T ( P ( ) * FA F D A S

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1 Supply and Demand Basics Law of Supply Law of Demand Equilibrium Key Topics Demand Supply Equilibrium (shortage/surplus) Floor/Ceiling Elasticity Indifference Curves Utility Physical Product (Supply Side) Cost Curves (Supply Side) Demand 1

2 Determinants of Demand Factors other than Price Income Tastes (Preferences) *FADS Prices of Related Goods Substitutes or Complements Expectations Number of Buyer International Effects 2

3 Supply Determinants of Supply Factors other than Price Price of Resources (inputs) Land, Labor, Capital, Entrepreneurship Technology Productivity Expectations Number of Producers Prices of Related Goods/Services International Effects Supply Change/Shift 3

4 Increase in Supply General Equilibrium Changes in Eq 4

5 Surplus Shortage Price Floor 5

6 Price Ceiling Supply and Demand A Theory of Price The theory of supply and demand is a theory of price and output in "highly competitive" markets. Adam Smith had argued that each good or service has a "natural price." If the price (of beer, for example), were above the natural price, then more resources would be attracted into the trade (brewing, in the example), and the price would return to its "natural" level. Conversely if the price began below its "natural" level. Supply and Demand Two Sides Like a good controversy, every market has two sides. In this case, the two sides are (obviously?) buyers and sellers. The buyers are the "demand side" of the market. Sellers are the "supply side" of the market. Alfred Marshall compared the supply and demand sides to the two blades of scissors -- one won't cut. You have to have both. 6

7 Equilibrium of Supply and Demand In economic theory, the interaction of supply and demand is understood as equilibrium. Market "equilibrium" exists when the price is high enough so that the quantity supplied just equals the quantity demanded. In a diagram, the "equilibrium" price is the price at which the demand and supply curves cross. The corresponding quantity is the quantity that would be traded in a market equilibrium. Elasticity Cross-Price Elasticity The Cross-Price Elasticity of Demand measures the rate of response of quantity demanded of one good, due to a price change of another good. If two goods are substitutes, we should expect to see consumers purchase more of one good when the price of its substitute increases. 7

8 Complements if the two goods are complements, we should see a price rise in one good cause the demand for both goods to fall. Your course may use the more complicated Arc Cross-Price Elasticity of Demand formula. Calculating the Cross-Price Elasticity of Demand CPEoD = (% Change in Quantity Demand for Good X)/ (% Change in Price for Good Y) Income Elasticity The Income Elasticity of Demand measures the rate of response of quantity demand due to a raise (or lowering) in a consumers income. 8

9 IEoD = Formula (% Change in Quantity Demanded)/ (% Change in Income) Indifference Curves Indifferent curves The aim of indifference curve analysis is to analyze how a rational consumer chooses between two goods. In other words, how the change in the wage rate will affect the choice between leisure time and work time. Indifference analysis combines two concepts; indifference curves and budget lines (constraints) The indifference curve An indifference curve is a line that shows all the possible combinations of two goods between which a person is indifferent. In other words, it is a line that shows the consumption of different combinations of two goods that will give the same utility (satisfaction) to the person. For instance, in Figure 1 the indifference curve is I1. A person would receive the same utility (satisfaction) from consuming 4 hours of work and 6 hours of leisure, as they would if they consumed 7 hours of work and 3 hours of leisure. Figure 1: An indifference curve for work and leisure 9

10 Work vs. Leisure Shapes The shape of the indifference curve Figure 1 highlights that the shape of the indifference curve is not a straight line. It is conventional to draw the curve as bowed. This is due to the concept of the diminishing marginal rate of substitution between the two goods. The marginal rate of substitution is the amount of one good (i.e. work) that has to be given up if the consumer is to obtain one extra unit of the other good (leisure). More Indifference Curves The marginal rate of substitution (MRS) = change in good X / change in good Y The relationship between marginal utility and the marginal rate of substitution is often summarised with the following equation; MRS = Mux / Muy It is possible to draw more than one indifference curve on the same diagram. If this occurs then it is termed an indifference curve map (Figure 2). 10

11 Effects of Change The substitution effect The substitution effect is when the consumer switches consumption patterns due to the price change alone but remains on the same indifference curve. To identify the substitution effect a new budget line needs to be constructed. The budget line B1* is added, this budget line needs to be parallel with the budget line B2 and tangential to I1. The income effect The income effect highlights how consumption will change due to the consumer having a change in purchasing power as a result of the price change. The higher price means the budget line is B2, hence the optimum consumption point is Q2. This point is on a lower indifference curve (I2). Multiple Curves Costs Chapter 22 11

12 Costs and Physical Product Production is simply the conversion of inputs into outputs Inefficient Efficient Cost/Ratio In economics, the cost-of-production theory of value is the theory that the price of an object is determined by the sum of the cost of the resources that went into making it. The cost can be composed of the cost of any of the factors of production including labor, capital, land, management, or even technology. Physical Product to Costs Physical Product = Output TPP = Total Output TC (Total Cost) = Total Cost for each Output ATC = Average Total Cost ATC = AFC (fixed) + AVC (variable) MC = Marginal Cost 12

13 Marginal Cost MARGINAL COST CURVE: A curve that graphically represents the relation between the marginal cost incurred by a firm in the short-run run product of a good or service and the quantity of output produced. This curve is constructed to capture the relation between marginal cost and the level of output, holding other variables like technology and resource prices constant. Three related curves are average total cost curve, average variable cost curve, and average fixed cost curve. Average Total Cost AVERAGE TOTAL COST: Total cost per unit of output, found by dividing total cost by the quantity of output. When compared with price (per unit revenue), average total cost (ATC) indicates the per unit profitability of a profit-maximizing firm. Average total cost is one of three average cost concepts important to short-run run production analysis. The other two are average fixed cost and average variable cost. A related concept is marginal cost. Average Variable Cost AVERAGE VARIABLE COST: Total variable cost per unit of output, found by dividing total variable cost by the quantity of output. When compared with price (per unit revenue), average variable cost (AVC) indicates whether or not a profit-maximizing firm should shut down production in the short run. Average variable cost is one of three average cost concepts important to short-run run production analysis. The other two are average total cost and average fixed cost. A related concept is marginal cost. 13

14 Average Fixed Costs AVERAGE FIXED COST: Total fixed cost per unit of output, found by dividing total fixed cost by the quantity of output. When compared with price (per unit revenue), average fixed cost (AFC) indicates whether or not a profit-maximizing firm should shutdown production in the short run. Average fixed cost is one of three average cost concepts important to short-run run production analysis. The other two are average total cost and average variable cost. A related concept is marginal cost. More Costs Costs, putting $ figures on resources used in production ATC (cost per unit of output) Total cost / # units output produced MC is change in costs / change in output Short run = Diminishing Marginal Returns All Cost curves have a U shape Even More Costs Variable Costs Costs that rise and fall as production Fixed Costs Costs that must be paid whether a firm produces or not 14

15 Short Run When there are fixed resources and fixed costs, the firm is operating in the short run. ATC is often referred to as SRATC Short Run (not shorter) In Economics, short-runrun refers to the decision-making time frame of a firm in which at least one factor of production is fixed. Costs which are fixed in the short-run run have no impact on a firms decisions. A generic firm can make three changes in the short-run: run: Increase production Decrease production Shut down In the short-run, run, a profit maximizing firm will: Increase production if marginal cost is less than price; Decrease production if marginal cost is greater than price; Continue producing if average variable cost is less than price, even if average total cost is greater than price; Shut down if average variable cost is greater than price. Thus, the fixed cost is the largest loss a firm can incur in the short-run. run. Long Run A firm can choose to relocate, build a new plant, or purchase additional capital only in the long run, or planning stage. LR decisions involve all SR situations All resources are variable DMR does not apply LRATC= lowest cost combination when all combination of resources are variable 15

16 Long Run (even longer) In economic models, the long run time frame assumes no fixed factors of production. Firms can enter or leave the marketplace, and the cost (and availability) of land, labor, raw materials, and capital goods can be assumed to vary. In contrast, in the short run time frame, certain factors are assumed to be fixed, because there is not sufficient time for them to change. This is related to the long run average cost (LRAC) curve, an important factor in microeconomic models. Producer Consumer Surplus Consumer Surplus 16

17 Consumer Surplus Cont Consumer surplus or Consumer's surplus (or in the plural Consumers' surplus) ) is the economic gain accruing to a consumer (or consumers) when they engage in trade. The gain is the difference between the price they are willing to pay (or reservation price) and the actual price. Producer Surplus The producer surplus is the amount that producers benefit by selling at a market price that is higher than they would be willing to sell for. Note that producer surplus flows through to the owners of the factors of production, unlike economic profit which is zero under perfect competition. 17

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