sss/Principles of Microeconomics

Spring 2019 Prin iples of Mi roe onomi s T. Tung

Part III

Interdependen e and the Gains from Trade

Produ tion de isions depend on the produ tion ombinations available to a produ er. We have a model that demon-

strates these ombinations. The produ tion possibilities frontier represents the di�erent produ tion possibilities a

produ er has available. We an use the PPF model to demonstrate the gains from trade and spe ialization:

The ran her and the farmer both fa e tradeo�s and hoose to produ e some of both meat and potatoes. Unlike

the previous examples of the PPF, both the ran her and the farmer have �at PPFs and an produ e either good

equally well. Both entities hoose to devote half of their time to produ e ea h good � this allows for enjoyment of

both potatoes and meat. However, both the ran her and the farmer are for ed to produ e in the feasible region of

their PPF urves. If the two parties hoose to spe ialize and trade, they will be better o�:

Spe ialization and Trade:

� If the farmer and the ran her hoose to spe ialize in produ ing either meat or potatoes, a larger level of

onsumption will be available. Spe ialization is driven by the on ept of omparative advantage. This pro ess

is is based o� of the two party's opportunity osts:

� Absolute Advantage: The ability to produ e a good using fewer inputs than another produ er. In the example

above, the ran her has an absolute advantage in meat produ tion (20 minutes per oun e vs 60 minutes for

the farmer).

� Opportunity Cost: Whatever has to be given up to obtain something else. In the ase of the ran her and

the farmer, the opportunity ost of time spent produ ing potatoes is the time spent produ ing meat instead.

They both fa e a produ tion trade-o�.

� Comparative Advantage: The ability to produ e a good at a lower opportunity ost than another produ er.

In other words, an entity that gives up less to produ e a good or servi e has the omparative advantage.

� The ran her an produ e 1 oun e of potatoes with 10 minutes of work. With those 10 minutes of work,

the ran her ould instead produ e 1/2 oun e of meat (sin e it takes the ran her 20 minutes to produ e

1 oun e of meat). Thus the opportunity ost of produ ing 1 oun e of potatoes is 1/2 oun e of meat.

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

� The farmer an produ e 1 oun e of potatoes in 15 minutes. With those 15 minutes of work, the farmer

ould instead produ e 1/4 of meat (sin e it takes the farmer 60 minutes to produ e 1 oun e of meat).

Thus the opportunity ost of produ ing 1 oun e of potatoes is 1/4 oun e of meat.

� Sin e the farmer's opportunity ost is lower than the ran her, the farmer has the omparative

advantage in potato produ tion.

� The opportunity ost for the farmer to produ e 1 oz. of meat is 4 oz. of potatoes

� The opportunity ost for the ran her to produ e 1 oz. of meat is 2 oz. of potatoes.

� Sin e the ran her's opportunity ost is lower than the farmer, the ran her has the omparative

advantage in meat produ tion.

� Spe ialization is based o� of omparative advantage: the produ er with the lower opportunity ost should

produ e more (or ex lusively) of that good.

� Sin e the ran her has a omparative advantage in potato produ tion, that is what he should spe ialize

in produ ing potatoes. The result of this pro ess is that the total amount of meat and potatoes in the

e onomy has in reased and both the ran her and the farmer have more to onsume. Thus, spe ialization

and trade bene�t every individual in this e onomy.

The Pri e of Trade:

� There are osts asso iated with trade:

� Who determines the pri e and quantity of what is traded?

� How are the gains from trade distributed?

� What transa tion osts are asso iated with the overall trading pro ess?

� The pri e of trade should be �in-between� the opportunity ost for ea h party to produ e 1 oz. of meat.

(In this ase the opportunity ost for the farmer to produ e one oun e of potatoes is 4 oun e of potatoes.

Similarly, it is 2 oun e of potatoes for the ran her). Thus, the trade above of 1 oz. of meat per 3 oz. of

potatoes works well. If the pri e of the trade was not within this range, the terms of the trade would favor

one party too mu h: No trade would o ur.

� As long as the gains from trade over ome any asso iated osts, the bene�ts in the e onomy outweigh the osts

and trade should o ur.

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

Part IV

The Market For es of Supply and Demand

The for es of supply and demand drive intera tions in markets.

� Markets o ur when groups of buyers and sellers intera t to ex hange parti ular goods and servi es

� Markets are a fundamental aspe t of e onomi s and humans onstantly intera t with ea h other within

markets

� Competitive Market: A market where there are many buyers and sellers. Most markets for goods are highly

ompetitive as sellers seek to gain more business than their ompetition. Due to the high number of sellers,

ea h seller has a negligible impa t on the market pri e.

Perfe t Competition:

This part relies on the assumption of perfe t ompetition. In perfe t ompetition, the market meets spe i�

riteria:

1. The goods o�ered in the market are all exa tly the same.

2. There are so many buyers and sellers that no individuals have any in�uen e over the market pri e.

3. Pri es are determined in the market. Thus, the buyers and sellers are all pri e takers.

Demand:

� Demand is driven by buyers/ onsumers. By studying the behavior of buyers, valuable information regarding

demand an be gathered.

� Quantity Demanded: The amount of a good that onsumers are willing and able to pur hase.

� Demand S hedule: A table that shows the relationship between the pri e of a good and the quantity demanded.

� Law of Demand: The laim that, other things equal, the quantity demanded of a good falls

when the pri e of the good rises.

Figure 1: Demand Curve� Visual representation of the relationship between the pri e and the quantity demanded

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

The above �gure demonstrates the demand urve of one individual in the e onomy. However, every market/e onomy

has numerous buyers who all have their own demand s hedule/ urve. To �nd market demand, every individual

demand urve need to be summed. Individual demand urves are added horizontally to �nd total market demand:

The market demand urve represents the total demand in an e onomy. From this point forward, it will be referred

to as the demand urve for the e onomy.

Shifts in Demand:

A key element of analyzing shifts in demand is the distin tion between a movement along the demand urve

and a shift in the demand urve. A hange in the pri e of the good is the only fa tor that an ause a movement

along the demand urve. This makes logi al sense be ause pri e is on the y-axis and the law of demand states that

at higher pri es, there is a lower level of quantity demanded. Any external fa tor that a�e ts demand will ause

a shift in the demand urve. Any fa tor that hanges the quantity demanded at every pri e auses a shift. An

in rease in demand shifts the urve to the right and a de rease in demand shifts the urve to the left. The following

fa tors ause a shift in the demand urve.

1. Changes in In ome

(a) For a normal good, an in rease in in ome will shift the demand urve to the right. Most goods are

normal goods in luding books, ats, movie ti kets, et .

(b) For an inferior good, an in rease in in ome will shift the demand urve to the left. An example of an

inferior good is top ramen. As an individual's in ome in reases, we would expe t them to demand less

top ramen (in favor of healthier, more expensive food).

2. Change in the Pri e of a Related Good

(a) Substitute goods an be onsumed in pla e of one another with no hange in onsumer happiness. Pizza

and burgers are substitutes be ause they an be onsumed in pla e of one another.

i. When the pri e of a substitute in reases, demand will shift to the right

ii. When the pri e of a substitute de reases, demand will shift to the left left

(b) Complementary good are onsumed together. Left shoes and right shoes are almost always onsumed

together. Thus, they are omplementary goods.

i. When the pri e of a omplement in reases, demand will shift to the left

ii. When the pri e of a omplement de reases, demand will shift to the right

3. Tastes � Human's tastes are onstantly evolving. This an have a positive or negative impa t on demand.

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

4. Expe tations of Future In ome or Pri es

(a) An expe tation of an in rease in future will in ome will ase demand to shift to the right

(b) An expe tation that the pri e of a good will de rease in the future will ause demand to shift to the left.

5. Number of Buyers

(a) An in rease in the number of buyers will in rease demand.

Supply:

� Supply is determined by the sellers in a market.

� Quantity Supplied: The amount of a good that sellers are willing and able to sell.

� Supply S hedule: A table that shows the relationship between the pri e of a good and the quantity supplied

� Law of Supply: The laim that, other things equal, the quantity supplied of a good rises when

the pri e of the good rises.

Figure 2: Supply Curve: A graph that shoes the relationship between the quantity supplied and the pri e of a

good.

The above �gure demonstrates the supply urve of one individual seller in the e onomy. However, every mar-

ket/e onomy has numerous sellers who all have their own demand s hedule/ urve. To �nd market supply, every

individual supply urve need to be summed. Individual supply urves are added horizontally to �nd total market

supply:

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

.

The market supply urve represents the total supply in an e onomy. From this point forward, it will be referred to

as the supply urve for an e onomy.

Shifts in Supply:

A key element of analyzing shifts in supply is the distin tion between a movement along the supply urve and

a shift in the supply urve. A hange in pri e of the good is the only fa tor that an ause a movement along the

supply urve. This makes logi al sense be ause pri e is on the y-axis and the law of supply states that at higher

pri es, there is a higher level of quantity supplied. Any external fa tor that a�e ts supply will ause a shift in

the supply urve. Any fa tor that hanges the quantity supplied at every pri e auses a shift. An in rease in supply

shifts the urve to the right and a de rease in supply shifts the urve to the left. The following fa tors ause a shift

in the supply urve.

1. Input Pri es

(a) When the pri es of inputs (I.e. raw materials, ingredients, et .) in reases, supply shifts to the left.

2. Te hnology

(a) Improvements in te hnology allow for more to be produ ed. Thus, supply shifts to the right.

3. Expe tations

(a) If a seller believes pri es in the future will rise, they will keep some of their supply in storage to apitalize

on this knowledge. Supply shifts to the left.

4. Number of Sellers

(a) A de rease in the amount of sellers will ase a de rease in supply and the supply urve shifts left.

Equilibrium:

� Equilibrium o urs when the market pri e has rea hed the level at whi h quantity supplied equals quantity

demanded.

� Equilibrium Pri e: The pri e that omes from demand and supply being in equilibrium � quantity supplied

and quantity demanded are balan ed. Also known as the market learing pri e.

� This pri e o urs where the demand and supply urve interse t.

� Equilibrium Quantity: The quantity demanded and the quantity supplied at the equilibrium pri e.

� This quantity o urs where the demand and supply urves interse t.

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

� A graph allows for visual determination of what the equilibrium and the equilibrium pri e will be:

� Surplus: A situation in whi h quantity supplied is greater than quantity supplied. Surplus is also referred to

as ex ess supply.

� Shortage: A situation in whi h quantity demanded is greater than quantity supplied. Shortage is also referred

to as ex ess demand.

� Surplus & Shortage are demonstrated on the following graphs.

In a shortage or surplus situation, buyers and sellers intera t ontinue to intera t with ea h other. The result

of these intera tions is movement ba k towards the equilibrium pri e. When the market experien es a shortage,

demand ex eeds supply. Consumers wait in line or get to stores immediately when they open to pur hase the good.

Thus, sellers an in rease the pri e with no impa t on revenues. As pri es in rease, quantity demanded will de rease

and quantity supplied will in rease. This pro ess ontinues until the equilibrium pri e o urs. The phenomena of

pri e adjustments to equilibrium are so pervasive that it is alled the Law of Supply and Demand.

3 Steps to Analyzing Changes in Equilibrium:

1. Determine whether the supply urve, the demand urve, or both urves shift.

2. Whi h dire tion is the shift (left/right or positive/negative)

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

3. Use the supply-demand diagram to ompare the initial and the new equilibrium. How do the shifts and

hanges in the system a�e t the overall pi ture.

(a) Note: Be very areful when there is a movement along the urve vs. a shift in the urve.

How Pri es Allo ate Resour es:

� We all a t as part of supply or demand in an e onomy whenever we intera t in a market.

� Pri es determine who produ es ea h good and how mu h is produ ed.

� Though the de ision making pro ess is highly de entralized, when parties intera t in markets at di�erent

pri es, e� ient allo ations an o ur.

Examples of Changes in Equilibrium:

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