Economics 1B Lecture 3 S2011

Economics 1B Lecture 3 S2011 - 4/5/2011 Economics 1B...

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Unformatted text preview: 4/5/2011 Economics 1B Economics 1B UC Davis Professor Siegler Spring 2011 I. Introduction Let s now move beyond the two person, two good Let's now move beyond the twoperson, twogood model of exchange to examine markets with many buyers and sellers. A market is formally defined as a group of buyers and sellers of a particular good or service. Sometimes the buyers and sellers meet in a centralized area together, but in most cases markets t li d t th b t i t k t are less centralized. For example, the market for gasoline or the "market" for marriage. 2 1 4/5/2011 I. Introduction The supply and demand model is the most widely pp y y used model in economics. A good understanding of this model is crucial for success in economics. The supply and demand model tells us what affects the price and quantity of a good or service. The supply and demand model, however, is a The supply and demand model however is "a bloodless account of exchange" since it assumes a wellfunctioning "market design." Like any model, the supply and demand model has both behavioral and market structure assumptions. 3 I. Introduction "Market design consists of the mechanisms that organize g g buying and selling; channels for the flow of information; stateset laws and regulations that define property rights and sustain contracting; and the market culture, its self regulating norms, codes, and conventions governing behavior. . . . A basic part of the government's role in market design is the defining of property rights. The surest way to destroy a market is to undermine people's belief in the security of their own property." John McMillan, Reinventing the Bazaar: A Natural History of Markets, pp. 911. 4 2 4/5/2011 II. Behavioral Assumptions Economic agents are rational and self interested. Economic agents are rational and selfinterested. Selfinterested behavior does not necessary mean selfish behavior. Households are assumed to maximize utility, subject to their budget constraints. Firms are assumed to maximize profits, subject to their resource constraints. 5 III. Market Structure Assumptions The market is assumed to be perfectly competitive. p y p The characteristics of perfect competition are: Households and firms are price takers (there are so many buyers and sellers that each takes the market price as given). Firms sell a homogeneous product. There is perfect information concerning prices and q quantities exchanged in the market. g There are no externalities in production and consumption. Freedom of entry and exit. Resources (factors of production) are perfectly mobile in the long run. 6 3 4/5/2011 III. Market Structure Assumptions Most realworld markets are not perfectly p y competitive. The supply and model is extremely robust, however, and often yields correct predictions even when all of the assumptions above are not met. For example, Taylor uses the market for bicycles in Chapter 3, but this market does not satisfy all the assumptions above. Beware, however, that if the market deviates too far away from perfect competition, it may yield misleading predictions. 7 IV. The Law of Demand The law of demand states that, other things equal The law of demand states that, other things equal (ceteris paribus), when the price of a good increases (decreases), the quantity demanded of that good decreases (increases). That is, price and quantity demanded are negatively related. Note that quantity demanded depends on price, but that economists, thanks to Alfred Marshall, put the that economists thanks to Alfred Marshall put the dependent variable on the horizontal axis instead of the vertical axis as is standard in mathematics. 8 4 4/5/2011 IV. The Law of Demand To make things concrete, let s first consider one To make things concrete, let's first consider one individual's demand for apples. Demand curves slope downward due to the substitution effect and the income effect. Demand slopes Down. 9 IV. The Law of Demand The Substitution Effect When you buy apples, you have less money to spend on other products such as bananas, bread, music, books, travel etc. The price of apples determines exactly how much of these other goods and services you sacrifice to get apples. Suppose that the price of apples is $2/lb and the price of bananas is $0.50/lb. In this case, the opportunity cost of one pound of apples is 4 pounds of bananas. However, if the price of apples drops to $0.50/lb, then you'll only have to i f l d t $0 50/lb th 'll l h t sacrifice 1 pound of bananas for each pound of apples. Given this smaller sacrifice (lower opportunity cost), you are likely to buy more apples, substituting apples for other goods such as bananas. 10 5 4/5/2011 IV. The Law of Demand The Income Effect A decrease in the price of apples means that a given amount of income will buy more of all goods and services, including apples. For example, suppose that you have $10 a week to spend on fruit and you buy one pound of apples at a price of $3 and spend $7 on other fruit. If the price of apples drops to $1 per pound, you original basket of fruit will cost only $8, so pound you original basket of fruit will cost only $8 so you'll have $2 left to spend as you please. In other words, a drop in price increases your real income. As your real income increases, you'll buy more of most goods, including apples. 11 IV. The Law of Demand Markets are made up of a large number of buyers (in the p g y ( case of perfect competition there must be so many buyers that no one buyer has any measurable influence on price). Market demand curves simply aggregate (add up) all individuals' demand curves. The law of demand says that demand curves are downward sloping. Curves don't have to be linear, but textbooks often show them as linear curves for simplicity. textbooks often show them as linear curves for simplicity A market demand curve shows the relationship between the price of a good or service and the quantity demanded of that good or service, holding all else equal (ceteris paribus). 12 6 4/5/2011 P $2 $1 D 300 500 Q 13 V. Shifts in Demand (Changes in Demand) When quantity demanded changes because the price When quantity demanded changes because the price of the good or service changes, it's a movement along a demand curve (called a change in the quantity demanded). When buyers decide to buy more (or less) at any given price, it's a shift in the demand curve (called a change in demand). The shift variables are the h i d d) Th hift i bl th exogenous variables. 14 7 4/5/2011 P The increase in demand from D0 to D1 shows that consumers want to buy more at any given price. D1 D0 Q 15 V. Shifts in Demand (Changes in Demand) Many factors cause demand curves to shift. Let's y examine some of the most important exogenous shift variables: Changes in Buyers' Income Normal Goods When income and demand are positively or directly related, the good (or service) is a normal good. Most goods are normal. Inferior Goods When income and demand are Inferior Goods When income and demand are negatively or inversely related, the good (or service) is called an inferior good. Possible examples include potatoes, bus travel, macaroni and cheese, and tooth extraction. With inferior goods, an increase in consumers' incomes causes a decrease in demand. 16 8 4/5/2011 V. Shifts in Demand (Changes in Demand) Changes in the Prices of Related Goods and g Services Complements Two goods (and/or services) are complements if an increase (decrease) in the price of one causes a decrease (increase) in the demand for the other (e.g., Chips and salsa, restaurant meals and movie prices). Substitutes Two goods (and/or services) are Substitutes Two goods (and/or services) are substitutes if an increase (decrease) in the price of one causes an increase (decrease) in the demand for the other (e.g., Coke and Pepsi, margarine and butter). 17 V. Shifts in Demand (Changes in Demand) Changes in Buyers' Expectations g y p Consumer expectations regarding their future incomes or the future prices of a good or service can also play an important role in many markets. If consumers expect their incomes to be higher in the future, then demand for a product can increase today. Changes in expectations regarding future prices can lead to a self fulfilling prophecy in which changes in expectations become reality today. For example, suppose that become reality today For example suppose that consumers expect prices of a good to rise in the future. This will cause consumers to buy more of the product now. This will increase demand for the product now and cause prices to rise today. 18 9 4/5/2011 V. Shifts in Demand (Changes in Demand) Changes in the Size of the Market Changes in the Size of the Market A larger market increases demand. Market size can increase as the result of population growth, demographic changes, and/or transportation and communication improvements that allow more people to participate in the market. 19 V. Shifts in Demand (Changes in Demand) Changes in Buyers' Tastes, Preferences, and g y , , Information As consumers get more information about a good or service, this can cause demand to shift. For example, medical studies can rapidly change demand for a product. Changes in consumers' tastes and preferences also influence demand. Fashion is an excellent example of i fl d d F hi i ll t l f changing tastes and preferences. The phrase "tastes and preferences" is used as a catch all term to account for many shifts in demand that do not easily fit into any other categories. 20 10 4/5/2011 V. Shifts in Demand (Changes in Demand) Changes in Taxes, Subsidies, and Regulations Changes in Taxes, Subsidies, and Regulations Government can influence demand through taxes, regulations, and subsidies that affect consumers. For example, the adoption of a regulation that requires fire alarms in all rooms would increase the demand for fire alarms. We will show the impact of taxes and u i ie a e subsidies later. 21 V. Shifts in Demand (Changes in Demand) Should there be a law requiring separate tickets and q g p separate (car) seats for infants on airplanes? Would such a law lead to fewer deaths and injuries of infants? An increase in the price of air travel would cause there to be an increase in demand for substitutes like highway travel. That is, families with infants would substitute car travel for air travel. Since the number of people killed per 100,000 miles is much higher in cars than in commercial airplanes, il i h hi h i h i i l i l the total number of fatalities would undoubtedly increase as a result of this law. A law with good intentions to make infants safer would actually lead to more injuries and fatalities. 22 11 4/5/2011 Question 3.1 The market for energy drinks has grown rapidly gy g p y over the past several years. One recent report predicts that energy drinks might replace coffee for the current generation of teens and young adults. This report implies that energy drinks and coffee are A) complements. B) substitutes. ) C) both inferior goods. D) both normal goods. Correct answer: B 23 Question 3.2 If, in response to an increase in the price of If, in response to an increase in the price of chocolate, the quantity demanded of chocolate decreases, economists would describe this as A) a decrease in demand. B) a decrease in quantity demanded. ) g C) a change in consumer income. D) a decrease in consumers' taste for chocolate. Correct answer: B 24 12 4/5/2011 Question 3.3 Which of the following leads to a decrease in Which of the following leads to a decrease in demand? A) An expectation of a decline in the product price in the future. B) A decrease in the good's own price. ) p C) An increase in the price of a substitute. D) A decrease in the price of a complement. E) An increase in the number of consumers. Correct answer: A 25 VI. The Law of Supply The Law of Supply states that, other things equal, pp y , g q , when the price of a good increases, the quantity supplied of the good also increases. S UPply slopes UP. The law of supply tells us that supply curves slope upward. That is, price and quantity supplied are p p q y pp positively related. As prices rise, producers' profits increase providing the incentive to produce more. The market supply curve is sum of all firms' individual supply curves. 26 13 4/5/2011 P S P1 P0 Q0 Q1 Q 27 VII. Shifts in Supply (Changes in Supply) When quantity supplied changes because the price When quantity supplied changes because the price of the good or service changes, it's a movement along a supply curve (called a change in the quantity supplied). When sellers decide to produce more (or less) at any given price, it's a shift in the supply curve (called a change in supply). The shift variables are the h i l ) Th hift i bl th exogenous variables. 28 14 4/5/2011 P S0 S1 An increase in supply from S0 to S1 shows that sellers are willing g to produce more at any given price Q 29 VII. Shifts in Supply (Changes in Supply) Many factors cause supply curves to shift. Let s Many factors cause supply curves to shift. Let's examine some of the most important exogenous shift variables: Changes in the Prices of the Factors of Production If the prices of raw materials, labor, or capital increase (decrease), then it becomes more (less) costly to produce the product. As a result, the supply curve will shift left the product As a result the supply curve will shift left (right). A leftward (rightward) shift in supply is a decrease (increase) in supply. 30 15 4/5/2011 VII. Shifts in Supply (Changes in Supply) Changes in Technology Changes in Technology Improvements in technology allow firms to produce more goods or services at the same price or produce the same amount at a lower price. Improvements in technology cause supply curves to shift right (supply to increase). 31 VII. Shifts in Supply (Changes in Supply) Changes in Sellers Expectations Changes in Sellers' Expectations Selffulfilling prophecies can also occur on the supply side. If sellers expect prices in the future to increase, for example, they will restrict supply now to sell it later at a higher price. However, the decrease in supply now raises prices now. 32 16 4/5/2011 VII. Shifts in Supply (Changes in Supply) Changes in Weather Conditions Changes in Weather Conditions Changes in the Number of Firms in the Market Changes in the Prices of Related Goods and Services in Production If the price of corn falls, for example, then some farmers will substitute away from corn and start planting wheat. As a result, the supply of wheat will increase. Changes in Government Taxes, Subsidies, and Regulations 33 VIII. Market Equilibrium Economists use the word "equilibrium" for a q situation that, once achieved, will not change unless something we have been holding constant changes. In equilibrium, the quantity demanded equals the quantity supplied. That is, there are neither shortages (excess demand) nor surpluses (excess supply) of a good or service. The perfectly competitive market system is also self p y p y correcting. If there is a shortage of a good or a service, prices rise and quantity supplied increases until quantity supplied equals quantity demanded. If a surplus occurs, prices fall until quantity demanded and quantity supplied equal one another. 34 17 4/5/2011 35 IX. Equilibrium Price and Quantity Changes Effects of Supply and Demand Curve Shifts Effect on Equilibrium Price Increase Decrease D Decrease Increase Effect on Equilibrium Quantity Increase Decrease D Increase Decrease Shift Increase in Demand Decrease in Demand D i D d Increase in Supply Decrease in Supply 36 18 4/5/2011 X. What Happens When Both Curves Shift? Effects of Supply and Demand Curve Shifts Effect on Eff t Equilibrium Price Indeterminate Indeterminate Increase Decrease Effect on Eff t Equilibrium Quantity Increase Decrease Indeterminate Indeterminate 37 Shifts Increase in Demand and Supply Decrease in Demand and Supply dS l Increase in Demand, Decrease in Supply Decrease in Demand, Increase in Supply Question 3.4 If quantity supplied is less than quantity demanded, If quantity supplied is less than quantity demanded, then A) there is a shortage in the market. B) prices will fall. C) equilibrium has been achieved. D) consumer incomes will increase. consumer incomes will increase. E) there is a surplus in the market. Correct answer: A 38 19 4/5/2011 Question 3.5 The market for apples is initially in equilibrium at the intersection of D1 and S1 (point A). If the price of oranges, a substitute for apples, decreases and the wages of apple decreases and the wages of apple workers increase, how will the equilibrium point change? A) The equilibrium point will move from A to E. B) The equilibrium point will move from A to B. C) The equilibrium point will move from A to C. D) The equilibrium will first move from A to B, then f A B h return to A. Correct answer: A. A decrease in the price of a substitute causes demand to decrease, while an increase in the price of an input (factor of production) causes supply to decrease. 39 20 ...
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