Week 2, Supply and Demand

Simultaneous Shifts: Effects

1) If both supply and demand increase: Price depends and quanity increases 2) If demand increase but supply decreases: price increases and demand depends 3) if demand and supply both decrease: price depends and quantity decreases 4) if demand demand decreases but supply increases: price decreases and quantity depends

Causes of Shifts in Demand

1) Prices of complements/substitutes When the price of a complement falls, demand shifts right, causing equilibrium price and quantity to rise. When the price of a substitute falls, demand shifts left, causing equilibrium price and quantity to fall. 2) Personal Income --Normal good: demand increases/decreases when income of buyers increases/decreases --Inferior good: demand decreases/increases when income of buyer increase/decreases 3) preference 4)population (size of market) 5) Expectations about future prices

Incentive Principle related to Market Equilibrium

An extraordinary feature of private markets for goods and services is their automatic tendency to gravitate toward their respective equilibrium prices and quantities. This tendency is a simple consequence of the Incentive Principle. The mechanisms by which the adjustment happens are implicit in our definitions of excess supply and excess demand. The upshot is that price has a tendency to gravitate to its equilibrium level under conditions of either excess supply or excess demand. And when price reaches its equilibrium level, both buyers and sellers are satisfied in the technical sense of being able to buy or sell precisely the amounts of their choosing.

Reservation Price

Another reason the demand curve slopes downward is that consumers differ in terms of how much they're willing to pay for the good. The Cost-Benefit Principle tells us that a given person will buy the good if the benefit he expects to receive from it exceeds its cost. The benefit is the buyer's reservation price, the highest dollar amount he'd be willing to pay for the good. The cost of the good is the actual amount that the buyer actually must pay for it, which is the market price of the good. In most markets, different buyers have different reservation prices. So, when the good sells for a high price, it will satisfy the cost-benefit test for fewer buyers than when it sells for a lower price.

Buyers and Sellers in Markets

Buyers motivation is to benefit from good sellers motivation is to make a profit Buyers and sellers jointly determine outcome market price balances the two forces (value buyers derive from the good and cost to produce one more unti of the good)

Why government intervention with market equilibrium doesnt work

Ex/ Rent control: If market equilibrium is $1,600 per month and gov says max price (Price ceiling) is $800, landlords will not be willing to rent out as many apartments and supply will drop. This is because it is more beneficial for them to sell or turn into condos. Conversely, that price will make demand increase for apartments. Therefore owners realize they don't need to spend as much on maintenance or be a good landlord. Other misallocations also result due to incorrect incentives. Roommates who hate eachother stay together, people don't reenter housing market, people can't leave apartment ever. Better alternatives to gov intervention 1) give the poor additional income and let them decide for themselves how to spend it. For far less than the waste caused by price controls, the government could afford generous subsidies to the wages of the working poor and could sponsor public-service employment for those who are unable to find jobs in the private sector.

Buyer/Seller surplus

In economics we assume that all exchange is purely voluntary. This means that a transaction cannot take place unless the buyer's reservation price for the good exceeds the seller's reservation price. When that condition is met and a transaction takes place, both parties receive an economic surplus. The buyer's surplus from the transaction is the difference between his reservation price and the price he actually pays. The seller's surplus is the difference between the price she receives and her reservation price. The total surplus from the transaction is the sum of the buyer's surplus and the seller's surplus. It is also equal to the difference between the buyer's reservation price and the seller's reservation price. Suppose there is a potential buyer whose reservation price for an additional slice of pizza is $4 and a potential seller whose reservation price is only $2. If this buyer purchases a slice of pizza from this seller for $3, the total surplus generated by this exchange is $4 − $2 = $2, of which $4 − $3 = $1 is the buyer's surplus and $3 − $2 = $1 is the seller's surplus.

Economic Efficiency and the Efficiency Principle

When the quantity of a good is less than the socially optimal quantity, boosting its production will increase total economic surplus. By the same token, when the quantity of a good exceeds the socially optimal quantity, reducing its production will increase total economic surplus. Economic efficiency, or efficiency, occurs when all goods and services in the economy are produced and consumed at their respective socially optimal levels. The Efficiency Principle: Efficiency is an important social goal because when the economic pie grows larger, everyone can have a larger slice.

What do economists believe is the best way to allocate scarce resources

free markets

What determines cost of a good

it is a combination of the cost of production and the value derived from it. Not just one or the other.

The market

the market for any good consists of all buyers and sellers of that good

Recap: Markets and Social Welfare

RECAP MARKETS AND SOCIAL WELFARE When the supply and demand curves for a good reflect all significant costs and benefits associated with the production and consumption of that good, the market equilibrium will result in the largest possible economic surplus. But if people other than buyers benefit from the good, or if people other than sellers bear costs because of it, market equilibrium need not result in the largest possible economic surplus.

Change vs. Shifts in Supply

- A change in quantity supplied results from a change in the price of a good. When price goes up, quantity supplied rises and vise versa --not a shift, nothing about sellers changes -If sellers are willing to sell less at every price, the entire supply curve shifts to the left. Key is that something has changed about sellers.

Change vs shift in demand curve

-A change in quantity demanded results from a change in the price of a good --nothing has changed about buyers -if buyers are willing to buy more at every price, the entire demand curve shifts to the right (change in demand vs change in qty demanded) --key is that something has changed about buyers

What do economists believe about rent control

-that it does more harm than good, and that it is a violation of free market economics

4 types of supply/demand shifts

1) Increase in demand: Equilibrium Price and quantity increase 2) Decrease in demand: Equilibrium price and quantity decrease 3) Increase in Supply: Equilibrium price decreases and quantity increases 4) Decrease in Supply: Equilibrium price increases and quantity decreases

Causes of supply Shifts

1) input prices When input prices rise, supply shifts left, causing equilibrium price to rise and equilibrium quantity to fall. 2) production technology When a new technology reduces the cost of production, supply shifts right, causing equilibrium price to fall and equilibrium quantity to rise. 3) number of sellers in the market 4) Expectations about future prices When a new technology reduces the cost of production, supply shifts right, causing equilibrium price to fall and equilibrium quantity to rise.

Market Equilibrium

A market is in equilibrium when there is no tendency for price or quantity to change from their current levels -quantity supplied equals quantity demanded where the Demand and supply curve intersect --nothing tendency for p or q to change if nothing changes about buyers or sellers -Equilibrium price and equilibrium quantity --the values of price and quantity for which quantity supplied and quantity demanded are equal -the reason the equilibrium is stable has to do with the incentive principle --if prices above equilibrium price, demand will go down and buyers will leave market...leads to excess supply since people aren't buying. if sellers aren't selling, they are incentivized to lower price so they can bring more buyers into market. --same thing happens if price is too low. Demand will exceed supply, sellers incentivized to raise prices. -invisible hand pushes prices to equilibrium -when inventory is too low, prices rise and vice versa In general, a system is in equilibrium when all forces at work within the system are canceled by others, resulting in a balanced or unchanging situation.

Substitution and Income Effect

Changes in Q come from -the Substitution Effect: When price of a given good drops and therefor becomes more attractive than whatever else that person was doing/spending money on, and therefor they switch to that good -the income Effect: When prices fall, people have more purchasing power

Excess Supply

Conversely, suppose that the price of pizza in our Chicago market were less than the equilibrium price—say, $2 per slice. As shown in Figure 3.5, buyers want to buy 16,000 slices per day at that price, whereas sellers want to sell only 8,000. And since sellers cannot be forced to sell pizza against their wishes, this time it is the buyers who end up being frustrated. At a price of $2 per slice in this example, they experience an excess demand of 8,000 slices per day. Excess Supply.When price exceeds equilibrium price, there is excess supply, or surplus, the difference between quantity supplied and quantity demanded.

Excess Deman

Excess Demand.When price lies below equilibrium price, there is excess demand, the difference between quantity demanded and quantity supplied.

Recap: Factors that shift supply and demand

Factors that cause an increase (rightward or upward shift) in demand: A decrease in the price of complements to the good or service. An increase in the price of substitutes for the good or service. An increase in income (for a normal good). An increased preference by demanders for the good or service. An increase in the population of potential buyers. An expectation of higher prices in the future. When these factors move in the opposite direction, demand will shift left. Factors that cause an increase (rightward or downward shift) in supply: A decrease in the cost of materials, labor, or other inputs used in the production of the good or service. An improvement in technology that reduces the cost of producing the good or service. An improvement in the weather (especially for agricultural products). An increase in the number of suppliers. An expectation of lower prices in the future. When these factors move in the opposite direction, supply will shift left.

When Markets are out of equilibrium

In some cases, market may be out of equilibrium -free markets like US should always be at equilibrium -prices held above or below equilibrium, artificially (gov policy) -minimum price above equilibrium is the "price floor" -MAx price below equilibrium is the "price ceiling" (ex/ rent control)

Recap: Market Equilibrium

Market equilibrium, the situation in which all buyers and sellers are satisfied with their respective quantities at the market price, occurs at the intersection of the supply and demand curves. The corresponding price and quantity are called the equilibrium price and the equilibrium quantity. Unless prevented by regulation, prices and quantities are driven toward their equilibrium values by the actions of buyers and sellers. If the price is initially too high, so that there is excess supply, frustrated sellers will cut their price in order to sell more. If the price is initially too low, so that there is excess demand, competition among buyers drives the price upward. This process continues until equilibrium is reached.

Supply Curve

Supply Curve is a schedule/graph showing the quantity of a good that sellers wish to sell at each price - Supply curve Slopes up (opposite of demand curve) --opportunity cost of selling increases at higher Q ---sellers must receive a higher price to make selling more of a product worthwhile ---that price will generally equal the opportunity cost of producing one more unit ---therefor slopes up -Summary: Supply curve represents the number of goods seller would want to sell at a given price, not necessarily the reality. As the price of a good goes up, the more of that good sellers want to produce and sell. This is because the greater they can sell these products for, the more likely to exceed the opportunity cost. -Also important: As production goes up, the cost of producing more are more expensive. Basically, if you have to produce more than your normal amount to meet demand, those additional units are more expensive to produce, and therefor price goes up...As prices go up, increasingly higher cost production is brought into the market

Demand Curve

The Demand curve -schedule or graph that tells us the quantity of a good that buyers wish to buy at each price --Remember we are talking about market as a whole, meaning that quantity is the overall amount sold to the market, not to one individual -negative slope --consumers buy less at higher prices --consumers buy more at lower prices -Summary: price on y axis, Quantity on x axis, line of inputs represents demand Buyers value goods differently Reservation price: the highest price an individual is willing to pay for a good -demand curve captures reservation price for market as a whole... everyone has their reservation price for a product, as price gets lower, more peoples reservation price meets or exceeds the market price, and therefore a higher quantity of goods are sold. Demand reflects the entire market, not one consumer -lower P brings more buyers into market -Lower P causes existing buyers to buy more Changes in Q come from -the Substitution Effect: When price of a given good drops and therefor becomes more attractive than whatever else that person was doing/spending money on, and therefor they switch to that good -the income Effect: When prices fall, people have more purchasing power

Low Hanging fruit principle

The fact that the supply curve slopes upward may be seen as a consequence of the Low-Hanging-Fruit Principle, discussed in the chapter on comparative advantage. This principle tells us that as we expand the production of pizza, we turn first to those whose opportunity cost of producing pizza is lowest, and only then to others with a higher opportunity cost.

Supply and Demand Recap

The market for a good consists of the actual and potential buyers and sellers of that good. For any given price, the demand curve shows the quantity that demanders would be willing to buy and the supply curve shows the quantity that suppliers of the good would be willing to sell. Suppliers are willing to sell more at higher prices (supply curves slope upward) and demanders are willing to buy less at higher prices (demand curves slope downward).

Sellers reservation price

The seller's reservation price for selling an additional unit of a good is her marginal cost of producing that good. It is the smallest dollar amount for which she would not be worse off if she sold an additional unit.

socially optimal quantity

The socially optimal quantity of any good is the quantity that maximizes the total economic surplus that results from producing and consuming the good. From the Cost-Benefit Principle, we know that we should keep expanding production of the good as long as its marginal benefit is at least as great as its marginal cost. This means that the socially optimal quantity is that level for which the marginal cost and marginal benefit of the good are the same.

Cash on the table

When people have failed to take advantage of all mutually beneficial exchanges, we often say that there's "cash on the table"—the economist's metaphor for unexploited opportunities.