Lecture 2

• Models


  Simplified representations of reality that focus on what is considered most important and treat everything else as assumptions
• Circular-flow diagram


  1. Firms produce and sell goods and services, hire and use factors of production

  2. Households buy and consume goods and services, own and sell factors of production

  3. Markets for goods and services: Firms supply, Households demand

  4. Markets for factors of production: Households supply, Firms demand
• The focus of this course is on the markets for goods and services
• Demand curve


  A graph of the relationship between price (P) and quantity demanded (Qd)
• Law of demand


  • As the price of a good rises (falls) and all other variables remain constant, the quantity demanded falls (rises)
• The demand curve usually has a negative slope
• Individual demand curve


  A demand curve for a single consumer or household
• Market demand curve


  The combined demand curve of all consumers
• A change in the price of a good (ceteris paribus)


  Leads to a movement along the demand curve; quantity demanded changes
• A change in a factor other than the price of the good

  Leads to a shift of the demand curve; demand changes
• Demand shifters


  Factors that can cause an increase or decrease in demand
• Six important demand shifters

  • Changes in the prices of related goods (substitutes and complements)
  • Changes in consumer income (normal goods and inferior goods)
  • Changes in consumer tastes and preferences
  • Changes in advertising and other marketing activities
  • Changes in population size and composition
  • Changes in consumer expectations
• Substitutes


  Goods where an increase (decrease) in the price of one good leads to an increase (decrease) in demand for the other good, shifting the demand curve to the right (left)
• Complements


  Goods where an increase (decrease) in the price of one good leads to a decrease (increase) in demand for the other good, shifting the demand curve to the left (right)
• Normal goods


  Goods where an increase (decrease) in income leads to an increase (decrease) in demand, shifting the demand curve to the right (left)
• Inferior goods


  Goods where an increase (decrease) in income leads to a decrease (increase) in demand, shifting the demand curve to the left (right)
• Normal and inferior goods


  The adjectives do not necessarily reflect the quality of the goods. Inferior goods are not always of lesser quality (or cheaper) than normal goods.
• Other demand shifters


  • Consumer tastes and preferences
  • Advertising and other marketing activities
  • Population size
  • Population composition
  • Consumer expectations regarding prices
  • Consumer expectations regarding income
• Demand function


  A mathematical representation of the demand curve for a good, showing how many units are demanded at alternative prices and alternative levels of other factors affecting demand
• The simplified demand function focuses on price by holding all other factors constant
• Inverse demand function


  Represents the same information as the demand function, but has price on the left-hand side and quantity on the right-hand side
• When economists use the term "demand function", they usually refer to the simplified demand function or its inverse
• Elements of a general market model

  • Demand curve
  • Demand shifters
  • Demand function
  • Supply curve
  • Supply shifters
  • Supply function
  • Price and quantity in a competitive market
  • Controls on prices
  • Comparative static analysis
• Quantity supplied


  The amount of a good (or service) that sellers are willing and able to offer per unit of time
• Supply curve


  A graph of the relationship between price and quantity supplied
• Supply schedule


  A corresponding table to the supply curve
• Law of supply


  As the price of a good rises (falls) and all other variables remain constant, the quantity supplied rises (falls)
• If another relevant factor changes simultaneously with the price, the law of supply is not (necessarily) applicable
• Individual supply curve


  The supply curve for a single firm
• Market supply curve


  The combined supply curve of all firms in the market
• A change in the price of a good


  Leads to a movement along the supply curve; quantity supplied changes
• A change in a factor other than the price of the good

  Leads to a shift of the supply curve; supply changes
• Six important supply shifters

  • Input prices
  • Prices of other goods in production (substitutes and complements)
  • Natural and social factors
  • Technology and regulations
  • Number of sellers
  • Producer expectations
• Supply function


  A mathematical representation of the supply curve for a good, showing how many units are supplied at alternative prices and alternative levels of other factors affecting supply
• The simplified supply function focuses on price by holding all other factors constant
• Inverse supply function


  Represents the same information as the supply function, but has price on the left-hand side and quantity on the right-hand side
• When economists use the term "supply function", they usually refer to the simplified supply function or its inverse
• n


  Represents the price firms must receive to supply alternative quantities. Useful when drawing a diagram.
• Rearrange the (simplified) supply function to determine the (simplified) inverse supply function

  1. Qs = 4000P - 40 000

  2. 4000P = 40 000 + Qs

  3. P = 10 + 0.00025Qs
• Market equilibrium


  • Demand curve
  • Demand shifters
  • Demand function
  • Supply curve
  • Supply shifters
  • Supply function
  • Price and quantity in a competitive market
  • Controls on prices
  • Comparative static analysis