Economics 221: Principles of Microeconomics Fall 2002 Capt Len Cabrera, Lessons 7-9: Introduction to Supply and Demand

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1 1 Economics 221: Principles of Microeconomics Fall 2002 Capt Len Cabrera, Lessons 7-9: Introduction to Supply and Demand New York City food delivery system - Feeds 10M people... enough food & right kinds of food "functions so seamlessly that it attracts virtually no notice" New York City's rental housing - City needs 20-40K new units each year to keep up with population growth Rate of new production is 6K Apartment houses are being demolished & vacant lots left behind Difference? housing relies on complex system of administrative rent regulations to allocate housing units; food allocation essentially in hands of market forces (supply & demand) "more than 90 percent of American professional economists believe that rent regulations like the ones implemented by New York City do more harm than good." Scarcity forces us to make tradeoffs... from lesson 2 ECONOMIC SYSTEMS Economic Systems - answers questions: 1. What (& how much) to produce? 2. How to produce? 3. For whom to produce? How to decide who gets it? ALLOCATION Lottery First come Market/Price Planner Force Share Need Main techniques for economic systems Price - market economy Voluntary exchange Consumers determine what Producers determine how Income depends on production (for whom) Prices are signals Plan - command or centrally planned economy Economic decisions made by government Planners decide what, how, and for whom

2 2 RESOURCE OWNERSHIP Government Ownership - state ownership of land & capital (socialism) Private Ownership - most resources owned privately (capitalism) Private State Market Market Capitalism North America Western Europe Asia (most of) Liberalization Plan/Command Privatization Command Socialism C. & E. Europe Former USSR China India Key Areas of Reform - Incentives - state ownership means lack of incentive for hard work & quality Privatization - convert state ownership of land & capital to private ownership; generates incentive for efficiency Informational Requirement - planned/command economy requires massive information collection in timely fashion Liberalization - move from state control of markets & prices to free markets; requires free prices, free entry, & free trade ** All covered in The Commanding Heights by Daniel Yergin ** Market - all the buyers and sellers of a good Smith & other early economists (including Karl Marx) thought market price of a good was determined by its cost of production Stanley Jevons (19th century) tried to explain price by focusing on value people derive from consuming goods & services Alfred Marshal (19th century) among first to show clearly how costs and value interact to determine both prevailing market price for good & amount bought and sold SUPPLY Q S = f (P; other variables) Supply Curve - schedule (table) or graph that shows how much sellers together would be willing to sell at each price; more detailed version: 1. Firm has resources & technology to produce it (possible... can afford it) 2. Can profit from producing it (want it) 3. Made a definite plan to price & sell it (will do it) Assumption - willing to sell as long as price received is sufficient to cover opportunity costs Upward-Sloping - higher price allows higher cost producers to enter market; also increasing (short run) costs of production

3 3 DEMAND Q D = f (P; other variables) Demand Curve - schedule or graph that shows how much buyers wish to buy at various prices; more detailed: 1. Want it 2. Can afford it 3. Definite plan to buy it Downward-Sloping - Substitution Effect - switch to relatively less expensive goods Income Effect - can't afford as many EQUILIBRIUM Q S = Q D Equilibrium - stable, balanced, unchanging situation where all forces at work within the system are canceled by others Market Equilibrium - no participant has any reason to alter his/her behavior so there's no tendency for production or prices to change Equilibrium Price (P*) - price where supply and demand curves intersect Equilibrium Quantity (Q*) - quantity where supply and demand curves intersect PRICE AS CORRECTING MECHANISM Surplus - excess supply; price above equilibrium; sellers have extra goods on shelves and lower prices to sell them Shortage - excess demand; price below equilibrium; buyers have incentive to offer higher price to obtain good

4 4 "Free markets have an automatic tendency to eliminate excess supply and excess demand." BUT, equilibrium doesn't mean everyone gets what they want (poor may not be able to afford equilibrium price) SO, legislators try to protect consumers, usually by mandating price: "Social reformers often fail to understand, however, that the laws of supply and demand cannot simply be repealed by an act of the legislature. And when legislators attempt to prevent markets from reaching their equilibrium prices and quantities, they almost always do more harm than good." Price Ceiling - maximum allowable price specified by law (e.g., rent controls; limits of price of gasoline or energy); price too low so consumers want to much... result in shortages Other Problems: Owners spend less on maintenance or ingredients Other ways to account for price ("finder's fees", "key deposits", blank market, etc.) Misallocations (preferential treatment, widow stays in large apartment) Price Floors - minimum allowable price specified by law (e.g., price supports; minimum wage); price too high so consumers don t want as much... result in surpluses Economist Way - subsidize poor through additional income, BUT careful not to weaken others' incentives to fend for themselves *** Review article *** EFFICIENCY Market Equilibrium - has advantages: Information - Price conveys important information to potential suppliers about value potential demanders plan on the good Efficiency - maximum possible economic surplus ** if supply & demand curves fully reflect costs & benefits associated with production & consumption... leads to externalities failure Equilibrium - market in equilibrium leaves no unexploited opportunities for individuals but may not exploit all gains achievable through collective action CHANGES Change in Quantity Demanded - movement along demand curve in response to change in price Change in Demand - shift of entire demand curve demand increasing curve shifts to the right demand decreasing curves shifts to the left

5 5 Non-Price Determinants of Demand - (PEPIP) Prices of Related Goods - quantity demanded depends on price of substitutes & complements Substitute - good that can be used in place of another good (e.g., bus ride vs. train ride; hamburger vs. hotdog; CD vs. tape); if price of substitute for a good increases, quantity demanded for substitute decreases (move up on curve) & demand for original good increases (curve shifts to right) Compliment - good that's used in conjunction with another good (e.g., hamburger & fries; spaghetti & sauce; tapes & walkmans); if price of complement rises, quantity demanded rises (move down on curve) & demand for original good increases (curve shifts to right) Expected Future Prices - if price of a good is expected to rise in future & if the good can be stored, current demand for good increases (curve shifts to right) Population - larger population means greater demand for all goods & services Demographics - larger percentage of population in certain age groups, affects demand for certain goods (e.g., teens CDs, fast food; college; 70+ nursing homes) Income - Normal Good - one for which demand increases as income increases Inferior Good - one for which demand decreases as income increases (e.g., Ramen, 75% ground beef, bus tickets) Preferences - individual's attitudes toward goods & services Quantity Demanded (point on curve) Price Price Price Demand (new curve) Related Goods Price of substitute Price of substitute Price of complement Price of complement Expected Future Price Expected to Expected to Population Population Population Income Income Income Preferences Change in Quantity Supplied - movement along supply curve in response to change in price Change in Supply - shift of entire supply curve supply increasing curve shifts down or right supply decreasing curves shifts up or left Non-Price Determinants of Demand - (PPETS) Prices of Productive Resources - inputs to production have direct impact on marginal costs so quantity supplied decreases if prices increases (minimum supply price) Prices of Related Goods Produced - Substitutes in Production - goods that can be produced using the same resources but can't be produced at the same time (e.g., blank tapes vs. recorded tapes); price of one rises means supply of other decreases Compliments in Production - goods that must be produced together (e.g., beef & cowhide); if price of one increases, supply of other increases Expected Future Prices - if price will rise in future, return from selling good in future is higher than it is in present so current supply decreases

6 6 Technology - new technologies create new products & lower costs of producing existing products Number of Suppliers - larger number of suppliers producing same good means greater supply of that good Quantity Supplied (point on curve) Price Price Price Supply (new curve) Prices of Inputs Price of inputs Price of inputs Related Goods Price of substitute Price of substitute Price of compliment Price of compliment Expected Future Price Expected to Expected to Technology Tech advances Suppliers # suppliers # suppliers Double Shift Problem S & D ** Order doesn't matter. 1. S means P & Q 2. D means P Overall: P & Q? (don t' know relative changes) Key: Track each step w/ arrows; if arrows go same way, that's result; opposite directions means indeterminate P P 1 P 2 P 3 D' S D S' Q 1 Q 2 Q 3 Q

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