Scarcity, Supply, and Demand

Scarcity §

• An opportunity cost pertains to what people must give up to obtain something else they want. It is the value of the next best alternative.

  • Every choice has an opportunity cost.
  • Opportunity cost is not necessarily tied to money. There is also time and effort to consider as well as the fact other opportunities are lost.
  • Knowing the opportunity costs can alter behavior.

• Marginal analysis - a form of analysis where we examine the costs and benefits of choosing a little more or a little less of a good.

• Utility pertains to the perceived value of a particular good.

  • A rational consumer purchases additional units of a product as long as marginal utility is greater than opportunity cost.
  • In rational decision making Sunk costs should not affect decisions.

• Generally, we can model scarcity and opportunity costs using either of the following

  • Budget constraint - all possible combinations of goods someone can afford, given the prices of goods, and assuming all income is spent. We use the relative prices of two goods (which are fixed).
  • Production Possibilities Frontier - indicates all possible allocations of a budget towards producing certain resources.
    • This is subject to the law of diminishing returns where the gains towards one production is determined by how much has already been spent towards it.
    • Along the production frontier, we have Productive efficiency which means that it is impossible to produce more than one good without decreasing production for another.
    • We can contrast productive efficiency with allocative efficiency where a particular combination of goods and services represents a socially desirable combination [^opp_1
    • Market Failure - a situation where the private market fails to achieve efficient output
  • Both of the above capture scarcity, tradeoffs, economic efficiency, and the self-interested nature of entities within the economy.

• The following assumptions are assumed when it comes to opportunity costs

  • Law of diminishing marginal utility - the more a person receives of a good, the less additional marginal utility.
  • Law of increasing opportunity cost / Law of diminishing returns - as production of a good or service increases, the marginal opportunity cost of producing the good increases as well.
    • This happens because some resources are better suited for some produce more than others.
    • The gains towards producing one good is determined by how much of the budget was already spent on it.

• Economies, due to different circumstances, tend to have different opportunity costs for various resources and for producing various goods.

  • These differences give rise to comparative advantages of a certain good.
  • When entities engage in Trade, they specialize in the production of the goods in which they have comparative advantage. This maximizes production and surplus for both parties.

Supply and Demand §

• Demand refers to the amount of some good that consumers are willing and able to purchase at each price. Aside from price, there are other factors that can affect demand.

  • It is based on needs and wants and the relationship between quantity and price.
  • More spending power = more demand since consumers can spend more money to buy more things.
    • Normal goods are those where increased spending power equates to increased demand
    • Inferior goods are those where increased spending power equates to decreased demand.
  • Changes in tastes
  • Changes in demographics. More people likely to buy the product = higher demand.
  • Changes in prices of related goods
    • A lower price for a substitute (which replaces a good) decreases the demand for the other product.
    • A lower price for a complement (which is used with a good) increases the demand for the other product.
  • Changes in expectations about future prices which can encourage or discourage buying.

• The Law of Demand states that as price increases, the quantity demanded decreases assuming all other variables are held constant.

• Supply refers to the amount of some good that a producer is willing to produce at each price. Aside from price, there are other factors that can affect supply.

  • It is based on the capacity of the producer to produce the good — its potential profits.
  • More profit = more supply.
  • More cost = less supply.
  • Geography
  • Innovation and technology relating to production methods.
  • Government regulations and taxes (which function as costs)
  • Government subsidies (which function as revenue).

• The Law of Supply states that as price increases, supply also increases assuming all other variables are held constant.

• Supply and demand curves meet at an equilibrium point which determines the price of the good in the market and the quantity sold.

  • At any price above equilibrium price, the quantity supplied exceeds the quantity demanded, meaning we have a surplus.
  • At any price below equilibrium price, the quantity supplied is lower than the quantity demanded, meaning we have a shortage.
  • Incentives exist to push the price and quantity towards equilibrium
  • Changes in equilibrium price and quantity are determined by shifts in the supply and demand curves.

• Price determines movement along a supply / demand curve. Other external factors cause the curve to shift.

• The price that a good sells for is set by the interaction between supply and demand.

• Efficiency can be measured in the supply and demand model. This occurs when the optimal amount of each good is consumed and produced (at equilibrium)

  • Consumer surplus - amount the consumers were willing to pay according to the demand curve minus the amount they actually paid.
  • Producer surplus - the price the producer received minus the price they would have sold the product according to the supply curve
  • Social surplus - the sum of consumer and producer surplus. This is maximized at equilibrium.
  • Deadweight loss - the loss in social surplus that occurs when the economy produces something inefficiently (as if the cost spent benefits no one). This blocks transactions that consumers and producers are willing to make.

• Price Controls - government policies that regulate prices. It can either be a price ceiling (an upper bound) or a price floor (a lower bound)

  • Price ceilings make the good more affordable.
    • However, when quantity demanded exceeds quantity supplied, a shortage tends to occur.
    • Additionally, it is the producers that suffer due to price ceilings
    • Quality tends to deteriorate to meet the demand while lowering the price sold.
  • Price floors prevent prices from falling below a certain level.
    • Typically, the government will end up buying the product to add demand and keep prices higher.
  • Price controls create efficiency since they prevent the market from adjusting to equilibrium price.
    • Price ceilings transfer producer surplus to consumers, favoring consumers.
    • Price floors transfer consumer surplus to producers, favoring producers.
  • Price controls that are extremely low (for price floors) or extremely high (for price ceilings) compared to the actual market price are nonbinding. They more or less have no effect on the market unless equilibrium surpasses them.

Elasticity §

• Price elasticity is the ratio between the percentage change in the quantity and the corresponding percent change in price. There are various kinds of elasticity

• Goods that are readily available are likely to have highly elastic supply curves.

• Luxury items that have a high price, and good with many substitutes are likely to have highly elastic demand curve.

• Goods with limited supply of inputs are likely to feature highly inelastic supply curves

• Necessities and goods with no clear substitutes as well as addictive substances are likely to have highly inelastic demand curves.

• Elasticity affects the dynamics between how fluctuations in price affects quantity and vice versa.

  • More inelastic = more price sensitive. More elastic = more quantity sensitive.
  • More inelastic demand = more revenue for the producer, the higher price that the good can be sold.
  • When supply / demand is inelastic, taxes are less effective at reducing the equilibrium quantity since producers (for supply) / consumers (for demand) bear the tax.
  • When supply / demand is elastic, taxes are less effective at reducing the equilibrium price. In this case, less of the good is sold instead.

• Elasticity is often lower in the short run rather than in the long run. This is due to changes in the quantity moreso than the changes in price.

  • In the long term, quantity tends to fluctuate more than price.
  • In terms of demand, this is due to spending habits as well as having more disposable income.
  • In terms of demand, this is due to expanding production and reducing costs long term.

Extensions §

• Income elasticity of demand - the precent change in quantity demanded divided by the percent change in income.

  • In most cases, the income elasticity of demand is positive. This is true for normal goods.
  • For inferior goods, the reverse is true. Income elasticity is negative.

• Cross-Price Elasticity of Demand - the percentage change in the quantity of good that is demanded as a result of a percent change in the price of good .

  • Substitute goods have positive cross-price elasticities of demand.
  • Complement goods have negative cross-price elasticities of demand.

• Wage Elasticity of Labor Supply - the percentage change in quantity of labor supplied divided by the change in wage.

• Elasticity of savings - the percentage change in the quantity of savings divided by the percentage change in interest rate.

Links §

• Shapiro, MacDonald and Greenlaw - Ch. 2 - 5