Econ 1000 Lecture 2 Mod2

1. Econ 1000 Lecture 2Mod2 C.L. Mattoli (C) Red Hill Capital Corp. 2008

2. This week • Mod 2, part1 • Chapter 3 (C) Red Hill Capital Corp. 2008

3. Learning objectives: Mod 2 On successful completion of this module (3 lectures), you should be able to: • Explain the concepts of demand, supply, and market equilibrium • Use the market modelto predict the direction of change in prices and quantities caused by changes in the market-place, and by policy changes • Explain the concept of market failureand discuss causes of such failure • Explain the concept of elasticity • Calculate and interpret price, income and cross-price elasticity of demand • Calculate and interpret price elasticity of supply. (C) Red Hill Capital Corp. 2008

4. This week • Supply • Demand • Market interaction of supply and demand. • Market equilibrium (C) Red Hill Capital Corp. 2008

5. Demand (C) Red Hill Capital Corp. 2008

6. Demand • We refer to concepts in economics as tools: demand is one of those tools. • Demand for goods and services in a capitalist economy displays a high degree of consumer sovereignty. • Consumer sovereignty means that consumers have freedom to choose without coercion from business or government. • The law of demand states that the quantity demanded has an inverse relation to price. (C) Red Hill Capital Corp. 2008

7. Behavior and demand • The law of demand can be derived from behavioral first principles. • The economic word for satisfaction is utility. • The behavioral starting point is the law of decreasing marginal utility. The first piece of cake tastes so good, the second piece is pretty good, but you start to appreciate cake less by the third or fourth piece. • From decreasing marginal utility flows the law of demand: people will purchase more, only if the price is less, ceteris paribus. (C) Red Hill Capital Corp. 2008

8. Demand schedules (curves) • In order to find the total demand for a good or service, we begin at the bottom with individuals. • The whole is the sum of the parts, so we begin with individual demand schedules and sum them up to get total aggregate demand. • A demand schedule is a summary of buying intentions. (C) Red Hill Capital Corp. 2008

9. Demand schedules (curves) • We can construct demand schedules only after we introduce a price variable. Then, the demand schedule will show how many units of something that a buyer would be willing to purchase at a given price. • Contrary to mathematical convention, wherein the dependent variable is always on the vertical axis, in economics, the dependent variable is sometimes displayed on the horizontal axis, as in this case demand. • On the next slide we show Pete’s demand for burgers. (C) Red Hill Capital Corp. 2008

10. Peter’s Demand Schedule • Pete’s demand is inversely related to price. • He will buy only 1 burger per week, if the price is $5.50 per burger. • He will buy 9, if the price drops to $1.50 • Note: ceteris paribus applies to the schedule. Other things can also affect demand, in addition to price. (C) Red Hill Capital Corp. 2008

11. Aggregate (Market) Demand • An individual demand schedule is composed of prices that a person thinks he or she would buy at given prices: they are buying intentions. • Then, to find total aggregated demand for the whole market, which is simply the aggregate of whatever aggregate we are looking at, we simply add up all of the intentions of the participants. • For example, a company might hire a market research firm to survey a large number of people in a particular area of the city or the country by having them fill out questionnaires that ask how many units of a product they would purchase at various prices. (C) Red Hill Capital Corp. 2008

12. Tabular Aggregate Demand: Add Columns • Once we have demand schedules for all of the members of a society, we can find aggregate demand by adding up the individual demands. (C) Red Hill Capital Corp. 2008

13. Market aggregate demand: an example of graph addition • We can also add the graphs, either by adding the graphical information, itself, or by making a table, adding the table information, and, then, graphing that. + + = (C) Red Hill Capital Corp. 2008

14. Other determinants of demand • Although price is one variable in determining demand, it is not the only variable. That is why we used the ceteris paribus phrase in describing Pete’s demand in the previous slide. • All other determinants of demand are referred to as non-price determinants. • Some major non-price determinants of demand (NPDD) include: 1) the number of market participants, 2) tastes and preferences, 3) incomes, 4)expectations about any number of things, and 5) prices of somehow-related goods. (C) Red Hill Capital Corp. 2008

15. A Lesson in Economic Language • What we have been discussing, so far, in the language of economics, is: changes in quantity demanded, which result solely from changes in price. • Thus, change in quantity demanded means moving along a stationary fixed demand curve, like those shown in previous slides, ceteris paribus. (C) Red Hill Capital Corp. 2008

16. Demand & Opportunity Costs • Demand involves opportunity costs. • People can buy and use only so many things. • Thus, in choosing to buy some, they give up buying others. • What they give up is the opportunity cost of what they buy. (C) Red Hill Capital Corp. 2008

17. A Lesson in Economic Language • A change in demand refers to a change of the whole demand curve to a new demand curve. Such changes in demand come from changesin the non-price determinants of demand. • We illustrate these concepts in the next slide. (C) Red Hill Capital Corp. 2008

18. Demand Changes Illustrated • We show cases of changes in quantity demanded and changes in demand, below. Causal chain Causal chain Change in demand Change in non-price Decrease in price Increase in quantity demanded P P D1 D2 A B Quantity demanded (C) Red Hill Capital Corp. 2008

19. Non-Price Determinants of Demand (C) Red Hill Capital Corp. 2008

20. Intro • To get downward-sloping demand we assumed everything else was held constant (ceteris paribus). • For example, if the price of Pepsi falls, but the price of coca cola falls faster, will demand for Pepsi really increase? • So, we take a look at what happens to the whole demand curve if other things, beyond the price of the good, change. (C) Red Hill Capital Corp. 2008

21. Number of buyers • Looking back at our demand addition in previous slides, we understand that adding buyers to a market, e.g., an increase in population, will shift the demand curve to the right. • A decrease in buyers, e.g., a decrease in population, in the market will shift the demand curve to the left. (C) Red Hill Capital Corp. 2008

22. Number of buyers • The market for a good or service might include both domestic and foreign buyers. • Then, for example, if China had restrictions on CD’s imported from the US and suddenly removed the restrictions, the market (number of buyers) for US CD’s would increase and the demand curve would shift to the right. (C) Red Hill Capital Corp. 2008

23. Tastes and preferences • Even though there is consumer sovereignty, we understand that what people will demand (consumer preference) is affected by fads, fashions, new products, and advertising. • Scooters were very “in” with children in the 1950’s. Then, cool bicycles took over in the 1960’s thru the 1990’s. (C) Red Hill Capital Corp. 2008

24. Tastes and preferences • Scooters became cool again in the early 2000’s when they became chrome-plated with break-down joints. • Pointy-toed women’s shoes were very “in” in the beginning of this century, but they have since become “out”. • Even though people have free choice, they are affected by advertising and other people’s opinions. (C) Red Hill Capital Corp. 2008

25. Income • To look at the affect of income on demand, economics, first, divides goods into 2 categories: 1) normal goods and 2) inferior goods. • Normal ‘goods’ are any good or service for which there is a direct relationship between changes in income and in demand. Thus, an increase in income causes demand to rise at all prices: demand curve shifts to the right. Examples are vacations, new cars, dinner at expensive restaurants. (C) Red Hill Capital Corp. 2008

26. Income • Inferior goods are goods and services for which there is an inverse relationship between changes in income and in demand. Examples are used cars, cheap jewelry, and rides on the bus. If you have a higher income, you will prefer a new car instead of a used one, gold jewelry instead of tin, and taxicabs instead of the bus. • Some textbooks use categories: luxuries and necessities. (C) Red Hill Capital Corp. 2008

27. Expectations of buyers • What would happen to present demand, if buyers expected future changes in: price, income, taxes, or other factors? • Suppose bad weather ruins the summer rice crop, will consumers expect to pay higher prices and bid up prices? They might increase quantity demanded at the same time because they expect a future shortage. • Suppose consumers expect prices to decrease? • Expectations can increase or decreasedemand. (C) Red Hill Capital Corp. 2008

28. Prices of related goods (or services) • Demand for a particular good can be affected by the prices of other goods in one of several possible ways, which are related to it in some way. • The first type of related good is called a substitute. • Substitute goods compete directly with a good for consumer purchases. (C) Red Hill Capital Corp. 2008

29. Prices of related goods (or services) • For example, a rise in the price of Pepsi might cause a rise in demand for Coca cola. • Complementary goods are jointly consumed. • For example, if the price of DVD players falls, there will be more DVD players purchased and the demand for DVD’s will increase. (C) Red Hill Capital Corp. 2008

30. Exercises • What will be the affect for demand of used cars, if, ceteris paribus, the price of new cars increases by $5,000. • If the price of popcorn at movie theaters decreases, what might you expect to happen to the demand for soft drinks? • Is Sprite a substitute or a complementary product for Coke? (C) Red Hill Capital Corp. 2008

31. Supply (C) Red Hill Capital Corp. 2008

32. Supply • In economics supply is the relationship between possible prices of goods and services and the quantity supplied in the law of supply. • The law of supply says that there is a direct relationship between the quantity of a good or service that a supplier is willing to supply, in a fixed time frame, and the price, ceteris paribus. • The relationship is underpinned by increasing opportunity costs. (C) Red Hill Capital Corp. 2008

33. Supply of one supplier • Supply is directly related to price. • The Supplier is willing to supply 220 burgers at $2/burger and 340 at $5/burger. • Note: ceteris paribus applies to the schedule. Other things can also affect supply, in addition to price. (C) Red Hill Capital Corp. 2008

34. Opportunity costs, Consumer Sovereignty, and the law of supply • We looked at opportunity costs when we studied the production possibilities frontier (PPF). • Therein, we learned that one good or service could be produced in higher quantities only by sacrificing the opportunity to produce the other, in the example of only two choices. (C) Red Hill Capital Corp. 2008

35. Opportunity costs, Consumer Sovereignty, and the law of supply • Consider, then, a company that has a plant that produces cloth goods, and that it has determined that its maximal mix of producing parachutes or towels is 70% towels and 30% parachutes. • To change their mix, one way or the other, they will incur opportunity costs equal to the amount of the one they sacrifice to produce more of the other. • Moreover, we have seen that opportunity costs are normally increasing. (C) Red Hill Capital Corp. 2008

36. Opportunity costs, Consumer Sovereignty, and the law of supply • Thus, in order to be induced to produce more of one, parachutes or towels, there must be an incentive: a higher price, which will overcome the increased opportunity costs of producing less of the other, ceteris paribus. • Consumer sovereignty plays a roll in this process. If consumers want more of a certain good or service, they will have to bribe producers to producer more: they will have to offer a higher price to encourage producers. (C) Red Hill Capital Corp. 2008

37. Exercise: Law of supply & university degrees • There was an increase in university applications to study internet technology with the boom in IT in the 1990’s, and a decrease after the IT fad went bust. • Similar enrolment trends have been seen, for example, in earth sciences. Enrolments increase when there is a boom in the minerals industries and decline dramatically when the boom is over. • Can you use the law of supply to explain university enrolments as described above? (C) Red Hill Capital Corp. 2008

38. Exercise answer • When students make a choice of which they degree to pursue at university they are looking to obtain qualifications that will allow them to supply their services to an industry that will welcome them with a quick job at a high pay. • Thus, the prospects for easy employment at a good salary increase the supply of students pursuing certain degrees, like USQ and accounting. • Therefore, the law of supply can be used to explain the phenomenon. (C) Red Hill Capital Corp. 2008

39. Market supply • We can find market supply in a similar manner as we found market demand: by summing up the quantities that would be supplied (are willing to sell) by the various suppliers in the market, which is the totality of suppliers and demanders, at various prices. • We can define the market in any way we like. We simply must be careful to include all the suppliers that belong in what we are defining as “the market”, no more, no less. • “The market” might be a section of a city, a city, a state, a region, a country, or the whole world. • We show the supply curve for the city market of burgers, of which the single supplier in the preceding slide is a part, in the next slide. (C) Red Hill Capital Corp. 2008

40. Supply of hamburgers in one city • Quantities supplied each by each supplier are summed for each price. • Suppliers are willing to supply 700 burgers at $2 and 1400 at $5/burger. • Note: ceteris paribus applies to the schedule. Other things can also affect supply, in addition to price. (C) Red Hill Capital Corp. 2008

41. Graphical summed supply of hamburgers • Like in the case of demand, we can sum the various quantities supplied by suppliers in the market in table form and graph it or directly sum the graphs + + = (C) Red Hill Capital Corp. 2008

42. Again, a language lesson • A change in quantity supplied is a move along a given supply curve, like those shown in previous slides. At a higher price, suppliers will offer larger quantities for sale. • Cause and effect: effect of price rise is increase in quantity supplied. • In contradistinction, a change in supply is a shift of the whole supply curve. A decrease in supply is a shift to the left. An increase in supply is a shift to the right. • These happen when ceteris paribus is lifted and non-price factors come into play. (C) Red Hill Capital Corp. 2008

43. Pictorial Supply Changes • We show cases of changes in quantity supplied and changes in supply, below. Causal chain Causal chain Increase in supply Change in non-price Increase in price Increase in quantity supplied P P S1 S2 B A Quantity Supplied (C) Red Hill Capital Corp. 2008

44. Non-price factors of supply • In addition to price, as was also the case with demand, non-price factors can affect supply. Major factors include: • We cover each, in turn (C) Red Hill Capital Corp. 2008

45. 1. Number of suppliers (sellers) • We have defined the market for supply as the sum of suppliers in the market, and we have demonstrated in our beginning study of supply that the quantity supplied will increase at every price as more sellers are added to the market. • Similarly, if suppliers exit the market for one reason or another, the supply curve will shift to the left. (C) Red Hill Capital Corp. 2008

46. 1. Number of suppliers (sellers) • Addition and disappearance of suppliers can happen for obvious or subtle reasons. • A factory can shift its own production from one good to another. • Barriers to trade can be erected or taken down by a country. • Disease can destroy a farmer’s crop. (C) Red Hill Capital Corp. 2008

47. Technological changes • Technological development has always made it possible to produce more goods more efficiently and cheaply. • Horses and oxen tied to a plough made it easier for farmers to plant crops. • PC’s allow workers to design things and make calculations more quickly and accurately. • Robots make automobiles more quickly and with more precision than people. • Technological developments are continually allowing supply curves to be shifted out. (C) Red Hill Capital Corp. 2008

48. Prices of inputs • Natural resources, raw materials, semi-finished goods, labor, capital, and entrepreneurship are all required as input to produce the output of supply. • Increases and decreases of any price of inputs will affect the prices that suppliers need to charge for output, and supply curves will be shifted. • Suppose that automobile workers sign a contract to increase their hourly wages. Then, the price that automobile companies must charge for cars will increase and the supply curve will be shifted upward (in the convention of the book: left). (C) Red Hill Capital Corp. 2008

49. Taxes and subsidies • Taxes are another type of expense that companies have in their businesses. • If a company is taxed more heavily, it will want to pass that extra cost on to the consumer. Consequently, the supply curve will shift upward, and the same quantities supplied will all be at higher prices. • Subsidies to industries can have the opposite affect. If a government pays subsidies to farmers who produce corn, the supply of corn will increase. (C) Red Hill Capital Corp. 2008

50. Expectations of producers • Producer expectations can also affect the supply curve. • Producers are doing business to make money, and they will act in their own self-interest. • For example, if a particularly cold winter is expected, there will be a high expected demand for woolen sweater, scarves, and coats. The response from suppliers of wool may, therefore, be to restrict, not to increase, supply, in order to get higher prices. (C) Red Hill Capital Corp. 2008