ECON 1000 Contemporary Economic Issues (Spring 2017) How a Market System Functions (portions relevant for Exam #1)

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1 ECON 1 Contemporary Economic Issues (Spring 217) How a Market System Functions (portions relevant for Exam #1) Relevant Readings from the Required Textbooks: Chapter 4, Organizing Principles of Capitalist Systems Definitions and Concepts: money an asset that is socially and legally accepted as a medium of exchange. three functions of money: medium of exchange an asset used as payment when purchasing goods/services store of value an asset that serves as a means of holding wealth unit of measure a basic measure of economic activity demand the relationship between the price of a good and the quantity that consumers are willing and able to purchase, all other factors fixed supply the relationship between the price of a good and the quantity that firms are willing and able to sell, all other factors fixed Law of Demand all other factors fixed, a greater quantity of a good will be demanded at lower prices (demand curves are downward sloping). Law of Supply all other factors fixed, a greater quantity of a good will be supplied at higher prices (supply curves are upward sloping). Horizontal Interpretation of Demand Curve start by focusing on a particular price, and then go over to the demand curve horizontally to determine the corresponding quantity demanded at this particular price. Vertical Interpretation of Demand Curve start by focusing on a particular quantity demanded, and then go up to the demand curve vertically to determine the corresponding price at which this particular quantity would be demanded. Horizontal Interpretation of Supply Curve start by focusing on a particular price, and then go over to the supply curve horizontally to determine the corresponding quantity supplied at this particular price. Vertical Interpretation of Supply Curve start by focusing on a particular quantity supplied, and then go up to the supply curve vertically to determine the corresponding price at which this particular quantity would be supplied. buyer's reservation price the maximum amount of money that he is willing to give up to acquire the item. seller s reservation price the minimum amount of money that she is willing to accept in exchange for the item. equilibrium a stable state for a system which will persist as long as outside factors do not change. at the market equilibrium no individual buyer and no individual seller can alter his or her own behavior in such a way as to increase his or her own surplus. excess supply a situation in which quantity supplied is greater than quantity demanded (resulting in downward pressure on price). excess demand a situation in which quantity demanded is greater than quantity supplied (resulting in upward pressure on price).

2 The Market Equilibrium in the model of Supply and Demand is: stable if we are there we will stay there, unless outside forces change unique there is one and only one equilibrium, a property which follows from the Law of Demand and Law of Supply self enforcing at higher prices there is downward pressure on price; at lower prices there is upward pressure on price therefore if we are at some other price, we will be pushed toward the equilibrium price Circular Flow of Economic Activity: Households Supply of Labor, Land, Capital, and other factors of production Income as Wages and Rents Consumer Expenditures Consumption of Finished Goods and Services Markets for Factors of Production (labor, land, capital, etc.) Markets for Goods and Services (output of firms) Labor, Land, Capital, and other factors of production hired Wages and Rents paid Firm Revenues Output of Finished Goods and Services Firms

3 5 Market Equilibrium What prices are stable? price Supply Excess Supply at a price of $5: quantity supplied (of 75) is greater than quantity demanded (of 15) [i.e., more sellers than buyers ] => downward pressure on price 3 2 Demand Excess Demand at a price of $2: quantity demanded (of 15) is greater than quantity supplied (of 4) [i.e., more buyers than sellers ] => upward pressure on price quantity D(5)=15 S(2)=4 D(3)=S(3)=55 S(5)=75 D(2)=15 Is a high price of p H 5 stable? At this price: buyers are willing and able to buy 15 units, while sellers are willing and able to sell 75 units. Since quantity supplied is greater than quantity demanded, there is excess supply. 6 of the sellers who would like to sell the item for $5 are not able to find buyers each of these sellers would have an incentive to instead accept $49.99 (and sell the item for one cent less, as opposed to not selling the item) => downward pressure on price. Any price for which there is excess supply is not stable. Is a low price of p L 2 stable? At this price: buyers are willing and able to purchase 15 units, while sellers are willing and able to sell 4 units. Since quantity demanded is greater than quantity supplied, there is excess demand. 65 of the buyers who would like to purchase the item for $2 are not able to find sellers each of these buyers would have an incentive to instead offer $2.1 (and buy the item for one cent more, as opposed to not buying the item) => upward pressure on price. Any price for which there is excess demand is not stable Only stable price is at the intersection of the demand curve and the supply curve. Only at this price do we have (quantity demanded)=(quantity supplied). At p * 3 : buyers are willing and able to purchase 55 units and sellers are willing and able to purchase 55 units (no excess demand ; no excess supply ). Further, all those potential buyers that don t make a purchase at this price do not want to make a purchase at this price. Likewise, all those potential sellers that don t make a sale at this price do not want to make a sale at this price. Nobody has anything to gain by changing their behavior => Stable Outcome. Market Equilibrium occurs at the intersection of supply and demand: equilibrium price is p * 3 and equilibrium quantity is q * 55.

4 Multiple Choice Questions: 2. Which markets are represented in the Basic Circular Flow Diagram? A. Markets for Imports and Exports and markets for Factors of Production. B. Markets for Goods and Services and markets for Factors of Production. C. Markets for Financial Assets and markets for Imports and Exports. D. Markets for Goods and Services and markets for Financial Assets. 3. One of the principle functions of money is that it serves as a unit of account. This role could be described by recognizing that money A. is an asset used as payment when purchasing goods and services. B. is an asset that can be used as a means to hold wealth. C. is used as a basic unit of measuring economic activity. D. None of the above answers are correct. 5. Supply A. refers to the entire relationship between the price of a good and the number of units that firms are willing and able to sell, all other factors fixed. B. refers to the amount of a good that firms are willing to sell at the equilibrium price. C. provides a summary of the behavior of buyers in a market. D. More than one (perhaps all) of the above answers is correct. 6. The Basic Circular Flow Diagram A. summarizes the different combinations of output that a society could produce, given their currently available productive resources. B. illustrates how Supply and Demand interact to determine the unique equilibrium price and equilibrium quantity in a market. C. illustrates the interaction between households and firms in a simplified free market economy. D. None of the above answers are correct. 11. Which of the following demonstrates the Law of Demand? A. After Clarissa got a raise at work, she bought more donuts at $6 per dozen than she did before her raise. B. After the price of flour increased by 12%, Sabrina chose to sell fewer donuts. C. Melissa chooses to sell more donuts at $7.25 per dozen than she chooses to sell at $6.75 per dozen. D. Joan chooses to buy fewer donuts at $9. per dozen than she chooses to buy at $7.75 per dozen.

5 12. Consider the market for oranges. If there is excess demand at a price of $2.35, then the equilibrium price must be: A. above $2.35. B. exactly equal to $2.35. C. below $2.35. D. None of the above answers are correct (since more information is needed to answer this question). 14. Last weekend Brenda won $1,5 at a casino in Biloxi, Mississippi. She decided to use the money to purchase a new TV from Walmart. She was able to use the money to acquire the new TV since money serves as a A. contract. B. medium of exchange. C. store of value. D. unit of account. For questions 15 and 16, refer to the graph below. This graph illustrates the supply and demand for hats in 213. price Supply (a) 12. (b) (c) (e) (f) (g) 7.5 (d) (h) Demand 213 1,85 3,7 5, In equilibrium hats will be traded, each at a price of. A. (5,15); ($17.75). B. (3,7); ($12.). C. (1,85); ($7.5). D. None of the above answers are correct. 16. In this market there would be at a price of $9.75. A. excess supply B. excess demand C. neither excess demand nor excess supply. D. both excess demand and excess supply. quantity

6 17. The Law of Demand implies that A. if the price of a good increases, then the quantity demanded of the good will decrease. B. demand curves should be downward sloping. C. demand for a good will increase if consumers realize an increase in income. D. More than one (perhaps all) of the above answers is correct. 18. A seller s reservation price A. refers to the maximum dollar amount a buyer is willing to pay for an item. B. refers to the minimum dollar amount a seller is willing to accept in exchange for an item. C. is visually illustrated by the vertical distance between the demand curve and the supply curve. D. More than one (perhaps all) of the above answers is correct. 19. In a free market, the equilibrium quantity of trade and equilibrium price of a good are determined by A. the interaction of both self-interested buyers and self-interested sellers in the marketplace. B. only the buyers in the market. C. only the sellers in the market. D. neither buyers nor sellers, but rather by a government bureaucrat. 21. The Basic Circular Flow Diagram builds upon the Preliminary Circular Flow Diagram by A. adding an illustration of the movement of money between households and firms, which facilitates the voluntary transfer of economic resources. B. adding an illustration of how equilibrium price and quantity are each determined in a market. C. adding an illustration of the role of government in collecting taxes from firms and households. D. deleting the illustration of the role played by firms in the economy. 22. The height of the demand curve at a particular quantity illustrates A. seller s reservation price for that unit. B. buyer s reservation price for that unit. C. magnitude of excess demand at the market equilibrium. D. spontaneous order.

7 Answers to Multiple Choice Questions: 1. C 2. B 3. C 4. D 5. A 6. C 7. B 8. B 9. A 1. B 11. D 12. A 13. B 14. B 15. B 16. B 17. D 18. B 19. A 2. C 21. A 22. B