ECON 111 - Basics of Supply and Demand PDF

1.1 The Themes of Microeconomics Trade Offs: There is no such thing as a free lunch. When you consume one good, you give up another, whether directly or indirectly. Consumers: Trade-offs in the purchase of more of certain goods over another. Trade-off between current and future consumption. Positive...

1.1 The Themes of Microeconomics Trade Offs: There is no such thing as a free lunch. When you consume one good, you give up another, whether directly or indirectly. Consumers: Trade-offs in the purchase of more of certain goods over another. Trade-off between current and future consumption. Positive vs Normative Analysis: Positive: Analysis using empirical data and cannot be approved or denied (ie. Increase in public infrastructure will increase government expenditure) Normative: Analysis on what SHOULD be done. Incorporates value judgment working on the basis of equity and equality. 1.2 What is a Market? Workers: Trade- offs in the choice of employment. Trade -off between labor and leisure. Firms: Trade-offs in what to produce. Trade-offs in the resources to use in production. Prices and Markets: Trade-offs are based on the prices faced by consumers, workers, or firms. A centrally planned economy are set by the government (soviet Russia). In a market economy, prices are determined by the interactions of consumers, workers, and firms in markets-collections of buyers and sellers that together determine the price of a good. Theories and Models: The use of theories and models will be prevalent in this course. They will be used to analyze and represent a firm, a market or some other entity. Statistics and econometrics will let us measure the accuracy of our predictions. When evaluating a theory, it is important to keep in mind that it is invariably imperfect and has limited success in making predictions. Market - Collection of buyers and sellers that, through their actual or potential interactions, determines the price of a product or set of products. Market Definition - Determination of the buyers, sellers, and range of products that should be included in a particular market. The extent of a market can be defined geographically and in terms of products produced and sold within it. It is important as a company must understand who its actual and potential competitors are for the various products that it sells or might sell in the future. Arbitrage - Practice of buying at a low price at one location and selling at a higher price in another. Competitive versus Noncompetitive Markets Perfectly Competitive Market - No single buyer or seller has an impact on the price. Many other markets are competitive enough to be treated as if they were perfectly competitive. Some markets contain many producers but are noncompetitive; that is individual firms can jointly affect the price. Market Price: Prevailing price in a competitive market. If a market is not competitive, firms might charge different prices for the same product. The market prices of most foods will fluctuate over time, and for many goods the fluctuation can be rapid. This is particularly true for goods sold in competitive markets. Consumer Price Index: Measure of the aggregate price level. Cost of delivery is included. >Insert formula from notes 1.3 Real vs Nominal Prices Other than inflation, there can be other factors involved in the increase in price. Nominal Price: Absolute price of good, unadjusted for inflation Real Price: Price of a good relative to an aggregate measure of prices; price adjusted for inflation. (We will use this) 𝑅 = 𝐶𝑃𝐼 𝑋 𝐶𝑃𝐼 𝑌 × 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑃𝑟𝑖𝑐𝑒 𝑖𝑛 𝑌 *Where Year X is the base year 𝑅 = 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑃𝑟𝑖𝑐𝑒 𝐼𝑛𝑑𝑒𝑥 𝑅𝑒𝑎𝑙 𝑌 − 𝑅𝑒𝑎𝑙 𝑋 𝑅𝑒𝑎𝑙 𝑋 × 100 Ex: CPI in 1970 is 38.8, CPI in 2015 is 237. Butter’s nominal price in 2015 is $3.48. Solve for the inflation: 38.8 237 1.4 Why Study Microeconomics? Corporate Decision Making and Public Policy Design. Microeconomics forces you to understand the consumers, the impact of decisions on those consumers and other stakeholders, the marginal benefits. The Basics of Supply and Demand × 100 *Alternative Formula for current year 𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 = Producer Price Index: Measure of the aggregate price level for intermediate products and wholesale goods. Cost of Delivery is not included. × $3. 48 = $0. 57 The nominal price of butter went up by 300% while the CPI went up by 511% Supply-demand analysis is a fundamental and powerful tool that can be applied to a wide variety of interesting and important problems. To name a few: Understanding and predicting how changing world economic conditions affect market price and production Evaluating the impact of government price controls, minimum wages, price supports, and production incentives. Determining how taxes, subsidies, and other factors affect 2.1 Supply and Demand Supply Curve Supply is the relationship between the quantity of a good that producers are willing to sell and the price of the good. There is an incentive to produce more at higher prices to maintain the profits. 𝑄𝑠 = 𝑄𝑠(𝑃) The supply curve, labeled S in the figure, shows how the quantity of a good offered for sale changes the price of the good changes. The supply curve is upward sloping: the higher the price, the more firms are able and willing to produce and sell. The quantity demanded may also depend on other variables such as income, the weather and the prices of other goods. A higher income level shifts the demand curve to the right. Income Effect: If price falls and income is retained, they can demand more. Substitution Effect: People will purchase goods which are relatively cheaper. Non-Price Determinants of Demand 1. Price of Related Goods: a. Complementary Goods (Ink & Printers b. Substitutes (Soft Drink and Juice) 2. Demographic Change 3. Real Income of Buyers 2.2 The Market Mechanism Supply and Demand If production costs fall, firms can produce the same quantity at a lower price or the greater quantity at a greater price. A shift. Non-Price Determinants: -Technological Change -Government Intervention -Price of Related Goods Demand Curve The relationship between the quantity of a good that consumers are willing to buy and the price of the good. 𝑄𝑑 = 𝑄𝑑(𝑃) At a higher price than P1, a surplus develops, so price falls. At the lower price P2, there is a shortage, so there is pressure for the price to build up. The assumption is that the market is competitive and that there is little ability to affect the market price. Equilibrium (Market Clearing Price): Price where quantity supplied and quantity demanded intersect. Market Mechanism: Tendency in a free market for price to change until the market clears Surplus: Situation in which the quantity supplied exceeds the quantity demanded Shortage: Situation in which the quantity demanded exceeds the quantity supplied When can we use the Supply-Demand model? We are assuming that at any given price, a given quantity will be produced and sold. This assumption makes sense only if a market is roughly competitive. Suppose that there is only one supplier, they may keep the quantity fixed but raise the price to maximize profits. 2.4 Elasticities of Supply and Demand Price Elasticity of Demand Percentage change in quantity demanded of a good resulting from a 1-Percent increase in its price. 0 < 𝐸𝑝 < 1 | Price Inelastic Demand Change is proportionally smaller 𝐸𝑝 = 1 | Unitary Elastic Demand Change is proportionally equal 𝐸𝑝 = 0 | Completely Inelastic Demand Change has no effect whatsoever 𝐸𝑝 = ∞ | Infinitely Elastic Demand Change leads to infinite change Basic Necessities (Giffen Goods) are usually Price Inelastics and Luxury Goods (Veblen Goods) are usually Price Elastic. The more substitutes of a good, the more elastic the demand. The more necessary the good is, the more inelastic. The higher the proportion of income spent on the good, the more elastic. If you can purchase a better quality phone, you will, rather than buying an inferior phone. Linear Demand Curve Linear Demand Curve that is a straight line. 𝑄 = 𝑎 − 𝑏𝑝 *Where a is the x intercept. 𝐸𝑝 = (%∆𝑄)/(%∆𝑃) 𝐸𝑝 = ∆𝑄/𝑄 ∆𝑃/𝑃 We use elasticity to find the percentage as it eliminates the units and the magnitude of the changes - normalizing it and making it comparable to other items. 𝐸𝑝 > 1 | Price Elastic Demand Change is proportionally greater Infinitely Elastic Demand The reason demand is is infinite is because ∆𝑃 is still 0. If you increase the price, no one will buy from you. price. PES is always positive and is always a movement. Completely Inelastic Demand When they are necessary for survival, people will buy regardless of the price. Think medicine and water. Point vs Arc Elasticities Point: Price elasticity at a particular point on the demand curve Arc: Price elasticity calculated over a range of points. 2.5 Short Run versus Long-Run Elasticities Gasoline: Short-Run and Long-Run Demand Curves Cross-Price Elasticity of Demand: Percentage change in the quantity demanded of one good resulting from a 1-percent increase in the price of another. Think Hamburgers and Soda. If the goods are complements, their cross-price elasticity of demand is going to be negative. This is because a price change of Good A and quantity demanded of Good B move in the opposite direction: If the price of Good A increases, the quantity demanded of Good B decreases. Price Elasticity of Supply Measure of how much the quantity supplied changes if there is a change in its own In the short run, an increase in price has only a small effect on the quantity of gasoline demanded. Motorists may drive less, but they will not change the kinds of cars they are driving overnight. In the longer run, however, because they will shift to smaller and more fuel-efficient cars, the effect of the price increase will be larger. Demand, therefore, is more elastic in the long run than in the short-run. Automobiles: Short-Run and Long-Run Demand Curves Cyclical Industries Industries in which sales tend to magnify cyclical changes in gross domestic product and national income. GDP and Investment in durable equipment Annual growth rates are compared for GDP and investment in durable equipment. The opposite is true for automobile demand. In the short-run, price increases have a large effect on the quantity demanded as consumers will defer from buying new cars and wait for prices to go lower - making it elastic. In the long run, old cars need to be replaced and prices would have fallen ideally and therefore consumers will have to buy what is available making it inelastic. Because the short run GDP elasticity of demand is larger than the long-run elasticity for long-lived capital equipment, changes in investment in equipment magnify changes in GDP. Consumption of Durables VS Nondurables Supply Short-Run and Long-Run Like that of most goods, the supply of primary copper, shown, is more elastic in the long run. Income Elasticity A shift. Measure of how much the quantity demanded of a good will respond to a change in consumers’ incomes. 𝐸𝑌 = %∆𝑄𝑑 𝑜𝑓 𝑋 %∆𝑌 For example, Rolex demand increases by 20% when there is a 10% increase in income. 20%/10% = 2. When 𝐸𝑌 is greater than 0, it is a normal good. When 𝐸𝑌 is less than 0, it is an inferior good. If price increases, firms would like to produce more but are limited by capacity constraints in the short run. In the longer run, they can add to capacity and produce more. Due to the weather, coffee is price inelastic in the short run. But later once there are plenty of beans in the market and due to its perishability, they become price elastic in the long-run. 2.7 Effects of Government Intervention - Price Controls Price Ceiling Mandated maximum a seller is allowed to charge for a product or service: usually applied to primary commodities to protect consumers. There is a shortage as a result of the price ceiling and welfare loss. It disincentivizes suppliers from producing more and efficiently. Price Floor Mandated minimum a seller is allowed to charge for a product or service to protect suppliers. There is a shortage as a result of the price floor and welfare loss. Typically, the government will subsidize suppliers in order to alleviate the surplus.