Chapter 2 Lecture Notes
1. Markets
a. Product market versus factor market
b. Show circular flow with firms and households, factor markets and product markets
2. Demand
a. Willingness and ability to buy
b. Product demand versus factor demand
i. Product: A good or service (e.g. a car, a haircut)
ii. Factor: An input (e.g. labor)
c. Individual Product Demand
d. Individual (consumer) demand function: Demand depends upon
i. Price
ii. Other influences
1. Income
2. Prices of substitutes and complements
3. Tastes (usually assumed fixed, but advertising may influence)
4. Expectations
iii. Demand curve: Plot quantity demand versus price
iv. Inverse demand curve
1. Plot price vertically and quantity horizontally
2. Intuition: Can think of P as depending upon Q
a. What price will lead to a given quantity bought?
3. Move along demand curve: When price changes
4. Shift in demand curve: When an influence other than price changes
e. Market Demand
i. Sum of individual demands
ii. Population then also influences demand
f. Consumer surplus
i. For the individual, it is difference between the amount the consumer is willing
to pay and the market price
ii. For the market, it is the total value created for consumers by trade.
iii. Show consumer surplus in a diagram
3. Supply
a. Willingness and ability to sell
b. Product supply versus factor supply
i. Product: A good or service (e.g. a car, a haircut)
ii. Factor: An input
c. Individual product supply
d. Individual (firm) supply function: Supply depends upon
i. Price
ii. Other influences
1. Income
2. Input prices
3. Taxes
4. Factors affecting labor productivity
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a. Technology (Better tools)
b. Capital accumulation (more tools)
5. Expectations
iii. Supply curve: Plot quantity supplied versus price
iv. Inverse supply curve
1. Plot price vertically and quantity horizontally
2. Intuition: Can think of P as depending upon Q
a. What price will lead to a given quantity sold?
3. Move along supply curve: When price changes
4. Shift in supply curve: When an influence other than price changes
e. Market Supply
i. Sum of individual suppliers
ii. Number of firms then also influences market supply
f. Producer surplus
i. For the individual firm, it is difference between the price received and the cost
of producing that unit. (And, the cost is the amount necessary to get the unit
produced long term.)
ii. For the market, it is the total value created for producers by trade, or total
profit.
4. Market Equilibrium
a. Supply equals demand
b. No surplus or shortage
5. Market adjustment
a. Shortage
i. Price increases
ii. Buyers do not want price increases, so they are hurt by shortages
iii. Sellers increase price because they can
1. Sellers always want to increase the price, so they are helped by
shortages
2. However, in equilibrium, and increase in price would lead to a surplus
where some good produced cannot be sold, so raising the price is not
profitable.
b. Surplus
i. Price decreases
ii. Sellers do not want price increases, so they are hurt by surpluses
iii. Sellers decrease price because it is better than not lowering it.
1. If the price is not decreased then some good produced cannot be sold,
so lowering the price profitable compared to not lowering it.
6. Price Restrictions
a. Price Floor
i. Government regulation which prevents the price from falling below a
specified value
ii. Designed to help sellers
1. Farm price supports
iii. Creates a surplus
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iv. Why does it cost less for government to pay existing farmers to not produce
than for government to buy up the surplus?
v. What is the deadweight cost to society if government buys the surplus and
gives it to the consumers most willing to pay.
b. Price Ceiling
i. Government regulation which prevents the price from going above a specified
value
ii. Designed to help buyers
1. Rent control
iii. Creates a shortage
1. Creates a deadweight loss
7. The Invisible Hand
a. In pursuing their own self interest, channeled through competitive markets, producers
promote the public interest more so than if they intended to promote it.
i. In purchasing labor (and other inputs): Average worker receives more than is
needed to get the worker to work (producer surplus). Employer helps the
worker.
ii. In selling product: Value of the product to the average buyer is worth more to
the buyer than the money paid for the product (consumer surplus).
iii. Normal profit: Revenue from sale of product=Costs of inputs used to produce
the product (including the normal profit necessary to get the production to
occur). The producer is not taking society backwards while making its
workers and customers better off.
iv. Economic Profit: Revenue exceeds costs (The producer creates value for
society). The producer is creating value for society while making its workers
and customers better off.
v. Adam Smith: It is not from the benevolence of the butcher or the baker that
we get our meat and bread, but from their own self interest
1. To compete short term, you must make good bread at low prices
2. To compete long term, you must improve your bread or reduce its
price
8. Comparative Statics
a. Start in equilibrium, identifying the initial market price and market quantity
b. Identify a shock to the market
c. Determine whether the shock first affects either supply or demand
d. Determine whether there is a surplus or a shortage
e. Determine the direction in which the market price will adjust in response to the
surplus or shortage
f. Determine how supply and demand will respond to the price adjustment
g. Identify the new market price and market quantity, after the price has adjusted to fully
eliminate the surplus or shortage
h. Summarize by stating how the shock to the market has changed the market price and
market quantity
9. Example: Health Care Market
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Chapter 2 Questions
Ch 2, Problem 1
In a supply-demand diagram, present a real estate market in which a rent control regulation keeps
the rent for 1 bedroom apartments below the market price. Label rent control price 𝑃𝐶 , for price
ceiling. Label the quantity real estate owners will supply to the market 𝑄 𝑆 , and label the quantity
of one bedroom apartments people will to rent 𝑄 𝐷 . Label the market price 𝑃𝑚 and the market
quantity 𝑄 𝑚 . Using capital letters label areas in your diagram as you see fit, use your letters to
identify the following:
Before rent control, when the market price is allowed to adjust to equilibrium (assume the market
quantity is 𝑄 𝑚 and the market price is 𝑃𝑚 ):
Cost of producing the apartments and getting them to market
Producer surplus (or profit of the providers of housing)
Consumer surplus
Total surplus = Consumer surplus + producer surplus
After rent control, when the market price is at the rent control price (assume the quantity of
housing actually provided and occupied is 𝑄 𝑆 , and the price paid by those who have the housing
is 𝑃𝐶 ,):
Cost of producing the apartments and getting them to market
Producer surplus (or profit of the providers of housing)
Consumer surplus
Total surplus = Consumer surplus + producer surplus
What consumer surplus is gained by consumers that is also producer surplus lost by producers?
What consumer surplus is lost by consumers, but not gained by producers?
What producer surplus is lost by producers, but not gained by consumers?
What is the “dead weight loss” associated with rent control, which is equal to the total surplus
lost?
Why does rent control produce a dead weight loss?
CH 2, Question 2
Identify a market of your choice, and a shock of your choice that can impact this market.
Conduct a comparative statics analysis that explains how the shock will impact the market price
and market quantity.
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