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Chapter 3

ECO-2013 Chapter Notes - Chapter 3: Economic Efficiency, Invisible Hand, Economic Equilibrium

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Joseph Calhoun

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Chapter 3: Supply, Demand, and the Market Process
I. Consumer Choice and the Law of Demand
a. Law of demand- a principle that states there is an inverse relationship between the price
of a good and the quantity of it buyers are willing to purchase. As the price of a good
increases, consumers will wish to purchase less of it. As the price decreases, consumers
will wish to purchase more of it
b. When the price increases, we look for:
i. Substitutes- goods that perform similar functions
c. The Market Demand Schedule
i. Demand schedule- simply a table listing the various quantities of something
consumers are willing to purchase at different prices
ii. the plotted line is called the “demand curve”
1. y-axis: price
2. x-axis: demand
iii. because the amount a consumer is willing to pay for a good is directly related to
the good’s value to them, the demand curve indicates the marginal benefit (or
value) consumers receive from additional units
d. Consumer Surplus
i. Consumer surplus- the difference between the maximum price consumers are
willing to pay and the price they actually pay. It is the net gain derived by the
buyers of the good
ii. The height of the demand curve measures how much buyers in the market value
each unit of the good
iii. Price indicates the amount they actually pay
iv. The difference between the two the triangular area below the demand curve but
above the price paid is the measure of the total consumer surplus
II. Changes in Demand Versus Changes in Quantity Demanded
a. Economists refer to a change in the quantity of a good produced in response solely to a
price change as a change in quantity demanded
i. Shown on demand curve as a movement from one point on the curve to another
b. Changes in factors other than a good’s price – such as consumers’ income and the prices
of closely related goods will also influence the decisions of consumers to purchase a
good. If one of these other factors changes, the entire demand curve will shift
inward/outward. Economists refer to a shift in the demand curve as a “change in
c. Some factors that cause a “change in demand” (inward/outward shift):
i. A change in consumer income will result in consumers buying less or more of a
product at all possible prices
1. Increase in demand- outward shift on demand schedule
2. Decrease in demand- inward shift on demand schedule
ii. Changes in the number of consumers in the market
1. Businesses that sell in college towns are greatly saddened when the
summer arrives (e.g. less pizza and beer sales)
iii. Changes in price of a related good
1. As gasoline prices rise, increased demand for gas-electric hybrid cars
2. Complements- products that are usually consumed jointly. A decrease in
the price of one will cause an increase in demand for the other (e.g.
peanut butter and jelly)
a. Lower prices for DVD players in the past decade have
substantially increased the demand for movies on DVD
iv. Changes in expectations
1. If you expect a hurricane to hit, you’ll have a higher demand for canned
2. Or “I’ll wait until it goes on sale” current demand will drop
v. Demographic changes
1. Population trends in age, gender, race and other factors can
increase/decrease demand for specific goods
a. Increased demand for iPods decreased demand for
vi. Changes in consumer tastes and preferences
1. People change, preferences change and therefore demand changes
III. Producer Choice and the Law of Supply
a. What influences the choices of consumers? Producers convert resources into goods and
services by doing the following:
i. Organizing productive inputs and resources, like land, labor, capital, natural
resources, and intermediate goods
ii. Transforming and combining these inputs into goods and services; and
iii. Selling the final products to consumers
b. Opportunity cost of production- the total economic cost of producing a good/service. The
cost component includes the opportunity cost of all the resources, including those owned
by the firm. The opportunity cost is equal to the value of the production of other goods
sacrificed as a result of producing the good
c. The opportunity cost of the assets owned by the firm is the earnings these assets could
have generated if they were used in another way
d. The Role of Profits and Losses
i. Profits- an excess of sales revenue relative to the opportunity cost of production.
The cost component includes the opportunity cost of all resources, including
those owned by the firm. Therefore, profit accrues only when the value of the
good produced is greater than the value of the resources used for its production
ii. The willingness of consumers to pay a price greater than a good’s opportunity
cost indicates that they value the good more than other things that could have
been produced with the same resources
iii. Loss- a deficit of sales revenue relative to the opportunity cost of production.
Losses are a penalty imposed on those who produce goods even though they are
valued less than the resources required for their production
iv. Losses and business failures free up resources being used unwisely so they can
be put to use by other firms providing consumers with more value
e. Supply and the Entrepreneur
i. Entrepreneurs take on a lot of risk (only 55%-65% make any profit 5 years in
their careers)
f. Market Supply Schedule
i. Law of supply- a principle that states there is a direct relationship between the
price of a good and the quantity of it produces are willing to supply. As the price
of a good increases, producers will wish to supply more of it. As the price
decreases, producers will wish to supply less
g. Producer Surplus
i. Producer surplus- the difference between the price that suppliers actually receive
and the minimum price they would be willing to accept. It measures the net gains
to producers and resource suppliers from market exchange. It is not the same as
ii. Producer surplus encompasses the net gains derived by all people who help
produce the good, including those employed by or selling to the firm
IV. Changes In Supply Versus Changes in Quantity Supplied (Price)
a. Factors that will cause a change in supply and shift the entire supply curve left or right:
i. Change sin resource prices
1. Higher resource prices will reduce supply of a good
ii. Changes in technology
1. A technological improvement increases supply and vice versa
iii. Elements of nature and political disruptions
1. Favorable weather or good political conditions increase supply and vice
iv. Changes in taxes
1. Lower taxes increase supply, higher taxes decrease supply
V. How Market Prices Are Determined: Supply and Demand Interact
a. Market- an abstract concept encompassing the forces of supply and demand and the
interaction of buyers and sellers with the potential for exchange to occur
b. Equilibrium- state in which the conflicting forces of supply and demand are in balance.
When a market is in equilibrium, the decisions of consumers and producers are brought
into harmony with one another and the quantity supplied will equal the quantity
c. Efficiency and Market Equilibrium
i. Economic efficiency- a situation in which all of the potential gains from trade
have been realized. An action is efficient if it creates more benefit than cost. With
well-defined property rights and competition, market equilibrium is efficient
VI. How Markets Respond to Changes in Demand and Supply
a. Market Adjustment to Increase in Demand
i. In a market economy, when the demand for a good increases, its price will rise,
which will 1.) motivate consumers to search for substitutes and cut back on
additional purchases of the good, and 2.) motivate producers to supply more of
the good. These two forces will eventually bring the quantity demanded and
quantity supplied back into balance
ii. How changes in demand and supply affect market prices and quantity:
1. Changes in Demand:
a. An increase in demand shown by a rightward shift of the
demand curve will cause an increase of both equilibrium price
and equilibrium quantity