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ECON 161
• Week 02: September 05, 2012
• The functioning of Markets: The interaction of buyers and sellers. (Chapter 3)
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Construction of Theory
• Abstractions
• Definitions
• Assumptions
• Implications
• Adoption of Theory
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Definitions
• Good: Anything that an individual wants to have more of, at zero price.
• Resource: Anything that can be used to produce goods.
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Assumptions
• Humankind has unlimited wants
• Our resources are limited
• Scarcity : Individually, and as a Society, we do not have enough resources to produce all the things we want.
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Implications of Scarcity
• Choice
• Economic Cost
• Competition
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Forms of Competition in Society
• Violence, or Threat of Violence
• Social/Political
• Economic/Market: competition based on offering the highest value in exchange.
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Primary Social Goal = Fairness
• Violence: not fair.
• Social political: not fair.
• Economic: not fair,
• Life is NOT FAIR !!
But, the market offers the broadest and most fair system
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What Economics Is About
• Microeconomics: decisions of individuals and firms: what to buy and what to produce.
• Macroeconomics: the whole economic system and the role of government.
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Mechanisms of Choice
• Political: our representatives make choices
• Economic/market: individuals and firms make choices based on relative prices about what to produce
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ECONOMIC Form of Competition
• Economic competition: We acquire $’s by producing value for others. We compete for goods by offering to trade $ dollars.
• Circular flow diagram: Shows the interaction of households and firms in two kinds of markets.
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Product Markets
FIRMSHOUSEHOLD
ResourceMarkets
$'s $'s Revenue
$'s Income$'s
Goods &Services
Goods &Services
Resources Inputs
Circular Flow Diagram of the Exchange Economy
CreditMarkets $'s$'s
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Circular Flow Diagram of the Exchange Economy
• Households: Decisions: What to sell? What to buy? Assume Maximize Utility
• Firms: Decisions: What inputs to use? What to produce? Assume Maximize Profits: (Total Revenue –Total Cost)
• Markets: Factor Markets, Product Markets, Credit Markets
Role of Money: The medium of exchange
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Scarcity Society Choices
• What to produce? Goal find the mixture of outputs that maximizes society’s value.
• How to produce? Goal: find the optimal mix of inputs to maximize technical output.
• For whom to produce? Who will get to consume the goods produced.
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Study of MarketsStudy of Markets
• MarketsMarkets are the interaction of buyers and sellers.• Some markets are local, some worldwide.
• Focus on buyers and sellers separately: Separate graphs for each group.
• Ceteris paribus: look at one thing at a time; All other things held equal.
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Marginal ValueMarginal Value
• Focusing on a buyer, we measure the personal marginal value of a good as the most $’s you are willing to give up to acquire an additional unit. (How much you are willing to trade)
• Graph the marginal value as a height above each additional unit per time period.
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Marginal Value Declines
• Plot the marginal value as a height above additional units.
• As you have more of any good, the marginal value declines.
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Marginal Value = The Most you are willing to pay for each additional unit
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MVx
Qtyx/T
$ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1
1 2 3 4 5 6 7 8 9 10
Marginal ValueThe height above each additional unit = the most you are willing to pay
Marginal Value
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How much are you willing to Buy?
• By comparing the marginal value with the $ Price at which the good is available, we can read the quantity you are willing to buy at each $ price. (horizontal distance)
• DemandDemand: A schedule of the alternative quantities that an individual is willing and able to buy at alternative $ prices.
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$Price x
Qtyx/T
$ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1
1 2 3 4 5 6 7 8 9 10
MVx = Demand X
Demand Curve
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$ P x
$ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1
1 2 3 4 5 6 7 8 9 10
Demand x
Demand shows the amounts purchased at alternative prices (horizontal distances at each price)
Qtyx /T
Dx
Dx
Demand for XDemand for X
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Demand Curve
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First Law of DemandFirst Law of Demand
• The higher the price of a good, the smaller the quantity demanded; the lower the price of a good, the greater the quantity demanded.
• Demand is downward sloping.• A change in price leads to a change in
quantity demanded = a movement along the function
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Change in Price Vs. Change in Demand
• A change in price is a move on the demand schedule.
• A change in demand is a shift of the function due to something else changing.
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$ P x
$ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1
1 2 3 4 5 6 7 8 9 10 11 12 Qtyx /T
Dx
Dx
Dx’
Dx’
Increase in Demand
Increase in demand is a rightward shift (greater quantity demanded at each price.)
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Determinants of Demand
• What factors determine the position of demand ?
• What changes in other factors will cause demand to increase (shift right) or decrease (shift left)?
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Determinants of Demand: (Shift Factors)
• Taste & preference: how much you like the good. If T&P increase, demand increases. (Rightward shift).
• Income: a change in income affects demand.– Normal good: increase in income increases
demand. (Right Shift)– Inferior good: increase in income decreases
demand. (Left Shift)
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Determinants of Demand, Continued
• Price of other goods:– Substitutes: most other goods are substitutes;
An increase in the price of a substitute increases demand (rightward shift).
– Complements: Goods used together; an increase in the price of complements decreases demand (leftward shift).
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Determinants of Demand, Continued
• Future Price Expectations: an increase in the expected future price will increase demand today.
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Market Demand
• The market demand is the sum of the individual demands of the buyers.
• An increase in the number of buyers will increase market demand.
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Market Supply
• Supply is a schedule of the alternative quantities which sellers are willing and able to sell at alternative prices.
• Supply is generally a positive relationship: at higher prices the quantity supplied is larger.
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Supply Curve$Price
$10
8
6
4
2
2 4 6 8 10 12 14 16 Qty x/ T
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Change in Quantity vs Shift in Supply
• If sellers can get a higher price, the increase in quantity supplied is a movement on the supply curve.
• If some other factor changes, the supply curve will shift.
• An increase in supply is a rightward shift.
• A decrease in supply is a leftward shift.
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Determinants of Supply:(Shift Factors)
• Price of inputs: an increase in price of inputs will decrease supply (leftward shift).
• Change in the value of alternative outputs: a rise in the value of alternative outputs would decrease supply
• Change in technology: an increase in technology will increase supply (rightward shift).
• Number of sellers: as more sellers enter a market the supply shifts rightward.
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$Price
$ 4
3
2.50
2.00
1.50
1.00
.50
.25
100 200 300 400 500 600 700 800 900 1000 1100 Q x/ T
Demand
Supply
Surplus at this $ PriceSurplus at this $ Price
The Market
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$Price
$ 4
3
2.50
2.00
1.50
1.00
.50
.25
100 200 300 400 500 600 700 800 900 1000 1100 Q x/ T
Demand
Supply
Shortage at this $ Price
The Market
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$Price
4
3
2.50
2.00
1.50
PePe 1.00
.50
.25
100 200 300 400 500 600 700 800 900 1000 1100 Q x/ T QeQe
Demand
Supply
Market EquilibriumMarket Equilibrium
DDxx = S = Sxx at P at Pee
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$ P x
$ 10 $ 9 $ 8 $ 7 $ 6 $ 5 $ 4 $ 3 $ 2 $ 1
1 2 3 4 5 6 7 8 9 10 11 12 Qtyx /T
SupplyDemand
DxSx
Market: Demand & Supply
At the equilibrium Price, theDx = Sx
Pe
Qe