Chapter 3 Circular Flow Model

Supply and Demand

What Determines a Person’s Income in the Market?This means… what is the value of the human being?Determined by:

a) value of their product…. Rock singer, athlete, Shaq, Oprah, department store clerk, insurance salesman, teacherb) supply and demand…. If lot of people doing same things you are… not likely to be paid much.(underwater welders) (dangerous- coal mining) (oil rigs) ……. As demand for product decreases, reduces number of available jobs… gas station jobs!c) if demand for product lacking- rewards minimal and number of competing workers is few, demand high, wages high. 20 years ago… heart surgeons

Who Determines the value of a product?

The value of the product is the worth that society puts on it….

What worth does society put on sports?What worth does society put on music

industry?What worth does society put on sport

cars, SUVs, large houses, motorcycles, eating out, designer clothes, entertainment. Etc, etc. etc.

Education?

Characteristics of Recession/InflationRecession:Businesses not selling what it producesInventories accumulateBusinesses then cut down on employment (hence

unemployment/layoffs)Inflation:Government and investors spending moreInventories begin to be depletedPrices increaseProduction increasesMore workers are hired

What is a Market?Any Place Where Goods and Services are

Voluntarily Exchanged (brings together buyers and sellers)

Price is a primary influence in determining allocation of resources in our free enterprise economy.

Difference between Price, Value, UtilityPrice= value of product in terms of moneyValue= has to do with relative scarcity = exchange

valueUtility = satisfaction that good or service can

provide

Law of Supply

As the price of the product increases, the quantity that the supplier tends to supply also increases.

****Ceteris Paribus

Law of Supply= positive relationship between the quantity of a good supplied and price.

PRICE IS THE INDEPENDENT VARIABLE

Determinants of Supply1. Technique of production (technology)

(ovens, organic farming)2. Resource Prices (Factor Costs)– cost of inputs3. Taxes and Subsidies4. Prices of Other Goods – (decline in wheat will

cause farmer to shift to corn)5. Expectations- (farmers expect price to rise..

Hold back production)6. Number of sellers in market – more sellers,

greater supply….

Important Concepts

Change in Supply (shifting of curve)OrChange in Quantity Supplied (movement along

curve)

Ability to Respond to Price varies

Often the ability of an individual firm to respond to an increase in price is limited or constrained by its existing scale of operations, or capacity, or ability to obtain resources….. IN SHORT RUNIN SHORT RUN

Examples:IN LONG RUNIN LONG RUN… can adjust. The greater the

amount of time producers have to adjust, the greater their output response.

Law of DemandAS THE PRICE OF A GOOD DECREASES THE

QUANTITY DEMANDED TENDS TO INCREASE….

***Ceteris ParibusPrice once again is the independent variable!

Wishing for a new boat does not constitute demand… one must be WILLING AND ABLE to purchase a boat.

Generally speaking…. The higher the price obstacle, the less of a product a consumers will buy.

Bargain days are based on law of demand.Two prices- Absolute and Relative.

Absolute = price in $ termsRelative = price in terms of another good.Price of a car relative to an airplane.

The greater the want satisfaction…. The greater the utility…

Marginal Utility… How much more utility do you get adding or subtracting units (more doughnuts… more cars… more steak in one day)

DIMINISHING MARGINAL UTILITY.As the number of units of a product a

consumer has increases, the satisfying power for each extra unit decreases.

Utility

Purpose of Utility analysis is to study how people behave not how they think.

Theory of consumer choice is based on the idea that each consumer spends his/her income in a way that yields the greatest satisfaction.

Determinants of Demand

PreferencesPrices of Related Goods Number of BuyersExpectations of future priceIncome

Determinants of Demand1. Tastes and preferences

Taste changes throughout our lifetime.

Prices of Related GoodsYour preference is Coke… price skyrockets….Affected in the market by substitute goods and

complimentary goods.*Substitute goods… anything that can be substituted for the product or service desired…

(Coke/Pepsi, Millers/Coors, potato chips/popcorn). If price of Coke rises… and consumer doesn’t feel strongly

about brand preference… will buy Pepsi until Coke price declines)

When two products are substitutes, the price of one good and the demand for the other are DIRECTLY RELATED.

*Complementary Goods… Goods that “go along with other goods consumer’s buy”peanut butter/jelly, beer/pretzels, milk/cookies, golf balls/golf tees,

When two goods are complements, an increase in the price of one good adversely affects the demand for the other and creates an inverse relationship.

Independent Goods… No connection between price and demand (golf clubs/bread)

Determinants Continued2. Number of buyers

The number of buyers will increase demand for the product which (if supply is fixed) will drive up the price.)

3. Income- RATHER OBVIOUS HERE.Show shifts…

Superior or Normal goods= commodities whose demand varies DIRECTLY with money income.

INFERIOR OR “POOR MAN’S” GOODS.Goods whose demand varies inversely with a

change in money income.

4. Expectations…If you are in medical school or law school, the expectation of you getting a larger income when you get out of school will affect your demand for goods… Inheriting money, winning the lottery!

IMPORTANT CONCEPTS OF DEMAND

Change in Demand ORChange in Quantity Demanded

Terms to RememberProfit:

TR-TCTotal Revenue

P x QMarginal Utility

To maximize utility, consumers should choose that good which delivers the most marginal utility per dollar. Optimal utility is then achieved.

Optimal consumption= mix of output that maximizes total utility for the limited amount of income you have to spend.

EquilibriumEquilibrium = market clearing price… supply

and demand are “in balance.”Does not occur often if ever with the

constantly changing “invisible hand” and the consumer fickleness.

In our U.S. economy we have consumer sovereignty… which tends to shift both curves or move along the curve almost continuously.

Ceilings and FloorsPrice Ceiling-a legally established maximum price that

sellers may charge (rent control) Direct effect of a price ceiling is a shortageSecondary effect- reduction in the quality

of the good, inefficient use, lower future supply, black markets,

Price FloorsPrice floor is a legally established minimum

price that buyers must pay. (minimum wage)

Direct effect= reduces employment of low-skilled labor

Indirect effects – reduction in nonwage component of compensation (perks), lesson-the-job training.

Recap Ceilings and Floors

Q

S

D

P

Q

S

D

P

Black Markets Markets that operate outside the legal

system Have a higher incidence of defective

products, higher profit rates, greater violence (cigarettes, drugs {both prescription and illegal}, Levis during cold war)

Equilibrium Tutorial

Equilibrium

Supply and Demand for Cowboy Tickets

http://www.tickco.com/football/cowboys_tickets.htm

http://www.tickco.com/schedule/new-england-patriots/

Activities for Check-point

1. Price of gasoline goes up, what happens to S & D if you keep your demand at the same level.

2. You lose your job, what happens to demand?3. Government subsidizes your pizza business. What

happens to your supply?4. Government sets a ceiling on price of hammers.

Draw that graph. What can you tell me about the outcome?

More practiceSuppose that short skirts that were fashionable in the 1990s became

unfashionable in the late 2000s. If other factors were held constant, then there would be:a. a rightward movement along the supply curveb. a rightward shift of the demand curvec. a leftward shift in the demand curved. a leftward movement along the supply curve

Assuming that turkey, chicken, pork and beef are substitutes, suppose that the price of turkey has fallen. This will, other things being equal:a. reduce demand for chicken, pork and beefb. Leave demand for chicken, pork and beef unchangedc. Increase demand for chicken, pork, and beefd. Increase quantity demanded of beef

Kiley is my best friend… SheSupplies a lot of love!