Simple Models: PPF & Supply/Demand

Rebecca Tuttle Baldwin

Bellevue Community College

From the perspective of a society

Choices about linking inputs to outputs through production (allocation & distribution of mix of goods)

Three fundamental questions: What will be produced How will it be produced For whom

What is possible?

Doesn’t mean it will be done but could be done

Can represent graphically or numerically Each possibility gains something but we

also face opportunity cost Can illustrate with Production Possibilities

Frontier (outermost curve, PPF)

Shape of PPF tells us something

Linear or “bowed” Constant or increasing rate of opportunity

cost Which is more “realistic”

David Ricardo

Theory of Comparative Advantage– Not absolute advantage– Explanation for trade

Among nations Exchange in markets between individuals

Types of Economies

related but not the same as political structure Differentiated by the way society answers those

fundamental questions Command—centralized authority is decision-

maker “laissez faire” or market economy has individual

economic agents making choices mixed

Focusing first on a market economy

Individual economic units as decision-makers

People in households Firms in business sector Interact in markets Inputs through production functions to

outputs (goods/services)

What is a Market?

A market is the collection of buyers and sellers that, through their actual or potential interactions, determine the price of a product or set of products.

Two types of goods

Consumer Goods—who uses? Capital Goods—also an input!

Time Matters

Market Outcome

Supply and demand interact through

the price signal to reach equilibrium (market price and associated quantity where neither a surplus nor shortage exists).

a b c d e

$1.25 1.00 0.75 0.50 0.25

8 14 20 26 32

Price per Quart

Quantity Demanded per Month (millions of quarts)

Exhibit 1a: The Demand Schedule for Milk

Exhibit 1b: The Demand Curve for Milk

Exhibit 1b: The Demand Curve for Milk

Pri

ce p

er q

uar

t

8 14 20 26 32

$1.25

1.00

0.75

0.50

0.25

0

a

b

c

d

e

D

Millions of quarts per month

Law of Demand

All other things being equal (ceteris paribus), the lower the price, the higher the quantity buyers will wish to purchase in a given time period.

Consumer Demand: Qd=f(P)

Taste/Preference Income/Wealth Price/availability of

other goods Expectations Number of consumers

D

Exhibit 2: An Increase in the Market Demand for Milk

Exhibit 2: An Increase in the Market Demand for Milk

$1.25

1.00

0.75

0.50

0.25

0 8 14 20 26 32

Millions of quarts per month

Pri

ce p

er q

uar

t

D

D'

gb

f

Exhibit 3a: The Supply Schedule for Milk

Exhibit 3a: The Supply Schedule for Milk

$1.25 1.00 0.75 0.50 0.25

28 24 20 16 12

Price per Quart

Quantity Supplied per Month (millions of quarts)

Exhibit 3b: The Supply Curve for Milk

Exhibit 3b: The Supply Curve for Milk

Pri

ce p

er q

uar

t

12 16 20 24 28

$1.25

1.00

0.75

0.50

0.25

0

S

Millions of quarts per month

Law of Supply

As the price of a good rises, the quantity that firms are willing to supply will increase, c.p.

Firms’ Supply: Qs=f(P)

Technology Prices of other goods

(factor prices) Expectations # of sellers

s

Exhibit 4: An Increase in the Supply of Milk

Exhibit 4: An Increase in the Supply of Milk

$1.25

1.00

0.75

0.50

0.25

0

12 16 20 24 28Millions of quarts per month

Pri

ce p

er q

uar

t

S'

j

i

S

h

Equilibrium

Price at which QD=QS Intersection of Supply & Demand Market forces bring us to equilibrium when

markets function Point we stay at until “ceteris paribus” condition is

violated for supply, demand, or both no forces acting for change not perfection

Shortage

QD greater than QS What has to happen to price to move us out

of the shortage? Laws of Supply & Demand tell us…as price

increases, QD falls and QS increases…c.p. Shortage=Excess Demand No one coordinates

Surplus

QS greater than QD Also called Excess Supply What has to happen to P to bring us to

equilibrium? Price has to fall

Ceteris paribus

Latin phrase, meaning “all other things being equal”

key assumption for some of our micro theories/models

Exhibit 5a: Equilibrium in the Milk Market (Market Schedules)

Exhibit 5a: Equilibrium in the Milk Market (Market Schedules)

Price per Quart

Quantity Dem anded

Quantity Supplied

Surplus or Shortage

Price W ill

$1.25 1.00 0.75 0.50 0.25

8 14 20 26 32

28 24 20 16 12

Surplus of 20 Surplus of 10 Equilibrium Shortage of 10 Shortage of 20

Fall Fall Rem ain the same Rise Rise

Millions of Quarts per Month

Exhibit 5b: Equilibrium in the Milk Market (Market Curves)

Exhibit 5b: Equilibrium in the Milk Market (Market Curves)

14 16 20 24 26 Millions of quarts per month

Pri

ce p

er q

uar

t $1.25

1.00

0.75

0.50

0.25

0

Shortage

Surplus

c

S

D

Price

Only piece of information individual agents on both side observe Allocation mechanism/ rationingwhat must be given in exchange for the good

Do all markets reach equilibrium?

time regulations (price ceiling/price floor) what happens then?

Effects of an Effects of an Increase in DemandIncrease in Demand

Effects of an Effects of an Increase in DemandIncrease in Demand

20 24 30 Millions of quarts per month

Pri

ce p

er q

uar

t

$1.00

0.75

0

S

D'

D

Effects of an Effects of an Increase in SupplyIncrease in Supply

Effects of an Effects of an Increase in SupplyIncrease in Supply

20 26 30 Millions of quarts per month

Pri

ce p

er q

uar

t

$0.75

0.50

0

S

D

S'

Indeterminate Effect of an Increase Indeterminate Effect of an Increase

in Both Supply and Demand (Shift in Demand Dominatesin Both Supply and Demand (Shift in Demand Dominates))Indeterminate Effect of an Increase Indeterminate Effect of an Increase

in Both Supply and Demand (Shift in Demand Dominatesin Both Supply and Demand (Shift in Demand Dominates))

p'

p

0

Pri

ce

Q Q ' Units per period

SS'

D'

D

Indeterminate Effect of an Increase in Both Supply and Demand Indeterminate Effect of an Increase in Both Supply and Demand

(Shift in Supply Dominates)(Shift in Supply Dominates)

Indeterminate Effect of an Increase in Both Supply and Demand Indeterminate Effect of an Increase in Both Supply and Demand

(Shift in Supply Dominates)(Shift in Supply Dominates)

p

p "

Pri

ce

Q Q" Units per period

DD"

SS"

0

Effects of Changes Effects of Changes in Both Supply and Demandin Both Supply and Demand

Effects of Changes Effects of Changes in Both Supply and Demandin Both Supply and Demand

Supply increases Supply decreases

Demand increases Demand decreases

Change in Demand

Ch

ang

e in

Su

pp

ly

Equilibrium price changeis indeterm inate. Equilibrium quantity increases. Equilibrium

price rises. Equilibrium quantity change is indeterm inate.

Equilibrium price fa lls. Equilibrium quantity change is indeterm inate. Equilibrium price change is indeterm inate. Equilibrium quantity decreases.

Effects of a Price Floor Effects of a Price Floor and Price Ceiling (Price Floor for Milk)and Price Ceiling (Price Floor for Milk)

Effects of a Price Floor Effects of a Price Floor and Price Ceiling (Price Floor for Milk)and Price Ceiling (Price Floor for Milk)

$1.00

Pri

ce p

er q

uar

t

14 24

S

D

Millions of quarts per month

Surplus

0

Effects of a Price Floor Effects of a Price Floor

and Price Ceiling (Price Ceiling for Rent)and Price Ceiling (Price Ceiling for Rent)Effects of a Price Floor Effects of a Price Floor

and Price Ceiling (Price Ceiling for Rent)and Price Ceiling (Price Ceiling for Rent)

$600

$400

Mo

nth

ly r

enta

l pri

ce

40 50 60

D

S

Shortage

Thousands of rental units per month

0

University lunchroom

Price per slice Demand Supply

1 420 0

2 210 100

3 140 140

4 105 160

5 84 170

Americans’ tastes have shifted from beef to chicken

describe market for beef before & after that change

describe market for chicken describe market for roadside hamburger

stands

For each of the following, decide whether shift or movement on what curve

The housing market: Consumers’ incomes fall shift in demand, movement along supply Sudden increase in price of milk, which is used to

produce frozen yogurt. supply shifts left, movement along demand

Classic Example of Market--Competitive

Many buyers Many sellers Perfect Information No barriers to entry or exit Homogenous good

Most markets are not the competitive ideal

So market power exists--

ability to influence price

The End!