Class 1 & 2 Notes: demand, supply, elasticity

Course Overview

  • Objectives: Understand economic language, logic, and concepts; "think like an economist" by considering incentives.
  • Main Topics: Supply & Demand; Elasticity & Welfare, Market Power & Pricing, Game Theory & Business Strategy, Economics of Information, Externalities & Environmental Economics.
  • Evaluation:
    • Group Presentation: 30\%
    • Quizzes: 40\% (5 quizzes: 10\%, 10\%, 8\%, 7\%, 5\%)
    • Final Exam: 50\%

Economic Models

  • Models are simplifications of reality, useful if they approximate well for their purpose.
  • The primary economic model introduced is Supply & Demand.

Demand

  • Demand Curve: Shows quantity demanded at each possible price (p), holding other factors constant.
  • Law of Demand: Quantity demanded rises as price falls; demand curves slope downward.
  • Movement along curve: Caused by a change in a good's own price.
  • Demand Function (e.g., coffee): Q = 8.5 - p + 0.5pt + 0.1Y (where pt is price of tea, Y is income).
  • Shifts in Demand: Caused by changes in income, prices of related goods (substitutes/complements), information, consumer tastes, or other factors.

Supply & Costs

  • Production: Firms combine inputs to produce output (Q). Production functions give rise to cost functions C(Q).
  • Cost Types:
    • Fixed Costs (FC): Do not vary with output.
    • Marginal Costs (MC): Incremental cost per additional unit (often increasing in industries).
    • Total Cost (TC): FC + VC. Variable Cost (VC): Sum of marginal costs.
    • Average Cost (AC): TC/Q.
  • Supply Curve: Shows quantity supplied at each price, holding other factors constant (e.g., Q_S = 9 + 0.5p).
  • Supply Curve Shifts: Caused by changes in input costs/availability, technology, etc.
  • Competitive Markets: Assumed for supply curves, characterized by many small buyers/sellers, identical products, full information, low transaction costs, free entry.

Market Equilibrium & Welfare

  • Equilibrium: Occurs when quantity supplied equals quantity demanded, where supply and demand curves intersect.
  • Shocks: Events that can shift supply or demand curves, impacting equilibrium price and quantity. Double shocks may have ambiguous effects on both without calculations.
  • Consumer Surplus (CS): Value consumers gain from buying a good below their willingness to pay.
  • Producer Surplus (PS): The area between the market price and the market supply curve (firm profits).
  • Total Surplus (TS): CS + PS. Maximized under perfect competition.
  • Deadweight Loss (DWL): Reduction in total surplus from inefficient market outcomes (e.g., output reduction below the competitive level).
  • Government Interventions: Policies like price ceilings (maximum prices) can lead to shortages. Other examples include taxes, subsidies, and quotas.

Elasticity

  • Definition: Measures the sensitivity of quantity demanded to price changes. (\varepsilon = (\%\Delta Q) / (\%\Delta p)).
  • Price Elasticity of Demand: Negative for downward-sloping demand curves.
  • Arc Elasticity (discrete changes): Calculated as \varepsilon = (\Delta Q / Q^) / (\Delta p / p^) using average (Q^, p^) values.
  • Point Elasticity (single point): For a linear demand curve Q = a - bp, it is \varepsilon = -b \cdot (p/Q).
  • Linear Demand Curve: Elasticity varies along the curve, increasing (in absolute value) as price rises.
  • Determinants: Primarily the substitutability of the product.
  • Impact: Affects the outcomes of supply shocks and taxes.