Three Basic Questions: All economies must answer three basic questions:
Allocation question: What goods and services should be produced? Production question: How should the selected goods and services be produced? Distribution question: Whom should receive the goods and services that are produced?
Every society must decide what goods, and what combinations of goods it will produce. There are many ways to do this: 1. Central planning: A government decides which goods,and how much of each, will be produced. 2. Regulated production: Society places restrictions are placed on which goods, or the
quantities of goods that can be produced. 3. Free markets: Individuals engage in exchange, trading good with little or no restriction. Simple Market Transactions: Markets are two-sided exchanges, with a group of buyers on one side of the market, and a groups of
sellers on the other. The market is supposed to have certain stability properties that allow it to work with a minimum of interventions from outside actors, such as the government. The government need only insure contracts are honored to permit a market to operate, though we may require some insurance that information is easily available. Auction Market: In this simple market, buyers call out bids for units of a good, and sellers ask for bids for the units of the good they hold. Anytime agreement is reached, the goods change hands.
Typical Market: There are many sellers and many buyers. We can constructa relationship between the price and quantity of goods buyers and sellers are willing to trade. We construct a Market Demand relationship, for the buyers, and a Market Supply relationship for the sellers. Determinants of Market Demand What factors determine the willingness and ability of a group of individuals to purchase quantities of a good. Some obvious influences: T - the tastes of individuals Y - income of individuals Pop - Size and distribution of the population in society Dist - Distribution of income in the society P - price of the good being examined Pi - price of other goods, i = 1,2,3..n Algebraic Formulation: Q = F(T,Y,Pop,Dist,P,Pi)
where Q = Quantity of the good individuals are willing and able to buy per period. It is difficult to study something with so many variables. Economists try to study the quantity of a good individuals are willing and able to buy, by letting variables change one at a time. Q = F(P; T,Y,Pop,Dist,Pi) OR Q = F(P) , ceteris paribus Ceteris Paribus means "all other influences on demand are held constant." Thus, Q = F(P), ceteris paribus, means:
Analyze the influence of the price of a good on the quantity of that good indiviudals are willing and able to buy, with no other variables changing. Market Demand: The quantity of a good individuals are willing and able to
buy at a list of prices, when all other influences on demand are not active, [are held constant] Demand Schedule for Fish Market $/ton tons/week 0 100 10 80 20 60 30 40 40 20 50 0
Demand Equation: P = P[Q=0] + [DP/DQ]*Q y = b + mx
This is a linear equation, by assumption. It is written in a format which should be familiar to all of you:
[y = b+mx] where b is the vertical intercept, and m is the slope of the line. For the data given above, the slope
of the line , [DP/DQ]= -1/2. The vertical intercept, the value of P when Q=0, is 50.
So, for our data, we get the following equation:
For our example: P = 50 -Q/2 LAW OF DEMAND: When the price of a good changes, all other things equal, the quantity demanded of the good
changes in the opposite direction.
If the price of a good rises, the quantity demanded of that good falls. If the price of a good falls, the quantity demanded of that good rises. Explanation: 1. As P falls, new buyers enter the market, who were not willing or able to buy the good before. 2. As P falls, buyers already in the market are willing and able to buy more of the good than they did before.
Determinants of Market Supply: As with market demand, there are many factors which determine the willingness and ability of a group of individuals to supply a good to the market. Tech - best technology of production available wi - price of various inputs, i = 1,2,3,...,m Op - opportunity cost of entrepreneurs P - price of the good being supplied As with market demand, we look only at one variable at a time, and we right
market supply as a function of the price of the good in question. Q = F(P), ceteris paribus. where Q = quantity of the good producers are willing and able to provide to the market. Supply Schedule for the Fish Market $/ton tons/week 0 -80 10 -40 20 0 30 40 40 80 50 120 Supply Equation: P = P[Q=0] + [DP/DQ]*Q y = b + mx For our example: P = 20+Q/4 Note, the slope is now positive. The quantity suppliedresponds positively to an increase in the price of the good.
LAW
OF SUPPLY: As the price of a good changes, the amount individuals
or
firms
are willing and able to sell changes in the same direction.
As P rises, sellers
are willing and able to provide more of the good.
As P falls, sellers
are willing and able to provide less of the good.
Explanation:
1. As P rises, more individuals enter the industry, seeking profitable opportunities.
2. As P rises,
suppliers already in the market will expand production and supply more
of the good.
Market
Equilibrium:
When the quantity individuals
are willing and able to buy at the going price
equals
the quantity others are willing and able to sell at that same price.
The data from the demand and supply schedules, above, gives us the two equations:
Demand curve: P = 50 - Q/2
Supply curve: P = 20 + Q/4
At Equilibrium, the
Curves Cross! P on Demand
curve = P on Supply curve
50 - Q/2 = 20 + Q/4
30 = 3Q/4
40 = Q*
30 = P*
We can put the demand and supply curves, and the equilibrium they yield, on the same graph.
Adjustment
to equilibrium: The meaning of a market
equilibrium is that the price and quantity will
remain
at the equilibrium level unless something causes either the demand curve
or the supply curve to move.
As long
as the curves remain stationary, that is, as long as the variables that
were held constant when we drew the demand
and supply
curve remain constant, then the equilibrium remains.
But, if something causes one or both of the curves to move, then the market equilibrium moves.
Supply Shift: Suppose the quantity supplied increase at each price by 60 units. This will cause a parallel shift in the supply curve.
P Old Quantity Supplied New Quantity Supplied
0
-80
-20
10
-40
20
20
0
60
30
40
100
New Supply curve equation: P = 5 + Q/4
There is no shift in demand; remember,
the variables that position the supply curve are not the same variables
that give the position of the demand curve.
Therefore, when supply shifts, there is no corresponding shift in demand
at the same time except by coincidence.
As noted above, equilibrium occurs where the curves cross, or where Pd = Ps
50 -Q/2 = 5 + Q/4
45 = 3/4 Q
Q* = 60
P* = 20
We can show the original equilibrium, and the new one, on the same graph.
Similarly, if supply had not shifted, but demand had shifted out by
30 units at each
price, we would have:
P Old quantity demanded New Quantity demanded
50 0
30
40 20
50
30 40
70
20 60
90
10 80
110
0 100
130
New Demand: P'd = 65 - Q/2
Equlibrium: P'd = Ps
65 - Q/2 = 20 + Q/4
45 = 3Q/4
60 = Q
35 = P
Minimum price: A price set above the equilibrium, because
society has decided the equilibrium is too low.
Minimum wage law is an example.
Also called a floor price.
Maximum price: A price set below the equilibrium, because society
has
decided the equlibrium is too high.
Rent control laws are an example.
Also caused a ceiling price.