Dr. Duffy Microeconomics
Notes from
CHAPTER 3 of
Frank and Bernanke
Three Basic Questions
Three Problems All Economic Systems
Must Address
• What should be produced?
• How should it be produced?
• For whom will it be produced?
Types of Economies
• Command Economy: government makes all
important decisions about production and
distribution.
• Market Economy: individuals and private
firms make the major decisions. Extreme
case (no government intervention) is called
“laissez-faire” economy.
• Mixed Economy has elements of both. All
modern economies are mixed.
A Pure Market Economy. . .
. . .has never existed. The closest to it
was probably England in the 19th century.
There has never been a pure “command economy” either,
although some of the older communist regimes (Stalin,
Pol Pot) may have been close.
U.S. Economic System
• Largely a market system
• However, we do have some laws and
regulations that affect market decisions.
• Can you think of some policies (state,
federal or local) that affect certain
markets?
Price Determination
• Assuming no or little government
intervention in a market, what determines
price?
• Explaining prices is a fundamental
question that drove the development of
modern economics.
• It is only recently (late 19th century) that
a good understanding of price
determination developed.
Supply and Demand
Supply and Demand determine prices in
individual markets.
Price is the mechanism that brings supply
and demand together.
Rationing by prices
Through prices, the market rations the
scarce goods of society among possible
uses.
The Demand Schedule
The demand schedule (demand curve)
shows the relationship between a
commodity’s market price and the quantity
of that commodity that consumers are
willing and able to purchase, other things
held constant.
Generally, the higher the price, the less the
quantity demanded.
The Dailey Demand Schedule for
Pizza in Chicago
Price Quantity Demanded
($/slice) (1000s of slices per day)
$5 4
4 8
3 12
2 16
1 20
The Daily Demand Curve
for Pizza in Chicago
Price
($ per slice)
4
3
2
Demand
Quantity
(1000s of slices per day)
8 12 16
Law of Downward Sloping Demand
When the price of a commodity is raised
(and other things are held constant), buyers
tend to buy less of the commodity. Similarly,
when the price is lowered, other things being
constant, quantity demanded increases.
There are two explanations for downward
sloping demand curves.
Reason 1: Substitution Effect
When the price of a good rises, I will
substitute other similar goods for it.
For example, if the price of beef rises,
I will eat more chicken and pork.
Reason 2: Income Effect
As the price of a commodity rises, my income
will not stretch as far as it used to. I am
therefore “poorer” in a relative sense,
than before the price increase and can’t buy
as many things as I did before.
Demand and Cost-Benefit
• The reservation price is the benefit the
buyer receives from the good
• The cost of the good is its market price
• If the reservation price (benefit) exceeds
the market price (cost) the consumer will
purchase the good
• At higher prices, benefit will exceed cost
for a smaller quantity than at lower prices
Buyers and Sellers In Markets
Horizontal Interpretation
Price
($ per slice)
4 Price determines
quantity demanded
3
2
Demand
8 12 16
Buyers and Sellers In Markets
Vertical Interpretation
Price
($ per slice)
4 Quantity measures the
marginal buyer’s
3 reservation price
2
Demand
8 12 16
Market Demand Curve
The market demand curve “adds up”
all the quantities demanded by individual
consumers at a given price.
It shows the total amount of a commodity
consumers are willing and able to buy at
a given price.
The Supply Schedule
The supply schedule (or supply curve) for
a commodity shows the relationship between
the market price and the amount of that
commodity that producers are willing and able
to produce and sell, other things held
constant. Generally, the higher the price the
more producers will supply.
The Daily Supply Schedule
for Pizza in Chicago
Price Quantity
($ per slice) (1000s of slices per day)
$4 16
3 12
2 8
1 4
The Daily Supply
Curve for Pizza in Chicago
Price
($ per slice)
Supply
4
3
2
Quantity
(1000s of slices per day)
8 12 16
Opportunity Costs and
Quantity Produced
• Question
• Will the opportunity cost of producing
additional units of pizza increase or decrease?
• Hint:Low-hanging-fruit principle
Supply Slopes Up
Supply slopes up because of the “law of
diminishing returns.” To get extra output
usually requires proportionally more extra
input.
Seller’s Reservation Price
The smallest dollar amount for which a seller
would be willing to sell an additional unit,
generally equal to marginal cost
Opportunity Costs and
Upward Sloping Supply
Sellers must receive a higher price to produce
additional units of product to cover the higher
opportunity costs of each additional unit
The Daily Supply
Curve for Pizza in Chicago
Horizontal Interpretation
Price
($ per slice)
Supply
4
3 Shows the
quantity produced
for each price
2
Quantity
(1000s of slices per day)
8 12 16
The Daily Supply
Curve for Pizza in Chicago
Vertical Interpretation
Price
($ per slice)
Supply
4
3 Shows the marginal
cost (reservation
price) for producing
2 each additional unit
Quantity
(1000s of slices per day)
8 12 16
Supply and Demand: Equilibirum
A market equilibrium comes at the place
where quantity demanded equals quantity
supplied.
Equilibrium takes place at the intersection
of the supply and demand curves.
Market Equilibrium
• Equilibrium
• A system is in equilibrium when there is no
tendency for it to change
• Market Equilibrium
• Occurs in a market when all buyers and
sellers are satisfied with their respective
quantities at the market price
Equilibrium Price and
Equilibrium Quantity
The values of price and quantity for which
quantity supplied and quantity demanded are
equal
The Equilibrium Price and
Quantity of Pizza In Chicago
Price
($ per slice)
Supply
4 Equilibrium at $3
Quantity Demanded =
3 Quantity Supplied
2
Demand
Quantity
(1000s of slices per day)
8 12 16
Market Equilibrium
• What Do You Think?
• Is the market equilibrium always an ideal
outcome for all market participants?
Market Equilibrium
• What Do You Think?
• Would buyers prefer a lower price than the
equilibrium price?
• Would sellers prefer a higher price than the
equilibrium price?
Points Along the Demand and
Supply Curves of a Pizza Market
Demand for pizza Supply of pizza
Quantity supplied
Price Quantity demanded Price
(1000s of
($/slice) (1000s of slices/day) ($/slice)
slices/day)
1 8 1 2
2 6 2 4
3 4 3 6
4 2 4 8
Note: There is no point in the table where price would make quantity
demanded equal quantity supplied. Our equilibrium price must fall
between $2 and $3.
Graphing Supply and Demand and
Finding the Equilibrium Price and Quantity
Price
($per slice) Supply
5
4
The Equilibrium Price = $2.50
3 The Equilibrium Quantity = 5
2.50
2
1
Demand
Quantity
0 (1000s of slices per day)
2 4 6 8 10
5
When we graph the curves, we can find the equilibrium price and
quantity.
Excess Demand: If price
is below equilibrium
Price
($ per slice)
Supply
4
Excess demand = 8,000
3 slices per day
2
Demand
Quantity
(1000s of slices per day)
8 16
This situation is called a shortage.
Excess Supply: If price is
above equilibrium
Excess supply = 8,000 slices per day
Price
($ per slice)
Supply
4
3
2
Demand
Quantity
(1000s of slices per day)
8 12 16
This situation is called a surplus.
Caution!
When economists use the word
“surplus” or “shortage” they mean that
the market is not in equilibrium. If there
is a surplus, products pile up,
un-purchased.
If there is a shortage, many consumers
cannot find the product to buy.
What is a shortage? Example.
The Christmas of 2000, there was a
shortage of the PlayStation II. Consumers
could not find the item on store shelves.
Gas prices rose this summer, but there
was no shortage because consumers
could find the gas to buy, although at
a higher price than before.
Factors Affecting Demand
• Size of market, e.g. how many
consumers.
• Income levels of consumers.
• Prices and availability of related goods.
• Tastes and preferences.
• Special influences, e.g. climate and
conditions.
Factors Affecting supply
• Changes in costs of inputs
• Technological change
• Prices of alternative products that could
be produced with same resources.
• Government policy
• Special factors (climate, culture)
Shifts of Supply or Demand
If one of the factors affecting a demand
or supply curve changes, the curve will
shift. This means the entire curve moves
to a new position on the graph.
Example: Shift of the demand curve
For most products, demand shifts outward as
income rises.
P
D'
D
Q
An Example
When students come back to school in the fall,
more pizzas are sold locally.
This is an increase in demand caused by an
increase in the size of the market!
Another Example
When low-carb diets were popular,
fewer loaves of bread were sold.
This is a decrease in demand caused
by a change in tastes and preferences.
Demand Increase or Decrease?
• What happens to demand for sunblock in
the summer?
• What happens to demand for fish when
chicken prices increase?
• What happens to the demand for luxury
cars when incomes fall?
• What will happen to the demand for sugar
if diabetes increases?
Normal Good vs. Inferior Good
If, when income rises, consumers purchase
more of a good, that good is called a “normal
good.”
Sometimes consumers may buy less of a
certain item when their incomes rise. That
good is called an “inferior good.”
Most items are normal goods. Can you think
of some inferior goods?
Shift of supply curve
P If the price of an input falls,
the supply curve shifts out.
S S’
Q
Shifts in curves change
equilibrium price and quantity
P
Supply increases
S’
S’’
P’
P”
D
Q
Q’ Q’’
Shifts in curves change equilibrium
P
Supply decreases
S’’
S’
P’’
P’
D
Q
Q” Q’
Shifts in curves change equilibrium
P Demand Increases
S
P”
P’
D”
D’
Q
Q’ Q”
Shifts in curves change equilibrium
P
S
Demand Decreases
P’
P”
D’
D”
Q
Q” Q’
There are four possibilities
• Price Up, Quantity Down ---- Supply decrease
• Price Down, Quantity Up -- Supply increase
• Price Up, Quantity Up -- Demand increase
• Price Down, Quantity Down -- Demand decrease
An Unregulated Housing Market
Monthly Rent
($/apartment) Supply
What Do You Think?
1,600 Is $1600 more than some
people can afford?
Demand
Quantity
(Millions of apartments/day)
2
Rent Controls
Monthly Rent
($/apartment) Supply
2,400
Excess demand = 2 million
1,600 apartments per month
Controlled = 800
Demand
Quantity
(Millions of apartments/day)
0 1 2 3
Rent Control
• Other consequences of rent controls
• Maintenance will decline and housing quality will
fall
• Illegal payments
• Creation of co-ops and conversion to
condominiums
• Reduction in household mobility
• Discrimination
Affordable Housing
• What do you think?
• How can we make housing affordable for
poor people without using rent ceilings?
Price Controls
In The Pizza Market
Price
($ per slice) Supply
4
Excess demand = 8,000 slices per day
3
Price ceiling = 2
Demand
Quantity
(1000s of slices per day)
8 12 16
Market Equilibrium
• Pizza Price Controls?
• Market responses to a pizza price ceiling
• Long lines
• Preferential treatment to selected customers
• Alternative pricing strategies
• Poorer quality ingredients
• Black-market pizzas
(We can look to old USSR for real-life examples.)
Predicting and Explaining
Changes In Prices and Quantities
• Distinguishing Between:
• A change in the quantity demanded
• A movement along the demand curve that occurs
in response to a change in price
• A change in demand
• A shift of the entire demand curve
An Increase In Quantity Demanded
vs. An Increase In Demand
Price
($/can)
6 Increase in
quantity
5 demanded
4
3
2
1
D
Quantity
(1000s of cans/day)
0 2 4 6 8 10 12
An Increase In Quantity Demanded
vs. An Increase In Demand
Price
($/can) D’
6 D
5
4
Increase in demand
3
2
D’
1
D
Quantity
(1000s of cans/day)
0 12
Predicting and Explaining
Changes In Prices and Quantities
• Change in the quantity supplied
• A movement along the supply curve that
occurs in response to a change in price
• Change in supply
• A shift of the entire supply curve
An Increase In Quantity Supplied
vs. An Increase In Supply
Price
($/can)
6
S
5
Increase in
4 quantity supplied
3
2
S
1
Quantity
(1000s of cans/day)
0 2 4 6 8 10
An Increase In Quantity Supplied
vs. An Increase In Supply
Price
($/can)
6 S S’
5
4
3
Increase in supply
2
1
S S’
Quantity
(1000s of cans/day)
0 2 4 6 8 10