Topic 3 Circular Flow Diagram + Supply and Demand

the two economic agents in the circular flow diagram. what do they each do

households (individuals)

• own and provide factors of prod.

• buy goods and services

firms (businesses)

• use factors of production

• produce and sell goods and services

two types of markets in circular flow diagram

product market - goods and services are being sold by firms to households

factor market - factors of production are being sold by households to firms

basic asumptions for supply and demand model

many buyers and sellers

identical products

no barriers to entry

market clears (prices and quantity adjust in response to market forces)

• equillibriate at Q_demanded = Q_supplied

Demand vs Quantity demanded

Demand is an entire given relationship curve for how the demand of a product changes as its price changes.

Quantitiy demanded is the value of the function evaluated at a specific price

why does demand slope downard as price increases (2 effects)

substitution effect:

• you substitute for something that’s cheaper, but has the same function

income effect:

• as the price of something falls, your purchasing power rises.

• if the product is a normal good, greater purchasing power means you buy more

  • but if it’s an inferior good you buy less of it

normal vs inferior good

normal goods increase in QD as price goes down ( or purchasing power or income goes up).

inferior goods do not necessarily drive more QD as purchasing power goes up. this is because as people get more purchasing power they may start buying the not inferior version of the good.

what is a move vs shift

move is when the goods own price changes, and you simply shift to another spot on the existing curve, QD changes.

shift is when you shift the curve. called change in demand

6 demand shifters and their typical effect

income - depeds on normal vs inferior

price of related goods - depends on substitute vs complement

tastes/preferences - more favorable causes greater demand

number of buyers/population - more buyers increases demand

expectations - depends on expected future conditions. if price is expected to go up, demand may go up right now.

taxes - can effect demand. (transaction cost)

substittute vs complements and how pricing/demand affects each other

substitutes are goods bought in replace of one another, coke and pepsi. price of one and demand for the other move together

complements are goods that are usually bought together like PB and jelly. Demands and prices move together

supply shifters

input costs

technology (makes it easier to produce supply)

prices of related goods (higher price of alternative output can reduce supply, OC)

number of firms (more firms, more supply)

expectations (if they expect a product price to be higher next month, may hold on to product for now to save for later higher demand, so lower supply rn)

taxes/subsidies (taxes reduce, subsidies increase)

market equilibrium

price st. QD = QS

shortage

QD>QS

aka excess demand

occurs when prices are below equil.

puts upward pressure on price, move towards equil.

Surplus

QS>QD

excess supply

when prices are greater than equil.

puts downward pressure on price, move towards equil.

how do shifts in demand and supply affect the equil. point (price and quantitiy)

if demand increases, equil price demand up, quantitiy up

if supply increases, equil. price down, quantitiy up.

for demand shifts, price and q move together

for supply shifts, price and q move opposite

if both happen at once, add the effects

note that a right shift, regardless of supply or demand, is always associate dwith an increase. this is mainteind by flipping the direction of the y axis. or x axis.

how to calc. equil. algebraically

set QD = QS