Economics: Supply & Demand Curves, Equilibrium, and Market Interventions

Supply curve

positive relationship between quantity supplied and price

Demand curve

negative relationship between quantity demanded and price

Equilibrium point

intersection point of the supply curve and the demand curve (Only at EP does Qs = Qd)

Price too low

shortage (Qd > Qs)

Price too high

surplus (Qd < Qs)

Price

primary allocator of resources in a free market system. (invisible hand = Adam Smith)

Shortage exists

prices will rise towards equilibrium

Surplus exists

prices will fall towards equilibrium

Price ceiling

law that says the price is not allowed to go above a certain price. (rent controls, price gouging laws)

Price floors

Law that says the price is not allowed to go below a certain price. (daily price supports, minimum wage)

Demand increase

Demand curve shifts right, Price increases, Quantity increases

Demand Decrease

Demand curve shifts left, Price decreases, Quantity decreases

Supply Increase

Supply curve shifts right, Price decreases, Quantity increases

Supply Decrease

Supply curve shifts left, Price increases, Quantity decreases

Normative Economics

how things should be (opinions, values).

Positive Economics

how things are (facts, testable).

Cost-Benefit Analysis

Used by individuals, firms, and governments. Decision rule = Benefits - Costs.

Substitutes

Price of X ↑ → demand for Y ↑ (e.g., Coke & Pepsi).

Complements

Price of X ↑ → demand for Y ↓ (e.g., Coffee & Cream).

Normal Goods

Income ↑ → demand ↑ (e.g., vacations, restaurants).

Inferior Goods

Income ↑ → demand ↓ (e.g., ramen, cheap beer).

Network Effect

Demand rises as more people use it (e.g., social media, iPhones, colleges).

Exogenous Supply Shocks

Sudden events that decrease supply (e.g., storms destroying crops, war reducing oil supply).

Economics

the study of how society allocates scarce resources

Microeconomics

studies individual markets, firms, consumer

Macroeconomics

studies all markets together (the economy)

Scarcity

a limited amount of resources in society.

Opportunity cost

The cost of something is what you give up to get it. Opportunity cost is the value of the best foregone alternative.

You came to class today. What is your opportunity cost of coming to class

whatever you would be doing if you did not come to class

Specialization

when resources such as labor are devoted exclusively or overwhelmingly to a specific production task

Specialization Example

A tax accountant only does taxes. He doesn’t make his own milk from scratch. A dairy farmer makes milk. He doesn’t do his own taxes.

Trade

The foundation of all business activity. Part of everyday life.

Comparative Advantage

The ability of an individual, firm, or country to produce a good or service at a lower opportunity cost than another.

Absolute advantage

the ability to produce more of a good or service with the same amount of resources, or produce the same amount with fewer resources

Production Possibilities Curve

Illustration of the trade-off society faces from scarcity. (Production Possibilities Frontier)

Resources

Land, Labor, and Capital.

PPC shifting outwards

Good. (More output can be produced given the resources)

PPC shifting inwards

Bad. (pandemic, natural disaster)

Opportunity cost

Slope of PPC between 2 points

Ceteris Paribus

All Else Equal

Supply curve

= positive relationship between quantity supplied and price

Demand curve

= negative relationship between quantity demanded and price

Equilibrium point

= intersection point of the supply curve and the demand curve (Only at EP does Qs = Qd)

Price too low

= shortage (Qd > Qs)

Price too high

= surplus (Qd < Qs)

Price

= primary allocator of resources in a free market system. (invisible hand = Adam Smith)

Shortage exists

= prices will rise towards equilibrium

Surplus exists

= prices will fall towards equilibrium

Price ceiling

= law that says the price is not allowed to go above a certain price. (rent controls, price gouging laws) +(Government sets price ceiling = Qd > Qs = shortage)

Price floors

= Law that says the price is not allowed to go below a certain price. (daily price supports, minimum wage) (Government sets price floor = Qd < Qs = surplus)

Circumstances in which society may not want price to allocate resources

= (ex. Organ donations, ethical objections to “markets for everything”)

Demand increase =

1. Demand curve shifts right

2. Price increases 

3. Quantity increases

Demand Decrease

1. Demand curve shifts left 

2. Price decreases

3. Quantity decreases

Supply Increase =

1. Supply curve shifts right 

2. Price decreases 

3. Quantity increases

Supply Decrease =

1. Supply curve shifts left

2. Price increases

3. Quantity decreases

Elasticity

Measures the sensitivity of economic activity to some external factor

Price elasticity of demand

Measures the responsiveness of buyers to price changes (ex. If Netflix increased the price from $12.99 to $14.99, how many customers would cancel their subscription?)

Formula

%change in Quantity/% Change in Price ((NEW – OLD) / OLD)

Example = Suppose that a decline in the price of Good X from

$147 to $145 causes an increase in the quantity

demanded from 8,730 to 8,870.

8870 - 8730 / 8730 = 0.01604

145-147 / 147 = -0.0136

0.01604 DIVIDED BY -0.0136 = -1.179

Example #2 = Suppose that an increase in the price of Good Y from $1,050 to $1,080 causes a decrease in the quantity demanded from 204 to 200.

200 - 204 / 204 = -0.0196

1080 - 1050 / 1050 = 0.2857

-0.0196 DIVIDED BY 0.2857 = 0.0686

-0.686

Income Elasticity of Demand

measures how changes in consumer income affects the amount of a given product consumers will buy.

Positive Income elasticity of demand

normal good

Negative Income elasticity of demand

inferior good

Cross-price of elasticity of demand

metric for measuring how sensitive demand for a given product is to changes in the price of other products

Positive cross-price

2 goods are substitutes ( If the price of Pepsi increases (positive), then the demand for Coke will increase (positive).

Negative cross-price

2 goods are complements (If the price of French Fries increases (positive), then the demand for ketchup will decrease (negative).

Price Elasticity of Supply

Measures responsiveness of sellers to changes in price

Labor Supply Elasticity

Measures responsiveness of workers’ hours to changes in

Taxable Income Elasticity

Measures responsiveness of taxable income to changes in tax

Normative Question

How should government evaluate policy

Utilitarianism

One such political worldview is utilitarianism. Jeremy Bentham and John Stuart Mill. Add up all the benefits to everyone and the costs to everyone and choose the option that

Utilitarianism in Practice

For all of its flaws, a utilitarianist approach exists in many aspects of everyday life, including many laws and regulations. Examples: Traffic flow, stop lights, Covid lockdown restrictions, Decisions involving war (in some cases), and Monetary policy

Consumer Surplus

Equals consumer’s willingness to pay for the next unit of a product minus the price actually paid

Producer Surplus

Equals price seller receives for a product minus the lowest price the seller would accept for the next unit (opportunity cost of next unit)

Bob is selling a used car. He is willing to sell the car for as low as $11,200. Susie is willing to pay as much as $13,600 for Bob’s used car. Suppose they agree on a price of $12,000. Susie’s Consumer Surplus

Susie’s Consumer Surplus = 13600 – 12000 = 1,600

Bob’s Producer Surplus = 12000 – 11200 = 800

Consumer Surplus assumes

that the value of a product to consumers is how much buyers are willing (and able) to pay for it

Burden on Buyers

Lost CS from the tax

Burden on Sellers

Lost PS from the tax

Less flexible

less elastic

Criteria for Evaluating Tax Policy:

1.  Economic efficiency (lesser DWL the better)

2.  Distributional Effects (Vertical Equity)

3.  Horizontal Equity

4.  Simplicity in compliance and ease of administration

5.  Politically acceptable way of raising revenue

Firms take inputs

output

Inputs from workers (labor) and other businesses (raw materials and capital / financing)

Costs

Output is sold to consumers

Revenue

Profit

difference between revenue and costs

a firm’s objective

maximize economic profit

Accounting Profit formula

Revenue – Explicit Costs

Economic Profit formula

Revenue – Implicit Costs – Explicit Costs (Accounting Profit – Implicit Costs)

Explicit Costs

Opportunity costs that show up on a financial statement. Typically money exchanges hands. (Ex: Pizza place paying the bakery for dough.)

Implicit Costs

Opportunity costs of the owner’s capital and owner’s labor that do not show up on a financial statement and are somewhat hidden. (Ex: Amy takes $100,000 from her savings account and quits her job as a teacher to open a pizza place.)

Principal-Agent Problem

Sometimes, the agent (employee) does not do what is in the best interest of the principal (owner) of a firm. (Examples: Shirking, Doing personal business at work, Intentionally making decisions that benefit, the employee and not the firm)

Carrot vs. Stick

Stick – fire or demote bad employees Carrot - promote and increase pay for good Employees

Key Decisions for Firms

Must decide on how much output (Q) to produce. Must decide the method to produce the output. Must decide on product attributes. Must decide on any alternative pricing schemes

Marginal Revenue

Marginal Cost

MR

MC

MARGINAL in economics

“additional”

Marginal revenue

the additional revenue the firm gets from producing one additional unit of output

Marginal Cost

the additional cost incurred from producing one additional unit of output (the change in total cost from producing one more unit of output.)

If MR > MC, producing too little.

If you produce one more unit, the additional revenue you get would be greater than the additional cost you would incur

If MR < MC, producing too much.

If you produce one less unit, the reduction in cost would be greater than the reduction in revenue.

Capital-Intensive vs. Labor-Intensive

Both are substitutes/complements