Overview
Chapter 3 introduces markets and provides an overview of the supply and demand model.
It begins by comparing central planning and the market as alternative methods of allocating resources. It includes a brief history of economic thought regarding markets and prices. Emphasizing a core principle of the book, the chapter next discusses the concept of equilibrium. It explains how market forces bring the price and quantity back to equilibrium in the case of surpluses and shortages and includes discussion of price controls (price ceilings and floors). Finally, the chapter explains how to use the supply and demand model to explain changes in prices and quantities.
Core Principles
Equilibrium Principle - The chapter presents the concept of equilibrium in the context of the supply and demand model.
Efficiency Principle - Social welfare and market efficiency are presented in the chapter, both in terms of how markets can achieve efficiency and when they do not.
Important Concepts Covered
• Supply and demand model
• Equilibrium/market equilibrium
• Cash-On-The-Table Principle
• Efficiency
• Excess supply/demand
• Change in demand versus change in quantity demanded
• Change in supply versus change in quantity supplied
• Socially optimal quantity
Teaching Objectives
After completing this chapter, you want your students to be able to Define demand
Identify the 5 factors that change demand
Illustrate the effect of a change in any of the 5 factors that affect demand
Explain the difference between a change in demand and a change in quantity demanded
Define supply and the 2 factors that change supply
Illustrate the effect of a change in either of the 2 factors that affect supply
Explain the difference between a change in supply and a change in quantity supplied Define equilibrium in general and in a market
Understand the impact of price controls on the market
Illustrate the effect of a change in supply, demand, or both on equilibrium price and quantity in a market
identify and understand the socially optimal output
In-Class Activities
Expernomics, Vol. 7, #1 (Spring 1998) classroom auction experiment dealing with markets.
Expernomics, Vol. 6, #1 (Spring 1997) classroom experiment "Demand Curves" dealing with demand.
Expernomics, Vol. 4, #1 (Fall 1995) classroom experiment dealing with markets.
"Supply and Demand" video from the "Introductory Economics" series.
"Markets and Prices" video #2 from the "Economics U$A" series.
"Supply and Demand" video #16 from the "Economics U$A" series.
Chapter Outline
I. Introduction/OverviewA. Markets in New York
B. Central Planning Versus the Market 1. central decision-making
2. free market (capitalist), private market decision-making II. Markets
A. Definition of market B. What determines prices?
1. historical misunderstandings 2. interaction of costs and value C. The demand curve
1. downward sloping a. substitution effect b. income effect
c. buyer’s reservation price
D. The supply curve 1. upward sloping
a. price covers opportunity cost b. low-hanging fruit principle c. seller’s reservation price E. Market Equilibrium
1. general principle 2. in markets
a. equilibrium price b. equilibrium quantity 3. excess supply
4. excess demand
5. gravitation toward equilibrium 6. rent control example
7. price ceilings
III. Predicting and Explaining Changes in Prices and Quantities A. Change in quantity demanded versus change in demand B. Change in quantity supplied versus change in supply C. Shifts in Demand
1. examples
a. decrease in the price of a complement b. changes in the price of substitutes
2. Economic Naturalist 3.1: “When the federal government implements a large pay increase for government employees, why do rents for apartments located near Washington metro stations go up relative to rents for
apartments located far away from metro stations?”
D. Shifts in Supply 1. examples
a. increase in the price of an input b. decrease in wages
2. Economic Naturalist 3.2: “Why do major term papers go through so many more revisions today than in the1970’s?”
a. normal goods b. inferior goods E. Four simple rules
1. factors that change supply 2. factors that change demand
3. changes in both supply and demand
4. Economic Naturalist 3.3: “Why do the prices of some goods, like airplane tickets to Europe, go up during the months of heaviest consumption, while others, like sweet corn, go down?”
III. Markets and Social Welfare A. Total economic surplus
1. buyer’s surplus 2. seller’s surplus
B. Equilibrium and economic surplus
C. Cash On The Table D. Socially optimal output
1. the efficiency principle
2. marginal cost = marginal benefit 3. costs that fall on other than sellers 4. benefits that fall on other than buyers 5. the market is not always socially optimal
Economic Naturalist Discussion Questions
1. Why does the price of gasoline increase when OPEC decreases its production quotas?
(there is a decrease in supply)
2. Why do some college courses have waiting lists after the first day of registration while others never fill up? (the price is constant across courses while the demand for courses and the number of seats available are different)
3. Why does the price of Christmas wrapping paper fall on December 26? (the demand falls after Christmas)
Answers to Text Questions and Problems
Answers to Review Questions1. The equilibrium price of a good is determined by the intersection of its supply and demand curves. We can know everything about a good’s cost of production (that, is we can know its supply exactly) yet still not know where the demand curve will intersect the supply curve.
2. A change in demand means a shift of the entire demand curve, whereas a change in the quantity demanded means a movement along the demand curve in response to a change in price.
3. If the price of gasoline were prevented by regulations from rising to its equilibrium level, we would expect to see symptoms of excess demand for gasoline, such as lines of cars waiting at the pumps to buy gas.
4. Under the horizontal interpretation, we begin with a price for the good and then go over to the demand curve to read the quantity demanded at that price on the horizontal axis. Under the vertical interpretation, we start with a quantity produced and then go up to the demand curve to read the marginal buyer’s reservation price for the product on the vertical axis.
5. It is smart for each individual in a crowded theater to stand to get a better view of the stage, yet it is dumb for all to stand since no one sees any better than if all had remained seated.
Answers to Problems 1a. Substitutes
b. Complements
c. Probably substitutes for most people, but complements for some others who like to eat ice cream and chocolate together.
d. Substitutes.
2. The supply curve would shift:
a. Right. The discovery is a technological improvement. The improved technique would enable more crops to be produced with the same inputs.
b. Right. Fertilizer is an input. Lower input prices shift the supply curve to the right.
c. Right. The new tax breaks make farming relatively more profitable than before.
Thus those who were employed in a job that was just a little better than being a farmer would switch to farming.
d. Left. Tornadoes destroy corn.
3a. Demand shifts right: income has risen and vacations are a normal good.
b. Demand shifts right: preferences have shifted from hamburger to pizza and other substitutes.
c. Demand shifts right: the price of a substitute has risen.
d. Demand is unaffected; there will be a movement along the curve—i.e., quantity demanded will fall.
4. The demand for binoculars might increase, leading to an increase in the quantity of binoculars supplied, but no change in the supply of binoculars should occur. The UFO sighting does nothing to change the factors that govern the supply of binoculars.
5. An increase in the cost of an input used in orange production will shift the supply curve of oranges to the left, resulting in an increase in the equilibrium price and a decline in the equilibrium quantity of oranges.
6. An increase in the birth rate will increase the population of potential buyers of land, and hence shift the demand curve for land to the right, resulting in an increase in the equilibrium price of land.
7. The discovery will shift the demand curve for fish to the right, increasing both the equilibrium price and the equilibrium quantity of fish.
8. An increase in the price of chickenfeed shifts the supply curve of chickens to the left, resulting in an increase in the equilibrium price of chickens, which are a substitute for beef. This shifts the demand curve for beef to the right, increasing both the equilibrium price and the equilibrium quantity of beef.
9. Compared with the rest of the year, there are more people who want to stay in hotel rooms near campus during parents’ weekend and graduation weekend. Thus the demand curve shifts to the right during these weekends. This implies a higher equilibrium price for hotel rooms (and, of course, a higher equilibrium quantity of rooms rented).
10. Automobile insurance and automobiles are complements. An increase in automobile insurance rates will thus shift the demand curve for automobiles to the left. Some people who would have bought new automobiles with the lower insurance rates will choose not to, maybe choosing a used car, public transportation or perhaps just getting some more miles from their current vehicle.
11. The mad cow disease announcement is likely to cause many consumers to forsake beef for substitute sources of protein—and hence produce a rightward shift in the demand for chicken. The discovery of the new chicken breed will cause a rightward shift in the supply curve of chicken. The two developments together will increase the equilibrium quantity of chicken sold in the United States, but we cannot determine the net effect on equilibrium price from the information given.
12. The population increase causes a rightward shift in the demand curve for potatoes, and the development of the higher yielding variety causes a rightward shift in the supply curve for potatoes. The equilibrium quantity of potatoes goes up, but the equilibrium price may go either down or up.
13. The discovery of the cold-fighting property causes a rightward shift in the demand curve for apples, and the fungus causes a leftward shift in the supply curve. The equilibrium price of apples will rise, but the equilibrium quantity may go either down or up.
14. Since butter and corn are complements, an increase in the price of butter will cause the demand curve for corn to shift leftward. The fertilizer price decrease causes the supply curve for corn to shift rightward. The equilibrium price of corn falls, but the equilibrium quantity may go either down or up.
15. Since both the demand and supply curves for tofu have shifted outward, the equilibrium quantity of tofu sold is higher than before. The equilibrium price may be either higher (left panel) or lower (right panel).
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