Economics Lecture Two

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One miracle is mentioned in all four Gospels of the Bible: the multiplication of the loaves and fish by Jesus to feed the crowd of thousands. It illustrates God easily overcoming a scarcity in food. Similarly, the devout Puritans overcame scarcity and created wealth under harsh conditions in New England in the early 1600s. Scarcity is no problem for God, but it can be a huge problem for those who turn away from God.

Economics is the study of the transfer of goods and services. What determines the price and quantity of goods transferred? How much must a buyer pay in order to acquire the good (the price), and how many units of the good (the quantity) will the seller be able to sell at that price?

Let's take an example. Suppose you own a candy store, and you sell chocolate candy bars. What price should you use to sell those candy bars? If you sell them for $1 each, many people will buy them. But if you charge $5 per candy bar, fewer will buy them at that price. You will not be able to sell as many candy bars at the price of $5 each. If, on the other hand, you sell the candy bars for only 10 cents per bar, you'll sell out quickly as people rush to buy the bars at that low price. It might seem like you'd be happy at selling so many, but you make much less money overall at 10 cents per bar than at $1 per bar. As the candy store owner you're worse off if you set the price at only 10 cents per bar, because you receive too little for each bar, and you're worse off if you set the price at $5 per bar, because you sell too few bars. The price at which you make the most money is probably around $1 per bar.

The above example is the sale of a good (a candy bar). The same analysis applies to the sale of services (such as a car mechanic repairing cars). People sell their time as much as they sell what they own. In this sense, "time is money" because time can be converted into money by spending that time working. You could convert 8 hours of time into about $60 by working at minimum wage.

Contents

Price of Stocks

The price of a company’s stock is a compromise between (i) the price at which people are willing to sell it (the supply price) and (ii) the price at which other people are willing to buy it (the demand price). A "sale" of the stock occurs only when the supply price equals the demand price.

Specifically, stock prices on the New York Stock Exchange and NASDAQ (the stock exchange for new and often high-tech companies) are determined entirely by the “bid” and “ask” prices of the buyers and sellers. Someone will “bid” a certain amount to buy a stock, and a seller will “ask” for a higher price. When the bid and ask prices are equal, then a sales transaction occurs. Prices can move very quickly and unpredictably when millions of people are involved. When the overall trend of most stocks from day-to-day is an increase in their prices, then it is known as a "bull market"; when the overall trend of stocks from day-to-day decreases in price, then it is known as a "bear market." You can remember that by thinking of how bears are scary, and stock markets that crash in their prices are scary things.

As explained above, the price that a stock trades on the exchange is where the “supply” by sellers equals the “demand” by buyers. When a seller of stock asks too high a price, then there are no buyers and the stock does not trade. When a buyer of stock offers to pay too little a price, then there are no sellers at that low price and the stock does not trade. The transaction (trade) occurs only when SUPPLY EQUALS DEMAND.

This is the most basic concept in all of economics: transactions occur only where "supply meets demand." Let's discuss this further.

Supply and Demand

The supply of a good is how much of it (the quantity), and at what price, is provided by a seller of the good. Grocery stores, factories, malls, amazon.com, and candy stores all supply goods. Services, like entertainment, are supplied by Hollywood, Major League Baseball, the NFL and also doctors, lawyers, accountants, and so on. The supply side consists of the producers, providers and sellers of goods and services.

The demand for a good is how much of it, and at what price, is wanted by the public seeking to buy it. Shoppers, moviegoers, baseball and football fans, and people needing medical care, are on the demand side. Often buyers of goods and services are called "consumers".

For any given good or service, there is a supply and demand. The supply can be described in terms of the possible production of different quantities at different prices. The demand can be described separately as the willingness of the public to purchase different quantities at different prices. The price is the key to both the supply and demand side; it is the price that determines the quantity transacted.

No company can afford to build cars (supply them) if the sales price is only $1. But at a sales price of $30,000, a vast number of cars can be built. The cause is price, and the effect is quantity: the higher the market price for something, the more that manufacturers will want to make and sell it.

Impress the girls with this Lamborghini sports car, at a cost of $350,000. Not a high demand at that price!

The demand for a good is also described in terms of price and quantity. At a given price, there is a specific quantity demanded by the public for the good. A billion people might buy a car if the price were only $1 (unrealistic). At a much higher price of $30,000, the demand drops to a quantity of millions sold (realistic). At a still higher price of more than $100,000, the demand falls much further to the range of only a few thousand that can be sold (these are the very luxurious cars, like the Lamborghini sports car shown at the right).

Because supply and demand can both be expressed in terms of price and quantity, they can be plotted on the same graph. Price (P) is on the y-axis, and quantity (Q) is on the x-axis. This is in alphabetical order: "p" for price is lower in the alphabet than "q" for quantity, and "p" appears first on the graph as one reads from left to right. Put another way, the graph is of "Ps and Qs," in that order from left to right (P on the y-axis to the left, and Q on the x-axis to the right).

The supply curve is always upward sloping: the higher the sales price, the higher the quantity that companies will produce for sale. That is because higher sales prices bring in greater revenue -- and greater profits -- to provide the incentive to increase the supply quantity.

The demand curve is always downward sloping: the higher the sales price, the lower the quantity the public is willing to buy. Few people will buy a candy bar if it costs $5: if that price is lowered to $2, then more people will want to buy it, and if its price is lowered to $1, then even more will want to buy it, and if its price is lowered to 50 cents, then the demand by the public for that candy bar will be even greater. As the price for something goes down, the demand goes up. That results in a downward-sloping demand curve: as the price goes down the slope of the curve, the quantity demanded (sought) by the public goes up (see the curve labeled "Demand" on the graph below).

The supply and demand form the most basic relationship in all of economics. They are independent of each other, but are placed on the same graph so that it becomes easy to find "equilibrium": the point where supply and demand have the same value for their price, and the same value for their quantity (the point of the intersection of their curves).

If the price is higher than the equilibrium price, then there will be unsold goods due to fewer people wanting to pay the higher price. The sellers then need to lower their price in order to sell these leftover or unsold goods, and that forces the price downward to the equilibrium price. Conversely, if the price is lower than the equilibrium price, then the sellers will not have enough goods to satisfy the higher demand by the public. The sellers will then increase their price (and their revenue) to take advantage of the higher demand. These market forces both above and below the equilibrium price are what push the final price to the point where the supply curve intersects the demand curve. At this point the price and quantity for the supply are precisely equal to the price and quantity for the demand.

The supply and demand curves usually look like this:

Supply and demand.gif

In the graph above, P* and Q* are the price and quantity at which the good is sold: the equilibrium price and quantity.

The point where supply equals demand can be found either by graphing the two curves and seeing the point of intersection or, if you have the equation for each curve, by solving the equations algebraically. For example, if the supply curve is P = 100 + Q and the demand curve is P = 500 - Q, then the point of intersection can be found by solving these two simultaneous equations as follows. When the P in the first equation equals the P in the second equation, then 100 + Q = 500 - Q, thus 2Q = 400, and thus Q = 200. From there you can solve for P by plugging Q back into one of the two original equations: P = 500 - 200 = 300. You can check this answer by plugging Q into the other original equation to confirm that you get the same P = 100 + 200 = 300. So the final answer -- the point where supply equals demand -- is this: P=300, Q=200.

Changes in Supply and Demand

The above model for supply and demand helps us consider the effect of changes or shifts in supply and demand. First consider an increase in demand by the public for a particular good, from demand curve 1 (D1) to demand curve 2 (D2):

Demand curve shift.gif

An increase in demand causes the price to rise from P1 to P2. The new equilibrium is at a point with higher price and greater quantity than before. What could cause an increase in demand? For gasoline, more people driving would cause an increase in demand. For heating oil, a colder winter would cause an increase in demand. For sports entertainment, a close rivalry (as in a close pennant race between the Yankees and Red Sox) can cause an increase in demand (spectators). In all these cases, price and quantity tend to rise. Conversely, if there is a decrease in demand by the public, then the opposite is generally true: prices and quantity decrease.

Next consider an increase in supply by the producers. Suppose farmers have better weather, for example, causing more crops at the harvest. Or suppose there is discovery of huge new oil reserves underground. Or suppose a new invention, such as Eli Whitney’s cotton gin, increases the production of a good (cotton). This curve shows what happens when there is an increase in supply, from supply curve S1 to supply curve S2:

Supply curve shift.gif

Can you interpret that? When the supply curve shifted to the right as supply increased, the price decreased but the quantity increased. The new equilibrium is at a lower price and greater quantity than before. Consumers are happier as supply increases. The discovery of new oil reserves, or inventions like the cotton gin, make consumers (the public) better off.

Laws exist to encourage greater supply, because it is good for the public. Antitrust laws, for example, make it illegal for companies to agree with each other to reduce supply.

The "Free Market"

The interaction of supply and demand is what we call the "market". The "free market" is the interaction of supply and demand without any interference or control by government. The dictionary definition states that the "free market" is "an economic market operating by free competition."[1]

The free market drives down prices, which helps the poor enormously. It is the free market that makes the Bible and food and communications inexpensive for the poor, and which helps bring Christian missionaries to serve the poor in faraway places. The following example illustrates how the free market has made air travel available to the poor, and available to others in order to help the poor.

In the 1960s and 1970s, government set the prices for airline tickets, and only the wealthy could afford to travel by plane. Then, in 1978, Congress "deregulated" the airplane industry, which allowed the free market to set the prices based on supply and demand. The benefits were tremendous in enabling far more Americans to be able to afford air travel:[2]

Airfares, when adjusted for inflation, have fallen 25 percent since 1991, and ... are 22 percent lower than they would have been had regulation continued. Since passenger deregulation in 1978, airline prices have fallen 44.9 percent in real terms according to the Air Transport Association. ... [W]hen figures are adjusted for changes in quality and amenities, passengers save $19.4 billion dollars per year from airline deregulation.

The above analysis was written five or more years ago. Airline fares have fallen even more since then. That is because the free market lowers costs for everyone. Poor people can buy airline tickets now, when they could not before.

Wal-Mart is another example of this, as it provides goods at lower and lower prices for everyone. This is very helpful to the poor. Someone can have no money, or lose all his money, and yet if he tries then he can live nearly as well as the wealthiest man in the nation -- if the free market is allowed to exist to drive down prices and provide equal opportunity. Where the free market does not exist -- as in many countries of the world -- then the poor may suffer, because prices are too high and opportunities are too limited for the poor to improve their lives. Thus one of the best ways to help the poor is to provide them with the free market in order to lower prices and increase opportunities for them.

The free market can have a politically beneficial effect also. The free market is a powerful force against tyranny. Government cannot easily control and limit free market supply and demand.

So the next time you're flat broke without any job and facing a hopeless economic situation, remember this: in the United States you still have the free market on your side, the most powerful tool of all. Put it to work for you. The free market is a hardworking servant.

What Supply and Demand Are Not

In learning what something is, it sometimes helps to learn what it is not.

The preference of any single individual, such as yourself, is nearly irrelevant to the overall supply and demand. You may dislike the Yankees, but your own view is less than a "drop in the bucket" compared to the view of the public. Similarly, the opinion of the wealthiest person in the world does not affect supply and demand any more than the opinion of the poorest person can, in a free market. Wealthy people may avoid Wal-Mart, but that did not keep it from becoming the richest and most successful store in the world. Supply and demand transcend and are above the views, preferences, and buying habits of any individual or small group of people. Supply and demand are like a massive ocean that's not going to change based on what a few people do.

Notice also that the free market treats everyone fairly and equally. Supply and demand do not care about someone's status in society. The free market is independent and above prejudice. A restaurant owner makes the same amount of money from the most disliked person in society as from the most popular person in town.

Notice this too: the "market price" set by supply and demand is often unrelated to the historical cost of the good. Someone may have paid $300,000 for his house in 2006, when houses were high in value, but the market price for that same house in 2009 may be only $200,000. When that person tries to sell his house in 2009 it does not matter what he paid for it in 2006. All that matters is what the supply and demand for that house is at the time he tries to sell it.

The free market and supply and demand are similar to a sports competition. It really doesn't matter how many trophies one team may have won in prior years, or who likes which side better, or who thinks which side should win. All that matters is which team is better on game day. Likewise, all that matters to setting the price in a free market is the supply and demand at the time of sale. That may seem harsh if it causes someone to lose money, just as it can be sad when someone trains extremely hard to win a match, but is defeated in an upset by someone nobody likes. But in other ways this is fair, because it gives full opportunity for someone to do well no matter who he is and no matter where he comes from.

Equilibrium

The important concept of “equilibrium” arises frequently in economics. It is similar to the concept of equilibrium as in chemical reactions. The term “equilibrium” means a state of balance between opposing forces. It is a settling down. In a tug of war between opposing teams, “equilibrium” would be where the rope is stationary with each side pulling an equal amount on it. But usually one side wins in a tug of war, so that is not the best example. A better example of an “equilibrium” is when you have eaten just enough to satisfy your hunger, and not too much to make you feel bloated or nauseous. You are then in “equilibrium” between hunger and overeating. If you're still hungry then you eat more; once you are "full", you stop eating until later.

“Equilibrium” is “where things are going” or where they have already arrived. Economic equilibrium is when all the imbalances in the forces of selling and buying have disappeared and a perfect balance between the sellers' desire to make more money (that's like hunger) and the buyers' desire to pay as little as possible (that's like not eating). When the market has reached a balance between these two powerful, opposing forces, then it is equilibrium. The opposing forces of the sellers trying to make money and the buyers trying to keep money are what "drive" the price to its equilibrium level, like a tug of war.

When there is perfect competition in the sale of a good or service, then the equilibrium is when the marginal revenue to the seller (the extra dollar that he charges and receives as revenue) equals his marginal cost in producing the good (the extra dollar he paid to produce the good). At that point the seller's marginal profit (the extra amount that he can keep after paying his costs) has fallen to zero and he has no incentive to produce any more goods. In other words, the supplier keeps producing more and more goods only until his marginal profit on each extra good falls to zero such that he does not make any more money by trying to sell additional quantity. The seller does not want his marginal revenue to fall below his marginal cost, because then he is losing money.

Here is an example. How long does the owner of a store keep it open at night? As long as the flow of customers into his store pays him more money (marginal revenue) than it costs him to keep the store open (marginal cost). As it gets later at night, the flow of customers declines, the owner makes less, and eventually his costs of keeping the store open will exceed the money that is being paid to him by new customers. As soon as the owner realizes that he is paying more to his workers to keep the store open than he is getting from new customers, he closes his store for the night. After a few weeks of this, the owner realizes that he usually makes money before a certain hour (perhaps 9pm), and loses money afterward. Then he puts a sign on his door telling everyone that he closes at 9pm every night. Marginal revenue exceeds marginal cost before 9pm for him (so he makes a marginal profit by staying open), while marginal costs exceed marginal revenue after 9pm (so he avoids losing money and closes his store for the night).

Example: Health Care

By far the single biggest industry in the United States is health care (medical care). It represents a massive one-sixth of our entire economy -- including annual expenditures of more than $2.2 trillion -- and costs are increasing each year. It has three major components: government-controlled (Medicare and Medicaid), insurance-controlled, and private pay or uninsured. Though many are unhappy with our system, it is the finest in the world and foreigners travel to the United States to have their medical problems treated. The survival rate for the most prevalent form of cancer in men -- prostate cancer -- is 92% in the United States, but the survival rate for that same disease in England is only 51% under its government-controlled system.

Most other countries have some form of government-controlled, or socialized, medicine. In the countries of Canada, North Korea and Cuba, it is actually illegal to pay money to a doctor to see you. You can see only a doctor paid by the government in those countries. In England, there is a two-tiered system: good care is provided to the few who can afford to pay for it, and free but inferior care is provided by the government to the vast majority who cannot afford it.

In the United States, under the free market, anyone can pay his own money for medical care at any time. But in Canada, someone with an illness is typically put on a waiting list and, depending on his age and likelihood of survival, may not see a doctor for months. In some cases, patients pass away before they obtain the treatment they need. The Canadian government sets limits on wages and prices for medical care, and that causes shortages because there is always less supply when the price is artificially lowered by government control. (Look again at the shape of the supply curve: at lower P, there is lower Q).

Lowering wages and prices prevents supply from rising to satisfy demand. Then demand is much greater than supply, and patients have to wait a long time to see a doctor. There is a lower survival rate for cancer in Canada than the United States because of the delays in diagnosis and treatment in Canada. In Buffalo, which is on the Canadian border, doctors treat many Canadians who come over the border to pay for immediate American medical care rather than wait for it in Canada.

This limiting of supply by government-set pricing causes what is known as "rationing". More people want the service (a medical operation or treatment) than is available. A waiting list is created to handle the surplus in demand over supply. But when someone has a cancer growing inside of him, delay by being placed on a waiting list can be agonizing and deadly. Quick treatment helps improve survival from cancer. In the United States, where government does not set all prices and there is not any rationing yet, the survival rate for five common forms of cancer is over 90%. Thanks to the powerful benefits of the free market, the rate of survival continues to improve in the United States.

But in Scotland, the birthplace of Adam Smith and his theory of the invisible hand that he wrote about in 1776, the survival rate from cancer under government-controlled medicine has fallen to "the worst in Europe, lagging behind countries such as Poland and Slovenia. ... Cancer experts blamed ... long waiting lists for the poor results."[3]

A free market in health care benefits children too. The life expectancy for a child born with cystic fibrosis in the United States is 37 years, but only 27 years in Ireland under its government-controlled (or nationalized) health care.

Assignment

Read the lecture, and reread any section that you did not fully understand. Complete the homework assignments through the level in which you choose to participate in this course. You can post your answers for prompt grading here: http://www.conservapedia.com/Economics_Homework , or hand them in next class. These questions are for a "free market" (when government does not control the prices and quantities).

1. Fill in the blanks in the following sentence: The supply and demand for a good determine both the _________ and ___________ at which the good is sold.

2. Suppose the price demand curve for a particular good is P = $30 - Q, where P is the price and Q is the quantity. Also suppose the price supply curve is P = $6 + Q. At which price and quantity will the good be sold?

3. When the supply of a good or service increases, such as increasing the number of oil wells, what happens to the market price of oil? Explain. When the demand for a good or service increases, such as more people driving cars that need gasoline (refined oil), what happens to the market price of oil? Explain.

4. Why do grocery stores lower the price of their fruit (such as grapes) when they have an oversupply of ripened fruit? Explain by citing the downward slope of a demand curve, and describe what happens to this fruit after the grocery store lowers its price.

5. When the New York Yankees built their new $1.5 billion ballpark, they made a decision about how many "obstructed view" bleacher seats to include. Due to the design of this new stadium, people sitting in these "obstructed view" bleacher seats would not be able to see all of the field because stadium walls or poles or other fans would block part of their view. An economist studied the "supply and demand" in the market, and developed this table:

Price/Ticket for an "Obstructed View" seat Supply quantity at that price Demand quantity at that price
$30 1000 (the high sales price => high supply) 300 (the high sales price => low demand)
$25 800 450
$15 600 600
$8 300 (the low sales price => low supply) 1200 (the low sales price => high demand)

(A) Given the above supply and demand (you might find it easier to graph it), how many "obstructed view" bleacher seats did the New York Yankees build, and how much does the team make from sales of "obstructed view" tickets at each game?
(B) Suppose the City of New York passed a law for a maximum price (a "price control") of $2 per "obstructed view" bleacher ticket, because politicians felt that fans should not pay more if they do not get a full view of the field. Will the obstructed-view seats sell out under this law, and will people have to wait in line in order to buy them? Would you oppose or support such a law, and why?

6. Suppose you own a restaurant, and your average customer spends $10. Suppose further that your marginal cost for each customer is $5. But in addition you have costs of $20 per hour in electricity and wages. From 6-7pm each night, you usually have about 40 customers, but then it decreases by 50% each hour thereafter as it gets later in the evening. At what time do you close your store for the night? Explain your answer.

7. Explain why waiting lists develop in countries (like Canada) where the government prohibits anyone from charging more than fixed prices for medical services, assuming that these fixed prices are lower than what the prices would be under supply and demand in the free market. (Hint: the reason is related to the effect of price controls on the supply of a good or service.)

Honors

Write an essay of about 300 words total on one or more of the following topics:

8. "Time is money." Explain. Or, as an alternative, improve on our definition of a "free market." Or, as a third alternative, explain how the free market is so much powerful than even the wealthiest people in the world.

9. Relate the supply and demand curves to the basic economic concept of scarcity. For a good that has no scarcity, such as air, are there any supply and demand curves that are meaningful? Discuss.

10. Discuss any aspect of the economics of health care.

11. How are the forces of supply and demand and the free market helpful to someone who might otherwise be an social outcast and victim of prejudice in a community? In addition or alternatively, discuss the social benefits of a "free market" more generally.

12. Compare "equilibrium" in economics to "equilibrium" in other fields (such as chemistry or physics) or in life itself (such the flow of traffic on highways), using specific examples.

References

  1. Merriam Webster's Collegiate Tenth Edition (1994).
  2. http://www.econlib.org/library/Enc/AirlineDeregulation.html (emphasis added, citation omitted).
  3. http://www.highbeam.com/doc/1P2-12923478.html
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