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The Power of Markets

(ch 1)

Dr. Katherine Sauer A Citizens Guide to Economics ECO 1040

In your own words, what are the main points of this chapter?

Overview 1. The Invisible Hand 2. Basic Economic Assumptions 3. The Market and Prices

The market aligns incentives in a way such that individuals working in self-interest leads to a better standard of living for society as a whole.

1. The Invisible Hand Adam Smith (1723 1790) is often referred to as the founder of modern economics. He was actually a Scottish philosopher of morality who got famous for writing The Theory of Moral Sentiments (1759). - people decide using sympathy, not just selfishness He was an example of the absent minded professor.

He studied astronomy. - liked the idea that even though planets moved in their own orbit, there was a natural harmony with the rest of the planets He thought that people could also move in different paths and yet harmonize with one another.

It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. - from An Inquiry into the Nature and Causes of the Wealth of Nations (1776)

Smith doesnt say that people are motivated ONLY by self-interest. He says that self-interest motivates more powerfully and consistently than things like kindness or altruism. The concept of the invisible hand appeared in Moral Sentiments before appearing his now more famous work, The Wealth of Nations.

He said that if each person seeks to promote their selfinterest, then society prospers. he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.

Smith never took nor taught an economics course. ECONOMICS DIDNT EXIST!!!! Until the 19th century, academics considered economics a part of philosophy.

2. Basic Economic Assumptions A. How Individuals Behave Individuals attempt to make themselves as well off as possible, given their individual preferences. maximize utility This is not the same thing as being selfish. - example from reading

Every decision we make involves a tradeoff. Give an example of a tradeoff involving - a present activity and future activity - work vs leisure/family time - two desirable activities in the present

Whenever we make a decision, we are weighing the benefits and costs of the action. - can be things other than money - often include money The higher the costs associated with an action, the higher the benefits need to be to get you to take the action.

B. How Firms Behave The goal of a firm is to maximize profits. Firms have 5 main decisions to make. 1) 2) 3) 4) 5)

A market economy will direct resources to their most productive use. Prices will signal information about the most valuable use.

3. The Market and Prices A. Demand The Law of Demand says that there is an inverse relationship between price and quantity demanded. (keeping other things constant income, etc). - as price rises, the quantity demanded falls - as price falls, the quantity demanded rises

This is why (in general) the demand curve slopes downward. Demand represents consumers willingness and ability to pay for a good or service.

B. Supply The Law of Supply says that there is a positive relationship between price and quantity supplied (holding other things constant like the price of raw material inputs). - as price rises, the quantity supplied rises - as price falls, the quantity supplied falls This is why (in general) the supply curve slopes upward. Supply represents producers production costs.

C. Market Equilibrium The Law of Supply & Demand says that the price will adjust to bring the quantity supplied and quantity demanded into equality. If the price were surplus Price Supply higher than equilibrium: P1 P1 Qs > Qd P* surplus price will fall

Demand Qd Q* Qs Quantity




If the price were lower than equilibrium: P2 Qd > Qs shortage price will rise

P2 shortage

Demand Quantity Qd



Surpluses put downward pressure on price.

Price Supply

Shortages put upward pressure on price. At P* Qd = Qs no shortage no surplus price is stable


Demand Qd=Qs Quantity

equilibrium price

D. Changes to Equilibrium Market for Heroin Example

The Market for Opium:

Price Supply New Supply P1 P2

Favorable weather conditions resulted in a bumper crop of opium. This would shift the supply curve to the right.

Demand Q1 Q2 Quantity

The price of Opium falls and the quantity rises.

The Market for Heroin:

Price Supply New Supply P1 P2

Opium is an input to Heroin. Since the price of Opium fell, the supply of Heroin will rise. The supply curve for Heroin shifts right.




The price of Heroin falls and the quantity rises.

Market for Tuna Example In the past decade Americans have really taken a liking to sashimi tuna, so it is ordered more often at restaurants.

Price P2 P1


When the demand for tuna increases, the demand curve shifts to the right. The price rises. The quantity rises.

New Demand Demand Q1 Q2 Quantity

But how are there magically more fish being caught?

Prices convey information. When the price of tuna increases, this is a signal to fishermen. They will be getting paid more for their catch. - keep boat in water longer - some switch from salmon fishing to tuna fishing The quantity of tuna caught rises.

Market for Wheat Example Pakistan is the worlds 9th largest producer of wheat. In 2010, Pakistan experienced widespread flooding that devastated the wheat crop.

New Supply Price Supply

P2 P1

When the supply of wheat decreases, the supply curve shifts to the left. The price rises. The quantity falls.

Demand Q2 Q1 Quantity

Market for Oil Example OPEC is well-known as the organization that controls the world supply of oil. From time to time, OPEC will restrict oil production in order to drive up its price. China is currently experiencing major economic growth. The middle class is increasingly able to afford major purchases like automobiles. The consumption of oil in China has dramatically increased in recent years.

OPEC restricts oil production

Chinese consume more oil

S2 P S1 P2 P1 P2 P1 D2 D1 Q2 Q1 Q Q1 Q2 D1 Q P S1

P rises, Q falls

P rises, Q ?

P rises, Q rises

Explain how markets and competition are good for consumers.

Explain what we mean when we say markets are amoral.

Economics assumes that people act rationally. - act in a way that makes them better off, not worse off

Give some examples of how people act irrationally.

Summary: Adam Smith is the founder of modern economics. Economists Assume - individuals maximize utility - firms maximize profits

Demand represents the inverse relationship consumers have with price and quantity demanded. Supply represents the positive relationship with price and quantity supplied. Price will adjust to bring the market into equilibrium. World events will change equilibrium price and quantity in various markets.

What did you learn today?

Please explain 2 concepts from todays class.