ECN 330 Lecture 1: “Markets and Economic Efficiency: An Economics Primer”
Economics is the study of how individuals, firms and societies deal with scarcity. In economics we can examine the notion of scarcity on two general levels: Microeconomics and macroeconomics.
Microeconomics examines economic decisions at the individual consumer or firm level:
• How consumers decide which goods and services to purchase, how to allocate scarce time, money and other resources toward purchases in order to maximize satisfaction. • How firms allocate their scarce productive resources (land, labor and capital) in order to decide which products to produce, and how to produce them – what inputs to use, in order to maximize profits. • When we put these two together (buyers and sellers) we get a “market”. Many markets together comprise and economy.
Thinking ahead… What are some environmental and natural resource scarcity issues that might fall under microeconomics? - local pollution issue - local or regional species preservation issue - regional fishery management problems
We can also expand up to a larger level and look at
Economic decisions at the society or economy-wide level, which are covered under Macroeconomics.
• How markets interact to determine production in an entire economy • How nations interact to allocate goods and services through trade • How government intervenes in markets through policy • How interest rates are determined • How inflation, unemployment and economic growth are determined and measured
Thinking ahead… What are some environmental and natural resource scarcity issues that might fall under macroeconomics? - The contribution of a nations natural resource endowments to a nations GDP (“ecological economics”) - National management of oil reserves and the implication of management alternatives for the general price level and inflation. - Highly migratory (eg: pelagic) fisheries management
In this course we’re going to be studying both levels…
Most of what we’ll cover will be more micro-focused, but when we get into things such as migratory fisheries issues, we might have to expand our focus to a more macro level.
It’s important to recognize that the two are not separate – most of the tools, models and intuition we get from microeconomics carries over and are used in macro, just in a larger context.
Within both branches of economics, we spend a great deal of time engaged in something known as positive analysis.
Positive analysis is analyzing or predicting the effects or consequences of actions that take place within economic systems (households, firms, markets, nations) without making subjective judgments.
Basically positive analysis is completing “if…then” statements.
Positive analysis is objective analysis completed without personal opinion or personal bias, such as examining and analyzing facts, data and theory without interjecting our personal beliefs or opinions.
We can break positive economics into 2 general ideas: • descriptive economics (describing facts based on specific data) • economic theory (generalizations about relationships that are commonly held true based on a collection of observations)
Examples of questions that might be addressed with positive analysis: • What will happen to tourism revenues if reef quality decreases by 10%? • What are tourists willing to pay to visit a marine park? • What will happen to employment and wages in the fishing industry if stocks decrease by 20%? • What will happen to employment and wages in the hotel industry if beach width decreases by 25%?
Macro egs: • What will happen to housing purchases if interest rates fall next quarter? • What happens to the price of U.S. goods if trade restrictions with other nations are imposed?
These are all examples of positive analyses • looking at cause and effect • what is actually going on • what exists
BLACKBOARD DISCUSSION EXERCISE: 1. Construct 2 micro-level environmental/natural resource questions that could be addressed with positive analysis. 2. Construct 2 macro-level environmental/natural resource questions that could be addressed with positive analysis.
In contrast to positive analysis where we don’t have subjective opinion or judgment, we can talk about “NORMATIVE ANALYSIS” where we do.
Normative analysis: making value judgments as to whether the effects or consequences of a particular action are a good thing or a bad thing. Trying to determine “what ought to be”.
As we study economics throughout the semester we’re going to do a ton of “real-world” examples - and we’re going to encounter issues where normative-type questions are raised.
We’re going to discuss pro’s and con’s a lot this semester (benefits vs. costs)
But for the most part we’re going to avoid making any normative conclusions, simply because we’re all individuals and we have our own opinions as to what “ought to be”. I consider it my job to teach you how to do the positive part – how to use the tools and theories of economics to see what’s happening and what the effects are or may be. But I’ll leave it up to you when we get to deciding whether or not the effects are a good or bad thing.
Typically economists do not do much normative analysis. Economists engage in positive analysis and report the results to politicians and policy makers who can then use their own normative analysis (or that of their voters) to weigh the results and make policy decisions.
“Models”
Much of what we’re going to be doing in this course involves modeling … models are descriptive, graphical or mathematical simplifications of reality.
In order to construct these models, we’ll have to make some assumptions in order to graphically or numerically represent some “real world” phenomenon or idea under simplified conditions that are easy to understand.
Given the assumptions, we can then analyze the model (by doing positive analysis) and the phenomenon in order to use the results to make inference about the real situation.
After the analysis we can then examine the importance of the assumptions, and whether or not the results of the modeling effort will change if the assumptions are relaxed. Another extremely important word in economics is: “MARGINAL” or “Margin” = on the edge, on the border…
The marginal unit is the “next” unit, or the “incremental unit”, or the “additional” unit.
Something we do a lot of in economics is measure and compare costs and benefits.
Comparing costs and benefits helps us to make rational choices.
We sometimes are faced with “yes” / “no” type choices. When this is the case, we simply look at total costs vs. total benefits.
The decision rule is straightforward: if the benefits of a given choice outweigh the costs (including the opportunity costs) then you can gain from making the choice.
If you get more out than you put in there is a net gain. Benefits go up. We can conclude that this action is a good idea.
This is common sense – you don’t even think about it – but this is the fundamental way we make decisions:
Eg: Should you get up at 4:00 in the morning today? Likely No. The costs will outweigh the benefits
Eg: Should you show up at class today and miss going to the beach? Likely yes. The benefits of going to class outweigh the costs.
This common sense decision-making process that you do all day every day can be a very powerful tool for economics when it is applied “at the margin”.
Sometimes choices are not as simple as “yes/no”, but rather are a decision of “how many”? What is the best quantity? • How many slices of pizza to eat? • How many cups of tea to drink? • How big of a house to purchase or build?
When this is the type of decision we have to make, comparing total costs and total benefits doesn’t work as well. We have to look at marginal costs vs. marginal benefits – This is a type of positive analysis called “Marginal Analysis”.
Example of marginal analysis with numbers:
Suppose you are sitting at a pizza restaurant eating slices of pizza.
Decision: how many slices should you buy to maximize your satisfaction from a limited budget?
… 2, 3, 4….??
Let’s say you eat 3 – why don’t you eat the 4th slice? – It costs too much and you’re full. In other words the costs of the 4th slice (the next slice, the additional slice, the marginal slice) outweigh the benefits.
To make the example more complete, let’s assume that the price of one slice = $1.50 (in other words, the additional or marginal cost of each slice is $1.50) and let’s also assume that we can measure the benefit of each slice (the marginal benefit of each slice) in dollars:
Slice marginal benefit marginal cost net gain 1 4.50 1.50 3.00 2 2.75 1.50 1.25 3 1.51 1.50 0.01 4 0.75 1.50 -0.75
Before we get to the marginal analysis, notice something about the marginal benefit numbers: Marginal benefit decreases as quantity increases. Why is this the case? Marginal benefit decreases as we consume more of a good (be it slices of pizza or any other good), because we get more full, or satisfied with each unit. Hence, the additional benefit gained from the second unit is likely to be lower than the first, and so on.
This is a fundamental principle of economics known as the principle of diminishing marginal benefit. This principle relies on the assumption that each unit is of the same quality (as is the case with our pizza example).
Back to the example: - What is the benefit from the 1st slice? - What is the cost of the 1st slice? - Benefit from the second slice? - Cost of the second slice?
Compare the additional cost with the additional benefit of each slice and decide how many slices to consume.
The best quantity for you is 3. For each slice up to and including the 3rd, you have MB > MC, so you experience a net gain. But after the 3rd slice, you have MC > MB, so you lose.
That’s marginal analysis. We compare the additional benefits with the additional costs of each unit, and then make a rational decision. Graphically:
$ (mb, mc)
3.00
2.00 MC 1.00 MB
1 2 3 4 5 Quantity of pizza
Question: A few minutes ago, I said that for quantity decisions (how many?), we couldn’t rely on a comparison of total costs and total benefits --- does anyone see why in this example?
What if I had asked: “should you consume 4 slices, yes or no”? And you compared the total costs and total benefits of 4 slices….
Total Cost = 1.50 x 4 = 6.00
Total Benefit = benefits from each slice added together = 4.50 + 2.75 + 1.51 + 0.75 = 9.51
TB > TC and net gain = $3.51
This is a positive number and so this question passes the cost/benefit test. However, this leads you to an inefficient solution – you’re not maximizing your gains.
Look at TC vs. TB for 3 slices and see: TC = 1.50 x 3 = 4.50 TB = benefits from each = 4.50 + 2.75 + 1.51 = 8.76
TB > TC and net gain = $4.26 (better off with a net gain of 4.26 than with 3.51) this is more efficient.
While cost-benefit analysis leads us to good decisions, employing marginal analysis leads us to the best decision.
Next let’s review the basics of supply and demand…
Supply and demand is simply a way of incorporating some fundamental principles of economics into a model of a market.
To see how Market Forces (Demand and Supply) work through the mechanism of prices to determine the allocation of scarce resources among competing uses.
Market forces (Demand & Supply) determine prices, and prices determine resource allocation.
Prices are the key – if someone who possesses a good (the supplier) and someone who desires the good (the demander) can agree on a price, then that good can be reallocated to the demander.
Whenever this takes place, whenever a buyer and seller come together and agree on a price and a transaction takes place, we say there is a market.
We’re familiar with all kinds of markets. We participate in markets everyday: • Whenever you go to the grocery store or the bookstore and buy something, you are participating in a market. • You pay your tuition at UNCW, you purchase an education from this university – you are participating in a market. • You drop $0.50 in the soda machine across the hall – that’s a market. • It doesn’t have to be face-to-face – you buy CD’s from a CD club or from amazon.com – market.
Transaction takes place = market. The transaction only takes place if both parties agree on the price. So a big question for us today is:
Where do prices come from?
→ The short answer is “supply and demand”. But we need a little more than that. To answer the question properly, we’re going to build a model of a market – one piece at a time, beginning with DEMAND. Notation: D = Demand S = Supply
PX = the price of X QX = the quantity of X QD = quantity demanded QS = quantity supplied
Demand for a good or service basically tells us how and why we want that item and how much we want at different prices.
Demand (D) is the relationship between the price of an item and how many units of that item are desired by a consumer or group of consumers.
Demand is not a number.
Demand tells us how many units of an item consumers are willing to purchase at all possible prices.
In other words, demand shows a series of possible alternative price and quantity combinations, all other things held equal.
We can construct a Demand Schedule (a list of alternative Price and Quantity combinations) by listing prices and the resulting quantities that are demanded. A graphical illustration of a demand schedule is called a demand curve.
Example: the demand schedule for cans of pinto beans by an individual per month:
P QD 1.00 2 0.75 3 0.50 4 0.25 5
For each price, we have a different quantity demanded. This entire set of numbers representing the relationship between price and quantity demanded for this good is called the “Demand” for this good.
• If price is $1.00 then this individual will purchase 2 cans of pinto beans per month. • If price falls to $0.75, then he or she wants more → 3 cans per month. • If price falls even more to $0.50 then she will demand 4 units.
We can make a few observations using these numbers.
First, price determines quantity demanded.
Second, higher prices mean lower quantity demanded, and lower prices mean higher quantity demanded (in other words, there is an inverse relationship between price and QD).
That much is pretty straightforward, but where does the exact nature of the relationship come from?
Could do this for a good that you consume? Could you examine a particular good or service (pick a meal at a restaurant you visit frequently, let’s say) and figure out how many times you’d consume that good at various prices?
I think yes.
But, where does that relationship come from?
What factors influence the way price affect quantity demanded for a particular consumer or for a group of consumers?
Factors that influence DEMAND (the relationship between P and QD) = “demand shifters” • Income/wealth (generally, the more income you have, the more you will demand at any given price) • Prices of substitute goods and services (if the price of a substitute good goes up, you will buy more of this other good) • Prices of goods and services that are complements to the good in question (if the price of a complement good goes up, you will buy less of this other good) • Current tastes/preferences/fashions (if you like something, you will buy more of it at any given price) • Your expectations about future prices • Your expectations about future income/wealth
Price is the most important determinant of quantity demanded, but each of these factors influences HOW price affects quantity demanded.
That is, each of these things goes into determining the relationship between the price of an item and the number of units that are demanded.
When we put all of these factors together (your income, prices of other goods, tastes and preferences, and expectations), we can figure out the relationship between price and quantity for a particular good.
That is, given all these factors, we can determine the relationship called DEMAND.
But, if one of these things changes, then the relationship will change.
Changing a factor causes a change in demand.
So over the past few minutes we’ve made an important distinction that we need to make sure we have clear before we move on. That is, the difference between “DEMAND” and “Quantity Demanded”.
DEMAND is a relationship and tells us how much will be demanded at all prices given that all the factors that influence demand are held constant (list).
QUANTITY DEMANDED is the number of units someone is willing and able to purchase at a particular price.
Here’s a sentence that makes the distinction:
“Given demand (all the factors listed above) price determines quantity demanded”.
We’re going to draw a DEMAND CURVE to illustrate the relationship between price and quantity for a particular good.
A demand curve is simply a graphical representation of a demand schedule.
Let’s draw one…let’s put price on the vertical axis and quantity on the horizontal axis.
What will the demand curve look like?
And what does this say about the nature of the relationship between price and quantity demanded? Demand Schedule P
P QD
1.00 1.00 2 0.75 3 0.75 0.50 4 0.50 0.25 5
0.25
Demand Curve
1 2 3 4 5 Quantity of beans
Let’s start down here at the bottom at P = 0.25 and increase price up to 0.50. Notice that quantity demanded falls from 5 to 4. General Explanation: an increase in price causes a decrease in quantity demanded
Notation: ↑ P ⇒ ↓ QD
We could go in the other direction & decrease price. Go from P = 1.00 to P = 0.75 → Quantity demanded increases from 2 to 3.
↓ P ⇒ ↑ QD
⇒ There is an inverse relationship between price and quantity demanded.
This is known as “The Law of Demand” – all other things equal, as the price of an item increases the quantity demanded falls, and as the price of an item decreases the quantity demanded rises.
The law of demand implies that demand curves are always downward sloping.
Why is this true? Why is there an inverse relationship between Price and Quantity demanded? Why is it that the law of demand works?
It seems so obvious that you don’t think about it: lower price ⇒ buy more.
But why is it that when the price of Jif peanut butter goes up, you buy less?
There are 3 factors that enforce the law of demand: 1. Simple affordability – price is an obstacle to buyers. ↓ P ⇒ ↑ ability to consume
2. The availability of substitutes for most goods and services. ↑ Price of dolphin ⇒ buy tuna instead
3. Law of diminishing marginal benefit (“utility” = satisfaction)
What happens to the satisfaction (utility) we derive from a particular good as we purchase more and more units of it? → Satisfaction goes down. ⇒ Since we’re getting less satisfaction from the next unit, the amount we are willing to pay decreases as well.
Let’s look at a new demand curve: one consumer’s demand for CD’s per year.
Demand schedule:
P QD 20 7 18 8 16 9 14 10 12 11 10 12
Graphing these points gives us the Demand Curve:
Price ($) 20
18
16
14
12
10
7 8 9 10 11 12 Quantity (number of CDs)
When the price of CD’s is $16.00 → then 9 CD’s per year are demanded.
P = 16.00 ⇒ QD = 9
If price falls to $14.00 and all other factors remain the same (income, prices of other goods, expectations) then quantity demanded rises to 10/year.
A change in price (holding all other factors constant) causes a change in quantity demanded.
We DID NOT CHANGE DEMAND – we did not change the relationship between price and quantity, we simply operated within that relationship.
We show change in QD by moving along the D curve from point A to point B
{Note of explanation for later: the supply curve must be shifting}
↑ P ⇒ ↓ QD (move up the D curve)
↓ P ⇒ ↑ QD (move down the D curve)
Now let’s change Demand – let’s change the relationship between price and quantity demanded by changing one of the factors that determine that relationship.
For example, let’s change INCOME.
? What if the income of our consumer increased? → What will happen to the demand for bagels?
Think about your own demand for something you like…
? What happens to the quantity of something you purchase – regardless of the price – as you have higher income?
--Demand goes up.
** More money ⇒ buys more stuff. note: “Normal goods” are goods that you buy more of as you have more income. “Inferior goods” are goods that you buy less of when you have more income.
Question to think about: What are some examples of “Inferior Goods”?
An increase in INCOME causes an increase in DEMAND for any normal good
At any price (in fact, at all prices) you will have a higher quantity demanded for normal goods if your income increases.
How do we show this on our graph ?
WE SHIFT THE DEMAND CURVE OUT TO THE RIGHT D1 PRICE D0 Notice that we can take any price and show that consumers will now purchase a higher quantity with that higher income. P
D D Q 0 Q 1 QUANTITY
An increase in the demand for the normal good (in this case due to a higher income) means that the quantity demanded at any and all prices will go up.
When we change income (or any of the other factors that influence demand – prices of other goods, expectations) we change the relationship between price and quantity demanded.
∴ We have to draw a new representation of that relationship. That is, we have to draw a new demand curve.
A “CHANGE IN DEMAND” is caused by a change in a factor other than the price of the good.
This is shown by SHIFTING THE DEMAND CURVE.
↑ D ⇒ shift demand curve to the right
↓ D ⇒ shift demand curve to the left
• Its important not to confuse a change in demand with a change in quantity demanded – they are not the same.
Change in Demand:
Caused by change in a factor that influences demand (income, prices of other goods, expectations of prices or income changes).
Shown by shift in the D curve.
Change in Quantity Demanded:
Caused by change in price.
Shown by movement along the D curve.
A CHANGE IN THE PRICE OF A GOOD WILL NOT CAUSE A CHANGE IN THE DEMAND FOR THAT GOOD.
This seems like an insignificant distinction based on terminology. However, understanding the difference between “Demand” and “Quantity Demanded” is essential to being able to utilize the market model developed here.
What else (other than an increase in income) might increase the demand for a particular good?
Prices of other goods may affect demand (Substitute good prices, complement good prices)
What other goods are we referring to?
Substitute goods – an alternative, something that can be used in place of something, something that serves the same function of.
Complement goods – that which completes or supplements.
E.g.: Consider the demand for KFC
What is a substitute for KFC? → Home cooked chicken is a substitute for KFC (there are many other substitutes of course).
What might happen to the demand for KFC if the price of store-bought chicken suddenly becomes very high?
Demand will go up. People substitute KFC for home-cooked chicken when home-cooked chicken become more expensive.
↑ Price of home-cooked chicken ⇒ people substitute towards KFC ⇒ ↑ demand for KFC ⇒ demand for KFC shifts to the right
PKFC In general:
D1 D0 ↑ PSUBSTITUTE ⇒ ↑ D QKFC
What if the price of home-cooked chicken decreased? ⇒ ↓ D for KFC PKFC ↓ PSUBSTITUTE ⇒ ↓ D
D0 D 1
QKFC What about the price of complements? How does that relationship work?
E.g. Consider the demand for automobiles
What is a complement for automobiles? Gasoline is a complement.
What would happen to the demand for automobiles if the price of gasoline were to increase significantly?
Consumers would likely demand fewer automobiles.
↑ PCOMPLEMENT ⇒ ↓ D ⇒ shift the D curve to the left (in)
Practice drawing this shift.
Similarly, ↓ PCOMPLEMENT ⇒ ↑ D ⇒ shift the D curve to the right (out)
Other demand shifters:
Tastes/preferences/fashions: When a good becomes more preferred by consumers or more fashionable, demand will increase.
What will happen to demand if a good falls out of fashion?
Expectations about the future price of a good: If price is expected to increase soon, today’s demand for the good will increase (consumers wish to buy today, before price increases tomorrow).
What will happen to demand if price is expected to decrease in the future?
Expectations about income: If consumers expect their income to increase in the near future, today’s demand will likely increase (consumers begin to spend their future income, through credit).
What will happen to today’s demand if consumers expect their income to decrease in the future?
Please practice each of these – know how changes in each factor will shift demand.
SUPPLY
• Supply is a relationship between the price of a good and the quantity supplied (QS) by firms. • Supply shows how much of a good suppliers are willing and able to bring to market at all possible prices.
Just as was the case with demand, price is the most important determinant of QS, but other factors influence how price affects quantity supplied.
Factors that influence supply (“supply shifters”): • Input prices • Current technology • Prices of other goods that can be produced with the same inputs • The number of sellers in the market
Again we need to make an important distinction:
The difference between SUPPLY and QUANTITY SUPPLIED…
SUPPLY IS A RELATIONSHIP between price and QS
QUANTITY SUPPLIED is the number of units of a good that suppliers are willing and able to bring to market at a particular price.
So, one Q corresponds with one P.
The list of all the P and Q combinations is SUPPLY.
We noted that there is an inverse relationship between price and QD – What type of relationship is there between price and QS?
→ Positive or “direct” relationship.
↑ P ⇒ ↑ QS and ↓ P ⇒ ↓ QS
This relationship is known as “The Law of Supply”
With Price on the vertical axis and quantity on the horizontal axis, what does the law of supply say about the shape of supply curves?
⇒ Supply curves will be upward sloping.
What are the factors that make this true?
That is, what enforces the law of supply?
FACTORS THAT ENFORCE THE LAW OF SUPPLY
1. Price is REVENUE for sellers (it was a deterrent to buyers, but it’s an inducement for sellers to produce and sell a product.
→ Holding costs of production constant, a higher price means higher profits per unit, hence a higher quantity of that item that sellers want to bring to market.
{NOTE: Profit = revenue – costs}
2. The Law of increasing costs tells us:
↑ Q ⇒ ↑ opportunity cost of producing the good
Hence, to induce higher quantity supplied price must be raised (to cover higher costs).
Let’s look at the difference between a change in SUPPLY and a change in QS:
A change in QS is the result of a price change:
Consider the market for fresh dolphin:
P Supply Curve
5.00
3.00
200 1000 Q
If we raise the price from $3.00 to $5.00 ⇒ QS increases from 200 to 1000.
∆ P ⇒ ∆ QS ⇒ Move along the S curve
In general: Change in QS is caused by ∆ P and is represented by a movement along the S curve.
{Note for later: the demand curve must be shifting for this to happen}
A CHANGE IN SUPPLY (the relationship between P and QS) is caused by a change in a factor other than price, and is represented by a SHIFT in the Supply curve.
Eg: Change the supply of dolphin
Suppose that there is an increase in the price of an input into dolphin production (gasoline used to power boats).
A higher cost of producing dolphin means that for each price, profit per pound of dolphin decreases. Hence suppliers will be less willing to supply dolphin at any price.
To show this result, we would decrease the supply of dolphin.
How should we shift the Supply curve?
To show a decrease in supply we shift the supply curve LEFT (in towards the origin} S1 Price S0
Quantity of dolphin
Higher input prices means supply will decrease (S curve shifts left)
What would happen to the supply of dolphin if the price of gasoline decreased?
Lower input prices mean higher profit per unit of dolphin at any price. Hence, sellers will be more willing to supply dolphin at any price. This means there will be an increase in Supply (S curve shifts right)
What else could cause a change in SUPPLY (and therefore shift the supply curve)?
Another factor that affects supply is technological advancement:
Better technology for producing a good means more output can be produced with the same inputs (or the same output can be produced with fewer inputs). This lowers the costs per unit of output, and results in higher profit per unit of output. Hence we would expect to see an increase in supply (supply curve shifts right).
Interesting thought to consider: Can technology decrease? That is, can you envision a change in technology that results in a decrease in supply?
Another factor that affects supply is the number of sellers in the market. This one is straightforward: more sellers mean higher quantity supplied at any price. When sellers enter a market, we therefore expect to see an increase in supply in that market (supply shifts right), and when firm leave a market (perhaps to pursue more profitable opportunities in another market) we expect to see a decrease in supply (leftward shift).
Finally, the price of other goods that can be produced with the same inputs can affect supply in a particular market. For example, suppose dolphin and billfish can be produced with the same inputs (boats, lines, labor, gasoline, etc). If the price of billfish were to increase, we’d expect to see a decrease in the supply of dolphin as producers shift their inputs toward the now more profitable billfish.
Now we are ready to put Demand and Supply together on the same graph to have a complete representation of a market.
The intersection of the Demand and Supply curves is known as “Market equilibrium”
In general, what is an “equilibrium”? What does this word mean?
Equally balanced; stable; at rest.
Equilibrium implies “a stable balance between opposing forces”.
Market equilibrium occurs when price and quantity are at rest. That is, they are not changing.
A market equilibrium occurs when price is such that QS = QD
An equilibrium price (P*) is a referred to as the “market clearing price” because at that price the quantity suppliers are willing and able to bring to market is exactly equal to the quantity that demanders are willing and able to purchase. In other words, the market clears… there is no shortage and there is no surplus. We show the market clearing price and the corresponding equilibrium quantity by plotting Demand and Supply together and finding their intersection.
P S
P*
D
Q* Q
At P* QD = QS = Q*
Let’s do a reality check…Do markets really exist in equilibrium?
Yes, at least temporarily. We know that if a market is NOT in equilibrium, then price will be changing. Prices don’t typically change hourly or daily or even weekly for most products. So, yes, markets do exist in equilibrium. There are changes, but they take time.
Next question: If markets do exist in equilibrium, how do they get there?
Where does this magical price that clears the market (P*) come from?
How do suppliers know how much to charge for their good? → Guessing? Do you just make up a price?
Maybe the first time….But what happens if the price is set too high?
E.g. suppliers initially set price above equilibrium price: PHIGH > P*
What happens?
Suppose you go to the SuperCenter and you see a sign that says “fresh bread: $25 per loaf”
Where is that price in relation to the equilibrium price? It is obviously too high.
How much bread is the SuperCenter going to sell at $25 per loaf? Probably none. All that bread is just going to sit there. There will be an overabundance. A plethora of unsold bread.
At this high price, the quantity supplied by SuperCenter will be far above the quantity demanded by consumers.
When price is set above P* we see: QS greater than QD , this is known as a “market surplus”
Let’s look at a surplus graphically:
P S $25 = PHIGH
$0.99=P*
D
D S Q Q* Q Quantity
The horizontal distance* between QD and QS is the amount of the SURPLUS
* We show the size of the surplus on the horizontal axis because a surplus is a quantity measure (how much is left over unpurchased) so we show it on the quantity axis.
MARKET SURPLUS = the amount by which QS exceeds QD when price is set above P*
What happens when there is a surplus of a good? → SuperCenter has a lot of bread sitting on the shelves going stale. How do they get rid of it?
The should lower the price.
Hence we see that a market surplus (because price was set too high) will put downward pressure on price.
How far will price fall?
Price will decrease as long as there is a surplus; hence price will fall until the surplus is eliminated. This occurs when price falls to P*, where quantity demanded equals quantity supplied.
How do we know this is true?
Because as long as P > P* there still is a surplus, so suppliers have too much, so they keep lowering price to try to get rid of it.
What happens when suppliers set price too low?
PLOW < P*
Suppose SuperCenter had instead priced their bread too low. Say, $0.25 per loaf. Everyone would try to purchase this bread, and SuperCenter will likely not have enough to go around.
The quantity demanded by consumers at that price is going to be much higher than the quantity SuperCenter is willing to supply.
When price is below the true equilibrium price, quantity demanded exceeds quantity supplied. This is known as a “market shortage”.
Lets look at a shortage graphically:
P S
$0.99=P*
$0.25 = PLOW D
S D Q Q* Q Quantity
MARKET SHORTAGE = the amount by which Qd exceeds Qs when price is set BELOW P* The horizontal Distance between quantity supplied and quantity demanded is the amount of the shortage. Again, we show the size of the shortage on the horizontal axis because a shortage is a quantity measure (by how much QD exceeds QS) so we show it on the quantity axis.
What happens when there is a shortage of a good? → SuperCenter does not have enough bread to go around at this very low price. How will they remedy this situation?
Price will be raised to alleviate the shortage.
That is, the existence of a market shortage will put upward pressure on price.
How far will price rise?
Price will increase until the shortage is eliminated.
How do we know this is true?
Because as long as P < P* there still is a shortage, so suppliers don’t have enough to sell, so they keep raising price to eliminate the shortage situation.
The key point here is that when a market is in equilibrium, then by definition QD = QS, and there is no shortage or surplus.
When a market is in disequilibrium, QD is not equal to QS {either a shortage or a surplus exists} then PRICE IS WHAT CHANGES to move the market back into equilibrium.
Shortage will cause price to rise to eliminate the shortage Surplus will cause price to fall to eliminate the surplus
“PRICE IS THE EQUILIBRATING FORCE”
PRICE SERVES TO RATION GOODS AND SERVICES
Now that we understand how equilibrium prices are determined the first time they are set, let’s now use the model of a market to understand how equilibrium prices change.
In short, changes in demand and supply cause changes in equilibrium
In order to change demand or supply, we must first have a change in one of the factors that affects supply or demand (that is, something changes to cause a shift of one of the curves). This shift of one curve implies movement along the other curve and a change in equilibrium price and quantity. For example, consider a decrease in demand (this would shift the demand curve to the left)
What could have caused this? - Decrease income/wealth of consumers - Decrease in the price of a substitute good - Increase in the price of a complement good - Decrease in the expected future price of the good - Decrease expected future income of consumers - Decrease in the popularity of the good
Graphically, when the demand curve shifts left along a stable supply curve, equilibrium price falls and equilibrium quantity falls
PRICE
S
P0
P1
D0
D1
Q1 Q0
A decrease in demand causes a lower equilibrium price and a lower equilibrium quantity. This is easy to see on the graph.
To really understand this idea, we must as WHY does price fall in this case?
Let’s really try to understand this… why does price fall when demand goes down?
What happens immediately after the decrease in demand, when price does not yet have a chance to fall?
For example, suppose there is a substantial increase in the price of gasoline, which causes a decrease in the demand for large automobiles. For the first few days after the gasoline price change, the price of automobiles is still high, but demand is now much lower…
Price initially remains at P0 with the new demand. What then must happen?
Where is quantity demanded with the old price (P0) and the new demand? (This quantity will be far below Q1 in the above graph)
Where is quantity supplied with the old price and the new demand? (Q0)
Hence, at the old price for automobiles and with the new demand (caused by higher gasoline prices), we have an initial situation where quantity demanded is far less than quantity supplied. That is, initially there is a market surplus.
Therefore we can say that it’s the existence of a temporary surplus that puts downward pressure on price when demand decreases.
Let’s do another example:
A decrease in supply – this means that at any and all prices, sellers are less willing to bring the good to market. A decrease in supply is shown by shifting the supply curve to the left.
What could have caused a decrease in supply? - Higher input prices - A decrease in the number of sellers in the market - An increase in the price of other goods that can be produced with the same inputs
Graphically, the supply curve shifts left along a stable demand curve ⇒ Equilibrium price rises and equilibrium quantity falls
PRICE S1
S0 P1
P0
D0
Q1 Q0 Quantity
Again, it is easy to see from the graph that a decrease in supply will result in higher equilibrium price and lower equilibrium quantity.
To truly understand this, we must understand why price rises in this case.
Consider what happens in the moment after the decrease in supply but before price has a chance to rise…
S With the new supply and the old (lower) price, Q is much lower than Q1 D With the new supply and the old (lower) price, Q remains at Q0
Hence a decrease in supply with no change in price implies that QD exceeds QS, or the market is in a state of shortage. We know that this shortage will put upward pressure on price.
A decrease in supply creates a temporary shortage at the old (low) price that causes price to rise to its new equilibrium.
We now need to discuss the idea of economic efficiency.
Additional online reading:
Supply and Demand from env-econ: http://www.env-econ.net/supply_demand.html
Demand vs. Quantity demanded from env-econ: http://www.env-econ.net/demand-vs-quantity-demand.html
The basics of supply and demand from Investopedia: http://www.investopedia.com/university/economics/economics3.asp