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ECO1104- Detailed Notes for chapters 4-6

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J Ianweizhen

Chapter 4 The Market Forces of Supply and Demand Market and Competition  A market is a group of buyers and sellers of a particular product o The type of market can be determined by the number of buyers and sellers  A competitive market is one with many buyers and sellers, each has a negligible effect on price. o Leads to many competitors within the marketplace  In a perfectly competitive market: o All goods are exactly the same o Buyers and sellers are so numerous that no one can affect market price – each is a “price taker”  Price is manipulated by the buyer  In the real world there is relatively few perfectly competitive markets. Most goods come in lots of different varieties- including ice-cream. o There are many markets in which the number of firms is small enough that some of them have the ability to affect the market price  In this chapter, we assume markets are perfectly competitive  Oligarchy: few sellers who work together in a group o Price is relatively stable Demand  The quantity demanded of any good is the amount of the good that buyers are willing and able to purchase.  Law of demand: the claim that the quantity demanded of a good falls when the price of the good rises, other things equal o In the law of demand, we must make a strong assumption that in order for all the things to be equal and work in linear fashion, thus price will be only affected by buyers decision making  When price increase, demand falls  When price decreases, demand increases o It is important to understand that that other things may affect the rise in demand other than price  Demand comes from the behaviour of buyers The Demand Schedule  Demand schedule: A table that shows the relationship between the price of a good and the quantity demanded o Ex. Helen’s demand for lattes Price Quantity of lattes of lattes demanded $0.00 16 1.00 14 2.00 12 3.00 10 4.00 8 5.00 6  Notice that Helen’s preference’s obey the law of demand 6.00 4 Helen’s Demand Schedule & Curve Price of lattes Quantity of lattes demanded $0.00 16 1.00 14 2.00 12 3.00 10 4.00 8 5.00 6 6.00 4 At the beginning Price is an independent variable but later affected by p. Market Demand vs. Individual Demand  It is possible to get market demand from the use of many buyers demand  The quantity demanded in the market is the sum of the quantities demanded by all buyers at each price.  Suppose Helen and Ken are the only two buyers in the Latte market ( Q = quantity demanded)  Quantity – x-axis  Price y-axis Market quantity corresponds to a different price levels The Market Demand Curve for Lattes d P Q (Market) $0.00 24 1.00 21 2.00 18 3.00 15 4.00 12 5.00 9 6.00 6 Demand Curve Shifters  The demand curve shows how price effects quantity demanded, other things being equal.  These “other things” are non-price determinants of demand (i.e., things that determine buyers demand for a good, other than the good’s price).  A demand curve shifter is any change that increases the quantity demanded at every price o Ex. An imaginary discovery about the nutritional benefits of ice-cream will shift the demand curve to the right which is called an increase in demand. o Any change that reduces the quantity demanded at every price shifts the demand curve to the left and is called a decrease in demand  Changes in them shift the D curve… Demand Curve Shifters: Number of Buyers  Increase in the # of buyers increases quantity demanded at each price, shift D curve to the right. Suppose the number of buyers increases. Then, at each P, Q will increase (by 5 in this example) Demand Curve Shifters: Income  Demand for a normal good is positively related to income o Increase in income causes increase in quantity demanded at each price, shift D curve to the right  (Demand for an inferior good is negatively related to income. An increase in income shifts D curve for inferior goods to the left  Normal goods: when your income increases, you would buy more of these kinds of products  Inferior goods: when your income increases you would buy more expensive version of these goods  Both normal goods and inferior goods are relative to the person being describes Demand Curve Shifters: Prices of Related Goods  Two goods are substitutes if an increase in the price causes an increase in demand for the other  Ex: pizza and hamburgers. An increase in the price of pizza increase demand for hamburgers, shafting hamburger demand curve to the right o Other ex: Coke and Pepsi, laptops and desktop computers, CDs and music downloads  Two goods are complements if an increase in the price of one causes a fall in demand for the other. o Ex: computers and software  If price of computer rises, people buy fewer computers and therefore less software. Software demand curve shifts left. o Other examples: college tuition and textbooks, bagels and cream cheese, eggs and bacon o Other ex: camera and films: the decline in photographic film cameras has led to a decline in the photographic film industry Demand Curve Shifters: Tastes  Anything that causes a shift in tastes toward a good will increase demand for that good and shift its D curve to right.  Ex. The Atkins diet that became popular in the 90s caused an increase in demand for eggs, shifted the egg demand curve to the right Demand Curve Shifter: Expectations  Expectation affect consumers’ buying decisions  Ex: o If people expect their incomes to rise, their demand for meals at expensive restaurants may increase o If the economy sours and people worry about their future job security,, demand for new automobiles may fall o Can also be used in relation to expectation of quality of goods  i.e. Apple IPhone 5C: didn’t meet expectations which may result in a decline in demand  Summary: Variables That Influence Buyers Memorize It must be noted that Price only causes a movement along the demand curve not a shift If the variable that is causing demand to change is NOT measured on either axis, the curve shifts Active Learning #1: Demand Curve Draw a demand curve for music downloads. What happens to it in each of the following scenarios? Why? a. The price of iPods falls  Music download and iPods are compliments of each other. A fall in price of iPods shifts the demand curve for music downloads to the right.  The price of downloads is the same, but the quantity demanded is now higher. At any given point the quantity is higher than before b. The price of music downloads falls  The D curve does not shift. Move down along to a point with lower P, higher c. The price of CD falls  CDs and music downloads are substitutes  A fall in price of CDs shifts demand for music downloads to the left Supply  The quantity supplied of any good is the amount that sellers are willing and able to sell.  Law of supply: the claim that the quantity supplied of a good rises when the price of the good rises, other things equal o When price increases, quantity increases o When prices falls, quantity supplied falls as well  This we say that quantity supplied is positively related to the price of the good  Supply comes from the behaviour of sellers The Supply Schedule  Supply schedule: A table that shows the relationship between the price of a good and the quantity supplied.  Ex. Starbucks’ supply of lattes o Notice that Starbucks’ supply schedule obeys the Law of Supply Starbucks’ Supply Schedule & Curve Market Supply vs. Individual Supply  The quantity supplied in the market is the sum of quantities supplied by all sellers at each price.  Suppose Starbucks and Jitters are the only sellers in this market (Q = quantity supplied) The Markey Supply Curve Supply Curve Shifters  The supply curve shows how price affects quantity supplied, other things being equal.  These “other things” are non-price determinants of supply.  A supply curve shifter is any change that increases the quantity supplied at every price o Ex.  Changes in them shift the S curve… Supply Curve Shifters: Input Prices  Has direct impact of the price of the product o i.e. if wages/materials, etc. increase, production price will increase as well  Ex. of input prices: o Wages o Prices of raw materials  A fall in input prices makes production more profitable at each output price (the price of the good that firms are producing and selling), so firms supply a larger quantity at each price, and the S curve shifts to the right  Suppose the price of milk falls. At each price, the quantity of lattes supplied will increase ( by 5 in this example) Supply Curve Shifters: Technology  Technology determined how much inputs are required to produce a unit of output.  A cost-saving technological improvement has the same effect as a fall in input prices, shift the S curve to the right o More efficiency with productions o Leads to more production at lower costs Supply Curve Shifter: Number of Sellers  An increase in the number of sellers increases the quantity supplied at each price, shifts S curve to the right. Supply Curve Shifters: Expectations  Ex. o Events in the Middle East leads to Expectations of higher oil prices. o In response owners of Texas oilfields reduce supply now, save some inventory to sell later at the higher price. o S curve shift left  In general, sellers may adjust supply (if good is not perishable) when their expectation of suture prices change. Summary: Variables that Influence Sellers *memorise Active Learning 2: Supply Curve Draw a supply curve for tax return preparation software like “TurboTax” and “Tax Cut”. What happens to it in each of the following scenarios? a) Retailers cut the price of software S curve does not shift. Move down along the curve to a lower P and lower Q b) A technological advancement allows the software to be produced at lower cost. S curve shifts to the right: at each Q increases. c) Professional tax return preparers raise the price for the services they provide This shifts the demand curve for tax preparation software, not the supply curve. Supply and Demand Together  Economy is a demand bound o When there is demand, there will be supply  Equilibrium: P has reached the level where quantity supplied equals quantity demanded Equilibrium price: the price that equates quantity supplied with quantity demanded To graph of Supply Demands Graph find the x and y intercepts +10 Q d (50, 0) Q s (10, 0) (0, 25) (0, -5) Equilibrium quantity: the quantity supplied and the quantity demanded at the equilibrium price Surplus (a.k.a. excess supply): when quantity supplied is greater than quantity demanded Example If P = $5 Then Q = 9 lattes And Q = 25 lattes Resulting in a surplus of 16 lattes Facing a surplus sellers try to increase sales by cutting price. This causes Q D to rise and Q to fall… …which reduces the surplus Prices continue to fall until market reaches equilibrium Shortage (a.k.a. excess demand): when quantity demanded is greater than quantity supplied Example If P - $1 Then Q = 21 lattes And Q S = 5 lattes Resulting in a shortage of 16 lattes D Facing a shortage sellers raise the price causing Q to fall and Q to rise … …which reduces the shortage Prices continue to rise until market reaches equilibrium Three Steps to Analyzing Changes in Equilibrium To determine the effects of any event, 1. Decide whether even shifts S curve D curve, or both. 2. Decide in which direction curve shifts. 3. Use supply-demand diagram to see shift changes eq’m P and Q Example: The Market for Hybrid Cars Hybrids are substitute traditional cars which are compliments of gas Example 1: A Shift in Demand EVENTS TO BE ANALYSED: Increase in price of gas STEP 1: D curve shifts STEP 2: D shifts right STEP 3: D The shift causes an increase in price and quantity of hybrid cars Notice: When P rises producers supply larger quantity of hybrids, even though the S curve has not shifted. *Note: Always be careful to distinguish between a shift in a curve and a movement and the curve Terms for Shift vs. Movement along Curve  Change in supply: a shift in the S curve occurs when a non-price determinant of supply changes (like technology or costs)  Change in quantity supplied: a movement along a fixed S curve occurs when P changes  Change in demand: a shift in the D curve occurs when a non-price determinant of demand changes ( like income or #of buyers)  Change in the quantity demanded: a movement along a fixed D curve occurs when P changes Example 2: A Shift in Supply EVENT: New technology reduces costs of producing hybrid cars STEP 1: S curve shifts STEP 2: S curve shifts right STEP 3: The shift causes price to fall and quantity to rise Example 3: A Shift in Both Supply and Demand EVENTS: price of gas rises AND new technology reduces STEP 1: Both curves shift STEP 2: Both curves shift to the right STEP 3: Q rises, but effect on P is ambiguous: If demand increases more that supply, P rises. But if supply increases more than demand, P falls. New market equilibrium is created from the intersection between P and Q . 2 2 Demand is dominant in determining market equivalent price. Change in supply has little effect on P If demand is dominant P*Q* changes in the same direction. If supply is dominant P*Q* changes in opposite directions Active Learning 3: Shifts in supply and demand Use the three-step method to analyse the effects of each event on the equilibrium price ad quantity of music downloads. Event A: A fall in the price of CDs STEPS 1. D curve shifts 2. D shifts left 3. P and Q both fall Event B: Sellers of music downloads negotiate a reduction in royalties they must pay for each song they sell STEPS S curve shifts S shifts right (Royalties are part of sellers’ costs) P falls, Q rises Sellers of music downloads negotiate a reduction in the royalties they must pay for each song they sell. This event causes a fall in “costs of production” for sellers of music downloads. Hence the S curve shifts to the right *Note: royalties are considered sellers’ cost of production Event C: Event A and B both occur STEPS Both curves shifts (see part A & B) D shifts left, S shifts right P unambiguously falls. Effect on Q is ambiguous: The fall in demand reduces Q, the increase is supply increase Q. Conclusion: How Prices Allocate Resources  One of the Ten Principles from Chapter 1: Markets are usually a good way to organise economic activity  In market economies, price adjusts to balance supply and demand. These equilibrium prices are the signal that guide economic decisions and thereby allocate scarce resources Chapter Summary  A competitive market has many buyers and sellers, each of whom has little or no influence on the market price  Economist use the supply and demand model to analyse competitive markets  The downward-sloping demand curve reflects the Law of Demand, which states that the quantity buyers demand of a good depends negatively on the good’s price.  Besides price, demand depends on buyers’ income, tastes, and expectations, the prices of substitutes and complements, and number if buyers. If one of these factors changes, the D curve shifts.  The upward-sloping supply curve reflects the Law of Supply, which states that the quantity sellers’ supply depends positively on the good’s price.  Other determinants of supply include input prices, technology, expectation and the # of sellers. Changes in these factors shift the S curve  The intersection of S and D curves determines the market equilibrium. At the equilibrium price, quantity supplied equals quantity demanded.  If the market price is above equilibrium, a surplus results, which causes the price to fall. If the market price is below equilibrium, a shortage results, causing the price to rise.  We can use the supply-demand diagram to analyze the effects of any event on a market: First, determine whether the event shifts one or both curves. Second, determine the direction of the shifts. Third, compare the new equilibrium to the initial one.  In market economies, prices are the signals that guide economic decisions and allocate scarce resources. Chapter 5 Elasticity  Basic Idea: Elasticity measures how one variable responds to changes in another variable o Scenario: You design websites for local businesses. You charge $200 per website, and currently sell 12 websites per month. o Your costs are rising (including the opportunity cost of your time), so you consider raising the price to $250. o The law of demand says that you won’t sell as many websites if you raise your price. How many fewer websites? How much will your revenue fall, or might it increase?  One type of elasticity measures how much demand for your websites will fall if you raise your price d s  Definition: Elasticity is a numerical measure of the responsiveness of Q or Q to one of its determinants o Measures the sensitivity of buyers in any change o Buyers can react to income increase, expectation, price change of good etc. Price Elasticity of Demand d  Price elasticity of demand measures how much Q responds to a change in P  Loosely speaking, it measures the price-sensitivity of buyers’ demand Example Price elasticity of demand equals The percentage change in demand is always put in the numerator and the percentage change in price in the denominator. This is demand responds to a price change Along a D curve, P and Q move in opposite direction, which would make price elasticity negative. We will drop the minus sign and report all price elasticities as positive numbers. Calculating Percentage Changes Standard method of computing the percentage (%) change: Going from A to B, the % change in P: Problem: o The standard method gives different answers depending on where you start. o From A to B, o P rises 25%, Q falls 33%, elasticity = 33/25 = 1.33 o From B to A, o P falls 20%, Q rises 50%, elasticity = 50/20 = 2.50  So we instead use the midpoint method:  The midpoint is the number halfway between the start and end vales, the average of those values.  It doesn’t matter which values you use as the “start” and which as the “end” – you get the same either way!  Using the midpoint method, the % change in P equals  The % change in Q equals  The price elasticity of demand equals Active Learning 1: Calculate an elasticity Use the following information to calculate the price elasticity of demand for hotel rooms: d if P = $70, d = 5000 if P =$90, Q = 3000 Use the midpoint method to calculate % change in Q d %change in P The price elasticity of demand equals What determines price elasticity? To learn the determinants of price elasticity, we look at a series of examples. Each compares two common goods. In each example:  Suppose the prices of both goods rise by 20%  The good for which Q falls the most (in percent) has the highest price elasticity of demand. Which good is it? Why?  What lesson does the example teach us about the determinants of the price elasticity of demand? Example 1: Breakfast cereal vs. Sunscreen d  The prices of both of these goods rise by 20%. For which does Q drop the most? Why? o Breakfast cereal has close substitutes (e.g., pancakes, Eggo waffles, leftover pizza), so buyers can easily switch if the price rises. o Sunscreen has no close substitutes, so consumers would probably not buy less if its price rises.  Lesson: Price elasticity is higher when close substitutes are available. Example 2: “blue Jeans” vs. “Clothing”  The price of both goods rise by 20% for which good does Q drop the most? Why? o For a narrowly defined good such as blue jeans, there are many substitutes (khakis, shorts, Speedos). o There a fewer substitutes available for broadly defined goods. (There aren’t too many substitutes for clothing, other than living in a nudist colony.) o In the first alternative there will be a percentage decrease in the quantity of blue jeans demanded. o In the second scenario, the price of all clothing rises by 20%, and observe almost no percentage decrease in demand for all clothing.  Lesson: Price elasticity is higher for narrowly defined goods than broadly defined ones. Example 3: Insulin vs. Caribbean Cruises d  The prices of both of these goods rise by 20%. For which good does Q drop the most? Why? o To millions of diabetics, insulin is necessity. A rise in its price would cause little or no decrease in demand. o A cruise is a luxury. If the prices rises, some people will forego it.  Lesson: Price elasticity is higher for luxuries than for necessities. Example 4: Gasoline In the Short Run vs. Gasoline in the Long Run  The price of gasoline rises 20%. Does Q drop more in the short run or the long run? Why? o There’s not much people can do in the short run, other than ride the bus or carpool. o In the long run, people can buy smaller cars or live closer to where they work.  Lesson: Price elasticity is higher in the long run than the short run. The Determinant of Price Elasticity: A Summary The price elasticity of demand depends on:  The extent to which close substitutes are available  Whether the good is a necessity or luxury  How broadly or narrowly the good is defined  The time horizon- elasticity is higher in the long run than the short run The Variety of Demand Curves  The price elasticity of demand is closely related to the slope of the demand curve.  Rule of thumb: The flatter the curve, the bigger the elasticity. The steeper the curve, the smaller the elasticity.  Five different classifications of D curves.… “Perfectly Inelastic Demand” (one extreme case) D curve: Vertical Consumers’ price sensitivity: None Elasticity: 0  The slope of this curve is the inverse of the slope in the demand function  When you see a vertical demand curve price elasticity equals zero  If Q doesn’t change, then the percentage change in Q equals zero, and this elasticity equals zero. o Ex. Insulin: a sufficiently large price will reduce demand for insulin a little, particularly among people with v. low incomes and no health insurance. o If elasticity is close v. close to zero, then demand curve is almost close to vertical and we can call it “perfectly inelastic” “Inelastic demand” D curve: relatively steep Consumers’ price sensitivity: relatively low Elasticity: < 1  Price elasticity would be small, but not zero  At a high price some students would not buy their books, but instead will share with a friend, or rather find them in the library, or take copious notes in class  Ex. gas in the short run “Unit elastic demand” increase D curve: intermediate slope Consumers’ price sensitivity: intermediate Elasticity: 1 1 is a threshold that can divide between elastic and inelastic demand The price change has no effect in the revenue “Elastic demand” D curve: Relatively flat Consumers’ price sensitivity: Relative high Elasticity: > 1  Ex. breakfast cereal, or anything with readily available substitutes  its relatively flatter than an inelastic demand curve “Perfectly elastic demand” (the other extreme) D curve: horizontal Consumers’ price sensitivity: extreme Elasticity: infinity  “Extreme price sensitivity” means the tiniest price increase causes demand to fall to zero.  “Q changes by any %” when the D curve is horizontal, quantity cannot be determined from the price.  Consumers might demand Q1 units one month, Q2 units another month, and some other quantity later. Q changes by any amount, but P always “changes by 0%” (i.e., doesn’t change). o Ex. a small family farm which grows wheat. The demand curve in this curve is downward-slopping, and the market demand and supply curve determines the price of wheat. Suppose that price is $5/bushel. Now consider the demand curve facing you, the individual wheat farmer. If you charge
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