Chapter 2: Economic Systems & Resource Allocation

Basic Economic Questions What to Produce (guns vs. butter) How to Produce (labor-intensive vs. capital-intensive technology) For Whom to Produce (rich vs. poor)

Economic Systems Tradition & Custom Economy Command & Control Economy Central Planning Market Economy Pure vs. Mixed Competitive vs. Non-competitive

Market System Network of buyers & sellers who transact in the market Buyers “demand” goods & services Sellers “supply” goods & services

Advantage of Market Economy Free interactions between buyers & sellers Full information to make decisions Free to choose between alternatives

Demand Definition: quantities of a good or service consumers are able to buy at various prices Law of Demand: price and quantity are negatively related Movement along demand is caused by a price change

Demand Schedule Demand for Pepsi Price Quantity Demanded $1.50 1,500 $2.00 1,000 $2.50 500

Demand Line Price D A 2.00 B 1.50 D Quantity 1000 1500

Shift in Demand Shift in demand is caused by a change in Consumer income & tastes Consumer expectations (price, income) Number of consumers Price of related goods (substitute, complementary)

Increase in Demand Price D’ D A C 2.00 B D’ D Quantity 1500 2000

Supply Definition: quantities of a good or service producers are able to sell at various prices Law of Supply: price and quantity supplied are positively related Movement along supply is caused by a price change

Supply Schedule Supply for Pepsi Price Quantity Supplied $1.50 500 $2.00 1,000 $2.50 1,500

Supply Line Price S 2.00 B 1.50 A S 500 1000 Quantity

Shift in Supply Shift in supply is caused by an change in production cost & technology number of firms price of related goods price expectations

Increase in Supply Price S B S’ A 1.50 C S S’ 500 1000 Quantity

Equilibrium A condition at which the independent plans of buyers and sellers exactly coincide in the marketplace. At equilibrium: Demand = Supply to determine equilibrium price & quantity

Equilibrium in Pepsi Market Market Equilibrium Equilibrium in Pepsi Market Price Quantity Demanded Quantity Supplied $1.50 1,500 500 $2.00 1,000 $2.50

Demand-Supply Interaction Price Surplus S 2.50 Equilibrium 2.00 B 1.50 Shortage S D Quantity 500 1000 1500

Stability Shortage: at a price below equilibrium quantity demanded > quantity supplied Surplus: at a price above equilibrium quantity supplied > quantity demanded Price adjustments eliminate shortages & surpluses

Increase in Demand: Price D’ D S B P’ A P D’ D S Quantity Q Q’ Higher Price Larger Quantity B P’ A P D’ D S Quantity Q Q’

Increase in Supply: Price D S S’ A P B P’ S D S’ Q’ Q Quantity Lower Price Larger Quantity B P’ S D S’ Q’ Q Quantity

Increase in Demand & Supply: Price D’ D S S’ P’ B Here: Higher Price Larger Quantity A P D’ S D S’ Quantity Q Q’

Market: Command Economy Price D S Shortage=AC if price is fixed B P’ C P A D’ D Q Q’ Quantity