Economic Principles 2007 Chapter Ten by fgy13313

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									   ISTANBUL BILGI UNIVERSITY
          Lecture Notes for EC151

 Introduction to Microeconomics
                  Delivered by

            Asaf Savaş Akat
                    based on
N.G.Mankiw: Principles of Economics (3th ed)

               Istanbul, 2007
             http://akat.bilgi.edu.tr
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                                                                              The word Economy . . .                                     Scarcity . . .
                                                           • Comes from a Greek word for “one who                     • Scarcity is a key word to understand economics
                                                             manages a household.”                                    • It means that society has less to offer than people
                                                           • Here are some questions that need answers                  wish to have
                  TEN PRINCIPLES OF                          – Who will work?                                         • Managing the resources of society is important
                     ECONOMICS                               – What goods and how many of them should                   because resources are scarce
                                                               be produced?                                           • Economics is the study of how society manages
                           Chapter 1                         – What resources should be used in their                   its scarce resources
                                                               production?                                               – How people make decisions
                                                             – At what price should the goods be sold?                   – How people interact with each other
                                                             – Who should get the goods produced?                        – The forces and trends that affect the economy
                                                           • We shall see the answers during this year                     as a whole



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            Ten Principles of Economics                    Ten Principles of Economics (continued)                    Ten Principles of Economics (continued)
                                                                                                                      • The third group of principles look at the
• The first group of principles look at the                • The second group of principles look at the                 behaviour of the whole society
  individuals in the society                                 interaction of individuals in the society                • What happens at the whole economy has an
• Our aim is to understand how people make                 • Our aim is to show the effects of the way                  effect on individuals and their interaction
  decisions of economic nature                               people interact with one another                         • How the Economy as a Whole Works
• We divide this group into four principles                      5. Trade can make everyone better off                      8. The standard of living depends on a
     1. People face tradeoffs                                    6. Markets are usually a good way to                        country’s production
     2. The cost of something is what you give                    organize economic activity                                9. Prices rise when the government prints
       up to get it                                              7. Governments can sometimes improve                        too much money
     3. Rational people think at the margin                       economic outcomes                                         10. Society faces a short-run tradeoff
     4. People respond to incentives                                                                                         between inflation and unemployment



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                  1. People face tradeoffs                    2. The cost of something is what you                     3. Rational people think at the margin
• To get one thing, we usually have to give up                          give up to get it
  another thing                                                                                                       • Marginal thinking plays a crucial role in
   – Guns vs. butter                                       • Decisions require comparing costs and benefits             economic actions
   – Food vs. clothing                                       of alternatives                                          • By “marginal” we mean small changes to an
   – Leisure time vs. work                                    – College vs. work                                        existing plan of action
   – Efficiency vs. equity                                    – Sleeping vs. studying                                 • The word “incremental” ise also used
• Efficiency means society gets the most it can               – Cinema vs. football game                              • Individuals make decisions by comparing the
  from its scarce resources                                • Opportunity cost is what you give up to obtain             costs and benefits at the margin
• Equity means the benefits of those resources               some item                                                • The last item therefore becomes very important
  are distributed fairly among the members of              • The final real cost of everthing is its oportunity       • An airline may sell the last ticket below
  society                                                    cost                                                       average cost but still make money
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         4. People respond to incentives.                  5. Trade can make everyone better off                    6. Markets are usually a good way to
                                                                                                                        organize economic activity
• Marginal changes in costs or benefits motivate         • People gain from their ability to trade with one     • Specialisation requires the exchange of products of
  people to respond                                        another                                                specialised producers
• The decision to choose one alternative over                                                                   • One way of doing it is caled the market economy
  another occurs when MB > MC                            • If there is competition in trading, then every
                                                           party gains from trade                               • In a market economy
           MB = Marginal Benefits                                                                                  – Households decide what to buy and who to work
           MC = Marginal Costs                           • Trade allows people to specialize in what they
                                                           do best                                                   for
• When they realise that the incentives have                                                                       – Firms decide who to hire and what to produce
  changed, economic actors take different                • Specialisation is the key to modern society
                                                                                                                • Households and firms interact is as if guided by an
  decisions                                              • It makes possible higher levels of productivety
                                                                                                                  “invisible hand”
• Safetly belts for drivers reduce injury per              leading to the high levels of income that
                                                           modern societies enjoy                               • More can be found in the FYI (p.10): “Adam Smith
  accident but also increase the accident rate                                                                    and the Invisible Hand”



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        7. Governments can sometimes                      8. The standard of living depends on a                       9. Prices rise when the government
           improve market outcomes                                 country’s production                                       prints too much money
• If markets fail (break down), government can          • Standard of living may be measured in different        • Inflation is an increase in the overall level of
  intervene to promote efficiency and equity              ways:                                                    prices in the economy
• Market failure occurs when the market can not            – By comparing personal incomes                       • Some countries in some periods have high levels
  allocate resources efficiently                           – By comparing the total market value of a              of inflation
• Market failure may be caused by an externality,            nation’s production                                 • Turkey had one of the highest inflation rates
  which is the impact of one person or firm’s           • Almost all variations in living standards are            among comparable countries in the world
  actions on the well-being of a bystander                explained by differences in the productivity level     • Usually the growth in the quantity of money is the
• Market failure may also be caused by market             of different countries                                   major cause of inflation
  power, which is the ability of a single person or     • Productivity is the amount of goods and services       • In other words inflation happens because
  firm to unduly influence market prices                  produced from each hour of a worker’s time               government prints too much money



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     10. Society faces a short-run tradeoff                                 Conclusion
     between inflation and unemployment                • When individuals make decisions, they face
                                                         tradeoffs and opportunity costs
• For many economies there exists a strong             • Rational people make decisions by comparing
  relation between the change in the level of            marginal costs and marginal benefits                                        THINKING LIKE AN
  unemployment and change in inflation                 • People can benefit by trading with each other
• The Phillips Curve summarises the relation           • Markets are usually a good way of coordinating                                 ECONOMIST
          ØInflation Ö ×Unemployment                     trade
                                                                                                                                           Chapter 2
• It’s a short-run tradeoff that applies to normal     • Government can potentially improve market
  situations                                             outcomes
• Higher inflation becomes the opportunity cost of     • Inflation results from increases in the quantity of
  lower unemployment                                     money
• At other times the relationship may break down       • Study carefully FYI (p.14): “How to Read This
                                                         Book”
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                             Learning economics                                                                                   The Scientific Method                                                             The Circular-Flow Model
    • Economists have a special way of thinking
    • Learning economics will allow you to                                                                   • Science develops by using abstract models to                                       • The circular-flow model is a simple way to
      understand it                                                                                            help explain how a complex, real world operates                                      show visually the economic transactions that
    • You will begin                                                                                         • Theories are proposed, data is collected and                                         occur in the economy
                                                                                                               analysed to prove or disprove the theories                                         • It is simple because we assume that there is no
       – To think in terms of alternatives
                                                                                                             • Theories always include abstract models                                              government, no financial system, no outside
       – To understand the cost of individual and
                                                                                                             • Models permit to analyse a complex real world                                        world (foreign trade), etc.
         social choices
                                                                                                               event in a simple manner                                                           • And concentrate on two categories of major
       – To see how certain events and issues are
                                                                                                             • Science uses two approaches:                                                         economic actors in the economy
         related with one another
                                                                                                                  • Descriptive (reporting facts, etc.)                                              – Households as consumers and owners of
    • The economic way of thinking involves thinking
                                                                                                                  • Analytical (abstract reasoning)                                                    factors of production
      analytically and objectively like the scientific
      method                                                                                                                                                                                         – Firms as producers



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                   The Circular-Flow Diagram                                                                                      Microeconomics and                                                The Production Possibilities Frontier
                                                                                                                                   Macroeconomics                                                • The production possibilities frontier is another
                                          Market for Goods and
                                                Services                                                      • An important distinction exist between micro                                       example using a simple model to understand
                   Goods and                                            Goods and                               (from Greek word small) and macro (from                                            complex reality
 Revenue                                                                                         Spending
                   services sold                                        services bought
                                                                                                                Greek word big) economics                                                        • It is presented by a graph showing various
                                                                                                              • Microeconomics focuses on the individual parts                                     combinations of output of two products that the
                                                                                                                of the economy                                                                     economy can possibly produce given the
       Firms                                                                                Households
                                                                                                              • It corresponds to the first two groups among the                                   available factors of production and technology
                                                                                                                Ten Principles                                                                   • It illustrates
                                                                                                              • Macroeconomics looks at the economy as a                                            – Efficiency
Wage, rent,
 and profit
                   Inputs for
                   production
                                                                            Labor, land
                                                                            and capital
                                                                                                  Income        whole                                                                               – Tradeoffs
                                          Market for Factors of
                                                                                                              • It corresponds to the last group among the Ten                                      – Opportunity Cost
                                              Production                                                        Principles                                                                          – Economic Growth



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          Production Possibilities Frontier                                                                        Production Possibilities Frontier                                                         Two Roles for Economists
 Quantity of
                                                                                                                                                      •When productivity increases
 Computers
   Produced
                                                                                                            Quantity of
                                                                                                            Computers
                                                                                                                                                      in computer industry, it is
                                                                                                                                                                                                 • Social reality imposes additional constraints on
                                                                                                              Produced

       3,000                                                    D                                                4,000                                possible to produce more
                                                                                                                                                                                                   the economics as a discipline
                                                                                                                                                      cars and more computers                    • Economics as a science requires economists to
       2,200
                                                      C                                                          3,000
                                                                                                                                                                                                   understand and explain the world
       2,000
                                                            A                                                                                                                                    • As such they are scientists
                                                                                                                 2,100
                                                                                                                 2,000
                                                                                                                                                              E                                  • But governments also ask economists to apply
                                                                                                                                                      A
                                                                                                                                                                                                   their knowledge to change the world
                                                                            Production
       1,000                          B                                     possibilities                                                                                                        • As such they become policymakers
                                                                            frontier
                                                                                                                                                                                                 • Policymaking always involves politics
                                                                                                                                                                                                 • The responsibilities of the economist as scientist
                                                                                                                          0                          700 750          1,000        Quantity of
               0                300               600 700                1,000               Quantity of                                                                      Cars Produced        and policymaker may easily be in conflict
                                                                                        Cars Produced
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   Positive versus Normative Analysis                                          Positive and Normative                                  Why Economists Disagree
  • The potential conflict between science and
                                                                                     Statements
                                                                                                                         • Economists are well known to disagree among
    policy leads to an important distinction in             • Here are some exemples of positive and                       themselves
    economics                                                 normative statements by economists                         • There are many jokes about economists
  • Positive statements are statements that describe        • An increase in the minimum wage will cause a               • They may disagree on theories about how the
    the world as it is                                        decrease in employment among the least-                      world works due to analytical premises
  • Positive economics is also called descriptive             skilled                                                    • At the same time usually they may hold different
    analysis                                                • Higher budget deficits will cause interest rates             values and thus, different normative views
  • Normative statements are statements about how             to increase                                                • Unfortunately many charlatans and cranks also
    the world should be                                     • The income gains from a higher minimum wage                  pose as economists and often obscure the
  • Normative economics is also called prescriptive           are worth more than any slight reductions in                 consensus among economists
    analysis                                                  employment



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     Examples of What Most Economists                                               Conclusion
                 Agree On
                                                             • Economics uses the scientific method
 • A ceiling on rents reduces the quantity and
   quality of housing available                              • Abstract models simplify otherwise very                                      GRAPHING: A BRIEF
 • Tariffs and import quotas usually reduce general            complex real world                                                               REVIEW
   economic welfare                                          • Economics is divided into microeconomics
 • Flexible and floating exchange rates offer an               and macroeconomics                                                                         Appendix to Chapter 2
   effective international monetary framework                • Economics relies on both positive and
 • Printing too much money always causes                       normative analysis
   inflation
                                                             • Economists often disagree among themselves




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                                                                                                                                                                                                     Individuals (23%)

                     Use of graphs                                              Single variable graphs                                          Private Insurers (32%)

• Economists make extensive use of graphs                 • There are three common single variable graphs                                 (a) Pie Chart                                                Other (4%)


• Graphs are used in economic theories to express         • Pie charts permit to show the distribution of a                                           1996 Value                                 Government (41%)

  ideas that are more difficult to understand only in       magnitude among its constituent items                                                   billions of dollars)
                                                                                                                                                      (in

                                                                                                                                                                                   General
  words                                                   • Example: distribution of income among wages,                                                                   $140
                                                                                                                                                                                   Electric
                                                                                                                                                                                  ($126 billion)
                                                                                                                                                                           120               Exxon
• Graphs also provide a convenient way of                   salaries, profits and rents                                             (b) Bar Graph
                                                                                                                                                                           100
                                                                                                                                                                                           ($99 billion)
                                                                                                                                                                                                    ($68 billion)
                                                                                                                                                                                                       IBM
  representing data about the real world                  • Bar graphs help compare the same category from                                                                  80
                                                                                                                                                                            60
                                                                                                                                                                                                             General
                                                                                                                                                                                                               Motors
                                                                                                                                                                                                             ($39 billion)
• Graphs permit to show                                     for different units                                                                                             40
                                                                                                                                                                            20

   – The breakdown into its constituents parts of a       • Example: income per head in four different                                                                  0
                                                                                                                                                 output per hour of labor,

     single variable                                        countries                                                                            Productivity Index (farm
                                                                                                                                                             1977 = 100)
                                                                                                                                                                            160
   – The relation between two or more variables           • Time-series graphs trace the bevahiour of a variable              (c) Time-Series Graph
                                                                                                                                                                            140
                                                                                                                                                                            120
• The latter are used more commonly in economic             over a time period                                                                                              100
                                                                                                                                                                             80

  theory                                                  • Example: rising productivity in the private sector                                                               60
                                                                                                                                                                             40
                                                                                                                                                                             20
                                                                                                                                                                               0
                                                                                                                                                                               1950    1960     1970      1980      1990
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                                                                                                                                                                                                                                                                                 Price of
                                                                                                                                                                                                                                                                                  Novels

                                Two variable graphs                                                                    Grade                                                                                                                                                         $11
                                                                                                                                                                                                                                                                                                  (5, $10)
• Single variable graphs have only limited use                                                                          Point
                                                                                                                      Average
                                                                                                                                                                                                                                                                                       10


• Often we try to establish a relation between two                                                                        4.0                                                                                                                                                               9
                                                                                                                                                                                                                                                                                                             (9, $9)


  factors                                                                                                                 3.5
                                                                                                                                                                                                                    Albert E.
                                                                                                                                                                                                                                                                                            8
                                                                                                                                                                                                                                                                                                                        (13, $8)


• An ordered pair makes it possible to show two                                                                           3.0                                                                                       (25, 3.5)                                                               7
                                                                                                                                                                                                                                                                                                                                   (17, $7)


  characteristic on the same graph                                                                                        2.5
                                                                                                                                                   Alfred E.
                                                                                                                                                                                                                                                                                            6
                                                                                                                                                                                                                                                                                                                                              (21, $6)


• Two dimensions require coordinates for graphs                                                                           2.0
                                                                                                                                                   (5, 2.0)                                                                                                                                 5                                                                 (25, $5)
                                                                                                                          1.5
• Vertical coordinate usually represents the nominal                                                                                                                                                                                                                                        4
                                                                                                                                                                                                                                                                                                                                                              Demand,         D
                                                                                                                                                                                                                                                                                                                                                                                  1
                                                                                                                          1.0
  variable; horizontal coordinate the quantity variable                                                                                                                                                                                                                                     3
                                                                                                                          0.5
• Curves are relations between two variables                                                                                                                                                                                                                                                2

• Their slope and what makes them shift is very                                                                                0               5               10            15                  20            25               30             35               40      Study
                                                                                                                                                                                                                                                                        Time
                                                                                                                                                                                                                                                                                            1

  important in economic analysis                                                                                                                                                                                                                (hours per week)
                                                                                                                                                                                                                                                                                            0          5     10           15             20              25              30       Quantity
                                                                                                                                                                                                                                                                                                                                                                                      of Novels
                                                                                                                                                                                                                                                                                Figure 2A-3                                                                                       Purchased




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   Price of
    Novels                                                                                                                         Price of
       $11                                                                                                                         Novels

                                                                                                                                         $11
         10
                                                    (13, $8)                                                                             10
              9

              8
                                                               (16, $8)
                                                                                When income increases,
                                                                                                                                          9                                                                                                                                                     INTERDEPENDENCE AND
                                (10, $8)                                                                                                                                                    (13, $8)

              7
                                                                                the demand curve
                                                                                shifts to the right.
                                                                                                                                          8

                                                                                                                                          7
                                                                                                                                                                    6   -    8     =    -    2
                                                                                                                                                                                                                                                                                                THE GAINS FROM TRADE
              6
                                                                                                                                                                                                                       (21, $6)
                                                                                                                                          6
                  When income                                                                                                                                                                21       -   13   -= 8
                                                                          D
              5                                                           3
                  decreases, the
                                                                   (income =        D         D      (income =                            5
                                                                                                                                                                                                                                     Demand,        D
                                                                                      1            2                                                                                                                                                     1
                  demand curve
              4                                                    $20,000)    (income =          $40,000)
                  shifts to the left.                                                                                                     4
                                                                               $30,000)
              3
                                                                                                                                          3

              2
                                                                                                                                                                                                                                                                                                                       Chapter 3
                                                                                                                                          2

              1
                                                                                                                                          1


              0             5              10      13   15 16             20      25              30     Quantity                         0               5                 10         13     15               20 21            25             30            Quantity
                                                                                                         of Novels                                                                                                                                       of Novels
                                                                                                        Purchased                                                                                                                                       Purchased
Figure 2A-4                                                                                                           Figure 2A-5




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                  What did we learn so far?                                                                                            What we learn in this chapter?                                                                                                                Self sufficiency or interdependence
• In the two previous chapters we introduced some                                                                     • In this chapter we look in detail into trade                                                                                                            • Economics studies how societies produce and
  basic concepts of economics                                                                                         • Remember Principle Five: trade can make                                                                                                                   distribute goods and services in an attempt to satisfy
• Ten basic principles of economics were organised in                                                                   everybody better off                                                                                                                                      the wants and needs of its members
  three groups: decisions by individual, the interaction                                                              • Common sense tells us that specialisation for                                                                                                           • One alternative would be for individuals and nations
  of individuals and the economy as a whole                                                                             individuals means more knowhow and therefore                                                                                                              to produce everything they need themselves
• Then we looked into the methods used by economics                                                                     more production                                                                                                                                         • This is called self-sufficiency
  as a science                                                                                                        • However, specialised individuals must exchange                                                                                                          • The other alternative is for individuals and nations
• Two models were developed as examples of macro                                                                        their products                                                                                                                                            to specialise and trade with one another
  and micro analysis                                                                                                  • Trading is selling something to buy something else                                                                                                      • This leads to economic interdependence
   – The circular flow of income and expenditure                                                                      • We try to establish how and why specialisation and                                                                                                      • The question before us is simple
   – The production possibilities frontier                                                                              trade is beneficial to individuals and nations                                                                                                          • Which is better and why? To be self-sufficient or
• Now we will look at the meaning of trade                                                                                                                                                                                                                                        economic interdependence?
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              Interdependence and trade                                                            What determines the pattern of                                    A parable for the modern
• We start with a general observation about the                                                       production and trade?                                                 economy
  society we live in                                                                                                                                  • We use a very simple model that is easy to handle
                                                                                           • Patterns of production and trade are based upon
• Individuals and nations rely on specialized                                                                                                         • The model does not reflect reality but helps us
                                                                                             differences in opportunity costs
  production and exchange as a way to address                                                                                                           understand the issues
  problems caused by scarcity                                                              • This is true within an economy among different
                                                                                             regions                                                  • Let us imagine a world with
• This gives rise to two questions                                                                                                                       – only two goods (potatoes and meat)
                                                                                           • Also among different communities and individuals
   – Why is interdependence the norm?                                                                                                                    – only two people (a potato farmer and a cattle
                                                                                           • It is also true among nations and regions
   – What determines production and trade when                                                                                                             rancher)
     individuals and nations are economically                                              • Almost all the products we consume have been
                                                                                             produced by the efforts of different individuals,        • What should each produce?
     interdependent?                                                                                                                                  • Why should they trade?
                                                                                             usually in many different countries of the world
• Interdependence occurs because people are better                                                                                                    • The table in the next slide gives the production of
  off when they specialize and trade with others                                           • Most individuals do not consume at all what they
                                                                                             themselves produce                                         each good by the farmer and the rancher



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     Production of farmer and rancher                                                                           Self-sufficiency                                      Self-sufficiency - farmer
                                                                                           • What happens if the farmer and the rancher decide
                Hours needed to make one pound of Amount Produced in 40 hours                to ignore each other                                                             (a) The Farmer’s Production Possibilites Frontier
                                                                                           • There is no exchange or trade among them                    Meat
                                                                                           • Therefore each can only consume their own                (pounds)
                      Meat                  Patatoes                   Meat     Patatoes     production
                                                                                           • In other words, for each one, the production
                                                                                             possibilities frontier is also the consumption
FARMER               20 hours/lb           10 hours/lb                  2 lbs   4 lbs        possibilities frontier                                                2
                                                                                           • Without trade, there are no economic gains
                                                                                           • There is no economy to talk about                                                       A
                                                                                                                                                                   1
                                                                                           • But each will be loosing the prospect of using their
RANCHER              1 hour/lb              8 hours/lb                 40 lbs    5 lbs       respective potential fully
                                                                                                                                                                   0                2                   4 Potatoes (pounds)


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                Self-sufficiency - rancher                                                              The farmer and the rancher                         How trade expands consumption
         (b) The Rancher’s Production Possibilities Frontier                                               specialize and trade                                    opportunities
                                                                                           • Our claim is that each would be better off if they        (a) How Trade Increases the Farmer’s Consumption
    Meat                                                                                     specialize in producing the product that they are             Meat
 (pounds) 40                                                                                 more suited to produce, and then trade with each          (pounds)
                                                                                             other                                                                                                               Farmer’s
                                                                                                                                                                                                       A*        consumption
                                                                                           • In our example the farmer should produce potatoes                            3                                      with trade

                                   B
                                                                                           • And the rancher should produce meat
                20                                                                                                                                                        2                                      Farmer’s
                                                                                           • The actual quantities will depend on factors that                                                                   consumption
                                                                                             determine the relative price of meat and patatoes                                              A                    without trade
                                                                                           • But an arbitrary trade bundle that is beneficial to                          1
                                                                                             both (otherwise there is no trade) is sufficient to
                     0           2½           5                      Potatoes (pounds)       make our point                                                               0                 2          3          4 Potatoes (pounds
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      How trade expands consumption                                                                        The gains from trade                                                          Measuring costs of production
              opportunities                                                                                                                                                      • Differences in the costs of production determine
                                                                                            Without Trade                                  With Trade
(b) How Trade Increases the Rancher’s Consumption                                                                                                                                  the following
                                                                                               Production                                                          Gains from
Meat
                                                                                                  and            Production         Trade            Consumption
                                                                                                                                                                     Trade          – Who should produce what?
       40                                                                                     Consumption
(pounds)                                                                                                                                                                            – How much should be traded for each product?
                                                                                   Farmer       1 pound          0 pounds    Gets 3   3 pounds                     2 pounds      • There are two ways to measure differences in costs
                                                                                                 meat              meat pounds meat meat                             meat          of production
                                        Rancher’s
             21             B*
                                        consumption                                            2 pounds          4 pounds for 1 pound 3 pounds                     1 pound          – The number of hours required to produce a unit
                                        with trade                                                                          potatoes
             20         B                                                                      potatoes          potatoes             potatoes                     potatoes           of output (for example, one pound of potatoes)
                                        Rancher’s
                                        consumption                                Rancher 20 pounds 24 pounds Gives 3 21 pounds                                   1 pound          – The opportunity cost of sacrificing one good for
                                        without trade                                                                                                                                 another
                                                                                             meat      meat pounds meat meat                                        meat
                                                                                           2½ pounds 2 pounds
                                                                                                               for 1 pound 3 pounds                                ½ pound       • Is it the latter that is the basis of trade between the
                0      2½    3        5                        Potatoes (pounds)                                 potatoes  potatoes                                potatoes        farmer and the rancher
                                                                                            potatoes potatoes



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                      Absolute advantage                                              Production of farmer and rancher - 2                                                                            Comparative advantage
• Before we move on, let us look at a different set of                                                                                                                            • Comparative advantage looks at relative costs, in
  production figures for the farmer and rancher                                                    Hours needed to make one pound of Amount Produced in 40 hours                    other words to the opportunity costs
• In the new example, the farmer produces more                                                                                                                                    • The producer who has the smaller opportunity cost
  patotoes while the rancher produces more meat                                                                                                                                     of producing a good is said to have a comparative
• The producer that requires a smaller quantity of
                                                                                                         Meat                 Patatoes                  Meat          Patatoes      advantage in producing that good
  inputs to produce a good is said to have an absolute                                                                                                                            • In our original example the rancher is able to
  advantage in producing that good                                                                                                                                                  produce more of both goods
• This is an easy but also uninteresting situation: the                            FARMER               20 hours/lb           4 hours/lb                 2 lbs        10 lbs      • Still, the farmer has comparative advantage in
  farmer will specialise in patatoes and the rancher in                                                                                                                             patatoes while the rancher has comparative
  meat                                                                                                                                                                              advantage in meat
• Our original example is interesting because the                                                                                                                                 • Farmer gives up 0.5 lb. of meat to produce 1 lb. of
  rancher is producing more of both patatoes and                                   RANCHER              1 hour/lb             8 hours/lb                 40 lbs        5 lbs        patatoes: the ratio is 8 to 1 for the rancher
  meat


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                        The principle of                                                         Other benefits of exchange                                                                            Trade among nations
                     comparative advantage                                                                                                                                       • What is true within a nation is also true among
                                                                                   • Specialisation permits each producer to have a
• Comparative advantage and differences in                                                                                                                                         nations
                                                                                     deeper knowledge and experience about the tasks
  opportunity costs are the basis for specialized                                                                                                                                • Exports are what Turkey sells to other countries
                                                                                     involved during production
  production and trade                                                                                                                                                           • Imports are what Turkey buys from other countries
                                                                                   • Better knowledge and experience means more can
• Whenever potential trading parties have differences                                                                                                                            • The principle of comparative advantage applies in
                                                                                     be produced by the same amount of effort
  in opportunity costs, they can each benefit from                                                                                                                                 international trade
                                                                                   • Higher productivity benefits everyone in society
  trade
                                                                                   • Precious talent is not wasted on doing things                                               • Absolute advantage in international trade works in
• Individuals, regions and nations specialise because                                                                                                                              limited areas of natural differences (oil, tourism, etc)
                                                                                     others can also do
  they have comparative advantage not absolute
                                                                                   • We don’t want Hagi to sing or John Lennon to                                                • Big differences in productivity among countries does
  advantage
                                                                                     play football                                                                                 not prevent international trade
• Specialisation and trade lead to higher levels of
                                                                                   • Our current welfare is wholly the result of high                                            • Turkey benefits from trade with US and EU even if
  consumption for all the parties that participate in
                                                                                     productivity due to specialisation                                                            they both have higher productivity
  trade
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                       Conclusion                                    PART TWO: SUPPLY AND                                            What we learn in Part Two?
• Self-sufficiency is not desirable                                        DEMAND I:                                     • Part Two introduces the model of supply and
• Specialisation leads to higher productivity for the
                                                                      HOW MARKETS WORK                                     demand in a market economy
  producers of goods and services
                                                                                                                         • Supply and demand is the basic tool of economic
• Interdependence and trade allow people to enjoy a
                                                                                                                           analysis
  greater quantity and variety of goods and services
                                                                                                                         • In Principle Five and Chapter 3 we learned that
• The person who can produce a good with a smaller                   THE MARKET FORCES OF                                  specialisation and trade makes everybody better off
  quantity of inputs has an absolute advantage.
• The person with a smaller opportunity cost has a                    SUPPLY AND DEMAND                                  • Principle Five tells us that markets are a good way
                                                                                                                           to organise economic activity
  comparative advantage
                                                                                        Chapter 4                        • Now we must see how markets work to achieve this
• The gains from trade are based on comparative
                                                                                                                           result
  advantage, not absolute advantage
                                                                                                                         • Markets work through supply and demand
• Turkey benefits from international trade



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                     Plan of Part Two                                            Plan of this chapter                                          Market forces of
                                                                                                                                              supply and demand
• There are three chapters in Part Two                     • We start by defining market types such as                   • Supply and demand are certainly the two words that
• Chapter 4: Market forces of supply and demand              competition, monopoly, oligopoly, etc.                        economists use most often
• It introduces the concept of supply and demand           • Then examine the factors that determine the demand          • Supply and demand are the forces that make market
  along with other basic concepts such as competition,       for a good or service in a competitive market                 economies work efficiently
  market type, etc.                                        • Next we look at the determinants of the supply of a         • Supply and demand determine the quantity of each
• Chapter 5: Elasticity and its applications                 good or service again in a competitive market                 good produced and the price at which it is sold
• It is about the relation between changes in prices and   • Supply and demand come together to set the price of         • Any event or policy that affects the economy will
  changes in quantities                                      the good or service and the quantity sold                     work through its impact on supply and demand of
• Chapter 6: Supply, demand and government policies        • We establish how changes in demand or in supply               some goods
• The tools of supply and demand are used to evaluate        conditions affect the price and quantity                    • Modern microeconomics is about supply, demand,
  different government policies towards markets            • And look at the key role of prices in the allocation          and the market equilibrium that results from their
                                                             of scarce resources of society                                interaction


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                         Markets                                                A Competitive Market                                          Types of markets
• The terms supply and demand refer to the behavior                                                                      • Economic theory distinguishes among four different
  of people as they interact with one another in           • A competitive market is a market
                                                                                                                           types of markets
  markets                                                     – with many buyers and sellers
                                                                                                                         • Perfect Competition
• A market is a group of buyers and sellers of a              – that is not controlled by any one person
                                                                                                                            – Competitive market where products are the same
  particular good or service                                  – in which a narrow range of prices are
                                                                                                                         • Monopoly
   – Buyers determine demand                                    established that buyers and sellers act upon
                                                                                                                            – One seller, and seller controls price
   – Sellers determine supply                              • The number of buyers and sellers are an important
                                                                                                                         • Oligopoly
• Some markets are formally organised with a                 part of the definition of competition
                                                                                                                            – Few sellers
  building, etc. such as the Stock Market,                 • The second element is that a buyer or seller cannot
                                                             influence prices by his own actions alone                      – Not always aggressive competition
  Commodities Market, etc.
• Most markets are not formally organised but they         • When these two characteristics exist the market is          • Monopolistic Competition
  exist because buyers and sellers know them                 called competitive                                             – Many sellers
• People know where to go to buy a car, bread, etc.                                                                         – Differentiated products
   Asaf Savaú Akat     Lecture Notes EC 151 (2007)   73      Asaf Savaú Akat              Lecture Notes EC 151 (2007)                                       74           Asaf Savaú Akat       Lecture Notes EC 151 (2007)                                        75


                 The Concept of Demand                                         Demand for Ice Cream                                                                                        Law of Demand
• We begin our analysis of demand by examining the                                                      Price of
                                                                                                      Ice-Cream
                                                                                                                                                                                                            Price of
                                                                                                                                                                                                          Ice-Cream
  behaviour of buyers in the market for a good or                                                         Cone                                                                                                Cone

  service
                                                            Price              Quantity   $3.00                                                                                               $3.00
                                                                                                                                                                      • The law of
• Quantity demanded is the amount of a good that            $0.00                12        2.50                                                                         demand states that     2.50

  buyers are willing and able to purchase                    0.50                10                                                                                     there is an inverse
                                                                                           2.00
• Quantitiy demanded will vary with the price of the         1.00                 8                                                                                     relationship           2.00


  good in question                                           1.50                 6        1.50                                                                         between price and      1.50
• The demand schedule is a table that shows the              2.00                 4                                                                                     quantity
                                                                                           1.00
  relationship between the price of the good and the                                                                                                                    demanded.              1.00

  quantity demanded
                                                             2.50                 2        0.50

• The demand curve is the downward-sloping line              3.00                 0                                                                                                            0.50


  relating price to quantity demanded                                                             0     1   2      3   4   5   6   7   8    9 10 11 12 Quantity of
                                                                                                                                                   Ice-Cream Cones                                    0     1   2       3   4   5   6   7   8   9 10 11 12 Quantity of
• Market demand is the sum of individual demands                                                                                                                                                                                                       Ice-Cream Cones




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                Determinants of Demand                                             Demand function                                                                                         Demand function
• What are the factors that determine how much of a       • We can present the determinants of demand by the                                                          • What is the meaning of the demand function
  product is bought in the market for that product?         symbols of a function                                                                                                  Q = F ( P , Y , Pn , Pe , D )
• In the previous slides we looked at the demand for                   Q = F ( P , Y , Pn , Pe , D )                                                                  • We look at the relation between price and quantity
  ice cream                                               • It is called the demand function                                                                            demanded while we keep other factors as constant
• What determines how much ice cream will be                                                                                                                          • In other words, P is the only independent variable,
                                                             – P = price of the good or service
  bought?                                                                                                                                                               the others are kept constant
   – Market price of ice cream                               – Y = income                                                                                             • Changes in income, other prices, price expectations
   – Consumer income                                         – Pn = prices of other goods and services                                                                  and tastes will cause a shift in the demand curve
   – Prices of related goods                                 – Pe = expectations about the change in price                                                            • Whereas changes in price only affect quantities
   – Tastes                                                  – D fashion and tastes of consumers                                                                      • Change in prices changes the quantity demanded but
   – Expectations                                                                                                                                                       not the demand function
   – Number of consumers



   Asaf Savaú Akat     Lecture Notes EC 151 (2007)   79      Asaf Savaú Akat              Lecture Notes EC 151 (2007)                                       80           Asaf Savaú Akat       Lecture Notes EC 151 (2007)                                        81

       Changes in income: normal and                             Effect of an increase in income:                                                                             Effect of an increase in income
              inferior goods                                               normal good                                                                                                 inferior good
• Changes in income cause a shift in the demand
  curve                                                                                       Price of                                                                                             Price of
                                                                                           Ice-Cream                                                                                            Ice-Cream
• Usually the direction of the shift is upward              • As income                        Cones                                                                     • As income                Cones
• In other words, higher income means more demand             increases the                                                    Increase
                                                                                                                               in demand
                                                                                                                                                                           increases the
  for most goods at all prices                                demand for a                                                                                                 demand for
• These are called normal goods                               normal good                                                                                                  an inferior
• However, for some goods, an increase in income              will increase.                                                                                               good will                                                    Decrease
  may actually result in less demand or a downward                                                                                                       Demand            decrease.                                                    in demand
  shift in the demand curve                                                                                                                Demand
                                                                                                                                           curve, D 1
                                                                                                                                                         curve, D 2
                                                                                                                                                                                                                                                     Demand
• These are called inferior goods                                                                                                                                                                                           Demand curve, D 3
                                                                                                                                                                                                                                                     curve, D 1
• They are consumed by the very poor                                                                         0                                        Quantity of                                                   0                                     Quantity of
                                                                                                                                                Ice-Cream Cones                                                                                     Ice-Cream Cones
   Asaf Savaú Akat          Lecture Notes EC 151 (2007)            82      Asaf Savaú Akat             Lecture Notes EC 151 (2007)                      83        Asaf Savaú Akat                 Lecture Notes EC 151 (2007)                                84


                 Prices of Related Goods                                                         Ceteris Paribus                                                        Change in Quantity Demanded
• The effects of changes in the prices of related goods                 • Warning about one aspect of the analysis so far                                                 versus Change in Demand
  depend on the characteristics of the goods                                                                                                                   • The distinction between change in demand and
                                                                        • We change one constant at a time while we keep the
• Two goods are called substitutes if they represent                                                                                                             change in quantity demanded is vital to understand
                                                                          remaining unchanged
  similar goods for the consumer: beans or chick peas                                                                                                            the analysis of demand
                                                                        • For example, when we look at the effect of a change                                  • Change in Quantity Demanded
  are close substitutes                                                   in income we keep the prices of related products
• A fall in the price of a substitute will reduce demand                                                                                                          – Movement along the demand curve.
                                                                          plus tastes plus price expectations unchanged                                           – Caused by a change in the price of the product
  for a good (demand curve shifts down)
                                                                        • Economic theory uses a short-cut to express this                                     • Change in Demand
• Two goods are called complements when consuming
                                                                          method                                                                                  – A shift in the demand curve, either to the left or
  one entails consuming the other: a car and tyres
• A fall in the price of a complement will increase                     • Ceteris paribus is a Latin phrase that means that all                                     right
  demand for a good (demand curve shifts up)                              variables other than the ones being studied are                                         – Caused by a change in a determinant other than
                                                                          assumed to be constant                                                                    the price (income, tastes, etc)



   Asaf Savaú Akat          Lecture Notes EC 151 (2007)            85      Asaf Savaú Akat             Lecture Notes EC 151 (2007)                      86        Asaf Savaú Akat                 Lecture Notes EC 151 (2007)                                87


        Change in Quantity Demanded                                            Changes in Quantity Demanded                                                                               Change in Demand
          versus Change in Demand
 Variables that
 Affect Quantity Demanded        A Change in This Variable . . .                  Price of
                                                                               Cigarettes,                                                                                Price of
                                                                                 per Pack                         A tax that raises the price of                       Cigarettes,
                                                                                                                                                                         per Pack
 Price                            Represents a movement along                                                     cigarettes results in a movement                                                            A policy to discourage
                                                                                                   C              along the demand curve.                                                                     smoking shifts the
                                  the demand curve                               $4.00
                                                                                                                                                                                                              demand curve to the left.

 Income                           Shifts the demand curve
                                                                                                                      A                                                                            B                       A
 Prices of related goods          Shifts the demand curve                          2.00                                                                                     $2.00

 Tastes                           Shifts the demand curve                                                                                                                                                         D2               D1
                                                                                                                                 D1
 Expectations                     Shifts the demand curve                                    0    12             20                     Number of Cigarettes                          0          10                    20                   Number of Cigarettes
                                                                                                                                           Smoked per Day                                                                                      Smoked per Day
 Number of buyers                 Shifts the demand curve



   Asaf Savaú Akat          Lecture Notes EC 151 (2007)            88      Asaf Savaú Akat             Lecture Notes EC 151 (2007)                      89        Asaf Savaú Akat                 Lecture Notes EC 151 (2007)                                90


                     The Concept of Supply                                                       Law of Supply                                                                                 Supply Curve
                                                                                                                                                                                                   Price of
                                                                        • The law of supply states that there is a direct                                                                       Ice-Cream
• Goods and services are supplied to the market by                        (positive) relationship between price and the                                                                              Cone

  producers who are also sellers                                          quantity supplied                                                                      Price              Quantity       $3.00

• Supply looks at the behaviour of the producers                        • At higher prices there will be higher quantities of the                                $0.00                0                2.50
• Quantity supplied is the amount of a good or                            good or service supplied                                                                0.50                0
  service that sellers are willing and able to sell                     • The supply schedule is a table that shows the                                                                                2.00
                                                                                                                                                                  1.00                1
• What determines the quantity supplied?                                  relationship between the price of the good or service
   – Market price of the good or service
                                                                                                                                                                  1.50                2                1.50
                                                                          and the quantity supplied
   – Input prices (of those used in its production)                                                                                                               2.00                3
                                                                        • The supply curve is the upward-sloping line relating                                                                         1.00

   – Technology (with which it was produced)                              price to quantity supplied                                                              2.50                4
   – Expectations about the future level of prices                      • Market supply curve is the sum of the supply curves                                     3.00                5                0.50


   – Number of producers of the good or service                           of the individual producers                                                                                                         0        1       2    3   4    5    6         Quantity of
                                                                                                                                                                                                                                                      Ice-Cream Cones
   Asaf Savaú Akat       Lecture Notes EC 151 (2007)                       91      Asaf Savaú Akat             Lecture Notes EC 151 (2007)                     92   Asaf Savaú Akat                        Lecture Notes EC 151 (2007)                               93


           Change in Quantity Supplied                                                     Change in Quantity Supplied
            versus Change in Supply                                                         versus Change in Supply                                                                           Increase in Supply
• As in the demand, attention must be paid to the
  difference between changes in the supply and                                   Variables that                                                                        Price of
                                                                                                                                                                    Ice-Cream
  changes in the quantity supplied                                               Affect Quantity Supplied             A Change in This Variable . . .                    Cone                                                                   Supply
                                                                                                                                                                                                                                               curve, S1
                                                                                                                                                                                                                                                                Supply
• Change in Quantity Supplied                                                    Price                                 Represents a movement along                                                                                                             curve, S2
   – Movement along the supply curve                                                                                   the supply curve
   – Caused by a change in the market price of the
     product                                                                     Input prices                          Shifts the supply curve
• Change in Supply                                                               Technology                            Shifts the supply curve                                                                                Increase
                                                                                                                                                                                                                              in supply
   – A shift in the supply curve, either to the left or
     right                                                                       Expectations                          Shifts the supply curve
   – Caused by a change in a determinant other than                              Number of sellers                     Shifts the supply curve                                    0                                                                         Quantity of
     price (input prices, technology, expectations, etc)                                                                                                                                                                                              Ice-Cream Cones




   Asaf Savaú Akat       Lecture Notes EC 151 (2007)                       94      Asaf Savaú Akat             Lecture Notes EC 151 (2007)                     95   Asaf Savaú Akat                        Lecture Notes EC 151 (2007)                               96


                                                                                           Supply and demand together                                                            Equilibrium of Supply and
                     Decrease in Supply                                         • Market works by the interaction of supply and                                                           Demand
                                                                                  demand
      Price of                                                                                                                                                         Price of
   Ice-Cream                   Supply curve, S3                                 • Now we can see how the two come together                                          Ice-Cream
        Cone                                            Supply                                                                                                           Cone
                                                       curve, S1                • Market equilibrium corresponds to a price where
                                                                                                                                                                                                                                                 Supply
                                   Decrease                                       quantitiy demanded and supplied is equal
                                   in supply                                    • Equilibrium Price                                                                                   Equilibrium price                                    Equilibrium
                                                                                                                                                                         $2.00
                                                                                   – The price that balances supply and demand. On a
                                                                                     graph, it is the price at which the supply and
                                                                                     demand curves intersect                                                                                                                                       Demand

                                                                                • Equilibrium Quantity
                                                                                                                                                                                                                             Equilibrium
                                                                                   – The quantity that balances supply and demand.                                                                                           quantity

                 0                                                Quantity of
                                                                                     On a graph it is the quantity at which the supply                                            0   1   2       3 4     5 6       7       8 9 10 11 12 13                 Quantity of
                                                            Ice-Cream Cones          and demand curves intersect                                                                                                                                      Ice-Cream Cones




   Asaf Savaú Akat       Lecture Notes EC 151 (2007)                       97      Asaf Savaú Akat             Lecture Notes EC 151 (2007)                     98   Asaf Savaú Akat                        Lecture Notes EC 151 (2007)                               99


            Markets Not in Equilibrium                                                                    Excess Supply                                                                           Excess Demand
• To understand the meaning of market equilibrium
  we can look at a market not in equilibrium
                                                                                           Price of                                                                                 Price of
• Outside of equilibrium there will be either unsold                                    Ice-Cream                                                                                Ice-Cream
                                                                                             Cone                                                                                     Cone
  products or unsatisfied customer demand                                                                             Excess
• Excess Supply                                                                                                       supply                 Supply                                                                                          Supply
   – Price is above equilibrium price                                                          $2.50
                                                                                                 2.00
   – Producers are unable to sell all they want at the                                                                                                                                $2.00

     going price                                                                                                                                                                       1.50
                                                                                                                                              Demand                                                               Excess
• Excess Demand                                                                                                                                                                                                    demand                     Demand

   – Price is below equilibrium price                                                                 0       4         7         10                 Quantity of
   – Consumers are unable to buy all they want at the                                                      Quantity            Quantity        Ice-Cream Cones                                0            4
                                                                                                                                                                                                        Quantity
                                                                                                                                                                                                                        7       10
                                                                                                                                                                                                                              Quantity
                                                                                                                                                                                                                                                   Quantity of
                                                                                                                                                                                                                                              Ice-Cream Cones
                                                                                                          demanded             supplied
     going price                                                                                                                                                                                        supplied             demanded
   Asaf Savaú Akat          Lecture Notes EC 151 (2007)     100       Asaf Savaú Akat                     Lecture Notes EC 151 (2007)                           101          Asaf Savaú Akat                          Lecture Notes EC 151 (2007)                              102


                     Changes in Equilibrium                                      How an increase in demand                                                                                 How a Decrease in Supply
                                                                                 affects market equilibrium                                                                                 Affects the Equilibrium
• For the market equilibrium to change one or more of                                            (a) Price Rises, Quantity Rises                                                                          (b) Price Rises, Quantity Falls
                                                                              Price of
  the determinants of demand or supply must have                           Ice-Cream                                    1. Hot weather increases                                       Price of
                                                                                                                                                                                                                                                  1. An earthquake reduces
                                                                                Cone                                    the demand for ice cream...                                 Ice-Cream
  changed                                                                                                                                                                                Cone                                        S2
                                                                                                                                                                                                                                                  the supply of ice cream...

• When faced with an event or policy that affects the                                                                                                                                                                                                 S1

  market                                                                                                                                          Supply
                                                                                                                                                                                                                         New
• First, we must try to understand whether the event                           $2.50                                                New equilibrium                                     $2.50                         equilibrium
  shifts the supply or demand curve (or both)                                     2.00                                                                                                     2.00                                     Initial equilibrium
                                                                     2. ...resulting
• Then we search for the direction of the shift(s) in the            in a higher                                                      Initial
                                                                                                                                    equilibrium
                                                                                                                                                                             2. ...resulting
                                                                                                                                                                             in a higher
                                                                     price...
  curve(s): upward or downward                                                                                                                         D2                    price...
                                                                                                                                                                                                                                                             Demand
• Only then can we determine the impact of the event                                                                                        D1
  or policy on the equilibrium price and quantities                                      0                         7           10                           Quantity of                           0   1   2   3   4            7     8 9 10 11 12 13                    Quantity of
• And also the direction of the change                                                       3. ...and a higher
                                                                                             quantity sold.
                                                                                                                                                      Ice-Cream Cones                                                                3. ...and a lower            Ice-Cream Cones
                                                                                                                                                                                                                                     quantity sold.




   Asaf Savaú Akat          Lecture Notes EC 151 (2007)     103       Asaf Savaú Akat                     Lecture Notes EC 151 (2007)                           104          Asaf Savaú Akat                          Lecture Notes EC 151 (2007)                              105


        Effects of Supply and Demand                                                            Some Examples                                                                                                     Conclusion
                     Shifts                                        • Weather conditions are important for the supply of                                                   • Trade happens in markets of different types, some
                                                                     most agricultural products                                                                             competitive other not
                       No Change An Increase A Decrease            • Exceptional temperatures below freezing in warm                                                      • Market economies harness the forces of supply and
                       in Supply in Supply in Supply                 climates lead to crop failures                                                                         demand
                                                                   • Read ITN (p.81) “Mother Nature Shifts the Supply                                                     • Demand comes from the consumers
  No Change              P same             P down      P up         Curve”                                                                                               • Quantity demanded of a good depends on its price,
  in Demand              Q same             Q up       Q down      • We have a more recent example from the US                                                              on income, on the prices of related goods, on
  An Increase            P up               P unknown P up           besides agriculture                                                                                    expectation, on tastes and fashion
  in Demand              Q up               Q up       Q unknown   • In September 2005 Hurricane Katrina hit hard a                                                       • When we analyse demand, only the price is allowed
                                                                     region with important oil refining and oil-gas                                                         to change while the other factors are kept constant
  A Decrease             P down             P down     P unknown     distribution networks                                                                                  (ceteris paribus)
  in Demand              Q down             Q unknown Q down       • Potentially distrupting the supply of energy                                                         • Quantity demanded is a decreasing function of price
                                                                   • Leading to higher prices in international oil markets


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                          Conclusion                                                                                                                                                          What we learn now?
• Changes in the other factors cause upward or                                                                                                                            • Everyday, in every market, billions of decisions are
  downward shifts in the demand curve                                                                                                                                       made by producers, consumers, governments, etc.
• Supply comes from producers or sellers                                                                                                                                  • In Ch.4 we developed our basic model to explain the
• Quantity supplied is a function of the price, of input                               ELASTICITY AND ITS                                                                   determination of prices and quantities in the markets
  prices, of technology, etc.                                                                                                                                             • By the interaction of supply and demand
• Higher prices increase quantity supplied                                               APPLICATIONS                                                                     • In Ch.5 we deal with some important characteristics
• Supply and demand together determine the prices of                                                                                                                        of supply and demand curves
  the economy’s goods and services as well as the                                                           Chapter 5                                                     • The word elasticity refers to
  quantities produced                                                                                                                                                        – How changes in prices affect quantities?
• Market equilibrium changes when supply or demand                                                                                                                           – How changes in quantities affect prices?
  (or both) shifts                                                                                                                                                        • Information about the reaction of prices and
• Prices are the signals that guide the allocation of                                                                                                                       quantities to one another is vital for many aspects of
  resources in the market economy                                                                                                                                           economic decision making
   Asaf Savaú Akat                    Lecture Notes EC 151 (2007)               109      Asaf Savaú Akat                    Lecture Notes EC 151 (2007)                110      Asaf Savaú Akat                 Lecture Notes EC 151 (2007)                  111


                                  Elasticity                                                         Price elasticity of demand                                                                            Some concepts
• Elasticity is a practical measure developed by                                      • Price elasticity of demand is the percentage change                                  • Before we proceed, some definitions are needed
  economists to enrich our understanding of the forces                                  in quantity demanded given a one percent change in                                   • Necessities: goods that people must buy for natural
  of supply and demand and how they interact                                            the price                                                                              or similar reasons, like food, shelter, medical
• Elasticity calculates the response of buyers and                                    • The price elasticity of demand is computed as the                                      services, including habit forming goods such as
  sellers to changes in market conditions                                               percentage change in the quantity demanded divided                                     cigarettes and drinks
• Through this measure producers and government                                         by the percentage change in price                                                    • Luxuries: goods that are bought for pleasure more
  gains valuable insights about the behaviour of                                      • Attention: price elasticity of demand is a measure of                                  than need, like fashion, travel, entertainement
  different markets                                                                     two points on the same demand curve                                                  • Close substitutes: different categories of food are
• We will learn about three types of elasticity                                                                          Percentage Change                                     usually very close substitutes, like beans and
   – Price elasticity of demand                                                                                        in Quantity Demanded                                    chickpeas
   – Income elasticity of demand                                                       Price Elasticity of Demand =                                                          • Market definition: food market is broad, market for
                                                                                                                         Percentage Change                                     green vegetables is less broad, market for spinach is
   – Price elasticity of supply                                                                                               in Price
                                                                                                                                                                               much narrower


   Asaf Savaú Akat                    Lecture Notes EC 151 (2007)               112      Asaf Savaú Akat                    Lecture Notes EC 151 (2007)                113      Asaf Savaú Akat                 Lecture Notes EC 151 (2007)                  114


                           Ranges of elasticity                                                     Perfectly inelastic demand                                                                Perfectly elastic demand
• Depending on the value of the price elasticity of
  demand we can say that demand is
• Perfectly Inelastic when the quantity demanded                                                     Price                                                                                        Price
                                                                                                                                               Demand
  remains unchanged when price changes                                                                                                                                                                      1. At any price
                                                                                                                                                                                                            above $4, quantity
• Perfectly Elastic when the quantity demanded                                                             $5                                                                                               demanded is zero.
  changes by very large amounts with small changes                                                          4                                                                                         $4                                      Demand
  in price                                                                                    1. An
                                                                                                                                                                                                                          2. At exactly $4,
• Unit Elastic when the quantity demanded changes                                             increase
                                                                                                                                                                                                                          consumers will
                                                                                              in price...
  by the same percentage as the price                                                                                                                                                                                     buy any quantity.
• Inelastic Demand when the quantity demanded does
  not respond strongly to price changes                                                                     0                               100             Quantity                              0                                               Quantity
                                                                                                                                                                                         3. At a price below $4,
• Elastic Demand when the quantity demanded                                                                          2. ...leaves the quantity demanded unchanged.                       quantity demanded is infinite.
  responds strongly to changes in price


   Asaf Savaú Akat                    Lecture Notes EC 151 (2007)               115      Asaf Savaú Akat                    Lecture Notes EC 151 (2007)                116      Asaf Savaú Akat                 Lecture Notes EC 151 (2007)                  117




                           Unit elastic demand                                                                       Elastic demand                                                                        Inelastic demand
             Price                                                                                  Price                                                                                 Price


                     $5                                                                                    $5                                                                                 $5
                 4                                                                                     4                                                  Demand                             4
        1. A 22%                                                    Demand                    1. A 22%                                                                               1. A 22%                                            Demand
        increase                                                                              increase                                                                               increase
        in price...                                                                           in price...                                                                            in price...


                      0                        80 100                Quantity                               0              50              100             Quantity                               0                       90     100          Quantity
                          2. ...leads to a 22% decrease in quantity demanded.                                   2. ...leads to a 67% decrease in quantity demanded.                                2. ...leads to an 11% decrease in quantity demanded.
  Asaf Savaú Akat             Lecture Notes EC 151 (2007)                          118          Asaf Savaú Akat                Lecture Notes EC 151 (2007)                       119                  Asaf Savaú Akat                      Lecture Notes EC 151 (2007)                       120


       Price                                                                                                     Determinants of                                                                          Computing the price elasticity of
          $7                  Elasticity is
                              larger                                                                        price elasticity of demand                                                                               demand
            6                 than 1.
                                                                                            • Demand usually is more elastic                                                                                                                                             (100 - 50)
                                                                                              – if the good is a luxury                                                                      Price                                                     ED                        100
            5
                                                            Elasticity is                     – the longer the time period                                                                                                                                          (4.00 - 5.00)
                                                            smaller                                                                                                                               $5
                                                                                                                                                                                                                                                                                  4.00
            4                                                                                 – the larger the number of close substitutes
                                                            than 1.
            3
                                                                                              – the more narrowly defined the market.                                                                 4                             Demand
                                                                                            • Demand tends to be more inelastic                                                                                                                                  50 percent
            2                                                                                 – if the good is a necessity                                                                                                                                                                 -2
                                                                                                                                                                                                                                                                - 25 percent
            1
                                                                                              – the shorter the time period
                                                                                              – the fewer the number of close substitutes                                                             0          50         100       Quantity        Demand is price elastic
                                                                                              – the more broadly defined the market.
             0        2   4          6        8        10         12        14   Quantity




  Asaf Savaú Akat             Lecture Notes EC 151 (2007)                          121          Asaf Savaú Akat                Lecture Notes EC 151 (2007)                       122                  Asaf Savaú Akat                      Lecture Notes EC 151 (2007)                       123


       A better way: midpoint method                                                                      Elasticity and total revenue                                                                          Elasticity and total revenue
                                                                                            • The price elasticity of demand has very important
• Wider ranges may pose some practical difficulties
                                                                                              practical implications
  in measuring elasticity
                                                                                            • Producers gain valuable information about the
• Narrow price ranges give more precise results                                                                                                                                              Price
                                                                                              impact of price changes on their sales
• Midpoint method is a better way
                                                                                            • Because there is a very strong relation between
• Assume the following prices and quantities:                                                 firm’s sales (total revenue) and price elasticity                                               $4
• Point A: Price $ 4            Quantity: 120                                               • Total revenue is the amount paid by buyers and
  Point B: Price $ 6            Quantity: 80                                                  received by sellers of a good
   Midpoint: Price $ 5          Quantity: 100                                                                                                                                                                           P X Q = $400
                                                                                            • Computed as the price of the good multiplied by the                                             P
                                                                                                                                                                                                                        (total revenue)                                        Demand
• The formula:                                                                                quantity sold
Midpoint Price Elasticity of Demand =                                                                              TR = P x Q
             ( Q2 – Q1 ) /[ ( Q2 + Q1 ) / 2 ]                                               • The behaviour of total revenue when prices change                                                   0                                                 100                                     Quantity
             ( P 2 – P 1 ) / [ ( P2 + P 1 ) / 2 ]                                             depend on the price elasticity of demand                                                                                       Q




  Asaf Savaú Akat             Lecture Notes EC 151 (2007)                          124          Asaf Savaú Akat                Lecture Notes EC 151 (2007)                       125                  Asaf Savaú Akat                      Lecture Notes EC 151 (2007)                       126


                    Effects on total revenue                                                             Elasticity and total revenue:                                                                         Elasticity and total revenue:
• With an elastic demand curve, an increase in price                                                            elastic demand                                                                                       inelastic demand
  leads to a decrease in quantity demanded that is
  proportionately larger                                                                                                                                                                     Price                                                     Price
                                                                                            Price                                           Price
• Producers facing elastic demand curves have
   – decreasing revenues when prices go up
   – increasing revenues when prices go down                                                                                                  $5
• With an inelastic demand curve, an increase in price                                        $4
  leads to proportionately smaller decrease in quantity                                                                      Demand                                           Demand                                                                      $3

• Producers facing inelastic demand curves have                                                                   Revenue = $200                             Revenue = $100
                                                                                                                                                                                                                                                                   Revenue = $240
   – increasing revenues when prices go up                                                                                                                                                     $1
                                                                                                                                                                                                               Revenue = $100             Demand                                         Demand
   – decreasing revenues when prices go down                                                    0             50                 Quantity       0     20                          Quantity        0                                 100       Quantity     0                        80         Quantity
• Unit elasticity means constant revenues
   Asaf Savaú Akat             Lecture Notes EC 151 (2007)          127       Asaf Savaú Akat             Lecture Notes EC 151 (2007)                128      Asaf Savaú Akat             Lecture Notes EC 151 (2007)            129


                         Some examples                                                 Income elasticity of demand                                                       Types of income elasticity
• Reducing the price of a toll-road (paralÕ otoyol)                        • There exists another elasticity of demand besides                             • Income elasticity of demand tells us about the
  may increase total revenue received by the owners                          price elasticity                                                                behaviour of demand when income changes
  (private or public)                                                      • Income elasticity of demand measures how much                                 • Higher income raises the quantity demanded for
• If the price elasticity is higher than one                                 the quantity demanded of a good responds to a                                   normal goods but lowers the quantity demanded for
• Read ITN (p.98) “On the Road with Elasticity”                              change in consumers’ income.                                                    inferior goods
• The same is also true for a Museum                                       • It is computed as the percentage change in the                                • Goods consumers regard as necessities usually have
• Reducing the admission price for a Museum may                              quantity demanded divided by the percentage                                     low income elasticity of demand
  result in such an increase in the number of visitors                       change in income.                                                                – Examples include food, fuel, clothing, utilities,
  that total revenue will be higher                                                                                            Percentage Change in             and medical services.
• Again it means price elasticity is higher than one                                                                            Quantity Demanded          • Goods consumers regard as luxuries usually have
                                                                            Income Elasticity of Demand =                                                    high income elasticity of demand
• Read CS (p.98) “Pricing Admission to a Museum”                                                                                Percentage Change
• It is possible to think of other such examples                                                                                     in Income                – Examples include sports cars, furs, and expensive
                                                                                                                                                                foods


   Asaf Savaú Akat             Lecture Notes EC 151 (2007)          130       Asaf Savaú Akat             Lecture Notes EC 151 (2007)                131      Asaf Savaú Akat             Lecture Notes EC 151 (2007)            132


                 Price elasticity of supply                                              Ranges of supply elasticity                                                       Perfectly inelastic supply
• Price elasticity of supply measures the response of                      • Perfectly Elastic
  quantity supplied to changes in price                                                                     ES = f                horizontal                       Price
• Price elasticity of supply is the percentage change in                   • Relatively Elastic                                                                                                                  Supply
  quantity supplied resulting from a one percent                                                            ES > 1                flat
  change in price                                                          • Unit Elastic
                                                                                                                                                                         $5

• The price elasticity of supply is computed as the                                                         ES = 1                                                         4
  percentage change in the quantity supplied divided                                                                                                          1. An
  by the percentage change in price                                        • Relatively Inelastic                                                             increase
                                                                                                            ES < 1                 steep                    in price...
                          Percentage Change in                             • Perfectly Inelastic
                            Quantity Supplied
   Elasticity of Supply =                                                                                   ES = 0                 vertical
                           Percentage Change                                                                                                                               0                                 100          Quantity
                                 in Price                                                                                                                                       2. ...leaves the quantity supplied unchanged.




   Asaf Savaú Akat             Lecture Notes EC 151 (2007)          133       Asaf Savaú Akat             Lecture Notes EC 151 (2007)                134      Asaf Savaú Akat             Lecture Notes EC 151 (2007)            135



                         Inelastic supply                                                        Unit elastic supply                                                                 Elastic supply

          Price                                                                      Price                                                                           Price


              $5                                                                         $5                                                                              $5

                4                                                                          4                                                                               4
   1. A 22%                                                                   1. A 22%                                                                        1. A 22%
   increase                                                                   increase                                                                        increase
   in price...                                                                in price...                                                                     in price...



                                                  100 110    Quantity                                                        100        125   Quantity                                   100                 200          Quantity

                     2. ...leads to a 10% increase in quantity supplied.                        2. ...leads to a 22% increase in quantity supplied.                             2. ...leads to a 67% increase in quantity supplied.
      Asaf Savaú Akat                    Lecture Notes EC 151 (2007)                            136            Asaf Savaú Akat            Lecture Notes EC 151 (2007)                      137        Asaf Savaú Akat                   Lecture Notes EC 151 (2007)                            138



                         Perfectly elastic supply                                                                                     Determinants of                                                               Application of elasticity
                                                                                                                                     elasticity of supply                                        • How do we apply elasticity to real world events
                                                                                                             • Price elasticity of supply measures the speed of the                              • In case of a change in price, start by examining
                 Price
                                                                                                               change in the production of a good or service                                       whether the shift is in the supply or demand curve
                             1. At any price                                                                                                                                                       or both
                             above $4, quantity                                                                demanded in the market
                   $5        supplied is infinite.                                                           • The availability or non-availability of a good is                                 • Determine the direction of the shift of the curve(s)
                     4                                                                                         influenced by many factors                                                        • Use the supply-and-demand diagram to see how the
                                                                                                                – Beach-front land is limited by nature (inelestic                                 market equilibrium changes
      1. A 22%                                   2. At exactly $4,
      increase                                   producers will
                                                                                                                  supply)                                                                        • You may want to distinguish between the short run
      in price...                                supply any quantity.                                           – Books, cars, and most manufactured goods can                                     and the long run
                                                                                                                  be produced at will (elastic supply)                                           • We now look at three exemples
                                                                                                             • Time period                                                                          – Farming
                                                            100                   Quantity
       3. At a price below $4,                                                                                  – Supply is more elastic in the long run.                                           – Drugs
       quantity supplied is zero.                                                                                                                                                                   – Oil


      Asaf Savaú Akat                    Lecture Notes EC 151 (2007)                            139            Asaf Savaú Akat            Lecture Notes EC 151 (2007)                      140        Asaf Savaú Akat                   Lecture Notes EC 151 (2007)                            141


                 Elasticity and farming income                                                                          An increase in supply in the                                                                       Reducing drug use
• Can good news for farming be bad news for farmers?                                                                         market for wheat                                                    • The second example is from harmful drugs
• What happens to wheat farmers and the market for                                                                     Price of
                                                                                                                                                              1. When demand is inelastic,       • Let’s evaluate two alternative policies to fight drugs
                                                                                                                        Wheat
  wheat when university agronomists discover a new                                                                                                            an increase in supply...
                                                                                                                                                                                                    – Better policing and the interdiction
  wheat hybrid that is more productive than existing                                                                                                              S1      S2                        – Better education of potential drug addicts
  varieties?                                                                                                    2. ...leads $3                                                                   • The first cause a reduction of supply: supply curve
• Key to solution: price elasticity of both supply and                                                          to a large
                                                                                                                                                                                                   shifts to left
                                                                                                                fall in
  demand is very low (inelastic) for food products                                                              price...
                                                                                                                             2
                                                                                                                                                                                                 • Price of drugs and profits of drug dealers go up but
• The innovation increases supply: shifts the supply                                                                                                                                               the quantity used is not affected
  curve to the right                                                                                                                                                       Demand                • The second cause a fall in demand: demand curve
• The result will be more production of wheat but                                                                                                                                                  shifts to left
                                                                                                                                 0                          100     110    Quantity of Wheat
  lower incomes for farmers                                                                                                                                                                      • Both the price of and quantity drugs fall
                                                                                                                                                      3. ...and a proportionately smaller
• Farmers’ dilemma: the more they produce, the                                                                                                        increase in quantity sold. As a result,
                                                                                                                                                                                                 • Price elasticity shows to policymakers the
                                                                                                                                                      revenue falls from $300 to $220.
  poorer they become                                                                                                                                                                               intelligent method of fighting drugs


      Asaf Savaú Akat                    Lecture Notes EC 151 (2007)                            142            Asaf Savaú Akat            Lecture Notes EC 151 (2007)                      143        Asaf Savaú Akat                   Lecture Notes EC 151 (2007)                            144


                          Fighting drug addiction                                                                          OPEC and the price of oil
                         (a) Drug Interdiction                             (b) Drug Education
                                                                                                             • Organisation of Petroleum Exporting Countries                                                       (a) The Oil Market in the Short Run                (b) The Oil Market in the Long Run
                                                     Price of                                                                                                                                          Price                                                 Price
    Price of
     Drugs                                            Drugs
                                                                                                               (OPEC) has control over the price of oil in the short                                   of Oil       1. In the short run, when supply         of Oil                1. In the long run,
                           1. Drug interdiction reduces                1. Drug education reduces                                                                                                                    and demand are inelastic,                                      when supply and
                           the supply of drugs...                      the demand for drugs...                 run because it can cut oil production                                                                a shift in supply...                                           demand are elastic,
                                                                                                                                                                                                                                  S2                                               a shift in supply...
                                 S2                                                      Supply              • In the short run the price elasticity of both demand                                                                      S1
                                                                                                                                                                                                                                                                                                   S2
         P                                S1                                                                                                                                                                                                                                                        S1
             2                                             P1                                                  and supply is very low for oil (inelastic)                                                   P                                  2. ...leads
                                                                                                                                                                                                 2. ...leads 2                                 to a small       P2
          P1                                               P2
                                                                                                             • Small cuts in production imply big jumps in price                                 to a large
                                                                                                                                                                                                 increase P                                    increase         P1
                                                                                                                                                                                                 in price. 1                                   in price.
  2. ...which
 raises the
                                                   2. ...which
                                                    reduces
                                                                                                             • OPEC is successful in increasing the oil revenues of
                                                                                                                                                                                                                                                                                               Demand
   price...                           Demand        the price...
                                                                               D2
                                                                                           D1                  its members in the short run                                                                                            Demand
             0              Q 2 Q 1 Quantity of Drugs        0            Q2        Q 1 Quantity of Drugs    • In the long run both supply and demand of oil is                                             0                          Quantity of Oil            0                      Quantity of Oil
                                 3. ...and reduces the                               3. ...and reduces the
                                 quantity sold.                                      quantity sold.            elastic as new wells come in and consumers switch
                                                                                                               to other sources of energy
                                                                                                             • OPEC finds it difficult to maintain high prices in
                                                                                                               the long run
   Asaf Savaú Akat         Lecture Notes EC 151 (2007)                       145     Asaf Savaú Akat          Lecture Notes EC 151 (2007)                      146      Asaf Savaú Akat          Lecture Notes EC 151 (2007)   147


                          Conclusion                                                                                                                                                  What we learn now?
• Elasticity is a practical measure that helps producers                                                                                                             • In Ch.2 we mentioned two roles for economists:
  and policymakers                                                                                                                                                      – As scientists they try explain the world
• Price elasticity of demand measures how much the                                                                                                                      – As policymakers they try to change the world
  quantity demanded responds to changes in the price                                         SUPPLY, DEMAND, AND                                                     • Ch.4 and Ch.5 analysed objectively how supply and
• If a demand curve is elastic, total revenue falls                                                                                                                    demand works in markets
  when the price rises                                                                       GOVERNMENT POLICIES                                                     • In Ch.6 we analyse various types of government
• If it is inelastic, total revenue rises as the price rises                                                                                                           policy towards the markets
• The price elasticity of supply measures how much                                                              Chapter 6                                            • To that purpose we will only use tools of supply and
  the quantity supplied responds to changes in the                                                                                                                     demand that we just developed
  price                                                                                                                                                              • The analysis will yield some surprising insights
• In most markets, supply is more elastic in the long                                                                                                                  about how markets work
  run than in the short run                                                                                                                                          • Common sense and economic analysis may give
                                                                                                                                                                       opposing advise to policymakers


   Asaf Savaú Akat         Lecture Notes EC 151 (2007)                       148     Asaf Savaú Akat          Lecture Notes EC 151 (2007)                      149      Asaf Savaú Akat          Lecture Notes EC 151 (2007)   150



     Supply, demand, and government                                                                         Price controls                                                                     Price ceilings
• In a free, unregulated market system, market forces                              • Price control: government sets an upper or lower                                • Price ceilings limit the maximum price that sellers
  establish equilibrium prices and quantities                                        limit (or both) to the price of good or service                                   can charge to their customers
• The market equilibrium may be efficient, but it may                              • Price controls are often used in many countries                                 • In other words, market price can be lower but can
  not leave everyone satisfied                                                     • Price controls are enacted by governments because                                 not be higher than the price fixed by government
• Those who consider themselves to be losing from                                    there is a demand for them from some sections of                                • Two outcomes are possible when the government
  the market outcomes will ask for government to                                     the public                                                                        imposes a price ceiling
  intervene in the market                                                          • Who, either as buyers or sellers feel that the existing                         • The price ceiling is not binding if it is set above the
• Government intervention in the markets may take                                    market price is unfair to them                                                    equilibrium price
  several ways, depending on the circumstances                                     • We will distinguish between two types of controls                               • It will have no impact on the market
• We will look at two different cases of direct                                    • Price Ceiling: a legally established maximum price                              • The price ceiling is binding if it is set below the
  government involvement in markets:                                                 at which a good can be sold.                                                      equilibrium price
   – Price controls                                                                • Price Floor: a legally established minimum price at                             • It will lead to shortages in the market as demand
   – Taxes levied on goods and services                                              which a good can be sold                                                          exceeds supply at that price


   Asaf Savaú Akat         Lecture Notes EC 151 (2007)                       151     Asaf Savaú Akat          Lecture Notes EC 151 (2007)                      152      Asaf Savaú Akat          Lecture Notes EC 151 (2007)   153


     A price ceiling that is not binding                                                    A price ceiling that is binding                                                               Effects of price ceilings
                                                                                                                                                                     • A price ceiling prevents the price to rise further even
               Price of                                                                          Price of                                                              if demand is high
                                                                                              Ice-Cream
            Ice-Cream
                 Cone                                                                              Cone                                                              • A binding price ceiling creates shortages because
                                                         Supply                                                                             Supply                     Q D > QS .
                                                                                            Equilibrium                                                              • Example: there was a margarine shortage in Turkey
                                                                    Price                     price
                     $4
                                                                   ceiling                                                                                             during 1978-79 crisis because the price was fixed
                     3                                                                                 $3                                                              too low to cover the costs of producers
           Equilibrium                                                                                                                                               • Shortages result in non-price rationing such as long
             price                                                                                      2                                             Price
                                                                                                                        Shortage
                                                                                                                                                     ceiling           lines in front of the shops, discrimination by sellers
                                                                                                                                                                       and as a rule the formation of a “black market”
                                                                                                                                                 Demand
                                                                  Demand                                                                                             • In Turkey there was a black market for dollars
                     0                 100                    Quantity of                               0         75              125            Quantity of
                                                                                                                                                  Ice-Cream
                                                                                                                                                                       before 1980s because the government had fixed the
                                                               Ice-Cream                                        Quantity         Quantity
                                    Equilibrium
                                     quantity                      Cones                                        supplied        demanded              Cones            exchange rate below the market equilibrium rate
         Asaf Savaú Akat                                 Lecture Notes EC 151 (2007)                                         154                 Asaf Savaú Akat                         Lecture Notes EC 151 (2007)                              155             Asaf Savaú Akat          Lecture Notes EC 151 (2007)   156


                                Price ceiling on gasoline                                                                                           Rent control: short and long run                                                                                                     Price floors
                                                                                                                                                              (a) Rent Control in the Short Run                        (b) Rent Control in the Long Run
                                                                                                                                                                                                                                                               • Price floors set the minimum price that buyers must
        Price of
                      (a) The Price Ceiling on Gasoline Is Not Binding

                                                                               Price of
                                                                                           (b) The Price Ceiling on Gasoline Is Binding

                                                                                                               S 2                              Rental
                                                                                                                                                             (supply and demand are inelastic)
                                                                                                                                                                                                           Rental
                                                                                                                                                                                                                       (supply and demand are elastic)           pay for a product
       Gasoline                                                               Gasoline                                2. ...but when
                                                                                                                      supply falls...
                                                                                                                                               Price of
                                                                                                                                             Apartment                 Supply
                                                                                                                                                                                                          Price of
                                                                                                                                                                                                        Apartment
                                                                                                                                                                                                                                                               • Market price can be higher but not below the price
1. Initially,
                                                          Supply,       S 1
                                                                                     P 2
                                                                                                                              S 1                                                                                                                                set by the government
                                                                                                                                                                                                                                                   Supply
the price
ceiling
is not
                                                                                                                                                                                                                                                               • When the government imposes a price floor, again
binding...
                P 1
                                                     Price ceiling
                                                                                     P 1
                                                                                                                          Price ceiling
                                                                                                                     3. ...the price
                                                                                                                                                                                                                                                                 two outcomes are possible
                                                                        4. ...
                                                                        resulting
                                                                                                                     ceiling becomes
                                                                                                                     binding...
                                                                                                                                                                                    Controlled rent                                        Controlled rent

                                                                                                                                                                                                                                                  Demand
                                                                                                                                                                                                                                                               • The price floor is not binding if it is set below the
                                                                        in a                                                                                                                                               Shortage

                0                        Q1
                                                  Demand
                                                          Quantity of
                                                                        shortage.
                                                                                     0     QS         QDQ 1
                                                                                                                       Demand
                                                                                                                              Quantity of
                                                                                                                                                                         Shortage
                                                                                                                                                                                        Demand
                                                                                                                                                                                                                                                                 equilibrium price
                                                           Gasoline                                                            Gasoline
                                                                                                                                                    0                                     Quantity of           0                                Quantity of   • It has no effect on the market
                                                                                                                                                                                         Apartments                                              Apartments

          A fall in supply turns an unbinding price ceiling                                                                                                                                                                                                    • The price floor is binding if it is set above the
                                                                                                                                                  Controling rents cause bigger shortages in the                                                                 equilibrium price
          into a binding ceiling and causes shortages of
                                                                                                                                                  long run because new construction becomes                                                                    • It leads to a surplus because demand is less than
          gasoline
                                                                                                                                                  unattractive, reducing long run supply                                                                         supply at that price


         Asaf Savaú Akat                                 Lecture Notes EC 151 (2007)                                         157                 Asaf Savaú Akat                         Lecture Notes EC 151 (2007)                              158             Asaf Savaú Akat          Lecture Notes EC 151 (2007)   159


                                                                                                                                                            A price floor that is binding                                                                                           Effects of a price floor
                 A price floor that is not binding                                                                                                                                                                                                             • A price floor prevents price to fall even if demand is
                                                                                                                                                            Price of
                                                                                                                                                          Ice Cream
                                                                                                                                                                                                                                                                 very low
                          Price of
                       Ice-Cream
                                                                                                                                                              Cones                                                    Supply                                  • When the market price hits the floor, it can fall no
                            Cone                                                                  Supply
                                                                                                                                                                                                        Surplus                                                  further, and the market price equals the floor price
                    Equilibrium                                                                                                                                    $4                                                                 Price floor              • A binding price floor causes a surplus of supply
                      price                                                                                                                                                                                                                                      over demand because at that price
                                   $3
                                                                                                                                                                    3
                                                                                                                                                                                                                                                                                      Q S > Q D.
                                                                                                                                                    Equilibrium                                                                                                • Agricultural support prices are typical examples
                                                                                                                  Price                               price
                                     2
                                                                                                                  floor                                                                                                                                        • When set above market levels, they result in large
                                                                                                                                                                                                                            Demand
                                                                                                                                                                                                                                                                 unsold stocks (tobacco?)
                                                                                                        Demand
                                                                                                                                                                   0                             80            120           Quantity of
                                                                                                                                                                                                                                                               • Minimum wage laws also set price floors for wages
                                     0                                      100                      Quantity of                                                                              Quantity
                                                                                                                                                                                             demanded
                                                                                                                                                                                                              Quantity
                                                                                                                                                                                                              Supplied
                                                                                                                                                                                                                              Ice Cream
                                                                                                                                                                                                                                  Cones
                                                                                                                                                                                                                                                               • Binding minimum wages prevent wages to go down
                                                                                                      Ice-Cream
                                                                          Equilibrium
                                                                           quantity                       Cones                                                                                                                                                  and therefore cause unemployment


         Asaf Savaú Akat                                 Lecture Notes EC 151 (2007)                                         160                 Asaf Savaú Akat                         Lecture Notes EC 151 (2007)                              161             Asaf Savaú Akat          Lecture Notes EC 151 (2007)   162


     Minumum wage law and employment                                                                                                                      Letting the price system work                                                                                                 Taxes: impact
                                                                                                                                            • Most economists believe in the superiority of the                                                                • Taxes levied on goods and services are called
                               (a) A Free Labor Market                               (b) A Labor Market with a Binding Minimum Wage
                                                                                                                                              price system in solving most problems                                                                              indirect taxes
       Wage                                                                   Wage
                                                                                                                                            • Therefore dislike government interference with the                                                               • The amount of tax fixed by the government is added
                                                          Labor
                                                          supply
                                                                                                  Labor surplus
                                                                                                                              Labor
                                                                                                                              supply          working of the price mechanism                                                                                     to the price and paid everytime the good is sold
                                                                         Minimum
                                                                                                 (unemployment)                             • Even in the case of natural disasters                                                                            • Taxes discourage market activity
                                                                          wage

 Equilibrium
                                                                                                                                            • Read ITN (p.119) “Does a Drought need to Cause a                                                                 • When a good is taxed, the quantity sold is smaller
   wage
                                                                                                                                              Water Shortage”                                                                                                  • Buyers and sellers share the tax burden
                                                      Labor
                                                     demand
                                                                                                                          Labor
                                                                                                                         demand
                                                                                                                                            • The author argues that increasing the price that                                                                 • Tax incidence is the study of who bears the burden
            0                    Equilibrium
                                 employment
                                                         Quantity of
                                                            Labor
                                                                                 0            Quantity
                                                                                             demanded
                                                                                                            Quantity
                                                                                                            supplied
                                                                                                                             Quantity of
                                                                                                                                Labor
                                                                                                                                              consumers pay for water would be a better way of                                                                   of a tax
                                                                                                                                              allocating scarce water in case of a major drought                                                               • Taxes result in a change in market equilibrium
      Minimum wage legislation increases both the real                                                                                      • A drought is always a natural event                                                                              • Buyers pay more and sellers receive less, regardless
      wage of employed and the number of unemployed                                                                                         • A water shortage is always a man-made event                                                                        of whom the tax is levied on
   Asaf Savaú Akat                  Lecture Notes EC 151 (2007)                         163           Asaf Savaú Akat                    Lecture Notes EC 151 (2007)                          164         Asaf Savaú Akat    Lecture Notes EC 151 (2007)   165


                                                                                                                                                                                                                    The burden of a payroll tax
             Impact of a 50¢ tax on buyers                                                                   Impact of a 50¢ tax on sellers                                                            • Taxes from the wages that firms pay to their
                                                                                                                                                                                                         employees are called “payroll taxes”
           Price of                                                                                            Price of
        Ice-Cream
                                                                                                            Ice-Cream
                                                                                                                                                                               A tax on sellers
                                                                                                                                                                                                       • Income tax, contribution to Social Security and to
                                                                                                                 Cone
     Price Cone                                                   Supply, S1                             Price
                                                                                                        buyers                      Equilibrium                        S2      shifts the supply         Unemployment Insurance are typical payroll taxes
    buyers                                                                                                                           with tax                                  curve upward by
      pay
              $3.30
                                                                                                          pay
                                                                                                                                                                       S1      the amount of           • When the Parliament passes legislation about these
                                                              Equilibrium without tax                             $3.30                                                        the tax ($0.50).
               3.00                                                                                     Price      3.00          Tax ($0.50)                                                             taxes, the issue of “who pays the tax” comes up
               2.80                                                                                    without     2.80                                                Equilibrium without tax
                                                                                                         tax                                                                                           • Read CS (p.127) “Can Congress Distribute the
    Price
                                     Equilibrium                                                            Price
                                                                                                                                                                                                         Burden of a Payroll Tax”
   sellers
   receive                            with tax                                                             sellers
                                                                                                           receive
                                                                                                                                                                                                       • Whether the tax is legally levied on employees or
                                                                                                                                                                                 Demand, D1
                                                                                                                                                                                                         employers makes little difference
                                                                                D1
                                                                           D2
                                                                                                                                                                                                       • Conditions in the labour market and the elasticities
                                                                                                                                                                                                         of demand and supply determine who pays the tax
                     0                          90 100                  Quantity of                                      0                             90 100                      Quantity of
                                                                  Ice-Cream Cones                                                                                            Ice-Cream Cones




   Asaf Savaú Akat                  Lecture Notes EC 151 (2007)                         166           Asaf Savaú Akat                    Lecture Notes EC 151 (2007)                          167         Asaf Savaú Akat    Lecture Notes EC 151 (2007)   168



     Payroll tax and the labour market                                                                                    The incidence of tax                                                                      Elasticity and tax incidence
           Wage                                                                                   • Tax incidence tries to establish who pays the tax in                                               • Elasticity enters the picture because total revenue in
                                                                                                    the end?                                                                                             the market depends on the price elasticity of demand
                                                                       Labor supply
                                                                                                  • In other words, in what proportions is the burden of                                                 and price elasticity of supply
                                                                                                    the tax divided between buyers and sellers?                                                        • We can distinguish among three major cases
 Wage firms pay                                                                                   • Alternatively, how do the effects of taxes on sellers                                                 – If demand is inelastic while supply is elastic, then
                                 Tax wedge                                                          compare to those levied on buyers?                                                                      a larger share of the tax will fall on the buyers
Wage without tax
                                                                                                  • This is an opportunity for us to see how the measure                                                  – If demand is elastic while supply is inelestic, then
  Wage workers                                                                                      of elasticity can be used in economics                                                                  a larger share of the tax will fall on the sellers
    receive
                                                                                                  • Because the answers to these questions depends on                                                     – If demand and supply are unit elastic, buyers and
                                                                                                    the elasticity of demand and the elasticity of supply.                                                  seller will share the tax burden equally
                                                                        Labor demand
                                                                                                  • We shall show that the burden of a tax falls more                                                  • Knowing the price elasticities of demand and supply
                0                                                                Quantity
                                                                                 of Labor
                                                                                                    heavily on the side of the market that is less elastic                                               permits the government to target correctly those
                                                                                                                                                                                                         whom it wishes to pay the tax


   Asaf Savaú Akat                  Lecture Notes EC 151 (2007)                         169           Asaf Savaú Akat                    Lecture Notes EC 151 (2007)                          170         Asaf Savaú Akat    Lecture Notes EC 151 (2007)   171


       Elastic supply, inelastic demand                                                                   Inelastic supply, elastic demand                                                                     Taxing luxuries or necessities?
                                                                                                                                                                                                       • There is always a demand from the public to tax
                                                                                                                                                                                                         luxuries but not necessities
                     Price                                                                                                                              1. When demand is more
                                                          1. When supply is more                                        Price                           elastic than supply...                         • Taxing goods that are considered luxuries is popular
                                                          elastic than demand...
    Price buyers pay
                                                                                                                                                                                                         both with the public and governments
                                                                                                     Price buyers pay                                          Supply
                                                                               Supply                                                                                                                  • Unfortunately luxury goods usually have high price
                                                                                                     Price without tax                                                      3. ...than on consumers.
                                                                               2. ...the                                                                                                                 elasticity of demand (bigger than 1)
                                             Tax                                                                                               Tax
                                                                               incidence of the
                                                                               tax falls more
                                                                                                                                                                                                       • Therefore taxes reduce the consumption of luxuries
   Price without tax                                                           heavily on
                                                                                                                                                                          Demand
                                                                                                                                                                                                       • Tax revenue is much lower than expected
                                                                               consumers...
Price sellers receive                                                                             Price sellers receive                                  2. ...the                                     • In turn, necessities have low price elasticity of
                                                                                                                                                         incidence of
                                              3. ...than on        Demand                                                                                the tax falls more                              demand (smaller than 1)
                                                                                                                                                         heavily on producers...
                                              producers.                                                                                                                                               • And yield high tax revenues to the government
                             0                                                       Quantity                                0                                                      Quantity           • In order to obtain revenues the government ends up
                                                                                                                                                                                                         by taxing necessities in Turkey
   Asaf Savaú Akat       Lecture Notes EC 151 (2007)   172      Asaf Savaú Akat       Lecture Notes EC 151 (2007)   173      Asaf Savaú Akat       Lecture Notes EC 151 (2007)   174


                        Conclusion                                             PART THREE
                                                                                                                                         What did we learn so far?
• The economy is governed by two kinds of laws:                                                                           • Part One introduced us to some basic concepts as
   – The laws of supply and demand                                        SUPPLY AND DEMAND – II                            well as tools of economics as a science
   – The laws enacted by government                                       MARKETS AND WELFARE                               – Ten principles (Ch.1)
• Prices can be controled by ceilings or floors                                                                             – Thinking like an economist (Ch.2)
• Price ceilings cause shortages and black market                                                                           – Exchange and trade (Ch.3)
• Price floors result in surpluses and unsold stoks held            CONSUMERS, PRODUCERS,                                 • Part Two introduced us to markets and how they
  by the government                                                                                                         work through the forces of supply and demand
• Taxes raise revenue to the government
                                                                     AND THE EFFICIENCY OF                                  – Supply and Demand (Ch.4)
• Taxes create new price equilibriums in which buyers                      MARKETS                                          – Elasticities (Ch.5)
  and sellers share the tax                                                                                                 – Markets and government policies (Ch.6)
• The incidence of the tax depends on the price                                         Chapter 7                         • Part Three looks on the welfare implications of the
  elasticity of demand and supply                                                                                           market system
• Necessities are taxed to get more revenue


   Asaf Savaú Akat       Lecture Notes EC 151 (2007)   175      Asaf Savaú Akat       Lecture Notes EC 151 (2007)   176      Asaf Savaú Akat       Lecture Notes EC 151 (2007)   177


         What do we learn in this part?                                 Market equilibrium revisited                                           Welfare economics
• We search for an answer to the following question          • Market equilibrium reflects the way markets                • Welfare economics study how the allocation of
• Are markets a good way to organise the social                allocate scarce resources                                    resources affects economic well-being in society
  process of production?                                     • Supply and demand determines the equilibrium               • It uses a new concept called “surplus”
• To answer it we develop the concepts of consumer             price and quantity for each good                           • And shows that buyers and sellers both receive
  surplus, producer surplus and total surplus                • Thus the resources that goes into its production as          benefits from taking part in the market
• They allow us to explain market efficiency                   well as who shall benefit from its consumption             • Therefore the equilibrium in a market maximizes the
• We then apply our new tools to understand the costs        • The next question is to find out if the equilibrium          total welfare of buyers and sellers
  of taxation and the benefits of international trade          price and quantity maximize the total welfare of           • Consumer surplus measures economic welfare from
• Part Three is made of                                        buyers and sellers?                                          the buyer side
• Ch.7 : Consumers, producers and market efficiency          • Welfare economics answers this question                    • Producer surplus measures economic welfare from
• Ch.8 : Application: Costs of taxation                      • And determines whether the market allocation is              the seller side
• Ch.9 : Application: International trade                      desirable or not from the perspective of society           • Together they allow us to evaluate the allocation of
                                                                                                                            scarce resources by markets


   Asaf Savaú Akat       Lecture Notes EC 151 (2007)   178      Asaf Savaú Akat       Lecture Notes EC 151 (2007)   179      Asaf Savaú Akat       Lecture Notes EC 151 (2007)   180


                     Willingness to pay                                           Consumer surplus                                   Willingness to pay with four
• Willingness to pay is the maximum price that a             • Consumer surplus is the key concept of welfare                              possible buyers
  buyer is willing and able to pay for a good or service       economics
• It corresponds to the value attributed by the buyer to     • The market demand curve shows the various
  the good or service demanded                                 quantities that buyers would be willing and able to                    Buyer                 Willingness to Pay
• The willingness to pay cannot always be directly             purchase at different prices
                                                             • As the price goes down, the quantity bought goes up                      John                           $100
  measured in the market but it is still there
• How much a buyer will be willing to pay for a good         • Consumer surplus is the difference between the                           Paul                                80
  or service is the maximum price at which he/she will         willingness to pay for the good or service and the
  purchase that good or service                                actual spending for it                                                George                                 70
• What determines the maximum price?                         • Consumer surplus is the amount a buyer is willing
• The benefits that the buyer expect to receive from           to pay for a good minus the amount the buyer                            Ringo                                50
  the consumption of that good or service                      actually pays for it
  Asaf Savaú Akat                      Lecture Notes EC 151 (2007)               181     Asaf Savaú Akat                     Lecture Notes EC 151 (2007)                   182      Asaf Savaú Akat   Lecture Notes EC 151 (2007)   183


          Willingness to pay with four                                                    Measuring consumer surplus with                                                          Consumer surplus, demand and price
                possible buyers                                                                  the demand curve                                                                • Consumer surplus is the area that lies below the
                                                                                                                                                                                   demand curve and above the market price
       Price                                     Buyer                Quantity                  Price of                                                                         • Consumer surplus depends on the demand curve,
                                                                                                 Album
                                                                     Demanded                        $100
                                                                                                                                                                                   which represents the willingness to pay
                                                                                                                             John’s consumer surplus ($30)                       • And the market price which represents market
More than $100 None                                                        0                           80
                                                                                                                                       Paul’s consumer surplus ($10)               equilibrium
                                                                                                       70
$80 to $100                       John                                     1                                   Total
                                                                                                                                                                                 • Ceteris paribus, changes in price and demand affect
                                                                                                       50      consumer                                                            consumer surplus
$70 to $80                        John, Paul                               2                                   surplus ($40)
                                                                                                                                                                                    – Lower market price increases consumer surplus
$50 to $70                        John, Paul, George                       3                                                                Demand                                  – Higher market price reduces consumer surplus
                                                                                                                                                                                    – Higher demand increases consumer surplus
$50 or less                       Ringo                                    4                               0      1      2         3       4                 Quantity of            – Lower demand reduces consumer surplus
                                                                                                                                                               Albums




  Asaf Savaú Akat                      Lecture Notes EC 151 (2007)               184     Asaf Savaú Akat                     Lecture Notes EC 151 (2007)                   185


      How the price affects consumer                                                                            Willingness to sell
                 surplus                                                               • We can now apply the concept of surplus to the
         Price
                                                                                         producers
                 A                                                                     • Market supply curve shows the various quantities
                                                                                         that producers would be willing and able to sell at
                   Initial                                                               different prices
                 consumer
                  surplus                                                              • It may be seen as a measure of supplier costs, that
           P1                      C           Consumer surplus
                 B                             to new consumers                          is, the opportunity cost of supplying various
                                             F
                                                                                         quantities of the good.
           P2
                 D
                     Additional
                                   E                                                   • The marginal opportunity cost of production
                     consumer
                     surplus to                                                          increases as market output expands
                     initial                            Demand
                     consumers                                                         • Because a producer’s cost is the lowest price he/she
                                                                                         will accept, cost is a measure of his/her willingness
            0                     Q1      Q2                          Quantity
                                                                                         to sell

								
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