Decision-making and Demand
and Supply Analysis
Thinking Economically: Marginal Analysis
• Optimization Assumption: an assumption that
suggests that the person in question is trying to
maximize some objective
• Marginal Benefit: the increase in the benefit that
results from an action
• Marginal Cost: the increase in the cost that results
from an action
• Total Net Benefits: the difference between all benefits
and all costs
Maximizing Total Net Benefits
• Total Way – select the level of the activity that
maximizes the difference between total benefits
and total costs
• Marginal Way – set the marginal benefit of to the
marginal cost of an extra unit
• Economist prefer the later because many decisions
are not all or nothing. Most times people are
deciding to increase or decrease the amount of
something that they are doing.
Marginal Way in Action
• The example of the boxes
• If the marginal benefit of an extra unity of the
activity is greater than its marginal cost, increasing
the activity will increase total net benefits.
• If the marginal cost of an extra unit of the activity
is greater than its marginal cost, increasing the
activity will decrease total net benefits.
• Therefore, to maximize total net benefits the level
of an activity that maximizes total net benefits is
where the marginal benefit equals the marginal
cost of an extra unit of the activity.
Boxes
• If an extra unit of the activity (trades) results in
getting more boxes (MB) than are being given up
(MC) the stack of boxes grows (TNB).
• If an extra unit of the activity (trades) results in
getting less boxes (MB) than are being given up
(MC) the stack of boxes shrinks (TNB).
• If an extra unit of the activity (trades) results in
getting the same amount of boxes (MB) that are
being given up (MC) the stack of boxes is at its
tallest ( maximum TNB).
Activity
1
2
3
4
5
MB
MC
5
4
3
2
1
TB
1
2
3
4
5
TC
5
9
12
14
15
TNB
1
3
6
10
15
4
6
6
4
0
Markets: The power of Demand
and Supply
• Competitive Markets
–
–
–
–
identical or homogeneous goods
many sellers and buyers
perfect Information
free entry and exit
• Non-Competitive Markets
– Monopoly – one seller
– Oligopoly – few sellers
– Monopolistically Competitive – differentiated products
Demand
•
Law of Demand – the price of a good and the quantity demanded are negatively (or
inversely) related, ceteris paribus
–
Price and the quantity demanded
•
Rational behavior
–
•
Cardinal Utility: Measurable Utility
–
–
–
•
–
–
–
–
Law of diminishing marginal utility
Jelly bean example and Econ U$A tape on the drought in California
MB fall as activity level increases
Ordinal Utility: Ability to rank bundles from most preferred to least preferred.
–
–
•
Utility maximization (MB=MC all over again)
Less restrictive assumption with the same conclusions as the theory of cardinal utility.
Income and substitution effects
» Substitution effect: as the price of a good falls its price relative to other goods fall, so consumers use more
of the good and less of other goods
» Income effect: as the price of a good falls, the real purchasing power of income increases and consumers
will buy more of the good (if the good is normal).
The theories of cardinal and ordinal utility predict that price and quantity demand will be inversely
related.
Demand schedule: numbers
Individual demand curve: graph
Demand Function: mathematical notation
Market demand curve: horizontal sum of individual demand curves
Catherine’s Demand Schedule
Figure 1 Catherine’s Demand Schedule and Demand
Curve
Price of
Ice-Cream Cone
$3.00
2.50
1. A decrease
in price ...
2.00
1.50
1.00
0.50
0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of
Ice-Cream Cones
2. ... increases quantity
of cones demanded.
Copyright © 2004 South-Western
• The demand function
– Price of related goods
• Complements
• Substitutes
–
–
–
–
–
Income
Number of Buyers
Tastes
Expectations
Government: Taxes and Subsidies
• Qd=F (P, PR,Y,NB,T,E,G)
• Market Demand Curve: The horizontal summation of all
the individual demand curves.
• Movement along and shifts of the demand curve
– Curve versus function
• The demand curve is created assuming ceteris paribus, so it
maps only the relationship between P and QD.
• The demand function shows all the determinants of demand.
All the factors other than P, such a PR and Y, are shift factors.
– Schedules
• Changes in price are described by the demand schedule.
• Shifts are shown as increases in QD at every price.
– Graphs
• A movement along the curve is a change in quantity demanded
• A shift of the curve is a change in demand
Figure 3 Shifts in the Demand Curve
Price of
Ice-Cream
Cone
Increase
in demand
Decrease
in demand
Demand
curve, D2
Demand
curve, D1
Demand curve, D3
0
Quantity of
Ice-Cream Cones
Copyright©2003 Southwestern/Thomson Learning
Supply
• Law of Supply - price and the quantity supplied are positively related,
ceteris paribus.
– Rational behavior implies that firms try and maximize profits, where the
MB = P and MC is dependent on how much output is produced.
– MC increase as Q increases because of the following phenomena:
• Law of increasing costs: as the production of a good increases, its opportunity
cost increases (re: PPF and specialized resources)
• Law of diminishing returns: as more and more of variable inputs is applied to
a fixed factor, eventually the extra output for each additional variable input
will fall, ceteris paribus.
– Both the LIC and LDMR predict that as Q goes up the productivity of
inputs will fall and MC will rise.
• Supply schedule
• Individual supply curve
• Market supply curve
Ben’s Supply Schedule
Figure 5 Ben’s Supply Schedule and Supply Curve
Price of
Ice-Cream
Cone
$3.00
1. An
increase
in price ...
2.50
2.00
1.50
1.00
0.50
0
1 2
3
4
5
6
7
8
9 10 11 12 Quantity of
Ice-Cream Cones
2. ... increases quantity of cones supplied.
Copyright©2003 Southwestern/Thomson Learning
• The supply function
–
–
–
–
–
–
Input prices
Prices of other outputs
Technology
Expectations
Number of sellers
Government taxes and subsidies
• Qs=F(P,PI,PO,T,E,NS,G)
• Market Supply: The horizontal summation of all the
individual firms’ supply curves.
Figure 7 Shifts in the Supply Curve
Price of
Ice-Cream
Cone
Supply curve, S3
Decrease
in supply
Supply
curve, S1
Supply
curve, S2
Increase
in supply
0
Quantity of
Ice-Cream Cones
Copyright©2003 Southwestern/Thomson Learning
Market Equilibrium
• Equilibrium price and quantity = market clearing
price and quantity
• Disequilibrium prices and quantities
– Shortage – Excess Demand
– Surplus – Excess Supply
• Comparative static analysis: changes in
equilibrium prices and quantities
• Shifts in curves versus movement along revisited
• Changes in demand and supply
Figure 8 The Equilibrium of Supply and Demand
Price of
Ice-Cream
Cone
Supply
Equilibrium
Equilibrium price
$2.00
Equilibrium
quantity
0
1
2
3
4
5
6
7
8
Demand
9 10 11 12 13
Quantity of Ice-Cream Cones
Copyright©2003 Southwestern/Thomson Learning
Figure 9 Markets Not in Equilibrium
(a) Excess Supply
Price of
Ice-Cream
Cone
Supply
Surplus
$2.50
2.00
Demand
0
4
Quantity
demanded
7
10
Quantity
supplied
Quantity of
Ice-Cream
Cones
Copyright©2003 Southwestern/Thomson Learning
Figure 9 Markets Not in Equilibrium
(b) Excess Demand
Price of
Ice-Cream
Cone
Supply
$2.00
1.50
Shortage
Demand
0
4
Quantity
supplied
7
10
Quantity of
Quantity
Ice-Cream
demanded
Cones
Copyright©2003 Southwestern/Thomson Learning
Figure 10 How an Increase in Demand Affects the
Equilibrium
Price of
Ice-Cream
Cone
1. Hot weather increases
the demand for ice cream . . .
Supply
New equilibrium
$2.50
2.00
2. . . . resulting
in a higher
price . . .
Initial
equilibrium
D
D
0
7
3. . . . and a higher
quantity sold.
10
Quantity of
Ice-Cream Cones
Copyright©2003 Southwestern/Thomson Learning
Figure 11 How a Decrease in Supply Affects the
Equilibrium
Price of
Ice-Cream
Cone
S2
1. An increase in the
price of sugar reduces
the supply of ice cream. . .
S1
New
equilibrium
$2.50
Initial equilibrium
2.00
2. . . . resulting
in a higher
price of ice
cream . . .
Demand
0
4
7
3. . . . and a lower
quantity sold.
Quantity of
Ice-Cream Cones
Copyright©2003 Southwestern/Thomson Learning
Comparative Statics
• Animal tracks help one to tell what kind of an
animal and the direction the animal went.
• Demand and supply shifts leave different tracks to
help us identify them and whether they are
increasing or decreasing.
• Movement of either D or S (confirm with graphs)
–
–
–
–
D↓, S constant → P↓, Q↓
D↑, S constant → P↑, Q↑
S↓, D constant → P↑, Q↓
S↑, D constant → P↓, Q↑
• Movement of both D and S (confirm with graphs)
S↓
S↑
D↓
P?, Q↓
P↓, Q?
D↑
P↑, Q?
P?, Q↑
Using Comparative Statics
• One can use comparative statics to identify
whether shifts in demand or shifts in supply are
the predominant influence in a market.
• Once the above is determined, one can then use
the demand or supply function to try and
determine what factors are causing the shifts.
• Two examples from NPR:
– Mad Cow and Market for Beef
– Tuition Increase in Higher Education
The Invisible Hand
• Economic Agents are motivated by self-interest
– consumers by utility maximization
– Producers by profit maximization
• Market prices are
– signals for resource allocation
– coordinate consumer and producer behavior
– incentives for buyers and sellers (MC for buyers and MB for
sellers)
– Ration scarce goods and services
– Provide information about scarcity and value
• Market or the Price System and Efficiency
– Competitive markets:
• produce the goods and service consumers want
• helps to ensure that the goods and services are produced at least
possible cost