Economics Principles of N. Gregory Mankiw Sixth Edition This is perhaps the most important chapter in the textbook. It’s worth mentioning to your students that investing extra time to master this chapter will make it easier for them to learn much of the subsequent material in the book. This is also one of the longest chapters in the textbook, and this PowerPoint file is one of the most graph-intensive. Many students taking economics for the first time have difficulty grasping the graphs, which are critically important in this and all subsequent chapters in the book. So an extra degree of hand-holding might be appropriate. Accordingly, this PowerPoint has carefully detailed animations that build many of the graphs with great care. For example, we show a demand or supply schedule next to the axes, and highlight each coordinate pair in the table as the corresponding point appears on the graph. Please be assured that the presentation of graphs is more streamlined in subsequent chapters. In this early chapter, though, we do not want to leave any students behind. If your students are already very comfortable with scatter-type graphs, you may wish to simplify or turn off the animation on these slides, in order to get through them faster.

In this chapter, look for the answers to these questions: What factors affect buyers’ demand for goods? What factors affect sellers’ supply of goods? How do supply and demand determine the price of a good and the quantity sold? How do changes in the factors that affect demand or supply affect the market price and quantity of a good? How do markets allocate resources?

Markets and Competition A market is a group of buyers and sellers of a particular product. A competitive market is one with many buyers and sellers, each has a negligible effect on price. In a perfectly competitive market: All goods exactly the same Buyers & sellers so numerous that no one can affect market price—each is a “price taker” In this chapter, we assume markets are perfectly competitive. In the real world, there are relatively few perfectly competitive markets. Most goods come in lots of different varieties—including ice cream, the example in the textbook. And there are many markets in which the number of firms is small enough that some of them have the ability to affect the market price. For now, though, we look at supply and demand in perfectly competitive markets, for two reasons: First, it’s easier to learn. Understanding perfectly competitive markets makes it a lot easier to learn the more realistic but complicated analysis of imperfectly competitive markets. Second, despite the lack of realism, the perfectly competitive model can teach us a LOT about how the world works, as we will see many times in the chapters that follow. 2

Demand The quantity demanded of any good is the amount of the good that buyers are willing and able to purchase. Law of demand: the claim that the quantity demanded of a good falls when the price of the good rises, other things equal Demand comes from the behavior of buyers. 3

Quantity of lattes demanded The Demand Schedule Price of lattes Quantity of lattes demanded $0.00 16 1.00 14 2.00 12 3.00 10 4.00 8 5.00 6 6.00 4 Demand schedule: a table that shows the relationship between the price of a good and the quantity demanded Example: Helen’s demand for lattes. Notice that Helen’s preferences obey the law of demand. 4

Helen’s Demand Schedule & Curve Price of Lattes Quantity of Lattes Price of lattes Quantity of lattes demanded $0.00 16 1.00 14 2.00 12 3.00 10 4.00 8 5.00 6 6.00 4 5

Market Demand versus Individual Demand The quantity demanded in the market is the sum of the quantities demanded by all buyers at each price. Suppose Helen and Ken are the only two buyers in the Latte market. (Qd = quantity demanded) $0.00 6.00 5.00 4.00 3.00 2.00 1.00 Price 4 6 8 10 12 14 16 Helen’s Qd 2 3 4 5 6 7 8 Ken’s Qd Market Qd + = 24 + = 21 This example violates the “many buyers” condition of perfect competition. Yet, we are merely trying to show here that, at each price, the quantity demanded in the market is the sum of the quantity demanded by each buyer in the market. This holds whether there are two buyers or two million buyers. But it would be harder to fit data for two million buyers on this slide, so we settle for two. + = 18 + = 6 9 12 15 6

The Market Demand Curve for Lattes P Qd (Market) $0.00 24 1.00 21 2.00 18 3.00 15 4.00 12 5.00 9 6.00 6 P Q 7

Demand Curve Shifters The demand curve shows how price affects quantity demanded, other things being equal. These “other things” are non-price determinants of demand (i.e., things that determine buyers’ demand for a good, other than the good’s price). Changes in them shift the D curve… 8

Demand Curve Shifters: # of Buyers Increase in # of buyers increases quantity demanded at each price, shifts D curve to the right. Income is the first demand shifter discussed in this chapter of the textbook. I chose to start with a different one (number of buyers), for the following reason: In discussing the impact of changes in income on the demand curve, the textbook also introduces the concept of normal goods and inferior goods. Students may find it easier to learn about curve shifts if the presentation focuses solely on a curve shift (at least initially) without simultaneously introducing other concepts. If you wish to present the demand shifters in the same order as they appear in the book, simply reorder the slides in this presentation. 9

Demand Curve Shifters: # of Buyers P Q Suppose the number of buyers increases. Then, at each P, Qd will increase (by 5 in this example). Beginning economics students often have trouble understanding the difference between a movement along the curve and a shift in the curve. Here, the animation has been carefully designed to help students see that a shift in the curve results from an increase in quantity at each price. (A more realistic scenario would involve a non-parallel shift, where the horizontal distance of the shift would be greater for lower prices than higher ones. However, to remain consistent with the textbook, and to keep things simple, this slide shows a parallel shift.) 10

Demand Curve Shifters: Income Demand for a normal good is positively related to income. Increase in income causes increase in quantity demanded at each price, shifts D curve to the right. (Demand for an inferior good is negatively related to income. An increase in income shifts D curves for inferior goods to the left.) 11

Demand Curve Shifters: Prices of Related Goods Two goods are substitutes if an increase in the price of one causes an increase in demand for the other. Example: pizza and hamburgers. An increase in the price of pizza increases demand for hamburgers, shifting hamburger demand curve to the right. Other examples: Coke and Pepsi, laptops and desktop computers, CDs and music downloads If you are willing to spend a couple extra minutes on substitutes and complements, and have a blackboard or whiteboard to draw on, here’s an idea: Before (or instead of) showing this slide, draw the demand curve for hamburgers. Pick a price, say $5, and draw a horizontal line at that price, extending from the vertical axis through the D curve and continuing to the right. Suppose Q = 1000 when P = $5. Label this on the horizontal axis. Now ask your students: If pizza becomes more expensive, but price of hamburgers does not change, what would happen to the quantity of hamburgers demanded? Would it remain at 1000, would it increase, or would it decrease? Explain. Some and perhaps most students will see right away that people will want more hamburgers when the price of pizza rises. After establishing this, note that the increase in the price of pizza caused an increase in the quantity demanded of hamburgers. Then state the term “substitutes” and give the definition. Before giving the other examples (listed in the 3rd bullet of this slide), do a similar exercise to develop the concept of complements. Finally, give the examples of substitutes and complements from the 3rd bullet point of this and the following slides, but mix up the order and ask students to identify whether each example is complements or substitutes. 12

Demand Curve Shifters: Prices of Related Goods Two goods are complements if an increase in the price of one causes a fall in demand for the other. Example: computers and software. If price of computers rises, people buy fewer computers, and therefore less software. Software demand curve shifts left. Other examples: college tuition and textbooks, bagels and cream cheese, eggs and bacon 13

Demand Curve Shifters: Tastes Anything that causes a shift in tastes toward a good will increase demand for that good and shift its D curve to the right. Example: The Atkins diet became popular in the ’90s, caused an increase in demand for eggs, shifted the egg demand curve to the right. 14

Demand Curve Shifters: Expectations Expectations affect consumers’ buying decisions. Examples: If people expect their incomes to rise, their demand for meals at expensive restaurants may increase now. If the economy sours and people worry about their future job security, demand for new autos may fall now. 15

Summary: Variables That Influence Buyers Variable A change in this variable… Price …causes a movement along the D curve # of buyers …shifts the D curve Income …shifts the D curve Price of related goods …shifts the D curve Tastes …shifts the D curve Expectations …shifts the D curve Students should notice that the only determinant of quantity demanded that causes a movement along the curve is price. Also notice: price is one of the variables measured along the axes of the graph. Here’s a handy rule of thumb to help students remember whether the curve shifts: If the variable causing demand to change is measured on one of the axes, you move along the curve. If the variable that’s causing demand to change is NOT measured on either axis, then the curve shifts. This rule of thumb works with all curves in economics that involve an X-Y relationship, including the supply curve, the marginal cost curve, the IS and LM curves (not covered in this book), and many others, though it does not apply to curves drawn on time series graphs. 16

ACTIVE LEARNING 1 Demand Curve Draw a demand curve for music downloads. What happens to it in each of the following scenarios? Why? A. The price of iPods falls B. The price of music downloads falls C. The price of CDs falls In each case, there are only three possible answers: - The curve shifts to the right - The curve shifts to the left - The curve does not shift (though there may be a movement along the curve) © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

ACTIVE LEARNING 1 A. Price of iPods falls Music downloads and iPods are complements. A fall in price of iPods shifts the demand curve for music downloads to the right. Price of music down-loads Quantity of music downloads D1 D2 P1 Q1 Q2 Point out to your students that there are no numbers or units on either axis, and we are using “P1” and “Q1” to represent the initial price and quantity, rather than specific numerical values. Tell them that this is common, because in much economic analysis, the goal is only to see the direction of changes, not specific amounts. (Besides, if we put numbers on this graph, they’d just have been made up, so why bother?) Also point out the following: The price of music downloads is the same, but the quantity demanded is now higher. In fact, this is the nature of a shift in a curve: at any given price, the quantity is different than before. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

ACTIVE LEARNING 1 B. Price of music downloads falls The D curve does not shift. Move down along curve to a point with lower P, higher Q. P1 Q2 P2 D1 Q1 Quantity of music downloads © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

ACTIVE LEARNING 1 C. Price of CDs falls CDs and music downloads are substitutes. A fall in price of CDs shifts demand for music downloads to the left. Price of music down-loads D1 D2 P1 Q1 Q2 Quantity of music downloads © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Supply The quantity supplied of any good is the amount that sellers are willing and able to sell. Law of supply: the claim that the quantity supplied of a good rises when the price of the good rises, other things equal Supply comes from the behavior of sellers. 21

Quantity of lattes supplied The Supply Schedule Price of lattes Quantity of lattes supplied $0.00 1.00 3 2.00 6 3.00 9 4.00 12 5.00 15 6.00 18 Supply schedule: A table that shows the relationship between the price of a good and the quantity supplied. Example: Starbucks’ supply of lattes. Notice that Starbucks’ supply schedule obeys the law of supply. 22

Starbucks’ Supply Schedule & Curve Price of lattes Quantity of lattes supplied $0.00 1.00 3 2.00 6 3.00 9 4.00 12 5.00 15 6.00 18 P Q 23

Market Supply versus Individual Supply The quantity supplied in the market is the sum of the quantities supplied by all sellers at each price. Suppose Starbucks and Jitters are the only two sellers in this market. (Qs = quantity supplied) $0.00 6.00 5.00 4.00 3.00 2.00 1.00 Price 18 15 12 9 6 3 Starbucks 12 10 8 6 4 2 Jitters Market Qs + = + = 5 + = 10 Again, the assumption of only two sellers is a clear violation of perfect competition. However, it’s much easier for students to learn how the market supply curve relates to individual supplies in the two-seller case. + = 30 25 20 15 24

The Market Supply Curve P QS (Market) $0.00 1.00 5 2.00 10 3.00 15 4.00 20 5.00 25 6.00 30 P Q 25

Supply Curve Shifters The supply curve shows how price affects quantity supplied, other things being equal. These “other things” are non-price determinants of supply. Changes in them shift the S curve… “Non-price determinants of supply” simply means the things—other than the price of a good—that determine sellers’ supply of the good. 26

Supply Curve Shifters: Input Prices Examples of input prices: wages, prices of raw materials. A fall in input prices makes production more profitable at each output price, so firms supply a larger quantity at each price, and the S curve shifts to the right. In the second bullet point, “output price” just means the price of the good that firms are producing and selling. I have used “output price” here to distinguish it from “input prices.” 27

Supply Curve Shifters: Input Prices P Q Suppose the price of milk falls. At each price, the quantity of lattes supplied will increase (by 5 in this example). Again, the animation here is carefully designed to help make clear that a shift in the supply curve means that there is a change in the quantity supplied at each possible price. If it seems tedious, you can turn it off. In any case, be assured that, by the end of this chapter, the animation of curve shifts will be streamlined and simplified. 28

Supply Curve Shifters: Technology Technology determines how much inputs are required to produce a unit of output. A cost-saving technological improvement has the same effect as a fall in input prices, shifts S curve to the right. 29

Supply Curve Shifters: # of Sellers An increase in the number of sellers increases the quantity supplied at each price, shifts S curve to the right. 30

Supply Curve Shifters: Expectations Example: Events in the Middle East lead to expectations of higher oil prices. In response, owners of Texas oilfields reduce supply now, save some inventory to sell later at the higher price. S curve shifts left. In general, sellers may adjust supply* when their expectations of future prices change. (*If good not perishable) 31

Summary: Variables that Influence Sellers Variable A change in this variable… Price …causes a movement along the S curve Input Prices …shifts the S curve Technology …shifts the S curve # of Sellers …shifts the S curve Expectations …shifts the S curve 32

ACTIVE LEARNING 2 Supply Curve Draw a supply curve for tax return preparation software. What happens to it in each of the following scenarios? A. Retailers cut the price of the software. B. A technological advance allows the software to be produced at lower cost. C. Professional tax return preparers raise the price of the services they provide. “Tax return preparation software” means programs like TurboTax by Quicken and TaxCut by H&R Block. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

ACTIVE LEARNING 2 A. Fall in price of tax return software Quantity of tax return software S curve does not shift. Move down along the curve to a lower P and lower Q. S1 P1 Q1 Q2 P2 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

ACTIVE LEARNING 2 B. Fall in cost of producing the software Price of tax return software S curve shifts to the right: at each price, Q increases. S2 S1 P1 Q2 Q1 Quantity of tax return software © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

ACTIVE LEARNING 2 C. Professional preparers raise their price Price of tax return software Quantity of tax return software S1 This shifts the demand curve for tax preparation software, not the supply curve. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cost and the Supply Curve Cost is the value of everything a seller must give up to produce a good (i.e., opportunity cost). Includes cost of all resources used to produce good, including value of the seller’s time. Example: Costs of 3 sellers in the lawn-cutting business. A seller will produce and sell the good/service only if the price exceeds his or her cost. Hence, cost is a measure of willingness to sell. name cost Jack $10 Janet 20 Chrissy 35 The material on cost, producer surplus, and the supply curve is analogous to the material earlier on WTP, consumer surplus, and the demand curve. Therefore, this section provides a bit less detail and should move a little more quickly. 37

Cost and the Supply Curve Qs Derive the supply schedule from the cost data: $0 – 9 10 – 19 1 20 – 34 2 name cost Jack $10 Janet 20 Chrissy 35 35 & up 3 Your students should be able to figure out how to get the Qs numbers in the second column of the table. 38

Cost and the Supply Curve Q P Qs $0 – 9 10 – 19 1 20 – 34 2 35 & up 3 The derivation of the staircase supply curve is analogous to that of the staircase demand curve in the earlier example. Hence, the animation is not as detailed. 39

Cost and the Supply Curve At each Q, the height of the S curve is the cost of the marginal seller, the seller who would leave the market if the price were any lower. Chrissy’s cost Janet’s cost For your students’ future reference, you might also note that we can use the term “marginal cost” as short-hand for “cost of the marginal seller.” Jack’s cost Q 40

Producer Surplus P Q PS = P – cost Producer surplus (PS): the amount a seller is paid for a good minus the seller’s cost Q 41

Producer Surplus and the S Curve PS = P – cost Suppose P = $25. Jack’s PS = $15 Janet’s PS = $5 Chrissy’s PS = $0 Total PS = $20 Chrissy’s cost Janet’s cost Jack’s cost Total PS equals the area above the supply curve under the price, from 0 to Q. Q 42

PS with Lots of Sellers & a Smooth S Curve Suppose P = $40. At Q = 15(thousand), the marginal seller’s cost is $30, and her producer surplus is $10. P Q Price per pair The supply of shoes S 1000s of pairs of shoes 43

PS with Lots of Sellers & a Smooth S Curve PS is the area b/w P and the S curve, from 0 to Q. The height of this triangle is $40 – 15 = $25. So, PS = ½ x b x h = ½ x 25 x $25 = $312.50 P Q The supply of shoes S h 44

How a Lower Price Reduces PS If P falls to $30, PS = ½ x 15 x $15 = $112.50 Two reasons for the fall in PS. P Q 1. Fall in PS due to sellers leaving market S 2. Fall in PS due to remaining sellers getting lower P 45

ACTIVE LEARNING 2 Producer surplus supply curve P A. Find marginal seller’s cost at Q = 10. B. Find total PS for P = $20. Suppose P rises to $30. Find the increase in PS due to: C. selling 5 additional units D. getting a higher price on the initial 10 units Q © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

ACTIVE LEARNING 2 Answers supply curve P A. At Q = 10, marginal cost = $20 B. PS = ½ x 10 x $20 = $100 P rises to $30. C. PS on additional units = ½ x 5 x $10 = $25 D. Increase in PS on initial 10 units = 10 x $10 = $100 Q © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Supply and Demand Together P Q Equilibrium: P has reached the level where quantity supplied equals quantity demanded S D We now return to the latte example to illustrate the concepts of equilibrium: shortage and surplus. 48

Equilibrium price: the price that equates quantity supplied with quantity demanded P Q S D P QD QS $0 24 1 21 5 2 18 10 3 15 4 12 20 9 25 6 30 49

Equilibrium quantity: the quantity supplied and quantity demanded at the equilibrium price P Q S D P QD QS $0 24 1 21 5 2 18 10 3 15 4 12 20 9 25 6 30 50

Surplus (a.k.a. excess supply): when quantity supplied is greater than quantity demanded P Q Example: If P = $5, S D Surplus then QD = 9 lattes and QS = 25 lattes resulting in a surplus of 16 lattes 51

Surplus (a.k.a. excess supply): when quantity supplied is greater than quantity demanded P Q Facing a surplus, sellers try to increase sales by cutting price. S D Surplus This causes QD to rise and QS to fall… …which reduces the surplus. 52

Surplus (a.k.a. excess supply): when quantity supplied is greater than quantity demanded P Q Facing a surplus, sellers try to increase sales by cutting price. S D Surplus This causes QD to rise and QS to fall. Prices continue to fall until market reaches equilibrium. 53

Shortage (a.k.a. excess demand): when quantity demanded is greater than quantity supplied P Q Example: If P = $1, S D then QD = 21 lattes and QS = 5 lattes resulting in a shortage of 16 lattes Shortage 54

Shortage (a.k.a. excess demand): when quantity demanded is greater than quantity supplied P Q Facing a shortage, sellers raise the price, S D causing QD to fall and QS to rise, …which reduces the shortage. Shortage 55

Shortage (a.k.a. excess demand): when quantity demanded is greater than quantity supplied P Q Facing a shortage, sellers raise the price, S D causing QD to fall and QS to rise. Prices continue to rise until market reaches equilibrium. Shortage 56

Three Steps to Analyzing Changes in Eq’m To determine the effects of any event, 1. Decide whether event shifts S curve, D curve, or both. 2. Decide in which direction curve shifts. 3. Use supply—demand diagram to see how the shift changes eq’m P and Q. Step 1 requires knowing all of the things that can shift D and S—the non-price determinants of demand and of supply. 57

EXAMPLE: The Market for Hybrid Cars Q price of hybrid cars S1 D1 P1 Q1 quantity of hybrid cars 58

EXAMPLE 1: A Shift in Demand EVENT TO BE ANALYZED: Increase in price of gas. P Q S1 D2 D1 STEP 1: D curve shifts because price of gas affects demand for hybrids. S curve does not shift, because price of gas does not affect cost of producing hybrids. P2 Q2 STEP 2: D shifts right because high gas price makes hybrids more attractive relative to other cars. P1 Q1 STEP 3: The shift causes an increase in price and quantity of hybrid cars. 59

EXAMPLE 1: A Shift in Demand Notice: When P rises, producers supply a larger quantity of hybrids, even though the S curve has not shifted. P Q S1 D2 D1 P2 P1 Q1 Always be careful to distinguish b/w a shift in a curve and a movement along the curve. Q2 60

Terms for Shift vs. Movement Along Curve Change in supply: a shift in the S curve occurs when a non-price determinant of supply changes (like technology or costs) Change in the quantity supplied: a movement along a fixed S curve occurs when P changes Change in demand: a shift in the D curve occurs when a non-price determinant of demand changes (like income or # of buyers) Change in the quantity demanded: a movement along a fixed D curve “Supply” refers to the position of the supply curve, while “quantity supplied” refers to the specific amount that producers are willing and able to sell. Similarly, “demand” refers to the position of the demand curve, while “quantity demanded” refers to the specific amount that consumers are willing and able to buy. If you’d like to be a rebel, delete this slide and all references to the jargon it contains, and just use the terms “movement along a curve” and “shift in a curve.” Note, however, that this is not the official recommendation of Cengage/South-Western or Dr. Mankiw. If you’d like to cover this slide but make it move more quickly, delete the text next to each second-level bullet (starting with “occurs when”). Instead, give the information to your students verbally or rely on them to read it in the textbook. 61

EXAMPLE 2: A Shift in Supply EVENT: New technology reduces cost of producing hybrid cars. P Q S1 S2 D1 STEP 1: S curve shifts because event affects cost of production. D curve does not shift, because production technology is not one of the factors that affect demand. STEP 2: S shifts right because event reduces cost, makes production more profitable at any given price. P1 Q1 P2 Q2 STEP 3: The shift causes price to fall and quantity to rise. 62

EXAMPLE 3: A Shift in Both Supply and Demand EVENTS: Price of gas rises AND new technology reduces production costs P Q S1 S2 D2 D1 STEP 1: Both curves shift. P2 Q2 P1 Q1 STEP 2: Both shift to the right. STEP 3: Q rises, but effect on P is ambiguous: If demand increases more than supply, P rises. 63

EXAMPLE 3: A Shift in Both Supply and Demand EVENTS: price of gas rises AND new technology reduces production costs P Q S1 S2 D2 D1 STEP 3, cont. P1 Q1 But if supply increases more than demand, P falls. P2 Q2 64

ACTIVE LEARNING 3 Shifts in supply and demand Use the three-step method to analyze the effects of each event on the equilibrium price and quantity of music downloads. Event A: A fall in the price of CDs Event B: Sellers of music downloads negotiate a reduction in the royalties they must pay for each song they sell. Event C: Events A and B both occur. Important note about Event B: The royalties that sellers must pay the artists are part of sellers’ “costs of production.” Typically, this royalty is a fixed amount each time one of the artist’s songs is downloaded. Event B, therefore, describes a reduction in sellers’ “costs of production.” © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

ACTIVE LEARNING 3 A. Fall in price of CDs The market for music downloads STEPS P Q 1. D curve shifts S1 D1 2. D shifts left D2 P1 Q1 3. P and Q both fall. P2 Q2 This is an extension of Active Learning exercise 1C, where we saw that a fall in the price of compact discs would cause a fall in demand for music downloads, because the two goods are substitutes. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

ACTIVE LEARNING 3 B. Fall in cost of royalties The market for music downloads STEPS P Q 1. S curve shifts S1 S2 (Royalties are part of sellers’ costs) 2. S shifts right D1 P1 Q1 3. P falls, Q rises. Q2 P2 NOTE: Don’t worry that the text on this slide looks garbled in “Normal view” (i.e., edit mode). It works fine in “Slide Show” (i.e., presentation mode). Event B: Sellers of music downloads negotiate a reduction in the royalties they must pay for each song they sell. This event causes a fall in “costs of production” for sellers of music downloads. Hence, the S curve shifts to the right. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1. Both curves shift (see parts A & B). ACTIVE LEARNING 3 C. Fall in price of CDs and fall in cost of royalties STEPS 1. Both curves shift (see parts A & B). 2. D shifts left, S shifts right. 3. P unambiguously falls. Effect on Q is ambiguous: The fall in demand reduces Q, the increase in supply increases Q. It’s not necessary to draw a graph here. The answers to steps 1 and 2 should be clear from parts A and B. The answer to step 3 is a combination of the results from A and B. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

CS, PS, and Total Surplus CS = (value to buyers) – (amount paid by buyers) = buyers’ gains from participating in the market PS = (amount received by sellers) – (cost to sellers) = sellers’ gains from participating in the market Total surplus = CS + PS = total gains from trade in a market = (value to buyers) – (cost to sellers) It might help to say “participating in the market” means buying and selling. It might also help to say that CS measures the net benefit to buyers: the value they get from the good is the gross benefit, minus what they pay leaves the net benefit, or CS. Similarly, PS is the net benefit to sellers. I did not put “net benefit” on this slide because it is not in the book. But if you wish, you may add it. After showing this slide in class, I show my students a short scene from the movie “Pretty Woman” as an example of these concepts. In this scene, Julia Roberts is taking a bubble bath in Richard Gere’s hotel room (don’t worry—there’s no nudity!). Gere comes into the bathroom and they negotiate a price for her to “be at his beck and call” for one week. After bargaining for a few seconds, they agree on a price of $3000. A minute later, he says he would have paid $4000 (his willingness to pay), and she says she would have accepted $2000 (her “cost”). From this, we can deduce that CS = $1000, PS = $1000, and total surplus = $2000. If this transaction did not occur, then these characters would not have received these “gains from trade.” Disclaimer: We officially urge you to consult with your institution’s legal advisor to verify that showing this brief clip in your class does not violate any copyright laws. We accept no responsibility in this matter. For example, we absolutely do not recommend that you rent “Pretty Woman” on DVD, download a free evaluation copy of a program like AoA DVD Ripper from the website www.aoamedia.com, and use that software to create a video clip of the above-described segment of Pretty Woman from the DVD, a video clip which could then be moved to the computer in your classroom to be shown in your classroom presentation of this chapter. We urge you to respect the intellectual property of others, and all copyright laws. 69

The Market’s Allocation of Resources In a market economy, the allocation of resources is decentralized, determined by the interactions of many self-interested buyers and sellers. Is the market’s allocation of resources desirable? Or would a different allocation of resources make society better off? To answer this, we use total surplus as a measure of society’s well-being, and we consider whether the market’s allocation is efficient. (Policymakers also care about equality, though our focus here is on efficiency.) Is the market’s allocation of resources desirable? This question is important, because the answer to it has implications for the proper role and scope of government. If the market’s allocation is generally desirable, then the role of government should be limited to the protection of property rights, national defense and so forth. If not, then public policy may potentially be able to improve upon the market’s allocation. 70

Efficiency Total surplus = (value to buyers) – (cost to sellers) An allocation of resources is efficient if it maximizes total surplus. Efficiency means: The goods are consumed by the buyers who value them most highly. The goods are produced by the producers with the lowest costs. Raising or lowering the quantity of a good would not increase total surplus. 71

Evaluating the Market Equilibrium Market eq’m: P = $30 Q = 15,000 Total surplus = CS + PS Is the market eq’m efficient? P Q D CS S PS 72

Which Buyers Consume the Good? Every buyer whose WTP is ≥ $30 will buy. Every buyer whose WTP is < $30 will not. So, the buyers who value the good most highly are the ones who consume it. P Q D S It may be worth reminding your students that, at each Q, the height of the D curve is the marginal buyer’s valuation of the good. Hence, the buyers from 0 to 15 all value the good at least as much as the price, so they will purchase the good at the market price. The buyers from 15 on up value the good less than $30, so they won’t buy the good. 73

Which Sellers Produce the Good? Every seller whose cost is ≤ $30 will produce the good. Every seller whose cost is > $30 will not. So, the sellers with the lowest cost produce the good. P Q D S Because the height of the S curve tells us sellers’ costs, we can determine the following: The sellers of the first 15 units have cost < $30, so it is worthwhile for them to produce the good. The other sellers have cost > $30, so they will not sell the good if P = $30. 74

Does Eq’m Q Maximize Total Surplus? At Q = 20, cost of producing the marginal unit is $35 value to consumers of the marginal unit is only $20 Hence, can increase total surplus by reducing Q. This is true at any Q greater than 15. P Q D S This slide shows that, if we are starting from a Q greater than the market equilibrium quantity, we can increase total surplus by reducing Q. The slide demonstrates this for one particular Q (20), but it is true for any Q greater than the equilibrium quantity. Thus, if we continue to reduce Q, total surplus will continue to increase—until we get to the equilibrium quantity. 75

Does Eq’m Q Maximize Total Surplus? At Q = 10, cost of producing the marginal unit is $25 value to consumers of the marginal unit is $40 Hence, can increase total surplus by increasing Q. This is true at any Q less than 15. P Q D S This slide shows that, if we are starting from a Q less than the market equilibrium quantity, we can increase total surplus by increasing Q. The slide demonstrates this for one particular Q (10), but it is true for any Q below the equilibrium quantity. Thus, if we continue to increase Q, total surplus will continue to increase—until we get to the equilibrium quantity. 76

Does Eq’m Q Maximize Total Surplus? The market eq’m quantity maximizes total surplus: At any other quantity, can increase total surplus by moving toward the market eq’m quantity. D S This slide summarizes the lesson of the preceding two slides. 77

Adam Smith and the Invisible Hand Passages from The Wealth of Nations, 1776 “Man has almost constant occasion for the help of his brethren, and it is vain for him to expect it from their benevolence only. He will be more likely to prevail if he can interest their self-love in his favor, and show them that it is for their own advantage to do for him what he requires of them… This and the following slide contain passages from The Wealth of Nations. It would be hard to overstate the impact of the ideas in these passages. I have included them here because students should be able to better understand and appreciate their significance after having just seen the analysis of market efficiency. If you’re pressed for time, you might delete the first of these two slides, as it is probably less important than the second one. The passages on this first slide convey the sense that the economy is made up of a completely uncoordinated mass of individuals, each acting in his or her own self interest. On the next slide, Smith discusses the invisible hand. It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest…. Adam Smith, 1723-1790 78

Adam Smith and the Invisible Hand Passages from The Wealth of Nations, 1776 “Every individual…neither intends to promote the public interest, nor knows how much he is promoting it…. He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. an invisible hand Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.” Adam Smith, 1723-1790 79

The Free Market vs. Govt Intervention The market equilibrium is efficient. No other outcome achieves higher total surplus. Govt cannot raise total surplus by changing the market’s allocation of resources. Laissez faire (French for “allow them to do”): the notion that govt should not interfere with the market.

The Free Market vs. Central Planning Suppose resources were allocated not by the market, but by a central planner who cares about society’s well-being. To allocate resources efficiently and maximize total surplus, the planner would need to know every seller’s cost and every buyer’s WTP for every good in the entire economy. This is impossible, and why centrally-planned economies are never very efficient. Example of central planner: the Communist leaders of the former Soviet Union.

CONCLUSION This chapter used welfare economics to demonstrate one of the Ten Principles: Markets are usually a good way to organize economic activity. Important note: We derived these lessons assuming perfectly competitive markets. In other conditions we will study in later chapters, the market may fail to allocate resources efficiently… 82

CONCLUSION Such market failures occur when: a buyer or seller has market power—the ability to affect the market price. transactions have side effects, called externalities, that affect bystanders. (example: pollution) We’ll use welfare economics to see how public policy may improve on the market outcome in such cases. Despite the possibility of market failure, the analysis in this chapter applies in many markets, and the invisible hand remains extremely important. The italicized terms market power and externalities will be formally defined in later chapters. 83

CONCLUSION: How Prices Allocate Resources One of the Ten Principles from Chapter 1: Markets are usually a good way to organize economic activity. In market economies, prices adjust to balance supply and demand. These equilibrium prices are the signals that guide economic decisions and thereby allocate scarce resources. In the textbook, the conclusion of this chapter offers some very nice elaboration on the second bullet point. There is also an “In the News” box with a very nice article titled “In Praise of Price Gouging.” 84

SUMMARY A competitive market has many buyers and sellers, each of whom has little or no influence on the market price. Economists use the supply and demand model to analyze competitive markets. The downward-sloping demand curve reflects the law of demand, which states that the quantity buyers demand of a good depends negatively on the good’s price. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

SUMMARY Besides price, demand depends on buyers’ incomes, tastes, expectations, the prices of substitutes and complements, and number of buyers. If one of these factors changes, the D curve shifts. The upward-sloping supply curve reflects the Law of Supply, which states that the quantity sellers supply depends positively on the good’s price. Other determinants of supply include input prices, technology, expectations, and the # of sellers. Changes in these factors shift the S curve. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

SUMMARY The intersection of S and D curves determines the market equilibrium. At the equilibrium price, quantity supplied equals quantity demanded. If the market price is above equilibrium, a surplus results, which causes the price to fall. If the market price is below equilibrium, a shortage results, causing the price to rise. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

SUMMARY We can use the supply-demand diagram to analyze the effects of any event on a market: First, determine whether the event shifts one or both curves. Second, determine the direction of the shifts. Third, compare the new equilibrium to the initial one. In market economies, prices are the signals that guide economic decisions and allocate scarce resources. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.