Microeconomics Principles

Chapter 2: Review

Objectives:After section II material, the student should

1. understand the importance of opportunity cost and be able to calculate it for simple situations.

2. understand the meaning and importance of comparative advantage.

3. understand the importance, use and reason for the shape of the production possibilities curve (PPC).

4. understand what efficiency means and why it is important.

5. understand the importance of specialization, and how it affects the economy.

Supply and Demand

Chapter 3

Objectives: At the completion of this section, the student should• understand the meaning and use of demand and

supply.• be able to construct and manipulate a simple

demand and supply graph.• understand the dynamics of the demand and

supply model (surpluses, shortages, incentives, & response to incentives)

• understand and be able to show on a supply and demand graph the effect of governmental interventions in the market

• understand the importance and measurement of economic surplus.

Basic Questions in Economics• What?

– What goods and services will be produced?– Ans: Those valued more than their opportunity cost.

• How?– How will the goods and services be produced?– Ans: With the least cost in resources.

• For Whom?– Who will get to consume the goods & Services?– Ans: Those willing and able to pay for them.

Demand• Price and quantity wanted combos

– (p1 ,q1 ; p2 ,q2 …)– menu of options

• Reservation price = max price for me to buy• As price rises,

– Each person wants fewer units– Fewer people willing to buy

• Demand is– Maximum quantity demanded, given price– Maximum price for given quantity demanded– Curve is maximum boundary

7

Demand as Boundary

• Will not buy beyond the demand curve

Demand

Pric

e

Quantity

Will not Buy

Will buy

Supply• Price and quantity willing to sell combos

– (p1 ,q1 ; p2 ,q2 …)– menu of options

• Reservation price = Min price for me to sell

• As price rises,– Each person wants to sell more units– More people willing to sell

• Supply is price and quantity combinations– Maximum quantity supplied, given price– Minimum price for given quantity to be supplied– Curve is maximum boundary

9

Supply as Boundary

• Will not sell beyond Supply

SupplyP

rice

Quantity

Will not Sell

Will Sell

10

Equilibrium• A tendency not to change• What Price ___________• What Price___________• Only price both like is S & D intersection

Demand

Pric

e

Quantity

Will not Buy

Will buy

Supply

Will not Sell

Will Sell

Both willing

Pe

Qe

Price such that Q demanded = Q supplied

Quantity @ Equilibrium P

Equilibrium• Desired Price and Quantity

– Demanders willing to buy Qe at this price– Suppliers willing to sell Qe at this price

• Process of getting to equilibrium– Excess Demand

• Price too low-– Demanders want more than suppliers willing to sell– Demanders bid price up as they try to get what they want

– Excess Supply• Price too high-

– Suppliers willing to sell more than demanders want– Sellers drop price attempting to attract customers

Process of getting to equilibrium

• Excess SupplyQS > QD

Forcing P dn

• Excess Demand QD > QS

Forcing P up

P

QD

S

Q1

P1

QD QS

QDQS

Conclusion: Only at equilibrium price (P1) is price stable.*

Demand Changes• Demand Increase

– Increases quantity demanded at each price– Shifts Demand curve out (more quantity)– Creates excess demand (shortage)– Forces equilibrium price up– Example: Demand for gasoline up now

• Demand Decrease – Decreases quantity demanded at each price– Shifts Demand curve in (less quantity)– Creates excess supply (surplus)– Forces equilibrium price down– Example: Demand for suntan oil down now

Demand Shift • Demand for

houses up now• More customers,

same QS

• Increasing P • Increasing Q• Along Supply

Curve

P

D

S

Q1

P1

Q

D2

Q2

P2QD2

Supply Changes• Supply Increase

– Increases quantity supplied at each price– Shifts Supply Curve out (more quantity)– Creates excess supply (surplus)– Forces equilibrium price down– Example: More computing power is available

• Supply Decrease– Decreases quantity supplied at each price– Shifts Supply Curve in (less quantity)– Creates excess demand (shortage)– Forces equilibrium price up– Example: Supply of oil is down

Supply shift

• Supply of gasoline down

• Less Supply, same QD

• Increasing P• Decreasing Q• Along Demand

Curve

P

D

S

Q1

P1

Q

S2

Q2

P2

QS2

Demand Shift Factors• Income –

– Normal goods – more income, _____ Q demanded @ each price

– Inferior goods – more income, _____Q demanded @ each price• Prices of Substitutes –

_____________________________________________• Prices of Complements –

_____________________________________________• Preferences (tastes) –

_____________________________________________• Price expectations –

_____________________________________________• Number of Consumers –

_____________________________________________• Advertising –

_____________________________________________

price of pens affects demand for pencils

price of speakers affects demand for stereo receivers

Fads affect demand for specific clothing

Expected future price affects demand for a stock

number of families in area affects demand for housing

“Intel Inside,” “Have it your way”

more

less

Supply Shift Factors• Input Prices –

______________________________________• Technology

______________________________________• Weather (acts of nature)

______________________________________• Expectations –

______________________________________• Number of suppliers

______________________________________

labor cost affects supply of cars Technological improvements affects the supply of computer power

Hurricane in Louisiana affects supply of gasoline Price expectations affects willingness of oil companies to supply oil now Internet has increased the number of suppliers in book market

Supply & Demand Example 1

• Assume that the above graph is for the market for gasoline, and that the center dot marks the initial equilibrium.

• When the BP well exploded the market likely moved to ____ (fill in the appropriate letter).

P

Q

AB

C

E

F

GH

I

DS

B:natural disaster decreases supply

P1

P2

Q1Q2

S’

Supply & Demand Example 2

• Assume that the above graph is for the market for small, efficient cars, and that the center dot marks the initial equilibrium.

• When the BP well exploded the market likely moved to ____ (fill in the appropriate letter).

P

Q

AB

C

E

F

GH

I

DS

F:substitute car that uses less gas

P1

Q1

P2

Q2

D’

Supply & Demand Example 3

• Assume that the above graph is for the market for large SUVs, and that the center dot marks the initial equilibrium.

• When the BP well exploded the market likely moved to ____ (fill in the appropriate letter).

P

Q

AB

C

E

F

GH

I

DS

E:complementary good effectP1

Q1

P2

Q2

D’

Supply & Demand Example 4

• Assume that the above graph is for the housing market, and that the center dot marks the initial equilibrium.

• If interest rates rise, the market likely will move to ____ (fill in the appropriate letter).

P

Q

AB

C

E

F

GH

I

DS

E:potential buyer effectA:new construction effect

P1

Q1

P2

Q2

P3

Q3

S’

D’

Supply & Demand Example 5

• Assume that the above graph is for housing market, and that the Center dot marks the initial equilibrium.

• If the expectations are for housing prices to increase in the future, the market will likely move to ____ (fill in the appropriate letter).

P

Q

AB

C

E

F

GH

I

DS

F: price expectations demand effectC:current owner effect

I:new housing effectThe size of the effects will determine the actual outcome.

P1

Q1

P2

Q2

P2

Q2

P2

Q3

S’ D’S’

Supply & Demand Example 6

• Assume that the above graph is for the market for half and half (cream), and that the center dot marks the initial equilibrium.

• When the price of coffee rises, the market will likely move to ____ (fill in the appropriate letter).

P

Q

AB

C

E

F

GH

I

DS

E:price of complement effectP1

Q1

P2

Q2

D’

Supply & Demand Example 7

• Assume that the above graph is for the market for cell phone service, and that the center dot marks the initial equilibrium.

• When cell phone companies give away free phones, the market will likely move to ____ (fill in the appropriate letter).

P

Q

AB

C

E

F

GH

I

DS

F:Price of complement effect

P1

Q1

P2

Q2

D’

Supply & Demand Example 8

• Assume that the above graph is for the market for high quality shoes, and that the center dot marks the initial equilibrium.

• When the income in the area falls, the market will likely move to ____ (fill in the appropriate letter).

P

Q

AB

CF

GH

I

DS

EE:Income effect on a normal goodP1

Q1

P2

Q2

D’

Supply & Demand Example 9

• Assume that the above graph is for the market for low quality shoes, and that the center dot marks the initial equilibrium.

• When the income in the area falls, the market will likely move to ____ (fill in the appropriate letter).

P

Q

AB

C

E

F

GH

I

DS

F:Income effect on inferior good

P1

Q1

P2

Q2

D’

Supply & Demand Example 10

• Assume that the above graph is for the market for airline travel to Milwaukee, Wisconsin, and that the center dot marks the initial equilibrium.

• When Southwest Airlines started flying to Milwaukee, the market likely moved to ____ (fill in the appropriate letter).

P

Q

AB

C

E

F

GH

I

DS

H:number of suppliers effectP1

Q1

P2

Q2

S’

Price CeilingRent control forces price below

equilibrium

Does not change D or S!

Increases quantity demandedDecreases quantity supplied QD > QS => Excess Demand Since price mandated, price

cannot adjustShortage permanent

P

Q

D

S

Q1

P1

QDQS

Shortage

Price Floor9

Agricultural price supports force price above equilibrium

Does not change D or S!

Decreases quantity demanded Increases quantity supplied QS > QD => Excess SupplySince price mandated, price

cannot adjustSurplus permanent

P

Q

D

S

Q1

P1

QD QS

Surplus

Comparative Advantage & Opportunity Cost Using Cost rather than Output

Time to perform tasks (one unit of the activity takes slited amount of time: Clean ShopGeorge 1 hr 2 hrSarah 0.5 hr 1.5 hrOpportunity Cost George Clean__________ _______George Shop __________ _______Sarah Clean ___________ _______Sarah Shop ____________ _______Who has comparative advantage in Shopping?___________

1 Shop / 2 Clean2 Clean / 1 Shop

1 Shop / 3 Clean 3 Clean / 1 Shop

0.5 S/C2 C/S0.33 S/C3 C/S

George