Foundations of Economic Analysis: Price Theory Flashcards
What is meant by a static model of a market?
Model of how prices are set and vary in a market:
In equilibrium Qd = Qs = Q*
But this is a static model - how does the equilibrium price and quantity change over time?
Equilibrium changes as a result of changes in the determinants of demand or supply other than the current price.
Example: suppose that a change in technology allows computers to be produced at a lower cost - what is rule one?
Rule 1 (supply increase): In general, if the supply curve shifts to the right (i.e. there is a rise in supply) then the equilibrium price of the good falls and the quantity increases
A reduction in costs means that more computers can be produced for a given price.
This causes the supply curve to shift to the right - to S’ on the diagram.
If the price remained the same at P1 then there would be excess supply in the market, so the bidding process takes the market to a new equilibrium where the new supply curve intersects with the original demand curve.
This applies to any reduction in costs, e.g. a cut in the interest rate on loans.
Suppose, e.g., that there is an increase in the price of computer chips for building computers: what is rule two?
Rule 2 (supply decrease): In general, if the supply of a good diminishes then the supply curve shifts to the left, resulting in a higher price and a lower quantity.
The rise in the price of the raw material means that fewer computers can be produced at any given price.
The supply curve therefore shifts to the left.
If the price remains at P1 then there is excess demand in the market so the price is bid upwards until the new equilibrium is reached.
At this point the price has increased to P2, while the quantity has decreased to Q2.
Suppose that a new use is found for computers, implying that the demand for computers would increase: what is rule three?
Rule 3 (demand increase): In general, an increase in the amount demanded, i.e. a shift of the demand curve to the right, results in an increase in the equilibrium price and quantity.
This means that at every given price more of the good is demanded.
The demand curve shifts to the right.
If the price remained at P1 then there would be excess demand, so the price of computers is bid upwards until it reaches the new equilibrium.
At this point the price is P2 and the quantity is Q2.
Suppose that there is a fall in computer use as people transfer to smart phones: what is rule four?
Rule 4 (demand decrease): In general, a decrease in demand for a good, i.e. the demand curve shifting to the left causes both the equilibrium price and quantity to diminish.
In the diagram the quantity demanded for each price has diminished so that the demand curve for computers shifts to the left.
If the price remained at P1 then there would be an excess supply of computers.
The price is bid down to a new equilibrium price and quantity.
The new equilibrium price is at P2 while the equilibrium quantity is at Q2.
Recap the four rules?
Rule 1 (supply increase): if the supply curve shifts to the right, P↓ & Q↑
Rule 2 (supply decrease): if the supply curve shifts to the left, P↑ & Q↓
Rule 3 (demand increase): If the demand curve shifts to the right, P↑ & Q↑
Rule 4 (demand decrease): If the demand curve shifts to the left, P↓ & Q↓
What is meant by shifts in both demand and supply?
The four rules are useful when one thing happens at once.
However, if both demand and supply shift at the same time then the situation is ambiguous.
Suppose demand increases at the same time that supply decreases.
Suppose demand increases at the same time that supply decreases.
In this case there is an increase in price, but what happens to quantity is ambiguous.
Rule 3 means P and Q rise, but Rule 2 means P rises and Q falls
Suppose now that there is an increase in both demand and supply - what takes place?
In this case we can unambiguously say that quantity has increased but the price is ambiguous.
Rule 3 means P and Q rise but Rule 1 means P falls and Q rises.
Assume that we have an equilibrium given by the two typical equations:
Demand: Qd = 50 - 2P
Supply: Qs = 20 + 3P
However Demand and Supply both shift such that the new curves are given by equations;
Demand: Qd = 100 - 2P
Supply: Qs = 10 + 3P
What does this represent?
This represents an increase in demand and a decrease in supply.
Therefore rule 3 suggests that for demand prices and quantities should increase while rule 2 suggests that for supply prices should increase and quantities should fall.
We can therefore predict that the equilibrium price will rise but we cannot predict the new equilibrium quantity.
How do we solve an equilibrium?
Solving for our first equilibrium where:
Demand: Qd = 50 - 2P
Supply: Qs = 20 + 3P
In equilibrium Qs = Qd, i.e. Quantity supplied = Quantity demanded. Therefore:
50 - 2P = 20 + 3P
Adding 2P to both sides and taking away 20 from both sides:
30 = 5P
Therefore equilibrium price is P = 6
To find the equilibrium quantity we substitute in P=6 into either of the two equations above. Substituting into the demand equation:
Q = 50 - 2 (6)
Therefore equilibrium quantity is Q = 38
What is another example of solving a second equilibrium?
Solving for our second equilibrium where:
Demand: Qd = 100 - 2P
Supply: Qs = 10 + 3P
In equilibrium Qs = Qd, i.e. Quantity supplied = Quantity demanded.
Therefore:
100 - 2P = 10 + 3P
Adding 2P to both sides and taking away 10 from both sides:
90 = 5P
Therefore equilibrium price is P = 18
To find the equilibrium quantity we substitute in P=18 into either of the two equations above. Substituting into the demand equation:
Q = 100 – 2(18)
Therefore equilibrium quantity is Q = 64
What do these two equilibrium examples therefore mean?
Therefore equilibrium price has increased from
P = 6 to
P = 18
And our equilibrium quantity has increased from
Q = 38 to
Q = 64
In this example we therefore have an increase in both price (as we predicted) but also an increase in quantity demanded.
What are prices and the price level?
What we have looked at in the last few lectures is the determination of prices for individual goods.
We do not look at the average over all prices in the economy. The latter is known as the “price level” and is a macroeconomic concept. Price levels are measured by price indices, such as the Consumer Price Index (CPI) or the Retail Price Index (RPI).
The growth in the price level is known as inflation. Since the price level is an average of prices rather than a price in itself, this means that one cannot use supply/demand analysis for inflation.
What is CPI and RPI?
Consumer price inflation is the speed at which the prices of goods and services bought by households rise or fall.
One way to understand a price index is to think of a very large shopping basket containing all the goods and services bought by households.
Consumer Price Indices (CPI) estimates changes to the total cost of this basket. The Office for National Statistics (ONS) publish CPIs monthly.
