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Chapter 3

econ ch. 3 + 4.pdf

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Avi Cohen

Chapter 3 – Show Me the Money. The Law of Supply Economists use the term “supply” to summarize all the influences on business decisions. Business decisions are “objective”, whenever consumer decisions tend to be more “subjectively” based on desires and preferences. Costs are opportunity costs Businesses must pay higher prices to obtain more of an input because opportunity costs change with circumstances. The marginal costs of additional inputs (like labour) are ultimately opportunity costs – the best alternative use of the input – Marginal cost - additional opportunity cost of increasing quantity supplied, and changes with circumstances – For working example, you are supplying time, and marginal cost of your time increases as you increase quantity of hours supplied (the least valuable time is given up first, and as the price offered rises, the time that is more valuable is given up too). – Suppliers supply more as the price rises – higher prices are necessary to compensate for the higher opportunity costs of more additional time (or other resources) given up – Differences between smart supply choices and smart demand choices are: – For demand, marginal benefit decreases as you buy more – For supply, marginal cost increases as you supply more Supply and demand choices reverse the comparison of benefits and costs – For demand, marginal benefit is satisfaction you get, marginal cost is measured in $ (price you must pay) – For supply, marginal benefit is measured in $ (wages you earn); marginal cost is opportunity cost of time (time you must give up) – any business supply decision involves the same smart choice between marginal benefit ($) and marginal cost (opportunity cost) as your work decision Sunk costs don't matter for future choices Sunk costs that cannot be reversed are not part of opportunity costs. Sunk costs do not influence smart, forward – looking decisions – Sunk costs – past expenses that cannot be recovered – Sunk costs are the same no matter which fork in the road you take, so they have no influence on smart choices The law of supply If the price of a product/service rises, quantity supplied increases. Businesses increase production when higher prices either create higher profits or cover higher marginal opportunity costs of production. – Supply – businesses' (or individuals) willingness to produce a particular product/service because price covers all opportunity costs of production – Quantity supplied - quantity you actually plan to supply at a given price – Marginal opportunity cost – complete name for any cost relevant to a smart decision – All opportunity costs are marginal costs; all marginal costs are opportunity costs – Opportunity cost focuses on the value of the opportunity given up when you make a decision. – Marginal cost rather focuses on additional cost that the decision produces – Increasing marginal opportunity costs arise because inputs are not equally productive in all activities. – (eg. There are always opportunity costs in switching between activities because time spent on piercing can no longer be spent on fingernails. Increasing opportunity costs arise because of the differences in employee skill levels and equipment in producing alternative services. The marginal opportunity of producing the first piercing is $20, therefore, Paola needs to receive a price of at least $20 to cover the costs of the alternative use of her inputs. Paola won't produce the fifth piercing unless she gets $100 for it, because that is what she is giving up from the best alternative use of her inputs (5 sets at $20 each. So, the price of the piercing will determine what quantity Paola will decide to produce. The higher the price, the greater quantity of piercing she supplies) – Where inputs are equally productive in all activities, marginal opportunity costs are constant – Market supply - sum of supplies of all businesses willing to produce a particular product/service – Supply – businesses' overall willingness to supply a product/service because the price covers all opportunity costs of production – (eg. For businesses to be willing to supply 100 piercings, the minimum price they are willing to accept is $20/piercing but to be willing to supply 500 piercings, the minimum price they are willing to accept is $100/piercing because of the increased opportunity costs – Law of supply – the positive relationship between price and quantity supplied (both go up together), if the price of a product/service rises, quantity supplied increases – higher prices create incentives for increased production through higher profits and by covering higher marginal opportunity costs of production – law of supply works only if other factors besides price do not change – In output markets, businesses are suppliers and households are demanders – In input markets, individuals/households are suppliers and businesses are demanders – For both types of markets, higher prices increase quantity supplied What can change supply? – Quantity supplied is changed only by a change in price. Supply is changed by all other influences on business decisions. - eg. The price for laptops dropped from $2000 to $1000, but the quantity of laptops sold increased. This can make us think, that the laptop businesses contradict with the “law of supply” (producers supply more for higher price not for lower), but in fact, it becomes t he signal that something else has changed. – Supply is a catch – all term summarizing all possible influences on businesses' willingness to produce a particular product/service – Supply changes with changes in technology, prices of inputs, prices of related products/services produced, expected future prices, number of businesses. – If the price of a product/service changes, that affects quantity supplied but if anything else changes, that affects supply – ONLY change in the price of a product/service itself changes QUANTITY SUPPLIED – change in quantity supplied (caused by a change in the price of the product itself) differs from a change in supply (caused by the changes listed below) Five important factors that can change market supply (the willingness to produce a product or service)are: 1. Improvement in technology – business will supply more of one product/service – an improvement in technology causes an increase when alternative product/services it produces fall in in supply, NOT a change in quantity supplied price – businesses will supply less when the alternatives – Increase in supply – an increase in the overall rise in price businesses to supply at any price – At any unchanged price, businesses are now willing 4. Expected Future Prices to supply a greater quantity – recall from ch.2, consumer demand changes if – eg. At a price of $20 businesses were willing to consumers expect lower or higher prices in the supply 100 piercings but with the technology's future, same holds true for businesses improvements, at the same price businesses are – a fall in expected future price causes an increase in willing to supply with 200 piercings supply today (better profits today) – For producing any unchanged quantity, businesses – eg. if Paola expects falling piercing prices in the are now willing to accept a lower price future, she will try to supply now, while the – eg. At a price of $40 businesses were willing to price is relatively high, and she can make the supply 200 piercings, and now they supply with most profit from it now because in future she will not be able to 200 at a price of $20 – a rise in expected future price causes a decrease in – new technology lowers marginal opportunity costs, supply today (better profits in future) so businesses can accept a lower price while still covering all costs – eg. (rise causes the opposite of fall); Paola might reduce her current supply to the market – the result = increase in supply (increase in and increase it in the future, when prices and businesses' willingness to produce) profits will be higher 2. Prices of Inputs REMEMBER: - if future prices expected to rise = supply – a fall in input prices causes an increase in supplydecreases in the present – a rise in input prices causes a decrease in supply – if future prices expected to fall = – businesses have to pay a price for inputs that supply increases in the present matches the best opportunity cost of the input owner (eg. At any price for piercings, lower costs 5. Number of Businesses mean Paola will earn higher profits, so, she will – an increased number of businesses causes an supply more) increase in supply – the effect of lower input prices has the same effect – a decreased number of businesses causes a decrease as technology improvement in supply – just like the other factors, number of businesses 3. Prices of Related Products and Services causes an increase in supply – lower prices for a related product/service a business – if profits are high, new competitors will enter a produces cause an increase in supply market, increasing the market in supply – higher prices for a related product/service cause a decrease in supply – therefore, if profits are lower than available – a change in the price of related product/service elsewhere in the economy, competitors will exit from the market, decreasing market supply (those produced makes businesses reconsider its most businesses will search for more profitable uses of profitable choices their resources) Summary of 5 imp. factors that can change market supply – any increase (or decrease) in supply can be described in alternative ways – at any given price, businesses are willing to supply a larger quantity (left to right description, eg. at a price of $20, businesses were willing to supply 100 piercings, but with technology improvements at $20, bus. can supply 200 piercings) – at any given quantity supplied, businesses are willing to accept a lower price because their marginal opportunity costs of production are lower (the right to left description, eg. Before the new technology businesses were willing to supply 200 piercings at a price of $40, and after they were willing to supply 200 at a price of $20) – relating price and quantity supplied for an increase in supply: 1) given price ↔ higher quantity supplied 2) lower prices ↔ given quantity supplied LAW OF SUPPLYAND CHANGES IN SUPPLY The Law of Supply the quantity supplied of a product/service Decreases if: Increases if: - price of the product/service falls - price of the product/service rises Changes in Supply The supply for a product/service Decreases if: Increases if: – price of an input rises – technology improves – price of a complement rises – price of an input falls – price of a related product/service rises – price of a complement falls – expected future price rises – price of related product/service falls – number of businesses decreases – number of businesses increases Price elasticity of supply Elasticity of supply measures how responsive quantity supplied is to a change in price, and depends on the difficulty, expense, and time involved in increasing production. With elastic supply, businesses can easily and inexpensively increase production; with inelastic supply, it is difficult and expensive to increase production. – the law of supply states that price and quantity supplied increase and decrease together – responsiveness of quantity supplied to a change in price is related to greed and the quest for profits, but mostly it has to do with how easy or costly it is to increase production In ch. 2, the price elasticity of demand measured the responsiveness of the quantity demanded by consumers to a change in price – Elasticity of supply measures by how much quantity supplied responds to a change in price – quantity supplied can be inelastic (unresponsive to a change in price) or elastic (very responsive) – Inelastic – for inelastic supply, small response in quantity supplied when price rises – eg. the supply of new gold nuggets is inelastic because quantity supplied is relatively unresponsive to even large rises in price – Value for formula is less than 1 – a small response in quantity supplied when the price rises – Elastic – for elastic supply, large response in quantity supplied when price rises – eg. the supply of snow-shovelling services in most Canadian towns is relatively elastic.If the price for the service rises, there is a willing supply of kids with shovels, or anyone with a truck can clear the driveways in his spare time. – even a small rise in price causes a large increase in the quantity supplied of shovelling services, so the supply is elastic – Value for formula is greater than 1 – large response in quantity supplied when the price rises Calculating elasticity of supply ELASTICITY OF SUPPLY = PERCENTAGE CHANGE IN QUANTITY SUPPLIED ÷ PERCENTAGE CHANGE IN PRICE – formula assumes that 5 factors that affect supply are unchanged, this is a controlled measurement of just the relationship (in the law of supply) between quantity and supplied price – if % change in quantity supplied is less than the percentage change in price, elasticity is less than 1 and is inelastic. Quantity supplied is relatively unresponsive to a change in price – if % change in quantity supplied is greater than the percentage change in price, elasticity of supply is more than 1 and is elastic. Eg1. working more hours for my boss. First time she asked, i was willing to work 20 hours at $10/hour, when she offered $20/hour (100% increase), you agreed to do 15 more hours, for a total of 35 hours 1) if we convert the increase in quantity into % (15 additional hours/20 original hours = 75%) 2) the elasticity of supply = 0.75 / 1 = 0.75 3) that is relatively inelastic response because a 100% increase in pay led me to increase my supply of hours only by 75% Eg2. Same offer of double time (% change in price = 100%), he worked 10 hours a week, and offers to supply 50 more hours for a total of 60. 1) 50 more hours/10 original hours = 500% 2) the elasticity of supply =5 / 1 = 5 3) he got relatively elastic response, his 100% increase in pay led to 500% increase in his supply of hours Factors determining elasticity of supply – Elasticity of supply of a product/service is influenced by: – availability of additional inputs – more available inputs means more elastic supply; eg. It is difficult to find new inputs for mining, while it is easy to attract new workers to snow shovelling. Easy availability of inputs makes for more elastic supply, while the difficulty and costly availability of new inputs makes for more inelastic supply – time production takes – less time means more elastic supply; eg. When the price of piercings rises Paola can quickly adjust her quantity supplied. When gold prices rise, it can take years or even decades for the quantity supplied to adjust, because it takes time to discover and exploit new mines. Industries with quick time to production tend to have more elastic supplies, and industries with slow time to production tend to have more inelastic supply – Elasticity of supply allows more accurate projections of future outputs and prices (smart choices), helping businesses avoid disappointed customers. – Smart decision is to pay no more for an input than you have to – Understanding elasticity of supply enables smart, informed choices, and can only help a business's bottom line STUDY GUIDE QUESTIONS 1. When higher-paying jobs are harder to find for workers, a business will have to pay more to hire labour. FALSE, with few alternatives, they may be willing to accept lower wages 2. Any smart business supply decision involves a choice between a business's marginal benefit from supplying its product or service and the business's marginal opportunity cost of producing the product or service TRUE 3. Any smart worker supply decision involves a choice between a worker's marginal benefit from supplying her work and the worker's marginal opportunity cost of working TRUE 4. Gordie's marginal opportunity cost of spending an extra hour on Facebook increases if he suddenly has the opportunity to go on a date with his high school crash TRUE 5. Businesses should consider the monthly rent when deciding whether to produce more of a product/service. FALSE, monthly rent payments are sunk costs and are not relevant to the decision of how much to produce 6. Sunk costs are part of opportunity costs. FALSE, sunk costs are not part of opportunity cost 7. Businesses need to receive higher prices to compensate for increasing marginal opportunity costs as output increases. TRUE 8. Opportunity cost equals what you get divided by what you give up. FALSE, it equals to what you give up divided by what you get 9. As you shift your time away from watching TV in order to work more hours, the marginal opportunity cost of working decreases FALSE, as you spend more time in any activity (eg. working instead of relaxing), the marginal opportunity cost of that activity increases 10. All opportunity costs are marginal costs, and all marginal costs are opportunity costs. TRUE 11. Arise in the price of inputs used by businesses decreases market supply. TRUE 12. A rise in the price of a related product or service a business produces increases market supply of the other product or service. FALSE, rise in price decreases market supply of the other product or service. 13. Supply is inelastic if a rise in price causes a very responsive change in quantity supplied. FALSE, the supply is elastic when quantity supplied is very responsive to price 14. The federal government of Canada introduced a Working Income Tax Benefit in its Budget 2007. This policy increases the return from working because it reduces the tax paid on earnings. We know that women's work-supply decision is more “elastic” to wages than men's, so women are more likely to benefit from this policy than are men. TRUE 15. If a 10-percent rise in price causes quantity supplied to increase by 40 percent, supply is elastic. TRUE 1. Your opportunity cost of watchingAmerican Idol increases if (c) you have an exam the next day 2. The opportunity cost of going to school is highest for someone who (b) has to give up a job paying $15/hour 3. Which statement is false? (a) marginal costs are opportunity costs (b) opportunity costs are marginal costs (c) sunk costs are marginal costs (d) marginal opportunity costs increase as quantity increases 4. Gamblers on slot machines often believe that the more they lose, the greater are their chances of winning on the next turn. However, the chances of winning on any turn are actually random – they do not depend on past turns. Therefore, the money lost on the previous turn is a (b) sunk cost 5. Your friend Larry is deciding whether to break up with his current girlfriend, Lucy. He tells you that his number-one reason for wanting to stay with her is because of his tattoo, which says “I love Lucy”. Based on economic thinking, you should advise him to ignore the fact that he has a tattoo because it is (c) sunk cost 6. If all workers and equipment are equally productive in all activities, the opportunity cost of increasing output is always (c) the same 7. The law of supply applies to an individual's decision to work because (d) all of the above 8. Which factor below does not change supply? (a) prices of inputs (b) expected future prices (c) price of the supplied product/service (d) number of businesses 9. The supply of a product or service increases with an (a) improvement in technology producing it 10. The market supply of tires decreases if (a) the price of oil – a major input used to produce tires – rises 11. The furniture industry has shifted to using particle-board (glued wood chips), rather than real wood, which reduces costs. This (a) increases supply 12. The statement “even after the reward was doubled, nobody volunteered for the mission” illustrates (c) inelastic supply 13. Supply is most likely to be elastic for producing (a) snow shovels 14. There would be a high elasticity of supply for a business (b) in a large town with many available workers 15. Since real trees take a very long time to grow, this year's supply of real Xmas trees is (d) inelastic. 1.Your boss asks you to work 20 additional hours next weekend. If you work those 20 hours, you will not be able to see your significant other. You really value the time you spend with your significant other, and the only time you've gone a weekend without seeing each other was when your friends offered to pay you $300 to spend the weekend with them instead. You agreed because this is the minimum amount you must be compensated for giving up a weekend with your significant other. (a) Should you agree to work the 20 weekend hours if your boss pays your regular wage rate of $10? $10 times 20 = $200 the value of spending the weekend with the significant other is $300, therefore the job offer has to be declined because $200 she will earn will not pay the value off (b) - // - pays the overtime rate of $15 per hour for the whole weekend? $15 times 20 = $300, therefore if she accepts the job, she will not only earn $300 dollars but she will also receive boss' good side for not declining the offer to help 2. Employees do not like working long weekdays and on weekends, so employers offer higher wages for the extra time in the form of “overtime pay”, which could be up to three times the regular wage. Why is it important for businesses to offer overtime pay? Employees who spend up to 1/3 of their life at work – 8 hours out of 24 in a day – value their free time. As employers want workers to put in more hours of work, the workers' free time becomes more scarce and valua
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