second edition chapter 3 supply and demand. introduction most important tools in economics: supply...
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Second Edition
Chapter 3 Chapter 3 Supply and DemandSupply and Demand
IntroductionIntroduction
Most important tools in economics: • Supply • Demand• Equilibrium
Oil market: arguably the most important market in the world.
We will learn to use these tools in the context of the oil market.
2
The Demand Curve for OilThe Demand Curve for Oil
Demand curve – a function that shows the quantity demanded at different prices.
Quantity demanded – the quantity that buyers are willing and able to buy at a particular price.
Let’s look at a hypothetical demand curve for oil.
3
The Demand Curve for OilThe Demand Curve for Oil
Quantity of Oil(MBD)
Price of oil/barrel
Demand
0 5 25 50
PricePrice Quantity Quantity DemandedDemanded
$40 5
$20 25
$5 50
$20
$5
$40
4
The Demand Curve for OilThe Demand Curve for Oil
Quantity of Oil(MBD)
Price of oil/barrel
Demand
0 5 25 50
$20
$5
$40
Demand Curves are read two ways:
1.Horizontally – At a given price how much are people willing to buy?
2.Vertically – What are people willing to pay for a given quantity?
5
Why Is the Demand Curve Downward Why Is the Demand Curve Downward Sloping?Sloping?
Oil is not equally valuable in all its uses.• If the price of oil is high, it is used in only
higher valued uses. Air Force One Commuting
• If the price of oil is low, it can be used also in lower valued uses. Manufacture “rubber duckies” Sight seeing
6
Why Is the Demand Curve Downward Why Is the Demand Curve Downward Sloping?Sloping?
Quantity of Oil(MBD)
Price of oil/barrel
Demand
0 5 25 50
$20
$5
$40
Higher valued uses
Lower valued uses
Law of Demand: ↑ price → ↓ quantity demanded 7
Consumer SurplusConsumer Surplus
Consumer surplus• The consumer’s gains from exchange, or,…• The difference between the maximum price
the consumer is willing to pay and the market price.
Total consumer surplus• Measured by the area below the demand
curve and above the market price.
Let’s use the demand curve for oil to show these concepts.
8
Consumer SurplusConsumer Surplus
Quantity of Oil(MBD)
Price of oil/barrel
Demand
0 30 60 120
$60
$40
$80
$20
Suppose the market price = $20
90 150
President’s consumer surplus
Delta Airlines consumer surplus
Frank’s (retiree) consumer surplusTotal Consumer Surplus
If the demand curve is linear, measuring consumer surplus is easy.9
Consumer SurplusConsumer Surplus
Quantity of Oil(MBD)
Price of oil/barrel
Demand
0 30 60 120
$60
$40
$80
$20
Suppose the market price = $20
90 150
President’s consumer surplus
Delta Airlines consumer surplus
Frank’s (retiree) consumer surplusTotal Consumer Surplus
If the demand curve is linear, measuring consumer surplus is easy.10
Consumer SurplusConsumer Surplus
Quantity of Oil(MBD)
Price of oil/barrel
Demand
0 30 60 120
$60
$40
$80
$20
90 150
11
Try it!Try it!
Your roommate just bought an iPad for $600. She would have been willing to pay $1,000 for a machine that could make her life so much more worthwhile. How much consumer surplus does your roommate enjoy from the iPad?a)$600b)$400c)$1600d)$1400 To next To next
Try it! Try it!
Try it!Try it!
If the price is $2010, what is the consumer surplus?a)$3,588,000b)$1,794,000c)$6,000,000d)$3,000,000
To next To next Try it! Try it!
What Shifts the Demand Curve?What Shifts the Demand Curve?
Increase in demand - shifts the demand curve to the right.• At the same price people are willing to buy more.
• At the same quantity, people are willing to pay a higher price.
Decrease in demand – shifts the demand curve to the left.• At the same price people are willing to buy less.
• At the same quantity, people are willing to pay a lower price.
Both of these can be shown in the following diagrams.14
Shifting the Demand CurveShifting the Demand Curve
Quantity of Oil(MBD)
Price of oil/barrel
Old Demand
0 70 140
$50
$25
An Increase in Demand
New Demand
Willing to pay a higher price for same quantity.
Willing to buy more at the same price.
15
Shifting the Demand CurveShifting the Demand Curve
Quantity of Oil(MBD)
Price of oil/barrel
Old Demand
0 74
$20
$40
An Decrease in Demand
New Demand
Willing to buy less at the same price.
Willing to pay a lower price for the same quantity
62
16
What Shifts the Demand Curve?What Shifts the Demand Curve?
Important Demand Shifters1. Income
Normal goods Inferior goods
2. Population
3. Price of substitutes
4. Price of complements
5. Expectations
6. Tastes
Let’s look at each of these in turn.17
Demand Shifter: IncomeDemand Shifter: Income
Normal good – demand ↑ when income ↑• Example: As income increases in India, many
people will buy their first car. This increases the demand for oil.
Inferior good – demand ↓ when income ↑• Example: As college students graduate, and
their incomes increase they eat less ramen noodles.
Let’s illustrate each of these with the demand curve.
18
Demand Shifter: PopulationDemand Shifter: Population
Increase in population → ↑ number of consumers → ↑ demand.
Demographic changes – some subpopulations increase faster than others.• Examples
The average age gets older. (e.g. the U.S.) The average age gets younger. (many developing
countries)
• Result: as average income grows, the demand for some categories of goods increases faster.
19
Demand Shifter: Price of SubstitutesDemand Shifter: Price of Substitutes
Substitute goods – those than can be used as alternatives for the other.
Decrease in the price of a substitute → ↓demand for a good.• Examples:
↓ price of natural gas → ↓ demand for petroleum. ↓ price of coffee → ↓ demand for tea. ↓ price of Toyota cars → ↓ demand for Ford cars.
20
Demand Shifter: Price ComplementsDemand Shifter: Price Complements
Complements – goods that are used together
Decrease in the price of a complement → ↑demand for a good.• Examples:
↓ price of computer software → ↑ demand for computers.
↓ price of cars → ↑ demand for gasoline. ↓ price of hamburger → ↑ demand for hamburger
buns.
21
Try it!Try it!
When the price of petroleum goes up, the demand for natural gas ______, the demand for coal ______, and the demand for solar power ______.a)increases; increases; increasesb)increases; increases; decreasesc)decreases; decreases; increasesd)decreases; decreases; decreasesTo next To next
Try it! Try it!
Demand Shifter: ExpectationsDemand Shifter: Expectations
Expectation of the future price of a good will shift the demand curve for that good.• Expected higher price → ↑ demand.• Expected lower price → ↓ demand.
Examples:• Trouble in the Middle East → higher expected
price of oil → ↑ current demand for oil.• News of a spring freeze in Florida → higher
expected price of oranges → ↑ current demand for oranges.
23
Demand Shifter: TastesDemand Shifter: Tastes
Changes in tastes shift demand curves all of the time.• Examples
Fad diets that advocate eating mostly protein → ↑ demand for beef.
People desire to have a lower “carbon footprint” → ↑ demand for hybrid cars.
Social stigma for wearing real animal fur → ↓ demand for fur coats.
24
What Shifts the Demand Curve? What Shifts the Demand Curve?
A “change in quantity demanded” is NOT the same as a “change in demand.”• “Quantity demanded” changes only when the
price of a good changes. It is a movement along a fixed demand curve.
• “Demand” changes only when a non-price factor (demand shifter) changes. It is a shift in the entire demand curve.
A “change in Quantity Demanded”A “change in Quantity Demanded”
A “change in Demand”A “change in Demand”
Try it!Try it!
When the price of a good increases the quantity demanded ______. When the price of a good decreases the quantity demanded ______. a)rises; risesb)rises; fallsc)falls; risesd)falls; falls
To next To next Try it! Try it!
The Supply Curve for OilThe Supply Curve for Oil
Supply curve – a function that shows the quantity supplied at different prices.
Quantity Supplied – the amount of a good that sellers are willing and able to sell at a particular price.
The next diagram shows a hypothetical supply curve.
27
The Supply Curve for OilThe Supply Curve for Oil
Quantity of Oil(MBD)
Price of oil/barrel
0 10 44
$20
$5
$40
Supply
30
PricePrice Quantity Quantity SuppliedSupplied
$40 44
$20 30
$5 10
28
The Supply Curve for OilThe Supply Curve for Oil
Quantity of Oil(MBD)
Price of oil/barrel
0 10 44
$20
$5
$40
Supply
30
Supply Curves are read two ways:
1.Horizontally – At a given price, quantity sellers are willing to sell.
2.Vertically – Minimum price that sellers must get to produce a given quantity.
29
Supply CurvesSupply Curves
Why is the supply curve upward sloping?• The cost of producing a good is not
equal across all suppliers.At a low price, a good is produced and
sold only by the lowest cost suppliers.At a high price, a good is also
produced and sold by higher cost suppliers.
30
The Supply Curve for OilThe Supply Curve for Oil
Why is the supply curve for oil upward sloping?• Not all oil costs the same to lift to the surface.
Saudi Arabia - $2.00 per barrel Iran & Iraq - $2.00 plus a bit more Nigeria and Russia - $5 to $7 per barrel Alaska - $10 per barrel North Sea - $12 per barrel. Canada’s tar sands - $22.50 per barrel U.S. - $27.50 per barrel Oklahoma oil shale - $40
Let’s see what this looks like in a supply curve.31
Higher-cost oil
Why Is the Supply Curve for Oil Upward Why Is the Supply Curve for Oil Upward Sloping?Sloping?
Quantity of Oil(MBD)
Price of oil/barrel
0 20 8060 100400
20
40
$60
Lowest-cost oil
Oil shale becomesprofitable here
Supply
●
●
Law of Supply: ↑ price → ↑ quantity supplied32
Producer SurplusProducer Surplus
Producer surplus• The producer’s gain from exchange• The difference between the minimum price
the seller is willing to accept and the market price.
Total producer surplus• Measured by the area above the supply curve
and below the market price.
Let’s use the supply curve for oil to show these concepts.
33
Producer SurplusProducer Surplus
Quantity of Oil(MBD)
Price of oil/barrel
0 20 8060 100400
20
40
$60Supply
Total producer surplusat a price of $40
34
Try it!Try it!
Using the following diagram, calculate total producer surplus if the price of oil is $50 per barrel. a)0b)$45c)$1,350d)$2,700
To next To next Try it! Try it!
What Shifts the Supply Curve?What Shifts the Supply Curve?
Increase in Supply - shifts the supply curve to the right.• At the same price producers are willing to sell
more.• At the same quantity, producers are willing to
accept a lower price Decrease in supply – shifts the supply curve
to the left.• At the same price sellers will offer less.• At the same quantity, sellers demand a higher
price.Both of these can be shown in the following diagrams.
36
What Shifts the Supply Curve?What Shifts the Supply Curve?
Quantity of Oil(MBD)
Price of oil/barrelOld supply
Increase in supply
0
20
40
$60
0 20 8060 10040
New supply
Greater quantity supplied at the same price
Willing to accept a lower price for the same quantity
18
37
What Shifts the Supply Curve?What Shifts the Supply Curve?
Quantity of Oil(MBD)
Price of oil/barrel Old supply
Decrease in supply
0
20
40
$60
0 20 8060 10040
New supply
Smaller quantity supplied at the same price
Higher price required for the same quantity28
38
What Shifts the Supply Curve?What Shifts the Supply Curve?
General rule: Cost changes shift the supply curve
• ↑ cost → supply curve shifts left (higher P)• ↓ cost → supply curve shifts right (lower P)
Important Supply Shifters1. Technological innovations and changes in the
prices of inputs2. Taxes and subsidies3. Expectations4. Entry and exit from the industry5. Changes in opportunity costs
Let’s look at these supply shifters in turn.39
Supply Shifter: Technological Innovations Supply Shifter: Technological Innovations and Changes in Price of Inputsand Changes in Price of Inputs
Improvement in technology• Results in lower cost to produce the same output.
Example: sidewise drilling.
Changes in prices of inputs• Increased labor costs
Higher wages Higher payroll taxes Higher cost of mandatory health insurance.
• Increased capital and materials costs Higher interest rates Higher energy costs
40
Supply Shifter: Taxes and SubsidiesSupply Shifter: Taxes and Subsidies
Taxes on commodities and services• Higher tax is considered an increase in cost.
Subsidy• Same as a negative tax• Considered a decrease in cost
It is easier to see this if we use a diagram.
41
Effect of a Tax on the Supply Curve of OilEffect of a Tax on the Supply Curve of Oil
Quantity of Oil(MBD)
Price of oil/barrelNew supply
Tax = $10/barrel
0
40
$50
0 20 8060 10040
Old supply
=
$10
Sellers require a $10higher price to sell thesame quantity
Note: A subsidy of $10 per barrel would shift the supply curve down.42
Taxes and SubsidiesTaxes and Subsidies
Taxes and subsidies affect profits and therefore supply.
A 10% yacht tax reduced the supply of yachts 53% in the early 1990s.43
Supply Shifter: ExpectationsSupply Shifter: Expectations
What sellers think the price of their product will be in the future can have a dramatic effect on current supply.• Examples
War in Middle East → ↑ expected prices of oil. Frost in Florida → ↑ expected price of orange juice. Favorable rains in mid-west →↓ expected price of wheat
Higher expected prices → Decreased supply Lower expected prices → Increased supply
44
Supply Shifter: ExpectationsSupply Shifter: Expectations
Higher expected future prices
Quantity of Oil(MBD)
Price of oil/barrel Supply today with higher expected future price
Supply today
40
$50
6040
Lower quantity at the same price
Into storage
45
Supply Shifter: Entry or Exit of ProducersSupply Shifter: Entry or Exit of Producers
This one’s easy: ↑ producers → increase supply• NAFTA resulted in Canadian firms entering the
U.S. lumber market• When patents expire more firms enter an
industry
Net entry into a market → Increased supply Net exit from a market → Decreased supply
Let’s look at each of the examples in turn.
46
Supply Shifter: Entry or Exit of ProducersSupply Shifter: Entry or Exit of Producers
47
Domestic Supply
Domestic Supply Plus Canadian Imports
Price
Quantity
Entry Increases Supply
Greater Quantity Supplied at the Same Price
Lower Price for the Same Quantity Supplied
Supply Shifter: Entry or Exit of ProducersSupply Shifter: Entry or Exit of Producers
Patent On a Medicine Expires
Quantity of Doses(millions)
Price/dose
New supply
Old supply
1.50
$2.75
40 60
Higher quantity at the same price
Entry
//
Supply Shifter: Opportunity CostsSupply Shifter: Opportunity Costs
Opportunity cost applied to supply• Suppose producers can produce alternative
products ↑ price of the alternative → ↑ opportunity cost of
producing the good. Example
• A farmer producing soybeans could also grow wheat.• An increase in the price of wheat → ↑opportunity cost of
soy beans
• ↑ opportunity cost → ↓ supply
Supply Shifter: Opportunity CostsSupply Shifter: Opportunity Costs
Effect of an increase in the price of wheat
Quantity of soybeans(millions of bushels)
Price of soybeans/bushel
Supply with low opportunity costs
Supply with higher opportunity costs
5
$7
2,000 2,800
Lower quantity at the same price
//
Higher pricerequired to sell the same quantity
Try it!Try it!
BACK TO
• Technological innovations in chip making have driven down the costs of producing computers. What happens to the supply curve for computers? Why?
Try it!Try it!
BACK TO
• The U.S. subsidizes making ethanol as a fuel made from corn. What effect does this subsidy have on the supply curve for ethanol?
TakeawayTakeaway
A demand curve shows the quantity demanded at different prices.
A supply curve shows the quantity supplied at different prices.
You should be able to define and show how consumer surplus and producer surplus are measured.
You should know what shifts the demand and supply curves and which direction.
Second Edition
End of Chapter 3End of Chapter 3
Second Edition
Chapter 4 Chapter 4 Equilibrium: How SupplyEquilibrium: How Supply
and Demandand Demand
Determine PricesDetermine Prices
Chapter OutlineChapter Outline
Equilibrium and the adjustment process Gains from trade are maximized at the
equilibrium price and quantity Does the model work? Evidence from the
laboratory X Shifting demand and supply curves Terminology: Demand compared to quantity
demanded and supply compared to quantity supplied
Understanding the price of oil56
Equilibrium and the Adjustment ProcessEquilibrium and the Adjustment Process
Definitions• Surplus – situation in which quantity supplied
is greater than quantity demanded Sellers will offer lower prices
• Shortage – situation in which quantity demanded is greater than quantity supplied Buyers will offer higher prices
• Equilibrium price – price at which quantity demanded equals quantity supplied
57
Market EquilibriumMarket Equilibrium
There is ONLY ONE PRICE where Qs = QdThis is “equilibrium price and “equilibrium price and quantity”quantity”
• No shortages• No surpluses
FREE MARKETS ALWAYS MOVE TOWARD EQUILIBRIUM PRICE
Equilibrium and the Adjustment ProcessEquilibrium and the Adjustment Process
65
$30Equilibrium Price
Equilibrium Quantity
Quantity of Oil (MBD)
Price of Oil per Barrel
Price is Determined by Supply and Demand
Supply Curve
Demand Curve
Equilibrium and the Adjustment ProcessEquilibrium and the Adjustment Process
Price of Oil per barrel
Quantity of Oil(MBD)
Supply
Demand
70
$70Equilibriumprice
Equilibrium quantity
P = $80 → surplus
$80
50//
90
Price is driven ↓
60
Equilibrium and the Adjustment ProcessEquilibrium and the Adjustment Process
Price of Oil per barrel
Quantity of Oil(MBD)
Supply
Demand
70
$70Equilibriumprice
Equilibrium quantity
P = $50 → shortage
$50
50//
90
=
Price is driven ↑
61
Try it!Try it!At a price of $3, quantity supplied is ______ and quantity demanded is ______, leading to a _______.a) 6; 2; surplus of 4 unitsb) 2; 4; surplus of 2 unitsc) 2; 6; shortage of 8 unitsd) 4; 2; shortage of 2 units
To next To next Try it! Try it!
Gains from Trade are Maximized at the Gains from Trade are Maximized at the Equilibrium Price and QuantityEquilibrium Price and Quantity
What this means1. The supply of goods is bought by buyers with
the highest willingness to pay.
2. The supply of goods are sold by the buyers with the lowest costs.
3. Between buyers and sellers, there are no unexploited gains from trade or any wasteful trades.
Let’s us the market model to show this.
63
Unexploited Gains From TradeUnexploited Gains From TradePrice of Oil per barrel
Quantity of Oil(MBD)
Supply
Demand
70
70Equilibriumprice
Equilibrium quantity
50
50//
90
=
$90
Suppose quantity is50: less than the
equilibrium quantity
At Q = 50:•Willingness to pay equals P = $90•Willingness to sell equals P = $50
Unexploited Gaines from trade
64
Unexploited Gains From TradeUnexploited Gains From TradePrice of Oil per barrel
Quantity of Oil(MBD)
Supply
Demand
70
70Equilibriumprice
Equilibrium quantity
50
90//
50
=
$90
Suppose quantity is90: greater than the equilibrium quantity
At Q = 90:•Willingness to sell at P = $90•Willingness to pay at P = $50
Unexploited Gaines from trade
65
Free Market Maximized Gaines From TradeFree Market Maximized Gaines From Trade
Price of Oil per barrel
Quantity of Oil(MBD)
Supply
Demand
70
70Equilibriumprice
Equilibrium quantity
50
90//
50
=
$90
Suppose quantity isEqual to the
equilibrium quantityAt Q = 70:
• Qd = Qs At P = $70• Pbuyers willing to pay =
Psellers willing to accept
Conclusion: No unexploited gains from trade
66
Gains from Trade Are Maximized at Equilibrium Gains from Trade Are Maximized at Equilibrium Price and QuantityPrice and Quantity
Sellers
Consumer Surplus
Producer Surplus
Non-Buyers
Non-SellersBuyers
Quantity of Oil (MBD)
Price of Oil per Barrel
A Free Market Maximizes Producer plus Consumer Surplus (the gains from trade)
Demand Curve
Supply Curve
$30
65Equilibrium Quantity
Equilibrium Price
Equilibrium and Total SurplusEquilibrium and Total Surplus
Equilibrium in a free market yields two important results:
• Goods must be produced at the lowest possible cost.
• Goods must satisfy the highest valued demands.
These results indicate that total surplus total surplus (both of the consumer and producer) is (both of the consumer and producer) is maximized in free markets. maximized in free markets.
Shifting Demand and Supply CurvesShifting Demand and Supply Curves
Another way to test the model is to examine its predictions about what happens when the demand and supply curves shift.
Key to learning• Do: Focus on how to use the model• Do not: try to memorize results of every
possible scenario• Do: memorize the shifters
Let’s take the model for a few “test drives”.
69
Shifting Demand and Supply Curves: Shifting Demand and Supply Curves: Market for LaptopsMarket for Laptops
Effect of ↓P of computer chips
Quantity of laptops
New Supply
Demand
Qb
Pb
//=
a
Price of laptops
↓price of chips → ↓ cost of laptops
Original Supply
bPa
Qa70
Shifting Demand and Supply Curves: Shifting Demand and Supply Curves: Market for SoftwareMarket for Software
Effect of ↓P of laptops
Quantity of software
New Demand
Qb
Pb
//=
a
Price of software
↓price of laptops → ↑ demand for software
Original Supply
b
Pa
Qa
Original demand
71
Shifting Supply and Demand Curves: Shifting Supply and Demand Curves: Higher Expected PricesHigher Expected Prices
Expectations about future prices affect us often.• Let’s look at the effect of a hurricane
approaching the Gulf states• Many oil refineries located in these states are
often shut down during hurricanes.• Electrical service is often interrupted for days if
not weeks.• What happens to the prices of some goods
before the hurricane arrives?
72
Shifting Demand and Supply Curves: Shifting Demand and Supply Curves: Market for GasolineMarket for Gasoline
Effect of higher expected prices
Quantity of gasoline
New Demand
Qb
Pb
//=
a
Price of gasoline
Approaching hurricane → ↑ expected future price.
Original Supply
b
Pa
Qa
Original demand
73
Shifting Demand and Supply Curves: Shifting Demand and Supply Curves: Market for GeneratorsMarket for Generators
Effect of higher expected prices
Quantity of generators
New Demand
Qb
Pb
//=
a
Price of generators
Approaching hurricane → ↑ expected future price.
Original Supply
b
Pa
Qa
Original demand
74
Try it!Try it!
To next To next Try it! Try it!
Flooding in Iowa destroys some of the corn and soybean crop. What will happen to the price and quantity for each of these crops?
Try it!Try it!
To next To next Try it! Try it!
With the increase in gasoline prices, demand has shifted away from large cars and SUVs and toward hybrid cars like the Prius. Draw a graph showing the supply and demand for hybrid cars before and after the increase in the price of gasoline. What do you predict will happen to the price of hybrids as the price of gasoline rises?
Terminology: Demand Compared to Terminology: Demand Compared to Quantity DemandedQuantity Demanded
Change in demand• Refers to a shift in the demand curve• Caused by a change in one of the shifters of
the demand curve
Change in quantity demanded• Refers to a movement along the same
demand curve• Caused by a change in the price
This can be illustrated with our model.77
Terminology: Demand Compared to Terminology: Demand Compared to Quantity DemandedQuantity Demanded
P P
D
D2
S2
S
PE2
D1
PE1
Change in quantity demanded
QE2QE1
S1
PE1
PE2
QE1 QE2
Change in demand
Note: the change in quantity demanded results from a change in supply.
78
Terminology: Supply Compared to Quantity Terminology: Supply Compared to Quantity SuppliedSupplied
Change in supply• Refers to a shift in the supply curve• Caused by a change in one of the shifters of
the supply curve
Change in quantity supplied• Refers to a movement along the same supply
curve• Caused by a change in the price
79
Terminology: Supply Compared to Quantity Terminology: Supply Compared to Quantity SuppliedSupplied
P
D2
S
D1
Q
PE1
PE2
QE1 QE2
Change in quantity supplied
Note: the change in quantity supplied results from a change in demand.
P
D
S2
PE2
PE1
Change in supply
QE2QE1
Q
S1
80
Understanding the Price of OilUnderstanding the Price of Oil
The supply and demand model can be used to understand the behavior of oil prices since 1960.
Let’s turn to the following diagram.
81
Understanding the Price of OilUnderstanding the Price of Oil
82
TakeawayTakeaway
Your understanding of this chapter should include the following:1.Market competition brings about an equilibrium in which quantity demand equals quantity supplied.
2.Only one price/quantity combination is a market equilibrium and you should be able to identify this equilibrium in a diagram.
3.You should understand and be able to explain the incentives that enforce the market equilibrium. What happens when the price is above the equilibrium price? Why? What happens when the price is below the equilibrium price? Why?
83
Try it!Try it!If garden gnomes regain
widespread popularity, what will happen?
a)Equilibrium Price and Quantity both fall.
b)Equilibrium Price and Quantity both rise.
c) Equilibrium Price falls and Quantity rises.
d)Equilibrium Price rises and Quantity falls.
To next To next Try it! Try it!
Try it!Try it!
To next To next Try it! Try it!
Try it!Try it!#1: New machine is invented that lowers the cost of harvesting oranges.
Try it!Try it!#2: The FDA announces health benefits to eating oranges.
Try it!Try it!#2: The income of consumers falls and some orange growers quit the business and turn their orange groves into housing developments..
Second Edition
End of Chapter 4End of Chapter 4
Second Edition
Chapter 7 Chapter 7 The Price System: The Price System: Signals, Speculation, Signals, Speculation, and Predictionand Prediction
Chapter OutlineChapter Outline
Markets link the world Markets link to each other Solving the great economic problem A price is a signal wrapped up in an
incentive speculation signal watching prediction markets
91
IntroductionIntroduction
Prices…• Convey important information• Create incentives
In other words, prices integrate markets and motivate entrepreneurs
We will see how the price system enables societies to mobilize knowledge and resources toward common ends…
All without central planning92
Markets Link the WorldMarkets Link the World
Just where did that rose you gave or received last Valentine’s Day come from?
Likely…• Grown in Kenya
• Flown to the largest flower auction in Holland
• Loaded onto cooled aircraft • Becomes a gift of love in
Stillwater, Oklahoma• All this in 72 hours.
93
Markets Link to Each OtherMarkets Link to Each Other
Shifts of supply and demand in one market affect the entire world market
Let’s see how the market for Oil and flowers are linked.
Example• Prior to 1970s – roses were grown in American
greenhouses.• Higher oil prices in the 1970s → ↑ costs of
growing roses in greenhouses• It became cheaper to grow flowers in warm
countries and ship them to colder countries• Flower production moved from California to Kenya
94
Markets Link to Each OtherMarkets Link to Each Other
Thus, one way that we economize on oil is by eating fewer donuts!
•The price of oil rose.
•Brazil shifted sugar cane into ethanol production (rather than table sugar).
•As a result, table sugar got more expensive.95
Try it!Try it!
96
Sawdust is used for bedding milk cows.
What did the end of the housing boom in 2007 do to the price of milk?
From Oil to Candy Bars and Brick From Oil to Candy Bars and Brick DrivewaysDriveways
The price of oil affects how driveways are built.• 42-gallon barrel of oil is refined into gasoline
and other products• Asphalt is what is left after the other products• High price of gasoline will cause refiners to ↑
production of gasoline and ↓ production of asphalt → ↑ price of asphalt
• ↑ price of asphalt → ↑ use of concrete, cobblestone, and brick
97
Solving the Great Economic ProblemSolving the Great Economic Problem
Great Economic Problem – limited resources, unlimited wants• Commodities (Oil) are not equally valuable in
all uses.• If the supply of oil ↓, oil should shift to higher
valued uses. How? Central planner – lacks information and incentives There is a better way.
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Solving the Great Economic ProblemSolving the Great Economic Problem
Price system• Each user compares the values of
commodities in alternative uses.• Each user has an incentive to give up a
commodity if it has a lower value than in alternative uses.
In the free market, the price of the good (asphalt) is equal to its opportunity cost.
Let’s use our model to show how the market allocates goods to their highest value uses
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Solving the Great Economic ProblemSolving the Great Economic Problem
Marketprice
Price of oilper barrel
Quantityof oil
(MBD)
Supply
Market Quantity
Unsatisfieddemands
Satisfieddemands
Demand
Any use of oil valued less than the market price will not get oil
Low Valued uses
High Valued uses
100
Solving the Great Economic ProblemSolving the Great Economic Problem
How does the market solve the problem created by a decrease in supply?
Marketprice
Price of oilper barrel
Quantityof oil
(MBD)
New Supply
New marketQuantity
Unsatisfieddemands
Satisfieddemands
Demand
Additional unsatisfied demands
Low Valued uses
High Valued uses
Old SupplyNew
Marketprice
MarketQuantity 101
SEE THE SEE THE INVISIBLEINVISIBLE HANDHAND
SEE THE SEE THE INVISIBLEINVISIBLE HANDHAND
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“the marvel is that in a case like that of the scarcity of one raw material, without an order being issued, without more than perhaps a handful of people knowing the cause, tens of thousands of people… are made to use the material or its products more sparingly; i.e., they move in the right direction”
- Nobel Laureate Friedrich Hayek
Hayek saw the invisible hand
A Price is a Signal Wrapped Up in an A Price is a Signal Wrapped Up in an IncentiveIncentive
How is order produced from freedom of choice?
When the price of oil rises,…• all users are encouraged to economize…
By using less, or,… Substituting to a lower cost alternative.
• It is a signal… To suppliers to invest more in exploration. To look for alternative sources of energy.
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A Price is a Signal Wrapped Up in an A Price is a Signal Wrapped Up in an IncentiveIncentive
Politicians and consumers sometime fail to understand the signaling role of prices.• Example: After a hurricane, prices of ice,
generators, and chainsaws skyrocket Consumers complain of price gouging Politicians call for price controls.
• This is a bad rap on the market
because it is just doing its job:
signaling for more resources to come to the rescue!
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A Price is a Signal Wrapped Up in an A Price is a Signal Wrapped Up in an IncentiveIncentive
Losses are also a signal• Businesses that fail to produce goods people
want at low prices will fail• Resources will go to firms that are able to do
this• Entrepreneurs with the best ideas may
succeed. Others will fail.
Result: In a successful economy there will be many unsuccessful firms.
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Try it!Try it!
Imagine that whenever the supply of oil rose or fell, the government sent text messages to every user of oil asking them to use more or less oil as the case warranted. Suppose that the messaging system worked very well. Is such a messaging system likely to allocate resources as well as prices? Why or why not? What is the difference between the message system and the price system?
To next To next Try it! Try it!
SpeculationSpeculation SpeculationSpeculation is the attempt to profit from future price is the attempt to profit from future price
changes.changes.• If a speculator believes the supply of a good will decrease
in the future (driving up its price), the speculator can make money by buying the good now when the price is low and selling the good in the future when the price is higher.
Speculators may not always be correct, but they have strong incentives to be as accurate as possible because when they are wrong, they lose money.
Speculation can smooth prices fluctuations.
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Speculation Tends Smoothens Prices and Speculation Tends Smoothens Prices and Increases WelfareIncreases Welfare
Prices without speculationPricePrice
QQProduction
futureProduction
today
SupplySupply
Today’sprice
Price infuture
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DemandDemand
Speculation Tends Smoothens Prices and Speculation Tends Smoothens Prices and Increases WelfareIncreases Welfare
Prices with speculationPricePrice
QQProduction
futureProduction
today
SupplySupply
Today’sPrice no
speculation
Price infuturePrice
withspeculation
SupplySupply
Consumption = Production plus inventory
Intostorage
Out ofstorage
Consumption = Production minus storage
Result:•Stable price•↑Welfare
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Loss in value
Gain in value
SpeculationSpeculation
Why Do Speculators Have an Image Problem?• They raise prices today but lower prices in the future
Everyone sees the price increase No one sees that the future price is lower than it would have
been
Why is society better off with speculation?• Oil is moved from when it is lower valued to when it is
higher valued. Speculators don’t always guess correctly, but…
• They use their own money.• They have a huge incentive to be right.• Bad speculators go bankrupt.
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TakeawayTakeaway
Markets are linked• Geographically• Through time• Across different goods
The market acts like a giant computer that arranges limited resources over space, time, and across different goods to satisfy as many of our wants as possible.
Prices are the signals that coordinate this economic activity.
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TakeawayTakeaway
Free market prices reflect information. Prices in futures markets can signal…
• War in the Middle East• Cold weather in Florida• Who will win the next election
Prediction markets are being created to help businesses, governments, and scientists predict future events.
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Second Edition
End of Chapter 7End of Chapter 7