substitutes in consumption if an increase in the price of one causes a rightward shift in the demand curve for the other

41 Fig Effect on the Market for Overnight Letter Delivery of a Decline in the Price of Internet Access

42 Income  Normal good  One whose demand curve shifts right when the incomes of buyers increase  Inferior good  One whose demand curves shifts left when the incomes of buyers increase

43 Fig The Effect of a Federal Pay Raise on the Rent for Conveniently Located Apartments

44 Simultaneous Shifts  If, at the same time,  Demand decreases and Supply increases  Demand shifts left  Lower price, lower quantity  Supply shifts right  Lower price, higher quantity  We can predict that price will fall  But, what happens to quantity?  We must know the magnitude of the shifts

45 Fig The Effects of Simultaneous Shifts in Supply and Demand

46 Naturalist Question Why did you pay $60 for a Christmas tree in 2000 which only cost $40 in 1999? Assume:  Inflation was not 50%  The number of Christmas trees sold year to year in the United States is fairly stable.  It takes six to eight years to grow a tree to the right size for Christmas trees.  There are over 15,000 Christmas tree farms in the US  Recall: there were significant forest fires in the northwest in 2000