1. 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. 2-2 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

3. 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

4. 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.

5. 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)

6. 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]

7. 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.

8. 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.

9. 2-9 The Supply and Demand Model

10. 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 $0.00550,000 $0.50440,000 $1.00330,000 $1.50220,000 $2.00110,000 $2.5000

11. 2-11 Figure 1 The Demand Curve 0 10 20 30 40 50 P Q/t $2.50 $2.00 $1.50 $1.00 $0.50 0 Demand

12. 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 $0.0000 $0.5000 $1.001,00010,000 $1.502,00020,000 $2.003,00030,000 $2.504,00040,000

13. 2-13 Figure 2 The Supply Curve 0 10 20 30 40 50 P Q/t $2.50 $2.00 $1.50 $1.00 $0.50 0 Supply

14. 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

15. 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 $2.50040,000

16. 2-16 Figure 3 The Supply and Demand Model 0 10 20 30 40 50 P Q/t $2.50 $2.00 $1.50 $1.00 $0.50 0 Supply Demand Equilibrium

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

18. 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.

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

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

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

22. 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

23. 2-23 Figure 4 The Effect of an Increase in Demand New Demand New Equilibrium 0 10 20 30 40 50 P Q/t $2.50 $2.00 $1.50 $1.00 $0.50 0 Demand Supply Old Equilibrium

24. 2-24 Figure 5 The Effect of a Decrease in Demand 0 10 20 30 40 50 P Q/t $2.50 $2.00 $1.50 $1.00 $0.50 0 Demand Supply Old Equilibrium New Demand New Equilibrium

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

26. 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

27. 2-27 Figure 6 An Increase in Supply 0 10 20 30 40 50 P Q/t $2.50 $2.00 $1.50 $1.00 $0.50 0 Demand Supply Old Equilibrium New Equilibrium New Supply

28. 2-28 Figure 7 A Decrease in Supply 0 10 20 30 40 50 P Q/t $2.50 $2.00 $1.50 $1.00 $0.50 0 Demand Supply Old Equilibrium New Supply New Equilibrium

29. 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

30. 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.

31. 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

32. 2-32 Alternative Ways to Understand Elasticity The Graphical Explanation

33. 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

34. 2-34 Figure 1 D1D1 Q/t P13 12 11 10 9 8 7 6 5 4 3 2 1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 12.5% change (9-8)/8 25% change (4-3)/4

35. 2-35 Figure 2 D2D2 Q/t P13 12 11 10 9 8 7 6 5 4 3 2 1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 50% change (12-8)/8 25% change (4-3)/4

36. 2-36 Figure 3 Higher Prices Means Greater Elasticity Demand Q/t P13 12 11 10 9 8 7 6 5 4 3 2 1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 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

37. 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

38. 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.

39. 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.

40. 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

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

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

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

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

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

46. 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

47. 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

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

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

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

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

52. 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.

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

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

55. 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=

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

57. 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

58. 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

59. 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.

60. 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

61. 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

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

63. 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.

64. 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

65. 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

66. 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

67. 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

68. 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

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

70. 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

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

72. 2-72 A Numerical Example LaborTotal OutputExtra Output of the Group 00 1100 2317217 3500183 4610110 570090 677070 783060 887040 990030 131000

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

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

75. 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

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

77. 2-77 Numerical Example OutputTVCTFCTCMC*ATCAVCAFC 008500 1002500850011000251102585 200380085001230013621943 300480085001330010441628 400600085001450012361521 500750085001600015321517 600950085001800020301614 7001250085002100030 1812 8001700085002550045322110.6 900225008500310005534259.4 1000325008500410001004132.58.5 * MC is per 100

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

79. 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

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

81. 2-81 Numerical Example For the Many Competitors Case QPTRMR* 0450 100454,50045 200459,00045 3004513,50045 4004518,00045 5004522,50045 6004527,00045 7004531,50045 8004536,00045 9004540,50045 10004545,00045 * MR is per 100

82. 2-82 Numerical Example For the No Competitors Case QPTRMR* 0750 100707,00070 2006513,00060 3006018,00050 4005522,00040 5005025,00030 6004527,00020 7004028,00010 8003528,0000 9003027,000-10 10002525,000-20

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

84. 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

85. 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).

86. 2-86 Numerical Example of Profit Maximization With Many Competitors QPTRTCMRMCProfit 04508,500-8,500 100454,50011,0004525-6,500 200459,00012,3004513-3,300 3004513,50013,3004510200 4004518,00014,50045123,500 5004522,50016,00045156,500 6004527,00018,00045209,000 7004531,50021,000453010,500 8004536,00025,50045 10,500 9004540,50031,00045559,500 10004545,00041,00045754,000

87. 2-87 Numerical Example of Profit Maximization With No Competitors QPTRTCMRMCProfit 07508,500-8,500 100707,00011,0007025-6,500 2006513,00012,3006013-3,300 3006018,00013,3005010200 4005522,00014,50040123,500 5005025,00016,00030156,500 6004527,00018,00020 9,000 7004028,00021,00010307,000 8003528,00025,5000452,500 9003027,00031,000-1055-4,000 10002525,00041,000-2075-16,000