economics for business lecture notes
ECONOMICS FOR BUSINESS LECTURE NOTES LECTURE 1 – INTRODUCTION LO1: TEN PRINCIPLES OF ECONOMICS What is economics? The word ‘economy’ comes from the Greek word meaning ‘one who manages a household’. Households and economies have much in common- both face a fundamental problem known as scarcity. Scarcity: available resources are limited and therefore cannot produce all the goods and services people desire. The problem of scarcity arises from people having infinite desires, whilst at the same time having limited or scarce resources. Economics: the study of how society manages its scarce resources. It is the social science that studies the choices that individuals, businesses, and governments make as they cope with scarcity and the incentives that influence those choices. It is divided into: a) Microeconomics: focuses on individual agents e.g. firms in the economy and how they make decisions & interact. It looks at: How scarce resources are allocated among alternative uses. The role of prices and markets. How economic policies can lead to better outcomes for society. b) Macroeconomics: focuses on the economy as a whole. It looks at economy-wide phenomena e.g. inflation, unemployment and economic growth. 10 lessons from economics These 10 lessons can be seen as central/unifying ideas of economics: 1. People face trade-offs. 2. The cost of something is what you give up to get it. 3. Rational people think at the margin. 4. People respond to incentives. 5. 6. 7.
Trade can make everyone better off. Markets are usually a good way to organise economic activity. Governments can sometimes improve market outcomes.
8. A country standard of living… 9. Prices rise when… 10. Society faces a trade-off…
How people make decisions Microeconomics How people interact
How the economy works as a whole
Macroeconomics
Lesson 1: People face trade-offs Due to scarce resources, making decisions requires trading off one goal for another. In other words, to get one thing, you must give up something else. If you want more of something, you must give up something else e.g. time, money. An important trade-off often discussed in economics is the trade-off between efficiency (getting the largest output from available resources) and equity (distributing those output fairly among society to increase overall well-being). It is difficult to obtain both equity and efficiency because if you want an equal society you must sacrifice some efficiency. Lesson 2: The cost of something is what you have to give up to get it In economics the cost of something is what you have to give up in order to get it- not just monetary costs, but opportunity costs. Opportunity cost: the opportunity cost of an item is the value of the best opportunity that you have to give up to obtain that item. It includes both the actual monetary amount paid (the explicit cost) and the monetary value of any other sacrifices made without direct payment (implicit cost). When making any decisions, individuals compare costs and benefits. To make a sound decision, it is necessary to be aware of the opportunity cost of that decision i.e. the true cost of that decision. Lesson 3: Rational people think at the margin Rational people choose the best option from available alternatives by comparing costs and benefits at the margin. Marginal change: a small incremental change or adjustment to an existing plan of action. Rational people compare the marginal cost of a decision with the marginal benefit. As long as the marginal benefit exceeds the marginal cost, it is profitable. Lesson 4: People respond to incentives Incentive: a reward or punishment that induces a person to act or not to act in a certain way, and there can be both positive and negative incentives e.g. penalties, bonus to an employee. It is often used by the gov. to encourage or discourage behaviours. Incentives (rewards and punishments) associated with a given decision alter the cost and benefit of that decision. Since rational people make decisions considering costs and benefits, they respond to incentives. E.g. a new law is introduced whereby anybody who is caught rink driving receives a life sentence.
LO2: THINKING LIKE AN ECONOMIST The economist as a scientist Economics is a social science. It is a science because it makes use of the scientific method i.e. observation, theory, more observation and so on. It develops theories and collects and analyses data to evaluate/test those theories. An obstacle in testing economic theories arises because it is difficult to use experiments to analyse social/economic phenomena. Physicists test theories in a laboratory where they can run repeated and controlled experiments- economists cannot. Economics often can only rely on observations the world happens to give them. Assumptions and economic models Assumptions are used to make the world easier to understand. The art in scientific thinking is deciding which assumptions to make. Assumptions are good if they simplify the problem at hand without substantially affecting the answer. Economists use different assumptions to answer different questions. Economic models omit many details to allow us to see what is truly important. A model is a simplified representation of reality intended to help people understand a complex problem. Models are built on assumptions. Most economic models are composed of diagrams/graphs and equations. Production Possibilities Frontier (PPF): a graph showing the combinations of output that an economy can possibly produce given: a) The available factors of production b) The available production technology This model assumes that there are only two goods in the world e.g. cars and computers. Efficiency and Opportunity Costs Quantity of Computers Produced 3000
(D) Not feasible (resources are scarce)
2200 2000
(C) (A) Feasible and efficient Production possibility frontier
1000
(B) Feasible but inefficient
0 300 600 700 1000 Quantity of Cars Produced All points on the frontier and below the frontier are combinations of output that can possibly be produced given the available factors of production and the available technologies of production. All points on the frontier are efficient e.g. (A), (C). All points below the frontier are inefficient e.g. (B). Efficient: an outcome is said to be efficient if the economy is getting all it can from its scarce resources. Opportunity cost: suppose we are at point (A) and are not happy with having only 2000 computers. We would like instead to have 2200 computers. What’s the opportunity cost of having extra 200 computers if we are at (A)? The opportunity cost is 100 less cars. Economic growth Computers Produced 4000 3000 2100 2000
(B) (A)
1000 0 700 1000 Cars Produced Suppose a new technology is discovered that increases productivity in computer production. This would create another production possibility frontier and more computers can be produced for the same amount of cars. The economist as a policy advisor When economists try to explain the world, they are scientist. When they try to improve the world, they are policy advisors. Positive vs. normative analysis: positive statements try to describe the world as it is i.e. descriptive analysis. Normative analysis try to describe how the world should be i.e. prescriptive analysis. When economists make normative statements, they are acting more as policymakers.
Economists serve as advisers in the policymaking process in all branches of government and independent agencies e.g. treasury, Reserve Bank, OECD. Economists also work n or advise the private sector e.g. financial institutions, industries and NGOs. Economists who advise policymakers may offer conflicting advice either because: a) Differences in scientific judgements- disagree about the validity of competing positive theories about how the world works. b) Differences in values- they have different normative views about what policies should try to accomplish.
LECTURE 2 – DEMAND & SUPPLY LO1: MARKETS AND COM PETITION Market: a group of buyers and sellers of a particular good or service. Whenever you have a group of buyers and sellers interacting to trade a good/service, you have a market. This interaction can occur in a physical place e.g. shopping centre or in a virtual one. Markets take many forms- sometimes they are highly organised e.g. Sydney’s fish markets, and sometimes less organised where the owner has the power to decide trading hours e.g. markets for ice-cream in Sydney. Competitive market: a market in which there are so many buyers and sellers that each has a negligible (insignificant, trivial) impact on the market price. The smaller the ability of each buyer/seller to affect market price, the more competitive the market. Throughout this subject, we will assume that markets are perfectly competitive (PC). To reach this highest form of competition, a market must have 2 characteristics: 1. The goods being offered for sale are exactly the same (homogeneous). 2. The buyers and sellers are so numerous that none can influence the market price. Price takers: a term given to buyers and sellers whom have to accept the market price as given. In the real world, there are some markets in which the assumptions of perfect competition apply e.g. agricultural markets. However, there are some markets in which there is no competition at all. In markets with only one seller i.e. a monopoly, the seller sets the price (price setter). The theory of supply and demand that we study here does not apply to these cases. Most real world markets fall between the extremes of perfect competition and monopoly. Perfect competition is a useful simplification and many of the lessons learned by studying supply and demand under perfect competition apply in more complex markets as well. Buyers determine demand. Sellers determine supply. LO2: DEMAND Quantity demanded of a good is the amount of a good that buyers are willing and able to purchase. a) Willing: a buyer wants to buy that amount, given his/her tastes and preferences. b) Able: given the price of the good, a buyer has enough income to buy the desired amount. Quantity demanded of a good depends on many factors such as the price of the good, tastes, disposable income and others. Law of demand: other things being equal, the quantity demanded of a good falls when the price of a good rises, and vice versa. Ceteris paribus: holding constant all other factors other than the price that may affect quantity demanded. It is the idea behind the law of demand in terms of other things being equal. There are 2 ways of representing the relationship between price and quantity demanded: a) Demand schedule: a table showing the relationship between price of a good and quantity demanded at different price points. b) Demand curve: a graph showing relationship between the price of a good and the quantity demanded. Demand schedule Price of an ice-cream (price per unit) $0.00 0.50 1.00 1.50 2.00 2.50 3.00
Quantity of ice-cream demanded (per month) 12 10 8 6 4 2 0
Note: this assumes that all factors (other than the price) that affect the demand of ice-creams are held constant (ceteris paribus assumption).
Demand curve
Note: the demand curve is downward sloping (Law of demand)
Market demand versus individual demand In a competitive market we have many buyers. To analyse how competitive markets work, we need to determine market demand. Market demand: the sum of all individual demands for a particular good or service. Graphically, individual demand curves are summed horizontally to obtain the market demand curve i.e. add individual demands together. The market demand curve shows how the total quantity demanded of a good varies with the price of the good, holding all other factors constant (ceteris paribus).
Movement along the demand curve A change in the price of a good generates movement along the demand curve. This is a change in the quantity demanded. Shifts in the demand curve A change in one or more of factors other than price generates a shift in the demand curve, either to the left or the right. A shift to the left indicates a decrease in demand, whilst a shift to the right indicates an increase in demand. In this case, we say there is a change in demand (as opposed to a change in the quantity demanded). Factors other than price that can affect demand include: a) Income: the relationship between income and demand depends on what type of good it is. i. Normal good: a good for which, other things being equal, an increase in income leads to an increase in demand. ii. Inferior good: a good which, other things being equal, an increase in income leads to a decrease in demand. b) Prices of related goods: the relationship between the price of a related good and demand depends on the type of product. i. Substitutes: two goods for which a decrease in the price of one good leads to a decrease in the demand for the other good. ii. Complements: two goods for which a decrease in the price of one good leads to an increase in demand for the other good. c) Tastes d) Expectations e.g. about future income, about the future prices of goods. e) Number of buyers: because market demand is derived from individual demand it positively depends on number of buyers. Useful general lesson: a curve shifts whenever there is a change in a relevant variable that does not appear on either axis of the demand curve.
LO3: SUPPLY We now turn our attention to the behaviour of producers/sellers i.e. supply. Quantity supplied: the amount of a goodo that sellers are willing and able to sell. a) Willing: producer wants to sell that amount b) Able: the amount is feasible given resources and technology. Law of supply: other things being equal, the quantity supplied of a good rises when the price of the good rises, and vice versa. Two ways of representing the relationship between price and quantity supplied: a) Supply schedule: a table showing the relationship between the price of a good and the quantity supplied. b) Supply curve: graph showing relationship between the price of a good and the quantity supplied.
Supply schedule Price of an ice-cream (price per unit) $0.00 0.50 1.00 1.50 2.00 2.50 3.00
Quantity of ice-cream demanded (per month) 0 0 1 2 3 4 5
Note: this assumes that all factors (other than the price) that affect the supply of ice-creams are held constant (ceteris paribus assumption)
Supply curve
Note: the supply curve is upward sloping (To reflect the law of supply)
Market supply versus individual supply In a competitive market we have many sellers. We need to determine the market supply. Market supply: the sum of all individual supplies for a particular good or service. Graphically, individual supply curves are summed horizontally to obtain the market supply curve. The market supply curve shows how the total quantity supplied of a good caries with the price of a good, holding all other factors constant. Movement along the supply curve A change in the price of a good generates movement along the supply curve. This is a change in the quantity supplied. Shifts in the demand curve A change in one or more of factors other than price generates a shift in the supply curve, either to the left or the right. A shift to the left indicates a decrease in supply, whilst a shift to the right indicates an increase in supply. In this case, we say there is a change in supply (as opposed to a change in the quantity supplied). As a result, the quantity supplied has changed at every price point. Factors other than price that can affect supply include: a) Input prices: the quantity supplied is negatively related to the price of inputs used to make the good i.e. if the price of an input rises, the supply of the good decreases, and vice versa. b) Technology: an improvement in the production technology increases productivity: with the same inputs, the producer can supply more. c) Expectations: e.g. if suppliers expect the price to rise they will be more likely to store some of the goods and supply less to the market today. d) Number of sellers: because market supply is derived from individual supply, it positively depends on the number of sellers. LO4: EQUILIBRIUM - SUPPLY AND DEMAND TO GETHER Equilibrium Equilibrium: a situation in which supply and demand have been brought into balance. Equilibrium price: the price that balances quantity supplied and quantity demanded. It is also known as market-clearing price. On a graph, it is the price at which the supply and demand curves intersect. Equilibrium quantity: is both the quantity supplied and the quantity demanded at the equilibrium price. On a graph, it is the quantity at which the supply and demand curves intersect.
Markets not in equilibrium- surplus When market price is higher than the equilibrium price, there is a surplus (or excess supply). It creates a situation where quantity supplied is larger than quantity demanded. Thus, suppliers lower price to increase sales, thereby moving toward equilibrium. Markets not in equilibrium- shortage When market price is lower than the equilibrium price, there is a shortage (or excess demand). It creates a situation where quantity supplied is smaller than quantity demanded. Thus, suppliers raise price due to too many buyers chasing too few goods, thereby moving toward equilibrium.
As we have seen, if the market is not in equilibrium, in perfectly competitive markets the actions of buyers and sellers naturally move the price- and hence the market- towards equilibrium. The laws of supply and demand claim that the price of any good adjusts to bring the supply and demand for that good into balance. This does not mean that markets are never out of equilibrium. Surplus and shortages exist. Once the equilibrium is reached, all buyers and sellers are satisfied and there is no upward or downward pressure on price. LO5: CHANGES IN EQUI LIBRIUM Together, demand and supply determine a market’s equilibrium i.e. the price and the amount of the good that buyers purchase and sellers produce. If some event occurs that shifts demand and/or supply, the equilibrium changes. The analysis of a change in equilibrium is called comparative statics: 1. Decide whether the event shifts the supply or demand curve, or both. 2. Decide in which direction the curve shifts. 3. Use the supply-and-demand diagram to see how the shift changes the equilibrium. Changes in equilibrium- increase in demand E.g. suppose that one summer gets very hot. How does this event affect the market for ice-cream? To answer, start from an initial equilibrium (point E), and do our comparative statics exercise: 1. Will hot weather affect demand or supply? Demand. 2. Will demand/supply increase or decrease? Demand increase. 3. Where is the new equilibrium? $2.50, equilibrium quantity of 10. Conclusion: high temperature in summer is likely to lead to an increase in the price of ice-cream as well as in the quantity sold and bought. Changes in equilibrium- decrease in supply E.g. a bushfire destroys several ice-cream factories. Do comparative statics exercise: 1. Will the bushfire affect demand or supply? Supply. 2. Will demand/supply increase or decrease? Supply decrease. 3. Where is the new equilibrium? Conclusion: a bushfire destroying several ice-cream factories is likely to lead to an increase in the price of ice-cream and a decrease in the quantity bought and sold.
Changes in equilibrium- all cases The following table reports all possible cases. The most difficult to analyse are those where D & S change simultaneously. No change in supply An increase in supply A decrease in supply No change in demand Price same, quantity same Price down, quantity up Price up, quantity down An increase in demand Price up, quantity up Price ambiguous, quantity up Price up, quantity ambiguous A decrease in demand Price down, quantity down Price down, quantity ambiguous Price ambiguous, quantity down LO6: SUMMARY Prices have a rationing function- prices are mechanisms for allocating scarce resources. Prices co-ordinate the actions of large numbers of buyers and sellers, each acting independently. The combination of freely made, individual buying and selling decisions determines market demand and supply. In turn, the interaction of market demand and supply sets the equilibrium price i.e. the price that clears the market, as well as the equilibrium quantity i.e. how much is produced and bought. In effect, the market mechanism of supply and demand means that any buyer who is willing and able to pay the equilibrium price can purchase the good. Similarly, any seller who is willing and able to produce and sell the good at the equilibrium price will do so. This is known as the ‘rationing function of prices’ or ‘prices as a mechanism for rationing resources’.
Trade can make everyone better off. Markets are usually a good way to organise economic activity. Governments can sometimes improve market outcomes.
8. A country standard of living… 9. Prices rise when… 10. Society faces a trade-off…
How people make decisions Microeconomics How people interact
How the economy works as a whole
Macroeconomics
Lesson 1: People face trade-offs Due to scarce resources, making decisions requires trading off one goal for another. In other words, to get one thing, you must give up something else. If you want more of something, you must give up something else e.g. time, money. An important trade-off often discussed in economics is the trade-off between efficiency (getting the largest output from available resources) and equity (distributing those output fairly among society to increase overall well-being). It is difficult to obtain both equity and efficiency because if you want an equal society you must sacrifice some efficiency. Lesson 2: The cost of something is what you have to give up to get it In economics the cost of something is what you have to give up in order to get it- not just monetary costs, but opportunity costs. Opportunity cost: the opportunity cost of an item is the value of the best opportunity that you have to give up to obtain that item. It includes both the actual monetary amount paid (the explicit cost) and the monetary value of any other sacrifices made without direct payment (implicit cost). When making any decisions, individuals compare costs and benefits. To make a sound decision, it is necessary to be aware of the opportunity cost of that decision i.e. the true cost of that decision. Lesson 3: Rational people think at the margin Rational people choose the best option from available alternatives by comparing costs and benefits at the margin. Marginal change: a small incremental change or adjustment to an existing plan of action. Rational people compare the marginal cost of a decision with the marginal benefit. As long as the marginal benefit exceeds the marginal cost, it is profitable. Lesson 4: People respond to incentives Incentive: a reward or punishment that induces a person to act or not to act in a certain way, and there can be both positive and negative incentives e.g. penalties, bonus to an employee. It is often used by the gov. to encourage or discourage behaviours. Incentives (rewards and punishments) associated with a given decision alter the cost and benefit of that decision. Since rational people make decisions considering costs and benefits, they respond to incentives. E.g. a new law is introduced whereby anybody who is caught rink driving receives a life sentence.
LO2: THINKING LIKE AN ECONOMIST The economist as a scientist Economics is a social science. It is a science because it makes use of the scientific method i.e. observation, theory, more observation and so on. It develops theories and collects and analyses data to evaluate/test those theories. An obstacle in testing economic theories arises because it is difficult to use experiments to analyse social/economic phenomena. Physicists test theories in a laboratory where they can run repeated and controlled experiments- economists cannot. Economics often can only rely on observations the world happens to give them. Assumptions and economic models Assumptions are used to make the world easier to understand. The art in scientific thinking is deciding which assumptions to make. Assumptions are good if they simplify the problem at hand without substantially affecting the answer. Economists use different assumptions to answer different questions. Economic models omit many details to allow us to see what is truly important. A model is a simplified representation of reality intended to help people understand a complex problem. Models are built on assumptions. Most economic models are composed of diagrams/graphs and equations. Production Possibilities Frontier (PPF): a graph showing the combinations of output that an economy can possibly produce given: a) The available factors of production b) The available production technology This model assumes that there are only two goods in the world e.g. cars and computers. Efficiency and Opportunity Costs Quantity of Computers Produced 3000
(D) Not feasible (resources are scarce)
2200 2000
(C) (A) Feasible and efficient Production possibility frontier
1000
(B) Feasible but inefficient
0 300 600 700 1000 Quantity of Cars Produced All points on the frontier and below the frontier are combinations of output that can possibly be produced given the available factors of production and the available technologies of production. All points on the frontier are efficient e.g. (A), (C). All points below the frontier are inefficient e.g. (B). Efficient: an outcome is said to be efficient if the economy is getting all it can from its scarce resources. Opportunity cost: suppose we are at point (A) and are not happy with having only 2000 computers. We would like instead to have 2200 computers. What’s the opportunity cost of having extra 200 computers if we are at (A)? The opportunity cost is 100 less cars. Economic growth Computers Produced 4000 3000 2100 2000
(B) (A)
1000 0 700 1000 Cars Produced Suppose a new technology is discovered that increases productivity in computer production. This would create another production possibility frontier and more computers can be produced for the same amount of cars. The economist as a policy advisor When economists try to explain the world, they are scientist. When they try to improve the world, they are policy advisors. Positive vs. normative analysis: positive statements try to describe the world as it is i.e. descriptive analysis. Normative analysis try to describe how the world should be i.e. prescriptive analysis. When economists make normative statements, they are acting more as policymakers.
Economists serve as advisers in the policymaking process in all branches of government and independent agencies e.g. treasury, Reserve Bank, OECD. Economists also work n or advise the private sector e.g. financial institutions, industries and NGOs. Economists who advise policymakers may offer conflicting advice either because: a) Differences in scientific judgements- disagree about the validity of competing positive theories about how the world works. b) Differences in values- they have different normative views about what policies should try to accomplish.
LECTURE 2 – DEMAND & SUPPLY LO1: MARKETS AND COM PETITION Market: a group of buyers and sellers of a particular good or service. Whenever you have a group of buyers and sellers interacting to trade a good/service, you have a market. This interaction can occur in a physical place e.g. shopping centre or in a virtual one. Markets take many forms- sometimes they are highly organised e.g. Sydney’s fish markets, and sometimes less organised where the owner has the power to decide trading hours e.g. markets for ice-cream in Sydney. Competitive market: a market in which there are so many buyers and sellers that each has a negligible (insignificant, trivial) impact on the market price. The smaller the ability of each buyer/seller to affect market price, the more competitive the market. Throughout this subject, we will assume that markets are perfectly competitive (PC). To reach this highest form of competition, a market must have 2 characteristics: 1. The goods being offered for sale are exactly the same (homogeneous). 2. The buyers and sellers are so numerous that none can influence the market price. Price takers: a term given to buyers and sellers whom have to accept the market price as given. In the real world, there are some markets in which the assumptions of perfect competition apply e.g. agricultural markets. However, there are some markets in which there is no competition at all. In markets with only one seller i.e. a monopoly, the seller sets the price (price setter). The theory of supply and demand that we study here does not apply to these cases. Most real world markets fall between the extremes of perfect competition and monopoly. Perfect competition is a useful simplification and many of the lessons learned by studying supply and demand under perfect competition apply in more complex markets as well. Buyers determine demand. Sellers determine supply. LO2: DEMAND Quantity demanded of a good is the amount of a good that buyers are willing and able to purchase. a) Willing: a buyer wants to buy that amount, given his/her tastes and preferences. b) Able: given the price of the good, a buyer has enough income to buy the desired amount. Quantity demanded of a good depends on many factors such as the price of the good, tastes, disposable income and others. Law of demand: other things being equal, the quantity demanded of a good falls when the price of a good rises, and vice versa. Ceteris paribus: holding constant all other factors other than the price that may affect quantity demanded. It is the idea behind the law of demand in terms of other things being equal. There are 2 ways of representing the relationship between price and quantity demanded: a) Demand schedule: a table showing the relationship between price of a good and quantity demanded at different price points. b) Demand curve: a graph showing relationship between the price of a good and the quantity demanded. Demand schedule Price of an ice-cream (price per unit) $0.00 0.50 1.00 1.50 2.00 2.50 3.00
Quantity of ice-cream demanded (per month) 12 10 8 6 4 2 0
Note: this assumes that all factors (other than the price) that affect the demand of ice-creams are held constant (ceteris paribus assumption).
Demand curve
Note: the demand curve is downward sloping (Law of demand)
Market demand versus individual demand In a competitive market we have many buyers. To analyse how competitive markets work, we need to determine market demand. Market demand: the sum of all individual demands for a particular good or service. Graphically, individual demand curves are summed horizontally to obtain the market demand curve i.e. add individual demands together. The market demand curve shows how the total quantity demanded of a good varies with the price of the good, holding all other factors constant (ceteris paribus).
Movement along the demand curve A change in the price of a good generates movement along the demand curve. This is a change in the quantity demanded. Shifts in the demand curve A change in one or more of factors other than price generates a shift in the demand curve, either to the left or the right. A shift to the left indicates a decrease in demand, whilst a shift to the right indicates an increase in demand. In this case, we say there is a change in demand (as opposed to a change in the quantity demanded). Factors other than price that can affect demand include: a) Income: the relationship between income and demand depends on what type of good it is. i. Normal good: a good for which, other things being equal, an increase in income leads to an increase in demand. ii. Inferior good: a good which, other things being equal, an increase in income leads to a decrease in demand. b) Prices of related goods: the relationship between the price of a related good and demand depends on the type of product. i. Substitutes: two goods for which a decrease in the price of one good leads to a decrease in the demand for the other good. ii. Complements: two goods for which a decrease in the price of one good leads to an increase in demand for the other good. c) Tastes d) Expectations e.g. about future income, about the future prices of goods. e) Number of buyers: because market demand is derived from individual demand it positively depends on number of buyers. Useful general lesson: a curve shifts whenever there is a change in a relevant variable that does not appear on either axis of the demand curve.
LO3: SUPPLY We now turn our attention to the behaviour of producers/sellers i.e. supply. Quantity supplied: the amount of a goodo that sellers are willing and able to sell. a) Willing: producer wants to sell that amount b) Able: the amount is feasible given resources and technology. Law of supply: other things being equal, the quantity supplied of a good rises when the price of the good rises, and vice versa. Two ways of representing the relationship between price and quantity supplied: a) Supply schedule: a table showing the relationship between the price of a good and the quantity supplied. b) Supply curve: graph showing relationship between the price of a good and the quantity supplied.
Supply schedule Price of an ice-cream (price per unit) $0.00 0.50 1.00 1.50 2.00 2.50 3.00
Quantity of ice-cream demanded (per month) 0 0 1 2 3 4 5
Note: this assumes that all factors (other than the price) that affect the supply of ice-creams are held constant (ceteris paribus assumption)
Supply curve
Note: the supply curve is upward sloping (To reflect the law of supply)
Market supply versus individual supply In a competitive market we have many sellers. We need to determine the market supply. Market supply: the sum of all individual supplies for a particular good or service. Graphically, individual supply curves are summed horizontally to obtain the market supply curve. The market supply curve shows how the total quantity supplied of a good caries with the price of a good, holding all other factors constant. Movement along the supply curve A change in the price of a good generates movement along the supply curve. This is a change in the quantity supplied. Shifts in the demand curve A change in one or more of factors other than price generates a shift in the supply curve, either to the left or the right. A shift to the left indicates a decrease in supply, whilst a shift to the right indicates an increase in supply. In this case, we say there is a change in supply (as opposed to a change in the quantity supplied). As a result, the quantity supplied has changed at every price point. Factors other than price that can affect supply include: a) Input prices: the quantity supplied is negatively related to the price of inputs used to make the good i.e. if the price of an input rises, the supply of the good decreases, and vice versa. b) Technology: an improvement in the production technology increases productivity: with the same inputs, the producer can supply more. c) Expectations: e.g. if suppliers expect the price to rise they will be more likely to store some of the goods and supply less to the market today. d) Number of sellers: because market supply is derived from individual supply, it positively depends on the number of sellers. LO4: EQUILIBRIUM - SUPPLY AND DEMAND TO GETHER Equilibrium Equilibrium: a situation in which supply and demand have been brought into balance. Equilibrium price: the price that balances quantity supplied and quantity demanded. It is also known as market-clearing price. On a graph, it is the price at which the supply and demand curves intersect. Equilibrium quantity: is both the quantity supplied and the quantity demanded at the equilibrium price. On a graph, it is the quantity at which the supply and demand curves intersect.
Markets not in equilibrium- surplus When market price is higher than the equilibrium price, there is a surplus (or excess supply). It creates a situation where quantity supplied is larger than quantity demanded. Thus, suppliers lower price to increase sales, thereby moving toward equilibrium. Markets not in equilibrium- shortage When market price is lower than the equilibrium price, there is a shortage (or excess demand). It creates a situation where quantity supplied is smaller than quantity demanded. Thus, suppliers raise price due to too many buyers chasing too few goods, thereby moving toward equilibrium.
As we have seen, if the market is not in equilibrium, in perfectly competitive markets the actions of buyers and sellers naturally move the price- and hence the market- towards equilibrium. The laws of supply and demand claim that the price of any good adjusts to bring the supply and demand for that good into balance. This does not mean that markets are never out of equilibrium. Surplus and shortages exist. Once the equilibrium is reached, all buyers and sellers are satisfied and there is no upward or downward pressure on price. LO5: CHANGES IN EQUI LIBRIUM Together, demand and supply determine a market’s equilibrium i.e. the price and the amount of the good that buyers purchase and sellers produce. If some event occurs that shifts demand and/or supply, the equilibrium changes. The analysis of a change in equilibrium is called comparative statics: 1. Decide whether the event shifts the supply or demand curve, or both. 2. Decide in which direction the curve shifts. 3. Use the supply-and-demand diagram to see how the shift changes the equilibrium. Changes in equilibrium- increase in demand E.g. suppose that one summer gets very hot. How does this event affect the market for ice-cream? To answer, start from an initial equilibrium (point E), and do our comparative statics exercise: 1. Will hot weather affect demand or supply? Demand. 2. Will demand/supply increase or decrease? Demand increase. 3. Where is the new equilibrium? $2.50, equilibrium quantity of 10. Conclusion: high temperature in summer is likely to lead to an increase in the price of ice-cream as well as in the quantity sold and bought. Changes in equilibrium- decrease in supply E.g. a bushfire destroys several ice-cream factories. Do comparative statics exercise: 1. Will the bushfire affect demand or supply? Supply. 2. Will demand/supply increase or decrease? Supply decrease. 3. Where is the new equilibrium? Conclusion: a bushfire destroying several ice-cream factories is likely to lead to an increase in the price of ice-cream and a decrease in the quantity bought and sold.
Changes in equilibrium- all cases The following table reports all possible cases. The most difficult to analyse are those where D & S change simultaneously. No change in supply An increase in supply A decrease in supply No change in demand Price same, quantity same Price down, quantity up Price up, quantity down An increase in demand Price up, quantity up Price ambiguous, quantity up Price up, quantity ambiguous A decrease in demand Price down, quantity down Price down, quantity ambiguous Price ambiguous, quantity down LO6: SUMMARY Prices have a rationing function- prices are mechanisms for allocating scarce resources. Prices co-ordinate the actions of large numbers of buyers and sellers, each acting independently. The combination of freely made, individual buying and selling decisions determines market demand and supply. In turn, the interaction of market demand and supply sets the equilibrium price i.e. the price that clears the market, as well as the equilibrium quantity i.e. how much is produced and bought. In effect, the market mechanism of supply and demand means that any buyer who is willing and able to pay the equilibrium price can purchase the good. Similarly, any seller who is willing and able to produce and sell the good at the equilibrium price will do so. This is known as the ‘rationing function of prices’ or ‘prices as a mechanism for rationing resources’.
