Transcript Chapter 7

Introduction To Economics
Chapter 7
Coordination After Changes In
Market Conditions
J. Patrick Gunning
February 20, 2007
Introduction
 Purpose of the chapter: next two chapters: to
present some simple examples of
entrepreneurial adjustment to change in
demand and supply conditions.
 Structure of the chapter:
 Part 1: The entrepreneurial coordination that occurs
after a change in demand conditions.
 Part 2: The entrepreneurial adjustments that results
from a change in supply conditions.
 Part 3: How government price controls may interfere
with the communication process and thereby inhibit
entrepreneurial coordination.
Part 1: Entrepreneurial Adjustment To A
Change In Demand Conditions
 A change in the quantity demanded due to a
change in price is shown by a movement along
a demand curve.
 In figure 7-1, a decrease in the sellers’ price
from $10 to $5 causes an increase in quantity
demanded from 590 to 1530 loaves.
 An increase in sellers’ price from $5 to $10
decreases quantity demanded from 1530 to
590 loaves.
The Demand For White Bread
(Figure 7-1)
A change in quantity demanded caused by a change in price.
Figure 7-2
An increase in demand: the marginal consumer is willing to
pay a higher price for each quantity.
Explanation Of Figure 7-2
 The increase in demand is shown by an
upward shift of the demand curve from D1 to
D2.
 This means that at each price, the quantity
demanded is greater.
 Examine the quantities demanded at $10 and
$8 per unit, before the increase in demand.
 Examine the quantities demanded at $10 and
$8 after the increase in demand.
Decrease In Demand:
Figure 7-3
A decrease in demand shifts the curve downward to the left.
Consumers are willing to buy less at each price.
A Change in the Demand and the
Marginal Consumer (Figure 7-4)
Explanation Of Figure 7-4
 An increase in demand also means that for any
quantity, the price that the marginal consumer is willing
to pay is higher than before.
 For the quantity 590, if the demand is D1, the marginal
consumer is willing to pay a maximum of $10. If the
demand is D2, the marginal consumer is willing to pay
a maximum of $13.90.
 For the quantity 980, the marginal consumer is willing
to pay $8 if the demand is D1 and $11.80 if the demand
is D2.
Representing How Producers Adjust:
Two Parts
 1. Compare a completely coordinated
market before the change with a
completely coordinated market after the
change.
 2. Describe the communication and the
incentive to adjust.
The Completely Coordinated
Industry (1) (From Chapter 6)
The Completely Coordinated
Industry (2)
 The price of each good equals the
marginal cost.
 Each seller of the good sells at exactly
the same price.
 The marginal cost rises because in order
to produce more bread, bakers must bid
specialized resources away from other
entrepreneurs.
Effects Of An Increase In Demand
(Figure 7-5)
An increase in demand would cause a shortage if producers
do not raise price.
The Completely Coordinated Industry:
Before And After (Figure 7-5)
 The increase in demand is represented
by a shift from D1 to D2.
 The increase causes the completely
coordinated price and quantity to change
from position 1 to position 2.
Communication And Incentives to Adjust
(Figure 7-5)
 The increase in demand by consumers raises
quantity demanded at the price of $.99 from
600 to 1360 loaves.
 This leads producers to try to produce a larger
amount.
 To obtain the additional resources, producers
must pay more per unit for resources.
 Producers communicate this to consumers by
raising their price.
 As the price rises, consumers demand less
than 1360 at the higher price.
What If Producers Did Not Raise
The Price?
 If producers did not raise price, the quantity
would fall to 600 units.
 The utility of the marginal consumer (the price
she was willing to pay) ($1.38) would be higher
than the marginal cost ($.99).
 Consumers would give producers an incentive
to produce more because they are willing to
pay a higher price. Otherwise, there would be a
shortage.
Who Is To Blame For The
Higher Prices?
 The ultimate responsibility for bidding up these prices
lies with the consumers themselves.
 Consumers of white bread have decided that they are
willing and able to buy more at each price.
 Other consumers are unwilling to give up the other
goods that could be produced with the resources
needed to satisfy the increased demand for bread.
 What happens in effect is that the consumers of white
bread must bid higher prices because they must
compete for resources with the consumers of other
consumer goods.
Effects Of An Decrease In Demand
(Figure 7-6)
Explanation Of Figure 7-6
 The decrease in demand is represented
by a shift from D1 to D2.
 The decrease causes the completely
coordinated price to fall from position 1 to
position 2.
Communication In Terms
Of Figure 7-6 (1)
 The decrease in demand by consumers for white bread
may lead producers to reduce output but not to reduce
price. If so, there would be a surplus of 430 loaves
(600 – 170). Price and quantity would temporarily move
from position 1 to position 3.
 As producers reduced their output, they would lay off
resources.
 Competition among the owners of the resources for
employment, particularly among the owners of
specialized resources, would causes the prices of
these resources to fall.
 The marginal cost at 170 loaves would fall to $.49 while
the price remained at $.99.
Communication In Terms
Of Figure 7-6 (2)
 Competition among producers for customers
would reduce the price.
 Competition would also bid up the prices of
resources.
 Consumers would demand more than
otherwise due to the lower price.
 Falling prices of bread and the increasing
amount of bread produced would cause a
movement from position 3 to position 2.
Part 2: Entrepreneurial Adjustments
To A Change In Supply
 We first show how to represent a change
in the conditions of production.
 Then we show the effects of a change
that causes marginal costs to rise.
Figure 7-7
Change In Quantity Supplied
(Figure 7-7)
 A change in the quantity supplied due to a change in
price is shown by a movement along a demand curve .
 In figure 7-7, an increase in the price that producers
expect to receive from $.99 to $1.25 causes an
increase in quantity supplied from 600 to 830 loaves.
The price and quantity supplied move from position A
to B.
 An decrease in the expected price from $1.25 to $.99
causes a decrease in quantity supplied from 830 to 600
loaves. The price and quantity supplied move from
position B to A.
A Decrease In Marginal Cost Causes An
Increase in Supply (Figure 7-9)
 An increase in supply is shown on a graph by a shift of the
supply curve downwards and to the right.
Explanation Of Figure 7-8
 At each quantity, the marginal cost is lower
than before the increase.
 Producers are willing to supply more at each
price.
 Before the change, producers are willing to
supply 46 loaves at a price of $.80 per loaf;
afterwards, they are willing to supply 95 loaves.
 Before the change, producers are willing to
supply 78 loaves at a price of $1.18 per loaf;
afterwards, they are willing to supply 128
loaves.
An Increase In Marginal Cost Causes A
Decrease in Supply (Figure 7-9)
A decrease in supply is shown on a graph by a shift of the supply curve
upwards and to the left.
Explanation Of Figure 7-9
 At each quantity, the marginal cost is higher than
before the increase.
 Producers are willing to supply less at each price.
 Before the change, producers are willing to supply 78
loaves at a price of $1.18 per loaf; afterwards, they are
willing to supply 70 loaves only if the price is $1.72.
 Before the change, producers are willing to supply 102
loaves at a price of $1.44 per loaf; afterwards, they are
willing to supply 102 loaves only if the price is $2.02.
Effects Of A Decrease In
Marginal Cost (Figure 7-11)
Effects Of A Decrease In Marginal Cost
Explanation Of Figure 7-11
 A decrease in marginal cost would cause the
completely coordinated price to fall from $.92 to $.78.
The completely coordinated quantity would rise from
1280 to 1480 loaves. From position 1 to position 2.
 Suppose that producers did not reduce price. Then
consumers would only buy 11280 loaves. At 1280
loaves MU > MC, as shown in the figure.
 Some entrepreneur would perceive that he could profit
by hiring more resources to produce a larger quantity.
To sell the large quantity, he would have to reduce
price.
Effects Of An Increase In
Marginal Cost (Figure 7-12)
Effects Of An Increase In Marginal Cost
Explanation Of Figure 7-12
 An increase in marginal cost would cause the
completely coordinated price to rise from $.78 to $.92.
The completely coordinated quantity would fall from
1480 to 1280 loaves. From position 1 to position 2.
 Suppose that producers did not raise price. Then they
would want to reduce their quantity supplied 630
loaves, as shown in the figure.
 But at this quantity, consumers would bid up the price.
The price would become $1.08 per loaf.
 Some entrepreneur would perceive that he could profit
by raising price and hiring more resources to produce a
larger quantity.
The Scenario Through The Eyes Of A
Surviving Baker
 Before the change, the typical baker was barely
making enough profit to continue in this activity.
 After marginal costs rise, she adjusts in the short run
by reducing the amount of bread that she produces
and sells.
 In the meantime, other bakers leave the industry. This
increases her customers and reduces her costs
because owners of the laid off resources are willing to
supply them at lower prices.
 This combination of more customers and falling costs
ultimately enables the surviving baker to earn a
minimal profit again.
Part 3: How Price Controls Block
Communication And Coordination (1)
 Retailers communicate with consumers
and producers of goods by offering and
accepting goods and resources for prices.
 Communication by means of markets
and prices enables the plans and
decisions of consumers to be
coordinated with the plans and decisions
of producers.
How Price Controls Block Communication
And Coordination (2)
 Price controls: laws that deter actors in
market interaction from changing the
prices as they would do under the
conditions of a pure market economy.
 We consider two types of price controls:
 A price ceiling.
 A price floor.
How Price Controls Block Communication
And Coordination (3)
 Price controls are likely to interfere with
communication and, therefore, with
coordination.
 They may eliminate the incentive to shift
resources in response to a change in
market conditions.
A Theory Of The Effects Of A Price Ceiling
 Price ceiling: a maximum price above
which sellers are prohibited from selling.
 Beginning with a completely coordinated
economy, suppose that you are a
neighborhood baker and that there is an
increase in demand for white bread.
 Assume that the ceiling price is exactly
equal to the price that retailers are now
charging.
Unwillingness To Respond To
An Increase In Demand
 Before the increase in demand, you are
earning a small profit.
 Because there is a price control, you cannot
afford to offer higher prices to resource
suppliers.
 So you are unwilling to respond to the increase
in demand by shifting resources.
 The effect is a shortage. The quantity
demanded is greater than the quantity supplied
at the current price.
Shortages In Markets Without
Price Controls
 Shortages are common in market interaction,
particularly among goods that take a long time
to produce.
 They lead sellers to raise the price and to give
resource suppliers incentives to shift resources
in and out of industries in response to changes
in market conditions.
 The resource shift tends to eliminate the
shortage.
Shortages In Markets With Price
Controls
 A price ceiling can prevent adjustment to
an increase in demand.
 A shortage may be permanent.
A Graph To Represent A Shortage Due
to a Price Ceiling (Figure 7-13)
Under a price ceiling, an increase in demand may cause a shortage. In
the graph the shortage is 720 loaves, as quantity demanded rises from
610 to 1330 loaves at the ceiling price of $2.
Dis-coordination
 The price ceiling prevents producing entrepreneurs
from receiving the message that they “should” shift
resources so that the higher consumer demand can be
accommodated with more production.
 To achieve a completely coordinated market, producing
entrepreneurs would have to shift resources away from
the production of other goods and into the production
of the good for which demand has risen.
 But this cannot occur because the entrepreneurs do
not receive the price signals that are necessary to give
them incentives to shift.
Incentive To Act Illegally
 The gap between the price that the marginal
consumer is willing to pay and the marginal
cost at 600 units (see figure 7-13) implies an
incentive to break the law by selling at a price
that is higher than the ceiling.
 Would-be law-breakers balance the
prospective gain against the risk cost.
 Law-breaker’s risk cost: a law-breaker’s
estimate of the harm he would incur if he was
caught times the probability that he would incur
that harm.
The Prospect for Corruption
 A prospective law-breaker may be able to
reduce her risk cost by bribing a police
officer, prosecutor, judge, or prison
official.
 In the real world, some types of
exchanges are banned.
 The ceiling price is zero.
 This leads to crime and corruption.
A Puzzle
 Suppose that the government controls
the price of airline tickets.
 A holiday arrives and there is an increase
in demand for tickets. The result is a
shortage of flights.
 What caused the shortage?
 Was it the increased holiday demand?
 Was it the price ceiling?
Shortage Due To An Increase In
Marginal Cost (Figure 7-14)
Under a price ceiling, an increase in cost may cause a shortage. In
the graph the shortage is 720 loaves, as quantity supplied falls from
1330 to 610 loaves, at the ceiling price of $2.
A Shortage Due To An
Increase In Costs
 Example: a bad growing season causes the
prices of wheat flour to rise.
 This, in turn, raises the costs to bakers. What
caused the shortage?
 1. Was it the bad weather?
 2. Was it the price control?
 Governments cannot change the weather, but
they can change a price control.
Dis-coordination
 The price ceiling causes more resources
to shift out of the industry than are
necessary to achieve complete
coordination.
 Because sellers do not communicate that
marginal price is higher than marginal
cost at 610 units, producing
entrepreneurs allow too many resources
to leave the industry.
A Theory Of The Effects Of A
Price Floor
 Price floor: a minimum price, established by
law, below which sellers are prohibited from
selling.
 The price floor is often used in industries like
farm products.
 Assume that the floor price on milk is exactly
equal to the price that milk producers are now
charging.
 There is a decrease in industry demand.
What Would Happen In the Absence of
a Price Floor?
 Milk producers would order fewer dairy workers
and other resources.
 Competing for employment, the owners of
those resources would reduce their prices.
 Competing milk producers would respond by
reducing their milk prices.
 In figure 7-15, the price and quantity would
tend toward the complete coordination at
position 3.
Graph Of A Price Floor (Figure 7-15)
EFFECTS OF A DECREASE IN DEMAND ON PRICE AND QUANTITY
The Price Floor Causes A Gap
Between Price and MC
 The price floor prevents price from falling. Milk
producers move from position 1 to position 2,
since consumers demand only 180 liters.
 But at position 2, there is a gap between price
and MC.
 It would seem that milk producers would be
making profit on the units they produce.
Alternative Ways To Compete
 Milk producers would like to compete for
customers by reducing price. But they cannot.
 They have alternative ways to compete:
 Maintain higher inventories.
 Increasing their advertising.
 Offer other services, like greater convenience or
delivery, that would otherwise not be offered.
 Evade the law by offering discount prices on
complementary goods or other products.
 Each of the alternatives is likely to cause costs
to be higher than otherwise.
Dis-coordination
 These competing actions would increase the marginal
cost of supplying milk.
 Marginal cost may even reach the point where it equals
the price of the product.
 If so, there would be no surplus and the market would
become coordinated.
 However, there would not be a completely coordinated
economy because costs would be higher than they
need to be.
 Not enough resources would be used to produce other
goods.