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INTRODUCTION TO ECONOMICS

AS F581

INTRODUCTION
Background Why study economics? What to expect from this unit? What is expected of you? Plagiarism Homework Mock Exam

WHAT IS ECONOMICS?

Economics is the study of how people choose to use resources. "Economics is the study of people in the ordinary business of life." -- Alfred Marshall, Principles of economics; an introductory volume (London: Macmillan, 1890) "Economics is the science which studies human behaviour as a relationship between given ends and scarce means which have alternative uses." -- Lionel Robbins, An Essay on the Nature and Significance of Economic Science (London: MacMillan, 1932) Economics is the "study of how societies use scarce resources to produce valuable commodities and distribute them among different people." -- Paul A. Samuelson, Economics (New York: McGraw-Hill, 1948)

ECONOMICS IS..

Economics is the study of how we choose to use limited resources to obtain the maximum satisfaction of unlimited human wants. This definition has four parts that we need to discuss: the "study of" economics choice scarcity maximizing satisfaction

OH CHOICES!!!

aa

VS

ACTIVITY 1

Make a in your own words of some of the economic choices at Your personal level Your family level Organisational Level The country level

SCARCITY..

The reason why I didn't have a castle, or the reason why you don't have everything that you want is because of SCARCITY. Scarcity highlights another point.the point of demand. Scarcity in economics doesnt mean that something is limited in resources but it means that something in limited and is not wanted/demanded.

SCARCITY EXAMPLE

Scarcity does not mean that only a little of something is available. For example, I grew up in Multan, Pakistan . About 30 miles away from my hometown was the town of Murkaan. Just outside of town a certain type of rock exists that occurs nowhere else in the world. They have named it Murkanite". Murkanite is only found near Murkaan, Pakistan and only a little of it has ever been found. BUT IT IS NOT SCARCE. -- WHY? - Because nobody wants it. For there to be scarcity things must be LIMITED and WANTED. There is plenty of MURKINITE and it IS NOT SCARCE because nobody wants it.

If I own a PS3 I would want unlimited games or the latest model of PS3.

WANTS AND NEEDS They are unlimited


A need is something that can be seen as being essential to survival, such as food, water, shelter and warmth. A want is something that we would like to have but which is not essential to survival - a car, the latest version of the PlayStation, that new top you have seen in Top Shop, the mobile phone with all the latest gadgets on etc.

COORDINATION PROBLEM

With so many decision makers in the economy how do we coordinate the wants and needs for all of them? How do we make them coherent? For this we need to understand the economic systems.

Market Economy Centrally Planned Economy Mixed Economy

Economy? The ways people try to fulfil their wants and needs. Incentives: Tax Breaks? Scrap car scheme? Money?

ECONOMY TYPES

Market economy: Market forces are allowed to guide the allocation (distribution?) of resources.

Prices play an important role. Role of competition Government undertakes the coordination role (allocation). Administratively a costly option Soviet bloc in 1990s, North Korea, Chavez, Cuba. Market Forces + Government Intervention Should governments be market friendly? Incentives VS. State Directives

Centrally Planned Economy:


Mixed Economy:

SOME BASIC QUESTIONS.

http://www.youtube.com/watch?v=t0rvubUAc7Y &feature=related Watch for 2 minutes.

MICRO AND MACRO


Microeconomics is the study of how households and firms make decisions in markets. Macroeconomics is the study of issues that affect economies as a whole, i.e., unemployment, fiscal, monetary etc.

ACTIVITY 2
Divide issues you came up with in Activity one in Micro and Macro. BBC website economics articles The Economist article http://www.economist.com/businessfinance/ec onomicsfocus/

Problem revolves around three Concepts 1 Scarcity 2 Choice 3 Opportunity Costs

SO WHAT IS A RESOURCE?
Finite, scarce or limited Renewable, Perishable, Natural, Basic Types: Land Labour Capital Entrepreneurship/Enterprise Resources available in an economy are called factors of production.

RESOURCES.

http://www.harpercollege.edu/mhealy/eco212i/l ectures/5es/5es.htm

HOMEWORK
Explain and make a mind map, poster, or other presentation of the economic problem as it affects yourself, your family or country.

AS ECONOMICS
Lecture 2

RECALL - SO WHAT IS A RESOURCE?


Finite, scarce or limited Renewable, Perishable, Natural, Basic Types: Land Labour Capital Entrepreneurship/Enterprise Resources available in an economy are called factors of production.

LAND

Land includes all of the natural physical resources for example the ability to exploit fertile farm land, the benefits from a temperate climate or the ability to harness wind and solar power and other forms of renewable energy. Some nations are richly endowed with natural resources and then specialise in the extraction and production of these resources for example the development of the North Sea oil and gas in Britain and Norway or the high productivity of the vast expanse of farm land in Canada and the United States and the oil sands in Alberta, Canada. Other countries have a smaller natural factor endowment and may be more reliant on importing these resources. Japan for example is the worlds second largest economy but remains heavily dependent on imported oil.

LABOUR

Labour is the human input into the production process. It is inevitable that some workers are more productive than others because of the education, training and work experience they have received. What matters is the size and quality of the workforce. An increase in the size and the quality of the labour force is vital if a country wants to achieve economic growth. In recent years the issue of the migration of labour has become important, can migrant workers help to solve some of the labour shortages that many countries experience? And what of the longterm effects on the countries who suffer a drain

CAPITAL

To an economist, investment is not the money that people put into the stock market or into bank and building society accounts. Instead, in economics the term capital means investment in capital goods that can then be used to produce other consumer goods and services in the future.
Fixed capital includes machinery, plant and equipment, new technology, factories and other buildings. Working capital refers to stocks of finished and semi-finished goods (or components) that will be

CAPITAL CONTINUED
Capital inputs and productivity New items of capital machinery, buildings or technology are generally used to enhance the productivity of labour. For example, improved technology in farming has vastly increased the productivity of our agricultural sector and allowed people to move out of working on the land into more valuable jobs in other parts of the economy. And, investment in information and communication technology can increase the efficiency of workers across many industries. Infrastructure Infrastructure is the stock of capital used to support the entire economic system. Examples of infrastructure include road & rail networks; airports & docks; telecommunications eg cables and satellites to enable

The Gatwick Express the railway infrastructure is an essential part of our transport network

The global oil and gas industry uses a huge amount of capital equipment to get the product crude oil to the refineries and processing stages.

ENTREPRENEURSHIP
An entrepreneur is an individual who seeks to supply products to a market for a rate of return (i.e. to make a profit). Entrepreneurs will usually invest their own financial capital in a business (for example their savings) and take on the risks associated with a business investment. The reward to this risk-taking is the profit made from running the business. Many economists agree that entrepreneurs are in fact a specialised part of the factor input

OPPORTUNITY COST

The cost of next best alternative thing forgone when a choice is made.

EXERCISE 1.1

Andrew has just started his AS courses, and has chosen to take economics, mathematics, geography and French. Although he was certain about the first three, it was a close call between French and English. What is Andrews opportunity cost of choosing French?

SOLUTION 1.1

TRADE-OFFS
A trade-off (or tradeoff) is a situation that involves losing one quality or aspect of something in return for gaining another quality or aspect. It implies a decision to be made with full comprehension of both the upside and downside of a particular choice. It is a situation that involves calculation. Same value??

Opportunity Cost and the PPC

Economists love making models and assumptions.


Why? Because the world is complicated and models provide simplified versions of reality. For example, If I am to measure how many of you would get A grades if you just take notes then I would have to make model whereby I could assume that in that model (unreal world) no book exists, no other academic help exists, no websites, you get the picture. The reason I am modelling this is because you could learn from other resources if you want to but there is no way

Curves
Economists rely heavily on diagrams to help in their analysis. Production possibility curve (PPC) shows the maximum combinations of quantities between two goods or services that can be produced in a set period of time given the available resources and technology.

Production Possibility Frontiers


Show the different combinations of goods and services that can be produced with a given amount of resources No ideal point on the curve Any point inside the curve suggests resources are not being utilised efficiently Any point outside the curve not attainable with the current level of resources Useful to demonstrate economic growth and opportunity cost

A production possibility curve


8 7 6 5 4 3 2 1 0 0 1 2 3 4 5 6 7 8

Units of food (millions)

Units of food Units of clothing (millions) (millions) 8m 7m 6m 5m 4m 3m 2m 1m 0 0.0 2.2m 4.0m 5.0m 5.6m 6.0m 6.4m 6.7m 7.0m

Units of clothing (millions)

A production possibility curve


8

a
7 6 5 4 3 2 1 0 0 1 2 3 4 5 6 7 8

Units of food (millions)

Units of food Units of clothing (millions) (millions) a 8m 7m 6m 5m 4m 3m 2m 1m 0 0.0 2.2m 4.0m 5.0m 5.6m 6.0m 6.4m 6.7m 7.0m

Units of clothing (millions)

A production possibility curve


8 7 6 5 4

Units of food (millions)

Units of food Units of clothing (millions) (millions) 8m 7m 6m 5m 4m 3m 2m 1m 0 0.0 2.2m 4.0m 5.0m 5.6m 6.0m 6.4m 6.7m 7.0m

b
3 2 1 0 0 1

Units of clothing (millions)

A production possibility curve


8 7 6 5 4 3 2 1 0 0 1 2 3 4 5 6 7 8

c
Units of food Units of clothing (millions) (millions) 8m 7m 6m 5m 4m 3m 2m 1m 0 0.0 2.2m 4.0m 5.0m 5.6m 6.0m 6.4m 6.7m 7.0m

Units of food (millions)

Units of clothing (millions)

A production possibility curve


8 7 6 5 4 3 2 1 0 0 1 2 3 4 5 6 7 8

Units of food (millions)

Units of food Units of clothing (millions) (millions) 8m 7m 6m 5m 4m 3m 2m 1m 0 0.0 2.2m 4.0m 5.0m 5.6m 6.0m 6.4m 6.7m 7.0m

Units of clothing (millions)

A production possibility curve


8 7 6 5 4 3 2 1 0 0 1 2 3 4 5 6 7 8

Units of food (millions)

Units of clothing (millions)

A production possibility curve


8 7 6 5 4 3 2 1 0 0 1 2 3 4 5 6 7 8

w x

Units of food (millions)

Units of clothing (millions)

economics questions and 5 maths questions in limited time period----What to do?

Add fig 1.1

Homework Hand ins Recap

Production Possibility Frontiers


Capital Goods Ym If it devotes all Assume a country If the country is resources to its capital If it reallocates can produce two at point A on the resources round goods it (moving could types of the PPF A to B) it can PPF Itfrom can produce agoods maximum produce more consumer with its resources of Ym. produce the goods but only at the capital goods combination of expense of fewer If it devotes allcapital its Yo and consumer goods. The opportunity resources to capital goods and goods cost of producing anit extra consumer goods Xo- consumer X1 Xo consumer goods is could produce a Yo Y1 capital goods. goods maximum of Xm

Yo

A (Xo, Yo)

Y1

Xo

X1 Xm Consumer Goods

Increasing opportunity costs


8 7 6

x
1

Units of food (millions)

5 4 3 2 1 0 0 1 2 3 4

y
1
2

z
1

Units of clothing (millions)

Economic Growth

Growth is triggered by investment in capital goods.

Total output in an economy in a given period is measured by its GDP (Gross Domestic Product)

Production Possibility Frontiers


Capital Goods
It Production can only produce at points outside the PPF inside the PPF if it finds a way of e.g. point B expanding its resources improves means or the the productivity of country is not those resources it usinghas. all This its will already resources push the PPF further outwards.

Y1 Yo

A
B

Xo X1

Consumer Goods

Fig 1.2

Scarcity

Inefficiency

Increase in one variable

Increase in television productivity

Activity

The car production industry in an economy is facing increasing competition from producers elsewhere. In order to offset this, car manufacturers have developed more advanced robots to carry out production.
1. 2.

3.

Draw PPC assuming1200 cars can be produced Approximately how many more cars can be produced when the number of television sets made is 1,000? How does the number of cars that can be produced change as television production falls

Increase in productive capacity Both variables

Productive Potential Positive Growth

Decrease in productive capacity

Productive Potential Negative Growth

SPECIALISATION & DIVISION OF LABOUR


How

many workers does it take to make a pin? 18th century economist, Adam Smith suggested that 10 people are needed to make a pin. A worker on its own produced 20 pins if he/she carried out all the steps by himself. But, 10 workers produced 200 pins

COLIN AND DEBBIES PRODUCTION TABLE 1.1


Colin Debbie Pots Bracelet Pots Bracelet s s 12 0 18 0 9 3 12 12 6 6 6 24 3 9 3 30 What strategy (combination) be used to get the maximum productivity and avail from their respective specialisation? 0 12 0 36

ACTIVITY
Calculating Opportunity cost for Debbie To make pots; 18/36 = 0.5 To make bracelets; 36/18 = 2 Calculating Opportunity cost for Colin To make pots; 12/12 = 1 To make bracelets; 12/12 = 1 It doesnt really matter for Colin but as Debbie is extremely good at making bracelets Colin would be better off concentrating on making pots. Resulting in 6 extra bracelets in the same

MONEY AND EXCHANGE


In order for a barter (exchange) to occur there has to be a double occurrence of wants in at least two parties. Money makes life simpler by becoming a portable medium of exchange. Money has the following characteristics; Store of Value: Money should be able to be used in the future. Unit of account: everybody in the market should agree on the units, dollars? Pounds? Dollar = ?

HOMEWORK

Essay on specialisation. How does it address the problem of scarcity?

Would you like to go through the book? Any questions from the book? Next Week Mock Exam

AS ECONOMICS
The Nature of Demand and Supply

Administrative Functions and Learning Outcome


Homework Mark sheet 5-10 minutes. Mock Exam on Wednesday. Do you need extra time for your homework submission? Anonymous feedback questionnaire. Frontor Apology!!! Problems with Graphs?

LEARNING OUTCOMES

Introduction

to the notion of demand for a good or service Relationship between price and demand Law of demand demand curve Movement along the curve and a shift in the curve Normal and inferior goods

WHAT IS DEMAND
The quantity of a good or service that consumers choose to buy at any possible price in a given period. 4 things influence demand for a good Price Price of other things (substitutes) Income Other personal preferences

CHOICES
INDIVIDUALS CHOOSE DIFFERENT PEOPLE VALUE THINGS DIFFERENTLY PEOPLE USE MARKETS TO EXCHANGE WHEN YOU STUDY THE MARKET, YOU STUDY YOURSELF

DEMAND
THE AMOUNT OF A GOOD OR SERVICE THAT A CONSUMER IS WILLING AND ABLE TO BUY AT VARIOUS POSSIBLE PRICES DURING A GIVEN TIME PERIOD

QUANTITY DEMANDED
THE AMOUNT OF A GOOD OR SERVICE THAT A CONSUMER IS WILLING AND ABLE TO BUY AT EACH PARTICULAR PRICE DURING A GIVEN TIME PERIOD

CETERIS PARIBUS

Latin. other things being equal. http://dictionary.reference.com/browse/ceteris+pa ribus A ceteris paribus assumption is often fundamental to the predictive purpose of scientific inquiry. In order to formulate scientific laws, it is usually necessary to rule out factors which interfere with examining a specific causal relationship. Under scientific experiments, the ceteris paribus assumption is realized when a scientist controls for all of the independent variables other than the one under study, so that the effect of a single independent variable on the dependent variable can be isolated. By holding all the other relevant factors constant, a scientist is able to focus on the unique effects of a given factor in a complex causal situation.

THE DEMAND CURVE


The

demand curve is the downwardsloping line that shows in graph form the quantities demanded at each possible price.

GOOD
Inversely proportional

LAW OF DEMAND
AN INCREASE IN A GOODS PRICE CAUSES A DECREASE IN THE QUANTITY DEMANDED AND A DECREASE IN PRICE CAUSES AN INCREASE IN THE QUANTITY DEMANDED

FACTORS THAT EFFECT DEMAND


INCOME EFFECT Any increase or decrease in consumers purchasing power caused by a change in price SUBSTITUTION EFFECT The substitution of similar, lower priced products. DIMINISHING MARGINAL UTILITY Satisfaction declines as more is consumed

DETERMINANTS OF DEMAND
CONSUMER TASTES AND PREFERENCES MARKET SIZE INCOME PRICE OF RELATED GOODS

SUBSTITUTE AND COMPLEMENTARY

CONSUMER EXPECTATIONS

HOMEWORK

Mock Exam

http://www.bized.co.uk/educators/1619/economics/markets/activity/demandsupply.h tm

SHIFT AND MOVEMENT ALONG THE DEMAND CURVE

Change in quantity

Change in price

DEMAND AND CONSUMER INCOMES


Normal Goods Goods where the quantity demanded increases in response to an increase in consumer incomes e.g. foreign holidays. Inferior Goods Goods where the quantity demanded decreases in response to an increase in consumer incomes, e.g. bus journeys

DEMAND AND CONSUMER INCOME


If you have more income, you could then demand certain things more, such as more of holidays. Notice that demand curve shifts to the right because of the change in the quantity demanded.

DEMAND AND CONSUMER INCOME


But then there are certain goods or service that you would demand less if your income rises. If you can afford a car then you would probably travel less by bus. Such goods are known as inferior goods. Notice the shift towards the left in the curve.

INCOME AND QUANTITY DEMANDED


For a normal good demand and income are directly proportional For an inferior good the demand and income are inversely proportional

SNOB EFFECT
Pointed out by Thorstein Veblen at the end of nineteenth century. Conspicuous (attracting special attention) consumption The argument is that some people would regard some goods highly simply because they are expensive. Rolex Watches, Luxusry Cars etc. It is to do with the joy people get when other people around them notice them wearing those goods.

DEMAND AND THE PRICE OF OTHER GOODS

Substitutes Two goods are said to be substitutes if the demand for one good is likely to rise if the price of the other good rises.

CONSUMER SURPLUS

The extra amount that a consumer is willing to pay for a product above the price that is actually paid.

Lets look at the Supply Side of Things.

Supply

Quantity Supplied by a firm

Firm
An organisation that brings together the factors of production to in order to produce output. Sole proprietor, partnership, public, private, limited etc.

Competitive Market

A market in which individual market can not influence the price of good or service they are selling because of competitions from other firms.

SUPPLY
THE QUANTITY OF GOODS AND SERVICES THAT PRODUCERS ARE WILLING TO OFFER AT VARIOUS POSSIBLE PRICES DURING A GIVEN TIME PERIOD

QUANTITY SUPPLIED
THE AMOUNT OF A GOOD OR SERVICE THAT A PRODUCER IS WILLING TO SELL AT A PARTICULAR PRICE

The Supply Curve

A graph showing the quantity supplied at any given price. The Supply Curve is the upward-sloping line that shows in graph form the quantities supplied at each possible price.

LAW OF SUPPLY
PRODUCERS SUPPLY MORE GOODS AND SERVICES WHEN THEY CAN SELL THEM AT HIGHER PRICES AND FEWER GOODS AND SERVICES WHEN THEY MUST SELL THEM AT LOWER PRICES

PROFIT
THE AMOUNT OF MONEY REMAINING AFTER PRODUCERS HAVE PAID ALL OF THEIR COSTS

Exercise 3.1

Determinants (Influences) of Supply


Production Cost The technology of production Taxes and subsidies Price of related goods Firms expectations about future prices

COSTS OF PRODUCTION
WAGES AND SALARIES RENT INTEREST ON LOANS BILLS RAW MATERIALS ANY OTHER GOODS AND SERVICES

Fixed Costs VS Variable Costs

Supply curve shift to the left

Shifts to the left when production costs increase.

Technology
Firms are there to maximise profits Improved technology means firms can produce more cost effectively i.e. cheaper

Taxes and Subsidies


VAT The price paid by consumers will be higher than the revenue received by the firms.

Prices of other goods

Substitution in firms factors of production i.e. a firm may be able to produce a range of different products. For example, a farmer may switch to growing swedes from potatoes if there is no price difference between potatoes and swedes.

Expected Prices
Production is time consuming that is why firms take supply decisions on the basis of expected future prices. With greater time period comes higher risk therefore higher returns e.g. commodity, oil, wine, bonds, financial instruments.

Movements along and shifts of the supply curve


If price changes there would be a movement along the curve However, as with demand curve, a change with any other influences (tax, cost & technology etc.) would cause a shift in the curve. As

GROUP DISCUSSION

The Heatwave of 2003 During the summer of 2003, the UK experienced record temperatures as a heatwave swept across the country. The hot weather encouraged people to visit coastal regions for the weekend, to take short break holidays in the UK rather than abroad and to get outside to enjoy the sunny weather. Such a scenario is likely to have an impact on the demand and supply of a number of different items. Look at the items below: Ice creams Pimms Beer Wheat Hotel rooms Lettuce Barley Barbeque charcoal Beef burgers Maize Garden swings Explain what you think is likely to happen to the demand and the supply of these items. Try to offer some ideas as to how far the demand and supply would change and why.

Now you have made some predictions, let's look at some facts: Sales of ice cream doubled in some parts of the country. Hardware stores reported sharp increases in the sales of garden swings and barbeque charcoal. Sales of Pimms rose by 300% compared to the same period the year before; beer sales also rose dramatically. Sales of salad items and barbeque food rose by around 40%. Hotel bookings at many resorts were significantly up on last year and in many places a reservation was hard to find! Supply of wheat, rice, maize and barley look as though they could be hit badly as predictions for harvests look gloomy. The price of most ice creams, salad items and so on did not rise in general during the heat wave although there may have been some differences

HOMEWORK
Lets play!! Know your group. Check Fronter. Exchange email contact details. Here are the rules: No group would have more than 12 minutes of presentation. It is up to you to determine how many slides you want to go through. Every one in the group would have to take part in the group presentation. If any member of the group is not contributing,

GROUP PRESENTATION COMPETITION


I want you to give me a group presentation on any of the topics that we have gone through so far. Winner Decision: Content of the presentation Delivery of the presentation. Popular/democratic vote. Weightage of my assessment. Presentation due next Wednesday!! Winner group would get a commendation

DEMAND AND SUPPLY MODEL


Chapter 4 AS Economics

Equilibrium: Putting Supply and Demand Together

When a market is in equilibrium


Both price of good and quantity bought and sold have settled into a state of rest The equilibrium price and equilibrium quantity are values for price and quantity in the market but, once achieved, will remain constant

Unless and until supply curve or demand curve shifts

The equilibrium price and equilibrium quantity can be found on the vertical and horizontal axes, respectively

At point where supply and demand curves cross i.e. Qd = Qs

108

Figure 1: Market Equilibrium


Price per Bottle 2. causes the price to rise . . . 3. shrinking the excess demand . . . S

E
3.00 H
Excess Demand

4. until price reaches its equilibrium value of 3.00 .

1.00

J D

1. At a price of 1.00 per bottle an excess demand of 50,000 bottles . . .

25,000 50,000 75,000

Number of Bottles per Month


109

Excess Demand

Excess demand

At a given price, the excess of quantity demanded over quantity supplied

Price of the good will rise as buyers compete with each other to get more of the good than is available

110

Figure 2: Excess Supply and Price Adjustment


Price per Bottle 1. At a price of 5.00 per bottle an excess supply of 30,000 bottles . . .
Excess Supply at 5.00 S

5.00 2. causes the price to drop, 3.00

3. shrinking the excess supply . . .

K E

L 4. until price reaches its equilibrium value of 3.00.

D
35,000 50,000 65,000 Number of Bottles per Month
111

Excess Supply

Excess Supply

At a given price, the excess of quantity supplied over quantity demanded

Price of the good will fall as sellers compete with each other to sell more of the good than buyers want

112

Solve for Equilibrium Algebraically

Suppose that demand is given by the equation , where D is D Q the good. Q 140 10 P the price of quantity demanded, P is Supply is given by where is Q S 80 5P quantity supplied. s Q What is the equilibrium price and quantity?

113

Income Rises: What Happens When Things Change

Income rises, causing an increase in demand

Rightward shift in the demand curve causes rightward movement along the supply curve Equilibrium price and equilibrium quantity both rise

Shift of one curve causes a movement along the other curve to new equilibrium point

114

Figure 3
Price per Bottle
4. Equilibrium price increases

3. to a new equilibrium.
S 2. moves us along the supply curve . . . 1. An increase in demand . . .

4.00 3.00 E

F'

D2 D1
5. and equilibrium quantity increases too. 50,000 60,000 Number of Bottles of Maple Syrup per Period
115

An Ice Storm Hits: What Happens When Things Change

An ice storm causes a decrease in supply

Weather is a shift variable for supply curve

Any change that shifts the supply curve leftward in a market will increase the equilibrium price

And decrease the equilibrium quantity in that market

116

Figure 4: A Shift of Supply and A New Equilibrium


Price per Bottle 5.00 S2 E'

S1

3.00

D 35,000 50,000 Number of Bottles


117

Using Supply and Demand: The Invasion of Kuwait

Why did Iraqs invasion of Kuwait cause the price of oil to rise?

Immediately after the invasion, United States led a worldwide embargo on oil from both Iraq and Kuwait A significant decrease in the oil industrys productive capacity caused a shift in the supply curve to the left

Price of oil increased

118

Figure 5: The Market For Oil


Price per Barrel of Oil S2 S1 E'

P2
P1 E

D
Q2 Q1 Barrels of Oil
119

Using Supply and Demand: The Invasion of Kuwait

Why did the price of natural gas rise as well?


Oil is a substitute for natural gas Rise in the price of a substitute increases demand for a good Rise in price of oil caused demand curve for natural gas to shift to the right

Thus, the price of natural gas rose

120

Figure 6: The Market For Natural Gas


Price per Cubic Foot of Natural Gas S

F' P4
F P3 D1 D2

Q3

Q4

Cubic Feet of Natural Gas


121

Figure 7: Changes in the Market for Handheld PCs


Price per Handheld PC 3. moved the market to a new equilibrium. 2. and a decrease in demand . . . S2002 S2003 1. An increase in supply . . .

4. Price decreased . . .

500
B

400
5. and quantity decreased as well. 2.45 3.33 D2002 D2003 Millions of Handheld PCs per Quarter
122

Both Curves Shift

When just one curve shifts (and we know the direction of the shift) we can determine the direction that both equilibrium price and quantity will move When both curves shift (and we know the direction of the shifts) we can determine the direction for either price or quantitybut not both

Direction of the other will depend on which curve shifts by more

123

The Three Step Process

Key Step 1Characterize the Market

Decide which market or markets best suit problem being analyzed and identify decision makers (buyers and sellers) who interact there Describe conditions necessary for equilibrium in the market, and a method for determining that equilibrium
Explore how events or government polices change market equilibrium

Key Step 2Find the Equilibrium

Key Step 3What Happens When Things Change

124

Examples of Markets The Labour Market


Firms demand labour and employees supply labour The demand for labour is derived demand. Derived Demand:

Firms want labour not for themselves but for the output it produces

125

Labour market

Firms would demand more if the price for labour is low More people would tend to offer themselves for work when the wages are high Price of labour = wages Demand for labour is downward sloping Supply for labour is upward sloping

126

Labour Market - Unemployment

If the wage rate is set above the equilibrium level at w1 employers would only demand Ld. At this point there are people who are offering themselves for work but can not find employment. i.e. There is unemployment in the market. Which is caused here by the higher wage rate.
127

The Foreign Exchange (FX) Market

There is a market where buying (transaction) is going on. When you go to Spain for holidays, you need to buy Euros. Similarly, when Spanish want to come to UK they need to buy pounds. So the demand for s (by Spanish) or Euros (by British) is dependent upon the exchange rate between Euros and Pounds. When the exchange rate for pounds is high, people would have fewer Euros to buy pounds, i.e. Demand would be relatively low.
128

FX

Similarly, when the pound is weak against Euros foreigners would be able to afford more pounds. Demand would increase. We could also derive from here the fact that when pound is strong, UK exports would not be that competitive and vice versa ceteris paribus. Pounds are supplied by Britishers wanting to buy Euros. When Euro/Pound rate is high, Britishers get more euro goods for their pounds and will tend to supply more. e* is the equilibrium point.
129

The Money Market

People have a demand for money due to operations of markets. Think of functions of money, Medium of exchange Store of value Unit of account Standard of deferred payment Demand for money predominantly depends upon income which influences the number of transactions people are willing to take. Is there a price of money? The price of money can be viewed in terms of opportunity cost. When people choose to hold money they incur an opportunity cost. Why? Rate of interest? Return? 130 Pleasure?

Money Money Money

Supply of Money Discussed in detail later in the course BOE takes charge of supply Assume for now that supply of money doesn't depend on the interest rate. Greater the interest rate, greater will be the sacrifice by holding money. Hence the downward sloping demand curve. At r* money market is at equilibrium
131

AS F581 MARKETS IN ACTION


Week 5

COMPARATIVE STATICS
Comparative static analysis examines the effect on equilibrium of a change in the external conditions affecting a market. As opposed to ceteris paribus where factors are kept constant, comparative static analysis looks at the before and after affects of a factor.

A MARKET FOR DRIED PASTA


Let us consider a simple basic staple foodstuff obtainable in any food store. Consider the graph as the before position. We shall now measure the effect of different factors by disturbing the equilibrium.

A CHANGE IN CONSUMER PREFERENCES

Suppose a new study proposes that Pasta is the next best food to caviar and this study is further strengthened by marketing campaign. People would buy more demand curve to the right market adjusts to new equilibrium both prices and quantity have increased. Movement along the supply curve

CHANGE IN THE PRICE OF SUBSTITUTE


If substitute (fresh pasta?) goes cheaper people would probably start buying more fresh pasta demand curve would shift towards left. Movement along supply curve. Market would reach a new equilibrium with

IMPROVEMENT IN PASTA TECHNOLOGY


With improved technology, cost is lowered. Firms would be willing to supply more. Now the supply curve would shift to the right. Comparative static analysis will show

AN INCREASE IN LABOUR COST


Pasta Worker Union negotiates a higher wage or H&S regulations have become stricter. Both would raise production costs. Which means firms would be willing to supply less pasta. Shift to the left New

GROUP EXERCISE

Ex 4.3 printoffs

ELASTICITY
Elasticity is a measure of responsiveness Many elasticities can be measured: price elasticity of demand, cross price elasticity of demand, income elasticity of demand, and elasticity of supply Elasticity measures are measures of proportionate responsiveness and are unit free

WHAT IS ELASTICITY?
If

my firm wants to raise revenue, should we decrease or increase the price? The answer relies on elasticity Elasticity is similar to responsiveness Price Elasticity of Demand a measure of how responsive quantity demanded is to a price change Price Elasticity of Supply a measure

PRICE ELASTICITY OF DEMAND


Mathematically
Priceelasticityof demand Percentagechangein quantitydemanded Percentagechangein price q ' q ( q ' q ) / 2 p ' p ( p ' p ) / 2

Priceelasticityof demand

EXAMPLE
What is the price elasticity of demand for CDs? At a price of $14 per CD, $14 there are 10,000 CDs $12 sold When the price is (11 10) (12 14) E D decreased to $12 per CD, (11 10) / 2 (14 12) / 2 11,000 CDs are sold

D 10 11 Thousands of CDs

E D (0.095) (0.154) 0.616

KEEP THIS IN MIND


Because

price and quantity are inversely related, the price elasticity of demand will be negative This is because a price decrease will cause an increase in quantity demanded (and vice versa) Most of the time, then, I will refer to the absolute value of the elasticity The magnitude is most important

CATEGORIES OF PRICE ELASTICITY OF DEMAND


1.

Inelastic Demand a change in price has very little effect on the quantity demanded (-1 < ED < 0)

These goods are often necessities

2.

Elastic Demand a change in the price has a relatively large effect on the quantity demanded (ED < -1)

These are often more unnecessary

3.

Unit-Elastic Demand the percentage change in quantity

Elasti c
Elasticity of Demand

UnitElastic

Inelastic

-1

ELASTICITY
1.

Varies along the demand curve for the same product

You respond differently if the price changes from 1 cent to 2 cents, than you do if the price changes from $5 to $10 (both are 100% increases)

2.

Varies across products


Regardless of where we are on the demand curve, you might expect the demand for milk to be less elastic than the demand for BMWs

More Inelastic

More Elastic

Demand Curve
Q

ELASTICITY AND TOTAL REVENUE


Total Revenue the amount of money a firm collects through sales TR = Price * Quantity How is Total Revenue related to Elasticity? Recall that a lower price leads to an increase in quantity demanded Whether Total Revenue increases or decreases change (due to a price decrease) will depend on whether the

Elastic

Unit Elastic
Inelastic

TR

WHAT DOES THIS GRAPH SHOW?


Should

you increase or decrease price to increase Total Revenue??? In the elastic portion of the demand curve, the % change in quantity demanded is greater than the % change in price, so you should decrease price in order to increase total revenue In the inelastic portion of the demand curve, the % change in quantity demanded is less than the % change

CONSTANT-ELASTICITY DEMAND CURVES

1.

For a downward sloping linear demand curve, the price elasticity changes as you move along the demand curve Some demand curves have an elasticity that does NOT vary along the demand curve Perfectly Elastic Demand Curve an increase in price reduces the quantity demanded to zero (horizontal demand curve)

Perfectly Elastic Demand

Perfectly Inelastic Demand

PRICE ELASTICITY OF DEMAND


of Substitutes the more substitutes are available for a good, the more elastic the demand (if the price increases, you might be likely to switch to another good) Proportion of a Consumers Budget Spent on the Good the larger the percentage of a consumers budget, the greater the price sensitivity (ex. comparison shopping
Availability

Price Elasticity of Supply


Mathematically
Priceelasticityof supply Percentagechangein quantitysupplied Percentagechangein price q ' q ( q ' q ) / 2 p ' p ( p ' p ) / 2

Priceelasticityof supply

Categories of Price Elasticity of Supply


1. Inelastic Supply a change in price has very little effect on the quantity supplied (0 < ES < 1) 2. Elastic Supply a change in the price has a relatively large effect on the quantity supplied (ES > 1) 3. Unit-Elastic Supply the percentage change in quantity supplied equals the percentage change in price (ES = 1)

UnitInelastic Elastic

Elastic

Elasticity of Supply

ELASTICITY OF SUPPLY ALSO VARIES

Just as the elasticity of demand varied both along the demand curve and across products, so does the elasticity of supply

More Inelastic

Supply Curve

More Elastic

Constant-Elasticity Supply Curves

1. 2.

For an upward sloping linear supply curve, the price elasticity changes as you move along the supply curve Some supply curves have an elasticity that does NOT vary along the supply curve Perfectly Elastic Supply Curve at the right price, any amount of the product will be supplied (horizontal supply curve) Perfectly Inelastic Supply Curve price changes have no effect on the quantity supplied, which is likely a fixed amount (vertical supply curve)

Perfectly Elastic Supply

Perfectly Inelastic Supply

Determinants of the Price Elasticity of Supply


Both depend on how easy it is to alter output when price changes Cost of Supplying Additional Output if it is costly to increase output, then a price increase wont cause the firm to expand output significantly (therefore, supply is inelastic) Time how long does the firm have to make the output change? The longer the time, the more elastic the supply

OTHER ELASTICITY MEASURES


Income

Elasticity of Demand a measure of the responsiveness of demand to changes in income Elasticity of Demand- a measure of how responsive one goods quantity demanded is to a change in the price of another good (i.e. how do brand Xs sales respond to changes in the

Cross-Price

INCOME ELASTICITY OF DEMAND


Normal

Good a good with an income elasticity greater than zero


Why is the elasticity greater than zero? Because the demand curve shifts out with income increases Most goods are normal goods

Inferior

Good a good with an income elasticity less than zero


Why is the Income Elasticity of Demand negative? Because the demand curve shifts in with income increases

CROSS-PRICE ELASTICITY OF DEMAND


Substitutes

if an increase in the price of one good leads to an increase in the demand for another good, they are substitutes
The Cross-Price Elasticity is POSITIVE Example: Coke and Pepsi have a positive cross-price elasticity

Complements

if an increase in the price of one good leads to a decrease in the demand for another good, they

ELASTICITY EXAMPLES
To

help us think about elasticity concepts, we are going to look at four different industries/products:
Cars, soft drinks, cereal, and beer Your book has a ton of other examples

When

you look at the elasticities, try to explain the differences among brands and products

Substitutability, proportion of income spent on the item, and time to make your

ELASTICITY OF AUTOMOBILES

Price elasticity of demand:


BMW 735i = -9.376 Honda Accord = -51.637 Ford Escort = -106.497

Cross-price elasticity of demand:


BMW 735i & Lexus LS400 = 0.336 BMW 735i & Honda Accord = 0.203 BMW 735i & Ford Escort = 0.009

Which cars are close substitutes? What role does income play? Which

ELASTICITY OF BREAKFAST CEREAL

Price elasticity of demand:

Kelloggs Corn Flakes = -3.379 Lucky Charms = -2.536 Rice Krispies = -2.340

Cross-price elasticity of demand:


Corn Flakes & Wheaties = 0.242 Corn Flakes & Lucky Charms = 0.019 Corn Flakes & Cinnamon Toast Crunch = 0.026 Lucky Charms & Cin. Toast Crunch = 0.102

ELASTICITY OF SOFT DRINKS

Price elasticity of demand:


Coke (2-liter bottle) = -3.89 7-Up (2-liter bottle) = -4.25 Mountain Dew (2-liter bottle) = -3.75

Cross-price elasticity of demand:

Coke & Pepsi = 0.63 Coke & Mountain Dew = 0.12 Coke & Diet Coke = 0.81

ELASTICITY OF BEER

Price elasticity of demand:

Miller Lite = -2.10 Budweiser = -3.80 Heineken = -0.42

Cross-price elasticity of demand:


Miller Lite & Bud Light = 1.26 Miller Lite & Heineken = 0.12 MGD & Bud = 1.68

QUESTIONS TO THINK ABOUT?


Why

is the price elasticity of the Ford Escort lower than the BMW? Why is the price elasticity of cereal less than the price elasticity of cars? Why is the cross-price elasticity greater for Corn Flakes & Wheaties than it was for Corn Flakes & Lucky Charms? Are Miller Lite and Bud Light closer

Selected Income Elasticities of Demand


Product Private education Automobiles Wine Owner-occupied housing Furniture Dental service Restaurant meals Shoes Chicken Spirits (hard liquor) Clothing Income Elasticity 2.46 2.45 2.45 1.49 1.48 1.42 1.40 1.10 1.06 1.02 0.92 Product Physicians services Coca-Cola Beef Food Coffee Cigarettes Gasoline and oil Rental housing Beer Pork Flour Income Elasticity 0.75 0.68 0.62 0.51 0.51 0.50 0.48 0.43 0.27 0.18 0.36

IN-CLASS PROBLEM TO SOLVE

Last year, Homer had an income of $40,000 from his job at the Springfield Nuclear Power Plant. At that level of income, Homer consumed 15 units of Good X. This year, Homer received a $15,000 raise. After his raise, he consumed 18 units of Good X.
a.

Using the above information, please calculate Homers income elasticity of demand.

SOLUTIONS
qnew qold I new I old EI qnew qold / 2 I new I old / 2 18 15 55,000 40,000 18 15 / 2 (55,000 40,000) / 2 3 15,000 0.1875 0.3158 16.5 47,500 0.59

% change in consumptio n EI change in income Normal % good => EI > 0 ? 0.59 ? 5.9 10