Products Assignment

Event Market for:

Price for hamburgers has risen; demand for hot dogs is rising. (Hot Dog Buns)

The President of the United States has released a statement that unemployment is falling, there is a rise in output in the Country, and manufacturing activity is rising

(Popular Vacation Spots)

The Chinese government has decided to subsidize its domestic automobile industry with stimulus money. (Automobiles in China)

Manufacturers who use petroleum as an input see prices of crude rising.

(Manufactured goods that use plastic as an input)

Using the table, for each line item, write a paragraph describing how the market for each specific product will be affected by the associated event. Describe which curve will shift (demand or supply or both), what effect it will have on price (rise or fall in price), and what will happen to quantity (rise or fall in quantity). Each line item requires a paragraph.

Demand, Supply,
and the Market Process

GWARTNEY – STROUP – SOBEL – MACPHERSON

To Accompany: “Economics: Private and Public Choice, 15th ed.”
James Gwartney, Richard Stroup, Russell Sobel, & David Macpherson
Slides authored and animated by: James Gwartney & Charles Skipton
Full Length Text —
Micro Only Text —
Part: 2
Part: 2
Chapter: 3
Chapter: 3
Macro Only Text —
Part: 2
Chapter: 3

First page

Consumer Choice and
the Law of Demand

15th
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Sobel-Macpherson

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First page

Law of Demand
Law of Demand:
the inverse relationship between the price of a good and the quantity consumers are willing to purchase.
As the price of a good rises, consumers buy less.
The availability of substitutes (goods that perform similar functions) explains this negative relationship.

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First page

Market Demand Schedule
A market demand schedule is a table that shows the quantity of a good people will demand at varying prices.
Consider the market for cellular phone service. A market demand schedule lays out the quantity of cell phone service demanded in the market at various prices.
We can graph these points (the different prices and respective quantities demanded) to make a demand curve for cell phone service.

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Market Demand Schedule
Cellular phone service price
(avg. monthly bill)
Cellular phone subscribers
(millions)
$ 92 7.6
$ 73 16.0
$ 58 33.7
$ 46 55.3
$ 143 2.1
$ 41 69.2
120
100
80
40
0
20
30
40
50
Price
(monthly bill)
Quantity
(million
subscribers)

60
70

140
Demand

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First page

Market Demand Schedule

Notice how the law of demand
is reflected by the shape of the demand curve.
As the price of a good rises …
consumers buy less.
120
100
80
40
0
20
30
40
50
Price
(monthly bill)
Quantity
(million
subscribers)

60
70

140
Demand

15th
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Sobel-Macpherson

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First page

120
100
80
40
0
20
30
40
50
Price
(monthly bill)
Quantity
(million
subscribers)

60
70

140
Demand

Market Demand Schedule

The height of the demand curve at any particular quantity shows the maximum price consumers are willing
to pay for that additional unit.
Thus, the height of the curve reflects the consumer’s valuation of the marginal unit.
For example, when 16 million units are consumed, the value
of the last unit is $73.

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First page

Consumer Surplus
Consumer Surplus:
the area below the demand curve but above
the actual price paid.
Consumer surplus is the difference between the amount consumers are willing to pay and the amount they have to pay for a good.
Lower market prices increase the amount of consumer surplus in the market.

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First page

Price and Quantity Purchased
140
120
100
60
0
10
15
20
25
Price
(monthly bill)
Quantity
(million
subscribers)

Consider the market for cellular phone service again. This time we will assume that the demand for cellular service is more linear and that the market price is $100.
At $100 (the market price),
the 30 millionth unit will not be purchased because the consumer
who demands it is only willing
to pay up to $60 for it.
The 5 millionth unit will be purchased because the consumer
who demands it is willing to pay
up to $133 for cell phone service.
The 17 millionth unit, and those that precede it, will be purchased because each of these units is valued as much or more than the $100 market price.

Demand

Market price = $100

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140
120
100
60
0
10
15
20
25
Price
(monthly bill)
Quantity
(million
subscribers)

Demand

Market price = $100
Consumer Surplus
Recall that consumer surplus is
the difference between what the consumer is willing to pay and
what they have to pay.
The first 17 million subscribers
are willing to pay more than $100
for cell phone service.
Hence, the area above the actual price paid (the market price) and below the demand curve represents consumer surplus.
Consumer surplus represents the
net gains to buyers from market exchange.

Consumer surplus

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First page

Elastic and Inelastic Demand Curves
Elastic demand
A change in price leads to a relatively large change in quantity demanded.
Demand will be elastic when close substitutes for the good are readily available.
Inelastic demand
A change in price leads to a relatively small change in quantity demanded.
Demand will be inelastic when few, if any, close substitutes are available.

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Elastic and Inelastic Demand Curves
When the market price for gasoline increases from $2 to $4 a gallon, the quantity demanded in the market
$4

Gasoline
market
D
$4
$2

Quantity
(gasoline)
Price
10

Taco
market
$2

Quantity
(tacos)
Price
10

… falls relatively little from 10 to 8 million units per week.
Because taco demand is highly sensitive to price changes, taco demand is described as elastic; because the demand for gas is largely insensitive to price changes, gasoline demand is described as inelastic.
… falls sharply from 10 to 4 million
units per week.
In contrast, when the market price
for tacos rises from $2 to $4, the quantity demanded in the market

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First page

Questions for Thought:
1.(a) Are prices an accurate reflection of a good’s total value? Are prices an accurate reflection of a good’s marginal value? What is the difference?
(b) Consider diamonds and water. Which of these goods provides the most total value? Which provides the most marginal value?

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First page

Changes in Demand versus
Changes in Quantity Demanded

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Changes in Demand
and Quantity Demanded
Change in Demand
– a shift in the entire demand curve.
Change in Quantity Demanded
– a movement along the same demand curve in response
to a change in its price.

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An Increase in Demand
If DVDs cost $30 each, the demand curve for DVDs, D1, indicates that Q1 units will be demanded.
If the price of DVDs falls to $10,
the quantity demanded of DVDs will increase to Q2 units (where Q2 > Q1).
Several factors will change the demand for the good (shift the entire demand curve).
As an example, suppose consumer income increases. The demand for DVDs at all prices will increase.
After the shift of demand, Q3 units are demanded at $10 instead of Q2 (Q3 > Q2 > Q1).
Price
(dollars)
30
20
10
Q1

Q2
Q3
D2
Quantity
(DVDs
per month)

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First page

A Decrease in Demand
If a pizza costs $20, then the demand curve for pizzas, D1, indicates that 200 units will be demanded.
If the price falls to $10, the quantity demanded of pizzas will increase to 300 units.
If the number of pizza consumers changes, then the demand for it will generally change.
For example, in a college town during the summer students go home and the demand for pizzas at all prices decreases.
After the shift of demand, 200 units are demanded at $10.
Price
(dollars)

Quantity
(Pizzas
per week)
20
10

200
300
D1

0
D2

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First page

Demand Curve Shifters
The following will lead to a change in demand
(a shift in the entire curve):
Changes in consumer income
Change in the number of consumers
Change in the price of a related good
Changes in expectations
Demographic changes
Changes in consumer tastes and preferences

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Questions for Thought:
1. Which of the following do you think would lead to an increase in the demand for beef:
(a) higher pork prices,
(b) higher incomes,
(c) higher grain prices used to feed cows,
(d) a scientific study linking high beef consumption
with cancer,
(e) an increase in the price of beef?
2. What is being held constant when a demand curve for a product (like shoes or apples, for example) is constructed? Explain why the demand curve for a product slopes downward and to the right.

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First page

Producer Choice and
the Law of Supply

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Cost and the Output of Producers
Producers purchase resources and use them to produce output.
Producers will incur costs as they bid resources away from their alternative uses.
Opportunity cost of production:
The sum of the producer’s costs of employing each resource required to produce the good.
Firms will not stay in business for long unless they are able to cover the cost of all resources employed, including the opportunity cost of the resources owned
by the firm.

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First page

Economic and Accounting Cost
Economic Cost
– the cost of all resources used to produce the good.
Accounting Cost
– often ignores the opportunity costs of resources owned
by the firm (for example, the firm’s equity capital).

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First page

Role of Profits and Losses
Profit occurs when a firm’s revenues exceed its costs.
Firms supplying goods for which consumers are willing
to pay more than the opportunity cost of the resources required to produce the good will make a profit.
Firms making profits will expand, while those making losses will contract.
In essence:
profits are a reward earned by firms that increase
the value of resources in the marketplace, and,
losses are a penalty imposed on firms that use resources in ways that reduce their market value.

15th
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Sobel-Macpherson

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First page

Law of Supply
Law of Supply:
there is a positive relationship between the price of a product and the amount of it that will be supplied.
As the price of a product rises, producers will be willing to supply a larger quantity.

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First page

Cellular phone service price
(avg. monthly bill)
Cellular phone subscribers
(millions)
120
100
80
40
0
20
30
40
50

60
70

140
Supply

$ 60 5.0
$ 73 11.0
$ 80 15.1
$ 91 18.2
$ 107 21.0
$ 120 22.5
Market Supply Schedule
Price
(monthly bill)
Quantity
(million
subscribers)

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First page

120
100
80
40
0
20
30
40
50

60
70

140
Supply

Price
(monthly bill)
Market Supply Schedule

Notice how the law of supply
is reflected by the shape of
the supply curve.
As the price of a good rises …
producers supply more.
Quantity
(million
subscribers)

15th
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Sobel-Macpherson

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First page

120
100
80
40
0
20
30
40
50

60
70

140
Supply

Price
(monthly bill)
Quantity
(million
subscribers)
Market Supply Schedule

The height of the supply curve at any quantity shows the minimum price necessary to induce producers to supply that unit.
The height of the supply curve
at any quantity also shows the opportunity cost of producing
that unit.
Here, producers require $73
to induce them to supply the
11 millionth unit …
while they would require $91 to supply
the 18.2 millionth unit.

15th
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Sobel-Macpherson

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First page

120
100
80
60

140
Price
(monthly bill)
Quantity
(million
subscribers)
Price and Quantity Supplied
Consider the market for cellular phone service again. This time we will assume that the supply for cellular service is more linear and that the market price is $100.
The 30 millionth unit will not be produced as the cost of supplying
it ($140) exceeds the market price.
The 5 millionth unit will be produced because the cost of supplying it ($60) is less than the market price of $100.
The 17 millionth unit, and all those that precede it, will be produced as the cost of supplying them is equal to or less than the market price.

Market price = $100

Supply
0
10
15
20
25
30

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First page

120
100
80
60

140
Price
(monthly bill)
Quantity
(million
subscribers)
Market price = $100
Supply
0
10
15
20
25
30

Producer Surplus
Producer surplus is the difference between the lowest price a supplier will accept to produce the good (the opportunity cost of the resources) and the price they actually get (the market price).
Producers are willing to supply
the first 17 million units for less
than $100.
Hence, the area above the supply curve but below the actual market price represents producer surplus.
Producer surplus represents the
net gains to producers from market exchange.

Producer surplus

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Elastic and Inelastic Supply Curves
Elastic supply
quantity supplied is sensitive to changes in price.
Thus a change in price leads to a relatively large change in quantity supplied.
Inelastic supply
quantity supplied is not sensitive to changes in price.
Thus, a change in price leads to only a relatively small change in quantity supplied.

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Elastic and Inelastic Supply Curves
When the market price for soft drinks increases from $1.00 to $1.50 a six-pack, the quantity supplied to the market rises from 100 to 200 million units per week.
When the market price for physician services rises from
$100 to $150 an office visit,
the quantity supplied rises from 10 to 12 million visits per week.
Because soft drink supply is quite sensitive to price changes, its supply is elastic; because the supply of physician services is relatively insensitive to changes
in price, its supply is inelastic.
$150

Soft drink market
$1.50
$1.00

Quantity
(million .
6-packs)
Price

10
Physician Services
market
$100
Quantity
(million. visits)
Price
12

S
100

50
150
200

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First page

Questions for Thought:
1. (a) What is being held constant when the supply curve for a specific good like pizza or cars is constructed?
(b) Why does the supply curve for a good slope upward and to the right?
2. What is producer surplus? Is producer surplus basically the same thing as profit?
3. What must an entrepreneur do in order to earn a profit? How do the actions of firms earning a profit influence
the value of resources? What happens to the value of resources when losses are present?

15th
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First page

Questions for Thought:
4. What does the cost of a good or service reflect?
Will producers continue to supply a good or service
if consumers are unwilling to pay a price sufficient to cover the cost?

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First page

Changes in Supply versus
Changes in Quantity Supplied

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First page

Changes in Supply
and Quantity Supplied
Change in Supply
– a shift in the entire supply curve.
Change in Quantity Supplied
– movement along the same supply curve in response
to a change in its price.

15th
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First page

An Decrease in Supply
If the market price for gasoline is $3.00
a gallon, the supply curve for gasoline
S1 indicates Q1 units would be supplied.
If the price fell to $2.00, the quantity supplied would fall to Q2 units (where
Q2 < Q1). If, somehow, the opportunity costs for gasoline producers changed then the supply of gas would change. Consider the case where the cost of crude oil (an input in the production of gasoline) increases … Price (dollars) $3 $2 $1 Q1 Q2 Q3 Quantity (units of gasoline per year) S2 S1 the supply of gasoline at all potential market prices would fall. Now at $2.00, Q3 units are supplied instead of Q2 (Q3 < Q2 < Q1). 15th edition Gwartney-Stroup Sobel-Macpherson Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page Supply Curve Shifters The following will cause a change in supply (a shift in the entire curve): Changes in resource prices Changes in technology Elements of nature and political disruptions Changes in taxes 15th edition Gwartney-Stroup Sobel-Macpherson Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page How Market Prices are Determined 15th edition Gwartney-Stroup Sobel-Macpherson Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page Market Equilibrium This table & graph indicate demand & supply conditions of the market for calculators. Equilibrium will occur where the quantity demanded equals the quantity supplied. If the price in the market differs from the equilibrium level, market forces will guide it to equilibrium. A price of $12 in this market will result in a quantity demanded of 450 … With an excess supply present, there will be downward pressure on price to clear the market. and a quantity supplied of 600 … resulting in an excess supply. 7 8 9 10 11 12 13 Quantity demanded = 450 Quantity supplied = 600 Price ($) 450 500 550 600 650 D S Excess supply Downward Price (dollars) Quantity supplied (per day) Quantity demanded (per day) 12 10 8 Condition in the market Direction of pressure on price >

600
450
550
550
500
650
Quantity

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First page

Excess
supply
Downward
Price
(dollars)
Quantity
supplied
(per day)
Quantity
demanded
(per day)
12
10
8
Condition
in the
market
Direction
of pressure
on price

600
450
550
550
500
650

7
8
9
10
11
12
13

Price ($)

450
500
550
600
650

D
S
Market Equilibrium
A price of $8 in this market will result in a quantity supplied of 500 …
With an excess demand present, there will be upward pressure on price to clear the market.
and quantity demanded of 650 …
resulting in an excess demand.
Quantity supplied
= 500
Quantity demanded
= 650

Excess
demand
Upward
< Quantity 15th edition Gwartney-Stroup Sobel-Macpherson Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page Excess supply Downward Price (dollars) Quantity supplied (per day) Quantity demanded (per day) 12 10 8 Condition in the market Direction of pressure on price >

600
450
550
550
500
650
Excess
demand
Upward
< 7 8 9 10 11 12 13 Price ($) 450 500 550 600 650 Quantity D S Market Equilibrium A price of $10 in this market results in quantity supplied of 550 … With market balance present, there will be an equilibrium present and the market will clear. and a quantity demanded of 550 … resulting in market balance. Quantity demanded = 550 Market Balance Equilibrium = Quantity supplied = 550 15th edition Gwartney-Stroup Sobel-Macpherson Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page Excess supply Excess demand Equilibrium price 7 8 9 10 11 12 13 Price ($) 450 500 550 600 650 Quantity D S Excess supply Price (dollars) Quantity supplied (per day) Quantity demanded (per day) 12 10 8 Condition in the market Direction of pressure on price >

600
450
550
550
500
650
Excess
demand
< Market Balance = Market Equilibrium At every price above market equilibrium there is excess supply and there will be downward pressure on the price level. At every price below market equilibrium there is excess demand and there will be upward pressure on the price level. At the equilibrium price, quantity demanded and quantity supplied are in balance. Equilibrium Upward Downward 15th edition Gwartney-Stroup Sobel-Macpherson Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page Net Gains to Buyers and Sellers 140 120 100 60 0 10 15 20 25 Price (monthly bill) Quantity (million subscribers) 80 30 5 Return again to the market for cell phone service. When the market is in equilibrium – where supply just equals demand – price equals $100. Recall that the area above the market price and below the demand curve is called consumer surplus … When equilibrium is present, all of the potential gains from production and exchange are realized. Supply Market price = $100 Demand Equilibrium Net gains to buyers and sellers and that the area above the supply curve but below the market price is called producer surplus. Together, these two areas represent the net gains to buyers and sellers. 15th edition Gwartney-Stroup Sobel-Macpherson Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page Equilibrium and Efficiency It is economically efficient to undertake actions when the benefits of doing so exceed the costs. What is the consumer’s valuation of the 10 millionth unit of cell phone service brought to market? What is the opportunity cost of delivering the 10 millionth unit to market? Does it make sense, from an economic efficiency standpoint, to bring the 10 millionth unit to market? 140 120 100 60 0 10 15 20 25 Price (monthly bill) Quantity (million subscribers) 80 30 5 Supply Demand 15th edition Gwartney-Stroup Sobel-Macpherson Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 44 Copyright ©2012 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. Equilibrium and Efficiency What is the consumer’s valuation of the 25 millionth unit of cell phone service brought to market? What is the opportunity cost of delivering the 25 millionth unit to market? Does it make sense, from an economic efficiency standpoint, to bring the 25 millionth unit to market? 140 120 100 60 0 10 15 20 25 Price (monthly bill) Quantity (million subscribers) 80 30 5 Supply Demand 15th edition Gwartney-Stroup Sobel-Macpherson Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page 140 120 100 60 0 10 15 20 25 Price (monthly bill) Quantity (million subscribers) 80 30 5 Supply Demand Equilibrium and Efficiency At the equilibrium output level (the 17 millionth unit), the consumer’s valuation of the marginal unit and the producer’s opportunity cost of the resources necessary to bring that unit to market are equal. In equilibrium all units valued more than their costs are produced and the potential gains from production and exchange are maximized. This outcome is economically efficient. 15th edition Gwartney-Stroup Sobel-Macpherson Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page Questions for Thought: 1. How is the market price of a good determined? When the market for a good is in equilibrium, how will the consumers’ evaluation of the marginal unit compare with the opportunity cost of producing the unit? Is the equilibrium price consistent with economic efficiency? 15th edition Gwartney-Stroup Sobel-Macpherson Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page How Markets Respond to Changes in Demand & Supply 15th edition Gwartney-Stroup Sobel-Macpherson Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page Effects of a Change in Demand When demand decreases – the equilibrium price and quantity will fall. When demand increases – the equilibrium price and quantity will rise. 15th edition Gwartney-Stroup Sobel-Macpherson Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page Market Adjustment to an Increase in Demand Consider the market for eggs. Prior to the Easter season, the market for eggs produces an equilibrium where supply equals demand1 at a price of $0.80 a dozen & output of Q1. Every year during the Easter holiday the demand for eggs increases (shifts from D1 to D2). What happens to the equilibrium price and output level? Now at $0.80, quantity demanded exceeds quantity supplied. An upward pressure on price induces existing suppliers to increase their quantity supplied. Equilibrium occurs at output level Q2 and price $1.00. What happens to price and output after the Easter holiday? Price ($ per doz) Quantity (million doz eggs per week) 1.20 1.00 0.80 0.60 Q1 D1 S Q2 D2 15th edition Gwartney-Stroup Sobel-Macpherson Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page Effects of a Change in Supply When supply decreases – the equilibrium price will rise and the equilibrium quantity will fall. When supply increases – the equilibrium price will fall and the equilibrium quantity will rise. 15th edition Gwartney-Stroup Sobel-Macpherson Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page Market Adjustment to a Decrease in Supply Consider the market for lemons. Initially equilibrium is present where supply1 equals demand at a market price of $0.20 and output of Q1. Suppose adverse weather, such as occurred in California in January 2007, reduces the supply of lemons (shift from S1 to S2). What happens to both the price and output level in the market? Now at $0.20, quantity demanded exceeds quantity supplied. Upward pressure on price reduces quantity demanded by consumers. Equilibrium occurs at a price of $0.30 and output level of Q2. What happens to price and output when weather returns to normal? Price ($ per lemon) Quantity (millions of lemons per week) 0.40 0.30 0.20 0.10 Q1 D S1 Q2 S2 15th edition Gwartney-Stroup Sobel-Macpherson Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page Questions for Thought: 1. How has the availability and growing popularity of online music stores (like Apple’s iTunes) affected the market for music CDs purchased from brick-and-mortar stores like Target or Wal-Mart? Use the tools of demand and supply to illustrate. 2. How have technological advances in miniature batteries and lower computer chip prices affected the market for cellular phones? Use the tools of demand and supply to illustrate. 15th edition Gwartney-Stroup Sobel-Macpherson Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page The Invisible Hand Principle 15th edition Gwartney-Stroup Sobel-Macpherson Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page The Invisible Hand Invisible hand: the tendency of market prices to direct individuals pursuing their own self interests into productive activities that also promote the economic well-being of society. This direction, provided by markets, is a key to economic progress. 15th edition Gwartney-Stroup Sobel-Macpherson Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page The Invisible Hand “ Every individual is continually exerting himself to find out the most advantageous employment for whatever capital [income] he can command. It is his own advantage, indeed, and not that of the society which he has in view. But the study of his own advantage naturally, or rather necessarily, leads him to prefer that employment which is most advantageous to society… He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was not part of his intention.” – Adam Smith, The Wealth of Nations (1776) 15th edition Gwartney-Stroup Sobel-Macpherson Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page Communicating Information Product prices communicate up-to-date information about the consumers’ valuation of additional units of each commodity. Without the information provided by market prices it would be impossible for decision-makers to determine how intensely a good was desired relative to its opportunity cost. 15th edition Gwartney-Stroup Sobel-Macpherson Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page Coordinating Actions of Market Participants Price changes coordinate the choices of buyers and sellers and bring them into harmony. Price changes create profits and losses which change production levels for products. 15th edition Gwartney-Stroup Sobel-Macpherson Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page Motivating Economic Participants Suppliers have an incentive to produce efficiently (at a low cost). Entrepreneurs have an incentive to both innovate and produce goods that are highly valued relative to cost. Resource owners have an incentive both to develop and supply resources that producers value highly. 15th edition Gwartney-Stroup Sobel-Macpherson Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page Market Order Competitive markets – the forces of supply and demand – lead to market order, low-cost production, and economic progress. The pricing system coordinates the choices of literally millions of consumers, producers, and resource owners and thereby provides market order. Central planning is neither necessary nor helpful. The market process works so automatically that the coordination and order it generates is often taken for granted. Thus the expression “invisible hand” is quite descriptive of the process. 15th edition Gwartney-Stroup Sobel-Macpherson Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page Qualifications The efficiency of market organization is dependent upon: The presence of competitive markets. Well-defined and enforced private property rights. 15th edition Gwartney-Stroup Sobel-Macpherson Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page Questions for Thought: 1. Consider a large business firm like Wal-Mart. Does it need to be regulated in order to assure that it produces efficiently? Is regulation needed to assure that it will supply the goods and services that consumers want? 2. How can you explain that the quantities of milk, bananas, candy bars, televisions, notebook paper and thousands of other items available in your hometown are approximately equal to the quantities of these items that local consumers desire to purchase? 15th edition Gwartney-Stroup Sobel-Macpherson Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page Questions for Thought: 3. What is the invisible hand principle? Does it indicate that “good intentions” are necessary if one’s actions are going to be beneficial to others? What are the necessary conditions for the invisible hand to work well? Why are these conditions important? 4. “The output generated by our economy should not be left to chance. We need to have someone in charge who will make sure that resources are used wisely.” (a) When resources and goods are allocated by markets, is the output “left to chance?” (b) In a market economy, what determines whether or not a good will be produced? 15th edition Gwartney-Stroup Sobel-Macpherson Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page End of Chapter 3 Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part. First page

The Stock Market: Its Function, Performance, and Potential as an Investment Opportunity

GWARTNEY – STROUP – SOBEL – MACPHERSON

To Accompany: “Economics: Private and Public Choice, 15th ed.”
James Gwartney, Richard Stroup, Russell Sobel, & David Macpherson
Slides authored and animated by: James Gwartney & Charles Skipton
Full Length Text —
Micro Only Text —
Part: 6
Part: 5
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Special Topic: 3
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Special Topic: 3

First page

The Economic Functions
of the Stock Market

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The Economic Functions
of the Stock Market
The stock market provides investors, including those
who are not interested in participating directly in the operation of the firm, with an opportunity to own a fractional share of the firm’s future profits.
New stock issues are often an excellent way for firms
to obtain funds for growth and product development.
Stock prices provide information about the quality of business decisions.

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Stock Market Performance:
The Historical Record

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The Economics of the Stock Market
The stock market allows investors to participate in the risks and opportunities of corporate America.
Real returns for the past 2 centuries have averaged 7% per year.
During the last 62 years, the S&P 500 indicates investors earned a 10.5% compound annual
rate of return.
Double-digit returns were earned during
38 of 62 years, while returns were negative during only 14.
S&P 500
Return
Avg compound return

– 30%
– 20%
– 10%
0%
10%
20%
30%
40%
50%
1950

1960
1970
1980
1990
2000
2012

– 40%

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5
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The Interest Rate, the Value of Future Income, and Stock Prices

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Stock Prices
Underlying the price of a firm’s stock is the present value
of the firm’s expected future net earnings, or profit.
The value of a share depends on:
the expected size of future net earnings,
when these earnings will be achieved, and,
the interest rate by which the investor discounts
the future income.

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Stock Prices
The present value of a future income stream
is dependent upon:
D – dividends (and gains from higher stock prices) earned during various future years (as indicated by the subscripts).
i – the discount or interest rate
It is calculated as:
D1
(1 + i)
+
D2
(1 + i)2
D n
(1 + i) n
+
D3
(1 + i)3
+
+
. . . . .

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The Price to Earnings Ratio, 1950-2012
The average price-earnings ratio for the S&P 500 index since 1950 is 18.
It was between 8 and 24 during the 1951
to 1997 period.
During the 1970s it stayed in the 8 to 10 range. It increased from 1985 – 1997
and soared above 30 in the 1998 to 2002 period.
A sharp decline in earnings during the 2008-2009 recession lead to its peaking near 80 in 2009.

Price-to-Earnings Ratio
1950
1960
1970
1990
1980
0
10
20
30
90
2012

2000
80
70
60
50
40

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The Random Walk Theory
of the Stock Market

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Random Walk Theory
When considering the future of stock prices, many economists stress the implications of the random walk theory.
According to this theory:
current stock prices already reflect known information
future changes in stock prices are determined by surprise occurrences
therefore, no one can forecast future stock prices with
any degree of precision

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How the Ordinary Investor
Can Beat the Experts

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How the Ordinary Investor
Can Beat the Experts
Savers invest in the stock market as a strategy to build wealth.
Investors that buy a diverse portfolio of shares and hold them over long periods of time, substantially reduce their risks.
Small investors can purchase stock in an equity mutual fund, a corporation that buys & holds shares of stock in many firms.
Equity mutual funds have reduced the risk of stock ownership and attracted large amounts of funds into the market.

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The Value of Equity Mutual Funds,
1980-2012
The amount of money that people put into U.S. equity mutual funds rose dramatically in the 1990s.
Purchasing shares in a mutual fund is a simple way for an individual
to buy and hold an interest in a large variety of stocks with one purchase.
Due to the recent financial crisis, the value of equity mutual funds fell by 43% from 2007 to 2008, before rebounding sharply in 2009-12.

Value of Stocks Owned Through Equity Mutual Funds
(Billions $)
1980
1985
1990
2000
1995
0
500
1,000
1,500
6,500
2012

2005
5,500
4,500
3,500
2,500
2,000

7,000
6,000
5,000
4,000
3,000

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Stocks are Less Risky When
Held for a Lengthy Time Period
This graphic highlights the best and worst annualized performance for each holding period from 1871 – 2012.
There is less risk of
a low or negative return when a portfolio of S&P 500 stocks is held for a longer period of time.
Highest and Lowest Period Annualized Total Real Return (%)
S&P 500 Index
20-year periods
13.8%
– 1.1%
35-year periods
9.5%
2.7%
5-year periods
29.8%
– 16.7%
1-year periods
47.2%

– 40.8%

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The Advantages of
Indexed Mutual Funds
A managed equity mutual fund is one with a portfolio manager who tries to pick stocks that maximize the fund’s rate of return.
An indexed equity mutual fund holds a portfolio of stocks that matches their share in a broad index like
the S&P 500.
Indexed mutual funds have substantially lower operating costs than managed funds as they engage
in less trading and have no need for either a market expert or research staff.
Historically, indexed funds have outperformed managed funds.

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Should you invest in a fund because of its past performance?
No.
Past performance is not a reliable indicator of future performance.
Why?
Some of the mutual funds with above-average returns during a period were merely lucky.
A strategy that works well in one environment (inflationary conditions, for example) is often disastrous when conditions change.
Should You Invest in a Fund
Because of its Past Performance?

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Questions for Thought:
1. A friend who just inherited $50,000 asks for your advice about how to invest it in the stock market for her retirement (in 30 yrs).
Is the stock market a good place for her funds? What do you think is the best plan for her to attain a high rate of return at a relatively low risk? Explain.
2. What is the random walk theory of stock prices? What does it imply about the ability of the “experts” to select stocks that will increase in price and avoid those that will decline in price.

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Questions for Thought:
3. “Stock prices are way too high. The stock market must fall.”

— Analyze this view.
4. Many personal finance magazines such as Money and Smart Money routinely give advice as to which stocks to buy.
— Should you take their advice?

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End of
Special Topic 3

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Supply and Demand,
Applications and Extensions

GWARTNEY – STROUP – SOBEL – MACPHERSON

To Accompany: “Economics: Private and Public Choice, 15th ed.”
James Gwartney, Richard Stroup, Russell Sobel, & David Macpherson
Slides authored and animated by: James Gwartney & Charles Skipton
Full Length Text —
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Chapter: 4
Chapter: 4
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First page

Linkage Between Resource
and Product Markets

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Linkage Between Resource
and Product Markets
Markets for resources and products are closely linked.
In the resource market, businesses demand resources, while households supply them.
Firms demand resources in order to produce
goods and services.
Households supply them to earn income.
Labor market is an important resource market.

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An increase in the demand for a product will lead to an increase in demand for the resources used to produce it.
In contrast, a reduction in the demand for a product will lead to a reduction in the demand for resources
to used produce it.
An increase in the price of a resource will increase the cost of producing products that use it, shifting their supply curve to the left.
A reduction in resource prices will have the opposite affect.
Linkage Between Resource
and Product Markets

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Resource Prices
and Product Markets
Resources
Market
Employment
(wait staff)
$10
DR
S1
Price
(wage)

E1
E2

S2
$8

Price
Product
Market
Q1

DP
Q2

S1
Quantity
(of meals)

$12
$11
Suppose there is a reduction in the supply of young workers …
Higher wages increase the restaurant’s cost, causing a reduction in supply in the product market …
that pushes restaurant waiters / waitress wages up.
leading to higher meal prices.

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The Economics of Price Controls

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Price Ceilings
A price ceiling establishes a maximum price that sellers are legally permitted to charge.
Example: rent control
When a price ceiling keeps the price of a good below market equilibrium, there will be both direct and indirect effects.
(Direct effect) Shortage: the quantity demanded will exceed the quantity supplied. Waiting lines may develop.
(Indirect effects) Quality deterioration and changes in other non-price factors favorable to sellers and unfavorable to buyers are likely to occur.
The quantity exchanged will fall and the gains from trade will be less than if the good were allocated by markets.

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Impact of a Price Ceiling
Consider the rental housing market where the price (rent) P0 would
bring the quantity of rental units demanded into balance with the quantity supplied.
A price ceiling like P1 imposes a price below market equilibrium …
causing quantity demanded QD …
Because prices are not allowed to direct the market to equilibrium, non-price elements will become more important in determining where the scarce goods go.
to exceed quantity supplied QS …
resulting in a shortage.
Price
(rent)

Quantity of housing units
Price
ceiling
D
QS
QD

P0
S
P1

Shortage
Rental housing market

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Effects of Rent Control
Shortages and black markets will develop.
The future supply of housing will decline.
The quality of housing will deteriorate.
Non-price methods of rationing will increase in importance.
Inefficient use of housing will result.
Long-term renters will benefit at the expense of newcomers.

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Price Floor
A price floor establishes a minimum legal price for the
good or service.
Example: minimum wage
When a price floor keeps the price of a good above market equilibrium, it will lead to both direct and indirect effects.
(Direct effect) Surplus: sellers will want to supply a larger quantity than buyers are willing to purchase.
(Indirect effects) Changes in non-price factors favorable to buyers and unfavorable to sellers.
The quantity exchanged will fall and the gains from trade will be less than if the good were allocated by markets.

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Impact of a Price Floor
Price

Quantity
A price floor like P1 imposes a
price above market equilibrium …
causing quantity supplied Qs …
Because prices are not allowed to direct the market to equilibrium, non-price elements of exchange will become more important in determining where scarce goods go.
to exceed quantity demanded
QD …
resulting in a surplus.
Price
floor
D
QD
QS

P0
S
P1

Surplus

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Minimum Wage:
An Example of a Price Floor
When the minimum wage is set above the market equilibrium for low-skill labor, the following will occur:
Direct effect:
Reduces employment of low-skilled labor.
Indirect effects:
Reduction in the non-wage components of compensation
Less on-the-job training
May encourage students to drop out of school

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Employment and the Minimum Wage
Price
(wage)

Quantity
(low-skill
employment)
Minimum wage level
D
E1
E0

$5.00
S
$7.25

Excess Supply

Low-skill
labor market
Consider the market for
low-skill labor where a price (wage) of $5 could bring the quantity of labor demanded into balance with the quantity supplied.
A minimum wage (price floor) of $7.25 would increase the wages of low-skill labor, but employment will decline from E0 to E1.
Those who lose their jobs
will be pushed into either unemployment or less preferred employment.

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Does the Minimum Wage
Help the Poor?
While increasing the minimum wage will increase the wages of low-skill workers, their on-the-job training opportunities, non-wage benefits, working conditions,
and employment will decline.
Who earns minimum wage?
Most minimum wage workers are young and / or only working part-time.
Fewer than 20 percent are from families with incomes below the poverty line.

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Questions for Thought:
Which of the following can be expected to result from
a price ceiling that keeps the price of a product below
the market equilibrium?
(a) A surplus of the product will result.
(b) A shortage of the product will result.
(c) Changes in non-price factors that will be favorable
to buyers and unfavorable to sellers will occur.
(d) Changes in non-price factors that will be favorable
to sellers and unfavorable to buyers will occur.
Note: More than one option may be correct.

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Questions for Thought:
2. How would an increase in the minimum wage from the current level to $10 per hour affect:
Employment in skill categories previously earning less than $10 per hour
(b) The unemployment rate of teenagers
(c) Availability of on‑the‑job training for low-skill
workers
(d) The demand for high‑skill workers who provide good substitutes for the labor offered by low-skill workers
who are paid higher wage rates due to the increase in the minimum wage.

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Black Markets and the
Importance of the Legal Structure

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Black Markets
Black market:
A market that operates outside the legal system.
The primary sources of black markets are:
Evasion of a price control
Evasion of a tax (e.g. high excise taxes on cigarettes)
Legal prohibition on the production and exchange of
a good (e. g., prostitution, marijuana and cocaine)
Black markets have a higher incidence of defective products, higher profit rates, and greater use of violence
to resolve disputes.

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Importance of the Legal System
A legal system that provides secure property rights
and an unbiased enforcement of contracts enhances
the operation of markets.
Markets will exist in any environment, but they can be counted on to function efficiently only when property rights are secure and contracts enforced in an evenhanded manner.
The inefficient operation of markets in countries like Russia following the collapse of communism illustrates the importance of an even-handed legal system.

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Questions for Thought:
1. How will the operation of black markets differ from the operation of markets where property rights are clearly defined and contracts are legally enforceable?

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The Impact of a Tax

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Tax Incidence
The legal assignment of who pays a tax is called the statutory incidence.
The actual burden of a tax (actual incidence) may differ substantially.
The actual burden does not depend on who legally pays the tax (statutory incidence).

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Impact of a Tax Imposed on Sellers
Price

D
500
750
$6,400

S plus tax

$7,000
$7,400

$1000 tax
Consider the used car market where a price of $7,000 would bring the quantity of used cars demanded into balance with the quantity supplied.
When a $1,000 tax is imposed on the sellers of used cars, the supply curve shifts vertically upward by the amount of the tax.
The new price for used cars is
$7,400 …
Consumers end up paying $7,400 instead of $7,000 and bear $400
of the tax burden.
Sellers end up receiving $6,400
(after taxes) instead of $7000
and bear $600 of the tax burden.
sellers netting $6,400
($7,400 – $1000 tax).
# of used cars
per month
(in thousands)

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First page

S plus tax

Price

500
750
$6,400
$7,000
$7,400
S
# of used cars
per month
(in thousands)
Impact of a Tax Imposed on Sellers

The new quantity of used cars that clear the market is 500,000.
As only 500,000 cars are sold after the tax (instead of 750,000), the area above the old supply curve and below the demand curve represents the consumer and producer surplus lost from the levying of the tax, called the deadweight loss to society.
Consumers bear $400 of the tax burden and as there are 500,000 units sold per month tax revenues derived from consumers = $200,000,000.
Sellers bear $600 of the tax burden and so, as there are 500,000 units
sold per month, tax revenues derived from the sellers = $300,000,000.
D

Deadweight
Loss due to
reduced trades

Tax revenue
from consumers

Tax revenue
from sellers

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Impact of a Tax Imposed on Buyers
Price

D
500
750
$6,400

$7,000
$7,400

# of used cars
per month
(in thousands)

$1000 tax
D minus tax

Suppose the $1,000 tax was levied on buyers rather than the sellers.
When a $1,000 tax is imposed on buyers of used cars, the demand curve shifts vertically downward
by the amount of the tax.
The new price for used cars is $6,400.
Consumers end up paying $7,400 (after taxes) instead of $7,000 and bear $400 of the tax burden.
Sellers end up receiving $6,400 instead of $7000 and bear $600
of the tax burden.
Buyers then pay taxes of $1000 making the after tax price $7,400.

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Price

D
$6,400
$7,000
$7,400
S
# of used cars
per month
(in thousands)
D minus tax
Impact of a Tax Imposed on Buyers

Deadweight
Loss due to
reduced trades

Tax revenue
from consumers

Tax revenue
from sellers
The new quantity of used cars
that clears the market is 500,000.
Consumers bear $400 of the tax burden and as there are 500,000 units sold per month tax revenues derived from consumers = $200,000,000.
Sellers bear $600 of the tax burden and as there are 500,000 units sold per month tax revenues derived from the sellers = $300,000,000.
The area above the supply curve
and below the old demand curve represents consumer & producer surplus lost due to the tax – the deadweight loss to society.
The incidence of the tax is the same regardless of whether it is imposed on buyers or sellers.
500
750

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Deadweight Loss
The deadweight loss of taxation is the loss of the gains from trade as a result of the imposition of a tax.
It imposes a burden of taxation over and above the burden of transferring revenues to the government.
It is composed of losses to both buyers and sellers.
The deadweight loss of taxation is sometimes referred
to as the “excess burden of the tax.”

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Elasticity and Incidence of a Tax
The actual burden of a tax depends on the elasticity
of supply relative to demand.
As supply becomes more inelastic, more of the burden
will fall on sellers and resource suppliers.
As demand becomes more inelastic, more of the burden will fall on buyers.

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Elastic and Inelastic Demand Curves
110

D
Luxury boat
market
194

80
Gasoline
market
S

$2.60
$2.50
Quantity
(thousands
of boats)

Quantity
(millions
of gallons)
Price
Price
(thousand $)
90
100
5
10
15
20
D

S plus tax

200

$3.00
S

S plus tax

Consider the markets for Gasoline
and Luxury Boats, each in equilibrium.
In the gasoline market, the demand is relatively more inelastic than its supply; hence, buyers bear a larger share of the burden of the tax.
In the luxury boat market, the supply is relatively more inelastic than its demand; hence, sellers bear a larger share of the tax burden.
If we impose a $0.50 tax on gasoline suppliers, the supply curve moves vertically by the amount of the tax.
Price goes up $0.40 and output falls
by 6 million gallons per week.
If we impose a $25K tax on Luxury Boat suppliers, the supply curve moves up by the amount of the tax. Price goes up by $5K and output falls by 5 thousand units.
105

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Tax Rates, Tax Revenues,
and the Laffer Curve

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Average Tax Rate
The average tax rate equals tax liability divided
by taxable income.
A progressive tax is one in which the average tax rate
rises with income.
A proportional tax is one in which the average tax rate stays the same across income levels.
A regressive tax is one in which the average tax rate
falls with income.

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Marginal Tax Rate
The marginal tax rate is calculated as the change in tax liability divided by the change in taxable income.
The marginal tax rate is highly important because it determines how much of an additional dollar earned must be paid in taxes (and therefore, how much one gets to keep). In this way, the marginal tax rate directly impacts an individual’s incentive to earn.

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Marginal & Average Tax Rate
— An Application
An excerpt from the 2012 federal income tax table is shown here.
Note, for single individuals, as income increases from $36,000
to $36,100 …
In this range, what is the individual’s marginal tax rate?
What is the individual’s average income tax rate?
their tax liability increases from $5,036 to $5,061.

2012 Tax Table Continued
If line 43
(taxable
income) is
And you are
At
least
But
less
than
Single
Married
filing
jointly
Married
filing
separately
Head
of a
house-
hold
$36,000
Your tax is …
36000
36050
36100
36150
36200
36250
36300
36350
36400
36450
36500
36550
36050
36100
36150
36200
36250
36300
36350
36400
36450
36500
36550
36600
5036
5049
5061
5074
5086
5099
5111
5124
5136
5149
5161
5174
4534
4541
4549
4556
4564
4571
4579
4586
4594
4601
4609
4616
4784
4791
4799
4806
4814
4821
4829
4836
4844
4851
4859
4866

5036
5049
5061
5074
5086
5009
5111
5124
5136
5149
5161
5174

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Tax Rate and Tax Base
Tax rate:
defined as the rate (%) at which an activity is taxed.
Tax base:
defined as the amount of the activity that is taxed.
Note: the tax base is inversely related to the rate
at which the activity is taxed.
Tax revenues:
defined as tax rate multiplied by tax base.

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Laffer Curve
The Laffer curve (next slide) illustrates the relationship between tax rates and tax revenues.
As tax rates increase from low levels, tax revenues will also increase even though the tax base is shrinking.
As rates continue to increase, at some point, the shrinkage in the tax base will dominate and the higher rates will lead to a reduction in tax revenues.
The Laffer Curve shows that tax revenues are low for both high and low tax rates.

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The Laffer Curve
At a tax rate of 0%, no taxes would be paid and, so, tax revenues would equal to $0.
As the tax rate increases from 0% to some level like A, tax revenues increase despite the fact some individuals work less.
At a tax rate of 100%, nobody would work, and so, tax revenues would be equal to $0.
As rates continue to increase (beyond B, for example), higher rates will eventually cause revenues to fall.
Still higher tax rates will lead to even less tax revenue (from B to C and beyond). This is because the tax base shrinks faster than tax revenues increase from higher tax rates.
There is no presumption that the level of the tax rate at B is the ideal tax rate, only that B maximizes tax revenue in the current period.
Tax rate
(percent)
Tax revenues
25
50
75
100
Maximum

A
C
0
B

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Laffer Curve and
Tax Changes in the 1980s
During the 1980s, the top Federal marginal income tax rate fell from 70% to 33%.
It is important to distinguish between changes in tax rates and changes in tax revenues.
Even though the top Federal income tax rates were cut sharply during the 1980s, the tax revenues and the share
of personal income tax paid by high earners rose during
the decade.

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The Impact of a Subsidy

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Impact of a Subsidy
A subsidy is a payment to either the buyer or seller of a good, usually on a per unit basis.
The supply & demand framework can be used to analyze the impact of a subsidy as it was used to analyze the impact of a tax.
As in the case of a tax, the division of the benefit from a subsidy is determined by the relative elasticities of demand & supply rather than to whom the subsidy is actually paid.
When supply is highly inelastic relative to demand, sellers will derive most of the benefits of a subsidy.
When demand is highly inelastic relative to supply, the buyers will reap most of the benefits of a subsidy.

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Impact of a Subsidy Granted to Buyers
Price

# Full-time
Students
per year

Q1
Q2
$8,000

$10,000
$12.000

S
D11

D2
(D1 plus
subsidy)

$4,000 subsidy

P2 =
P1 =
new
gross
price
new
net
price
When a $4,000 per year tuition subsidy is granted to students, the demand for college shifts vertically by the amount of the subsidy.
The equilibrium price for college rises from P1 = $10,000 to P2 = $12,000
(the new gross price for students).
With the $4,000 subsidy, the net price of the subsidized students is $8,000
per year (a gain of $2,000 for them).
Colleges also benefit from the tuition subsidy through higher prices for their services (P2 is $2,000 higher than before the subsidy).
Who benefits when government subsidizes college students
– the student or the college?

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Real World Subsidy Programs
There are now more than 2,000 federal subsidy programs, twice the number of the mid-1980s.
The primary beneficiaries of subsidy programs are often different than the group receiving the subsidy.
For example, suppliers derive substantial benefits when the purchasers are subsidized, particularly when the supply of the service is highly inelastic
When subsidies are granted to some (the elderly, the poor, certain college students, etc) but not others the group that is not subsidized is generally harmed. They often have to pay higher prices than would otherwise be the case.

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Real World Subsidy Programs
Two examples:
Subsidies to college students:
Grants and loans to college students have grown substantially in recent decades. While these subsidies have helped students pay for college, they have also driven up the cost of college.
Health care subsidies:
Subsidies to health care consumers have driven up the cost of health care. Health care prices have risen at twice the rate of other prices since the passage of Medicare and Medicaid.
Politicians often us subsidy programs to obtain votes and political contributions from interest groups benefiting from the subsidies. The ethanol subsidies provide an example.

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Questions for Thought:
1. The Laffer Curve indicates that:
a. an increase in tax rates will always lead to an increase
in tax revenues.
b. when tax rates are low, an increase in tax rates will generally lead to a reduction in tax revenues.
c. when tax rates are high, a rate reduction may lead to
an increase in tax revenue.
d. the deadweight losses resulting from taxation are small at the tax rate that maximizes the revenues derived by the government.

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Questions for Thought:
2. The burden of an sales tax imposed on a product will fall primarily on buyers when:
a. the demand for the product is highly inelastic and supply is relatively elastic.
b. the demand for the product is highly elastic and the supply is relatively inelastic.
c. the tax is legally imposed on the seller.
d. the tax is legally imposed on the buyer.
3. “We should impose a 20% luxury tax on expensive cars (those with a sales price of more than $80,000) in order to collect more tax revenue from the wealthy.” Will the burden of such a tax fall primarily on the wealthy?

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Questions for Thought:
4. Several cities and states have recently increased the taxes they levy on cigarettes by a dollar or more per pack. How will these taxes affect:
(a) the quantity of cigarettes sold in the city or state,
(b) the tax revenues collected from the tax,
(c) the incidence of smoking.

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End of
Chapter 4

Supply and Demand

How are scarce resources and products allocated within an economy?

· Who or what determines at what price consumers will be willing and able to pay for a product?

· Who or what determines at what price producers and suppliers will be willing and able to supply a product?

Markets. Markets bring together the consumers and producers and suppliers of goods and services, and it is in markets where the exchange process occurs. For brevity sake, producers will be used to represent suppliers too.

· Because the exchange process involves a market where consumers and producers come together to make the exchange, there is ultimately an agreed-upon price and quantity between the two parties.

· In order to more fully understand how this exchange process takes place and how the consumer and producer determine price and quantity, we are going to discuss specifically first the DEMAND process, and then the SUPPLY process.

Quantity demanded is a function of, or depends upon, price. There are certain variables which affect or change demand from one level to a lower or higher level. Price of related goods, population, preferences, expectations, taxes, substitutes, complements, number of buyers, and income are some of the main variables that will affect demand.

Because there is a negative, or inverse relationship, between quantity (dependent variable) and price (independent variable), the slope of the demand curve will most often be negatively downward sloped.

Due to that notion, as you move down the demand curve from left to right, as price falls, or at lower prices, quantity demanded rises; going up the demand curve from right to left, as price rises, or at higher prices, quantity demanded is less. That is the Law of Demand. When all you are doing is comparing one price and quantity to another price and quantity, that is “movement along the demand curve;” if one of those variables changes, that is going to lead to a new demand curve, and that is referred to “a change in demand.”

Quantity supplied is a function of price. There are certain variables which affect or change supply from one level to a lower or higher level. Price of other goods, nature, taxes, technology, capacity, number of producers, and expectations are some of the main variables that will affect supply.

Because there is a positive, or direct relationship, between quantity (dependent variable) and price (independent variable), the slope of the supply curve will most often be positively downward sloped.

· Like the demand curve, moving up or down the supply curve implies “movement along the supply curve” in which at higher prices, quantity supplied is higher (direct relationship); at lower prices, quantity supplied is lower.

· That is the Law of Supply. If any one of the variables for supply changes, then a new supply curve will ensue, and that is referred to “a change in supply.”

In summary, markets exist to allow an exchange between a consumer and a producer. Consumers will be willing and able to purchase a good based upon the sensitivity between quantity and price.

Because there is a negative relationship between quantity and price, at higher prices, quantity demanded will be less, while at lower prices, quantity demanded will be higher.

That is the Law of Demand, and when one of the variables (price of related goods, population, preferences, expectations, taxes, substitutes, complements, number of buyers, and income) changes in the market, a new demand curve will ensue, and it can shift either left or right of the original demand curve (leftward always indicates less, while rightward shift indicates more).

Similarly, quantity supplied will be contingent upon price, and producers will be willing and able to supply based upon quantity and price. There is a positive relationship between quantity and price, so quantities supplied will coincide with higher or lower prices, which is the Law of Supply.

A shift in supply (new supply curve) will occur when one or more of the variables (price of other goods, nature, taxes, technology, capacity, number of producers, and expectations) changes (leftward shift is less, and rightward shift is more). When the demand and supply curves are presented together, the market equilibrium price and quantity are found.

Equilibrium

Markets inherently seek equilibrium. Due to scarcity, finite resources, and unlimited consumer wants and needs, markets bring together consumers and producers to an equilibrium point where both parties agree on price and quantity.

The Circular Flow Diagram of Economic Activity exemplifies this process of consumers and firms coming together to make possible markets and the exchange process: Households, which are the individuals within an economy or market, provide the factor resources (factors of production) to firms to produce the goods and services households need and want; compensation or rewards for those resources to households come in the form of income, wages, interest, or rent, from which the consumption and purchase of the goods and services transpires.

Leakages to the circular flow manifest when taxes are imposed, imports from foreign markets, and savings; injections to the circular flow occur with exports to foreign markets, consumption, and investment.

· None of the leakages or injections are necessarily good or bad, since we must consider the specific variables involved for unique economic situations when they occur. However, market disruptions can occur with the imposition of price floors, price ceilings, taxes, and producer subsidies.

A price artificially set above the equilibrium point where demand and supply cross is called a price floor. The laws of demand and supply are applied to determine the price floor’s effects. Because at higher prices quantity demanded is less (Law of demand), and because at higher prices quantity supplied is more (Law of Supply), surpluses ensue in markets. More simply stated, quantity demanded is less than quantity supplied.

· One common example used for price floors is minimum wages. When a minimum wage is mandated in markets, the price of labor will not be allowed to fall below that specific floor (or minimum price) to come back down to equilibrium.

· Unemployment actually can result. Thus, at that higher price, the negatively-sloped demand curve is affected first when moving from that price on the vertical axis (Y axis or price axis) horizontally across to determine quantity, indicating a discrepancy between quantity demanded and quantity supplied.

A price artificially set below the equilibrium point where demand and supply cross is called a price ceiling. Here, too, the laws of demand and supply determine the price ceiling’s effects. Because at lower prices quantity demanded is greater, and because at lower prices quantity supplied is less, shortages ensue.

Quantity demanded is greater than quantity supplied. If, for example, a price ceiling were imposed on gasoline, consumers would be more willing and able to consume higher quantities at that lower price. However, for the producer, his marginal costs would rise if he were to try to keep up with the increase in quantity demanded; the producer would be left with no choice but to cut back on production to lower his marginal costs, as marginal revenues cannot increase due to the price ceiling. Shortages.

Taxes remove private property from consumers. Taxes are also imposed on firms. Taxes are needed to run a government, but anything greater than what is “needed” can lead to deadweight losses and disequilibrium. When we refer back to the variables affecting demand and supply, we see that taxes are common to both.

· If taxes are increased, for example, that will have a contracting effect on markets in which the demand curve (aggregate demand) shifts leftward and the supply curve (aggregate supply) shifts leftward.

· When both curves shift leftward, for example, quantity output (X axis or horizontal axis) is reduced, and price is indeterminate (depends whether demand rises or falls more than supply).

Lastly, a subsidy leads to disequilibrium. Most commonly, producers subsidies are imposed on markets. When a producer subsidy is imposed, the higher quantity desired, usually by the government issuing the subsidy, leads to a shift in supply and a new supply curve.

Falling on a lower point on the demand curve, quantity demanded is higher, quantity supplied is higher, and the difference between the market equilibrium price and the “promised” price, or subsidy price, is what the producer will sell for economic profits. The discrepancy between the producer subsidy price and the actual selling price will be deadweight losses (or welfare losses) to society. Overproduction and inefficiencies ensue from there.

Thus, markets seek equilibrium. The Circular Flow of Economic Activity reveals the efficient processes between the consumer and producer. Breaks in the process will cause disruptions, inefficiencies, and equity problems within the economic system.

Price floors artificially lead to surpluses, price ceilings lead to shortages, taxes can affect demand and supply, and producer subsidies can lead to overproduction and inefficiencies. Efficiency and equity are most clearly found when markets reach natural equilibrium.

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