Microeconomics Supply and Demand

Microeconomics Supply & Demand

 

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Class Outline

• Review and Finish PPF • Supply & Demand — and their shifts

Depending on time

• Equilibrium

• Multiple shifts • Practice Quiz

Announcements:

1. Quiz on Monday– short & on basics of this past Monday and Today 2. Problem Set has been posted — due 6/29 3. Resources posted on Blackboard 4. Practice questions for Friday to be posted tonight

 

 

Review Production Possibilities Frontier Fruitland Example

Berries

• PPF = curve showing efficient production levels for a two good economy

• Resources & Technology are assumed constant

• Productive efficiency = can’t produce more of one good without producing less of another good

Apples

A B C D

Berries 100 60 30 0

Apples 0 60 75 80

 

 

Practice Questions • How are scarcity and trade offs illustrated in the PPF? • What’s the opportunity cost on an apple in the range of B to C? • Suppose we wanted to produce 30 Berries and 60 apples. Is that feasible? Is

that efficient? • The PPF typically has a shape described as being “bowed outward”– the slope

becomes larger in magnitude as we move to the right. Why do we think this is often the case in real life? (Hint: Principle of… and the reasoning behind it )

 

The PPF typically has a shape described as being “bowed outward”– the slope becomes larger in magnitude as we move to the right. Why do we think this is often the case?

Efficiency • Feasible/Infeasible • Efficiency/Inefficient

A B C D

Berries 100 60 30 0

Apples 0 60 75 80

 

 

How are scarcity and trade offs illustrated in the PPF?

Scarcity → we might want a very large amount of berries and apples, but our resources are limited– so we can’t satisfy all of our desires. Trade offs → Because there’s scarcity, we have to trade off between apples and berries

A B C D

Berries 100 60 30 0

Apples 0 60 75 80

 

 

What’s the opportunity cost on an apple in the range of B to C?

Slope = Change in Max. Berries / Change in Apples

→ Slope = “what I give up” in berries if I produce more apples

B to C: Gain 15 Apples, Lose 30 Berries → 2 Berries per Apple

 

A B C D

Berries 100 60 30 0

Apples 0 60 75 80

 

 

Suppose we wanted to produce 30 Berries and 60 apples. Is that feasible? Is that efficient?

 

A B C D

Berries 100 60 30 0

Apples 0 60 75 80

Efficient? Feasible?

Above PPF

N/A No

On PPF Yes Yes

Below PPF

No Yes

 

 

The PPF typically has a shape described as being “bowed outward”– the slope becomes larger in magnitude as we move to the right. Why do we think this is often the case in the real world?

• Principle of Increasing Cost • As I produce more of a good, the opportunity

cost of that good goes up. • As we produce more, we have to use

resources “less well-suited” towards producing that good.

 

 

 

The PPF and Economic Growth

Growth = capacity to produce more Goods and services

Causes of Growth….

1. Increase in resources (Technically Factors of Production)

2. Technological improvement

 

 

Economic Growth in More Recent History

 

 

Economic Growth in past 2000 years

 

 

Supply & Demand

• Explains how prices and quantities changes in response to events • Guidance for how to effectively change price and quantities • Very helpful in policy analysis

Key Assumption:

• Assume the market is competitive. There are many consumers and many producers.

 

 

Demand Schedule

• A table showing the quantity demanded at any given price. • Law of Demand: All else equal, as the price rises, quantity demanded

does down

• Demand is about consumers.

Quantity Demanded (Tacos) Price

500 $1

400 $3

100 $5

40 $7

5 $9

 

 

Demand Curve

• The demand curve is based upon the demand schedule. • It graphically shows quantity demand at any given price.. • The demand curve is downward-sloping. • Price on Y-axis. Quantity on X-axis • Price for any given quantity on the

consumer side is often called the “Willingness to Pay”

 

 

But why?

1. Substitution Effect a. When the price drops, what I give up in terms of other goods drops, and so I

find it more worthwhile to buy the good.

2. Income Effect a. When the price drops, I can afford more of the good — so I buy more.

 

 

What’s a shift in Demand look like?

Note: Change in Demand refers to a shift.

Movement along the demand curve refers to a price change on a single demand curve.

 

 

Events that shift demand

• Changes in Prices of Complementary or Substitute Goods. • Changes in # of Consumers • Change in Tastes • Changes in Expectations

• expectations of future income • demand shifts with expectations of future prices

• When income changes • Acronym = I.R.E.N.T or iRent

 

 

Changes in Income

• If you have more money, you can buy more. • Normal Goods → Income rises, demand increases.

• Examples: The vast majority of goods

• Inferior Goods → Income rises, demand decreases. • Examples: Bologna, eggs, thrift shop clothes, generic cereal that comes in a bag.

 

 

Changes in Prices of Complementary or Substitute Goods

• Complementary Goods • Goods are complements if a rise in the price of one good makes you less likely to buy the

other good. These are goods you consumer together usually.

• Substitute Goods • Goods are substitutes if a rise in the price of one good makes you more likely to

consume the other good.

Complementary Substitutes

 

 

Practice Problems

1. Suppose we experience a recession– causing everyone’s income to go down. What should happen to demand for thrift clothes? What should happen to demand for high-quality clothing? Try drawing this.

2. Suppose the price of guns goes up in Illinois. What should happen to demand for guns in Illinois? What should happen to demand for guns in Indiana (a substitute good)?

 

 

Answers

1. & Thrift Clothes

High Quality Clothes

 

 

Practice Problem Answers

2. Guns in Illinois

Guns in Indiana

 

 

Changes in Expectations

• Income expectations • If you expect to have more money in the future, demand for normal goods increases

today. • Imagine finding out you have a filthy rich ancestor, and you’re going to receive $20 million

dollars 5 years from now.

• Price expectations • If you expect the price to rise in the future, demand increases today.

 

 

Changes in the Number of Consumers

More people means more individual demand curves, which means a larger market demand.

An Aside on types of demand curves

• Each consumer has their own individual demand curve. • The market demand curve is an aggregation of the individual

demand demand curves of all the individuals in the market.

 

 

Individual vs. Market Demand Curves

• Chuck’s Individual Demand Schedule

• Tamar’s Individual Demand Schedule

• Market Demand Schedule???

Price $1 $3 $5 $7 $9

Qd 4 2 0 0 0

Price $1 $3 $5 $7 $9

Qd 3 2 1 0 0

 

 

Individual vs. Market Demand Curves

• Chuck’s Individual Demand Schedule

• Tamar’s Individual Demand Schedule

• Market Demand Curve

Price $1 $3 $5 $7 $9

Qd 4 2 0 0 0

Price $1 $3 $5 $7 $9

Qd 3 2 1 0 0

Price $1 $3 $5 $7 $9

Qd 7 4 1 0 0

 

 

Changes in Tastes

• Sometimes people’s preferences just change. • Advertising • New Information about product

• Medical benefits or harms

• Reputation changes • Scandals • Charitable cause

• Cultural changes

 

 

iRent

• i = income • R = (price of) Related goods and services • e = expectations • n= number of consumers • t= tastes

 

 

1. Consumer start to suspect that the houses in a neighborhood are going to become much more expensive in the future. What happens to demand for houses in that neighborhood today?

2. Everyone in your city starts to suspect that many of the jobs are going away — people now expect incomes to be lower in the future. What happens to demand for luxury cars in your city?

3. A series of funny commercial with Kevin Hart come out, reminding people of the energy boost that Mountain Dew brings. What should happen to demand for Mountain Dew?

4. A charity donate tons of clothes, substantially lowering the price of resale clothes. What should happen to demand for cheaper clothes from local businesses, a substitute good?

5. The government builds a wall around the Mexican border. The number of people grocery shopping in US border towns drop dramatically. What should happen to demand for grocery items in these border towns?

 

 

1. Future prices rise → demand increases 2. Future incomes drop → demand decreases 3. Tastes change in favor of a good → demand increases 4. Price of substitute drops → demand decreases 5. Number of consumers drops → demand decreases

“demand increases” “demand decreases”

 

 

Let’s Speculate! Explain the price changes using Demand shifts

 

 

The Supply Curve and Schedule

• Supply Schedule: Table with quantity supplied at any given price • Law of Supply: Price and Quantity supplied move in same direction, all else equal • Supply is about Producers. The Supply Curve graphically shows the Supply

Schedule. It’s upward-sloping. Price on Y-axis. Quantity on X-axis.

Quantity Supplied

(Tacos)

Price

500 $5

400 $3

300 $2

200 $1

100 $.5

 

 

But why?

• The supply curves show the lowest price a producer will accept for a certain quantity– we call this their cost.

• When the price is higher, the quantity (if purchased) that maximizes producer profits is higher. • We’ll learn thoroughly why that’s the case later on in the

course. • It has to do with the costs of producing more units.

• Similarly, if the price is lower– producers will want to produce less, because the profit maximizing quantity is lower.

 

 

But why? (You don’t need to understand this logic yet. But if each additional unit costs more than the next, then the profit maximizing production level will increase when the price increases).

Unit 1 (worthwhile) 2 (worthwhile) 3 (worthwhile) 4 (not worthwhile anymore ) 5

Price of Unit 5 5 5 5 5

Additional Cost to make this Unit

2.5 3.5 4.5 5.5 6.5

Unit 1 (worthwhile) 2 (still worthwhile) 3 (not worthwhile anymore ) 4 5

Price of Unit 4 4 4 4 4

Additional Cost to make this Unit

2.5 3.5 4.5 5.5 6.5

 

 

When does Supply Shift? (iRent)

• i= Input Cost changes • R = (price of) Related goods or services • e = expectation changes • n= number of producers • t = technological change

 

 

Changes in Input Cost

• If the input prices increases, supply decreases, shifts leftward • If the input prices decrease, supply increases & shifts rightward.

The price producers need for any quantity depends on the cost. If the costs to make the item go up, you aren’t willing to supply as much at any given price. If the costs to produce go down, you are willing to supply more at any given price.

 

 

Changes in Prices of Related Goods or Services

• Substitutes in Production • If an increase in quantity supplied (presumably due to a demand increase) of one good

reduces supply of the other good– those goods are substitutes in production.

• Complements in Production • If an increase in quantity supplied (presumably due to a demand increase) of one good

increases supply of the other good– those goods are complements in production.

 

 

Substitutes in Production– explanation

If a producer chooses between producing two different goods– then an increase in the price of one good will cause them to allocate their resources towards that good, and away from the other good.

Suppose a farmer can use their land for tomatoes or cucumbers. If cucumbers rise in value, they will use more farmland for cucumbers — resulting in them supplying less tomatoes.

Farm’s original set up Farm after cucumber price increases

Tomatoes Cucumbers Tomatoes Cucumbers

 

 

Complements in Production — explanation

If producing more of one good increases supply of another good, we call those complements in production. These are goods you tend to produce together.

Examples:

Beef and Leather.

If the price of beef goes up, I will produce more beef. This results in me having a lot of cow hide available to make leather out of. Thus, I am willing to sell more leather at any given price.

 

 

Changes in Expectations

• Assuming some choice in when they put their good up for sale • If producers expect prices to be higher in the future, supply will decrease today.

• Your selling your car. You hear someone is willing to pay a really high price for it– but not for another month. Consequently, the price you’re willing to sell for today goes up.

If producers expect prices to be lower in the future, supply will increase today.

• You want to sell your good today knowing you won’t get as good of a price in the future.

 

 

Changes in the Number of Producers • Each producer has their own individual supply curve. • The market supply curve is an aggregation of the individual supply curves of all the suppliers in the market.

El Milagro’s Supply Schedule

Big Star’s Supply Schedule

Market Supply Schedule???

Price $.5 $1 $2 $3 $5

Qs 50 100 150 200 250

Price $.5 $1 $2 $3 $5

Qs 50 100 150 200 250

 

 

Changes in the Number of Producers • The market supply curve is an aggregation of the individual supply curves of all the suppliers in the market.

El Milagro’s Supply Schedule

Big Star’s Supply Schedule

Market Supply Schedule

Price $.5 $1 $2 $3 $5

Qd 50 100 150 200 250

Price $.5 $1 $2 $3 $5

Qd 50 100 150 200 250

Price $.5 $1 $2 $3 $5

Qd 100 200 300 400 500

 

 

Changes in Technology

• Technological improvements allow producers to produce more with their current amount of inputs — or produce the same amount with less inputs.

• People’s costs are effectively going down, so producers can profitably produce more at any given price.

 

 

When does Supply Shift? (iRent)

• i= Input Cost changes • R = (price of) Related goods or services • e = expectation changes • n= number of producers • t = technological change

 

 

Practice Problems 1. Suppose car dealerships hear early about a scandal within the auto industry– and they expect prices to

fall in the future. What happens to the supply for cars today? Supply increases.

2. Suppose a bunch of new Chinese restaurants open up in the community. What will happen to the supply of Chinese food? Supply increases.

3. Your company applies the “assembly line” process to their production — a technological improvement. What happens to their supply? Supply increases.

4. Suppose the price of wooden coffee tables goes up. What will happen to the supply of wooden desks (a substitute in production)? Supply decreases.

5. Suppose the price of cotton drops. What will happen to the supply of cotton shirts? Supply increases.

 

 

Market Equilibrium– putting Supply and Demand Together

• Equilibrium: a situation where no one has any incentive to change their behavior

• Market Equilibrium: price and quantity where quantity supplied equals quantity demanded

• Supply and Demand curves intersect, Qs = Qd • Equilibrium Price

• Price where Qs = Qd • Equilibrium Quantity

• Quantity where Cost = Willingness to Pay

 

 

Disequilibrium

• What if the price is too low? • There will be a shortage • Consumers bid price up OR • Producers raise prices to make profit

• What if the price is too high? • There will be a surplus • Producers lower their prices to sell what they have.

 

 

 

Increase in Demand and New Equilibrium

1. Quantity demanded at any given price is larger 2. A shortage occurs.

3. Suppliers raise prices to increase profits

4. Qd goes down as prices rise, shrinking shortage

5. Process continues until they reach equilibrium.

Price and Quantity will both increase.

 

 

Decrease in Demand and New Equilibrium

1. Quantity demanded at any given price is smaller 2. A surplus occurs.

3. Suppliers lower prices to sell what they have

4. Qd goes up as prices lower, shrinking surplus

5. Process continues until they reach equilibrium.

Price and Quantity will both decrease.

 

 

Increase in Supply and New Equilibrium

• Producers produce more at any price • Surplus results: Qs > Qd • Producers lower prices to sell leftover goods

• Qs decreases– movement along supply curve • Qd increases– movement along demand curve

• Surplus is reduced • Process continues until equilibrium Price will decrease and Quantity will increase.

 

 

Decrease in Supply and New Equilibrium

• Quantity supplied lowers across prices • A shortage results

• Qs < Qd • Producers raise prices and produce more • Process repeats until equilibrium is achieved

Price will increase and Quantity will decrease.

 

 

How to deal with multiple shifts

• Draw each shift • The same two things will likely change: price and quantity • For each, ask “do the shifts change price or quantity in the same

direction? • If yes, that’s how price or quantity changes. • If no:

• Ask, “is one shift clearly larger? Does it dominate?” • If yes, then that shift determines how price or quantity changes • If no, then it’s ambiguous.

 

 

Practice Problems with Multiple Shifts

1. Assume the market is for automobiles. Suppose we apply the assembly line process- improving technology. At the same, incomes go up. Supply increases. Demand increases.

2. Assume the market is for tomatoes. Suppose the price of cucumbers goes up, a substitute in production. At the same time, medical research suggests tomatoes are great for your health and reduce risk of diabetes. Assume the latter effect dominates. Supply decreases. Demand increases.

3. The government starts taxing wood– increasing the cost of wood for skateboard companies. At the same time, kids stop thinking skateboarding is cool. What happens to the market for skateboards? Supply decreases. Demand decreases.

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