MAXIMIZING BEHAVIOR SUPPLY AND DEMAND THE CIRCULAR FLOW THE TWO MARKETS THE TWO MARKETS

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1 Chapter 3 SUPPLY AND DEMAND MAXIMIZING BEHAVIOR Consumers maximize their utility (satisfaction) given limited resources. Businesses try to maximize profits by using resources efficiently in producing goods. Government maximizes general welfare of society. The basic goals of utility maximization, profit maximization, and welfare maximization explain most market activity. 2 ECONOMIC INTERACTIONS WITH OTHERS OCCUR BECAUSE: We can t produce all of the goods we need or desire. Even if we could produce all our own goods and service, it still makes sense to specialize. We have limited time, energy, and resources to produce things we could make for ourselves. THE CIRCULAR FLOW Four different groups participate in our economy: Consumers Business firms Government Foreigners 3 4 THE TWO MARKETS Factor markets are any place where factors of production (e.g., land, labor, capital) are bought and sold. Product Markets are any place where finished goods and services (products) are bought and sold. THE TWO MARKETS Foreigners both buy and sell in both product and factor markets. Governments buy resources from factor markets and provides services to businesses and consumers. The consumer is the final recipient of all goods and services produced. 5 6

2 THE CIRCULAR FLOW Goods and services ed Product markets International participants Goods and services supplied SUPPLY AND DEMAND There must be a buyer and a seller in every market transaction. The seller is on the supply side of the market. The buyer is on the side of the market. Consumers Factors of production supplied International participants Governments Factor markets Business Firms Factors of production ed 7 Supply is the ability and willingness to sell (produce) specific quantities of a good at alternative prices in a given time period, ceteris paribus. Demand is the ability and willingness to buy specific quantities of a good at alternative prices in a given time period, ceteris paribus. 8 INDIVIDUAL DEMAND DEMAND SCHEDULE AND CURVE A exists only if someone is willing and able to pay for a good. A schedule is a table showing the quantities of a good a consumer is willing and able to buy at alternative prices in a given time period, ceteris paribus. A curve is a curve describing the quantities of a good a consumer is willing and able to buy at alternative prices in a given time period, ceteris paribus. 9 Demand Schedule Quantity Demanded $ PRICE $ A B C D E F Quantity Of Typing Demanded G H I INDIVIDUAL DEMAND Demand is an expression of consumer buying intentions of a willingness to buy not a statement of actual purchases. According to law of, the quantity of a good ed in a given time period increases as its price falls, ceteris paribus. DETERMINANTS OF DEMAND Determinants of market include: Tastes desire for this and other goods. Income of the consumer. Other goods their availability and price. Expectations for income, prices, tastes. Number of buyers

3 OTHER GOODS Substitute goods substitute for each other. When the price of good x rises, the for good y increases, ceteris paribus. Complementary goods are frequently consumed in combination. When the price of good x rises, the for good y falls, ceteris paribus. SHIFTS IN DEMAND A curve (schedule) is valid only so long as the underlying determinants of remain constant. A shift in is a change in the quantity ed at any (every) given price. The entire curve shifts to the right when income goes up. An increase in taste (desire) also shifts the curve to the right MOVEMENTS VS. SHIFTS MOVEMENTS VS. SHIFTS Changes in quantity ed movements along a curve, in response to price changes for that good. Changes in shifts of the curve due to changes in tastes, income, other goods, or expectations. PRICE $ d 1 Shift in Movement along curve d 2 g 1 D2 increased D 1 initial Quantity MARKET DEMAND Market is the total quantities of a good or service people are willing and able to buy at alternative prices in a given time period. The separate s of individual consumers is added up to determine the total quantity ed at any given price. CONSTRUCTION OF THE MARKET DEMAND CURVE $ Tom s curve George s curve Lisa s curve My curve = See Page 54 18

4 CONSTRUCTION OF THE MARKET DEMAND CURVE = $ A B C The market curve D E F G H Quantity Demanded I SUPPLY is the total quantities of a good that sellers are willing and able to sell at alternative prices in a given time period, ceteris paribus. The determinants of market supply include: Factor costs Taxes and subsidies Technology Expectations Other goods Number of sellers 19 LAW OF SUPPLY According to the law of supply, the quantity of a good supplied in a given time period increases as its price increases, ceteris paribus. is an expression of sellers intentions an offer to sell not a statement of actual sales. MARKET SUPPLY Quantity Supplied By: (per page) Ann Bob Cory Market j $ i h g f e d c 1.5 b MARKET SUPPLY SHIFTS OF SUPPLY $ b Quantity supplied increases as price rises c d e f g h i j Changes in the quantity supplied movements along the supply curve. Changes in supply shifts in the supply curve Quantity Supplied 23 24

5 EQUILIBRIUM The equilibrium price is the price at which the quantity of a good ed in a given time period equals the quantity supplied. Only one price and quantity are compatible with the existing intentions of both the buyers and the sellers. MARKET CLEARING An equilibrium doesn t imply that everyone is happy with the prevailing price or quantity. Although not everyone gets full satisfaction from the market equilibrium, that unique outcome is efficient EQUILIBRIUM PRICE Quantity Supplied Quantity Demanded $ surplus surplus surplus surplus surplus surplus equilibrium shortage shortage 57 EQUILIBRIUM PRICE $ Market At equilibrium price, quantity ed equals quantity supplied Equilibrium price Quantity THE INVISIBLE HAND The market mechanism is the use of market prices and sales to signal desired outputs (or resource allocations). Adam Smith characterized this market mechanism as the invisible hand. MARKET SURPLUS A market surplus is the amount by which the quantity supplied exceeds the quantity ed at a given price excess supply. A market surplus is created when the seller s s asking prices are too high. 29

6 MARKET SHORTAGE SURPLUS AND SHORTAGE A market shortage is the amount by which the quantity ed exceeds the quantity supplied at a given price excess. A market shortage is created when the seller s s asking prices are too low. $ Market Surplus x Shortage y Quantity SELF-ADJUSTING PRICES A market surplus will emerge when the market price is above the equilibrium price. A market shortage will emerge when the market price is below the equilibrium price. SELF-ADJUSTING PRICES To overcome a surplus or shortage, buyers and sellers will change their behavior. Only at the equilibrium price will no further adjustments be required SURPLUS AND SHORTAGE $ Market Surplus 25 x y 15 Equilibrium price Shortage Quantity CHANGES IN EQUILIBRIUM No equilibrium price is permanent. The equilibrium price will change whenever the supply or curve shifts. Changes in supply and d occur when the determinants of supply and change. Should the curve shift, the result will be a change in equilibrium price and quantity. Should the supply curve shift, the result will be a change in equilibrium price and quantity

7 CHANGES IN EQUILIBRIUM CHANGES IN EQUILIBRIUM $5 $5 E 2 New E 3 E 1 E 1 Initial Initial Quantity Quantity MARKET OUTCOMES The market mechanism resolves the basic economic questions: WHAT we produce is determined by the equilibrium of the markets. HOW we produce is determined by profit seeking behavior and using resources efficiently. FOR WHOM we produce is determined by those willing and able to pay the equilibrium price. ELECTRIC SHOCK: ENERGY-PRICE SPIKES People are often upset with the market outcome. In a market-driven economy, electricity prices are set by the forces of supply and. Electricity prices increased in California because of an increase in and a decrease in supply. The curve shifted rightward. The supply curve shifted leftward. 39 DISEQUILIBRIUM PRICING The California legislature put a price ceiling on retail electricity prices. A price ceiling is the upper limit imposed on the price of a good. ceilings have three predictable effects: Increase the quantity ed. Decrease the quantity supplied. Create a market shortage. PRICE CEILINGS CREATE SHORTAGES > 1 ectricity watt-hour) Of Ele (cent per kilow D 1 Old D 2 New shift in shortage S 2 New supply E 2 shift in supply E 1 qs c qe 2 qd c Quantity Of Electricity (megawatts per hour) S 1 Old supply ceiling 41 42

8 PRICE CEILINGS CREATE SHORTAGES Letting prices rise would have: Reduced the quantity ed. Increased the quantity supplied. Alleviated the market shortage. PRICE FLOOR Setting a price below which prices cannot go is called a price floor. floors have three predictable effects, opposite of price ceilings: Decrease the quantity ed. Increase the quantity supplied. Create a market surplus End of Chapter 3 SUPPLY AND DEMAND