Difference between revisions of "Economics Lecture Two"

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Can you improve on our definition of a "free market"?  The homework assignment gives you an opportunity to do so.
 
Can you improve on our definition of a "free market"?  The homework assignment gives you an opportunity to do so.
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<alternative definitions, such as opportunity>
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== What is Irrelevant to Supply and Demand? ==
 
== What is Irrelevant to Supply and Demand? ==

Revision as of 22:08, 24 August 2009

Economics Lectures - [1 - 2 - 3 - 4 - 5 - 6 - 7 - 8 - 9 - 10 - 11 - 12 - 13 - 14]

In the last lecture we introduced the fundamental concepts of economics. Now we are ready to explore several issues in greater detail.

A focus of economics is on the purchase and sale of goods and services in free enterprise. By “free enterprise,” I mean business transactions that are "free of" interference by someone other than the buyer and seller, such as government. Free enterprise has little or no government interference in the setting of prices and selling of the goods or services. Assume that transactions discussed in this course are in free enterprise unless stated otherwise.

The first obvious question about the purchase and sale of goods is this: what determines the price and quantity of goods sold? In other words, how much must a buyer pay for the good (the price), and how many units of the good 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 Hershey candy bars. What price should you use for 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. Your quantity of goods sold will be much less. 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 at 10 cents per bar than at $1 per bar. So 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 best price for you to use for the candy bars is around $1 per bar.

The above analysis applies to the sale of a good (a candy bar), but the same analysis applies to the sale of services (such as a car mechanic selling his car repair services). 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 take convert 8 hours of time a day into about $50 by working at McDonalds each day, for example.

We could spend the remainder of this course on pricing goods and services. Millions of businesses succeed or fail based on how they price their goods or services. Thousands of people and factors affect the pricing of a good or service, so this question is not as simple as it looks. Assumptions have to be made in order to draw conclusions. In some cases, price behavior baffles even the greatest experts in the field.

Price of Stocks

The price of a company’s stock reflects the price at which people are willing to sell it (the supply price) and 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. The overall value of a company at any given time is the price per share of its stock, multiplied by the number of shares of stock. A company that has one billion shares of stock in the market, each valued at $15 per share, has a market value of $15 billion. Logic dictates that when a stock increases its value, then the company is increasing its overall value.

Note that stock values, like economics in general, reflects the future rather than the past. Often a company announces a profit for the year, and yet its stock value decreases on the news. That happens when people do not expect the company to be as profitable in the future as it has been. Past profits do not matter to the price of a stock today; profits in the future do. General Motors was once the most profitable company in the world; now it is worthless, because it cannot make any profits in the future.

During the internet “dot-com” boom of the late 1990s, stock prices surprisingly increased for companies that were losing money. That was because people expected the companies to be very profitable in the future. Sometimes it even seemed like the more a dot-com company lost money, the higher its stock would go! That was very unusual, but was based on expectations about the future. As it turned out, most of these companies went bankrupt, and the internet became profitable for only a few companies like Google.

Stock prices on the New York Stock Exchange and NASDAQ (the stock exchange for new and often high-tech companies) are determined entirely by “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 certain price. When the bid and ask amounts equal, then a sales transaction occurs. Prices can move very quickly and unpredictably when millions of people are involved. When the overall trend of stocks from day-to-day increases in price, 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 that bears are scary, and stock markets that crash in price 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 too little a price, then there are no sellers and the stock does not trade. The transaction only occurs when SUPPLY EQUALS DEMAND.

This important principle of "supply and demand" is the most basic concept in all of economics, and next we explain it further.

Supply and Demand

The supply of a good is how much of it, 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 is made up 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.

For any given good or service, there is a supply and demand. The supply can be described in terms of different quantities at different prices. The demand can separately be described as different quantities at different prices. The price has enormous influence over the quantity on both the supply and demand side.

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 demand for a good is also described in terms of price and quantity. At a given price, there is an amount of demand by the public for the good. A billion people might buy a car if the price were only $1. At a much higher price of $30,000, the demand drops to a quantity in the millions range. At a still higher price of $100,000, the demand falls much further to the thousands range.

Because supply and demand can both be expressed in terms of price and quantity, they can be plotted on the same graph. In a confusing convention, the y-axis is typically price, and the x-axis is usually quantity. (In most other graphs the cause is placed on the x-axis and the effect is on the y-axis, but you will find that economists often seem to have things backwards!) Just memorize this rule and stick with it: price is on the y-axis, and quantity is on the x-axis. This might help you remember: "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.

The supply curve is 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 fund the costs of making the good or providing service.

The demand curve is downward sloping: the higher the sales price, the lower the quantity that people are 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 greater still. 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.

The supply and demand is the most basic relationship in all of economics. They have 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). This equilibrium is the point for the price and quantity of the good in a free market.

The supply and demand curves usually look like this:

Supply and demand.gif

The above model for supply and demand helps us to consider the effect of shifts in demand and supply. First consider an increase in demand:

Demand curve shift.gif

An increase in demand causes price to rise. 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 can cause an increase in demand (spectators). In all those cases, price and quantity tend to rise. If there is a decrease in demand, then the opposite is generally true: prices and quantity tend to decrease. Next consider an increase in supply. 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:

Supply curve shift.gif

Can you interpret that? When the supply curve shifted downward as supply increased, the price decreased but the quantity increased. The new equilibrium is at 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 better off.

Example: The Tyndale Bible

The Tyndale Bible was an illegal translation of portions of the Bible into English, the first high-quality English translation that was based on the ancient Greek. Though prohibited by King Henry VIII and the Catholic Church, William Tyndale secretly did the translation in the early 1500s (around the same time that Martin Luther was translating the Bible into German), and then Tyndale arranged for sale of copies of his work to the public in England.

Demand by the public in England was high for this Bible, but the supply was low due to limitations of the printing press and the opposition by the King and other authorities. High demand and low supply means this: a high price. The King and church authorities began buying up copies of this Bible to keep it out of the hands of the public, but often had to pay the "market price" to buy up the copies. This money then went to the printers and provided the funds for them to pay for the printing of more Tyndale Bibles. The operation of supply and demand made it difficult to censor and suppress this Bible.

Supply and demand comprise a very powerful force, stronger than any individual or government. Over time, supply and demand prevail, and ultimately all authorities endorsed the idea of an English translation of the Bible, leading to the printing of the magnificent King James Version in 1611. But the unstoppable effect of supply and demand did not occur soon enough to help Tyndale himself; he was executed as a heretic in 1536 after he refused to recant his beliefs.

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 Merriam-Webster dictionary does not define the term "free market," which originated as recently as 1907, as precisely as we do. The dictionary says that the "free market" is "an economic market operating by free competition." Can you see flaws in this definition? "Competition" is part of a "free market," but its essence is the interaction or interplay between supply and demand. A "free market" can exist with only one supplier, without any competition. Or there can be competition, such as between the Post Office and Federal Express, without it being a "free market" (because the government interferes by funding the Post Office and imposing limitations on Federal Express).

Can you improve on our definition of a "free market"? The homework assignment gives you an opportunity to do so.

<alternative definitions, such as opportunity>

<discussion of how the free market helps the poor more than the wealthy>

What is Irrelevant to Supply and Demand?

Many things that you might think are important to the pricing of a good or service in the market are actually irrelevant. Supply and demand by many people determine the price, and thus the preferences of any single individual are irrelevant. The wealthiest person in the world cannot affect supply and demand any more than the poorest person can, in a free market. Supply and demand transcends and is above the views, preferences, and buying habits of any individual or small group of people.

Note also that supply and demand do not care who a person is or what his background may be. The store owner sells a chocolate candy bar for the same price to the richest man in the world as to the poorest man in the world. The President pays the same price as the most disliked person in town. Supply and demand, and the free market, treats everyone fairly and equally. Someone who walks into a candy store and offers to buy all the candy bars in the store may receive a slightly better price per candy bar because he is paying so much, but he won't receive any better treatment than anyone else, even the most disreputable person in town, who might also offer to buy all the candy bars in the store. The free market responds to powerful economic forces above any possible prejudice, gossip, or personal preferences.

The "market price" set by supply and demand often is often unrelated to the historical cost of the good. Someone may have paid $300,000 for his house in 2006, when houses were relatively expensive, but the market price of that house in 2009 may be only $150,000. 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 when 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 the day of the contest. Likewise, all that matters to setting the price in a free market is the supply and demand at the time of sale. In some ways that might seem harsh if it causes someone to lose money, just as it can be sad when one favored side loses a competition. But in other ways this fair, because it gives full opportunity for someone to do well no matter who he is and no matter where he comes from. As long as the seller obtains the free market price, he does not care who the buyer is.

Equilibrium & Information

Consider these three basic principles of economics:

  1. When demand exceeds supply at a given price, the price tends to rise. Likewise, when supply exceeds demand, the price tends to decrease.
  2. A rise in price tends to increase supply and decrease demand. Conversely a fall in price tends to decrease supply and increase demand.
  3. Price tends to move towards the amount at which the quantity in demand is equal to the quantity in supply: SUPPLY EQUALS DEMAND.

Note the use of the verb “tend” in the laws of economics cited above. Companies that consistently lose money “tend” to go bankrupt and out of business. But it does not happen immediately, especially if the company is large. It takes time for the market to come to equilibrium. Ultimately supply does equal demand, but only after enough time and activity passes for the conditions to attain equilibrium.

“Equilibrium” is “where things are going” or where they have already arrived. The equilibrium for the universe is complete disorder and chaos, with every creature extinct. A constant increase in entropy is what drives situations to their equilibrium. (Devolution is the process, not the so-called evolution.) Economic equilibrium is when all the imbalances in selling and buying prices have disappeared and there are no more trends to different price levels. Randomness and profit-making pressures drive pricing towards equilibrium.

The ultimate equilibrium when there is perfect competition occurs when the marginal revenue to the seller equals its marginal cost of the product. In other words, the supplier keeps producing more and more goods until its marginal profit on each extra good falls to very close to zero. That profit decline may be because the goods are not selling as quickly or due to unsold goods. For example, the first SUV produced by Ford may sell at a high price, but its last SUV in a given year will have to be discounted heavily. Ford doesn’t want to make any more SUVs in a given year that it might have to take a loss on. It produces just enough so that marginal revenue falls to marginal cost, as best as can be predicted.

Imbalances in information are a reason for the delay in pricing to reach equilibrium. Buyers do not immediately realize when they can obtain the same good more cheaply another way. For many years people continued to pay high costs for renting telephones after it became legal to buy inexpensive ones. The effects of competition are not often felt overnight. A lower-priced competitor has to educate the public of the availability of its goods, and that takes time.

There is also a more permanent imbalance in information between the buyer and seller of a good. The seller always knows more about his good than the buyer does. The seller does not want to disclose the disadvantages, weaknesses, defects, and outright dangers of his good. The buyer has to beware in paying money to the seller for a good: caveat emptor (Latin for “let the buyer beware”).

Tobacco companies did not want to disclose that cigarettes cause cancer. Abortion providers do not want to disclose that abortions cause breast cancer, infertility, and severe psychological problems. There would be far fewer abortions if full disclosure of their harm were made prior to performing the service, and if taxpayer money was not used to fund the service.

Disclosure of harm is a problem for used car dealers who do not want to tell buyers that a car is a lemon (i.e., constantly needs fixing). Food manufacturers do not want to disclose all the fat and artificial ingredients in their products.

Governmental regulations require some of these disclosures (but not for abortion in New Jersey, which is one reason why New Jersey has more abortions than other states that do require full disclosures). Mandatory disclosure about goods and services may be the best and only effective type of governmental regulation. Food packaging now must state what the ingredients are and how much fat is contained. The buyer doesn’t have to guess about this information. The buyer must still beware, but can do so with more information than before.

Socialized Medicine

The single biggest industry in the United States is health care, and it is sharply increasing in expenditures each year. It has three major components: government-controlled (Medicare and Medicaid), insurance-controlled, and private pay or uninsured. Each year, the demands for the government to take over the field grow louder, as insurance costs sky-rocket.

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

The Canadian government destroyed free enterprise in medicine there, and took over the health care system. The government now sets limits on wages and prices. Lowering the wages and prices prevents supply from rising to satisfy demand. Because demand is much greater than supply, patients have to wait a long time to see a doctor. There is a lower survival rate from cancer in Canada than the United States because of the delays in diagnosis and treatment there.

If an elderly Canadian is vacationing in Florida and falls and breaks his hip, which is very painful, the Canadian system of health care will not even reimburse the patient for surgery at the nearest hospital. Instead, the patient must fly back to Canada in excruciating pain to be operated on by a government-controlled doctor there.

In the United States, where health care still includes free enterprise, a patient can enter a doctor’s office or hospital at any time and receive services based on a promise to pay for them by check or cash. Prices vary, and it is worth shopping around. Immediate care always remains available at some price.

Medical care in the United States has the highest survival rates for cancer and the most advanced procedures. People from all over the world come to the United States to obtain the best care possible. 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.

In the summer 2009, the President Obama and the Democrats in control of Congress proposed a bill calling for a partial government takeover of health care. Their proposal included a "public option," which would be a government-controlled health insurance program like Medicare and yet available to persons of all ages. Their proposal includes many other controversial features, including:

  • a “public option” that will define which treatments will be allowed and which will not, with a goal of limiting costs.
  • mandatory insurance requiring people to buy what they do not currently want, and which may not cover what they need.
  • requirements that "self-insured employers" provide insurance for their employees, even if the small business cannot afford it.
  • government-defined health benefits, like abortion or sex-change operations, that must be included by insurance as a condition of being able to participate in a government managed "Health Insurance Exchange."
  • "home visits" by government agents to "improve immunization coverage" (require proof of vaccination).

Sarah Palin, the Republican Vice Presidential candidate in 2008, criticized this plan as follows:

The Democrats promise that a government health care system will reduce the cost of health care, but as the economist Thomas Sowell has pointed out, government health care will not reduce the cost; it will simply refuse to pay the cost. And who will suffer the most when they ration care? The sick, the elderly, and the disabled, of course. The America I know and love is not one in which my parents or my baby with Down syndrome will have to stand in front of Obama’s “death panel” so his bureaucrats can decide, based on a subjective judgment of their “level of productivity in society,” whether they are worthy of health care. Such a system is downright evil.

Thomas Sowell is an African American economist who consistently supports free market solutions to health care and other challenges.

In America children having cystic fibrosis live an average of 37 years, but under nationalized health care in Ireland the life expectancy for children with this condition is only 27 years. Government-run health care does not cover many special-needs conditions, and once everyone is in the government system there is not enough of a free market to fund proper care for special needs persons.

In America the survival rate for prostate cancer is 92% (after five years), but only 51% in England under its government-run health system.

Assignment

Read, and reread, the lecture. Complete the homework assignments through the level in which you choose to enroll in this course:

1. The supply of a good, and the demand for that good, determine both the ______ and ______ at which the good is sold (in a free market without interference).

2. Suppose the price demand curve is P = $30 - Q, where P is price and Q is quantity. Also suppose the price supply curve is P = $6 + Q. At what 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 a good or service increases, such 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 too many of that fruit and they are on the verge of rotting? 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 bleacher seats could not see all of the field because something blocks part of their view. Here is what the supply and demand are for those obstructed-view seats:

Quantity of "Obstructed-View" Tickets Demand Price/Ticket Supply Price/Ticket
300 $10 $3
600 $5 $5
900 $3 $7
1000 $2 $9

(A) How many "obstructed view" bleacher seats did the New York Yankees build, based on the above data, and how much does the team make from sales of these 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. Will the obstructed-view seats sell out under this law, and will people have to stand in long lines in order to buy them? Would you oppose or support such a law, and why?

6. "Time is money." Explain. Or, as an alternative, improve on our definition of a "free market."

7. Suppose you work for a store and its owner arrives one day and tells you that wants to set new prices for every good in the store. He declares that he is the owner, and he should be able to sell his goods and whatever price he chooses. Will he succeed in this strategy, or is there another force outside the control of the owner that will determine the sales prices? Explain to the owner what your opinion is of his approach, using basic concepts in this lecture.

Honors

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

8. Discuss the effect of supply and demand and the Tyndale Bible.

9. Is there a supply and demand curve for homeschooling, or homeschooling courses? Discuss.

10. Explain your opinion of the Democratic health plans pending in Congress.

11. How are the forces of supply and demand and the free market helpful to someone who might otherwise be an outcast in a community?

12. Should providers of abortion services be required to fully disclose to mothers the harm that abortion causes? Discuss in the context of requiring disclosure of information by sellers of goods and services.