Ch. 3 - Supply and Demand

Economic Efficiency

A condition that occurs when all goods and services are produced and consumed at their respective socially optimal levels

Inferior Good

A good whose demand curve shifts leftward when the income of buyers increase and rightward when the incomes of buyers decrease

Normal Good

A good whose demand curve shifts rightward when the income of buyers increase and leftward when the incomes of buyers decrease

Supply Curve

A graph or schedule showing the quantity of a good that sellers wish to sell at each price

Equilibrium Principle

A market in equilibrium leaves no unexploited opportunities for individuals but may not exploit all gains achievable through collective action

Price Ceiling

A max. allowable price, specified by law -- EX: rent control

Change in the Quantity Demanded

A movement along the demand curve that occurs in response to a change in price

Change in the Quantity Supplied

A movement along the supply curve that occurs in response to a change in price

Demand Curve

A schedule or graph showing the quantity of a good that buyers wish to buy at each price

Change in Demand

A shift of the entire demand curve resulting from change in anything other than price

Change in Supply

A shift of the entire supply curve resulting form change in anything other than price

"Cash on the Table"

An economic metaphor for unexploited gains from exchange -- When people have failed to take advantage of all mutually beneficial exchanges

Horizontal Interpretation (S)

As price of a good goes up (down) quantity suppliers wish to sell will increase (decrease) -- Price determines the quantity supplied

Horizontal Interpretation (D)

As price of a good or service goes down, the quantity consumers wish to buy will increase (decrease) -- Price determines quantity demanded

Why does the demand curve slope downwards?

Demanders are willing to buy less at higher prices -- Assuming buyers differ in their reservation prices at higher prices, fewer consumers will pass the cost-benefit test and so fewer will buy

Efficiency Principle

Efficiency is an important social goal b/c when the economic pie grows larger, everyone can have a larger slice

Price Floor

Govt. Set minimum limit to a price -- It cannot fall any further -- Set above market price -- EX: minimum wage

Not Efficient or in equilibrium

If people other than buyers benefit from the good, or if people other than sellers bear costs b/c of it, market equilibrium will not result in the largest possible economic surplus

Market Price

In equilibrium, market price measures both the value of last unit sold and cost of resources required to produce it

Factors that shift demand

Income -- Taste -- Population -- Expectations -- Price of substitutes and complements

Market Equilibrium

Occurs in a market when all buyers and sellers are satisfied w/ their respective quantities at the market price

Problems w/ Central Planning

Planners can't carry out coordination of tasks of economy due to lack of necessary data & computational complications arising from interdependence b/w sectors

Excess Demand

Price lies below its equilibrium value -- Frustrated buyers are motivated to offer higher prices and the upward pressure on prices persists until equilibrium is reached

Excess Supply

Price of a good lies above its equilibrium value -- Motivates sellers to cut their prices and price continues to fall until equilibrium is reached

Positive Externality

Private MB less than social MB -- Too little is produced, so economic surplus will increase if production and consumption is increased -- EX: vaccinations

Negative Externality

Private MC less than social MC -- Too much is produced, so economic surplus will increase if production and and consumption is reduced -- EX: cigarette smoke

Consequences of Price Ceilings

Rent-control laws lead to severe housing shortages, black marketeering, and a rapid deterioration of the relationship b/w landlords and tenants -- Prices charge in illegal market are higher than those that would be charge in the free market to pay for illegally marketing the goods

Vertical Interpretation (S)

Sellers must receive a higher price to produce additional units of a good to cover the higher opportunity costs of each additional unit -- Quantity determines the marginal seller's reservation price

Why does the supply curve slope upwards?

Suppliers are willing to sell more at higher prices b/c of low-hanging fruit principle (as quantity supplied rises so does the OC) -- More sellers pass the cost-benefit test

Consequences of Price Floor

Surplus develops -- Problem of disposal -- Sellers offer discounts in disguise -- Over-investment in the industry (inefficient businesses will enter)

Factors that shift supply

Technology -- Input prices -- Expectations -- # of sellers -- Weather -- Taxes/Subsidies

Income Effect

The change in the quantity demanded of a good that results b/c a change in the price of a good changes the buyer's purchasing power

Substitution Effect

The change in the quantity demanded of a good that results b/c buyers switch to or from substitutes when the price of a good changes

Buyer's Surplus

The difference b/w the buyer's reservation price and the price he or she actually pays

Total Surplus

The difference b/w the buyer's reservation price and the seller's reservation price

Seller's Surplus

The difference b/w the price received by the seller and his or her reservation price

Vertical Interpretation (D)

The larger the quantity demanded, lower will be the price a consumer will wish to pay for one extra unit of the good -- Quantity determines the marginal buyer's reservation price

Buyer's Reservation Price

The largest dollar amount the buyer would be willing to pay for a good

Socially Optimal Quantity

The quantity of a good that results in the maximum possible economic surplus from producing and consuming the good -- MC = MB

Seller's Reservation Price

The smallest dollar amount for which a seller would be willing to sell an additional unit -- Generally equal to marginal cost

Complements

Two goods are complements in consumption if an increase in the price of one causes a leftward shift in the demand curve for the other (or if a decrease causes a rightward shift)

Substitutes

Two goods are substitutes in consumption if an increase int eh price of one causes a rightward shift in the demand curve for the other (or if a decrease causes a leftward shift)

When do market achieve efficiency?

When MB to individual buyer reflects the true MB to society -- When the MC to the seller reflects the true social OC

Efficiency & Equilibrium

When the supply and demand curves for a good reflect all significant costs and benefits associated w/ production and consumption of that good, the market equilibrium will result in the largest possible economic surplus