Economics 1010 - Chapters 3&4

What we consider the influence of one variable at a time by deductive reasoning

• Holding all other variables constant.

• Other things being equal.

• Other things given.

• Ceteris paribus.

In this way, we can come to understand the importance of each variable.

Quantity Demanded

The amount of a good or service that consumers want to purchase during some time period. A desired quantity. Flow of purchases per period of time. If sufficient quantities are not available, the amount consumers want to purchase may exceed the amount they actually purchase.

The total amount of some product that consumers in the relevant market want to buy during a given time period is influenced by 6 important variables

1. Product's own price.

2. Consumer's income.

3. Prices of other products.

4. Consumers' preferences (or "tastes").

5. Population.

6. Significant changes in weather.

Law of Demand

A basic economic hypothesis is that the price of a product and the quantity demanded are related negatively, other things being equal. That is, the lower the price, the higher the quantity demanded; the higher the price, the lower the quantity demanded.

Two related approaches for representing the law of demand

1. Demand schedule.

2. Demand curve.

Demand Schedule

A table showing the relationship between quantity demanded and the price of a product, other things being equal.

Demand Curve

The graphical representation of the relationship between quantity demanded and the price of a product, other things being equal.

Demand

The entire relationship between the quantity of a product that buyers want to purchase and the price of that product, other things being equal.

Consumers' Income

• If average income rises, how will demand change?

• For most normal goods, we expect: Afford more → buy more → Increase in demand.

• However, for some products that are inferior to others, we expect: Afford more → buy less → Decrease in demand.

Normal Goods

Goods for which the quantity demanded increases when income rises.

Inferior Goods

Goods for which quantity demanded falls when income rises.

Prices of other goods

• If products complement one another (i.e., bought together), we expect:
  Increase in other price → desire less of both products → Decrease in demand.

• However, if products substitute for each other, we expect:
  Increase in other price → desire more of relatively cheaper product → Increase in demand.

Complements in Consumption

Goods that tend to be consumed together.

Substitutes in Consumption

Goods that can be consumed in place of another good to satisfy similar needs or desires.

Consumers' Preferences.

• Preferences (or "tastes") is a catch-all term for referring to specific wants, likes, and dislikes that determine purchasing decisions. We expect: Increase in preference for a product → Increase in demand.

Population.

• Increases in population → Increase in demand for products purchased by/for new people.

Significant Changes in Weather

• Demands for some products are affected by dramatic weather events.

• E.g., cold winters → Increase in demand of electricity for heating.

Quantity Supplied

The amount of a good or service that producers want to sell during some time period.

• A flow variable, representing a quantity per unit of time.

• It is the amount that producers are willing to offer for sale at a given price, not necessarily the amount they succeed in selling.

Law of Supply

A basic economic hypothesis is that the price of the product and the quantity supplied are related positively, other things being equal. That is, the higher the product's own price, the more its producers will supply; the lower the price, the less its producers will supply.

• As price rises, producing and selling this product becomes more profitable.

• Firms interested in increasing profit will increase supply.

Two related approaches for representing the law of supply

1. Supply schedule.

2. Supply curve.

Supply Schedule

A table showing the relationship between quantity supplied and the price of a product, other things being equal.

Supply Curve

The graphical representation of the relationship between quantity supplied and the price of a product, other things being equal.

There are many factors that cause the supply curve to shift. We now consider six common factors:

1. Price of inputs.

2. Technology.

3. Government taxes or subsidies.

4. Prices of other products.

5. Significant changes in weather.

6. Number of suppliers.

Price of Inputs

Other things being equal, the higher the price of any input, the less profit there will be and the less the firm will produce. We expect:

Increase in input prices → Decrease in supply.

Technology

An innovation that decreases inputs needed per unit of output reduces production costs and increases profits. We expect:

Increase in technological progress → Increase in supply.

Government Taxes or Subsidies.

Governments often levy special "excise" taxes on production of specific goods, which raise costs and decrease profits. We expect:

Increase in taxes → Decrease in supply.

Price of Other Products

Changes in price of one product may affect supply of some other product.

• E.g., Decrease in price of oats → farmers increase in supply of wheat.

• E.g., If the market price of oil increases, producers will drill more oil wells but this also leads to more discoveries of natural gas.

Significant Changes in Weather

• Especially in agriculture, weather has a significant effect on supply.

• Dramatic weather events can also reduce supply in industrial sectors by causing massive damage to industrial production facilities.

Number of Suppliers

If profits are being earned by current firms, then more firms will choose to enter and begin producing, leading to increase in supply across the industry.

The demand-and-supply model makes three important assumptions

1. There is a large number of consumers of the product, each of whom is small relative to the size of the market.

2. There is a large number of producers of the product, each of which is small relative to the size of the market.

3. Producers sell identical (or "homogeneous") versions of the product.

   Put differently, no person or firm has market power.

Market

Any situation in which buyers and sellers can negotiate the exchange of goods or services.

Excess Demand

A situation in which, at the given price, quantity demanded exceeds quantity supplied.

Excess Supply

A situation in which, at the given price, quantity supplied exceeds quantity demanded.

The Equilibrium Price or the Market-Clearing Price

The price at which the quantity demanded equals the quantity supplied.

Disequilibrium Price

Any price at which the market does not "clear" —that is, quantity demanded does not equal quantity supplied.

There are four possible curve shifts:

• Increase in demand.

• Decrease in demand.

• Increase in supply.

• Decrease in supply.

Endogenous Variable

A variable that is explained within a theory. Sometimes called an induced variable or a dependent variable.

Exogenous Variable

A variable that is determined outside the theory. Sometimes called an autonomous variable or an independent variable.

Comparative Statics

The derivation of predictions by analyzing the effect of a change in a single exogenous variable on the equilibrium.

There is a decrease in the supply of some product

• Supply curve contracts (shifts left).

• Increase in production and decrease in quantity.

Price Elasticity of Demand 

• Elastic when quantity demanded is very responsive to price changes.

• Inelastic when quantity demanded is relatively unresponsive to price changes.

Vertical Demand (e.g., public utilities, life-saving medication)

• Consumers buy the same quantity regardless of the price.

• np = 0.

Horizontal Demand (e.g., demand faced by a single firm)

• Consumers buy unlimited amount at market price but nothing if price increased (i.e., buy from competitor instead).

• np undefined.

Elasticity of demand is mostly determined by

1. Importance in consumers' budgets ("income").

2. Availability of substitutes ("other products").

3. Time period.

Importance in Consumer Budgets

• If the price of a product increases, will consumers

  • Buy a lot less or keep buying almost as much.

• To some extent, the answer depends on how much expenditure the product represents out of a consumer's total budget:

  • Small % of total budget → inelastic demand.

  • Large % of total budget → elastic demand. 

Availability of Substitutes

• If the price of a product increases, will consumers

  • Buy a lot less or keep buying almost as much. 

• To some extent, the answer depends on if there are close substitutes:

  • Close substitutes (e.g., Coke vs. Pepsi) → elastic demand.

  • No close substitutes (e.g., electricity) → inelastic demand.

Time Peroid 

• For products that take time to adopt, demand is inelastic in the short run and elastic in the long run.

• E.g., consider the market for solar panels.

Elasticity of supply is mostly determined by

1. Ease of substitution.

2. Time Peroid.

Ease of Substitution

• If the price of a product increases, will producers

  • Produce a lot more or Keep producing almost as much. 

• To some extent, the answer depends on how easy it is to expand production:

  • If producers can easily reallocate production from one good to another (e.g., wheat vs. canola) → elastic supply.

  • Products not easily produced (e.g., helium) → inelastic supply.

  • For products that take time to develop, supply is inelastic in the short run and elastic in the long run.

  • E.g., consider the market for crude oil. 

Tax Incidence

The location of the burden of a tax—that is, the identity of the ultimate bearer of the tax. Typically shared between consumers and producers.

Taxation on demand and supply

• If demand is inelastic, consumers bear the burden of the tax.

• If supply is inelastic, producers bear the burden of the tax.

How quantity demanded responds to changes in two other determinants of demand

1. Consumers' incomes.

2. Prices of other products.

Normal Goods

A good for which quantity demanded rises as income rises— its income elasticity is positive.

Normal Goods on Elasticity

• A normal good may be income inelastic, 0 < ny < 1.

  • Quantity demanded does not change very much when income changes.

  • Typically occurs for necessities (e.g., bread, cereals, vegetables).

• A normal good may be income elastic, ny > 1.

  • Quantity demanded changes a lot when income changes.

  • Typically occurs for luxuries (e.g., prepared meals, artisanal cheeses, wine).

Inferior Good

A good for which quantity demanded falls as income rises-its income elasticity is negative. Occurs when consumers substitute away from one good towards another.

The sign of the cross elasticity informs whether goods X and Y are

1. Substitutes.

2. Complements.

Cross Elasticity 

• Goods X and Y are substitutes if nxy > 0.

  • Price of Y increases → Consumers switch to buying more of X.

  • X was substituted for the more expensive Y.

  • E.g., hamburgers vs. hot dogs.

• Goods X and Y are complements if xy < 0.

  • Price of Y increases → Consumers also stop buying as much of X.

  • X was a complement of the purchase of Y.

  • E.g., hamburgers and hamburger buns.