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ECON7000
Foundations in Microeconomics
LECTURE 3
Topic 2.
Demand and Supply
Last lecture feedback
Q1. Which of the following is true?
a. Under free (unrestricted) international trade, the economically
stronger country gains at the expense of the economically weaker
country.
b. If absolute advantage determines who produces what, efficiency
is maximised.
c. To maximise total output, comparative advantage identifies who
should specialise in producing what.
d. If Ralph can produce 2 units of X per hour while Pat can only
produce 1 unit of X per hour, it is more efficient for Ralph to
produce X and for Pat to produce something else.
e. Both b) and d).
Lecture 3 ECON7000
2
Last lecture feedback
Q2. To say some person has a comparative advantage in the
writing of an economics textbook means they:
a. can write a textbook faster than anyone else.
b. have the best word-processing technology.
c. will have more features in the textbook.
d. the textbook will be the easiest to read.
e. they have a low opportunity cost for writing an economics
textbook.
Lecture 3 ECON7000
3
How Decisions are Coordinated.
Topic 1: Thinking like an Economist.
Rational self-interested decision-makers and
how they make, or should make, choices.
Topic 2: Supply and Demand.
How an economic system coordinates many
rational choices of self-interested decision-makers.
Lecture 3 ECON7000
4
Plan of Lecture 3.
First half
1. Understanding Demand and Supply theory.
Second half
2. Economic efficiency of competitive markets.
– a look at consumer and producer surplus
– deadweight loss
Lecture 3 ECON7000
5
How Decisions are Coordinated.
Central Planning (eg: Cuba, North Korea)
vs
Decentralised Planning (Market System)
All economic systems must address:
1. What should be produced?
2. How should it be produced?
3. For whom will it be produced?
Lecture 3 ECON7000
6
Market System.
individual preferences and purchasing power
+
costs of production
generate prices
act as signals that coordinate decision making
guide resource allocation in the economy
7
Market System.
Decentralised market economies often
outperform centrally planned economies in
terms of efficiently allocating resources.
BUT, not always
sometimes they fail
Lecture 3 ECON7000
8
The Market System – setting a price?
 Transactions take place in a market, where
consumers have a willingness to pay (demand)
and suppliers have a willingness to sell (supply)
 Note that there are TWO sides to any transaction
involving a buyer and a seller.
Demand and consumers
Supply and producers
Lecture 3 ECON7000
9
Demand and the Individual Consumer
A Real World Observation:
As the price a product (or service) decreases, given that
we live in a world where the scarcity principle applies,
we tend to consume more.
Note: an inverse relationship between price and
quantity demanded.
Demand in economics is represented as a relationship
between price and quantity demanded.
Lecture 3 ECON7000
10
Developing Individual Demand.
Individuals will consume different quantities of a
product for the same price. We are all different!
Individual Demand (a simplified approach)
Price ($/kg)
1
2
3
4
John
8
7
6
5
Quantity
(kg)
Sue
12
10
8
6
Tim
18
15
12
9
Developing Individual Demand curves
4.5
4
Price ($/kg)
3.5
3
2.5
2
1.5
1
John
0.5
Tim
Sue
0
0
5
10
15
20
Quantity Demanded (kg)
12
Developing Individual Demand
Points to note:
1. Demand is a relationship between prices and the
quantities demanded at those prices, sometimes
referred to as a “willingness to pay curve”.
2. Demand is a downward sloping relationship.
3. As price increases, the quantity demanded by
consumers decreases.
4. The area under the demand curve is the amount of
money a consumer spends.
13
Developing Individual Demand
5. The “Ceteris paribus” assumption in Latin
meaning “all else being equal”.
 needed to develop the demand model.
 when analysing two variables (such as price and
quantity), it is assumed all other variables are
held constant (not able to be changed).
Lecture 3 ECON7000
14
Developing Individual Demand curves
4.5
4
Price ($/kg)
3.5
3
2.5
Consumer Expenditure
= $3 /kg * 6 kg
= $18
2
1.5
1
0.5
0
0
2
4
6
8
10
Quantity Demanded (kg)
15
Developing Market Demand
All individuals’ behaviours combine to create a
market. The sum of all individual demand results in
the market demand for a product (or service).
Market Demand Table (John + Sue + Tim = Market)
Price
Quantity
($/kg)
(kg)
John
Sue
Tim
Market
1
8
12
18
38
2
7
10
15
32
3
6
8
12
26
4
5
6
9
20
Developing Market Demand
4.5
4
Price ($/kg)
3.5
3
2.5
2
1.5
1
Sue
0.5
Market
Demand
Tim
0
0
5
10
15
20
25
30
35
40
Quantity Demanded (kg)
17
Using Economic Models
Individual Demand and Market Demand
Used to explain how individuals make choices
Demand relationship is an economic model.
Lecture 3 ECON7000
18
Two important concepts to get clear!
1. What do economists mean by the statement:
“movement along a demand curve”.
2. What do economists mean by the statement:
“a shift in demand”.
Both fundamental concepts required in
understanding and applying economic models.
Lecture 3 ECON7000
19
Two important concepts to get clear!
1.
“movement along a demand curve”.
An individual consumer faces a price rise in the
product they consume.
Response: consume less.
Move upward and to the left along the demand
curve.
Lecture 3 ECON7000
20
Effect of a Price Rise
4.5
4
Price ($/kg)
3.5
2
3
Move along the
Demand Curve
2.5
1
2
1.5
1
0.5
0
0
2
4
6
7
8
10
Quantity Demanded (kg)
21
Two important concepts to get clear!
2 . “a shift in demand”
A bit more complicated than a change in price.
This will be discussed in detail later.
Lecture 3 ECON7000
22
Supply and the Individual Producer.
A Real World Observation:
As the price a product (or service) increases, and
assuming ceteris parabis, producers will supply
more.
Note: there is an upward sloping (positive) relationship
between price and quantity supplied. A change in price
results in a movement along the supply curve.
Supply in economics is represented as a
relationship between price and quantity supplied.
23
Developing Individual Supply
Some firms will be able to produce different
quantities of a product (service) for the same price.
Why?
Individual Supply (a simplified approach)
Price ($/kg)
1
2
3
4
A
3
5
7
9
Quantity
(kg)
B
6
9
12
15
C
11
12
13
14
Developing Market Supply
All individual producers’ quantities supplied add to
create a market supply for a product (or service).
Market Supply Table
Price
Quantity
($/kg)
(kg)
A
B
C
Market
1
3
6
11
20
2
5
9
12
26
3
7
12
13
32
4
9
15
14
38
25
Individual and Market
Supply Curves
4.5
4
Price ($/kg)
3.5
Market
Supply
3
2.5
2
1.5
1
A
C
B
0.5
0
0
5
10
15
20
25
Quantity supplied (kg)
30
35
40
The interaction of Supply and Demand.
Market Equilibrium
(market clearing point)
4.5
4
Price ($/kg)
3.5
3
2.5
$2.50/kg
2
1.5
1
0.5
29
0
0
10
20
30
40
Quantity Demanded and Supplied (kg)
27
The interaction of supply and demand.
 The intersection of the supply and demand curves so
i) quantity supplied = quantity demanded
ii) selling price = purchase price
 A point where suppliers are happy to sell a given
quantity at a certain price, and this exactly matches
the price consumers are willing to pay for this
quantity supplied.
 a situation where there is no tendency for the price to
change (both consumers and suppliers are happy).
Arriving at the Market Clearing Point
Competitive market
 has many buyers and many sellers.
 Prices and quantities continue to adjust until a market
clearing point is reached, eliminating shortages and
surpluses.
 note the market clearing point and the model
suggests equilibrium is a static point. In reality, it
can continually move. ie: the point is dynamic.
Lecture 3 ECON7000
29
Impacts of Government Intervention on
competitive markets – an introduction.
What happens if governments aim to control
prices in an otherwise competitive market?
Price can be set higher than market clearing
price floor
Price can be set lower than market clearing
price ceiling
30
Impacts of Government Intervention.
1. Price floor
= a price set by law makers (government) that
is HIGHER than the market clearing price.
Why a higher price?
(eg: milk prices for dairy farmers, minimum wages)
Use the supply and demand model to explain the logic
and problems of doing this.
Lecture 3 ECON7000
31
Price Floor.
Supplier Revenue
= 3.5 * 35
= $122.50
4.5
4
Price ($/kg)
Supply
Legal Price = $3.5/kg
3.5
3
Consumer Expenditure
= 3.5 * 23
= $80.50
2.5
2
1.5
Demand
1
0.5
Qs = 35
Qd = 23
0
0
10
20
30
Quantity Demanded and Supplied (kg)
40
Impacts of Government Intervention.
Price floor
 used by governments to set a legally determined
price to protect suppliers.
 the price is set above the market clearing price,
and becomes a minimum price for suppliers
 this minimum price is then guaranteed by the
government
 What about the excess quantity supplied ????
Lecture 3 ECON7000
33
Impacts of Government Intervention.
2. Price ceiling
= a price set by law makers (government) that
is LOWER than the market clearing price.
Why a lower price?
Use the supply and demand model to explain the logic
and problems of doing this.
Lecture 3 ECON7000
34
Price Ceiling
(and a shortage in quantity demanded).
4.5
4
Supply
Price ($/kg)
3.5
Shortage and consumer
expenditure NOT possible
3
2.5
Legal Price = $2/kg
2
1.5
Supplier Revenue
= 2 * 26
= $52
1
0.5
Demand
$12
Qs = 26
0
0
10
20
Qd = 32
30
Quantity Demanded and Supplied (kg)
40
Impacts of Government Intervention.
Price ceiling
 used by governments to set a legally determined
price to protect consumers (eg: tenants who rent,
petrol “price caps” when oil prices rising fast)
 the price is set below the market clearing price,
to help protect consumers from higher prices.
 the legal price is a maximum that can be charged
by suppliers.
 What about illegally paying higher prices for the
quantity that is available? Black Markets?
Black Markets – Supply and Demand Model.
4.5
4
Price ($/kg)
3.5
3
2.5
2
1.5
1
0.5
0
0
10
20
30
40
Quantity Demanded and Supplied (kg)
37
Debate: (at the onset of the GFC):
“ Let free markets rule and governments just
stay out of it! The market is always right and
will always sort things out”.
Market Failure:
= an inefficient allocation of goods and
services in a market.
eg: traffic congestion (view as a market failure)
solved by imposing a peak travel time tax.
Definitions.
To assess impacts of government intervention into
competitive markets, economists introduced
consumer surplus and producer surplus.
Consumer Surplus.
The maximum price an individual consumer is
prepared to pay less the clearing price set by the
market = an individual’s consumer surplus.
Producer Surplus.
The market clearing price less the minimum price a
supplier would have been willing to accept in a sale.
39
Defining individual consumer surplus
Individual consumer surplus for the
first packet of chips
$3.00
= (3-1.80)*1 = $1.20
Price
($/packet)
Supply
$1.80
Demand
0
1
Quantity
(packets of chips)
Defining individual consumer surplus
Individual consumer surplus for the
second packet of chips
$3.00
$2.80
= (2.80-1.80)*1 = $1.00
Price
($/packet)
Supply
$1.80
Demand
0
1 2
Quantity
(packets of chips)
Lecture 3 ECON7000
Total Consumer Surplus
Price
($/packet)
Total consumer surplus for the market
of interest = the area under the demand
curve and above the market price.
$$$$
Mkt Price
= $1.80
Supply
Demand
Quantity
(packets of chips)
0
Lecture 3 ECON7000
Individual Producer Surplus
Price
($/packet)
Individual producer surplus for the first
packet of chips
= (1.80 -1.00)*1 = $0.80
Supply
$1.80
$1.00
0
Demand
1
Quantity
(packets of chips)
Lecture 3 ECON7000
Individual Producer Surplus
Price
($/packet)
Individual producer surplus for the second
packet of chips
= (1.80 -1.20)*1 = $0.60
Supply
$1.80
$1.20
Demand
0
1 2
Quantity
(packets of chips)
Lecture 3 ECON7000
Total Producer Surplus
Price
($/packet)
Total producer surplus for the market
of interest = the area above the supply
curve and below the market price.
Supply
$1.80
= Mkt Price
$$$$
Demand
Quantity
(packets of chips)
0
Lecture 3 ECON7000
45
Economic Surplus in a competitive Market
Price
($/packet)
Total Economic surplus
= total consumer surplus + total producer surplus
(maximised in competitive markets)
$$$$
Supply
Market
clearing
price
$$$$
Demand
Quantity
(packets of chips)
0
Market clearing quantity
Economic Surplus in a competitive Market
(no government restrictions imposed)
Competitive markets, lots of buyers and sellers.
A market clearing price and quantity reached
Economic surplus is maximised.
Economic efficiency
(where MB = MC, more later)
47
Government Intervention in Markets
Do competitive markets make every individual
better off ?
Competitive markets maximise the economic
surplus for society overall, BUT
Any individual consumer would like to pay
less, and any individual supplier would like to
charge more, than the market clearing price.
Lobby/pressure governments to intervene!
48
Government Intervention in Markets
Lobby/pressure governments to intervene!
Causes a move away from the competitive
market equilibrium price output quantity
Results in economic inefficiency (a reduction
in total surplus called dead weight loss)
a. Dead weight loss from Price Floor
Price Floors to protect producers
price above market clearing price
(wheat & wool farmers, minimum wages)
Price
($/unit)
Legal price
floor
A
Supply
B
Market
clearing
price
D
C
E
Demand
0
Qd
Qequil
Qs
Quantity
(units)
Dead Weight Loss from a Price Floor
When at the market clearing point:
Consumer surplus = A + B + C
Producer surplus =
D+E
Economic Surplus = A + B + C + D + E
Lecture 3 ECON7000
51
Dead weight loss from Price Floor
When Government intervenes and sets price
above the market clearing price:
Consumer surplus = A
Producer surplus =
B +D
Economic Surplus = A + B + D
Lecture 3 ECON7000
52
Dead weight loss from Price Floor
Reduction in Total Surplus once government
intervenes is:
Total Surplus (before interv) = A+B+C+D+E
Total Surplus (after interv) = A +B + D
Loss of Economic Surplus = C + E
Dead weight loss = C + E
economic
inefficiency from government intervention.
Lecture 3 ECON7000
53
Conclusions.
 The interaction of supply and demand determines
market clearing price and quantity.
 a competitive market equilibrium exists when there
are many buyers and many sellers, who reach a price
and quantity for an exchange to take place, leaving
both parties happy.
 Governments can influence market equilibrium.
 Supply and demand model useful predictive tool to
assess changes in equilibrium prices and quantities.
Lecture 3 ECON7000
54
Next Lecture
 Lecture 4.
Demand and Supply (Part 2)
Lecture 3 ECON7000
55
ECON7000
Foundations in Microeconomics
LECTURE 4
Topic 2.
Demand and Supply (continued)
Last lecture feedback
Q1. Which of the following is false?
a. Demand is a relationship.
b. A price floor has the price set below the market clearing price.
c. An increase in price will see an increase in quantity supplied.
d. A decrease in price will see an increase in quantity demand.
2
Last lecture feedback
Which of following is not true of an equilibrium price?
a. Consumers who are willing to pay the equilibrium price can
acquire the good.
b. It measures the value of the last unit sold to consumers.
c. Firms who are willing to accept the equilibrium price can sell
what they produce.
d. It measures the cost of resources required to produce the last
unit.
e. It is always a fair and just price.
3
Plan of Lecture 4.
First half
1. Understanding shifts in demand and
supply.
Second half
2. Application of theory to actual markets.
Lecture 4 ECON7000
4
Two important concepts and the Terminology.
Firstly:
Understand:
“movement along the demand or supply curve ”.
An change in the price results in a change in the
quantity demanded (or supplied).
(with the “Ceteris paribus” assumption and “all else
being equal”)
Lecture 4 ECON7000
5
Effect of a Price Rise
4.5
4
Price ($/kg)
3.5
2
3
Move along the
Demand Curve
2.5
1
2
1.5
1
0.5
0
0
2
4
6
7
8
Quantity Demanded (kg)
10
Two important concepts and the Terminology
Secondly:
Understand “a shift in demand or a shift in supply”.
How does demand or supply change when something
other than the price changes?
Lecture 4 ECON7000
7
http://www.smh.com.au/opinion/political-news/big-tobacco-loses-high-courtbattle-over-plain-packaging-20120815
An “Increase” in Demand
Increase in demand
Price
($/can)
=
Right shift in demand
6
5
=
Positive movement in demand
4
3
2
D1
1
0
8
D2
16
Quantity
(‘000s of cans)
A “Decrease” in Demand
Price
($/can)
decrease in demand
=
left shift in demand
=
negative movement in demand
6
5
4
3
D1
2
D2
1
0
8
16
Quantity
(‘000s of cans)
Some factors causing a shift in demand
1. Change in consumer taste (or preference)
2. Change in population
3. Change in expectations of future price rises
Requires the assumption that price remains fixed and
some other factor changes so as to affect the quantity
demanded by the consumer
Lecture 4 ECON7000
11
Some factors causing a shift in demand
1. Change in consumer taste (or preference).
Example: Explain what happens to demand for gym
memberships when gym owners deliberately advertise
the “attractiveness” that comes with looking fit and healthy.
Price
Quantity
12
Some factors causing a shift in demand
2. Change in population.
Example: Explain what happens to the demand for
groceries in a small country town supermarket when
a sudden influx of city tourists arrive unexpectedly.
Price
Quantity
13
Some factors causing a shift in demand
3. Change in expectations of future prices.
Example: The price of oil surges on overseas oil
markets. Explain the effects on demand for
petrol in Australia.
Price
Quantity
14
Some more Economic Definitions.
Substitutes.
 A product or service that can be used in place of
other products or services. ie: used as replacements.
Example: LPG gas as a substitute for petrol.
Complements.
 Products or services that are consumed together.
Examples: computer ink and paper, Big Mac and
fries, beer and peanuts.
15
Some more economic definitions
Normal Goods (more preferred).
 As income increases, consumer demand
increases for the product or service. As income
decreases, consumer demand decreases for the
product or service.
Inferior goods (less preferred).
 As income decreases, consumer demand
increases for the product or service. As income
increases, consumers demand decreases for the
product or service.
16
Some other factors causing a shift in demand
4.
5.
6.
7.
Change price of a substitute
Change in price of a complement
Change in income (and the product is normal)
Change in income (and the product is inferior)
Requires the assumption price remains fixed and some
other factor changes to affect the quantity demanded by
the consumer.
Lecture 4 ECON7000
17
Some factors causing a shift in demand
4. Change in price of a substitute.
Example: Explain what happens to the demand
of Coke when the price of Pepsi goes up.
Price
Price
Quantity
Quantity
Some factors causing a shift in demand
5. Change in price of a complement.
Example: Explain what happens to the demand
for paper when computer ink price rises.
Price
Price
Quantity
Quantity
Some factors causing a shift in demand
6. Change in income (and the product is normal)
Example: Explain what happens to the demand
for prawns when a consumer’s income rises
(assuming prawns are a normal good).
Price
Quantity
20
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