1. ECO1000 Economics Semester One, 2004 Lecture Three

2. Brief Recap of Last Week PPF’s are used to display production choices and the opportunity costs of those choices. From a table of figures we plot the PPFs, calculate opp. costs, work out comparative advantages and decide who specialises in what. This is a simple but useful tool.

3. Good Question: Does (Complete) Specialisation And Trade Always Lead to Increased Consumption Possibilities? The answer is yes. The proof can be displayed geometrically: *

4. Another Good Question: Is the Opportunity Cost the Slope? The Answer is yes (and no). Importantly, a slope can be negative but opportunity cost is not. For those with a bit of maths experience: Opportunity cost can be thought of as the absolute value of the slope. Δy/Δx = -2/3 = -0.66 Δy equals -2 because we give up 2 food to gain 3 cloth (PPF slopes downwards) Opportunity cost = |-0.66| = 0.66 Δx/Δy = 3/2 = 1.5 (or 1/0.66) From applying these ideas we can see that once we calculate the opportunity cost of one good (absolute value of the slope), the opportunity cost of the other is simply its inverse. (numbers from last week’s lecture)

5. Outline or Plan of Today’s Lecture Material Covered: Module Two, Part One Reading: Text Chapter Four plus Chapter Four of Hakes and Parry. Topics Considered: Markets and Supply and Demand.

6. Purpose or Objectives of Today’s Lecture You will learn about: What a market is The determinants of demand The determinants of supply The allocation role of prices in a market economy.

7. Relevant Economic Principles 3. Rational People Think at the Margin 4. People Respond to Incentives 6. Markets Are Usually a Good Way to Organise Activity

8. Reasons for learning about markets There are three reasons: It is fundamental to economics It is crucial to business It helps you understand your own behaviour as a consumer and social person

9. What is a Market? A market is not a thing or a place. It is a process. The interaction of buyers and sellers determines demand and supply.

10. Demand Or, How Consumers Behave

11. What Determines an Individual’s Demand for a Product or Service? Price (law of demand) Income Prices of Related Goods Tastes Expectations

12. A Note on Normal Versus Inferior Goods As income increases, demand increases for a NORMAL good. As income increases, demand decreases for an INFERIOR good. Example: If your income rises you are likely to buy less of the generic branded goods (inferior) and more brand-name products (normal)

13. Caspar’s Demand For Chocolate Bars

14. Estimating Caspar’s Ceteris Paribus Demand Curve Price ($/bar) Quantity (bars/wk) 8 10 6 14 7 16 4 * * * * * 0 12 2 * 1310 D

15. What Does Ceteris Paribus Mean? Latin phrase meaning “other things equal”. We use it in economics when we want to indicate that the change (in a curve or number) occurs in isolation. Example: when income rises, we say demand rises (for a normal good), Ceteris Paribus. That is, nothing else is happening to offset the change we are talking about.

16. Market Demand (sum of individual demands) Each consumer has a different utility and therefore a different demand curve Utility is a subjective thing The market demand for a good or service can be calculated by adding up all of the individual demand curves.

17. A Two-Buyer Market For Chocolate Bars Price ($/bar) Q (bars/wk) 8 10 6 11.5 13 17.5 4 * * * * * 0 12 2 * 16 14.5 Caspar Louise

18. Total Demand for Chocolate Price Quantity demanded by Caspar Quantity demanded by Louise Plus all other consumers Total quantity demanded 12110???550 10411.5???600 8713???650 61014.5???700 41316???750 21617.5???800

19. Market Demand for Chocolate Bars Price ($/bar) Q (bars/wk) 8 10 6 550 600 650 800 4 * * * * * 0 12 2 * 750700

20. A Change in Quantity Demanded Price Quantity D P0P0 P0P0 Q0Q0 Q1Q1 An increase or decrease in price is represented by a movement ALONG the demand curve. This is called a change in quantity demanded. The curve does NOT shift.

21. A Change in Demand As opposed to a change in quantity demanded, a change in demand is: a change in the quantity demanded at all prices.

22. Change in Demand Price Quantity Q1Q1 D1D1 Q2Q2 D2D2 P Q0Q0 D0D0 A change in demand is represented by a movement of the demand curve.

23. A Change in Demand Occurs When There is: A change in income a change in population a change in taste a change in the price of a substitute a change in the price of a complement Expectations about future income Expectations about future prices

24. Increase in demand Decrease in demand Change of tastes (+) Increased income if normal or luxury good Increase in price of substitute Decrease in price of complement Increase in population Change of tastes (-) Increased income if inferior good Decrease in price of substitute Increase in price of complement Decrease in population

25. Substitutes Complements Similar goods that consumers will accept as a substitute for each other Eg two brands of cola If price of A increases, demand for B increases If price of A decreases, demand for B decreases Goods that are used together in consumption activities video recorders and videos Cars and petrol If price of A increases, demand for B decreases & vice versa

26. Increase in the Price of a Complement Price Quantity Q1Q1 D1D1 P Q0Q0 D0D0

27. Increase in the Price of a Substitute Price Quantity Q0Q0 D1D1 P Q1Q1 D0D0

28. Negative Change in Taste Price Quantity Q1Q1 D1D1 P Q0Q0 D0D0

29. An example: Demand for VHS tapes before and after a decrease in the price of DVDs (a substitute) Price57911131517 Qty 0 (‘000/wk) 21181512963 Qty 1 (‘000/wk) 19161310741

30. Change in Demand For VHS Tapes Price Q 2 4 6 8 10 12 14 16 18 20 D1D1 18 16 14 12 10 8 6 4 2 0 D0D0

31. Supply Or, how producers behave

32. What Determines an Individual Producer’s Supply of a Good or Service? Price (law of supply) Input Prices Technology Expectations

33. The ‘Law’ of Supply As the price increases, firms are inclined to increase production As the price decreases, firms are inclined to decrease production Or, in real world terms, if you are offered more money you might be inclined to produce more Therefore, a supply curve slopes upward and to the right

34. A Change in Quantity Supplied Price Quantity S P1P1 P0P0 Q0Q0 Q1Q1

35. Points to Note The producers are prepared to sell more at a higher price and less at a lower price A change in the quantity supplied is only related to changes in price a change along the curve A change in supply leads to a shift in the curve

36. Increase in Supply Decrease in Supply Decrease in cost of factors of production New technology Decreased price of substitutes in production Increase in cost of factors of production Increased price of substitutes in production Expecting higher prices in the future (storage)

37. A Change in Quantity Supplied Price Quantity S0S0 P Q1Q1 Q2Q2 Q0Q0 S2S2 S1S1

38. An example: Supply of novels before and after a decrease in the cost of paper (an input) Price57911131517 Qty 0 (‘000/wk) 2468101214 Qty 1 (‘000/wk) 681012141618

39. A Change in Supply Price Q 2 4 6 8 10 12 14 16 18 20 S1S1 18 16 14 12 10 8 6 4 2 0 S0S0

40. Equilibrium The Intersection of Supply and Demand

41. Price Searching In a market, consumers are ‘shopping around’ looking for lower prices Firms are adjusting prices in an effort to sell all their product, but get as high a price as possible There is tendency towards equilibrium

42. Let’s Think About Equilibrium…

43. Equilibrium Price Quantity S P0P0 Q0Q0 All that is produced is consumed D

44. What Assumptions Are We Making? At equilibrium there is market clearance There is a competitive market with many buyers and many sellers There is no collusion on prices Each brand of the particular good is much like another (homogenous)

45. Changes in the Market When supply or demand change, the equilibrium price and/or quantity changes This is happening all the time consumers are ‘price searching’ producers are responding to price searching In reality markets are never stationary there is a tendency towards an equilibrium price and quantity

46. A Change in Demand Price Quantity S P0P0 Q0Q0 A new equilibrium price and quantity D0D0 P1P1 Q1Q1 D1D1

47. A Negative Change in Supply Price Quantity S0S0 P0P0 Q0Q0 A new equilibrium price and quantity D1D1 P1P1 Q1Q1 S1S1 What could cause this?

48. A Positive Change in Supply Price Q 2 4 6 8 10 12 14 16 18 20 S1S1 18 16 14 12 10 8 6 4 2 0 S0S0 D New Equilibrium

49. A Negative Change in Supply & A Positive Change in Demand Price Quantity S0S0 P0P0 Q0Q0 NB In this situation price will increase but changes in quantity cannot be predicted without actual figures D0D0 P1P1 Q1Q1 S1S1 D1D1

50. How Markets Allocate Resources A Preliminary Assessment

51. Markets Allocate Resources By… Markets determine who gets the scarce resources. Markets also determine who will produce scarce resources. Competitive behaviour eventually balances supply and demand until something disturbs equilibrium. Remember, no one is determining how much food to produce. It is all worked out by individuals acting in their own interests using market prices as signals.

52. Let’s Think About the Market for Hamburgers… What Would Happen if: The cost of meat increases There is increased inward migration There is an outbreak of botulism in hamburger cafes The price of chicken burgers decreases A new chain of hamburger stores opens up

53. Conclusions A market is a process Markets and market prices play a key role in allocating resources There are several determinants of demand There are several determinants of supply The intersection of the two curves represents equilibrium Equilibrium is really a thing of beauty.

54. Next Week Next week’s lecture: Material Covered: Module Two, Part Two Reading: Text Chapter Five, Hakes and Parry Chapter Five Topics: Elasticity

55. THE END