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  1. ECON1001 Tutorial 3

  2. Q1 Your economics professor told you that the quantity demanded of a good is higher when prices are lower, and the quantity demanded is lower when prices are higher. But you can think of a lot of people who would rather shop in an upscale mall than in a discount warehouse. This is A) inconsistent with the economic model because it shows that people are irrational. B) evidence that the abstract economic model of demand does not apply in the real world. C) because malls and warehouse stores are two different markets, so have different demand curves. D) because the supply curve is more important in determining where people like to shop. • because the people you know have not studied economics. Ans: c

  3. Law of Demand • P↑(↓) Qd ↓(↑) • Negative relationship • Purchase behavior within ONE market • What is ONE MARKET/ ONE PRODUCT?

  4. Are they the same product? • Watch: Swatch vs Rolex • Clothing: Giordano vs Gucci • Bags: Nike vs L.V. What kind of goods to include in a market depends on the purpose/scope of our analysis. Sometimes, close substitutes are grouped in the same market (i.e., the same product). Sometimes, we may not even distinguish Swatch and Rolex although they have very different customer bases. However, in Q1, the information suggested that the goods sold in the upscale and discount warehouse should be treated as two markets. That is, we can make sense of the observed phenomenon only when they are treated as two markets.

  5. Option D • “because the supply curve is more important in determining where people like to shop.” • The observation and this reason make little sense only if the supply of upscale is more than that of discount warehouse. That is, more people end up shopping in the upscale stores – at equilibrium. • However, it does not seem reasonable to assume that the supply of upscale store is more than that of discount warehouse (or the cost of upscale store is lower than that of discount warehouse).

  6. Q2 Gertie saw a pair of jeans that she was willing to buy for $35. The price tag, though, said they were $29.99. Therefore, A) Gertie should not buy the jeans because they will be of lower quality than she expected B) Gertie should not buy the jeans because the price is not equal to her reservation price. C) Gertie should only buy the jeans if she can negotiate a better price with the salesperson. D) Gertie should buy the jeans because the price is less than her reservation price. • Gertie should buy the jeans because the price is more than her reservation price. Ans: d

  7. Buyer’s Reservation Price • Definition: “the max price the consumer is willing to pay for an extra unit of product” • Not that the vertical interpretation of demand curve is Marginal Benefit of consuming that unit.

  8. Buyer’s Reservation Price • Decision to make: unit of purchase • Cost-benefit principle suggests that buyers should buy an additional unit only if the marginal benefit (reservation price) is larger than marginal cost (price paid). • Decision Rule: Market Price ≤ Reservation Price  BUY Market Price > Reservation Price  NOT BUY

  9. Buyer’s Economic Surplus • Economic surplus to buyers (MB-MC) is also called “Consumer Surplus” for an additional unit. Market Price < Reservation Price  positive consumer surplus for that MARGINAL UNIT Market Price = Reservation Price  zero consumer surplus for that MARGINAL UNIT • Usually Marginal Benefit curve: downward sloping • Thus buying up to marginal unit: P=MB • Note that when P=MB, it does not matter whether the buyers purchase the additional unit (because it does not change the total economic surplus to the buyers).

  10. Q3 Which of following is not true of an equilibrium price? A) Consumers who are willing to pay the equilibrium price can acquire the good. B) It measures the value of the last unit sold to consumers. C) It is always a fair and just price. D) Firms who are willing to accept the equilibrium price can sell what they produce. • It measures the cost of resources required to produce the last unit. Ans: c

  11. Meaning of Equilibrium Price Price • Market equilibrium is the price-quantity pair at which both buyers and sellers are satisfied. • P*: criterion to separate winners from losers in market • i.e. who is able to get the good? • Those buyers who are willing to pay P* • Those sellers who are willing to receive P* Supply P* Demand Quantity Q*

  12. Meaning of Equilibrium Price Price At equilibrium, • P=MB for marginal unit of consumption • P=MC for marginal unit of production • There is no cash on the table. Supply=MC P* Demand=MB Quantity Q*

  13. Option C • “(equilibrium price) is always a fair and just price” • Fair/ just? How to justify? • Fairness or just is a normative judgment. The criteria is difficult to formalize. Rationality assumption says that our goal is to maximize total economic surplus. • The only criteria to judge the market equilibrium is the concept of optimality, i.e., whether total economic surplus is maximized at the equilibrium. The market equilibrium is socially optimal • if there is no external cost not borne by the sellers and • if there is no benefit not accrued to the buyers.

  14. Q4 You have noticed that there is a persistent shortage of English teachers in Hong Kong. Based on this observation, you suspect that A) The wage for English teachers is higher than the wage of Chinese teachers. B) The wage for English teachers is lower than the equilibrium wage. C) There is an excess supply of English teachers. D) The wage for English teachers is the equilibrium wage, but teachers don't apply economic concepts. • The reservation price among English teachers is lower than for other professions. Ans: b

  15. Persistent shortage • Price is persistently/ effectively kept below equilibrium • Qd > Qs at that price level • Usually resulted from ‘gov’t intervention’ (if no price floor/ ceiling, price will go to equilibrium by market forces)

  16. A) ”The wage for English teachers is higher than the wage of Chinese teachers.”  difficult to compare because these are two different markets. C) ”There is an excess supply of English teachers.”  because excess supply and shortage are two opposite concepts. Excess supply means no shortage and shortage means no excess supply. • The reservation price among English teachers is lower than for other professions.  difficult to compare because these are two different markets (E teachers and other professions). Whether there is a shortage depends on price, supply and demand. “reservation price among English teachers” is only a supply side story.

  17. Q5 Which of the following would cause an increase in quantity supplied of wheat? A) The price farmers receive for their wheat rises. B) The price of fertilizer farmers' use in their fields decreases. C) The price firms pay for liability insurance falls. D) New, better technology for farming are introduced. • Transportation costs for the wheat decreased. Ans: a

  18. Increase Quantity Supplied ≠increase Supply Increase Quantity Supplied = ↑Qs Only the “ON-GOING”/Current MARKET PRICE can change Qs P S P2 P1 Q Q1 Q2

  19. Increase Quantity Supplied ≠increase Supply • Increase Supply = shift the WHOLE curve  lots of factors (more on Q7) P S1 S2 Q

  20. Other options • The price of fertilizer farmers' use in their fields decreases.  CHEAPER production cost  shift down Supply Curve • The price firms pay for liability insurance falls.  lower cost of supply additional unit  shift down Supply Curve

  21. Other options • New, better technology for farming are introduced.  more efficient prod method LOWER prod cost for additional unit  shift down Supply Curve • Transportation costs for the wheat decreased.  CHEAPER prod  shift down Supply Curve

  22. Q7 What might cause Supply to shift from the Original Supply to the New Supply? price A) A storm in South America wipes out the entire coffee crop. B) New technology reduces the amount of coffee beans necessary to make a good-tasting pot of coffee. C) A news report that coffee consumption greatly increases productivity. D) An increase in the price of tea. • An increase in the coffee drinking population. Ans: b

  23. Factors that shifts Supply CURVE • Technology • Cost of production • Weather • Number of suppliers • Price EXPECTATIONS

  24. A) A storm in South America wipes out the entire coffee crop. • At each & every market price, quantity supplied DROPS • i.e. Supply decreases • Supply curve shifts left / up P S2 S1 Q

  25. B) New technology reduces the amount of coffee beans necessary to make a good-tasting pot of coffee. • At each & every market price, sellers can produce higher quantity with respect to production cost • i.e. Supply increases • Supply curve shifts right / down P S1 S2 Q

  26. Other options • A news report that coffee consumption greatly increases productivity.  Demand Increases • An increase in the price of tea.  Quantity demanded for TEA drops  Tea & Coffee: Substitutes  Coffee Demand increases • An increase in the coffee drinking population.  More consumers coming into market NOT because of price changes  Demand increases

  27. Q6 What might cause Demand to shift from the Original Demand to the New Demand? price A) An expectation that coffee prices will fall in the future. B) An increase in the price of coffee creamer. C) A decrease in the price of tea. D) A report that coffee is bad for your health. • An increase in income. Ans: e

  28. Factors that shifts Demand CURVE • Income • Preferences • Price of Substitutes • Price of Complements • Population of Potential Buyers • Price EXPECTATIONS

  29. An expectation that coffee prices will fall in the future.What will happen TODAY? • At each & every market price, quantity demanded DROPS • i.e. Demand decreases • Demand curve shifts left or down. P D1 D2 Q

  30. An increase in the price of coffee creamer Qd (creamer) Drops coffee creamer + coffee complements • At each & every market price, quantity demanded for coffee DROPS • i.e. Demand decreases • Demand curve shifts left or down P D1 D2 Q

  31. A decrease in the price of tea.  Qd (Tea) increases Tea , coffee Substitutes • At each & every market price, quantity demanded for coffee DROPS • i.e. Demand decreases • Demand curve shifts left or down P D1 D2 Q

  32. A report that coffee is bad for your health.  potential buyers drops • At each & every market price, quantity demanded for coffee DROPS • i.e. Demand decreases • Demand curve shifts left or down P D1 D2 Q

  33. An increase in income • At each & every market price, quantity demanded for coffee increases • i.e. Demand increases • Demand curve shifts right or up P D2 D1 Q

  34. Q8 Suppose the coffee lobby convinced the legislature to impose last year a price control requiring that coffee prices must be at least $2.50 when the original demand function and supply function were applicable. The most likely result with the new demand and supply would be A) a short term excess demand for coffee, followed by an increase in price. B) a short term excess supply of coffee, followed by a decrease in price. C) excess demand for coffee that would not correct itself because price is set by law. D) excess supply of coffee that would not correct itself because price is set by law. • new equilibrium at a price of $2.50 and a quantity of 50 cups. Ans: d

  35. Q8 I) fixed price at $2.5 II) original demand & Supply cruves price Red Arrow: Excess supply  Price floor  min price set by external forces (lobby)  can price freely go back to equilibrium?

  36. Q9 Assume that column A and column B are demand and supply curves. The market would achieve an equilibrium at a price of • $20. • $30. • $40. • $50. • $60. Ans: c

  37. If $20: Qd>Qs excess demand • If $60 Os>Qd Excess Supply Will ONLY happen when there’s some external forces that prevent market price from moving towards the market equilibrium.

  38. Q10 One observes that the equilibrium price of apples falls and the equilibrium quantity increases. Which of the following best fits the observed data? A) An increase in demand with supply constant B) A decrease in supply with demand constant C) An increase in demand coupled with an increase in supply D) A decrease in demand with supply constant • Demand constant and an increase in supply Ans: e

  39. A) An increase in demand with supply constant P D2 S D1 P2 P1 Q Q1 Q2

  40. B) A decrease in supply with demand constant P D1 S2 S1 P2 P1 Q Q2 Q1

  41. D) A decrease in demand with supply constant P D1 S D2 P1 P2 Q Q2 Q1

  42. E) Demand constant and an increase in supply P D1 S1 S2 P1 P2 Q Q1 Q2

  43. An decrease in demand coupled with an decrease in supplyCase I P D1 S2 D2 S1 P2 P1 Q Q2 Q1

  44. An decrease in demand coupled with an decrease in supplyCase II P D1 D2 S2 S1 P1 P2 Q Q2 Q1

  45. What if An increase in demand coupled with an increase in supply?Case I P D2 S1 D1 S2 P1 P2 Q Q1 Q2

  46. What if An increase in demand coupled with an increase in supply?Case II P D2 S2 S1 D1 P2 P1 Q Q1 Q2