#### Transcript Decision Making and Demand and Supply

```Decision-making and Demand
and Supply Analysis
Thinking Economically: Marginal Analysis
• Optimization Assumption: an assumption that
suggests that the person in question is trying to
maximize some objective
• Marginal Benefit: the increase in the benefit that
results from an action
• Marginal Cost: the increase in the cost that results
from an action
• Total Net Benefits: the difference between all benefits
and all costs
Marginal Way in Action Simplified
• The Box Example
• If the marginal benefit of an extra unity of the
activity is greater than its marginal cost, increasing
the activity will increase total net benefits.
• If the marginal cost of an extra unit of the activity
is greater than its marginal cost, increasing the
activity will decrease total net benefits.
• Therefore, to maximize total net benefits the level
of an activity that maximizes total net benefits is
where the marginal benefit equals the marginal
cost of an extra unit of the activity.
Boxes
• If an extra unit of the activity (trades) results in
getting more boxes (MB) than are being given up
(MC) the stack of boxes grows (TNB).
• If an extra unit of the activity (trades) results in
getting less boxes (MB) than are being given up
(MC) the stack of boxes shrinks (TNB).
• If an extra unit of the activity (trades) results in
getting the same amount of boxes (MB) that are
being given up (MC) the stack of boxes is at its
tallest ( maximum TNB).
Maximizing Total Net Benefits
• Total Way – select the level of the activity that
maximizes the difference between total benefits
and total costs
• Marginal Way – set the marginal benefit of to the
marginal cost of an extra unit
• Economist prefer the later because many decisions
are not all or nothing. Most times people are
deciding to increase or decrease the amount of
something that they are doing.
Basic Definitions for MB and MC and
Maximization of TNB
•
•
•
•
•
•
MB=∆TB/ ∆Q=(TBNew-TBOld)/(Qnew-Qold)
MC=∆TC/ ∆Q=(TCNew-TCOld)/(Qnew-Qold)
TB=∑MB + (any fixed benefits which we generally assume to be zero)
TC=∑MC+ (any fixed costs which we generally assume to be zero)
TNB =TB-TC
Max TNB at that level of Q where MB=MC
Example of Maximizing TNB
• See Hand out and Excel Spreadsheet
(Maximizing TNB)
Aplia Demand and Supply
Experiment
• The market simulation summarized
seller a seller cost (MC)
– Both buyer and seller tried to maximize their gain
• Seller Gain Seller cost – price
– Repeated trials brought about a market price that cleared the
market
– As the price approached the market price the total gain to buyers
and sellers together increased
• Let´s generalize this by presenting the theory of markets.
Markets: The power of Demand
and Supply
• A market is simply an institution that bring buyers and sellers together
to agree on price and quantity traded.
• Competitive Markets
– many sellers and buyers →no one buyer or seller affect the price or they
are price takers
– identical or homogeneous goods→price is the only decision factor
– perfect information →there is only one price
– free entry and exit →profits (economic) will be zero in the long-run
• Non-Competitive Markets
– Monopoly – one seller
– Oligopoly – few sellers
– Monopolistically Competitive – differentiated products
The Theory of Demand for Goods and Services
• Households or consumers buy goods and services for a
variety of reasons, but can we model it?
• Economics assume that individuals are rational – they
weigh the costs and benefits of their actions and then try
and maximize TNB.
• What are the benefits? Economists have modeled benefits
as satisfaction or utility (an injection is useful but usually
not pleasant – it provides utility).
• What are the costs? Economist argue that the costs are
opportunity costs – i.e. what does one give up to get a good
or service.
• A person’s preferences or tastes, along with other factors,
determine the benefit from a good.
• The price of the good, the price of similar or substitute
goods, a person’s limited income, along with other factors,
determine the opportunity costs of the good.
• Basically, the theory of demand is getting the most
satisfaction from the goods and service one buys given the
prices of goods and one’s income.
• While many factors affect demand, we begin by
concentrating on the price of the good. Why? In
competitive markets, the price of the good is the MC to the
The Law of Demand
• Law of Demand – the price of a good and the quantity
demanded are negatively (or inversely) related, ceteris
paribus (Latin – all other things equal).
• Rational behavior suggests that as the MC↑, ceteris
paribus, an individual will ↓Q, it’s that simple.
• Early theorists, however, concentrated on MB rather than
MC. The believed that utility was measurable, so-called
cardinal (after numbers) utility.
– Law of Diminishing Marginal Utility
– Jelly bean example and Econ U\$A tape on the drought in
California.
– If people are to buy more (↑Q), since the MB↓, the price must fall
(↓P)
• More recent theorists use the concept of ordinal
utility to come to a similar conclusion. A person is
assumed to be able to rank bundles from most
preferred to least preferred.
– Reaches the Law of Demand with less restrictive
assumptions than cardinal utility.
• The Law if Demand and the Income and
Substitution Effects
• Substitution Effect: as the price of a good falls its
opportunity cost relative to other similar or
substitute goods falls, so consumers use more of the
good and less of other goods
– Example: Papples=\$1/lb of A (\$1/A) and Poranges=\$1/lb of O
(\$1/O) → the relative price of A in terms of O : PA/PO →
1 A requires us to give up 1 0. If the PA falls to \$.5/A, the
PA/PO → 1 A requires us to give up only .5 O. Apples are
thus cheaper and we buy more apples and less oranges.
Oranges are now more expensive ( 2 A for every 1 O).
• Income Effect: as the price of a good falls,
the real purchasing power of income
increases and consumers will buy more of
the good (if the good is normal).
– Example: If PA=\$1, A \$100 a week of income
will allow us to buy 100 A. Or, the real
income, measured in apples, is 100 A. If the PA
falls to \$.5/A, our real income is now 200 A.
– The effect of incomes on demand is not clear.
For normal goods, increases in income,
increase demand, and for inferior goods the
opposite happens.
• Cardinal utility, ordinal utility, and MB=MC, all
arrive at Law of Demand.
• We now look at the Law of Demand and the
Theory of Demand using numbers/schedules,
graphs/curves, and mathematical functions (don’t
panic). These representations make it easier to
understand the implications of theory, but they
require study and practice.
• We will use the book example and then shift to a
handout to practice.
Catherine’s Demand Schedule
Figure 1 Catherine’s Demand Schedule and Demand
Curve
Price of
Ice-Cream Cone
\$3.00
2.50
1. A decrease
in price ...
2.00
1.50
A movement
1.00
along the curve
0.50
is caused by
changes in P only
0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of
Ice-Cream Cones
2. ... increases quantity
of cones demanded.
• The Demand Function
– PR - Price of related goods
• Complements
• Substitutes
– Y - Income
– NB - Number of Buyers (added when all individuals curves are
summed together – see market demand)
– T -Tastes
– E -Expectations
– G- Government: Taxes and Subsidies
• In mathematical notation:
– Qd=F (P , PR ,Y,NB,T,E,G), where F() is “related to”
• Signing the determinants of demand. - is an inverse
relationship and + is a direct relationship.
• Market Demand Curve: The horizontal summation of all
the individual demand curves (handout). In our Aplia
experiment, the buyer values were ranked from high to
low.
Movements Along vs Shifts of the
Demand Curve
• Demand Curve versus the Demand Function
– The demand curve is created assuming ceteris paribus, so it maps
only the relationship between P and QD.
– The demand function shows all the determinants of demand. All
the factors other than P, such a PR and Y, are shift factors.
• Schedules
– Changes in price are described by the demand schedule.
– Shifts are shown as increases in QD at every price.
• Graphs/Curves
– A movement along the curve is a change in quantity demanded and
is only caused by the change in the price of the good itself.
– A shift of the curve is a change in demand is caused by any other
factor other than the price of the good itself.
• Qd=F (P | PR,Y,NB,T,E,G)
Figure 3 Shifts in the Demand Curve
Price of
Ice-Cream
Cone
Increase
in demand
Decrease
in demand
Demand
curve, D2
Demand
curve, D1
Demand curve, D3
0
Quantity of
Ice-Cream Cones
Theory of Supply
• Economists assume that businesses are rational as
well. We assume their primary interest is
maximizing profits.
• Profits are the difference between total revenues
and total costs. Revenues are analogous to benefits
• Once again, we concentrate on price first. Why?
In competitive markets, price is equal to MB (or
marginal revenue) to firms. Every time the firm
sells another unit, its revenue increases by the
price of the good.
• Law of Supply - price and the quantity supplied are
positively related, ceteris paribus.
– Rational behavior implies that firms try and maximize profits,
where the MB = P and MC is dependent on how much output is
produced.
– As the P ↑, the MB ↑ → Q supplied ↑ to maximize profits.
• Classical theorist approached the Law of Supply from the
costs perspective. They posited that the MC ↑ as Q ↑.
– Law of Diminishing Marginal Returns → LDMR comes from the
productivity decline as more and more of a variable input is added
to fixed input, eventually the extra output for each additional
variable input will fall, ceteris paribus. Thus, MC ↑ of producing
• Drilling for oil in Economics U\$A video, Dairy Queen example, and
growing the world’s food supply in a flower pot.
• Law of Increasing Costs: as the production of a good
increases, its opportunity cost increases (re: PPF and
specialized resources)
– Remember that the L of IC occurs because of resource specialization.
• Both the LIC and LDMR predict that as Q ↑ up the
productivity of inputs will fall and MC ↑.
• The Law of Supply arises because prices must rise to cover
the higher MC of producing additional units of output.
• We can better work with the Law of Supply using
schedules, graphs/curves, and mathematical equations.
Ben’s Supply Schedule
Figure 5 Ben’s Supply Schedule and Supply Curve
Price of
Ice-Cream
Cone
\$3.00
1. An
increase
in price ...
2.50
2.00
1.50
Change in
Qs is a movement
And caused only by Price
1.00
0.50
0
1 2
3
4
5
6
7
8
9 10 11 12 Quantity of
Ice-Cream Cones
2. ... increases quantity of cones supplied.
• The Supply Function
–
–
–
–
–
PI - Input prices
PI -Prices of other outputs
Te -Technology
E -Expectations
NS -Number of sellers (occurs when adding individual
supply curves together)
– G - Government taxes and subsidies
• Qs=F(P,PI,PO,Te,E,NS,G)
• Market Supply: The horizontal summation of all
the individual firms’ supply curves.
Movements vs. Shifts Again
• Qs=F(P,PI,PO,Te,E,NS,G)
• The price of the good itself causes movements
along the supply curve or changes in the quantity
supplied.
• Anything other than the price of the good causes
shifts in the supply curve or changes in supply.
• Market supply comes from horizontally adding all
the individual supply curves (see handout).
Figure 7 Shifts in the Supply Curve
Price of
Ice-Cream
Cone
Supply curve, S3
Decrease
in supply
Supply
curve, S1
Supply
curve, S2
Increase
in supply
0
Quantity of
Ice-Cream Cones
Market Equilibrium
• Market – an institution that bring buyers and sellers
together to agree upon price and quantity traded.
• Remember buyers key off of price in competitive markets
because it is their MC and for sellers it is their MB.
• Equilibrium price and quantity are those that clear the
market (neither shortages or surpluses) because the Qd=Qs.
• Disequilibrium prices and quantities
– Shortage – Excess Demand
– Surplus – Excess Supply
• At the Pe and Qe , buyers and sellers behavior are
coordinated.
Figure 8 The Equilibrium of Supply and Demand
Price of
Ice-Cream
Cone
Supply
Equilibrium
Equilibrium price
\$2.00
Equilibrium
quantity
0
1
2
3
4
5
6
7
8
Demand
9 10 11 12 13
Quantity of Ice-Cream Cones
Figure 9 Markets Not in Equilibrium
(a) Excess Supply
Price of
Ice-Cream
Cone
Supply
Surplus
\$2.50
2.00
Demand
0
4
Quantity
demanded
7
10
Quantity
supplied
Quantity of
Ice-Cream
Cones
Figure 9 Markets Not in Equilibrium
(b) Excess Demand
Price of
Ice-Cream
Cone
Supply
\$2.00
1.50
Shortage
Demand
0
4
Quantity
supplied
7
10
Quantity of
Quantity
Ice-Cream
demanded
Cones
Figure 10 How an Increase in Demand Affects the
Equilibrium
Price of
Ice-Cream
Cone
1. Hot weather increases
the demand for ice cream . . .
Supply
New equilibrium
\$2.50
2.00
2. . . . resulting
in a higher
price . . .
Initial
equilibrium
D
D
0
7
3. . . . and a higher
quantity sold.
10
Quantity of
Ice-Cream Cones
Figure 11 How a Decrease in Supply Affects the
Equilibrium
Price of
Ice-Cream
Cone
S2
1. An increase in the
price of sugar reduces
the supply of ice cream. . .
S1
New
equilibrium
\$2.50
Initial equilibrium
2.00
2. . . . resulting
in a higher
price of ice
cream . . .
Demand
0
4
7
3. . . . and a lower
quantity sold.
Quantity of
Ice-Cream Cones
Comparative Statics
• Animal tracks help one to tell what kind of an
animal and the direction the animal went.
• Demand and supply shifts leave different tracks to
help us identify them and whether they are
increasing or decreasing.
• Movement of either D or S (confirm with graphs)
–
–
–
–
D↓, S constant → P↓, Q↓
D↑, S constant → P↑, Q↑
S↓, D constant → P↑, Q↓
S↑, D constant → P↓, Q↑
Role of Prices
• Price play an important role in markets because it:
–
–
–
–
Provides information about MC and MB
Determines resource allocation
• Although the equilibrium graph is interested it is
sterile, we are interested in what happens when
circumstances change, i.e. demand and supply
shocks (shifts).
Rocking and Rolling: Comparative
Statics
• When either the demand curve or the supply curve shift, Pe
and Qe change predictably.
• These is done by comparing two static equilibriums or
comparative statics.
• Demand Shifts/Shocks:
– D↑→P↑Q↑
– D↓→P↓Q↓
• Supply Shifts/Shocks:
– S↑→P↓Q↑
– S↓→P↑Q↓
• Like animals, D and S shocks leave unique tracks.
Using Comparative Statics to Predict or
Explain Market Behavior
• Predicting:
– Demand can increase, remain the same, or
decrease.
– Supply can increase, remain the same, or
decrease.
– So comparative statics tells us that there are 9
different possible comparative static predictions
Comparative Statics Table
(too confusing – use graphs)
(? - ambiguous change)
D↑
D unchanged
D↓
S↑
P↑Q↑
P↓Q↑
P? Q ↑
P Q
P↓Q↑
P↓Q↑
P↓Q↓
P↓Q↑
P↓Q?
S unchanged
P↑Q↑
P Q
P↑Q↑
P Q
P Q
P Q
P↓Q↓
P Q
P↓Q↓
S↓
P↑Q↑
P↑Q↓
P↑ Q ?
P Q
P↑Q↓
P↑Q↓
P↓Q↓
P↑Q↓
P?Q↓
Explaining Markets with Tracks
• If P↑Q↑ , what kind of animal is it? D or S?
Which way is it going?
• If P↓Q↓, explain.
• If P↓Q↑, explain.
• If P↑Q↓, explain.
• Listening to market information on movements of
P and Q, help explain what is the primary
influence on the market, D or S.
• NPR examples: Mad Cow and Tuition
The Invisible Hand
• Adam Smith summarized the remarkable coordination that
results even as people follow their own self-interest. He
called in the ¨Invisible Hand¨.
• As we saw in the Aplia experiment, consumer simply try
to maximise their utility (TNB or gain) and producers try
and maximize their profit (TNB or gain).
• Market prices are
– signals for resource allocation
– coordinate consumer and producer behavior
– incentives for buyers and sellers (MC for buyers and MB for
sellers)
– Ration scarce goods and services
– Provide information about scarcity and value
• Prices help markets allocate resources more
efficiently. Markets are efficient when
– They produce what consumers want or most highly
value, and
– Produce those goods and services at least possible cost
– In Aplia, we saw the total gain increased as we moved
to the equilibrium prices and quantities.
– We will explore the implications of this remarkable
human creation as we proceed through the course.
```