2-1 Definitions Supply and Demand: the name of the most important model in all economics Price: the amount of money that must be paid for a unit of output Market: any mechanism by which buyers and sellers negotiate price Output: the good or service and/or the amount of it sold

2-2 Definitions (continued) Consumers: those people in a market who are wanting to exchange money for goods or services Producers: those people in a market who are wanting to exchange goods or services for money Equilibrium Price: the price at which no consumers wish they could have purchased more goods at that price; no producers wish that they could have sold more Equilibrium Quantity: the amount of output exchanged at the equilibrium price

2-3 Quantity Demanded and Quantity Supplied Quantity demanded: how much consumers are willing and able to buy at a particular price during a particular period of time Quantity supplied: how much firms are willing and able to sell at a particular price during a particular period of time

2-4 Markets Capitalism –free markets in financial capital as well as goods and services –freedom to borrow or lend –profits go to the owners of capital Communism –capital and the profit that it generates is controlled by a government authority. –a government authority decides how the money is used. Socialism –a significant part of the profit generated by financial capital goes to government in the form of taxes. –a government uses the tax money to counter the wealth impacts of the distribution of profit.

Hong Kong 1 [90.3] Singapore 2 [87.4] Ireland 3 [82.4] Australia 4 [82.0] United States 5 [80.6] New Zealand 6 [80.2] Canada 7 [80.2] Chile 8 [79.8] Switzerland 9 [79.7] United Kingdom 10 [79.5] Denmark 11 [79.2] Estonia 12 [77.8] Netherlands 13 [76.8] Iceland 14 [76.5] Luxembourg 15 [75.2] Finland 16 [74.8] Japan 17 [72.5] Mauritius 18 [72.3] Bahrain 19 [72.2] Belgium 20 [71.5] Heritage Foundation Index of Economic Freedom (Most Free)

Heritage Foundation Index of Economic Freedom (Most Oppressed) Haiti 138 [48.9] Sierra Leone 139 [48.9] Togo 140 [48.8] Central African Republic 141 [48.2] Chad 142 [47.7] Angola 143 [47.1] Syria 144 [46.6] Burundi 145 [46.3] Congo, Republic of 146 [45.2] Guinea Bissau 147 [45.1] Venezuela 148 [45.0] Bangladesh 149 [44.9] Belarus 150 [44.7] Iran 151 [44.0] Turkmenistan 152 [43.4] Burma 153 [39.5] Libya 154 [38.7] Zimbabwe 155 [29.8] Cuba 156 [27.5] Korea, North 157 [3.0]

2-7 The Scientific Method and Ceteris Paribus Scientists –conduct experiments in laboratories. –use replication and verification to ensure the accuracy of their conclusions. Social Scientists –cannot experiment on their subjects. –must use models and look at the effects of individual variables within those models. Economists –hold variables constant within models to examine the effect of other variables. –use the Latin phrase ceteris paribus which means “holding other things equal” to identify this is the case.

2-8 Demand and Supply Demand is the relationship between price and quantity demanded, ceteris paribus. Supply is the relationship between price and quantity supplied, ceteris paribus.

2-9 The Supply and Demand Model

2-10 The Demand Schedule The Demand Schedule presents, in tabular form, the price and quantity demanded for a good. PriceIndividual Q D Q D for 10,000 $ ,000 $ ,000 $ ,000 $ ,000 $ ,000 $2.5000

2-11 Figure 1 The Demand Curve P Q/t $2.50 $2.00 $1.50 $1.00 $ Demand

2-12 The Supply Schedule The Supply Schedule presents, in tabular form, the price and quantity supplied for a good. PriceIndividual Q s Q S for 10 firms $ $ $1.001,00010,000 $1.502,00020,000 $2.003,00030,000 $2.504,00040,000

2-13 Figure 2 The Supply Curve P Q/t $2.50 $2.00 $1.50 $1.00 $ Supply

2-14 Equilibrium, Shortages, and Surpluses Equilibrium is the point where the amount that consumers want to buy and the amount that firms want to sell are the same. This occurs where the supply curve and the demand curve cross. Shortage (Excess Demand): the condition where firms do not want to sell as many as consumers want to buy. Surplus (Excess Supply): the condition where firms want to sell more than consumers want to buy

2-15 A Combined Supply and Demand Schedule PriceQDQD QSQS ShortageSurplus $0.0050,0000 $0.5040,0000 $1.0030,00010,00020,000 $1.5020,000 $2.0010,00030,00020,000 $ ,000

2-16 Figure 3 The Supply and Demand Model P Q/t $2.50 $2.00 $1.50 $1.00 $ Supply Demand Equilibrium

2-17 All About Demand The Law of Demand –The relationship between price and quantity demanded is a negative or inverse one.

2-18 Why Does the Law of Demand Make Sense? The Substitution Effect –moves people toward the good that is now cheaper or away from the good that is now more expensive The Real Balances Effect –When a price increases it decreases your buying power causing you to buy less. The Law of Diminishing Marginal Utility –The amount of additional happiness that you get from an additional unit of consumption falls with each additional unit.

2-19 The Law of Supply The Law of Supply is the statement that there is a positive relationship between price and quantity supplied.

2-20 Why Does the Law of Supply Make Sense? Because of Increasing Marginal Costs firms require higher prices to produce more output.

2-21 Determinants of Demand Taste Income –Normal Goods –Inferior Goods Price of Other Goods –Complement –Substitute Population of Potential Buyers Expected Price

2-22 Movements in the Demand Curve Determinant Result of an increase in the determinant Result of a decrease in the determinant Taste D shifts right D shifts left Income-Normal Good D shifts right D shifts left Income-Inferior Good D shifts left D shifts right Price of Other Goods-Complement D shifts left D shifts right Price of Other Goods-Substitute D shifts right D shifts left Population of Potential Buyers D shifts right D shifts left Expected Future Price D shifts right D shifts left

2-23 Figure 4 The Effect of an Increase in Demand New Demand New Equilibrium P Q/t $2.50 $2.00 $1.50 $1.00 $ Demand Supply Old Equilibrium

2-24 Figure 5 The Effect of a Decrease in Demand P Q/t $2.50 $2.00 $1.50 $1.00 $ Demand Supply Old Equilibrium New Demand New Equilibrium

2-25 The Determinants of Supply Price of Inputs Technology Price of Other Potential Output Number of Sellers Expected Future Price

2-26 Movements in the Supply Curve Determinant Result of an increase in the determinant Result of a decrease in the determinant Price of InputsS shifts left S shifts right TechnologyS shifts right S shifts left Price of Other Potential Outputs S shifts left S shifts right Number of SellersS shifts right S shifts left Expected Future PriceS shifts left S shifts right

2-27 Figure 6 An Increase in Supply P Q/t $2.50 $2.00 $1.50 $1.00 $ Demand Supply Old Equilibrium New Equilibrium New Supply

2-28 Figure 7 A Decrease in Supply P Q/t $2.50 $2.00 $1.50 $1.00 $ Demand Supply Old Equilibrium New Supply New Equilibrium

2-29 Elasticity Elasticity: the responsiveness of quantity to a change in another variable Price Elasticity of Demand: the responsiveness of quantity demanded to a change in price Price Elasticity of Supply: the responsiveness of quantity supplied to a change in price Income Elasticity of Demand: the responsiveness of quantity demanded to a change in income Cross Price Elasticity of Demand: the responsiveness of quantity demanded of one good to a change in the price of another good

2-30 The Mathematical Representation of Elasticity Elasticity = %ΔQ %ΔP = ΔQ ΔP Q P Because the demand curve is downward sloping and the supply curve is upward sloping the elasticity of demand is negative and the elasticity of supply is positive. Often these signs are implicit and ignored.

2-31 Elasticity Labels Elastic : the condition of demand when the percentage change in quantity is larger than the percentage change in price Inelastic: the condition of demand when the percentage change in quantity is smaller than the percentage change in price Unitary Elastic: the condition of demand when the percentage change in quantity is equal to the percentage change in price

2-32 Alternative Ways to Understand Elasticity The Graphical Explanation

2-33 The Relationship Between Slope and Elasticity Elasticity and the slope of the demand curve are not the same but they are related. At a given price level, elasticity is greater with a flatter demand curve. With a linear demand curve (meaning a demand curve that has a single value for the slope) elasticity is greater at higher prices

2-34 Figure 1 D1D1 Q/t P % change (9-8)/8 25% change (4-3)/4

2-35 Figure 2 D2D2 Q/t P % change (12-8)/8 25% change (4-3)/4

2-36 Figure 3 Higher Prices Means Greater Elasticity Demand Q/t P B A C D 12.5% change (9-8)/8 25% change (4-3)/4 50% change (3-2)/2 9.1% change (11-10)/11

2-37 Alternative Ways to Understand Elasticity A good for which there are no good substitutes is likely to be one for which you must pay whatever price is charged. It is also likely to be one for which a lower price will not induce substantially greater consumption. Thus, as price changes there is very little change in consumption, i.e. demand is inelastic and the demand curve is steep. Inexpensive goods that take up little of your income can change in price and your consumption will not change dramatically. Thus, at low prices, demand is inelastic. The Verbal Explanation

2-38 Seeing Elasticity Through Total Expenditures Total Expenditure Rule: if the price and the amount you spend both go in the same direction then demand is inelastic while if they go in opposite directions demand is elastic.

2-39 Determinants of Elasticity Number of and Closeness of Substitutes –The more alternatives you have the less likely you are to pay high prices for a good and the more likely you are to settle for something that will do. Time –The longer you have to come up with alternatives to paying high prices the more likely it is you will shift to those alternatives.

2-40 Extremes of Elasticity Perfectly Inelastic: the condition of demand when price changes have no effect on quantity Perfectly Elastic: the condition of demand when price cannot change

2-41 Elasticity and the Demand Curve How the Elasticity of Demand Affects Reactions to Price Changes

2-42 Figure 4 Perfectly Inelastic Demand D Q/t P S2S2 Q 1 =Q 2 P2P2 S1S1 P1P1

2-43 Figure 5 Perfectly Elastic Demand Q/t P D S2S2 P 1 =P 2 Q2Q2 S1S1 Q1Q1

2-44 Figure 6 Inelastic Demand (at moderate prices) P Q/t D S1S1 P1P1 Q1Q1 Q2Q2 S2S2 P2P2

2-45 Figure 7 Elastic Demand (at moderate prices) Q/t P Q1Q1 D S1S1 P1P1 S2S2 P2P2 Q2Q2

2-46 Elasticity Examples Inelastic GoodsPrice Elasticity Eggs0.06 Food0.21 Health Care Services0.18 Gasoline (short-run)0.08 Gasoline (long-run)0.24 Highway and Bridge Tolls0.10 Unit Elastic Good (or close to it) Shellfish0.89 Cars1.14 Elastic Goods Luxury Car3.70 Foreign Air Travel1.77 Restaurant Meals2.27

2-47 Price Elasticity Supply Identical in concept to elasticity of demand. –Formula is the Same –It is also related to the slope of the supply curve but is not simply the slope of the supply curve. –Terminology is the same

2-48 S Q/t P D2D2 Q 1 =Q 2 P2P2 D1D1 P1P1 Perfectly Inelastic Supply

2-49 P Q/t P1P1 Q1Q1 Q2Q2 P2P2 S D2D2 D1D1 Inelastic Supply

2-50 Q/t P Q1Q1 P1P1 P2P2 Q2Q2 S D2D2 D1D1 Elastic Supply

2-51 Q/t P P 1 =P 2 Q2Q2 Q1Q1 S D2D2 D1D1 Perfectly Elastic Supply

2-52 Consumer and Producer Surplus Consumer Surplus: the value you get that is in excess of what you pay to get it –On a graph, consumer surplus is the area below the demand curve and above the price line. Producer Surplus: the money the firm gets that is in excess of its marginal costs –On a graph, producer surplus is the area below the price line and above the supply curve.

2-53 Figure 12 Value to the Consumer: OACQ* Q/t P 0 Supply Demand P* Q* A B C

2-54 Figure 12 Money Consumers Pay Producers: OP*CQ* P Q/t 0 Supply Demand P* Q* A B C

2-55 Figure 12 Consumer Surplus: P*AC C P Q/t 0 Supply Demand P* Q* A B Value to the Consumer Amount Consumer pays producer Consumer Surplus = minus=

2-56 Figure 13 Variable Cost to the Producer: OBCQ* P 0 Supply Demand P* Q* A B C

2-57 P Q/t 0 Supply Demand P* Q* A B C Amount consumer pays producer Variable cost to producer Producer Surplus =minus = Figure 13 Producer Surplus: BP*C

2-58 P Q/t 0 Supply Demand P* Q* A B C Consumer Surplus Producer Surplus Figure 14 Net Benefit to Society = CS+PS: BAC

2-59 Market Failure Market Failure: the circumstance where the market outcome is not the economically efficient outcome –Possible Sources: Consumption or production can harm an innocent third party. A good may not be one for which a company can profit from selling it though society profits from its existence. The buyer may not be able to make a well-informed choice. A buyer or seller may have too much power over the price.

2-60 Exclusivity and Rivalry Exclusivity: the degree to which the consumption of the good can be restricted by a seller to only those who pay for it Rivalry: the degree to which one person’s consumption reduces the value of the good for the next consumer

2-61 Private and Public Goods Purely private good: a good with the characteristics of both exclusivity and rivalry Purely public good: a good with the neither of the characteristics exclusivity and rivalry Excludable public good: a good with the characteristic of exclusivity but not of rivalry Congestible public good: a good with the characteristic of rivalry but not of exclusivity

2-62 Kick it Up a Notch Consumer and Producer Surplus in a Supply and Demand Model

2-63 The Optimality of Equilibrium and Dead Weight Loss At equilibrium the sum of producer and consumer surplus is as big as it can be (ABC). Away from equilibrium the sum of producer and consumer surplus is smaller. The degree to which it is smaller is called the dead weight loss. That is, it is the loss in societal welfare associated with production being too little or too great.

2-64 Figure 16 Dead Weight Loss When the Price is Above P* Q/t P Demand Supply A C 0 Q’ Q* E F P’ P* B Value to the Consumer: 0AEQ’ Consumers Pay Producers: OP’EQ’ The Variable Cost to Producers: OBFQ’ Consumer Surplus: P’AE Producer Surplus: BP’EF DWL FEC

2-65 Figure 17 Dead Weight Loss When the Price is Below P* Q/t P Demand Supply A P* C 0 Q’ Q* E F P’ B Value to the Consumer: 0AEQ’ Consumers Pay Producers: OP’FQ’ The Variable Cost to Producers: OBFQ’ Consumer Surplus: P’AEF Producer Surplus: BP’F DWL FEC

2-66 Basic Definitions Profit: The money that business makes: Revenue minus Cost Cost: the expense that must be incurred in order to produce goods for sale Revenue : the money that comes into the firm from the sale of their goods

2-67 Economic vs. Accounting Cost Economic Cost: All costs, both those that must be paid as well as those incurred in the form of forgone opportunities, of a business Accounting Cost: Only those costs that must be explicitly paid by the owner of a business

2-68 Production Production Function: a graph which shows how many resources we need to produce various amounts of output Cost Function: a graph which shows how much various amounts of production cost

2-69 Inputs to Production Fixed Inputs: resources that you cannot change Variable Inputs : resources that can be easily changed

2-70 Concepts in Production Division of Labor: workers divide up the tasks in such a way that each can build up a momentum and not have to switch jobs Diminishing Returns: the notion that there exists a point where the addition of resources increases production but does so at a decreasing rate

2-71 Figure 1 The Production Function Output Workers Production Function A B C D

2-72 A Numerical Example LaborTotal OutputExtra Output of the Group

2-73 Costs Fixed Costs: costs of production that we cannot change Variable Costs: costs of production that we can change

2-74 Figure 2 The Total Cost Function Output Total Cost Total Cost Function A B C D

2-75 Cost Concepts Marginal Cost: the addition to cost associated with one additional unit of output Average Total Cost: Total Cost/Output, the cost per unit of production Average Variable Cost: Total Variable Cost/Output, the average variable cost per unit of production Average Fixed Cost: Total Fixed Cost/Output, the average fixed cost per unit of production

2-76 Figure 3 Marginal Cost, Average Total, Average Variable, and Average Fixed Cost P Q MC ATC AVC AFC

2-77 Numerical Example OutputTVCTFCTCMC*ATCAVCAFC * MC is per 100

2-78 Revenue Marginal Revenue : additional revenue the firm receives from the sale of each unit

2-79 Figure 4 Setting the Price When There are Many Competitors Our Firm P Market for Memory P D S P* P*=Marginal Revenue

2-80 Figure 5 Marginal Revenue When there are No Competitors MR Market for Memory P D

2-81 Numerical Example For the Many Competitors Case QPTRMR* , , , , , , , , , ,00045 * MR is per 100

2-82 Numerical Example For the No Competitors Case QPTRMR* , , , , , , , , , ,000-20

2-83 Maximizing Profit We assume that firms wish to maximize profits

2-84 Market Forms Perfect Competition: a situation in a market where there are many firms producing the same good Monopoly: a situation in a market where there is only one firm producing the good

2-85 Rules of Production A firm should a) produce an amount such that Marginal Revenue equals Marginal Cost (MR=MC), unless b) the price is less than the average variable cost (P<AVC).

2-86 Numerical Example of Profit Maximization With Many Competitors QPTRTCMRMCProfit 04508,500-8, ,50011, , ,00012, , ,50013, ,00014, , ,50016, , ,00018, , ,50021, , ,00025, , ,50031, , ,00041, ,000

2-87 Numerical Example of Profit Maximization With No Competitors QPTRTCMRMCProfit 07508,500-8, ,00011, , ,00012, , ,00013, ,00014, , ,00016, , ,00018, , ,00021, , ,00025, , ,00031, , ,00041, ,000