second edition chapter 3 supply and demand. introduction most important tools in economics: supply...

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


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



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?


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



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



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



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


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


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


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



Price of oil/barrel

0 10 44

$20

$5

$40

Supply

30

PricePrice Quantity Quantity SuppliedSupplied

$40 44

$20 30

$5 10

28



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


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?


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


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


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



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



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


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


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


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


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


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


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


Price of Oil per barrel


Supply

Demand

70

$70Equilibriumprice

Equilibrium quantity

P = $80 → surplus

$80

50//

90

Price is driven ↓

60




Supply

Demand

70

$70Equilibriumprice


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


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


Supply

Demand

70

70Equilibriumprice


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


Supply

Demand

70

70Equilibriumprice


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



Supply

Demand

70

70Equilibriumprice


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!


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!


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

QQ

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.


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


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.

98


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

99


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


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

102

“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.

103


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!

104


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.

105

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?


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.

107

Speculation Tends Smoothens Prices and Speculation Tends Smoothens Prices and Increases WelfareIncreases Welfare

Prices without speculationPricePrice

QQProduction

futureProduction

today

SupplySupply

Today’sprice

Price infuture

108

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

109

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.

110

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.

111

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.

112

Second Edition


second edition chapter 3 supply and demand. introduction most important tools in economics: supply...

Documents

demand slide

oil demand curve

price quantity

hypothetical demand

demand curves

market price

price people

higher price