Lesson 5. Adam Smith and the Free Market 1/27/2013. Markets and Competition. Unit 2. Krugman, Module 67 pp

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1 Unit 2 Adam mith and the Free Market Lesson 5 Krugman, Module 67 pp 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. A perfectly competitive market: all goods exactly the same Large numbers of buyers & sellers so that no one can affect market price In this chapter, we assume markets are perfectly competitive. CHATER 2 1 ummary: Variables That Affect emand Variable rice A change in this variable causes a change along the curve Tastes Income shifts the curve shifts the curve More/less buyers shifts the curve Expectations Related goods shifts the curve shifts the curve 2 1

2 ummary: Variables That Affect upply Variable rice Government Other rofit Opportunities No. of sellers Investment CHATER 2 A change in this variable causes a movement along the curve shifts the curve shifts the curve shifts the curve shifts the curve Cost of Resources shifts the curve Expectations shifts the curve 3 OBJECTIVE What is market equilibrium? 4 upply and emand Together Equilibrium: has reached the level where quantity supplied equals quantity demanded CHATER 2 5 2

3 Equilibrium price: The price that equates quantity supplied with quantity demanded $ CHATER 2 6 Equilibrium quantity: The quantity supplied and quantity demanded at the equilibrium price $ CHATER 2 7 urplus: when quantity supplied is greater than quantity demanded urplus Example: If = $5, then = 9 lattes and = 25 lattes resulting in a surplus of 16 lattes CHATER 4 8 3

4 urplus: when quantity supplied is greater than quantity demanded urplus Facing a surplus, sellers try to increase sales by cutting price. This causes to rise and to fall which reduces the surplus. CHATER 4 9 urplus: when quantity supplied is greater than quantity demanded urplus Facing a surplus, sellers try to increase sales by cutting price. This causes to rise and to fall. rices continue to fall until market reaches equilibrium. CHATER 2 10 hortage: when quantity demanded is greater than quantity supplied hortage Example: If = $1, then = 21 lattes and = 5 lattes resulting in a shortage of 16 lattes CHATER

5 hortage: when quantity demanded is greater than quantity supplied hortage Facing a shortage, sellers raise the price, causing to fall and to rise, which reduces the shortage. CHATER 2 12 hortage: when quantity demanded is greater than quantity supplied Facing a shortage, sellers raise the price, causing to fall and to rise. rices continue to rise until market reaches equilibrium. hortage CHATER 2 13 Three teps to Analyzing Changes in Equilibrium To determine the effects of any event, 1. ecide whether event shifts curve, curve, or both. 2. ecide in which direction curve shifts. 3. Use supply-demand diagram to see how the shift changes eq m and. CHATER

6 EXAMLE: The Market for Hybrid Cars price of hybrid cars 1 1 CHATER quantity of hybrid cars EXAMLE 1: A Change in emand EVENT TO BE ANALYZE: Increase in price of gas. TE 1: curve shifts because TE 2: price of gas affects demand for shifts right hybrids. because TE curve 3: high gas price makes does hybrids not shift, The shift because causes price an more attractive of increase relative gas does in price to other not cars. affect and quantity cost of of producing hybrid cars. hybrids. CHATER EXAMLE 1: A Change in emand Notice: When rises, producers supply a larger quantity of hybrids, even though the curve has not shifted Always be careful to distinguish b/w a shift in a curve and a movement along the curve CHATER

7 Terms for hift vs. Movement Along Curve Change in supply: a shift in the curve occurs when a non-price determinant of supply changes (like technology or costs) Change in the quantity supplied: a movement along a fixed curve occurs when changes Change in demand: a shift in the 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 curve occurs when changes 18 EXAMLE 2: A Change in upply EVENT: New technology reduces cost of producing hybrid cars. TE 1: curve shifts because TE 2: event affects cost of production. shifts right because curve does not shift, TE because 3: event reduces cost, production The shift causes makes production technology is price not to more profitable one fall of the at factors and quantity any given that price. affect to rise. demand. CHATER EXAMLE 3: A Change in Both upply and emand EVENT: price of gas rises AN new technology reduces 1 2 production costs TE 1: Both curves shift. TE 2: Both shift to the right. CHATER TE 3: rises, but effect on is ambiguous: If demand increases more than supply, rises

8 EXAMLE 3: A Change in Both upply and emand EVENT: price of gas rises AN new technology reduces 1 production costs 2 TE 3, cont. But if supply increases more than demand, falls CHATER 4 21 Changes 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 compact discs Event B: ellers 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. 22 A. fall in price of Cs The market for music downloads TE 1. curve shifts 2. shifts left and both fall

9 B. fall in cost of royalties The market for music downloads TE curve shifts (royalties are part 2. shifts right of sellers costs) 3. falls, rises C. fall in price of Cs AN fall in cost of royalties TE 1. Both curves shift (see parts A & B). 2. shifts left, shifts right. 3. unambiguously falls. Effect on is ambiguous: The fall in demand reduces, the increase in supply increases. 25 Changes 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 compact discs Event B: ellers 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. 26 9

10 A. fall in price of Cs The market for music downloads TE 1. curve shifts 2. shifts left and both fall B. fall in cost of royalties The market for music downloads TE curve shifts (royalties are part 2. shifts right of sellers costs) 3. falls, rises C. fall in price of Cs AN fall in cost of royalties TE 1. Both curves shift (see parts A & B). 2. shifts left, shifts right. 3. unambiguously falls. Effect on is ambiguous: The fall in demand reduces, the increase in supply increases

11 CHATER UMMARY 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 emand, which states that the quantity buyers demand of a good depends negatively on the good s price. CHATER 2 30 CHATER UMMARY Besides price, demand depends on buyers incomes, tastes, expectations, the prices of substitutes and complements, and # of buyers. If one of these factors changes, the curve shifts. The upward-sloping supply curve reflects the Law of upply, 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 curve. CHATER 4 31 CHATER UMMARY The intersection of and curves determine 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. CHATER

12 CHATER UMMARY 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. econd, 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. CHATER