Why produce more when prices rise?

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1 Supply Supply Curve a function that shows the quantity supplied at different prices. Quantity Supplied the amount of a good that sellers are willing and able to sell at a particular price. Producer Surplus the producers gain from exchange, or the difference between the market price and the minimum price at which a producer would be willing to sell a particular quantity. Producer Surplus the area above the supply curve and below the price. Why produce more when prices rise? You spent a few weeks analyzing this in microeconomics. Basically when resources have competitive uses, it tends to be more costly to produce extra output in the short-run. Hence, higher prices are required to cover costs that increase at the margin. 9

2 Two ways to read a supply curve It can be read horizontally or vertically. Horizontally given the price of a good, how much will be produced? Start with the price. then to get Q. Vertically given the amount people want to sell, what is the lowest price they willing to charge? Start at Q. Read then to get price. Figure 4 illustrates this. 10

3 Figure 4: A graph from (Cowen and Tabarrok, 2011, ch. 3): Two ways to read a supply curve. 11

4 Figure 5: A graph from (Cowen and Tabarrok, 2011, ch. 3). Given the price of oil is $40, the producer surplus will be the area below $20 and above the supply curve, which is shaded in green. Producer Surplus What benefits do producer get from trade? It depends on the difference between how much they are willing to accept to produce and what they actually get paid for producing that amount. It s the difference between price and the supply curve. See Figure 5. 12

5 Changes in Supply When something alters how much you are willing to produce of a good at each possible market price, we say that supply has changed. Graphically, this appears as a shift in the location of the supply curve. There is a new set of prices for each quantity (or new quantities for each set of prices). Increase in Supply Producers are willing to produce more of the good at existing prices. Supply shifts to the right. Decrease in Supply Producers aren t willing to produce as much of the good at existing prices. Supply shifts to the left. 13

6 What changes or shifts supply? 1. Technological innovations technology improves, supply increases, shifting to the right. 2. Changes in input (resource) prices resource prices rise, costs rise and supply decreases, shifting supply curves to the left. 3. Taxes and subsidies taxes increase costs and decrease supply (shift left), subsidies reduce costs and increase supply (shift right). 4. Entry or exit of producers into industry more firms usually means more competition which tends to increase supply. 5. Changes in opportunity costs in general, higher opportunity costs reduce supply. 14

7 Equilibrium The demand curve is a simple model of how consumers behave in a market. The supply curve is a model of the provision of those goods or services. Together, they form a market and, provided that institutions that govern ownership, buying, and selling are goods ones, prices will adjust to bring about a balance between the wishes of both sides of the market. This balance is referred to as equilibrium. Equilibrium Price the price at which quantity supplied is equal to quantity demanded. Surplus when quantity supplied exceeds quantity demanded. Cause: price is above equilibrium. Shortage when quantity demanded exceed quantity supplied. Cause: price is below equilibrium 15

8 The adjustment process If buyers compete with one another for scarce goods, then rivalry tends to drive prices up. So, when there are shortages, prices rise as potential buyers outbid each other. Suppliers are willing to provide more in response to the rising prices. Eventually, the shortages are eliminated as equilibrium is approached. If sellers compete with each other for customers, then there is an incentive for prices to fall towards the cost of production eliminating all excess profits. Surpluses are eliminated by competition among sellers which result in falling prices. Falling prices discourage production and the surplus is eliminated as equilibrium is appoached. So, as long as we have sufficient competition markets are self-equilibrating. Furthermore, as long as all of the benefits of consuming go to the buyer and the costs to the seller, the equilibrium quantity and price maximize the net benefits of trade in that good to society. This is shown if Figure 6. 16

9 Figure 6: A graph from (Cowen and Tabarrok, 2011, ch. 4): Surplus drives price down, shortage drive prices up. Markets tend to be self-equilibrating provided there is sufficient competition. 17

10 Who competes with whom? Common Fallacy Sellers want higher prices and buyers want lower prices so buyers and sellers compete against one another. This is False! Fact Sellers compete against each other, which causes prices to fall. Fact Consumers compete against each other for access to goods; this causes prices to rise. If the price of a good that you want is high, should you blame the seller? Not if the market is competitive. Instead, you should blame other buyers for outbidding you. (Cowen and Tabarrok, 2011, p.49) 18

11 Gains from trade are maximized at equilibrium prices and quantities This statement requires a little qualification. There are some things that have to go right for markets to maximize gains from trade. These conditions suggest goods that carry significant spillover costs or benefits may not be optimal. Or, goods for which you are unable to prevent non buyers (referred to as free riders) from consuming once the good is provided (public goods). Still, most goods don t carry large spillovers and technology and property rights are making it easier to charge free-riders for consumption. Provided there is sufficient competition among buyers and among sellers Buyers get all of the benefits that are associated with the good. Sellers bear all of the costs associated with producing the good. The conclusion is based on the supply and demand model that shows the market price maximizes the total surplus from trade. This is illustrated in Figure 7. 19

12 Figure 7: A graph from (Cowen and Tabarrok, 2011, ch. 4): Maximizing gains from trade in free markets. This demonstrates one dimension of what Adam Smith was talking about when he referred to an Invisible Hand. 20

13 Shifting Curves A picture is worth a thousand words? Probably. See Figure 8. Be sure you know how to describe the difference between changes in demand and changes in quantity demanded. Likewise for supply. Describing changes Change in Quantity Demanded Move along a given demand curve. This is caused by a change in price. Change in Demand This shifts the demand curve. This is caused by changes in income, population, prices of other goods, expectations, or tastes and preferences. Change in Quantity Supplied Move along a given supply curve. This is caused by a change in price. Change in Supply This is a shift in the supply curve. This is caused by changes in technology, input prices, taxes, subsidies, entry or exit from the industry, or changes in opportunity costs. 21

14 Figure 8: A graph from (Cowen and Tabarrok, 2011, ch. 4): Shifting supply and demand and determining the effects on equilibrium prices and quantities. 22

15 Bibliography Cowen, Tyler and Alex Tabarrok (2011), Modern Principles of Economics, 2nd edn, Worth, New York. 23