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Module Title:
Put the title of your module in this box(6 words or less).
Module 1: Review: Manipulating Economic Models
Module Overview:
Put your introductory or overview paragraph for the module in this box(No more than half a page).
This module provides an overview of the course, distinguishing macroeconomics from
microeconomics, and introduces two models of the macroeconomy: the Production Possibilities
Frontier (PPF) and the Circular Flow of income and production.
Module Reading Assignment(s):
Required Reading
Mankiw, Brief Principles of Macroeconomics:
Chapter 2, “Thinking Like an Economist.”
Chapter 4, “Supply and Demand.”
Objectives:
Put your learning objectives into this box. Objectives should be measurable and achievable, and
simply stated. Use verbs such as describe, discuss, analyze, present, create, construct, and
research.
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By the end of this module, students will be able to:
1. Describe the structure of Econ 202 and its goals.
2. Distinguish the goals and subjects of macroeconomic analysis from
those of microeconomics.
3. Explain the role of models in economics.
4. Manipulate the Circular Flow model to analyze the sources and uses
of production and income, and to recognize that production and
income are interdependent flows.
5. Manipulate the Production Possibilities Frontier model to analyze
changes in preferences, growth, and opportunity cost.
6. Use supply and demand to analyze how real-world events might affect
market equilibrium price and quantity.
7. Use supply and demand analysis to identity (or limit) the set of realworld events that may have caused a given set of changes in market
price and quantity.
Suggested Content for Online Presentation:
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[Insert video welcoming students to Econ 202 and describing its
structure and goals.]
A. Some Basic Definitions
ECONOMICS is the study of how society manages its scarce resources. That is,
economics addresses how we deal our inability to supply absolutely everything
that everyone wants: How we choose what to produce, what determines the
limits of what we can produce, how we decide who gets the products.
As former London School of Economics student Mick Jagger puts it,
“You can’t always get what you want. But if you try sometimes, you’ll find you get
what you need!”
How do we organize our efforts as members of society to get what we want?
How do we induce the builder to produce the amount of housing that people
need, the farmer to produce the food we need, the doctor to look after our
health? Who looks after the needs of the builder, the farmer, and the doctor?
Why do some countries have more housing, food, and medical care than others?
There are two levels at which economists typically can look at these kinds of
questions. One is at the level of the firm or individual person; one is at the level
of society as a whole:

Microeconomics is the study of how households and firms make decisions
and interact in specific markets. It includes topics such as prices and
quantities of individual goods and services, profit and loss, consumer
incentives, competition, and monopoly.

Macroeconomics is the study of the economy as a whole. It includes topics
such as inflation, unemployment, growth, national income, interest rates,
exchange rates, and money.
B. Economic Models:
All Models are Wrong. Some are Useful. (George Box)
Economic Models are representations of reality that attempt to improve our
understanding of economic processes and outcomes. Models are built from
assumptions that simplify or even contradict reality in a controlled way. A good
model will help us predict future outcomes.
Why Model? TO UNDERSTAND AND PREDICT.
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Like all other scientists, macroeconomists create models of the world that they
test against observations of the world.
Like all other people, macroeconomists sometimes disagree because their
values are different. Sometimes macroeconomists disagree because they are
using different models. The world is also infested with economic “experts” who
are in fact charlatans or cranks. (You’ll find them on the internet!) Cranks and
charlatans typically don’t have coherent models, don’t test their models against
observable facts, or they focus on a few facts and ignore other facts that are too
important to ignore. They also often use fear as a persuader. We economists try
to weed out the cranks from our ranks by stating our economic models clearly
and testing them with data.
However, macroeconomic models are tough to test rigorously, since we rarely
get a chance to do a controlled experiment with an entire economy. Hence,
legitimate economists construct models that tell coherent and compelling stories
about the economy that fit observed facts. Evein if a particular model makes
incorrect predictions, it may still be useful. If the model is clearly stated we can at
least understand where and why the predictions went wrong.
OUR FIRST MODEL: The Circular Flow
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Circular Flow is a simple model of the economy in which firms and households
interact in factor and goods markets. It illustrates income, production, nominal
versus real flows, and the interconnectedness of the macroeconomy. The model
is illustrated above. In it two agents (firms and households) interact with each
other in two markets (product and resource) exchanging two classes of assets
(real goods & services, and money).
Shaded arrows in the diagram indicate flows of real goods & services, and
arrows with dollar signs indicate flows of money used to pay for them.
HOUSEHOLDS are groups of people living together as a decision making unit. They
include your family, you and your roommates, or anyone else who is consuming
goods and services in the economy and selling labor and other resources to
firms. In other words, households are the people.
FIRMS are organizations that produce goods and services. They hire input factors
and sell outputs (products). They include McDonald’s, Ford Motor Company, and
your dentist’s business. They are run by people, owned by people, and they have
people working for them, but (Citizens United notwithstanding) they are not
people.
PRODUCT (OUTPUT) MARKETS are markets in which consumer goods and services
are sold by firms to households.
For example, in the product market:
You (household) buy a hamburger (product) from McDonald’s (firm).
You (household) buy a computer (product) from Apple (firm).
You (household) pay a dentist (firm) to pull a tooth (product).
In each product market transaction, money flows from households to firms.
RESOURCE MARKETS (sometimes called “Factor markets” or “Input markets”) are
markets in which the factors of production (Land, Labor, Capital) are sold by
households to firms.
For example, in the resource market:
McDonald’s (firm) pays you (household) wages to cook (labor)
Ford Motor Company borrows money to buy new robots (capital) for its
factories, The money comes from household savings, and Ford must pay
interest to the households for the use of their funds.
A neighboring farmer (firm) rents land from you (household) for cultivation.
In each resource market transaction, money flows from firms to households.
For labor, the payments are called wages.
For land, the payments are called rent.
For capital, the payments are called interest (or dividends).
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If we add up all the payments in a market, we get a measure of the size of the
economy. Since the flow of money is circular, the amount measured will be the
same no matter where in the circle you measure it. We can measure the size of
the economy either as the flow through the product market or the flow through
the factor market.
We give different names to the flow depending on where we measure it. Dollar
flow through the PRODUCT MARKET measures PRODUCTION.
Dollar flow through the FACTOR MARKET measures INCOME.
Since the two flows are the same, income and production are equal!
(To understand this, remember that when you buy a product you pay for it out of
your income, which you obtain by selling your labor, land, and capital.)
Therefore, if the people of a country want more income, they must find
ways to increase their firms’ production.
Notice that this circular flow model is much simpler than the real world. For
example, it lacks a government sector, though clearly the government is an
important participant in the national economy. Yet the model helps us to
understand some key facts about the real world, and to get a good mental image
of how the macroeconomy functions as a whole.
Our Second Model: The Production Possibilities Frontier (PPF)
Definition: The PPF is a graph that shows the various combinations of output
that the economy can produce, given available resource inputs (land, labor,
capital) and technology.
Available resources and current technology (i.e., known methods of production)
limit our choices as to what we can produce, but they still leave us choices. The
PPF illustrates those choices.
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Here we have a simple economy that can produce nothing but cars and tanks.
The resources (workers and factories) that produce tanks can, with minor
modifications, be used to produce cars. But there are limited amounts of those
resources, so the choices of what to produce are limited.
The PPF is the arc line in the graph. It shows all the combinations of cars and
tanks that our people and factories are capable of producing using the mines,
farmland, and other resources from our land. We may choose whether we want
to produce nothing but cars, nothing but tanks, or some combination of cars and
tanks. For example, if we decide to produce 200 cars, we’ll have enough
resources left over to produce at most 50 tanks (point B). If we decide to produce
500 cars, producing those additional 300 cars will use up more resources, so at
most we’ll be able to produce 20 tanks (point A).
Bear in mind that each point along the PPF represents a production choice that
can not be realized unless we use all available resources to the fullest. Thus,
point A represents a choice to use all of our resources to produce a lot of cars
and a few tanks. Point B represents a choice to use all of our resources to
produce a lot of tanks and a few cars. We might choose point A if we were at
peace, but wanted to keep our peacetime military supplied with new tanks as
they wear out. We might choose point B if we were at war.
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If we choose to waste some of our resources, we won’t be able to reach any of
the points on the PPF. Suppose for example that some of our available labor
goes to waste (that is, it is left unemployed). In that case, if we choose to
produce 200 cars with the resources we do employ, because of the wastage of
labor we won’t have enough resources to produce 50 tanks. Point D represents
such a waste of resources.
By the same token, we may want to produce both more tanks and more cars
(point C), but we can’t because we don’t have the resources to produce both 50
tanks and 500 cars.
To summarize, and put some names to the concepts I’ve introduced above:
EFFICIENCY means the economy is getting all it can from available resources, All
points on the PPF are efficient, and efficient points (such as A and B) are found
only on the PPF.
Attainable points are all points on the graph that the economy can produce,
given current resources and technology. All points on the PPF, and all points
inside the PPF (such as points A, B, and D), are attainable.
Unattainable points are points on the graph that the economy is incapable of
producing, given current resources and technology. They are found outside the
PPF (Point C, for example).
The Production Possibilities Frontier Illustrates Opportunity Cost
Opportunity Cost is the best alternative given up when you make a choice. “The
cost of something is what you give up to get it.” All real cost is opportunity cost.

If we move from point A (20 tanks) to point B (50 tanks), the opportunity cost
of those 30 additional tanks is the number of cars we give up (300 cars, or
ten cars per tank.)

If we get 30 more tanks by moving from point D to point B, there’s no cost
(why?).
The PPF Illustrates Economic Growth and Technological Progress
Each PPF we draw represents production choices at a particular point in time.
That is, it represents what we can produce with current amounts of resources
and current technology. The amount of resources and technology change over
time, though.
When the amount of resources increases (say the working population grows due
to immigration) or technology improves, the economy’s ability to produce
increases and the PPF shifts outward.
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After the shift, the number of attainable points increases. Now the economy can
produce 50 tanks and 500 cars. Of course, it’s also possible for the PPF to shift
inward, perhaps due to a failure to replace worn-out machinery or due to a war
destroying factories and killing workers.
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The PPF is of course an economic model and therefore a simplification of reality.
In the actual economy, there are millions of products and services, and to draw
the PPF of the US economy we’d have to draw a graph with equal millions of
axes, one per product. The principle is clear enough, but it’s impossible to do.
Still, we can gain insights by aggregating (i.e., grouping) similar goods together
and drawing a new PPF. For example, the PPF below illustrates the tradeoff
between producing capital goods (machinery and factories used in production)
and consumer goods (such as hamburgers and large-screen television sets).
Capital goods are a resource, and producing more capital goods therefore adds
to the economy’s productive capacity. If we produce more capital goods this year
(point B rather than A) we’ll be able to consume less this year, but since capital is
a resource we’ll increase the amount we’ll be able to produce (and therefore
consume) next year. In other words, if we produce at point B the PPF will shift
outward. If we produce at A we’ll get more good stuff this year, but at the cost of
having less next year.
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The Basic Model of Economics: Supply and Demand
As we have seen, economists find it useful to create models of real-world
phenomena to help us think clearly, and to make predictions. Each economic
model is useful (and perhaps dangerous) in its own way, but the most useful and
widely-used model of all is the market supply and demand model of
microeconomics that you learned about in Econ 201.
The microeconomic supply and demand is so useful and pervasive, in fact, that
pretty much all of the macroeconomic models that you’ll be learning about in
Econ 202 are really just supply and demand models as well. The micro supply
and demand model explains movements of price and quantity in an individual
market. The macro supply and demand models explain movements of more
abstract and unfamiliar variables such as interest rates and loanable funds, the
value and quantity of money, and (ultimately) the aggregate price and aggregate
production of the economy as a whole. Because the micro model and the macro
models are all in the “family” of supply and demand models, if you understand
how to manipulate the micro model, you won’t have too much trouble
manipulating the macro models.
Before you can interpret the macro models, of course, you will have to learn
about the macro variables they explain, and learn how they are measured. That’s
the purpose of the next module. In this module, I am going to refresh your
memory of the micro supply and demand model. I will concentrate on showing
how you formally manipulate the micro model, because you will manipulate the
macro models in the same way.
Every model in the supply and demand “family” of models has two variables
(usually price and quantity), and two curves (supply and demand). Where the two
curves intersect is the solution point (equilibrium). The curves must intersect
because the demand curve slopes downward from left to right, and the supply
curve slopes upward. To understand and use the model, therefore, you must be
able to:
1. Identify and understand the variables measured on each axis.
2. See why each curve in the model has the slope that it has.
3. See what real-world events will make each curve shift.
4. See how the model’s solution (equilibrium) is reached
5. Analyze how that solution changes when the curves shift.
6. Relate that solution to the real-world variables that we’re modeling.
Because you should have mastered the micro supply and demand model in Econ
201, I will emphasize those points here that will help you most in learning
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macroeconomics. Econ 202 requires you to manipulate the macro models and
interpret their solutions, so my description will concentrate on how you
manipulation and interpretation. That is, I will spend most of my effort explaining
points 3, 5, and 6. You should read the textbook chapter carefully to get a fuller
understanding of the supply and demand model.
The (microeconomic) supply and demand model explains variation of the price
and quantity produced and consumed of a specific good or service in a specific
geographic market over a specific time period.
The variables on the axes of the market supply and demand model for a specific
good or service are therefore the
price (vertical axis) and
quantity produced or consumed (horizontal axis)
of that good in that market and time period.
The two curves in the model are, of course, the demand and supply curves. One
represents the buyers, the other represents the sellers. What follows is a
description of the slopes of those curves and broad categories of real-world
factors that will shift those curves.
The Demand Curve: Slope and Shifters
The Demand curve for a good gives information about the preferences of the
good’s BUYERS. Specifically, the demand curve tells us how eager the buyers are
to purchase the good at different prices. It plots out the quantity of the good that
buyers will want to purchase at each price.
Definition: The Demand for a good is the RELATIONSHIP between the price of
the good and the quantity that buyers will actually seek to buy in the market
over a given time period.
Note that Demand is a relationship between two variables, one of which is the
QUANTITY DEMANDED:
Definition: The QUANTITY DEMANDED (QD) of a good is the amount that buyers
will actually seek to buy in a given time period.
So, when we talk about “quantity demanded” we are talking about a point on the
horizontal axis. When we talk about “demand” we are talking about the
downward sloping curve. Don’t confuse demand with quantity demanded! In
the figure, at a price of $1.50, the “quantity demanded” is 10 doughnuts (point A).
At a price of $1.00, the “quantity demanded” is 15 doughnuts (point B). “Demand”
is the relationship between P and QD that includes both A and B, and all of the
other points on the demand curve.
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I mentioned that the demand curve is downward sloping. In other words, if you
want to sell more of a good, you can lower its price. If you raise its price,
consumers will buy less of it, other things held equal. This aspect of the demand
relationship is called the LAW OF DEMAND.
Note: A change in price causes a movement along the demand curve. If the
price of a doughnut increases to $100, the demand relationship doesn’t change
(that is, the curve doesn’t shift). Instead, the market moves to a different point on
the existing curve.
Shifts in the Demand Curve
So, if raising or lowering the price never shifts the demand curve, what does?
Anything (other than a change in the good’s price) that affects consumers’
eagerness to purchase a good will shift its demand curve. Events that increase
consumers’ eagerness to buy shift it outward (to the right). I’ll write an outward
shift of the demand curve as “D.”
Events that reduce consumers’ eagerness to buy shift it inward (to the left.)
I’ll write an inward shift of the demand curve as “D.”
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Changes in any of the following will shift the demand curve.
(MEMORIZE THIS LIST, as it will really help you solve supply and demand
problems on exams!)
1. Changes in consumer Income.
For normal goods (defined as goods that people buy more of when their
income rises, such as restaurant meals and good wool suits) the demand
curve shifts to the right when income increases.
Income  Demand for normal goods.
For inferior goods, (defined as goods that people buy less of when their
income rises, such as ramen noodles and polyester pants) the demand curve
shifts to the left when income increases.
Income  Demand for inferior goods.
2. Changes in expected future income affect the demand curve the same way
as changes in current income.
Expected future income  D for normal goods, D for inferior goods.
That’s why accounting majors buy new suits and new cars in the Spring of
their senior year, but comparative literature majors don’t!
3. Changes in the PRICE OF RELATED GOODS shift the demand curve. Again,
there are two types of related goods to consider:
Complements are goods used along with the good in question. Thus, large
pickup trucks and gasoline are complements, as are tires and gasoline, and
doughnuts and coffee. When the price of gasoline rises, people drive less, so
they wear out their tires more slowly and demand for tires falls. If the price of
a cup of coffee falls, I am more eager to buy coffee, and therefore more
eager to buy a doughnut to go with it.
Price of a complement  Demand
Substitutes are Goods used instead of the good in question. Thus, large
pickup trucks and compact pickup trucks are substitutes, as are gasoline and
diesel fuel, and coffee and tea. When the price of large pickup trucks rises,
people are more eager to buy small trucks, and the demand for small pickup
trucks increases. When the price of coffee rises, I am more likely to get my
caffeine fix from tea, so the demand for tea increases.
Price of a substitute  Demand
4. Changes in the CONSUMERS’ EXPECTED FUTURE PRICE of a good can shift the
current demand curve for that same good. Thus, if paddlers are expecting a
sale (price reduction) on kayaks to start next week, they will be less eager to
buy kayaks today, and current demand for kayaks will fall. Many gun owners
expected the price of guns to rise when President Obama took office, so they
became more eager to buy guns right away.
Consumers’ Expected future price  Demand.
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5. Tastes and preferences of consumers affect demand just the way you
might think. If people are turned off by something Mel Gibson says, the
demand for Mel Gibson movies will fall. If American Christians become more
religious, demand for Bibles will increase.
Preferences  D.
6. Population increases increase the demand for nearly every good. Market
demand for a good is the sum of individuals’ demands for that good. Thus,
more people, more demand.
Population  D.
The picture below shows an increase in demand for doughnuts from D0 to D1,
reflecting increased eagerness of consumers to buy doughnuts at each possible
price. Thus, at a price of $1.50, after the demand shift (to D1) consumers will
seek to buy 17 doughnuts rather than the 10 they would have wanted before the
shift (point A to point C). At a price of $1.00, consumers will seek to buy 22 rather
than 15 doughnuts (point B to point E).
What could have caused the increase in consumer eagerness to buy doughnuts
(D) shown in the graph? It could have been an increase in current or expected
future income (assuming doughnuts are a normal good and not an inferior good),
or a decrease in the price of coffee (complement), or an increase in the price of
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muffins (substitute), or an announcement that doughnut prices will double soon
(expected future price of doughnuts), or a medical research finding that doughnut
calories don’t cause weight gain (preferences), or an increase in population in
the market area.
The demand increase (demand curve shift) could NOT have been caused by a
decrease in the price of doughnuts from $1.50 to $1.00. That doughnut-price
decrease by itself would simply have increased the quantity of doughnuts
demanded from 10 to 15 (move from point A to point B). It also could NOT have
been caused by an increase in the price of coffee. Why?
When I ask you to analyze the effect of a real-world event on a particular market,
you will always start by seeing if the event fits into one of the six categories of
demand curve shifters named above. That’s why you need to memorize and
understand that list of six demand curve shifters!
The Supply Curve: Slope and Shifters
The Supply curve for a good gives information about the preferences of the
good’s SELLERS. Specifically, the supply curve tells us how eager the sellers are
to produce and offer the good for sale at different prices. It plots out the quantity
of the good that sellers will try to sell at each price.
Definition: The Supply of a good is the RELATIONSHIP between the price of
the good and the quantity that sellers will actually offer for sale in the market
over a given time period.
Note that Supply is a relationship between two variables, one of which is the
QUANTITY SUPPLIED:
Definition: The QUANTITY SUPPLIED (QS) of a good is the amount that sellers
will actually offer for sale in a given time period.
So, when we talk about “quantity supplied” we are talking about a point on the
horizontal axis. When we talk about “supply” we are talking about the upward
sloping curve. Don’t confuse supply with quantity supplied! In the figure, at a
price of $1.50, the “quantity supplied” is 10 doughnuts (point A). At a price of
$1.00, the “quantity supplied” is 5 doughnuts (point B). “Supply” is the
relationship between P and QS that includes both A and B, and all of the other
points on the supply curve.
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I mentioned that the supply curve is upward sloping. In other words, when the
price of a good rises, sellers are more eager to produce it and offer it for sale,
other things held equal. This aspect of the supply relationship is called the LAW
OF SUPPLY.
Why do sellers offer doughnuts for sale? Mostly, it’s in the hope of making a
profit. Profitability is all about selling at a price higher than cost, so the shape of
the supply curve reflects the increasing cost of trying to produce more doughnuts
from a given doughnut factory. It takes more effort (and is costlier per doughnut)
to produce doughnuts faster.
Note: A change in price causes a movement along the supply curve. If the price
of a doughnut increases to $100, the supply relationship doesn’t change (that is,
the curve doesn’t shift). Instead, the market moves to a different point on the
existing supply curve. Sellers will make a huge and costly effort to sell $100
doughnuts, but nothing fundamental about the costs of producing doughnuts
changes when the price of doughnuts changes.
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Shifts in the Supply Curve
If raising or lowering the price never shifts the supply curve, what does? Anything
(other than a change in the good’s price) that affects sellers’ eagerness to
produce a good and offer it for sale will shift its supply curve. Events that
increase sellers’ eagerness to produce the good shift the curve outward (to the
right). I’ll write a rightward shift of the supply curve as “S.”
Events that reduce sellers’ eagerness to produce shift it inward (to the left.)
I’ll write a leftward shift of the supply curve as “S.”
Changes in any of the following will shift the supply curve.
(MEMORIZE THIS LIST, as it will really help you solve supply and demand
problems on exams!)
1. Changes in the PRICES OF INPUTS (land, labor, capital, and materials) needed
to produce the good, will shift the supply curve. That is, changes in wages,
interest, rent, and materials price shift the supply curve.
An increase in the price of an input will shift the supply curve to the left. For
example, a farmer facing an increase in the wage he must pay his workers
will reduce the amount of labor he hires, and hence will reduce the amount of
his crop he produces, at any given price of the crop.
Input Prices  Supply
2. Changes in TECHNOLOGY will shift the supply curve. Technology is the
method used to produce the good. If a better method is found to produce
doughnuts, sellers’ profits per doughnut will increase and producers will be
more eager to produce doughnuts at each price. Therefore, improvements in
technology shift the supply curve to the right.
Technology  Supply
3. Changes in PRODUCERS’ EXPECTED FUTURE PRICE of the good will shift the
current supply curve. If a producer expects the price of his product to rise
soon, he will be less eager to offer the good for sale at today’s lower price,
shifting the supply curve to the left.
Producers’ Expected Future Price  Supply
4. Changes in the NUMBER OF SUPPLIERS will shift the supply curve. If new firms
enter the market, the amount of production will tend to increase,and the
supply curve will shift to the right.
Number of suppliers  Supply
The picture below shows an increase in the supply of doughnuts from S0 to S1,
reflecting increased eagerness of sellers to offer doughnuts for sale at each
possible price. Thus, if the market price is $1.50, sellers will offer 17 doughnuts
(point G) after the supply shift rather than the 10 they would have offered before
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the shift (point A). If the market price is $1.00, sellers will offer to sell 12
doughnuts (point H) after the supply shift rather than the 5 doughnuts (point F)
that they would have offered before the shift.
What could have caused the increase in producer eagerness to sell doughnuts
(S from S0 to S1 ) shown in the graph? The rightward supply shift could have
been caused by a decline in the price of flour used to produce doughnuts (an
input price decline), or perhaps doughnut makers have improved their production
methods (an improvement in technology), or perhaps sellers expect the price of
doughnuts to fall soon (a decline in expected future price of output), or perhaps a
new doughnut company moved into town (increased number of suppliers).
The supply increase (curve shift) could NOT have been caused by a change in
the price of doughnuts from, say, $1.00 to $1.50. That price increase by itself
would simply have increased the quantity of doughnuts supplied from 5 to 10
(move from point F to point A). The increase in supply also could NOT have been
caused by an increase in the wages paid to workers in the doughnut shop. Why?
When I ask you to analyze the effect of a real-world event on a particular market,
you will always start by seeing if the event fits into one of the four categories of
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supply curve shifters named above. That’s why you need to memorize and
understand that list of four supply curve shifters!
Supply and Demand Together
The supply and demand curves for doughnuts appear together on a single
diagram above, just as the produers and consumers of doughnuts appear
together in a single market for doughnuts. At each price, the quantity supplied
(QS) can be read from the supply curve and the quantity demanded (QD) can be
read from the demand curve.
When the price is “too low,” it tends to rise. At a price of $1.00, consumers seek
to buy QD = 15 doughnuts, while sellers offer only QS = 5 doughnuts. At a price of
$1.00, therefore, there is a SHORTAGE of doughnuts. Consumers want to buy (QD
– QS =) 10 more doughnuts than are offered for sale, leaving consumers waving
their money and clamoring for doughnuts. When the price is below equilibrium
there’s a shortage, which causes the price to rise.
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When the price is “too high” it tends to fall. At a price of $1.90 sellers offer QS=16
doughnuts but consumers are willing to buy only QD = 5 doughnuts, so sellers
end up with an 11-doughnut SURPLUS, getting stale on the shelf. Time to discount
those doughnuts and move them out! When the price is above equilibrium,
there’s a surplus, which causes the price to fall.
Equilibrium is the “just right” price. At a price of $1.50, sellers and buyers agree
on the quantity to be sold: QD = QS = 10 doughnuts. Consumers are willing to buy
all the doughnuts that producers are willing to offer for sale, and vice versa.
$1.50 is the EQUILIBRIUM PRICE (defined as the price that sets QD = QS), and once
it’s reached the market “clears” and there’s no pressure on price to either rise or
fall.
To summarize: A price above the equilibrium price causes a surplus that drives
the price down toward equilibrium. A price below the equilibrium price causes a
shortage that drives the price up toward equilibrium.
How to Use the Supply and Demand Model
We’ve now completely set up the supply and demand model. What’s it good for?
Mainly, we use it to organize our thinking about the effect of real-world events on
market price and quantity.
In particular, there are THREE STEPS TO FOLLOW when you are wondering how an
event will affect the price (P) and quantity sold (Q) of a particular good:
1) Which curve will shift?
(Supply or Demand?)
2) Which way will it shift?
(Rightward or leftward?)
3) What is the effect on equilibrium P and Q?
(Do both increase? Both decrease? Does one rise and the other fall?)
Memorize these three steps!
They are the most important part of this whole module!!
Always follow the three steps in order. Use the lists of supply and demand curve
shifters to answer the first two questions. Then use a supply and demand
diagram to answer the third question. Do that, and you’ll nearly always get the
right answer.
For example, suppose there is a new medical study that shows that doughnut
calories “don’t count”; that is, eating doughnuts will not make you fat. (I can
dream can’t I?) What will be the effect of this news on the price and quantity sold
of doughnuts?
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Step 1): Which curve shifts?
People who are concerned about their weight and preferred not to eat doughnuts
before getting the good news about doughnut calories will be more inclined to eat
them after getting that news. This is demand curve shifter #5: “Tastes and
preferences of consumers” so the D curve shifts.
Step 2): Which way will it shift?
Consumers are more eager to buy doughnuts after getting the news, so it’s an
increase in demand (a rightward shift from D0 to D1 in the diagram below).
Step 3): What is the effect on equilibrium P and Q?
The diagram shows the equilibrium point moving from A to B as a result of the
Demand curve shift. Price increases from $1.50 to $1.70, and the quantity sold
increases from 10 to 14 doughnuts. Thus, P, Q.
We can summarize this change as follows: Preferences  D  P & Q.
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Now suppose instead that there is a drop in the wages that doughnut makers
must pay their workers. How will this affect the market price and quantity of
doughnuts sold?
Step 1): Which curve shifts?
Labor is an input into the production of doughnuts, and the wage rate is the price
of labor. Thus, we are looking at a case of supply curve shifter #1: “Changes in
the Prices of Inputs” so the Supply curve shifts.
Step 2): Which way does it shift?
A fall in wages means a decrease in an input price and therefore a lower cost of
producing doughnuts, higher profits from producing doughnuts, and hence
sellers are more eager to produce and sell doughnuts. Therefore, Supply
increases and the Supply Curve Shifts Rightward.
Step 3): What is the effect on equilibrium P and Q?
The diagram shows the supply curve shift moving the equilibrium from point A to
point B. The price consequently falls from $1.50 to $1.30 and the quantity of
doughnuts sold increases from 10 to 14.
We can summarize this change as follows: Input Price  S  P and Q.
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Finally, suppose that the magical doughnut study and the drop in doughnutworker wages happen at the same time. What will happen to the price and
quantity of doughnuts in the market?
When you get a question like this, with two events, ANALYZE EACH EVENT
SEPARATELY. We’ve already done the analysis of each event, and all that remains
is to combine the two results and draw conclusions.
We know the following from our previous analysis:
Preferences  D
 P, Q.
Input Price  S
 P, Q.
Examining these results, we can see that each event individually caused the
quantity sold in the market to increase, so if both events occur the quantity will
definitely rise.
On the other hand, the demand shift caused price to rise, while the supply shift
caused price to fall, so the combination of events may either make the price rise
or fall. If the demand shift is bigger, the price will rise. If the supply shift is bigger,
the price will fall. If the supply and demand shifts are equal, the price will stay the
same.
We can therefore say that the combination of events {D + S} will cause Q,
but the effect on price is ambiguous (or indeterminate).
You should be able to follow the three steps outlined above to analyze the effects
of a real-world event on market price and quantity. Don’t skip a step or try to
avoid the process altogether. Practice using those three steps until they are
second nature. This module is all about the process of analyzing events. If you
follow the steps, you’ll get the right answer, so LEARN TO APPLY THE THREE
STEPS OF SUPPLY AND DEMAND ANALYSIS!
Summary of Effects of Curve Shifts on Equilibrium Price and Quantity:
We can summarize the effects of supply and demand shifts as follows:
D  {P,Q} (an increase in demand increases both P and Q)
D  {P,Q} (a decrease in demand decreases both P and Q)
S  {P,Q} (an increase in supply decreases P, increases Q)
S  {P,Q} (a decrease in supply increases P, decreases Q)
You should go ahead and draw diagrams to confirm each of the effects
summarized above.
Notice that a demand curve shift causes equilibrium price and quantity to change
in the same direction (either both rise, or both fall). On the other hand, a supply
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curve shift causes equilibrium P and Q to change in opposite directions (one falls
while the other rises).
Finally, you should be able to combine your results from analyses of two (or
more) events to find the combined effect of both events. For example, looking at
the summary of shift effects shown above, do you see that an increase in supply
(S) coupled with a decrease in demand (D) will cause price to fall, but has an
ambiguous effect on the quantity sold?
Explaining Price and Quantity Changes
Often economic analysts (like you!) are faced with the problem of finding a realworld event that could explain a given change in market price and quantity. This
is more or less the reverse of the analysis outlined above, which reasons from
events to their effects on P and Q.
Given an observed change in market equilibrium price and quantity, you should
be able to list possible causes and eliminate others. To do so, you should reason
in these steps:
1) Identify the changes in equilibrium P and Q ( or  for each).
2) Identify which curve must have shifted (S or D).
3) Identify which direction the curve shifted (right  or left ).
4) Find possible explanations for curve shift you have identified.
Suppose, for example, you notice that the price of gasoline has risen, at the
same time that the quantity sold of gasoline has increased (P,Q). Price and
quantity moved together, so you know that the demand curve must have shifted.
Both P and Q increased, so you are looking for an event that would have
increased demand. So, you might scan the headlines and business pages for an
event such as an increase in consumer income, or a drop in the price of large
trucks (complement), or an increase in the price of commuter train tickets
(substitute), or an increase in the driving population.
A commentator on the radio blames the price increase on new environmental
regulations that have increased the cost of obtaining crude oil. Another
commentator blames it on a conspiracy of Wall Street speculators to restrict
crude oil supply and thereby jack up the price.
As a good economist, you disagree with both commentators. Why? You have
observed that both price and quantity increased in the gasoline market (P,Q).
An increase in the cost of crude oil due to regulations or conspiracy could not
explain (P,Q) because an increase in the price of crude oil is clearly a gasoline
producer issue (supply curve shift due to an input price increase), not a gasoline
consumer issue. The regulations or conspiracy would therefore shift the supply
curve, not the demand curve. A decline in supply caused by regulations would
increase price, but it would also decrease the quantity sold (P, Q), and that’s
not what happened.
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Practice doing this! It’s fun, and it’s useful.
There will definitely be problems of both kinds (i.e., reasoning from events to
expected effects on P and Q, and reasoning from changes in P and Q to possible
events) on all exams in Econ 202.
Discussion Question(s):
Put your discussion question(s) for this module in this box. They should be short conversationstarters. Include the question(s) the students must reply to, and include instructions as well.
Instructions. Each of the questions below will be the subject of a threaded
discussion. Threaded discussions are graded on the basis of participation. You must
contribute at least two substantive remarks to the discussions in this module to get
one point.
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1. In the tanks/cars PPF above, if we produce 30 more tanks by moving
from point D to point B, there’s no cost. Why?
2. If the economy moves from a point on the PPF (point A, say) to a point
inside the PPF, what is the effect on the circular flow? If the PPF shifts
outward, what is the effect on the circular flow?
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2. For the imaginary country of Scarceland, consider the PPF above,
which illustrates Scarceland’s tradeoff between government-produced
goods and services (e.g., police, public schools and state universities,
highways, parks) and privately-produced goods and services (e.g.,
hamburgers, gasoline, plumbing, cars). Scarceland’s consumers are of
two types. Both types of consumers like some of both types of goods,
but one type (the “Privs”) especially likes private-sector goods, and the
other type (“Guvs”) especially likes government goods.
a. Using the concept of opportunity cost, explain why the PPF has a
“bowed-out” shape.
b. Suppose Scarceland’s economy were perfectly efficient, and the
Privs and Guvs were debating about how the economy’s scarce
resources should be allocated. The Privs would prefer point _____
and the Guvs would prefer point ____.
c.
Suppose that the Scarceland economy is currently in recession, so
that there is a high level of unemployment. The Privs currently
have enough government goods, and the Guvs have enough
private goods, but each group has less of its own favored goods
than it wants. What point is the economy at? _____ Is it possible
to make both groups better off? How?
d. Both groups agree that unemployment is bad, and they want the
government to do something about it. The Guvs favor an increase
in government production to reduce unemployment. The Privs
favor a reduction in taxes and regulations to stimulate private
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production directly. List the pros and cons of each of these
proposals.
e. Some of the Privs argue that the increase in government
production can not move the economy away from point C because
any resources used to increase government production must
necessarily be taken away from private production. What’s wrong
with this argument?
f.
Some of the Guvs argue that the increase in government
production will make everyone happier, since it will move the
economy toward the efficient frontier. What’s wrong with this
argument?
g. A politician seeks support from both Privs and Guvs by promising
to implement policies that will lead the economy to produce the
amount of private goods favored by the Privs and government
goods favored by the Guvs. What point is the politician promising?
Why? What’s wrong with this promise? Could it be fulfilled now?
Could it be fulfilled in time? How?
3. The Circular Flow model shown below has firm and household sectors,
but it does not have a government sector. The real economy does
have a government sector. How would you add a government sector to
the Circular Flow model? You’ll need to draw arrows indicating taxes,
flows of government goods and services, labor and capital used by
government agencies, and welfare payments. Which arrows in your
expanded diagram represent real goods and services? Which arrows
represent dollar payments?
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This help sheet was developed by West Virginia University iDesign.